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SECURITIES AND EXCHANGE COMMISSION



17 CFR Part 240



[Release No. 34-37619A ; File No. S7-30-95]



RIN 3235-AG66



Order Execution Obligations



AGENCY: Securities and Exchange Commission



ACTION: Final Rules



SUMMARY: The Securities and Exchange Commission ("Commission")



is adopting a new rule requiring the display of customer limit



orders and amending a current rule governing publication of



quotations to enhance the quality of published quotations for



securities and to enhance competition and pricing efficiency in



our markets. These rules have been designed to address growing



concerns about the handling of customer orders for securities.



Specifically, the Commission is adopting new Rule 11Ac1-4



("Display Rule") under the Securities Exchange Act of 1934



("Exchange Act") to require the display of customer limit orders



priced better than a specialist's or over-the-counter ("OTC")



market maker's quote or that add to the size associated with such



quote. The Commission also is adopting amendments to Rule 11Ac1-1



("Quote Rule") under the Exchange Act to require a market maker



to publish quotations for any listed security when it is



responsible for more than 1% of the aggregate trading volume for



that security and to make publicly available any superior prices



that a market maker privately quotes through certain electronic



communications networks ("ECNs") ("ECN amendment"). Finally, the

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Commission is deferring action on proposed Rule 11Ac1-5 ("Price



Improvement Rule").



Effective Date: [insert date 120 days from the date of



publication in the Federal Register]. For specific phase-in



dates for the Display Rule, see section III.A.3.d of this



Release.



FOR FURTHER INFORMATION CONTACT: Elizabeth Prout Lefler or Gail



A. Marshall regarding amendments to the Quote Rule and David



Oestreicher regarding the Display Rule at (202) 942-0158,



Division of Market Regulation, Securities and Exchange



Commission, 450 Fifth Street, N.W., Mail Stop 5-1, Washington,



D.C. 20549.

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SUPPLEMENTARY INFORMATION:



I. Introduction and Summary



On September 29, 1995, the Commission issued a



release-[1]- proposing for comment new Rules 11Ac1-4 and



11Ac1-5 and amendments to Rule 11Ac1-1-[2]- under the



Exchange Act.-[3]- As proposed, new Rule 11Ac1-4 would



require the display of customer limit orders that improve certain



OTC market makers' and specialists' quotes or add to the size



associated with such quotes. The proposed amendments to the



Quote Rule would require OTC market makers and specialists who



place priced orders with ECNs to reflect those orders in their



published quotes. The proposed Quote Rule amendments also would



require OTC market makers and specialists that account for more



than 1% of the volume in any listed security to publish their



quotations for that security ("Mandatory Quote Rule"). The Price



Improvement Rule would have required OTC market makers and



specialists to provide their customer market orders an



opportunity for price improvement; it also would have included a



non-exclusive safe harbor to satisfy the price improvement



obligation.



The Commission received 152 comment letters (from 145







---------FOOTNOTES----------

-[1]- Securities Exchange Act Release No. 36310

(September 29, 1995), 60 FR 52792 (October 10,

1995) ("Proposing Release").



-[2]- 17 CFR 240.11Ac1-1.



-[3]- 15 U.S.C. 78a to 78ll (1988).

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commenters) in response to the Proposing Release.-[4]-



Commenters generally supported the Display Rule and the Mandatory



Quote Rule, with some commenters suggesting specific



modifications or alternatives to the proposed rules. Commenters



also supported the objectives of the ECN amendment, but many



expressed concerns that diminishing the anonymity of such systems



would threaten their viability. Most commenters believed the



Price Improvement Rule would be costly to implement and would not



be necessary if the other proposals were adopted.



After considering the comments and relevant economic



research, and based on the Commission's experience with the



development of the national market system ("NMS") and its



knowledge of current market practices, the Commission is adopting



the Display Rule and the proposed amendments to the Quote Rule,



with certain modifications. The Commission believes that these



modifications are consistent with the proposals and responsive to



many of the concerns voiced by the commenters.





---------FOOTNOTES----------

-[4]- The comment letters and a summary of comments have

been placed in Public File No. S7-30-95, which is

available for inspection in the Commission's

Public Reference Room. The Commission received

comments on the proposals from 77 individual

investors, ten industry associations, seven

exchanges and the National Association of

Securities Dealers ("NASD"), eight academics, 41

market participants and the United States

Department of Justice. In addition, the

Commission met with representatives of broker-

dealers, self-regulatory organizations ("SROs"),

industry associations, and the U.S. Department of

Justice to discuss the proposals. The Commission

has conducted its own economic analysis of the

likely economic effects of the various proposals.

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The Display Rule adopted today requires OTC market makers



and specialists to display the price and full size of customer



limit orders when these orders represent buying and selling



interest that is at a better price than a specialist's or OTC



market maker's public quote. OTC market makers and specialists



also must increase the size of the quote for a particular



security to reflect a limit order of greater than de minimis size



when the limit order is priced equal to the specialist's or OTC



market maker's disseminated quote and that quote is equal to the



national best bid or offer.



The Commission has modified the proposed Display Rule in



some respects in response to comments. The proposal included an



exception to permit a specialist or OTC market maker to deliver a



limit order to an exchange or registered national securities



association ("association") sponsored system that complies with



the Display Rule. This exception has been expanded to permit



delivery to ECNs that display and provide access to these orders.



Additionally, with regard to implementation of the rule, the



Commission has provided for a phase-in over a one year period for



non-exchange-traded securities covered by the Display Rule.



Today, the Commission also is adopting two significant



amendments to the Quote Rule. These amendments are designed to



ensure that more comprehensive quotation information is made



available to the public. The first amendment requires a



specialist or OTC market maker to make publicly available the



price of any order it places in an ECN if the ECN price is better

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than the specialist's or OTC market maker's public quotation.



The Commission has adopted this amendment as proposed, with an



alternative ("ECN display alternative") that deems OTC market



makers and specialists in compliance with the Quote Rule if



prices these OTC market makers and specialists enter into an ECN



are publicly disseminated and the ECN provides access to other



broker-dealers to trade at those prices.-[5]- Thus, OTC



market makers and specialists may comply directly with the ECN



amendment by changing their public quote to reflect their ECN



order, or by using an ECN that facilitates their compliance with



the rule as described above.



Implementation of the ECN display alternative requires the



cooperation of the SROs in order to include the ECN prices in the



public quotation system and to provide equivalent access to these



quotations. The Commission expects the SROs to work



expeditiously with ECNs that wish to avail themselves of this



alternative to develop rules or understandings of general



applicability. The Commission is prepared to act if necessary to



ensure implementation of the ECN display alternative prior to the



effective date of the Quote Rule.



The second amendment to the Quote Rule expands the



categories of securities covered by the Mandatory Quote Rule. As



amended, the Quote Rule will require that OTC market makers and



specialists publish quotes in any listed security if their volume



---------FOOTNOTES----------

-[5]- This alternative means of compliance with the ECN

amendment is referred to hereinafter as the "ECN

display alternative".

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in that security exceeds 1% of the aggregate volume during the



most recent calendar quarter. Previously, these requirements



applied only to certain listed securities.-[6]-



The Commission is deferring final action on the Price



Improvement Rule at this time. The Commission will consider the



effect of the new Display Rule and the amendments to the Quote



Rule adopted today before determining the appropriate course of



action on that proposal.



In a parallel action, the Commission today is proposing for



comment an additional amendment to the Quote Rule. The proposed



amendment would require OTC market makers and specialists that



account for more than 1% of the volume in any Nasdaq security to



publish their quotations for that security.-[7]-



II. Basis and Purpose of the Display Rule and Quote Rule

Amendments



Twenty years ago, Congress directed the Commission -- having



due regard for the public interest, the protection of investors,



and the maintenance of fair and orderly markets -- to use the



Commission's authority granted under the Exchange Act to



facilitate the establishment of a national market system for







---------FOOTNOTES----------

-[6]- Additional amendments to the Quote Rule adopted

today provide that certain Quote Rule provisions

that previously applied to market makers that

elected to quote a Nasdaq National Market security

now also will apply to market makers electing to

quote a Nasdaq SmallCap security. See section

III.B.d.iii.



-[7]- See Securities Exchange Act Release No. 37620

(August 28, 1996) ("Companion Release").

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securities.-[8]- Congress further determined that the



public interest, investor protection and the maintenance of fair



and orderly markets required the NMS to feature:



(i) economically efficient executions;



(ii) fair competition among brokers and dealers, among



exchange markets, and between exchange markets and



markets other than exchange markets;



(iii) public availability of quotation and transaction



information;



(iv) an opportunity to obtain best execution; and



(v) an opportunity to obtain execution without dealer



intervention to the extent consistent with



economically efficient executions and the



opportunity to obtain best execution.-[9]-



The years since the 1975 Amendments have witnessed dramatic



developments in the U.S. securities markets. Last sale



reporting, which enables investors to determine the current



market for a security, has been extended to OTC-traded



securities. The Consolidated Quotation System ("CQS"), which



allows investors to view in a single source quotes disseminated



---------FOOTNOTES----------

-[8]- Pub. L. No. 94-29, 89 Stat. 97 (1975) ("1975

Amendments").



-[9]- Exchange Act Section 11A(a)(1), 15 U.S.C. 78k-

1(a)(1). This Section also recites the

Congressional findings that: the securities

markets are an important national asset which must

be preserved and strengthened; and new data

processing and communications techniques create

the opportunity for more efficient and effective

market operations.

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from dispersed market centers, did not exist in 1975. The



Intermarket Trading System ("ITS"), which permits investors'



orders in certain exchange-listed securities to be routed to the



market center displaying the best quotation, has greatly



facilitated quote competition. Moreover, technological



developments not envisioned twenty years ago have enabled market



centers to handle volume levels many times greater than those



that led to the "back office" crisis of the late 1960s and early



1970s. Taken together, these and other developments have made it



possible for investors' orders to be executed much more rapidly



and at far lower cost.



