Release No. 34-51808
File No. S7-10-04

Regulation NMS

Section X: Consideration of Burden on Competition, and Promotion
of Efficiency, Competition, and Capital Formation
Section XI: Regulatory Flexibility Act
Section XII: Response to Dissent

Table of Contents

X. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

Section 3(f) of the Exchange Act⁸⁶² requires the Commission, when engaging in rulemaking that requires the Commission to consider or determine whether an action is necessary or appropriate in the public interest, to consider whether the action will promote efficiency, competition and capital formation. Section 23(a)(2) prohibits the Commission from adopting any rule that would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act.⁸⁶³ To assist the Commission in evaluating the costs and benefits of Regulation NMS, the Commission solicited comment in the Proposing Release and the Reproposing Release on whether any of the proposals discussed therein would have an adverse effect on competition that was neither necessary nor appropriate in furtherance of the purposes of the Exchange Act, and whether they would promote efficiency, competition and capital formation. The Commission also requested commenters to provide empirical data and other factual support for their views on these subjects. The Commission has considered comments received and has adopted the rules as discussed above, taking into account these comments.

A. Order Protection Rule

The Commission agrees with commenters that supported the Reproposed Rule⁸⁶⁴ that the price protection that will be provided by the Order Protection Rule will encourage greater use of limit orders, which will help improve the price discovery process, and contribute to increased liquidity and depth in the markets. The more limit orders available at better prices and greater size, the more liquidity available to fill incoming marketable orders. Greater depth and liquidity will, at a minimum, lower the search costs associated with trying to find liquidity and should lead to improved execution quality, particularly for larger-sized institutional orders. The Commission also believes that the Order Protection Rule, by providing intermarket price protection for accessible, automated orders (but not requiring automated markets to wait for responses from non-automated markets), will help promote efficiency in the markets by more effectively linking markets together and integrating trading centers with different market structures into the NMS, and by providing an incentive for non-automated markets to automate. Rule 611 also will promote investor confidence in the markets by helping to assure, on an order-by-order basis, that customer orders are executed at the best price available and providing protection against limit orders being bypassed by inferior priced executions. In particular, the Commission believes that the providing enhanced protection for the best bids and offers of each exchange, The NASDAQ Stock Market, and the ADF will represent a major step toward achieving the objectives of intermarket price protection. The Order Protection Rule thus will promote best execution for retail investors on an order-by-order basis, given that most retail investors justifiably expect that their orders will be executed at the NBBO.

The Commission believes that Rule 611 will promote intermarket competition by leveling the playing field between automated and non-automated markets and, to the extent that the existing trade-through rule serves to constrain competition, by removing this barrier to competition. The Commission recognizes the vital importance of preserving competition among market centers,⁸⁶⁵ but continues to believe that commenters have overstated the risk that such competition will be eliminated by adoption of an order protection rule without an opt-out exception. The Commission believes that markets likely will have strong incentives to compete and innovate to attract both marketable orders and limit orders. Market participants and intermediaries responsible for routing marketable orders, consistent with their desire to achieve the best price and their duty of best execution, will continue to rank trading centers according to the total range of services provided by such markets. The most competitive trading center will be the first choice for routing marketable orders, thereby enhancing the likelihood of execution for limit orders routed to that trading center. Because likelihood of execution is very important to limit orders, routers of limit orders likely will be attracted to this preferred trading center. More limit orders will enhance the depth and liquidity offered by the preferred trading center, thereby increasing its attractiveness for marketable orders, and beginning the cycle over again. In addition, Rule 611 will not require that limit orders be routed to any particular market. Consequently, the Commission believes that competitive forces will be fully operative to discipline markets that offer poor services to limit orders, such as limiting the extent to which limit orders can be cancelled in changing market conditions or providing slow speed of cancellation.

Conversely, trading centers that offer poor services, such as slow response times, will likely rank near the bottom in order-routing preferences of market participants and intermediaries. Whenever a least-preferred trading center is merely posting the same price as other trading centers, orders will be routed to the other trading centers. Competitive forces will continue to dictate that the lowest ranked trading center in order-routing preference will suffer from offering a poor range of services to the routers of marketable orders. The Commission therefore does not believe that Rule 611 will eliminate competition among markets.

Commenters have, however, identified a troubling potential for intermarket price protection to lessen the competitive discipline that market participants now can impose on inefficient trading centers.⁸⁶⁶ The Order Protection Rule generally requires that trading centers match the best quoted prices, cancel orders without an execution, or route orders to the trading centers quoting the best prices. This is good for investors generally, but may not be if the quoting market is inefficient. For example, a market center may have poor systems that do not process orders quickly and reliably. Or a low-volume market may not be nearly as accessible as a high-volume market.

Currently, consistent with their best execution and other agency responsibilities, participants in the market for Nasdaq stocks can choose not to deal with any trading center that they believe provides unsatisfactory services. Under the Order Protection Rule, market participants can limit their involvement with any trading center to routing IOC orders to access only the best bid or best offer of the trading center. Nevertheless, even this limited involvement potentially could lessen the competitive discipline that otherwise will be imposed on an inefficient trading center. The Commission therefore believes that this potentially serious effect must be addressed at multiple levels in addition to the specific exceptions included in the Rule that were discussed above.

First, trading centers themselves have a legal obligation to meet their responsibilities under the Exchange Act to provide venues for trading that is orderly and efficient.⁸⁶⁷ Through registration and other requirements, the Exchange Act regulatory regime is designed to preclude entities that are not capable of meeting high standards of conduct from doing business with the public. This critically important function will be undermined by a trading center that displayed quotations in the consolidated data stream, but could not, because of poor systems or otherwise, provide efficient access to market participants and efficient handling of their orders. In addition, a trading center will violate its Exchange Act responsibilities if it failed to comply fully with the requirements set forth in Rule 600(b)(3) and (4) for automated quotations and automated trading centers. In particular, an automated trading center must implement such systems, procedures, and rules as are necessary to render it capable of meeting the requirements for automated quotations and must immediately identify its quotations as manual whenever it has reason to believe that it is not capable of displaying automated quotations. These requirements place an affirmative and vitally important legal duty on trading centers to identify their quotations as manual at the first sign of a problem, not after a problem has fully manifested itself and thereby caused a rippling effect at other trading centers that damages investors and the public interest.

Second, those responsible for the regulatory function at SROs have an affirmative responsibility to examine for and enforce all Exchange Act requirements and the SRO rules that apply to the trading centers that fall within their regulatory authority. One of the key policy justifications for a self-regulatory system is that industry regulators will have close proximity to, and significant expertise concerning, their particular trading centers. In addition, industry regulators typically have greater flexibility to address problems than governmental authorities. Implementation of the Order Protection Rule will heighten the importance of effective self-regulation. Those responsible for the market operation functions of an SRO may have business incentives that militate against dealing with potential problems in an effective and forthright manner. Regulatory personnel are expected to be independent of such business concerns and have an affirmative responsibility to prevent improper factors from interfering with an SRO's full compliance with regulatory requirements.

Finally, the Commission itself plays a critical role in the Exchange Act regulatory regime. Effective implementation of the Order Protection Rule also will depend on the Commission taking any action that is necessary and appropriate to address problem trading centers that fail to meet fully their regulatory requirements. The Commission and its staff must continue to monitor the markets closely for signs of problems and listen to the concerns of market participants as they arise, especially with regard to the new requirements imposed by the Order Protection Rule. Quick and effective action will be needed to assure that all responsible parties do not feel that inattention to problems is an acceptable course of action.

The Commission therefore believes that Rule 611 will not impose any competitive burden that is not necessary and appropriate in furtherance of the purposes of the Exchange Act. The Commission believes that the Order Protection Rule will help create an NMS that more fully meets the needs of a wide spectrum of investors, particularly long-term investors and publicly traded companies, by providing increased efficiency and improved depth and liquidity to our capital markets. By providing increased efficiency and promoting investor confidence in quality executions, investors may be more willing to invest in our capital markets, thus promoting the ability of listed companies to raise capital at lower cost.

B. Access Rule

Rule 610 establishes standards governing access to quotations in NMS stocks that: (1) prohibit trading centers from unfairly discriminating against non-members members or non-subscribers that attempt to access their quotations through a member or subscriber of the trading center, and enable access to NMS quotations through private linkages; (2) establish an outer limit on the cost of accessing such quotations of no more than $0.003 per share; and (3) require SROs to establish, maintain, and enforce rules that, among other things, prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross the automated quotations of other trading centers. The amendment to Rule 301(b)(5) under Regulation ATS lowers the threshold that triggers the Regulation ATS fair access requirements from 20% to 5% of average daily volume in a security.

The access provisions are intended to bolster investor confidence in the markets by helping to assure investors that their orders will be executed at the best prices and will not subject to hidden fees, regardless of the market on which the execution takes place. By generally imposing a uniform fee limitation of $0.003 per share, the Rule will promote equal regulation of different types of trading centers, where currently some are permitted to charge fees and some are not, thereby leveling the playing field among diverse market centers. Moreover, the Commission believes that, by prohibiting a trading center from imposing unfairly discriminatory terms that would prevent or inhibit the efficient access of any person through members, subscribers, or customers of such trading center, the Rule will promote competition among trading centers.

The Commission believes that Rule 610 also will increase transparency and efficiency in the market, thereby enhancing investor confidence, and thus capital formation. Specifically, the Rule will permit private linkages between markets, rather than mandating a collective intermarket linkage facility. Private linkages will permit market centers to connect through cost effective and technologically advanced communications networks. Such systems are widely utilized in the market for Nasdaq-listed stocks today and likely will provide speed and flexibility to trading centers and their market participants. The use of private linkages can encourage interaction between the markets and reduce fragmentation by removing impediments to the execution of orders between and among marketplaces, thereby increasing efficiency and competition.

Several commenters expressed concerns regarding the impact that the access fee proposal could have on competition.⁸⁶⁸ As discussed in detail in Section III above, the Commission believes that the flat limitation on access fees of $0.003 per share is the fairest and most appropriate solution to what has been a longstanding and contentious issue. A single accumulated fee cap will apply equally to all types of trading centers and all types of market participants, thereby promoting the NMS objective of equal regulation of markets and broker-dealers, and allowing those entities to compete on equal footing.⁸⁶⁹

A fee limitation also is necessary to preclude individual trading centers from raising their fees substantially in an attempt to take improper advantage of strengthened protection against trade-throughs and the adoption of a private linkage regime. In particular, the fee limitation is necessary to address "outlier" trading centers that otherwise might charge high fees to other market participants required to access their quotations by the Order Protection Rule. It also precludes a trading center from charging high fees selectively to competitors, practices that have occurred in the market for Nasdaq stocks. In the absence of a fee limitation, the adoption of the Order Protection Rule and private linkages could significantly boost the viability of the outlier business model. Outlier markets might well try to take advantage of intermarket price protection by acting essentially as a toll booth between price levels. The high fee market likely would be the last market to which orders would be routed, but prices could not move to the next level until someone routed an order to take out the displayed price at the outlier market. Therefore, the outlier market might see little downside to charging exceptionally high fees, such as $0.009, even if it is last in priority. While markets would have significant incentives to compete to be near the top in order-routing priority,⁸⁷⁰ there might be little incentive to avoid being the least-preferred market if fees were not limited.

The $0.003 cap will limit the outlier business model. It will place all markets on a level playing field in terms of the fees they can charge and the rebates they can pass on to liquidity providers. Some markets may choose to charge lower fees, thereby increasing their ranking in the preferences of order routers. Others may charge the full $0.003 and rebate a substantial proportion to liquidity providers. Competition will determine which strategy is most successful.

The Commission notes that the $0.003 fee limitation is consistent with current business practices, as very few trading centers currently charge fees that exceed this amount.⁸⁷¹ It appears that only two ECNs currently charges fees that exceed $0.003, charging $0.005 for access through the ADF. These ECNs currently do not account for a large percentage of trading volume. In addition, while a few SROs have large fees on their books for transactions in ETFs that exceed a certain size (e.g., 2100 shares), it is unlikely that these fees generate a large amount of revenues. Accordingly, the adopted fee limitation will not impair the agency market business model. The Commission recognizes that agency trading centers perform valuable agency services in bringing buyers and sellers together, and that their business model historically has relied, at least in part, on charging fees for execution of orders against their displayed quotations. Under current conditions, prohibiting access fees entirely would unduly harm this business model.

In addition, the Rule is designed to reduce the instances of locked and crossed quotations, which will promote capital formation by providing market participants a clear picture of the true trading interest in a stock. Moreover, the Commission believes that the access provisions will encourage interaction between the markets and reduce fragmentation by removing impediments to the execution of orders between and among marketplaces, thereby increasing efficiency and competition. Finally, the Commission believes that the access provisions likely will assist broker-dealers in evaluating and complying with their best execution obligations. The Commission therefore believes that Rule 610 will not impose any competitive burden that is not necessary and appropriate in furtherance of the purposes of the Exchange Act.

C. Sub-Penny Rule

The Commission has considered Rule 612 in light of Sections 3(f) and 23(a)(2) of the Exchange Act and believes that the Rule will not impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. To the contrary, by preserving the benefits of decimalization and guarding against the less desirable effects of further reducing the MPV, Rule 612 should promote fair and vigorous competition. The Commission acknowledges that the rule will, in some circumstances, prevent market participants from offering marginally better prices (through quoting or placing orders in sub-pennies). Some commenters argued that a prohibition on quoting in sub-pennies, at least in some NMS stocks, would inhibit price competition and artificially widen spreads.⁸⁷² Nevertheless, the Commission is concerned that sub-penny quoting may be used by market participants more as a means of stepping ahead of competing limit orders for an economically insignificant amount than of promoting genuine price competition.

The Commission believes that Rule 612 will assist broker-dealers in evaluating and complying with their best execution obligations and other rules premised on identifying the price of a security at a particular moment in time. The Commission also believes that Rule 612 will enhance market depth and improve transparency by preventing trading interest from being spread across an unnecessarily large number of price points. Therefore, we believe Rule 612 will encourage market participants to use limit orders, an important source of liquidity, and thereby promote market efficiency, competition, and capital formation. The Commission also believes that the new Rule will bolster investor confidence by helping ensure that their orders, especially large orders, can be executed without incurring large transaction costs. This increase in investor confidence also will promote market efficiency, competition, and capital formation.

Rule 612 will establish common quoting conventions that will increase transparency in the securities markets. Moreover, the Commission believes that the Rule will encourage interaction between the markets and reduce fragmentation by removing impediments to the execution of orders between and among markets. The increased transparency in the markets and reduction of fragmentation between the markets will bolster investor confidence, thereby promoting capital formation.

D. Market Data Rules and Plan Amendments

The Commission believes that the adopted Plan amendment updating the current revenue allocation formulas will promote efficiency in the marketplace by eliminating incentives for market participants to engage in distortive trading practices such as wash trades, trade shredding, and SRO print facilities to obtain market data revenues. Similarly, commenters supported the need to update the current allocation formulas.⁸⁷³ In addition, the Commission believes, and several commenters concurred, that the adopted Plan amendment requiring the creation of non-voting advisory committees will promote efficiency in the administration of the Plans by allowing interested parties other than SROs to have a voice in Plan matters,⁸⁷⁴ which can, in turn, contribute to the resolution of potential disputes that SRO participants will otherwise bring before the Commission. Furthermore, we expect Rule 603(a) will promote efficiency and competition among market centers by helping to assure that independently reported trade and quotation information is distributed on terms that are fair and reasonable and not unreasonably discriminatory. Commenters that discussed this Rule generally agreed that adopted Rule 603(a) would allow investors and vendors greater freedom to make their own decisions regarding the data they need and that the proposal should lead to lower costs to investors.⁸⁷⁵ The Commission agrees with these commenters and notes that efficiency is promoted when broker-dealers who do not need the data beyond the prices, sizes, market center identifications of the NBBO and consolidated last sale information are not required to receive (and pay for) such data. The Commission also believes that efficiency is promoted when broker-dealers may choose to receive (and pay for) additional market data based on their own internal analysis of the need for such data. Adopted Rule 603(b) also likely will promote efficiency in the dissemination of consolidated market information by requiring that all SROs act jointly through the Plans to disseminate such information to the public.

The Commission believes that the adopted Plan amendments will assist in capital formation through a more appropriate allocation of the Networks' revenues to those SROs that contribute most to public price discovery. Rule 603(c) also will eliminate the requirement to display a complete montage of quotations from all market centers and will therefore promote capital formation by reducing the costs to vendors and broker-dealers that are currently required to display quotations that may be far away from the NBBO. One commenter stated that broker-dealers currently are discouraged from making quotation and price information on a stock available because, under the current rule, this information must be accompanied by consolidated information for which they must pay market data fees.⁸⁷⁶ Accordingly, the Commission believes that, in certain circumstances, Rule 603(c) will result in additional market data information being provided, which will assist capital formation.

The Commission further believes that the adopted amendments to the Plans and to Rules 601 and 603 will not impose any competitive burden that is not necessary and appropriate in furtherance of the purposes of the Exchange Act. One regional exchange urged the Commission to consider the impact of the formula on competition, because, according to this commenter, most regional market centers rely on market data revenues to fund a significant portion of their budgets and thus a material decrease in such revenues could affect their financial plans, making it infeasible to compete with listing markets, which can survive on listing revenues.⁸⁷⁷ Although any change to the current formulas may result in a competitive advantage for some SROs and in a competitive disadvantage for other SROs, the Commission does not believe that this should preclude the adoption of an allocation formula that would provide a more useful distribution of market data revenues based on the quality of an SROs contribution of quotations and trades to the consolidated data stream. The Commission also believes that the adopted Plan amendment requiring the Plans to form non-voting advisory committees will enhance and promote competition by broadening Plan governance to include non-SRO parties, and thereby provide greater transparency in the administration of such Plans. Furthermore, we expect adopted Rules 601 and 603 to lessen the burden on vendors and broker-dealers from having to comply with certain consolidated display requirements. A few commenters generally noted that allowing market centers to independently disseminate certain market data information could increase competition among markets.⁸⁷⁸ The Commission agrees that the competition among market centers will be enhanced when such markets also choose to independently distribute their own market data. In addition, the amendment providing that all SROs consolidate information in each NMS stock and disseminate such information through a single processor per security will clarify that SROs are on an equal competitive footing with each other. Thus, the Commission believes that the amendments will enhance rather than burden competition by creating a more equal competitive environment for market centers and others.