The Commission recognized that U.S. equity markets had



undergone significant changes since passage of the 1975



Amendments and were likely to undergo further changes of equal



magnitude.-[10]- Accordingly, the Commission announced in



July 1992 that its Division of Market Regulation ("Division")



would undertake a study of the structure of the U.S. equity



markets and of the regulatory environment in which those markets



operate.-[11]-



In January 1994, the Division published a



study,-[12]- which reviewed, among other things, market



---------FOOTNOTES----------

-[10]- See Securities Exchange Act Release No. 30920

(July 14, 1992), 57 FR 32587 (July 22, 1992)

("Market 2000 Concept Release").



-[11]- Id.



-[12]- Division of Market Regulation, Market 2000: An

Examination of Current Equity Market Developments

(January 1994) ("Market 2000 Study" or "Study").

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practices and structures that could affect the ability of



customers to obtain opportunities for better prices. The Market



2000 Study noted that U.S. equity markets had evolved since 1975



to provide a much wider array of trading venues to meet the



diverse needs of investors and made a series of recommendations



intended to facilitate the further development of a national



market system. As expected, U.S. equity markets have continued



to evolve since the Market 2000 Study was published.



This evolution of the markets is reflected in part by



comparing trading volumes and the venues in which orders are



executed. In 1976, the New York Stock Exchange ("NYSE") average



daily trading volume was approximately 21.2 million



shares.-[13]- By 1995, average daily trading volume



exceeded 346 million shares.-[14]- Third market trading,



i.e., OTC trading of listed securities, in NYSE-listed issues



accounted for 4.57% of consolidated volume in 1976.-[15]-



By 1995, third market trading increased to 7.94% of consolidated



volume.-[16]- In 1987, the NYSE handled almost 74% of



trades of NYSE-listed issues reported on the consolidated tape;



in 1995, it handled 70.22% of such trades.-[17]-



---------FOOTNOTES----------

-[13]- 1982 NYSE Fact Book.



-[14]- 1995 NYSE Annual Report.



-[15]- 1982 NYSE Fact Book.



-[16]- 1995 NYSE Fact Book.



-[17]- Regional exchanges, namely, the Boston Stock

Exchange ("BSE"), the Philadelphia Stock Exchange

(continued...)

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Comparable figures for The Nasdaq Stock Market ("Nasdaq")



are even more dramatic. In 1975, Nasdaq annual volume was



approximately 1.39 billion shares.-[18]- By 1995, Nasdaq



annual volume increased to 101.2 billion shares,-[19]-



which means that more shares traded hands on three average



trading days in 1995 than in all of 1975. In 1993, volume in all



proprietary trading systems combined represented 13% of the total



volume in Nasdaq/National Market securities;-[20]- by



January 1996, volume on Instinet alone represented approximately



15% of total Nasdaq volume and 20% of total volume for the 250



---------FOOTNOTES----------

-[17]-(...continued)

("Phlx"), the Cincinnati Stock Exchange ("CSE"),

the Chicago Stock Exchange ("CHX"), and the

Pacific Stock Exchange ("PSE"), have captured a

significant share of volume in NYSE-listed issues,

particularly with respect to smaller investor

orders. In 1995, the regional exchanges accounted

for 9.96% of consolidated volume in NYSE-listed

issues but accounted for 19.01% of trades of NYSE-

listed issues reported on the consolidated tape.

Id. They also accounted for approximately 35% of

share volume in trades of 100 to 2,099 shares.

Shapiro, U.S. Equity Markets: Recent Equity

Developments, in GLOBAL EQUITY MARKETS:

TECHNOLOGICAL, COMPETITIVE, AND REGULATORY

CHALLENGES 21 (R. Schwartz ed. 1995). In January

1996, trades of 100-499 shares represented between

65-72% of all trades in NYSE-listed issues on

regional exchanges; such trades represented only

37% of all trades on the NYSE. Ross, Shapiro and

Smith, Price Improvement of SuperDOT Market Orders

on the NYSE (NYSE Working Paper 96-01) (March 11,

1996 draft) (prepared for the NYSE Conference for

the Search for Best Price) ("Ross, Shapiro and

Smith").



-[18]- 1992 Nasdaq Fact Book.



-[19]- 1995 NASD Annual Report.



-[20]- Market 2000 Study at Appendix IV-2.

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Nasdaq stocks with the highest median dollar volume.-[21]-



The Study addressed the development of certain practices,



such as internalization,-[22]- payment for order



flow-[23]- and the non-disclosure of certain customer



trading interest to all market participants, that raise a variety



of market structure and customer order handling concerns. For



example, brokers today may quote one price publicly to retail



customers, while showing a better price privately to other



investors and dealers on an ECN. In addition, the quotes



displayed to public investors may not accurately reflect the best



price for a security because limit orders, which specify the



price at which customers will buy or sell a security, are not



---------FOOTNOTES----------

-[21]- The Introduction of NAqcess into the Nasdaq Stock

Market: Intent and Expectation, NASD Economic

Research Staff, June 6, 1996 ("NASD Study"),

Exhibit D to Securities Exchange Act Release No.

37302 (June 11, 1996), 61 FR 31574 (June 20, 1996)

(Notice of Filing of Amendment No. 2 to Proposed

Rule Change by National Association of Securities

Dealers Relating to the NAqcess System and

Accompanying Rules of Fair Practice)("NAqcess

Release 2").



-[22]- Internalized orders are customer orders routed by

a broker-dealer to an affiliated specialist or

executed by that broker-dealer as a market maker.



-[23]- The Commission now requires enhanced disclosure of

payment for order flow practices on customer

confirmations and account statements, as well as

upon opening new accounts. Securities Exchange

Act Release No. 34902 (October 27, 1994), 59 FR

55006 (November 2, 1994) (adopting rules requiring

enhanced disclosure of payment for order flow

practices on customer confirmations, and account

statements, as well as upon opening new accounts)

("Payment for Order Flow Release"). See also

Securities Exchange Act Release No. 35473 (March

10, 1995), 60 FR 14366 (March 17, 1995).

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uniformly required to be included in the quote.



The Study recommended that the exchanges and the NASD



consider taking action to respond appropriately to certain of



these developments. Since that time, Nasdaq market makers



holding customer limit orders have been prohibited from trading



ahead of those orders,-[24]- and some market makers have



begun to offer price improvement opportunities in OTC



transactions to their retail customers.-[25]- In addition,



the NYSE now requires almost all limit orders transmitted through



SuperDOT to be displayed to the market.-[26]- Further,



Commission rules require enhanced disclosure of payment for order



flow practices on customer confirmations and account statements,



as well as upon opening new accounts.-[27]-



Notwithstanding the progress achieved in this period, the



Commission believes that further regulatory initiatives are



warranted at this time. These changes, as indicated in the



Proposing Release, are intended to address current market



practices that inhibit opportunities for order interaction and



---------FOOTNOTES----------

-[24]- Securities Exchange Act Release No. 34279 (June

29, 1994), 59 FR 34883 (July 7, 1994) ("Manning

I"); Securities Exchange Act Release No. 35751

(May 22, 1995), 60 FR 27997 (May 26, 1995)

("Manning II").



-[25]- See, e.g., Louis, Schwab Debuts New Trading

System, San Francisco Chronicle, October 17, 1995,

at D1.



-[26]- Securities Exchange Act Release No. 36231

(September 14, 1995), 60 FR 48736 (September 20,

1995).



-[27]- See Payment for Order Flow Release supra note 23.

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that are inconsistent with Congress's vision of the national



market system. These changes also address certain problems in



Nasdaq. The Commission recently reported that, among other



things: (i) Nasdaq market makers widely followed a pricing



convention concerning the increments they used to adjust their



displayed quotes; (ii) adherence to the pricing convention was



not the result of natural economic forces, often impacted the



fairness and accuracy of public quotation information and



interfered with the economically efficient execution of customer



transactions; (iii) the pricing convention impaired the ability



of investors to ascertain the best market for their trades,



increased the costs of transactions, and resulted in unfair



discrimination among classes of market participants; (iv)



numerous market makers collaborated in ways that misled and



disadvantaged their customers and other market participants and



frequently failed to honor their price quotations; and (v) many



market makers have not consistently reported their trades on time



or appropriately designated them as late as required by NASD



rules.-[28]-



The Commission has taken specific regulatory and enforcement



actions to address these problems.-[29]- The Display Rule



and Quote Rule amendments adopted today should bring about other,



---------FOOTNOTES----------

-[28]- Report Pursuant to Section 21(a) of the Securities

Exchange Act of 1934 Regarding the NASD, the

Nasdaq Market, and Nasdaq Market Makers,

Securities Exchange Act Release No. 37542 (August

8, 1996) ("21(a) Report").



-[29]- See id.

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significant changes in the operation of Nasdaq, by ensuring the



disclosure of customer and market maker buying and selling



interest that heretofore has been hidden from many market



participants. At the same time, the new rules will benefit



investors in the exchange markets by increasing transparency in



those markets and improving opportunities for the best execution



of customer orders.



The Commission firmly believes that the actions it is taking



today are consistent with the regulatory framework for a national



market system established by Congress in the 1975 Amendments.



Congress envisioned a national market system supported by



accurate and reliable public quotation and transaction



information, and fair competition among market centers. Congress



also believed that linking all markets for qualified securities



through communication and data processing facilities would foster



efficiency, enhance competition, increase information available



to market participants and contribute to the best execution of



customer orders.-[30]-



The Commission recognizes that investors will lose



confidence in the fairness of the markets unless market



structures and practices treat all investors fairly. The



regulatory initiatives adopted today address current market



practices that hinder competition among markets and affect the



prices at which customer orders are executed. The Display Rule





---------FOOTNOTES----------

-[30]- See Exchange Act Section 11A(a)(1)(D), 15 U.S.C.

78k-1(a)(1)(D).

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and Quote Rule amendments enhance transparency and facilitate



best execution of customer orders in a manner that preserves



maximum flexibility for the markets to design and implement



trading and communication systems that are consistent with the



objectives of the national market system. These rules contribute



to the achievement of the full potential of the national market



system as envisioned by Congress. They represent one more step



to facilitate the development of an efficient, competitive and



transparent national market system in which all market



participants can achieve best execution of their orders.