E. Regulation NMS

Rule 600, the redesignation of the existing NMS rules as Regulation NMS, and the related conforming changes to other Commission rules will help to promote efficiency and capital formation by making the NMS rules easier to understand, thereby helping to reduce compliance costs for entities subject to the rules. Enhanced clarity in the definitions used in Regulation NMS also will benefit investors and the public interest by facilitating compliance with the requirements of Regulation NMS. Because Rule 600 will clarify the existing definitions used in Regulation NMS without imposing new requirements, and because the redesignation of the NMS rules as Regulation NMS and the conforming changes to other Commission rules will create no new substantive requirements, Rule 600 and the related changes will not impose a burden on competition or alter the competitive standing of entities subject to Regulation NMS.

XI. Regulatory Flexibility Act

The Commission certified, pursuant to Section 605(b) of the Regulatory Flexibility Act, that the Order Protection Rule will not have a significant economic impact on a substantial number of small entities.⁸⁷⁹ This certification was incorporated into the Reproposing Release.⁸⁸⁰ The Commission did not receive any comments on this certification.

B. Access Rule

The Commission certified, pursuant to Section 605(b) of the Regulatory Flexibility Act, that Rule 610 and the amendments to Rule 301 of Regulation ATS will not have a significant economic impact on a substantial number of small entities.⁸⁸¹ This certification was incorporated into the Reproposing Release.⁸⁸² The Commission received one comment discussing the certification. The commenter, an ADF participant, believed that the Commission in the certification recognized that Rule 610 could result in a significant economic impact on small firms, just not a substantial number of small firms.⁸⁸³ This commenter continued to express its concerns with the proposed access requirements, stating its belief that the proposal to require ADF participants to establish the necessary connectivity that would facilitate efficient access to their quotations would create a cost barrier that discriminates against smaller firms in the ADF.⁸⁸⁴

The Commission does not believe that its adopted access approach in Rule 610(b)(1) discriminates against smaller firms or creates a barrier to access for innovative new market entrants. Rather, smaller firms and new entrants have a range of alternatives from which to choose that will allow them to avoid incurring any costs to meet the connectivity requirements of Rule 610(b)(1) if they wish to do so. This approach is fully consistent with Congressional policy set forth in the Regulatory Flexibility Act, which directs the Commission to consider significant alternatives to regulations that accomplish the stated objectives of the Exchange Act and minimize the economic impact on small entities.⁸⁸⁵

Small ATSs are exempt from participation in the consolidated quotation system and, therefore, from the connectivity requirements of Rule 610. Under 301(b)(3) of Regulation ATS, an ATS is required to display its quotations in the consolidated quotation stream only in those securities for which its trading volume reaches 5% of total trading volume. Consequently, smaller ATSs are not required to provide their quotations to any SRO (whether an SRO trading facility or the NASD's ADF) and thereby trigger the access requirements of Rule 610. Moreover, potential new entrants with innovative trading mechanisms can commence business without having to incur any costs associated with participation in the consolidated quotation system.

Some smaller ATSs, however, may wish to participate voluntarily in the consolidated quotation system. Such participation can benefit smaller firms and promote competition among markets by enabling smaller firms to obtain wide distribution of their quotations among all market participants.⁸⁸⁶ Here, too, such firms will have alternatives that would not obligate them to comply with the connectivity requirements of Rule 610(b)(1). ATSs and market makers that wish to trade NMS stocks can choose from a number of options for quoting and trading. They can become a member of a national securities exchange and quote and trade through the exchange's trading facilities. They can participate in The NASDAQ Market Center and quote and trade through that facility. By choosing either of these options, an ATS or market maker would not create a new connectivity point that all other market participants must reach and would not be subject to Rule 610(b)(1). Some firms, however, may not want to participate in an SRO trading facility. These ATSs and market makers can quote and trade in the OTC market. The existence of the NASD's ADF makes this third choice possible by providing a facility for displaying quotations and reporting transactions in the consolidated data stream.⁸⁸⁷

As noted above in Section III.A.1, however, the NASD is not statutorily required to provide an order execution functionality in the ADF. The Commission believes that market makers and ECNs should continue to have the option of operating in the OTC market, rather than on an exchange or The NASDAQ Market Center. As noted in the Commission's order approving Nasdaq's SuperMontage trading facility, this ability to operate in the ADF is an important competitive alternative to Nasdaq or exchange affiliation.⁸⁸⁸ Therefore, the Commission has determined not to require small trading centers to make their quotations accessible through an SRO trading facility.

Instead, Rule 610(b)(1) requires all trading centers that choose to display quotations in an SRO display-only quotation facility (currently, the ADF) to provide a level and cost of access to such quotations that is substantially equivalent to the level and cost of access to quotations displayed by SRO trading facilities. Rule 610(b)(1) therefore may cause trading centers that display quotations in the ADF to incur additional costs to enhance the level of access to their quotations and to lower the cost of connectivity for market participants seeking to access their quotations. The extent to which these trading centers in fact incur additional costs to comply with the adopted access standard will be largely within the control of the trading center itself. As noted above, ATSs and market makers that wish to trade NMS stocks can choose from a number of options for quoting and trading, including quoting and trading in the OTC market. As a result, the additional connectivity requirements of Rule 610(b) will be triggered only by a trading center that displays its quotations in the consolidated data stream and chooses not to provide access to those quotations through an SRO trading facility.

Currently, nine SROs operate trading facilities in NMS stocks. Market participants throughout the securities industry generally have established connectivity to these nine points of access to quotations in NMS stocks. By choosing to display quotations in the ADF, a trading center effectively could require the entire industry to establish connectivity to an additional point of access. Potentially, many trading centers could choose to display quotations in the ADF, thereby significantly increasing the overall costs of connectivity in the NMS. Such an inefficient outcome would become much more likely if an ADF trading center were not required to assume responsibility for the additional costs associated with its decision to display quotations outside of an established SRO trading facility.

Although the Exchange Act envisions an individual broker-dealer having the option of trading in the OTC market,⁸⁸⁹ it does not mandate that the securities industry in general must subsidize the costs of accessing a broker-dealer's quotations in the OTC market if the NASD chooses not to provide connectivity. The Commission believes that it is reasonable and appropriate to require those ATSs and market makers that choose to display quotations in the ADF to bear the responsibility of providing a level and cost of access to their quotations that is substantially equivalent to the level and cost of access to quotations displayed by SRO trading facilities. Under Rule 610(b)(1), therefore, ADF participants will be required to bear the costs of the necessary connectivity to facilitate efficient access to their quotations.⁸⁹⁰ This standard will help ensure that additional connectivity burdens are not imposed on the securities industry each time an additional ADF participant necessitates a new connectivity point by choosing to begin displaying quotations in the consolidated quotation stream. The Commission believes that this requirement will help reduce overall industry costs by more closely aligning the burden of additional connectivity with those entities whose choices have created the need for additional connectivity.

As just discussed, the Commission recognizes that trading centers subject to Rule 610(b)(1) may incur costs associated with providing access to their quotations, although the costs will vary depending upon the manner in which each trading center provides such access. The Commission notes that to meet the standard contained in Rule 610(b)(1), a trading center will be allowed to take advantage of the greatly expanded connectivity options that have been offered by competing access service providers in recent years.⁸⁹¹ These industry access providers have extensive connections to a wide array of market participants through a variety of direct access options and private networks. A trading center potentially could meet the requirement of Rule 610(b)(1) by establishing connections to and offering access through such vendors. The option of participation in existing market infrastructure and systems should reduce a trading center's cost of compliance.⁸⁹²

Section 3(a) of the Regulatory Flexibility Act⁸⁹³ requires the Commission to undertake an Initial Regulatory Flexibility Analysis of proposed rules on small entities unless the Commission certifies that the proposed rules, if adopted, would not have a significant economic impact on a substantial number of small entities. The Commission continues to believe that the Access Rule will not have a significant economic impact on a substantial number of small entities.

C. Sub-Penny Rule

This Final Regulatory Flexibility Act Analysis ("FRFA") relating to Rule 612 of Regulation NMS has been prepared in accordance with the Regulatory Flexibility Act.⁸⁹⁴

1. Need for and Objective of Rule 612

Although the conversion from fractional to decimal trading benefited investors by clarifying and simplifying prices, making our markets more competitive internationally, and reducing trading costs by narrowing spreads, these benefits could be diluted if market participants could quote NMS stocks in increments less than a penny. The Commission is particularly concerned that sub-penny orders may be used to step ahead of competing limit orders for an economically insignificant amount.

New Rule 612 prohibits an exchange, association, vendor, ATS, or broker-dealer from accepting, ranking, or displaying an order, quotation, or indication of interest in an NMS stock priced in a sub-penny increment (except for an order, quotation, or indication of interest priced less than $1.00 per share, in which case the price may not extend beyond four decimal places). The rule is designed to improve market depth by preventing quotations from spreading across an unduly large number of price points, while also encouraging the use of limit orders – an important source of liquidity – by preventing competing market participants from stepping ahead of a limit order by an economically insignificant amount. We expect the rule to reduce the instances of quote flickering and to facilitate broker-dealers' efforts to meet their best execution and other regulatory duties premised on identifying a security's prevailing market price.

2. Significant Issues Raised by Public Comment

The IRFA appeared in the Proposing Release and in the Reproposing Release.⁸⁹⁵ The Commission requested comment in the IRFA on the impact the proposals would have on small entities and how to quantify the impact. The Commission did not receive any comment letters addressing the IRFA.

3. Small Entities Subject to the Rule

Rule 612 applies to every national securities exchange, national securities association, ATS, vendor, and broker-dealer. Each type of market participant that will be affected by the new Rule 612 is discussed below.

a. National Securities Exchanges and National Securities Associations

Rule 0-10(e) under the Exchange Act⁸⁹⁶ provides that the term "small business" or "small organization," when referring to an exchange, means any exchange that: (1) has been exempted from the reporting requirements of Rule 601 under the Exchange Act; and (2) is not affiliated with any person (other than a natural person) that is not a small business or small organization, as defined by Rule 0-10. No national securities exchange meets these criteria; therefore, no national securities exchange is a small entity. Currently, there is one national securities association (NASD) that is subject to Rule 612. NASD is not a small entity as defined by 13 CFR 121.201.

b. Broker-Dealers

Commission rules generally define a broker-dealer as a small entity for purposes of the Exchange Act and the Regulatory Flexibility Act if the broker-dealer had total capital (net worth plus subordinated liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared, and the broker-dealer is not affiliated with any person (other than a natural person) that is not a small entity.⁸⁹⁷ The Commission estimates that, as of the end of 2003, there were approximately 6,565 Commission-registered broker-dealers,⁸⁹⁸ of which approximately 905 are considered small entities pursuant to Rule 0-10(c) under the Exchange Act.⁸⁹⁹

c. Vendors

A vendor is any securities information processor engaged in the business of disseminating transaction reports or last sale data with respect to transactions in reported securities to brokers, dealers, or investors on a real-time or other current and continuing basis, whether through an ECN, moving ticker, or interrogation device.⁹⁰⁰ Rule 0-10(g)⁹⁰¹ provides that the term "small business" or "small organization," when referring to a securities information processor, means any securities information processor that: (1) had gross revenues of less than $10 million during the preceding fiscal year (or in the time it has been in business, if shorter); (2) provided service to fewer than 100 interrogation devices or moving tickers at all times during the preceding fiscal year (or in the time that it has been in business, if shorter); and (3) is not affiliated with any person (other than a natural person) that is not a small business or small organization under this section. The Commission estimates that there are approximately 80 vendors, 16 of which are considered small entities.

4. Reporting, Recordkeeping, and Other Compliance Requirements

Rule 612 will not impose any new reporting, recordkeeping, or other compliance requirements on any entities subject to the rule, including small entities.

5. Agency Action to Minimize Effect on Small Entities

Rule 612 establishes a uniform pricing increment for NMS stocks. All entities subject to the rule generally are prohibited from displaying, ranking, or accepting an order, quotation, or indication of interest priced in a sub-penny increment. Imposing different compliance requirements for small entities would be impractical and undermine the goal of uniformity. Furthermore, the Commission does not believe it necessary or appropriate to consider whether small entities should be permitted to use performance rather than design standards to comply with Rule 612. The rule already establishes performance standards and does not dictate any particular design standard that must be employed to achieve the rule's objectives.

D. Market Data Rules and Plan Amendments

1. Regulatory Flexibility Act Certification for the Plan Amendments

The Commission certified, pursuant to Section 605(b) of the Regulatory Flexibility Act, that amending the Plans to: (1) modify the current formulas for allocating market data revenues, and; (2) require the establishment of non-voting advisory committees will not have a significant economic impact on a substantial number of small entities.⁹⁰² This certification was incorporated into the Proposing Release and Reproposing Release.⁹⁰³ The Commission did not receive any comments on this certification.

This FRFA has been prepared in accordance with the Regulatory Flexibility Act.⁹⁰⁴ This FRFA relates to Exchange Act Rules 11Aa3-1 and 11Ac1-2 (redesignated as Rules 601 and 603).

a. Need for and Objectives of Rules 601 and 603

The Commission believes that an overall modernization of the rules for disseminating market data to the public is necessary to address problems posed by the current market data rules. In adopting Rules 601 and 603 as reproposed, the Commission retains the core elements of the existing rules – price discovery and mandatory consolidation – which provide important benefits to investors and to others who use market information, but amends other parts of the existing rules that have resulted in serious economic and regulatory distortions. More specifically, adopted Rules 601 and 603 reduce the burden on, and provide simplification and uniformity for, those market centers, broker-dealers, and data vendors that have to comply with requirements under the Rules.

Adopted Rules 601 and 603 are designed to fulfill several objectives, including: (1) providing market centers, including ATSs and market makers, with flexibility to independently distribute their own trade reports, aside from their obligation to provide their trade reports and best quotations to an SRO or to the Networks (depending on the type of market center); (2) providing uniform standards for all market centers, including non-SRO market centers and entities that are exclusive processors of SRO market data, for the independent distribution of market data; (3) providing that all SROs act jointly through the Plans and disseminate their consolidated information through a single processor, to clarify the practice among the SROs and to require continued participation in the Plans and dissemination through one processor per security; (4) reducing consolidated display requirements on broker-dealers and vendors and limiting their consolidated display obligations to the disclosure of the NBBO and consolidated last sale information and to the display of market information in a trading or order-routing context; and (5) easing the burden of compliance by simplifying the current consolidated display requirements under the Rule and by rescinding old provisions in the Rule that are outdated and no longer necessary.

b. Significant Issues Raised by Public Comment

The IRFA appeared in the Proposing Release and in the Reproposing Release.⁹⁰⁵ The Commission requested comment in the IRFA on the impact the proposals would have on small entities and how to quantify the impact. The Commission did not receive any comment letters addressing the IRFA.

c. Small Entities Subject to the Rule

Adopted Rules 601 and 603 affect ATSs, market makers, broker-dealers, and SIPs that could potentially be small entities. Paragraph (c) of Rule 0-10 under the Exchange Act⁹⁰⁶ defines the term "small business" or "small organization," when referring to a broker-dealer, to mean a broker or dealer that had total capital of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared, or, if not required to file such statements, that had total capital of less than $500,000 on the last business day of the preceding fiscal year; and is not affiliated with any person (other than a natural person) that is not a small business or small organization. ATSs and market makers would be considered broker-dealers for purposes of this definition. Paragraph (g) of Rule 0-10⁹⁰⁷ defines the term "small business" or "small organization," when referring to a SIP, to mean a SIP that had gross revenues of less than $10 million during the preceding fiscal year and provided service to fewer than 100 interrogation devices or moving tickers at all times during the preceding fiscal year; and is not affiliated with any person (other than a natural person) that is not a small business or small organization.

In the IRFA included in the Reproposing Release, the Commission estimated that, as of December 31, 2003, there were approximately 905 registered broker-dealers, including ATSs and market makers that would be considered small entities. In addition, approximately 16 SIPs would be considered small entities. In the Proposing Release and in the Reproposing Release, the Commission requested comment on the number of small entities that would be impacted by adopted Rules 601 and 603, including any available empirical data. No commenters responded with cost estimates pertaining to the requested data listed above. Adopted Rule 601 enables small market centers, including ATSs and market makers, that contribute to consolidated information, if they so choose, to also independently distribute their own trade reports. Adopted Rule 603 reduces the compliance burden on small broker-dealers and SIPs by limiting the data required to be displayed under the Rule.⁹⁰⁸

d. Reporting, Recordkeeping and Other Compliance Requirements

Adopted Rules 601 and 603 do not impose any new reporting, recordkeeping or other compliance requirements on ATSs, market makers, broker-dealers, and SIPs that are small entities. SROs that would be subject to these proposed amendments are not considered small entities.⁹⁰⁹

e. Agency Action to Minimize Effects on Small Entities

As required by the Regulatory Flexibility Act, the Commission has considered alternatives that would accomplish the stated objective, while minimizing any significant adverse impact on small entities. As discussed in the Proposing Release and in the Reproposing Release, the Commission has considered the following alternative models for disseminating market data to the public: (1) a competing consolidators model under which each SRO would be allowed to sell its market data separately to any number of consolidators; (2) a rescission of the consolidated display requirement and allowing all SROs and other market centers to distribute their market data individually; and (3) a hybrid model that would retain the consolidated display requirement and existing Networks solely for the dissemination of the NBBO, but allow the SROs to distribute their own quotations and trades independently and without a consolidated display requirement.

The primary goal of the adopted amendments to Rules 11Aa3-1 and 11Ac1-2 (redesignated as Rules 601 and 603) is to retain the benefits of the consolidated display requirement, which provides a uniform, consolidated stream of data and is the single most important tool for unifying all of the market centers trading NMS Stocks, while providing market centers that contribute to consolidated information with the ability to independently distribute their own market data and reducing the consolidated display requirements on broker-dealers and SIPs. As stated in the Proposing Release and in the Reproposing Release and in Section V.A.1 above, the Commission believes that these potential alternative models pose an unacceptable risk of losing important benefits that investors and other information users receive under the current system – an affordable and highly reliable stream of quotations and trades that is consolidated from all significant market centers trading an NMS Stock.