III. Discussion



A. Display of Customer Limit Orders



1. Introduction



As discussed above, the 1975 Amendments contain an explicit



statutory mandate for the establishment of a national market



system. Congress considered mandating certain minimum components



of the national market system, but instead created a statutory



scheme granting the Commission broad authority to oversee the



implementation, operation and regulation of the national market



system.-[31]- At the same time, Congress charged the



Commission with the responsibility to assure that the national



market system develop and operate in accordance with specific













---------FOOTNOTES----------

-[31]- S. Rep. No. 75, 94th Cong., 1st Sess. 8-9 (1975)

("Senate Report").

==========================================START OF PAGE 17======



goals and objectives.-[32]- The Commission believes that



the adoption of a limit order display rule furthers these goals



and objectives determined by Congress.



Specifically, the display of customer limit orders advances



the national market system goal of the public availability of



quotation information, as well as fair competition, market



efficiency, best execution and disintermediation. The enhanced



transparency of such orders increases the likelihood that limit



orders will be executed because contra-side market participants



will have a more accurate picture of trading interest in a given



security. Further, this increased visibility will enable market



participants to interact directly with limit orders, rather than



rely on the participation of a dealer for execution.



Moreover, as noted in the Proposing Release, the display of



limit orders that are priced better than current quotes addresses



at least three regulatory concerns. First, displaying customer



limit orders in the quotation can increase quote competition. If



the quotes from a market or market maker represent only market



maker buying and selling interest in a given security, the market



or market maker faces less price competition than if customer





---------FOOTNOTES----------

-[32]- Id. at 9. Among other things, Congress found it

in the public interest and appropriate for the

protection of investors and the maintenance of

fair and orderly markets to assure an opportunity

for investors' orders, in both dealer and auction

markets, to be executed without the participation

of a dealer, to the extent that this was

consistent with economically efficient executions

of such orders in the best market. Exchange Act

Section 11A(a)(1(c), 15 U.S.C. 78k-1(a)(1)(C).

==========================================START OF PAGE 18======



buying and selling interest is made public. As a result, the



price discovery process may be constrained. Second, the display



of limit orders can narrow quotation spreads. Third, because



many markets and market makers offer automatic executions of



small orders at the best displayed quotes, the display of limit



orders that improve the best displayed quotes can result in



improved executions for these orders.



Limit orders currently are handled differently in the



various auction and dealer markets. Generally, the rules of most



exchanges require that a limit order be displayed in the



quotation for a security when it improves the best bid or offer.



NYSE specialists, for example, must reflect a customer limit



order in their quotations at the limit price when requested to do



so.-[33]- In addition, the NYSE's order handling



procedures assume that all limit orders routed to a specialist



through SuperDOT contain a display request.-[34]-



Therefore, except in the unusual and infrequent circumstance



where a specialist believes market conditions suggest the



likelihood of imminent price improvement, a limit order received





---------FOOTNOTES----------

-[33]- See NYSE Rule 79A.10 (when a limit order is

presented to the specialist by a floor broker, the

floor broker must affirmatively request that the

specialist display the limit order; failure to so

request leaves the decision whether to display the

limit order to the discretion of the specialist);

see also NYSE Rule 60 (requiring specialists to

promptly report, inter alia, the best bid and

offer in the trading crowd in each reported

security in which the specialist is registered).



-[34]- NYSE Information Memo 93-12 (Mar. 30, 1993).

==========================================START OF PAGE 19======



by a specialist through SuperDOT should be reflected in the



specialist's quote as soon as practicable following receipt of



the order.-[35]- According to the NYSE, 93% of all



SuperDOT limit orders that improve the best bid or offer



displayed are reflected in the specialist's quote within two



minutes of receipt, while 98% of such limit orders are reflected



within five minutes of receipt.-[36]-



A recent NYSE policy statement requires specialists to



display the full size of all orders received through SuperDOT as



well as orders received by specialists manually that are



subsequently entered into the electronic book.-[37]- When



a member requests that less than the full size of the order be



shown, the specialist is obligated to show the size requested.



Specialists must display as soon as practicable any order that,





---------FOOTNOTES----------

-[35]- Id.



-[36]- Telephone Conference between Edward A. Kwalwasser,

Executive Vice President, NYSE, and Holly H.

Smith, Associate Director, Division of Market

Regulation, SEC, January 9, 1995.



Other exchanges also have rules regarding dissemination of

bids and offers. However, no uniform standard has been

adopted among the exchanges. Generally, the rules either

cite, in whole or in part, language from the Quote Rule, or

are drafted in such a manner as to allow for broad

interpretation with respect to the display of limit orders.

See, e.g., BSE Guide, Rules of the Board of Governors,

Chapter II, Sec. 7, (CCH) 2020; PSE Guide, Rules of the

Board of Governors, Rule 5.6(f), (CCH) 3979; American

Stock Exchange Guide, General and Floor Rules, Rule 115,

(CCH) 9265; CHX Guide, Article XX, Rule 7, (CCH) 1688;

Phlx Guide, Rules 105 and 229 (CCH) 2105 and 2229;

Cincinnati Stock Exchange Rules, Rule 11.9.



-[37]- See supra note 26.

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in relation to current market conditions in a particular



security, represents a material change in the supply or demand



for that security. This requirement includes increasing the size



of a quotation for orders at the same price as the current bid or



offer. If the quotation already reflects significant supply or



demand, and the specialist receives an order that is de minimis



in relation to such supply or demand, the specialist may take a



reasonable time (generally not more than two minutes) before



updating the size of the quotation.-[38]-



Currently in the OTC market, the quote for any security



typically represents a dealer's own bid and offer. The rules of



the NASD do not require market makers to display customer limit



orders, whether or not they better the best bid or offer for the



security.-[39]- Generally, customer limit orders in OTC



securities either will be routed to a broker-dealer's market



making desk or to another market maker for execution if the



customer's firm does not make a market in the security. In the



past, market makers typically did not execute limit orders until



the best bid (for sell orders) or offer (for buy orders)





---------FOOTNOTES----------

-[38]- The NYSE provides the following example of when a

specialist may take a reasonable time to update

the size of the quotation: If the market in XYZ

security is 20 (5,000) - 20 1/4 (50,000), and the

specialist receives an order to sell 200 shares at

20 1/4, such order would be considered de minimis

and the specialist would be permitted to wait a

reasonable period of time (but not more than two

minutes) before changing the size of the offer to

50,200.



-[39]- See NASD Manual, Rule 4613.

==========================================START OF PAGE 21======



displayed on Nasdaq reached the limit price. This practice has



changed, however, in recent years. In June 1994, the Commission



approved a rule change filed by the NASD that prohibits broker-



dealers from trading ahead of their customers' limit



orders.-[40]- This rule was expanded in May 1995, to



prohibit broker-dealers from trading ahead of customer limit



orders they accept from other brokers.-[41]- The NASD also



has filed a proposed rule change that would require, in certain



circumstances, the display of customer limit orders for exchange-



listed securities traded OTC.-[42]-



The exchanges and the NASD use automated trading systems to



route and, in some instances, execute orders up to a



predetermined size. Some of these systems accept limit orders.



---------FOOTNOTES----------

-[40]- See Manning I, supra note 24.



-[41]- See Manning II, supra note 24.



-[42]- See Securities Exchange Act Release No. 35471

(March 10, 1995), 60 FR 14310 (March 16, 1995).

The NASD proposal, applicable to exchange-listed

securities traded OTC, generally would require a

market maker either to execute immediately a limit

order of less than the minimum quotation size

priced better than the market maker's quotation,

or display the order in its quotation for an

amount equal to the minimum quotation size.

Market makers would have to display a limit order

greater than the minimum quotation size for that

security but would not have to display the full

size of the order. Any portion of the order not

displayed, however, would have to be executed at a

price at least as favorable as the displayed price

if the displayed portion is executed in its

entirety. At the NASD's request, the Commission

has postponed final action on the NASD's proposal

in order to permit the NASD to evaluate its

proposal in light of the Commission's actions on

the proposals it is adopting today.

==========================================START OF PAGE 22======



Each system, however, may differ in its handling of limit orders



that are not executed immediately upon receipt. For example, the



NYSE's SuperDOT system routes limit orders to the specialists'



posts where they are handled in accordance with NYSE rules



governing specialist representation of such orders. The American



Stock Exchange's ("Amex") PER system routes limit orders in the



same manner as SuperDOT and the orders are handled in accordance



with Amex rules. The NASD's Small Order Execution System



("SOES") treats limit orders priced at the current inside market



as market orders that are immediately executed.-[43]- All



other limit orders reside in a limit order file that can be



viewed only by market makers.-[44]- SOES does not provide



an opportunity for limit orders to interact with incoming market



orders. The Commission has published for comment an NASD



proposal to replace SOES with "NAqcess," a system that would



include a limit order file designed to display certain customer













---------FOOTNOTES----------

-[43]- Preferenced orders (i.e., orders routed to a

specific market maker pursuant to a pre-existing

agreement) are executed immediately at the inside

quote. Unpreferenced orders are executed against

market makers in a security in rotation. SOES,

however, does not execute an unpreferenced order

against a single market maker more than once every

15 seconds.



-[44]- The current SOES rules have been extended, with

certain changes that do not affect the handling of

limit orders, through January 31, 1997.

Securities Exchange Act Release No. 37502 (July

30, 1996), 61 FR 40869 (August 6, 1996).

==========================================START OF PAGE 23======



limit orders.-[45]-



The disparate treatment of limit orders across markets was



raised as an issue in the Market 2000 Study. The Commission



received numerous comments concerning whether the optimal degree



of pre-trade disclosure of limit orders was being achieved within



the U.S. equity markets. Some commentators alleged that



specialists and third market dealers sometimes fail to display



limit orders priced better than the displayed



quotation.-[46]- Questions also were raised about the lack



---------FOOTNOTES----------

-[45]- See Securities Exchange Act Release No. 36548

(December 1, 1995), 60 FR 60392 (December 8, 1995)

("NAqcess Release 1"); NAqcess Release 2, supra

note 21. As proposed, NAqcess would act as an

order delivery system with a limited public limit

order file.