The Commission believes that different compliance or reporting requirements for small entities, and further clarification, consolidation, or simplification of Rules 601 and 603, is not necessary because adopted Rules 601 and 603 do not establish any new reporting, recordkeeping or other compliance requirements for small entities and, in fact, adopted Rule 603 should reduce the compliance burden on small broker-dealers and SIPs by limiting the data required to be consolidated and displayed under the Rule. The Commission also notes that the amendments contain performance standards and do not dictate for entities of any size any particular design standards (e.g., technology) that must be employed to achieve the objectives of the adopted amendments.

E. Regulation NMS

The Commission certified, pursuant to Section 605(b) of the Regulatory Flexibility Act, that Rule 600 and the redesignation of the NMS rules as Regulation NMS will not have a significant economic impact on a substantial number of small entities.⁹¹⁰ This certification was incorporated into the Reproposing Release.⁹¹¹ The Commission did not receive any comments on this certification.

XII. Response to Dissent

The Commission has added this section to its release to respond directly to the dissent's claims that the Commission's "statutory interpretations and policy changes are arbitrary, unreasonable and anticompetitive" and that they are "not supported by substantial evidence that, notwithstanding their anti-competitive effect, they are necessary or appropriate to further the purposes of the Exchange Act."⁹¹² Previous sections of this release discuss in greater detail the basis of the Commission's decision to adopt Regulation NMS. By modernizing and strengthening the regulatory structure of the U.S. equity markets, Regulation NMS will protect investors, promote fair competition, and enhance market efficiency. Because the dissent appears to have misconstrued a number of the Commission's policy positions and the reasoning underlying them, we are including this section to clarify the record.

We understand that reasonable minds can disagree with the policy decisions reflected in Regulation NMS. In light of the substantial record, however, the Commission rejects any assertion that this rulemaking is arbitrary, unreasonable, anticompetitive, or otherwise outside the agency's authority. In making this claim, the dissent appears to ignore the clear statutory authority for the Commission's action, the many public comments strongly supporting the adoption of Regulation NMS, and the extensive and comprehensive rulemaking process undertaken by the Commission. As discussed below, the drafters of the Exchange Act itself repeatedly affirmed the basic principles that underlie Regulation NMS. In particular, they specifically contemplated and endorsed the Commission's authority to adopt an intermarket price protection rule.⁹¹³ In addition, the comments supporting Regulation NMS were submitted by a broad spectrum of investors, listed companies, academics, market centers, and other market participants, many of which have extensive experience and expertise regarding the inner workings of the equity markets.⁹¹⁴

Moreover, Regulation NMS is the culmination of a long and open process that included the original proposals, a public hearing, a supplemental request for comment, the reproposals, eight in-depth analyses of relevant trading data, and more than 2000 public comments. The issues raised by Regulation NMS undoubtedly are multifaceted. Reaching decisions in this complex area requires an understanding of the relevant facts and of the often subtle ways in which the markets work, and the balancing of policy objectives that sometimes may not point in precisely the same direction. Perhaps not surprisingly, there continue to be differences of opinion, even after this long process, among Commissioners, investors, market participants, and the public in general concerning the most appropriate future regulatory structure for the U.S. equity markets.

In sum, the Regulation NMS rulemaking process has required the Commission to grapple with many difficult and contentious issues that have lingered unresolved for many years. The Commission has devoted a great deal of effort to studying these issues, assessing the views of all commenters, and modifying its proposals to respond appropriately to their comments. Indeed, this release discusses at length our response to commenters, particularly those that disagree with the proposals. However, decisions must be made and contentious issues must be resolved so that the markets can move forward with certainty concerning their future regulatory environment and appropriately respond to fundamental economic and competitive forces. The Commission always seeks to achieve a consensus, but when positions have become entrenched after many years of study and debate, waiting for consensus can mean indefinite gridlock that ultimately could damage the competitiveness of the U.S. equity markets, both at home and internationally. The Commission believes that further delay is not warranted and that the time has come to make the difficult decisions necessary to modernize and strengthen the national market system.

A. Statutory Authority for Order Protection Rule

The dissent suggests that the Commission is exceeding its authority by attempting to impose an "optimal market structure."⁹¹⁵ This claim misconstrues the nature and impact of the Order Protection Rule and ignores the clear mandate provided to the Commission by Congress in Section 11A(a)(2) of the Exchange Act to facilitate the establishment of a national market system. Regulation NMS does not dictate any particular structure for the markets; rather, it establishes basic "rules-of-the-road" for all markets that will promote competition on terms that benefit investors. In particular, competition will be guided by three basic principles – price transparency, open access, and best price. As a result, all investors will be able to ascertain the best prices for NMS stocks, obtain fair and non-discriminatory access to the markets displaying such prices, and have assurance that their orders will be executed at the best prices that are immediately and automatically accessible. Within this regulatory framework of transparency, access, and best price, competitive forces will determine the optimal market structure.

1. Intermarket Price Protection Rule

The dissent cites a selected few passages from the legislative history of the 1975 Amendments⁹¹⁶ to the Exchange Act as support for the claim that an intermarket price protection rule is inconsistent with the Exchange Act.⁹¹⁷ A more complete review of the legislative history, however, makes it clear that the Order Protection Rule is squarely consistent with the policy determinations made by Congress in 1975 – indeed, it may be the dissent's disagreement with those Congressional policy determinations that explains its opposition to the Order Protection Rule. In particular, the national market system is premised on promoting fair competition among individual markets, while at the same time assuring that these markets are linked together in a unified system that promotes competition among the orders of buyers and sellers in individual NMS stocks. The most succinct statement of order competition is found in the House Report on the 1975 Amendments: "Investors must be assured that they are participants in a system which maximizes the opportunities for the most willing seller to meet the most willing buyer."⁹¹⁸ This Congressional mandate for the national market system is not achieved when trades occur at prices inferior to the best quotations that are immediately and automatically accessible.

The dissent appears to focus on the NMS objective of fair competition among markets, without giving appropriate weight to the important Congressional objective of integrating markets into a system that promotes order interaction and the best execution of investor orders.⁹¹⁹ The House Report gives the following overview of the "goals and principles to serve as a guide" to the Commission that specifically endorses price protection for investor orders:

Briefly stated, these embrace the principles of competition in which all buying and selling interests are able to participate and be represented. The objective is to enhance competition and to allow economic forces, interacting within a fair regulatory field, to arrive at appropriate variations of practices and services. Neither the markets themselves nor the broker-dealer participant in these markets should be forced into a single mold. Market centers should compete and evolve according to their own natural genius and all actions to compel uniformity must be measured and justified as necessary to accomplish the salient purposes of the Securities Exchange Act, assure the maintenance of fair and orderly markets and to provide price protection for the orders of investors.⁹²⁰

The establishment of a "fair regulatory field" that will "provide price protection for the orders of investors" is precisely what the Order Protection Rule is designed to do.

Similarly, the Senate Report on the 1975 Amendments emphasizes both competition among markets and integration of those markets into a unified system:

S. 249 would lay the foundation for a new and more competitive market system, vesting in the SEC power to eliminate all unnecessary or inappropriate burdens on competition while at the same time granting to that agency complete and effective powers to pursue the goal to centralized trading of securities in the interest of both efficiency and investor protection.⁹²¹

By "centralized trading," the Senate Report did not mean a single market, but rather NMS rules and facilities that link the markets into a unified system to assure best execution of investor orders – the approach incorporated in Regulation NMS. For example, the Senate Report specifically addresses the importance of intermarket price protection:

[A] limited price order is presently "protected" as to price priority on the exchange on which it is held but it is not protected in any way [with] respect to trading on another exchange or in the third market. As a consequence, a limit order for a listed security held in only one of several markets for that security need not be executed before a transaction is effected at the same price or at a price less favorable to the other party in another market. In the Committee's view this is the basic problem caused by fragmentation of the securities markets: the lack of a mechanism by which all buying and selling interest in a given security can be centralized and thus assure public investors best execution.⁹²²

Consequently, the Commission's challenge in meeting its NMS responsibilities is to promote both competition among markets and competition among orders, as well as to assure a regulatory structure that is workable and minimizes regulatory costs. Notably, Congress chose not to mandate any particular NMS rules in order to give the Commission greater flexibility to use its expertise in achieving NMS objectives:

The Committee considered mandating certain minimum components of the national market system but rejected this approach. The nation's securities markets are in dynamic change and in some respects are delicate mechanisms; the sounder approach appeared to the Committee, therefore, to be to establish a statutory scheme clearly granting the Commission broad authority to oversee the implementation, operation, and regulation of the national market system and at the same time to charging it with the clear responsibility to assure that the system develops and operates in accordance with Congressionally determined goals and objectives. Section 11A(a) and 11A(c), taken together, would establish such an arrangement.⁹²³

Although the dissent may disagree with the policy of an intermarket price protection rule, there is no basis for the claim that Regulation NMS is at odds with the Commission's statutory mandate to facilitate the establishment of a national market system.