Limit orders up to 9,900 shares would be permitted in

NAqcess for the top 250 Nasdaq National Market securities,

defined by median daily dollar volume, and for 1,000 shares

for all other Nasdaq securities. Market makers would be

allowed to query the entire limit order file. All other

market participants would be limited to viewing the top of

the NAqcess limit order file (i.e., the best priced buy and

sell limit orders, and the size associated with those orders

- the NAqcess inside market). This inside market would be

factored into the calculation for the inside quote for each

Nasdaq security. Although use of NAqcess would be

voluntary, limit orders not entered in NAqcess would be

provided with market-wide price protection under the

proposal.



-[46]- See generally Thomas H. McInish & Robert A. Wood,

Hidden Limit Orders on the NYSE, 21 J. Portfolio

Mgmt. 19 (No. 3, Spring 1995) ("McInish & Wood

Study"). The authors asserted that NYSE

specialists only display about 50% of limit orders

that better existing quotes. In their opinion,

this practice represents a serious policy issue

because it places both public investors and

regional exchanges at a disadvantage. They

asserted that hiding limit orders impedes

(continued...)

==========================================START OF PAGE 24======



of limit order exposure on Nasdaq. After considering these



comments, the Division recommended in the Study that the



securities exchanges consider whether to encourage the display of



all limit orders in listed stocks priced better than the best



intermarket quotes, unless the ultimate customer requests that



the order not be displayed. The Market 2000 Study also



recommended the display of limit orders in Nasdaq stocks when the



orders are at prices better than the best Nasdaq quotes, unless



the customer requests that the order not be



displayed.-[47]-



2. Discussion





---------FOOTNOTES----------

-[46]-(...continued)

strategic decisions on order placement; results in

publicly submitted market orders receiving

inferior prices; hampers the monitoring of order

executions; reduces the probability of a limit

order being executed; results in a delay in

reporting limit order executions; interferes with

the ability of the regional exchanges to execute

public orders; and artificially improves NYSE

performance relative to the regional exchanges

using a common benchmark. The authors also

claimed that NYSE Rule 60 is ambiguous in that the

specialists may have some leeway in choosing what

to disclose in their quotes.



In its comment letter to the Market 2000 Study, however, the

NYSE asserted that its publicly disseminated best bid or

offer includes all firm trading interest announced on the

floor as required by the exchange's rules. See Letter from

William H. Donaldson, Chairman and Chief Executive Officer,

NYSE, to Jonathan G. Katz, Secretary, SEC at 25-26 (November

24, 1992). In addition, the NYSE issued a policy statement

that reiterates that specialists have an obligation to

reflect in their quotes certain limit orders received

manually or via SuperDOT that are not executed on receipt.

See supra note 26.



-[47]- Market 2000 Study, at IV-6.

==========================================START OF PAGE 25======



a. Basis For Adoption of the Rule



After carefully considering all of the comments as well as



economic research regarding the Display Rule, and based on the



Commission's experience and knowledge of current market practices



and conditions, the Commission believes that adoption of the



Display Rule will promote transparency and enhance execution



opportunities for customer orders, and encourage



liquidity.-[48]- The Commission stresses, however, that



---------FOOTNOTES----------

-[48]- See, e.g., Letter from Thomas F. Ryan, Jr.,

President and Chief Operating Officer, Amex, to

Jonathan G. Katz, Secretary, SEC, dated February

1, 1996 ("Amex Letter"); Letter from David E.

Shaw, Ph.D., Chairman, D.E. Shaw & Co., to

Jonathan G. Katz, Secretary, SEC, dated January 9,

1996 ("D.E. Shaw Letter") (rule will promote

transparency); Letter from Paul A. Merolla, Vice

President, Associate General Counsel, Goldman,

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

dated January 26, 1996 ("Goldman Sachs Letter")

(rule would benefit marketplace); Letter from

Craig S. Tyle, Vice President and Senior Counsel,

Securities and Financial Regulation, Investment

Company Institute, to Jonathan G. Katz, Secretary,

SEC, dated January 16, 1996 ("ICI Letter")

(increased transparency of customer limit orders

in all markets could produce benefits to the

markets and investors); Letter from Donald L.

Crooks, Managing Director, Lehman Brothers, Inc.,

to Jonathan G. Katz, Secretary, SEC, dated

February 26, 1996 ("Lehman Letter") (rule promotes

transparency and results in improved opportunities

for execution of customer orders); Letter from

Bernard L. Madoff and Peter B. Madoff, Bernard L.

Madoff Investment Securities, to Jonathan G. Katz,

Secretary, SEC, dated January 12, 1996 ("Madoff

Letter") (rule will help achieve true price

discovery and fairness to investors); Letter from

Andrew E. Feldman, Director and Associate General

Counsel, Smith Barney Inc., to Jonathan G. Katz,

Secretary, SEC, dated January 29, 1996 ("Smith

Barney Letter") (rule will promote transparency

and assist in achieving best execution of orders).

(continued...)

==========================================START OF PAGE 26======



the rule is not meant to displace any SRO rules that provide



additional order handling protections to customer limit orders.



Instead, the Commission rule represents only a minimum display



standard.



The Commission believes that limit orders are a valuable



component of price discovery. The uniform display of such orders



will encourage tighter, deeper, and more efficient markets.



Limit orders convey buying and selling interest at a given price.



The display of limit orders can be expected to narrow the bid-ask



spread when this buying and selling interest is priced better



than publicly disclosed prices.-[49]- Both large and small



orders stand to benefit from the Display Rule's effect on price



discovery.-[50]- In fact, the importance of limit orders



---------FOOTNOTES----------

-[48]-(...continued)

But see Letter from Charles R. Hood, Senior Vice

President and General Counsel, Instinet, to

Jonathan G. Katz, Secretary, SEC, dated January

16, 1996 ("Instinet Letter") (exceptions to rule

eliminate potential positive impact on

transparency).



-[49]- For example, limit order trading allows investors

the opportunity to trade at prices superior to

those represented by the prevailing inside bid and

offer. See NASD Study, supra note 21.



-[50]- According to SuperDOT trade data analyzed by the

Commission's Office of Economic Analysis ("OEA"),

customer limit orders account for 50% of all NYSE

customer trades originating from orders routed

through SuperDOT ("customer trades") of 100-500

shares; 66% of all customer trades of 600-1,000

shares; 71% of all customer trades of 1,100-3,000

shares; and 74% of all customer trades of 3,100-

9,900 shares. The Commission believes that these

high percentages are based, at least in part, on

the fact that limit orders routed through SuperDOT

(continued...)

==========================================START OF PAGE 27======



in the trading process was documented in recent



studies.-[51]- The author quantified the impact of



exposing limit orders on quoted spreads and effective transaction



costs. Using NYSE data, he determined that the quote spreads



resulting from participation of the limit order book were



approximately 4 to 6 cents smaller than the spreads not set by



the limit order book. Further, trading costs on the NYSE were



approximately 3-4 cents less per share on a "round trip"



transaction when both the purchase and the sale were executed



against the limit order book.-[52]-



---------FOOTNOTES----------

-[50]-(...continued)

are required to be displayed in the specialist's

quote. The Commission believes that these

percentages help demonstrate the benefits

associated with limit order display for both large

and small order sizes. In addition, OEA data

shows that NYSE customer limit orders routed

through SuperDOT narrow the NYSE quote 22% of the

time and match the quote 39% of the time for

customer limit orders of 100-1,000 shares; narrow

the quote 17% of the time and match the quote 43%

of the time for customer limit orders of 1,100-

3,000 shares; and narrow the quote 14% of the time

and match the quote 46% of the time for customer

limit orders of 3,100-9,900. OEA data also shows

that, when the NYSE bid-ask spread was 1/4 point

or more, customer limit orders routed through

SuperDOT narrow the NYSE spread between 41% and

50% of the time, depending on the size of the

customer order.



-[51]- See Jason T. Greene, The Impact of Limit Order

Executions on Trading Costs in NYSE Stocks (An

Empirical Examination), December 1995 ("Greene

Study"); see also Jason T. Greene, Limit Order

Executions and Trading Costs for NYSE Stocks, June

1996 ("Greene Study II").



-[52]- The Commission further believes that the display

requirement will improve price transparency in

(continued...)

==========================================START OF PAGE 28======



The uniform display of limit orders also will lead to



increased quote-based competition. Market makers will not only



be competing amongst themselves, but also against customer limit



orders represented in the quote. The Commission believes that



this result will reduce the possibility of certain trading



behavior on Nasdaq that was recently the subject of a Commission











---------FOOTNOTES----------

-[52]-(...continued)

securities with diverse trading characteristics.

Based on SuperDOT trade data, the Commission's OEA

has determined that for NYSE securities with an

average daily trading value ("ADTV") of under

$100,000, customer limit orders account for 57% of

all NYSE customer trades originating from orders

routed through SuperDOT ("customer trades") of

100-500 shares; 69% of all customer trades of 600-

1,000 shares; 76% of all customer trades of 1,100-

3,000 shares; and 83% of all customer trades of

3,100-9,900 shares. Limit orders also are

frequently used for securities with higher ADTVs.

For example, for NYSE securities with an ADTV of

over $5,000,000, customer limit orders account for

48% of all NYSE customer trades of 100-500 shares;

68% of all customer trades of 600-1,000 shares;

72% of all customer trades of 1,100-3,000 shares;

and 73% of all customer trades of 3,100-9,900

shares. Moreover, OEA data shows that for NYSE

securities with an ADTV of under $100,000,

customer limit orders routed through SuperDOT

narrow the NYSE quote 30% of the time and match

the quote 32% of the time. For less liquid

securities, therefore, the display of customer

limit orders narrows spreads, improves price

discovery, and increases market depth. For NYSE

securities with an ADTV of $5,000,000 or more,

customer limit orders routed through SuperDOT

narrow the NYSE quote 18% of the time and match

the quote 41% of the time.



The NASD has suggested that the greater the size of the

displayed spread, the greater the use of limit orders. See

NASD Study, supra note 21.

==========================================START OF PAGE 29======



investigation.-[53]- As reported in the 21(a) Report,



Nasdaq market makers widely adhered to a "pricing convention,"



whereby Nasdaq market makers maintained artificially inflexible



quotations and as a result often traded with the public at prices



unduly favorable to such market makers.-[54]- In addition,



the Commission determined that Nasdaq market makers adhered to a



"size convention" that deterred Nasdaq market makers from



narrowing their quotes to create a new inside market unless the



market makers were willing to trade at least 2,000 to 5,000



shares at that price, rather than the minimum quotation size as



determined by NASD rules.-[55]- This practice prevented





---------FOOTNOTES----------

-[53]- See 21(a) Report, supra note 28. The

investigation identified a number of practices in

the Nasdaq market that are similar to practices

identified in the 1963 Special Study. See SEC,

Report of Special Study of Securities Markets

(1963). For example, the 1963 Special Study

discussed cooperation and information sharing

between traders, as well as other non-competitive

practices. Id. at pt. 2, 576-577.; See also

Competitive Impact Statement of the U.S.

Department of Justice Antitrust Division, United

States v. Alex. Brown & Sons, et. al., (S.D.N.Y.

1996).



-[54]- As a result of this convention, most Nasdaq stocks

were quoted only in increments of 1/4. Under the

convention, stocks with a dealer spread of 3/4 or

more would only be quoted in even-eighths (i.e.,

1/4, 1/2, 3/4), thereby giving rise to a minimum

inside spread of 1/4. Stocks with dealer spreads

less than 3/4 would be quoted in both even and

odd-eighths, thereby allowing a minimum inside

spread of 1/8. The pricing convention

significantly limited the flexibility and

competitiveness of price quotations in the Nasdaq

market.



-[55]- See 21(a) Report, supra note 28.

==========================================START OF PAGE 30======



the dissemination of improved quotes when a trader sought to



trade stock only at a size equal to the minimum quotation size.



Thus, the true buying and selling interest in a given security



was not reflected in the published quotes.



In addition to the Commission's actions, and those of the



Department of Justice in connection with its investigation of the



Nasdaq market, the Commission believes the requirement to display



customer limit orders in market maker quotes would inhibit market



makers from engaging in the conduct described above. Moreover,



the display of limit orders reduces the potential for certain



other conduct described in the 21(a) Report, including market



maker collaboration and coordination of trade and quote



activities. Market makers will be less able to improperly



coordinate such behavior due to the display of competing customer



order flow and the resulting transparency of ultimate buying and



selling interest. The Commission believes that the display



requirement will both foster renewed quote-based competition



among market makers and introduce new competition from customer



limit orders.



The Commission also believes that overall market liquidity



should be enhanced due to the increased trading volume that is



expected to result from the display of limit orders.-[56]-



---------FOOTNOTES----------

-[56]- See Greene Study and Greene Study II, supra note

51 (limit orders affect the quoted spread, provide

liquidity to traders that demand immediacy of

execution, and may contribute to reduced trading

costs); NASD Study, supra note 21 (the liquidity

supplied by limit orders reduces trading costs of

(continued...)

==========================================START OF PAGE 31======



As noted previously, customer limit orders account for a



significant percentage of total customer orders on the NYSE,



where customer limit orders generally are required to be



displayed when they represent a better price.-[57]-



Moreover, previous Commission initiatives designed to enhance



transparency have resulted in increased competition and liquidity



for the markets.-[58]-



Customers also will be better able to monitor the quality of



their executions. Currently, the failure to display limit orders



often results in inferior or missed executions for these orders.



The Commission has received frequent complaints from customers



whose limit orders have not been filled while other executions



are reported at prices inferior to their limit order prices.



Requiring the display of customer limit orders in specialist and



market maker quotes, although not guaranteeing that such limit



orders will be executed, will help ensure that other orders are



not executed at inferior prices until better priced limit orders



are executed. Similarly, customers entering market orders will



be able to determine whether their orders are receiving the best





---------FOOTNOTES----------

-[56]-(...continued)

market participants); OEA Data, supra notes 50 and

52 (limit orders narrow spreads, improve price

discovery, and increase market depth).



-[57]- See OEA Data, supra notes 50 and 52.



-[58]- See Market 2000 Study at Study IV. See also

discussion at section III.A.b.iii., infra; Simon &

Colby The National Market System For Over-The-

Counter Stocks ("Simon and Colby"), 55 Geo. Wash.

L. Rev. 17 (1986).

==========================================START OF PAGE 32======



price available. Customers also will be in a better position to



compare the execution quality provided by different broker-



dealers.-[59]-



The absence of a uniform limit order display requirement



across all markets has contributed to the controversy among



market participants regarding the availability of true price



improvement opportunities. Many claim that "hidden" limit orders



in exchange markets contribute to distorted price improvement



figures for these markets.-[60]- This potential distortion



---------FOOTNOTES----------

-[59]- The Commission notes that if the Display Rule

leads some market makers to charge commissions for

handling limit orders, Commission rules require

disclosure of such charges. See 17 CFR 240.10b-

10.



-[60]- See James J. Angel, Who Gets Price Improvement on

the NYSE?, Working Paper, December 1994. In

studying the availability of price improvement on

the NYSE, the author noted that over 18% of the

market orders that were price improved were filled

by SuperDOT limit orders. Based on this

percentage, the author estimated the percentage of

orders price improved by "hidden" limit orders and

determined that if such limit orders were

represented in the specialist's quote rather than

"hidden," spreads would have been narrower and

NYSE price improvement statistics would have

declined. See also, McInish & Wood Study, supra

note 46; Mitchell A. Petersen & David Fialkowski,

Posted Versus Effective Spreads: Good Prices or

Bad Quotes, 35 J. Fin. Econ. 269 (1994) (the fact

that so many orders execute inside the posted

spreads indicates that quotes do not represent the

true supply and demand of a given security, and

may be based, in part, on the failure to display

public limit order interest in the quote). Cf.

Ross, Shapiro and Smith, supra note 17 (although

the authors did not examine limit orders in

detail, and discounted the effect of "hidden"

limit orders on their statistics, the authors

found that limit orders provide 27% of the price

(continued...)

==========================================START OF PAGE 33======



also hinders a customer's ability to monitor execution quality.



Pursuant to the Display Rule, the vast majority of limit orders



will be publicly disclosed, thus enabling a more accurate



comparison of price improvement opportunities, and enabling



customers and broker-dealers to make more informed order routing



decisions.-[61]-



Moreover, the Commission believes that the display of limit



orders will benefit orders routed to automated execution systems.



To the extent these systems execute orders at prices based on the



best displayed quotation for a particular security,-[62]-



customers whose orders are executed through these systems will



receive the benefit of prices that more accurately reflect buying



and selling interest in the market.



In sum, the Commission believes the adoption of the Display



Rule is an important step in furthering the goals expressed by



Congress in the 1975 Amendments. The Display Rule will provide





---------FOOTNOTES----------

-[60]-(...continued)

improvement afforded to SuperDOT market order

volume).



-[61]- See, e.g., Amex Letter (rule would help eliminate

hidden limit orders); Letter from Frederick Moss,

Chairman of the Board, CSE, to Jonathan G. Katz,

Secretary, SEC, dated January 16, 1996 ("CSE

Letter") (elimination of hidden limit orders will

eliminate illusion of superior price improvement);

Letter from Harold S. Bradley, Vice President and

Director of Trading, Investors Research

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

dated January 13, 1996 ("Investors Research

Letter") (hidden limit orders are not justified).



-[62]- Compare discussion of best execution at section

III.C.2.

==========================================START OF PAGE 34======



enhanced opportunities for public orders to interact with other



public orders, consistent with congressional goals.-[63]-



In addition, the display requirement will, among other things,



narrow quotes, enhance market liquidity, and improve an



investor's ability to monitor the quality of its



executions.-[64]- This will create a better environment



for execution of both limit and market orders without the



participation of a dealer. The increased order interaction will



result in quicker and more frequent executions of customer limit



orders. The Display Rule, therefore, will increase the



---------FOOTNOTES----------

-[63]- See 15 U.S.C. 78k-1(a)(1)(C)(v).



-[64]- The Commission notes that a few commenters are

concerned about the potential effects of the

Commission's proposals on institutional customers.

See Goldman Sachs Letter; Letter from Howard J.

Schwartz, Chairman and Chief Executive Officer,

and James Hanrahan, Managing Director - Trading,

Lynch, Jones & Ryan, Inc., to Jonathan G. Katz,

Secretary, SEC, dated February 9, 1996 ("LJR

Letter"); Letter from A.B. Krongard, Chairman, SIA

Board of Directors, and Bernard L. Madoff and

Robert Murphy, Co-Chairmen, Order Execution

Committee, Securities Industry Association, to

Jonathan G. Katz, Secretary, SEC, dated February

26, 1996 ("SIA Letter"). The Commission believes

that the Display Rule will benefit both retail and

institutional customers, while preserving the

access to the markets that institutional customers

have today. For example, an institutional

customer's block size limit order would not be

subject to the rule unless such customer requests

that the order be displayed. Moreover, any

customer, whether individual or institutional, can

request that its non-block size limit order not be

displayed. The Commission also notes that

increased quote competition and enhanced

transparency should improve the prices at which

institutions and market makers begin their

negotiations for the execution of institutional

orders. See also 21(a) Report, supra note 28.

==========================================START OF PAGE 35======



likelihood that limit orders will be executed, a result that the



Commission believes is consistent with the duty of best



execution.



b. Response to Comments-[65]-



The Commission proposed Rule 11Ac1-4 to establish minimum



display requirements for customer limit orders that improve a



specialist's or OTC market maker's best bid or offer for a



particular security as well as the size of such orders. In



addition, the rule requires the display of the size of certain



limit orders priced at the national best bid or offer ("NBBO").



Although the rule generally would mandate the display of limit



orders, market makers and specialists still would retain some



flexibility in handling limit orders accepted for execution.



Specifically, the rule allows an OTC market maker or



specialist, immediately upon receipt of a limit order, to: (1)



change its quote and the size associated with its quote to



reflect the limit order; (2) execute the limit order; (3) deliver



the limit order in an exchange- or association-sponsored system



that complies with the requirements of the rule; or (4) send the



limit order to another market maker or specialist who complies



with the requirements of the rule. The rule would require a



specialist or OTC market maker to display a customer limit order



when the order was "held" by the specialist or OTC market maker.