2. Long-Term Investors

The dissent questions the Commission's authority to give precedence to the interests of long-term investors in those limited contexts where their interests conflict with the interests of short-term traders.⁹²⁴ As is discussed elsewhere in this release,⁹²⁵ the interests of long-term investors and short-term traders in fair and efficient markets coincide most of the time. In those few contexts where the interests of long-term investors directly conflict with short-term trading strategies, we believe that, in implementing regulatory structure reform, the Commission has both the authority and the responsibility to further the interests of long-term investors, and that the record provides substantial support for the Commission's determination to further their interests.

As discussed above, intermarket price protection will significantly benefit the more than 84 million individual investors in the U.S. equity markets by reducing their transaction costs and thereby enhancing their long-term investment returns.⁹²⁶ Price protection may, however, interfere to some extent with the extremely short-term trading strategies that can depend on millisecond response times from markets for orders taking displayed liquidity. It also may interfere with short-term trading strategies that benefit from volatile and illiquid markets. The dissent claims that the "length of time an individual owns a stock is not a relevant factor in distinguishing among groups of investors" and that the distinction between long-term investors and short-term traders is arbitrary and unreasonable.⁹²⁷ But in those limited contexts where the interests of long-term investors conflict with short-term trading strategies, the conflict cannot be reconciled by stating that the NMS should benefit all investors. In particular, failing to adopt a price protection rule because short-term trading strategies can be dependent on millisecond response times would be unreasonable in that it would elevate such strategies over the interests of millions of long-term investors – a result that would be directly contrary to the purposes of the Exchange Act.⁹²⁸

As discussed earlier in this release,⁹²⁹ the legislative history of the Exchange Act from its adoption in 1934 emphasizes the Congressional concern to protect the interests of the many average investors who are not active traders or market intermediaries, but who depend on their equity investments, whether directly in corporate stocks or indirectly through their investment in mutual funds and retirement accounts, to meet their long-term financial goals. The dissent suggests that these statements of Congressional concern for millions of average investors were no longer relevant when Congress adopted the 1975 Amendments, but the legislative history of the 1975 Amendments does not support this proposition.⁹³⁰

The dissent also argues that short-term traders often provide liquidity to the market and thereby benefit long-term investors. The Commission certainly agrees with this statement as a general matter, but believes that, in the specific context of an intermarket price protection rule, directly promoting the display of limit orders, which directly provide liquidity to the market, rather than promoting short-term trading strategies that require millisecond response times for orders that take displayed liquidity, is the most appropriate approach to protect investors and enhance market efficiency. Many commenters agreed with this policy decision. For example, T. Rowe Price stated that "we do not believe that speed of access considerations should drive market structure issues if to do so would jeopardize legitimate market linkage initiatives. Connected markets provide the opportunity for information gathering, block trading, and improved price discovery, as well as the legitimacy of the 'last-sale' price. While speed of access and execution are crucial, there is a limit to how fast such linkages need to be in order to protect and enhance our markets."⁹³¹ Similarly, the Committee on Investment of Employee Benefit Assets, which represents 110 of the nation's largest corporate retirement funds managing $1.1 trillion on behalf of 15 million plan participants and beneficiaries, stated that "it is unclear with the advance of automation why we would need or should allow anything other than the best price requirement for investors. Our constituency is concerned with long-term growth and market stability and the ability to opt-out [of the best price requirement] could place long-term investors at a disadvantage."⁹³² Finally, the National Association of Investors Corporation emphasized that "[m]ake no mistake, the best price best serves investors. It is part of the value equation when buying and selling stock. Please keep in mind that individual investors are long-term investors and price is of utmost importance to them."⁹³³ Although the dissent may disagree with the policy views of these commenters on the best means to protect investors and to promote market integrity and liquidity, it does not provide a basis for concluding that the commenters' views, which the Commission shares, are arbitrary or unreasonable.

B. Basis for Adoption of Order Protection Rule

A prior section of this release discusses at length the Commission's basis for adopting the Order Protection Rule.⁹³⁴ This section responds to certain specific claims made in the dissent where the dissent appears to have misconstrued the Commission's decision-making process and conclusions, and highlights the critical policy issues on which the views expressed in the dissent simply conflict with the considered views of the Commission and many commenters.

The dissent asserts that the Commission's objectives for the Order Protection Rule have been "a moving target, morphing from the protection of limit orders, to the need to increase market depth and liquidity, to the reduction of transaction costs for long-term investors and issuers."⁹³⁵ In fact, the Commission's objectives have remained consistent throughout the NMS rulemaking.⁹³⁶ While certain details in the original proposal have been modified to respond appropriately to public comment, the policies underlying the Rule as proposed, reproposed, and adopted have remained the same. Indeed, the dissent seems not to appreciate that the "moving targets" it identifies – the objectives of protecting limit orders, increasing market depth and liquidity, and reducing investor transaction costs – are all quite closely inter-related. As the Commission has explained quite consistently in this release and in the proposing releases, protecting limit orders contributes to market depth, which in turn reduces investor transaction costs. In addition, the Commission has consistently emphasized that intermarket price protection will promote the best execution of investor orders and fair and orderly markets.⁹³⁷

1. Investor Protection

As discussed previously in this release,⁹³⁸ the Commission believes that the Order Protection Rule is needed to strengthen the protection of investors in the U.S. equity markets. Many commenters agreed with the Commission on the need for strengthened price protection to protect investors. For example, the Consumer Federation of America believed that "the brokers' duty of best execution is simply too vague to serve as an effective deterrent to abuse. It is too vague for the broker to know with certainty that it has satisfied its best execution obligation and too vague to be enforced consistently and effectively. In fact, one of the real benefits of the proposed trade-through rule is that it has the potential to simplify compliance with best execution rules."⁹³⁹ The Committee on Investment of Employee Benefit Assets also recognized the vital importance of maintaining equity markets in which all investors can participate with confidence: "[I]n light of the scandals in the securities and mutual fund industries, our first priority should be to restore investor confidence in our capital markets. To allow trading to take place outside of the best price will continue to raise questions of fairness and could diminish investor confidence."⁹⁴⁰ Other commenters shared these concerns about the impact of trade-throughs on investor confidence in the fairness of the U.S. equity markets.⁹⁴¹

The dissent, however asserts that the Trade-Through Study prepared by Commission staff to estimate trade-through rates does not substantiate investor protection concerns.⁹⁴² The dissent further suggests that the Commission has "cherry-picked" statistics that support its position, while ignoring, or even failing to disclose, statistics that do not support its position.⁹⁴³ While the Commission believes that the total number of trade-throughs should not be the sole consideration in making its policy choices, an earlier section of this release discusses in detail the data demonstrating the significance of trade-through rates found in the Study,⁹⁴⁴ and that discussion makes clear that the Commission has not ignored or failed to disclose the findings of the Trade-Through Study. Indeed, at the time the Reproposing Release was published, the Study was placed in the public file specifically to assure that all commenters had a full opportunity to evaluate its data and methodologies.

The Study used a variety of calculation methodologies that generated many different statistics on trade-through rates, but summarized its findings as follows: "Depending on the methodology applied, the overall trade-through rate ranged from 2% to 10% of trades and from 2% to 13% of share volume. Using the more conservative of these methods, we estimate that 2% to 3% of all trades and 2% to 8% of all share volume are trade-throughs."⁹⁴⁵ The Reproposing Release explained why the Commission believed that the most relevant measure is 2.5% of total trades, representing more than 7% of total share volume, that trade through the best displayed prices. The Reproposing Release also explained the deficiency of the dissent's preferred measure – the displayed size of quotations that are traded through. This measure primarily reflects the current shortage of displayed size, which is a symptom of one of the primary problems that the Order Protection Rule is designed to address.⁹⁴⁶ It therefore is not a useful means to assess the potential upside of strengthened price protection.

The dissent also asserts that the Trade-Through Study did not indicate "that investors are not obtaining best execution, that their orders are being unfairly treated, or that investors are otherwise suffering economic harm."⁹⁴⁷ The Study, however, found that 2.5% of trades in Nasdaq stocks do not receive the best prices that are immediately and electronically accessible and that the average amount by which such trades miss the best prices is 2.3 cents per share.⁹⁴⁸ In addition, Nasdaq submitted statistics with its comment letter on the reproposal indicating that the trade-through rate for dealers that internalize customer orders in Nasdaq stocks was 3.2% in 2003. The dissent attempts to minimize the seriousness of these statistics on a variety of grounds, but it concedes that the trade-through rate for customers in Nasdaq stocks was between 1% and 2% in 2004 and states that "these numbers speak for themselves" that customers are not being treated unfairly.⁹⁴⁹

Even if the Commission accepted the dissent's focus on a limited portion of the rulemaking record, we strongly believe that the evidence contained in this record would raise serious investor protection concerns. Because of the enormous volume of trading in the U.S. equity markets, even small percentages can translate into significant harm to investors. For example, even a 1.5% trade-through rate for customers in Nasdaq stocks in 2004 would mean that 14.3 million customer orders received a price that was inferior to an immediately and automatically accessible quotation.⁹⁵⁰ Because of the difficulties faced by retail investors in monitoring whether their orders receive the best prices, it is likely that a great many of these customers were not aware that they in fact received an inferior price for their order.⁹⁵¹ We suspect that the millions of customers who received inferior prices, had they known, would believe that they had been treated unfairly.