If the specialist or OTC market maker immediately sends the order





---------FOOTNOTES----------

-[65]- For further discussion of the views of commenters,

see the Summary of Comments, supra note 4.

==========================================START OF PAGE 36======



to a system or to another specialist or OTC market maker that



complies with the rule, the specialist or OTC market maker that



routed the order would have satisfied its obligation to display



the order. These alternatives are intended to allow market



makers, specialists, and market centers an opportunity to



continue to provide their valuable services while offering



customers the best available execution opportunities.



The Display Rule as adopted maintains these alternatives as



proposed. Additionally, to better achieve its aims and to



respond to comments, the Commission has made some modifications



to the proposed rule. For example, the Commission has decided to



permit a specialist or OTC market maker to deliver a limit order



to certain ECNs as an alternative to representing the limit order



in its quote. This change is an extension of the proposed



exception that permits a specialist or OTC market maker to



deliver a limit order to an exchange- or association-sponsored



system that complies with the Display Rule. Moreover, with



regard to implementation of the rule, the Commission is providing



for a four-stage phase-in over a one year period for non-



exchange-traded securities.



Of the commenters who specifically addressed the proposed



Display Rule, an overwhelming majority strongly support the



inclusion of customer limit orders in the quote.-[66]- One



---------FOOTNOTES----------

-[66]- See, e.g., Amex Letter; Letter from Marshall E.

Blume, Director, Howard Butcher Professor of

Financial Management, The Wharton School of the

University of Pennsylvania, to Jonathan G. Katz,

(continued...)

==========================================START OF PAGE 37======



commenter notes that true price discovery and fairness for public



investors can only be achieved when limit orders are reflected in



the NBBO.-[67]- Other commenters, expressing strong



support for the proposed rule, believe that market-wide limit



order procedures will improve the markets by enhancing overall







---------FOOTNOTES----------

-[66]-(...continued)

Secretary, SEC, dated January 11, 1996 ("Blume

Letter"); Letter from George W. Mann, Jr., Senior

Vice President and General Counsel, BSE, to

Jonathan G. Katz, Secretary, SEC, dated January

26, 1996 ("BSE Letter"); Letter from Robert H.

Forney, CHX, to Jonathan G. Katz, Secretary, SEC,

dated January 23, 1996 ("CHX Letter"); D.E. Shaw

Letter; Letter from Antitrust Division, U.S.

Department of Justice, to SEC, dated January 26,

1996 ("DOJ Letter"); Letter from Preston Estep,

Estep Trading Partners L.P., to Jonathan Katz,

Secretary, SEC, dated December 21, 1995 ("Estep

Letter"); Goldman Sachs Letter; ICI Letter; Lehman

Letter; Madoff Letter; Letter from William A.

Lupien, Chairman and Chief Executive Officer,

Mitchum, Jones & Templeton, Inc., to Jonathan G.

Katz, Secretary, SEC, dated January 8, 1996 ("MJT

Letter"); Letter from Joseph R. Hardiman,

President, National Association of Securities

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

SEC, dated January 26, 1996 ("NASD Letter");

Letter from James E. Buck, Senior Vice President

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

Secretary, SEC, dated January 15, 1996 ("NYSE

Letter"); Letter from David S. Pottruck, President

and Chief Operating Officer, The Charles Schwab

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

dated May 7, 1996 ("Schwab Letter II"); SIA

Letter; Letter from William R. Rothe, Chairman,

and John L. Watson III, President, Security

Traders Association, to Jonathan G. Katz,

Secretary, SEC, dated January 15, 1996 ("STA

Letter"); Letter from John F. Luikart, President

and Chief Executive Officer, Sutro & Co., to

Jonathan Katz, Secretary, SEC, dated January 16,

1996 ("Sutro Letter").



-[67]- Madoff Letter.

==========================================START OF PAGE 38======



market transparency-[68]- and eliminating the advantages



derived by some markets from hidden limit orders.-[69]-



The Department of Justice states that the proposed rule



encourages quote competition, which is likely to reduce



spreads,-[70]- and allows customer orders to interact with



one another.-[71]- In this regard, several commenters



recognize that the proposed rule would assist in achieving best



execution of customer orders-[72]- by increasing the



opportunities for execution of limit orders, and improving the



prices for market orders.-[73]- Another commenter states



that the proposed rule is consistent with investor expectations



and will act to protect retail customer interests.-[74]-



Other commenters oppose the proposal. Several commenters in



this group have raised the following general concerns regarding



the proposed rule.







---------FOOTNOTES----------

-[68]- See, e.g., Amex Letter; CHX Letter; CSE Letter;

D.E. Shaw Letter; ICI Letter; Investors Research

Letter; Lehman Letter; Smith Barney Letter.



-[69]- See, e.g., Amex Letter (rule would help eliminate

hidden limit orders); CSE Letter (elimination of

hidden limit orders will eliminate illusion of

superior price improvement); Investors Research

Letter (hidden limit orders are not justified).



-[70]- DOJ Letter.



-[71]- Id; see also Amex Letter; Lehman Letter.



-[72]- See, e.g., Lehman Letter; Smith Barney Letter.



-[73]- Lehman Letter.



-[74]- D.E. Shaw Letter.

==========================================START OF PAGE 39======



i. Distinction Between Markets



Several commenters argue that the Display Rule does not take



into account distinctions between auction and dealer markets.



Some of these commenters, discussing the Proposing Release as a



whole, argue that the Commission's proposals would "auctionize"



the dealer market.-[75]- One commenter warns that, because



auction and dealer markets are fundamentally different, a single



set of rules for both auction and dealer markets would reduce



quote quality and damage overall market integrity in dealer



markets.-[76]- Although the SIA reports that the consensus



view of its Ad Hoc Committee on Order Execution is to require a



market maker to reflect customer limit orders in the quote, the



SIA argues that the adoption of the proposed rule, without



suggested modifications, could adversely affect the dealer market









---------FOOTNOTES----------

-[75]- See, e.g., Letter from R. Steven Wunsch,

President, AZX, Inc., to Jonathan G. Katz,

Secretary, SEC, dated January 15, 1996 ("AZX

Letter"); Goldman Sachs Letter; Letter from David

Rich, Vice President, Jefferies & Company, Inc.,

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

25, 1996 ("Jefferies Letter"); Letter from Robert

W. Murphy, President, RPM Specialist Corporation,

to Jonathan G. Katz, Secretary, SEC, dated

February 26, 1996 ("RPM Letter"); Letter from

Robert A. Schwartz, Professor of Finance and

Economics, and Yamaichi Faculty Fellow, Leonard N.

Stern School of Business, New York University, and

Robert A. Wood, Distinguished Professor of

Finance, Fogelman College of Business and

Economics, University of Memphis, to Jonathan G.

Katz, Secretary, SEC, dated January 23, 1996

("Schwartz & Wood Letter"); SIA Letter.



-[76]- RPM Letter.

==========================================START OF PAGE 40======



so as to weaken competition between dealer and auction



markets.-[77]-



The Commission believes that the application of the



principles underlying the limit order display rule to the dealer



market is neither a new nor radical concept. In 1975, Congress



envisioned an NMS in which public limit orders in qualified



securities would have a central role.-[78]- Congress



anticipated that the NMS would make all specialists and market



makers aware of public customer limit orders held anywhere in the



system, and provide enhanced protection and priority for limit



orders in stocks qualified for trading in a national market



system.-[79]- The Commission has consistently recognized



since 1975 that, in order to satisfy this Congressional vision,



multiple-market display of limit orders was an important





---------FOOTNOTES----------

-[77]- SIA Letter. Cf. Letter from A.B. Krongard,

Chairman, SIA Board of Directors, and Bernard L.

Madoff, Chairman, Trading Committee, to Jonathan

G. Katz, Secretary, SEC, dated August 1, 1996

("SIA NAqcess Letter") (the SIA, in its letter to

the Commission regarding the NASD's NAqcess

proposal, states that the Commission's Order

Execution Obligations proposal would narrow

quotation spreads, improve transparency, and

provide customers with best execution of their

orders, consistent with the 1975 Amendments).



-[78]- Senate Report, supra note 31.



-[79]- Id. The Senate Report stressed the need to

establish a mechanism by which specialists and

market makers could be made aware of customer

orders within the NMS. The Senate Report was

"satisfied that [the legislation] grant[ed] the

Commission complete and effective authority to

implement a system for the satisfaction of public

limit orders." Id. at 18.

==========================================START OF PAGE 41======



component for qualified securities.-[80]- More recently,



the Market 2000 Study recommended that the SROs, including the



NASD, consider requiring the display of customer limit



orders,-[81]- and the NASD, in a proposed rule change filed



with the Commission, proposed that CQS market makers display in



their quotes certain customer limit orders for exchange-listed



securities traded OTC.-[82]- The NASD also has proposed a



mechanism for the display and protection of customer limit orders



in Nasdaq securities.-[83]-



Although some commenters claim that the Commission is



attempting to "auctionize" the dealer market, the display



requirement is based on transparency and agency concerns,



including a broker-dealer's obligation to provide its customers



with best execution.-[84]- The display of customer limit



orders will act to narrow spreads, improve price discovery, and



---------FOOTNOTES----------

-[80]- See Securities Exchange Act Release No. 15671

(March 22, 1979), 44 FR 20360 (April 4, 1979)

(Development of a National Market System Status

Report). See also Securities Exchange Act Release

No. 18738 (May 13, 1982), 47 FR 22376 (May 24,

1982) (proposing limit order display requirement

for Rule 19c-3 securities).



-[81]- Market 2000 Study, at IV-6.



-[82]- See supra note 42.



-[83]- See supra note 45.



-[84]- See NASD Study, supra note 21 (enhancements to

limit order handling, within the dealer market

structure, will create significant benefits for

investors). See also Manning II, supra note 24

(Commission's extension of limit order protection

to Nasdaq does not suggest an intention to

"auctionize" the dealer market).

==========================================START OF PAGE 42======



increase market depth. The enhanced transparency resulting from



the Display Rule will increase the likelihood that customer limit



orders will be executed, improve the execution prices of market



orders, and strengthen an investor's ability to monitor the



quality of executions.-[85]- These results further several



Congressional goals.



In keeping with Congressional intent, the Commission



believes the treatment of limit orders should reflect the very



real changes in market structure that have taken place since the



enactment of the 1975 Amendments. These changes include the



development of a robust, liquid OTC dealer market that attracts



significant investor trading interest, that trades at many



multiples of the volume extant in 1975, and that is characterized



by the inclusion of thousands of securities that meet the NMS



designation.-[86]- In addition, the Commission believes



that application of the Display Rule should also benefit



investors in those securities that do not yet meet the NMS











---------FOOTNOTES----------

-[85]- See Senate Report, supra note 31 at 16-18

(discussing desirability of incorporating certain

auction market principles, such as limit order

display and protection, for certain qualifying

securities in dealer markets).



-[86]- To date, approximately 4,000 Nasdaq securities

have qualified for the NMS designation. In order

to qualify as an NMS security, transaction reports

are required to be reported on a real-time basis

pursuant to an effective transaction reporting

plan approved by the Commission. See 17 CFR

240.11Aa2-1 and 11Aa3-1.

==========================================START OF PAGE 43======



designation.-[87]- As noted earlier, the Commission



believes that the increased use of limit orders in these



securities will lead to a narrowing of spreads and ameliorate



certain anti-competitive practices that have developed in the



Nasdaq market.-[88]- The Commission has determined that



certain practices on Nasdaq have contributed to artificially wide



spreads for OTC securities.-[89]- The display of customer



limit orders in all Nasdaq securities will promote accurate



pricing and convey the true buying and selling interest in such



securities.



A few commenters believe that the Display Rule was proposed



solely to address problems in the OTC market, and accordingly



there is no need for a uniform rule applicable to exchange



markets.-[90]- As noted previously, the Commission's



intention is to create a minimum standard for the handling of



limit orders across all markets, consistent with market



transparency, competition, and best execution principles.



---------FOOTNOTES----------

-[87]- As discussed below, the Display Rule will apply

only to "covered securities." At the present

time, the Commission does not believe the rule

should be extended to securities for which market

makers are not required to quote continuous firm

two-sided markets, such as OTC Bulletin Board

securities.



-[88]- See supra discussion at section III.A.2.a.



-[89]- 21(a) Report, supra note 28.



-[90]- See, e.g., BSE Letter; NYSE Letter; RPM Letter;

Letter from David E. Humphreville, Executive

Director, The Specialist Association, to Jonathan

G. Katz, Secretary, SEC, dated February 2, 1996

("Specialist Assoc. Letter").

==========================================START OF PAGE 44======



Currently, the national securities exchanges do not handle limit



orders uniformly, and in fact the non-display of retail-size



limit orders is permitted under certain circumstances. The rule



will ensure that investors benefit from the display of limit



orders, no matter where an order is sent for



execution.-[91]- A minimum standard also addresses



concerns regarding the prevalence of hidden limit



orders.-[92]- The Commission believes, therefore, that a



market-wide limit order display requirement is most consistent



with the duty of best execution and the expectations of



investors.



ii. Distinction between Quotes and Orders





---------FOOTNOTES----------

-[91]- See, e.g., Greene Study & Greene Study II, supra

note 51.



-[92]- See generally McInish & Wood Study, supra note 46

(hidden limit orders result in, among other

things, artificial price improvement statistics

and inferior order executions); Traders Accuse

Specialists of Holding Back Limit Orders,

Investment Dealers' Digest, 8, (February 14, 1994)

(some traders have continued to accuse NYSE

specialists of hiding limit orders even after the

NYSE issued an Information Memo reminding

specialists of their duties); Greene Study and

Greene Study II, supra note 51 (one explanation

for the significantly lower bid-ask spreads in the

1994-95 sample than in the 1990 sample, and the

increase in the percentage of transactions at the

quoted prices from the 1990 sample to the 1994-95

sample, may be that NYSE specialists were more

diligent in reflecting the limit order book in

their quotes as per Information Memo 93-12); Amex

Letter (rule would help eliminate hidden limit

orders); CSE Letter (elimination of hidden limit

orders will eliminate illusion of superior price

improvement); Investors Research Letter (hidden

limit orders are not justified).

==========================================START OF PAGE 45======



Some commenters maintain that the rule blurs the distinction



between quotations and orders.-[93]- One commenter states



that limit orders represent only a finite trading interest while



quotes represent the "actual" market for a security; thus,



displaying limit orders would not reflect the "true" state of the



market and impair the quality of quotation



information.-[94]- The commenter suggests that a separate



limit order file would be more appropriate in light of these



distinctions.-[95]- In this vein, several commenters



mention the NASD's proposed NAqcess system,-[96]-



suggesting that the Commission postpone implementation of the



Display Rule until the Commission has an opportunity to assess













---------FOOTNOTES----------

-[93]- See, e.g., Letter from Raymond L. Aronson, Senior

Managing Director, Bear, Stearns & Co. Inc., to

Jonathan G. Katz, Secretary, SEC, dated February

1, 1996 ("Bear Stearns Letter"); Instinet Letter;

Letter from Carol L. Cunniff, Executive Vice

President, Ruane, Cunniff & Co., Inc., to Jonathan

G. Katz, Secretary, SEC, dated February 23, 1996

("Ruane Letter"); Letter from Charles R. Schwab,

Chairman and Chief Executive Officer, The Charles

Schwab Corporation, to Jonathan G. Katz,

Secretary, SEC, dated January 25, 1996 ("Schwab

Letter"). But see Schwab II Letter (supporting

the Display Rule).



-[94]- Ruane Letter.



-[95]- Id. See also Bear Stearns Letter (discussion of

proposed central limit order file for The Nasdaq

Stock Market so as to preserve distinction between

dealer quotes and agency or proprietary orders).



-[96]- See supra note 45.

==========================================START OF PAGE 46======



the effects of NAqcess.-[97]- A few commenters suggest the



implementation of an industry-wide consolidated limit order book



as an alternative or a logical outgrowth of the Display



Rule.-[98]-



The Commission believes that the display of limit orders is



an essential component of accurate price discovery. A quote



provides market participants with information regarding a market



maker's or specialist's trading interest at a given price. A



market maker or specialist could be willing to purchase or sell



---------FOOTNOTES----------

-[97]- See, e.g., Letter from A.B. Krongard, Chief

Executive Officer, Alex. Brown & Sons, Inc., to

Jonathan G. Katz, Secretary, SEC, dated February

29, 1996 ("Alex. Brown Letter"); Letter from

Albert G. Lowenthal, Chairman of the Board,

Fahnestock & Co., Inc., to Jonathan G. Katz,

Secretary, SEC, dated January 15, 1996

("Fahnestock Letter"); Jefferies Letter; Letter

from Gerard S. Citera, Deputy General Counsel,

First Vice President, PaineWebber Incorporated, to

Jonathan G. Katz, Secretary, SEC, dated February

9, 1996 ("PaineWebber Letter"); Schwab Letter; STA

Letter; Letter from Charles Snow, Counsel,

Securities Traders Association of New York, to

Jonathan G. Katz, Secretary, SEC, dated January

30, 1996 ("STANY Letter"); see also Letter from C.

Robert Paul, III, Associate General Counsel, Dean

Witter Reynolds, Inc., to Jonathan G. Katz,

Secretary, SEC, dated January 31, 1996 ("Dean

Witter Letter"); Goldman Sachs Letter.



-[98]- See, e.g., DOJ Letter; MJT Letter; Schwab Letter;

Letter from Junius W. Peake, Monfort Distinguished

Professor of Finance, University of Northern

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

dated January 15, 1996 ("Peake Letter"); Letter

from Jeffrey P. Ricker, CFA, to Jonathan G. Katz,

Secretary, SEC, dated January 15, 1996 ("Ricker

Letter"); Letter from Peter W. Jenkins, Chairman,

and Holly A. Stark, Vice Chairman, Institutional

Committee, Securities Traders Association, to

Jonathan G. Katz, Secretary, SEC, dated January

19, 1996 ("STAIC Letter").

==========================================START OF PAGE 47======



additional shares above its quoted size.-[99]- Entry of a



customer limit order that improves the quote serves a similar



purpose. A limit order accurately represents trading interest



for a specific volume of a security at the limit price. There



are few practical differences between customer limit orders and a



market maker's quotation that is firm only for its quoted size.



Nonetheless, the proposed rule was not intended to equate



customer limit orders with market maker quotes. Instead, the



proposed rule was designed to facilitate greater transparency of



customer trading interest, with the expectation that orders would



have an increased opportunity for best execution without the



interaction of a dealer. In the Commission's opinion, these



objectives are more difficult to achieve if customer trading



interest is not routinely represented in publicly displayed



quotes. The Commission notes that the Display Rule provides



other means by which a market maker or specialist may comply with



the requirements of the rule in the event a specialist or market



maker elects not to display customer trading interest in its



quote.-[100]-



Further, the Commission does not agree with the suggestion





---------FOOTNOTES----------

-[99]- Under Commission rules, the market maker's quote

is only required to be firm up to its published

size. See 17 CFR 240.11Ac1-1(c)(2).



-[100]- For example, a market maker or specialist may

deliver a customer limit order immediately upon

receipt to another market maker or specialist, or

to an ECN or an exchange or association sponsored

system pursuant to the rule. Section 240.11Ac1-

4(c)(5) & (6).

==========================================START OF PAGE 48======



that the Commission postpone the adoption of the Display Rule



until the Commission has had an opportunity to evaluate the



NASD's NAqcess proposal.-[101]- Although the NASD has



argued that limit orders entered into NAqcess, as proposed, would



result in greater display of OTC limit order prices, there is no



assurance that market makers will enter such orders into NAqcess



rather than hold the orders internally.-[102]- Therefore,



the Commission believes that the Display Rule is necessary to



ensure display of these orders in the OTC market.-[103]-



If approved, NAqcess can assist in compliance with the Display



Rule to the extent that the system incorporates customer limit



orders in the consolidated quote stream, thereby allowing market



makers to enter limit orders in NAqcess rather than displaying



limit orders in their quotes.-[104]- As noted earlier,



the Commission has identified important benefits associated with



limit order display. Accordingly, the Commission believes that



it is not necessary to observe the effects of NAqcess in order to





---------FOOTNOTES----------

-[101]- The Commission notes that the proposed NAqcess

system is a significant and controversial proposal

which has generated approximately 1,100 comment

letters. The Commission is in the process of

reviewing the comments and has yet to decide what

action to take on the proposal.