Moreover, the dissent does not appear to take into account the practical difficulties faced by retail customers in monitoring and obtaining best execution of their orders. Such difficulties vary depending on the type of order. As discussed previously in this release,⁹⁵² retail customers who submit market and marketable limit orders seeking the best available market price generally can ascertain the best quotations at the time they submit their orders, but quotations can change rapidly, thereby making it quite difficult for customers to know whether their orders were in fact executed at the best quotations at the time of order execution.⁹⁵³ In contrast, retail customers who display non-marketable limit orders at the best prices can readily see when their orders are traded through – the inferior trade prices will be disseminated in the consolidated trade stream.⁹⁵⁴ These customers legitimately may feel that their orders have not been treated in a fair and orderly fashion. By establishing strong intermarket price protection, the Order Protection Rule will benefit investors who use both types of orders. It will promote the execution of investor market orders at the best prices on an order-by-order basis,⁹⁵⁵ as well as protect displayed limit orders, no matter how small or large their displayed size, from trade throughs. In both contexts, the Rule will significantly enhance the protection of investors in all NMS stocks.

2. Improved Depth and Liquidity in Nasdaq Stocks

The dissent asserts that there is no evidence of a need for greater depth in Nasdaq stocks that would warrant application of the Order Protection Rule.⁹⁵⁶ In making this assertion, the dissent does not address the views of many commenters that intermarket price protection is needed to improve depth and liquidity in all NMS stocks, including those listed on Nasdaq. For example, the Investment Company Institute, whose members account for more than 95% of all U.S. mutual fund assets, noted that "[b]y affirming the principle of price priority, a trade-through rule should encourage the display of limit orders, which in turn would improve the price discovery process and contribute to increased market depth and liquidity."⁹⁵⁷ It therefore "strongly recommend[ed] that the Commission adopt a uniform trade-through rule that applies across all market centers and to all types of securities, including Nasdaq-listed securities."⁹⁵⁸ Similarly, the Bank of New York stated that "[w]e agree with the Commission that a uniform trade-through rule would encourage the use of displayed limit orders and aggressive quotation. In the market for Nasdaq securities, for example, many investors are reluctant to show their full trading interest for fear of having others use that information to their detriment. A uniform trade-through rule would incentivize these investors to display their interest, knowing their order must be filled before the next-priced order. Accordingly, a well-formulated trade-through rule will promote transparency and liquidity in the national market system."⁹⁵⁹ Many other commenters similarly believed that an intermarket price protection rule is needed to promote market depth and liquidity in all NMS stocks.⁹⁶⁰

In addition to not addressing the views of commenters, the dissent does not refute the significance of data analyses prepared by Commission staff to assess the views of commenters that intermarket price protection is needed to promote depth and liquidity in Nasdaq stocks. First, the dissent does not mention the staff studies that found that short-term price volatility is significantly higher in Nasdaq stocks than in NYSE stocks.⁹⁶¹ Excessive short-term price volatility indicates a need for greater depth and liquidity to dampen price fluctuations. Although acknowledging that the drafters of the 1975 Amendments identified "the maintenance of stable and orderly markets with maximum capacity for absorbing trading imbalances without undue price movements" as one of the "paramount" objectives for the NMS,⁹⁶² the dissent does not address the staff volatility analyses indicating the need to address price volatility in Nasdaq stocks.⁹⁶³

Second, the dissent fails to appreciate the significance of staff studies examining fill rates and other order execution quality statistics for marketable limit orders in Nasdaq stocks.⁹⁶⁴ The dissent incorrectly interprets the Commission's evaluation of these studies as critical of the trading strategy of submitting "pinging" orders – orders with sizes greater than the displayed size of quotations.⁹⁶⁵ The Commission's evaluation of low fill rates in Nasdaq stocks is not a criticism of pinging orders. The use of pinging orders is a valid strategy for trading stocks on electronic markets and certainly will continue after implementation of the Order Protection Rule. Indeed, an important goal of the Rule is to improve the execution quality for such orders by increasing their fill rates and, thereby, the ability of investors to trade Nasdaq stocks in larger sizes. As discussed earlier in this release,⁹⁶⁶ the important consideration is not that fill rates in Nasdaq stocks are lower than fill rates in NYSE stocks. This difference likely is explained by broad structural differences unrelated to market efficiency. Rather, the problem is that fill rates, as well as the executed share volume, in Nasdaq stocks for orders with sizes ranging from 2,000 to 9,999 shares are very low in absolute terms (falling as low as 12% to 27%), even for many active stocks included in the Nasdaq-100 Index.⁹⁶⁷ The Commission believes that this data supports the views of commenters that intermarket price protection is needed to promote greater depth and liquidity across the whole range of Nasdaq stocks.

3. Effectiveness of Order Protection Rule

The dissent suggests that the Order Protection Rule will not meet its goals because some trade-throughs will continue even after implementation of the Rule. The dissent notes that the Rule contains exceptions for intermarket sweep orders, flickering quotations, trading centers that are experiencing a material delay, volume weighted average price ("VWAP") orders, and stopped orders, and questions whether, given these exceptions, the Rule will lead to a significant reduction in trade-through rates.⁹⁶⁸

The dissent fails to appreciate both the methodology of the staff study of trade-through rates and the operation of the Order Protection Rule. As explained at length earlier in this release,⁹⁶⁹ the staff used a conservative methodology in the Trade-Through Study that did not include trade-throughs attributable to intermarket sweep orders, flickering quotations, and VWAP trades in its calculation of trade-through rates. Thus, given the consistency between the Study's methodology and the Rule's exceptions, the Commission believes that implementation of the Rule will lead to the elimination of the great majority of the types of trade-throughs found in the Trade-Through Study.⁹⁷⁰

Moreover, the exceptions in the Order Protection Rule are fully consistent with the principle of price protection. For example, to comply with the exemptions for intermarket sweep orders, VWAP orders, and stopped orders as a practical matter, market participants must trade with, rather than trade through, the displayed size of protected quotations.⁹⁷¹ Intermarket sweep orders must, by definition, be routed to execute against the full displayed size of protected quotations, while the dealers that execute VWAP and stopped orders typically will execute trades in the public markets to establish the positions necessary to fill the orders. In addition, the exceptions for flickering quotations and trading centers experiencing a material delay are consistent with intermarket price protection because they are designed to exclude quotations that are not truly accessible. The existence of these exceptions, therefore, will not detract from the effectiveness of the Rule in strengthening price protection.

The dissent also states that the Order Protection Rule will not increase market depth and liquidity because the Rule does not provide what the dissent views as complete protection of limit orders.⁹⁷² In particular, it points to the Commission's decision to protect only quotations that are the best bids and offers ("BBOs") of markets, and to the ability of markets to match the best prices displayed in other markets. The Commission's reasons for protecting market BBOs are discussed in detail earlier in this release.⁹⁷³ The practice of price matching, by definition, does not cause investors to receive inferior prices or result in trade-throughs of displayed quotations. Most importantly, the dissent's assertion that the other approaches might have given greater protection to limit orders does not dispose of the relevant question, which is whether strengthening the current level of price protection for market BBOs will lead to greater depth and liquidity.⁹⁷⁴

4. Promoting Competition

The dissent claims that the Order Protection Rule will limit competition, stifle innovation, and create regulatory barriers to entry. The dissent argues that intermarket protection of the best accessible prices will "reduce markets to the lowest common denominator."⁹⁷⁵ As discussed in an earlier section of this release, the Commission believes that markets will continue to have strong incentives to compete and innovate, particularly to be the first preference of order routers at any given price and thereby maximize their share of trading volume.⁹⁷⁶ Liquidity providers will be able to compete on both price and size through use of the intermarket sweep order exception, which will allow them to execute immediately a large transaction at prices outside the best prices by routing orders to execute against the displayed size of better-priced quotations.⁹⁷⁷ Finally, the Order Protection Rule will promote competition among markets by assuring new or smaller markets that, if they display the best prices, they will attract order flow, because larger, dominant markets will not be allowed to ignore their quotations. New or smaller markets also will benefit from the price transparency and open access elements of Regulation NMS, which preclude dominant markets from unreasonably restricting the availability of their market information or unfairly discriminating against competing markets by denying access to their displayed quotations.

The dissent also claims that the Order Protection Rule will create barriers to competition and regulatory barriers to entry, largely because the Rule protects quotations that are displayed by SROs registered under the Exchange Act.⁹⁷⁸ Here, however, the dissent appears to take issue with one of the most basic elements of the Exchange Act regulatory scheme – the equity market registration requirement. Congress enacted this registration requirement in 1934 to assure that all significant equity markets have the capacity and integrity to meet their responsibilities to protect investors and promote the public interest. The Commission strongly believes that this basic registration requirement is an essential element of any effective scheme of securities regulation. Consistent with this requirement, the SROs for many years have been responsible for collecting quotations and disseminating them to the public in the consolidated quotation stream. Broker-dealers and ATSs can participate in the consolidated quotation stream by providing their quotations to an SRO. They will continue to be able to do so after implementation of the Order Protection Rule and, to the extent their quotations constitute the best bids or offers of the SRO, such quotations will be protected. Moreover, small ATSs with less than 5% of trading volume are exempted from participation in the consolidated quotation stream, thereby reducing barriers to entry for new markets.⁹⁷⁹ But these aspects of the U.S. regulatory scheme all flow from the basic Exchange Act registration requirement for significant equity markets, not Regulation NMS.

5. Scope of Order Protection Rule

The dissent argues that the scope of the Order Protection Rule has been substantially expanded beyond the reproposal without the benefit of the normal notice and comment process, and further states that the "practical effect is that market participants must exhaust liquidity in reserve prior to moving to the next price level."⁹⁸⁰ Both of these assertions are incorrect. The scope of the Order Protection Rule has not been expanded from the reproposal, nor does the Rule, as reproposed or adopted, require market participants to route orders to execute against reserve size or any other liquidity that is not displayed. As reproposed and adopted, the Rule protects the best displayed prices of protected quotations, without regard to their sizes,⁹⁸¹ but provides an exception for transactions at inferior prices if intermarket sweep orders simultaneously are routed to execute against the "full displayed size" of the protected quotations.⁹⁸² Therefore, the removal of references to size in the definition of quotation has no effect on the operation of the Rule as adopted.

Market participants will not be required to route oversized orders in an attempt to execute against reserve size, as the dissenters claim. While a technical correction to a reproposed Regulation NMS definition has been made, it does not raise a notice and comment issue. A clause was deleted from the definition of "quotation" in reproposed Rule 600(b)(63), but this clause was not relevant to the Order Protection Rule or to any other rule in Regulation NMS, as reproposed or adopted.⁹⁸³

The dissent minimizes the role of the intermarket sweep order exception in the operation of the adopted Order Protection Rule. It states that, under the Rule as reproposed, "trading centers could route an order to a protected quotation's full displayed size and simultaneously execute an order at an inferior price," and then implies that this practice is no longer allowed under the adopted Rule.⁹⁸⁴ But simultaneously executing orders at multiple price levels is precisely what the intermarket sweep order exception allows under the reproposed and adopted Rule. Regardless of the dissent's position, there is no indication that commenters were confused concerning the importance of the exception or operation of the Rule.⁹⁸⁵

6. Benefits and Costs of Order Protection Rule

The dissent states that the Commission's estimate of $321 million in annual benefits to investors from the Order Protection Rule constitutes a "mere rounding error" compared to the $18.7 trillion in total dollar value of trading in 2003.⁹⁸⁶ However, the dissent also states that $143.8 million in one-time start-up costs and $22 million in annual costs to comply with the Rule, which ultimately will be paid by investors, are "very high."⁹⁸⁷ These statements appear to be inconsistent. If more than $300 million in net annual benefits is an inconsequential amount to investors, why is less than one-half of that amount in one-time start-up costs a significant burden for investors?

In fact, of course, both of the amounts are substantial, and the dissent has used an "apples-to-oranges" comparison. The $321 million amount measures the estimated reduction in investor transaction costs. Even the total amount of transaction costs will always be a fraction of the total dollar volume of trading in the U.S. equity markets. Indeed, if transaction costs were ever to represent a large proportion of the total dollar volume of trading, investors would cease to trade, liquidity would dry up, and the cost of capital for listed companies would be prohibitive. All transaction costs, however, eat away at the long-term returns of investors. One of the keys to successful long-term investing is to minimize, wherever possible, transaction costs of all kinds. Even under the conservative estimate used in the Commission's cost-benefit analysis, which is based on the dissent's preferred trade-through measure – the share volume of quotations that are traded through⁹⁸⁸ – investors would benefit over a five-year period by a total of more than $1.3 billion.⁹⁸⁹ Moreover, this estimate is conservative because it does not include any benefits for investors that would result from improved market depth and liquidity,⁹⁹⁰ nor does it reflect the non-monetary benefits associated with enhanced investor confidence in the fairness and orderliness of the equity markets. The Commission believes that all of these benefits amply justify the costs of the Order Protection Rule.

7. Alternatives to Order Protection Rule

The dissent states that the Commission did not seriously consider alternatives to the Order Protection Rule.⁹⁹¹ It suggests that the Commission first could have adopted only access standards, and then adopted a price protection rule later if deemed necessary, or, alternatively, that the Commission could have adopted a price protection rule in stages for some markets, while waiting to evaluate its effect before applying the rule to other markets. Both of these alternatives were considered, and the Commission believed that they would have led to continued uncertainty concerning the future regulatory structure of the U.S. equity markets, and that the second alternative would have perpetuated inconsistent regulatory requirements for different NMS markets and stocks. At bottom, these alternatives simply reflect the dissenters' policy view that a price protection rule is not needed and will not be effective. Indeed, it is not clear why the dissent believes that the alternatives should have been seriously considered when they also believe that intermarket price protection in general will not be effective. It is even more difficult to understand how these alternatives could be suggested by the dissenters if they believe that the very basis of intermarket price protection is "arbitrary, unreasonable and anticompetitive." The Commission disagrees and believes that further delay in reaching final decisions on vital NMS issues could have caused significant harm to the U.S. markets.

The dissent also states that the Commission failed to consider the alternative of prohibiting only those trade-throughs that are more than three cents inferior to the best prices. A three-cent trade-through threshold is analogous to the temporary exemption from the ITS trade-through provisions that was originally granted in 2002 for trading in three exchange-traded funds.⁹⁹² These derivative securities, one of which tracks the Nasdaq-100 Index (then referred to as the "QQQ"), are highly liquid and their value is readily derived from the values of their underlying stocks. The deficiencies of the ITS trade-through provisions, which protect both automated and manual quotations, were most evident in these securities. The Commission granted the exemption to address the pressing need for regulatory action in these securities, while it continued to evaluate a more comprehensive resolution of NMS issues.

The dissent argues that the exemption led to increased competition, narrowing of spreads, and a significant reduction in trade-through rates, citing an October 2002 study of trading in the QQQs by the Commission's Office of Economic Analysis that was referenced in the Proposing Release.⁹⁹³ This study, however, found that trade-through rates were extremely high both before and after the exemption was granted – 48% before and 47% after. The exemption therefore essentially ratified trading activity that already was occurring.⁹⁹⁴ Consequently, data on trading before and after the exemption provides little basis for drawing conclusions on the effect of the exemption.

Most importantly, the Commission considered and rejected a rule with a three-cent trade-through threshold because it so clearly would fail to achieve any of the primary objectives of the Order Protection Rule, including investor protection, fair and orderly markets, and increased depth and liquidity. Such a rule would allow intermediaries and markets to execute investor orders at prices significantly inferior to the best prices that are immediately and automatically accessible. In many NMS stocks, quoted spreads are as low as one penny. A three-cent trade-through on a single trade would represent a 300% increase in investor transaction costs in these stocks. In addition, allowing three-cent trade-throughs would seriously undercut the objectives of encouraging the display of limit orders. The average trade-through amount is 2.3 cents per share in Nasdaq stocks and 2.2 cents per share in NYSE stocks.⁹⁹⁵ Consequently, a rule with a three-cent threshold would not affect the majority of trade-throughs and thereby have little beneficial effect on the incentives to display limit orders.

C. Market Data

The dissent addresses issues relating to the level of market data fees and the single consolidator model for disseminating market data. As discussed above,⁹⁹⁶ the Commission has determined that the most appropriate forum in which to address the level of market data fees is its review of SRO structure, and it has retained the single consolidator model primarily because of its significant role in protecting investors.

D. Conclusion

The dissent concludes by stating that Regulation NMS is "far from final" and that it fears that "inevitable delays in obtaining guidance, the attendant regulatory uncertainty, and concomitant costs will harm a competitive marketplace."⁹⁹⁷ In fact, the Commission has taken great care to craft clear and workable rules for market participants to follow. Indeed, as discussed throughout this release, a variety of changes to the rules as originally proposed have been made specifically to respond to the comments of market participants.⁹⁹⁸ Given the wide range of participants in the securities markets, the particular means chosen by different entities to comply with the NMS rules may vary. The staff, under the purview of the Commission, will be available to work with the securities industry and the public to provide any desired guidance on implementation questions. In this regard, the NMS rules are no different from other rules that the Commission adopts, including previously-adopted NMS rules, such as those relating to limit order display and execution quality disclosure, which were widely cited by commenters as effective regulation. The Commission's experience with these other rules has demonstrated the wisdom of this approach.

⁸⁶² 15 U.S.C. 78c(f).

⁸⁶³ 15 U.S.C. 78w(a)(2).

⁸⁶⁴ See supra, section II.A.1.

⁸⁶⁵ Many commenters believed that an opt-out exception would be necessary to promote competition among trading centers, particularly competition based on factors other than price, such as speed of response. See supra, section II.A.4.a.

⁸⁶⁶ See, e.g., Fidelity Reproposal Letter at 2; MFA Reproposal Letter at 2; Morgan Stanley Reproposal Letter at 2; TIAA-CREF Reproposal Letter at 2.

⁸⁶⁷ See, e.g., Exchange Act Sections 6(b)(1) and 6(b)(5); Exchange Act Section 15; Exchange Act Sections 15A(b)(2) and 15A(b)(6); Exchange Act Section 11A(a)(1)(C); Regulation ATS.

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