-[102]- See NAqcess Releases, supra note 45. As noted

above, limit orders not entered in NAqcess would

be provided with market-wide price protection.



-[103]- In any event, NAqcess will not address at all the

issues of disparate limit order handling practices

or hidden limit orders in the exchange markets.



-[104]- See Section 240.11Ac1-4(c)(5).

==========================================START OF PAGE 49======



determine the benefits of the limit order display requirement.



iii. Liquidity



Several commenters assert that application of the Display



Rule to Nasdaq securities could reduce liquidity in the Nasdaq



market.-[105]- These commenters believe that market maker



profits may decline due to narrowed spreads or increased



compliance costs, with the result that many firms will decide not



to make the necessary capital commitment to continue their market



making operations. The commenters conclude that as the number of



market makers in a security declines, liquidity will be adversely



affected, leading to wider spreads. Moreover, some commenters



believe that the decrease in liquidity will impair the capital



formation process, especially for securities that are not mature



enough for auction trading.-[106]-



At least one commenter states that the usefulness of limit



orders could be diminished by the refusal of some market makers



to accept such orders, or by the imposition of high commission





---------FOOTNOTES----------

-[105]- See, e.g., Alex. Brown Letter; Bear Stearns

Letter; Dean Witter Letter; Letter from Robert F.

Mercandino, Senior Vice President, Dillon, Read &

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

dated March 15, 1996 ("Dillon Letter"); Jefferies

Letter; Lehman Letter; Letter from Robert J.

McCann, Managing Director, Co-Head, Global Equity

Markets, Merrill Lynch, Pierce, Fenner & Smith

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

dated January 26, 1996 ("Merrill Letter"); NASD

Letter; PaineWebber Letter; Letter from David P.

Semak, Vice President Regulation, PSE, to Jonathan

G. Katz, Secretary, SEC, dated January 15, 1996

("PSE Letter"); SIA Letter.



-[106]- See, e.g., NASD Letter; SIA Letter.

==========================================START OF PAGE 50======



costs charged to recoup lost profits on spreads.-[107]-



Other commenters believe, however, that it will be difficult for



market makers to increase their commissions for limit



orders.-[108]- They believe commission charges would not



compensate for lost trading profits or prevent the ebb of market



liquidity.-[109]-



Other commenters believe the proposed rule will not have a



negative impact on market liquidity. One commenter explicitly



states that the benefits of the proposed rule would outweigh any



potential adverse effects on liquidity.-[110]- Another



commenter says that the proposed rule would not result in any



significant reduction in market making activity.-[111]-



The CSE notes that it has not noticed any negative effects on



market liquidity as a result of the implementation of its own



limit order display rule.-[112]- Yet another commenter



---------FOOTNOTES----------

-[107]- Letter from David K. Whitcomb, Professor of

Finance and Economics, Rutgers University Graduate

School of Management, to Secretary, SEC, dated

January 12, 1996 ("Whitcomb Letter").



-[108]- See, e.g., Letter from Irving M. Pollack, Alan B.

Levenson, and Robert H. Rosenblum, Fulbright &

Jaworski L.L.P., on behalf of Herzog, Heine and

Geduld, Inc., to Jonathan Katz, Secretary, SEC,

dated January 16, 1996 ("HHG Letter"); STA Letter.



-[109]- Id.



-[110]- Lehman Letter.



-[111]- Letter from Daniel G. Weaver, Ph.D., Assistant

Professor of Finance, Marquette University, to

Jonathan G. Katz, Secretary, SEC, dated January

10, 1996 ("Weaver Letter").



-[112]- CSE Letter.

==========================================START OF PAGE 51======



states that although it currently does not trade OTC securities,



it expects that many market participants, including the



commenter, would begin trading such securities if the proposed



rule was adopted, thereby increasing market



liquidity.-[113]-



The display of limit orders is designed, among other



objectives, to publicize accurate market interest and increase



quote competition.-[114]- The Commission understands that



certain costs, including a diminution in market maker profits,



are associated with this increased market transparency. For



example, a market maker that holds a customer limit order has, in



effect, a private "option" to execute the order as principal.



The longer this "option" remains open, the more time the market



maker has to determine whether it can profit from executing the



order as principal.-[115]- This private market maker



"option," however, is potentially detrimental to the execution



opportunities for the limit order. The Display Rule will limit



this "option" and expose the order to market-wide trading



interest. Moreover, increased price competition from limit



---------FOOTNOTES----------

-[113]- The commenter noted further that it does not

currently trade OTC securities because it cannot

be sure that its order will be represented to the

whole market. Estep Letter.



-[114]- See Market 2000 Study, at Study IV.



-[115]- The Commission recognizes that there is also a

cost associated with holding that limit order,

because a market maker is required to execute that

limit order if it has engaged in a transaction for

its own account that would have satisfied the

limit order. See Manning I & II, supra note 24.

==========================================START OF PAGE 52======



orders may reduce market maker profits through the narrowing of



spreads.-[116]- As a result, the Display Rule may force



less efficient competitors to stop making markets in some of the



securities they now quote.



Although the rule could lead to a reevaluation by some



market makers of the services they wish to provide, after



considering the available evidence, and in light of its



experience, the Commission does not believe that there will be a



significant negative impact on the markets for covered



securities. The Commission is not convinced that the loss of



some market competitors in securities with many market makers



would impair liquidity in these securities.-[117]- The



Commission believes that customer orders are the ultimate source



of liquidity to the markets, and that adoption of a rule that



improves the handling of such orders will have the effect of



enhancing market liquidity.-[118]- The Commission



---------FOOTNOTES----------

-[116]- See supra notes 53 - 55 and accompanying text

(display of customer limit orders in market maker

quotes will act to eliminate certain trading

behavior on Nasdaq and foster quote competition).



-[117]- See, e.g., STAIC Letter (limit orders are critical

to market liquidity).



-[118]- The Commission does not thereby denigrate the

contribution OTC market makers provide in a dealer

market. The Commission notes, however, that most

market makers provide primarily intra-day

liquidity to customers, and generally seek to end

the trading day with a limited inventory position

in order to minimize inventory risk. Customer

limit orders represent buying or selling interest

at specified prices for their stated duration,

which may be longer than intra-day. Market makers

(continued...)

==========================================START OF PAGE 53======



believes that a limit order display requirement will encourage



new limit orders in securities to be entered, thus providing



additional liquidity to the market from customers.-[119]-



The potential of limit orders to narrow quotes also may encourage



the entry of additional market orders.-[120]- The



Commission believes that the additional liquidity due to narrower



spreads and increased customer orders will outweigh any potential



loss of liquidity provided by market makers.



As noted above, some commenters expressed concern regarding



the effect of the Display Rule on the availability of liquidity



to small issuers.-[121]- In response to these comments,



the Commission's OEA examined market maker participation in 4,839



---------FOOTNOTES----------

-[118]-(...continued)

holding customer limit orders rely in part on

these limit orders in quoting their own prices to

buy and sell securities.



-[119]- See Greene Study & Greene Study II, supra note 51

(limit orders affect the quoted spread and provide

liquidity); NASD Study, supra note 21 (limit

orders, like market maker quotes, supply liquidity

to the markets); OEA Data, supra notes 50 and 52.



-[120]- See NASD Study, supra note 21 (those investors

that demand immediate execution, e.g. those

entering market orders, will pay less for

executions due to the augmented liquidity supplied

by limit orders); Greene Study and Greene Study

II, supra note 51 (limit orders provide liquidity

to traders that demand immediacy of execution and

may contribute to reduced trading costs); OEA

Data, supra notes 50 and 52 (display of limit

orders narrows spreads, improves price discovery,

and increases market depth for a variety of

securities, including those NYSE securities that

are thinly traded).



-[121]- This concern also was raised in the context of the

ECN Amendment to the Quote Rule.

==========================================START OF PAGE 54======



Nasdaq issuers over a one month period in 1996. The findings



indicate that: (1) the median number of market makers in a



security is not appreciably lower for initial public offering



("IPO") issuers or for securities with the smallest market



capitalization; (2) broker-dealers that participated in IPO



underwriting syndicates were active participants in aftermarket



trading, but were not alone in providing significant market maker



liquidity; and (3) in Nasdaq securities with the smallest market



capitalization ($2 million or less), the single most active



market maker in an issue typically participated in one-third or



fewer trades. Thus, there is no convincing evidence that Nasdaq



issuers, including IPO issuers, are dependent for liquidity on



any one market maker. The pattern of market making activity



indicates that significant liquidity is provided by market makers



who are not the "most active" market makers in a security.



Because there does not appear to be high concentration in market



making, and because of the Commission's belief that customer



order flow is a critical source of market liquidity, the



Commission believes that the proposals adopted today will not



unduly impact liquidity for small or new issuers.



Furthermore, Commission experience has been that



enhancements to transparency result in improved



liquidity.-[122]- The Commission believes that these



---------FOOTNOTES----------

-[122]- In several instances in the past, commenters have

claimed that other Commission initiatives to

increase transparency would act to reduce

liquidity; others have warned that such

(continued...)

==========================================START OF PAGE 55======



improvements are attributable, at least in part, to the impact of



transparency on market integrity and investor confidence. In



addition, while market maker profits per trade may be reduced as



spreads are narrowed, increased volume over time may result in



stable profit levels.-[123]-



---------FOOTNOTES----------

-[122]-(...continued)

initiatives would decrease the competitiveness of

the U.S. markets in relation to foreign

counterparts. These claims, however, have not

been borne out. For example, many industry

participants argued that the NASD's adoption of

its "Manning" rules would severely impact market

liquidity. See Market 2000 Study. However, there

has been no evidence offered to the Commission of

adverse liquidity consequences caused by these

limit order protections, and the Commission is not

aware of any significant diminution in liquidity.

Further, as discussed in the Market 2000 Study,

other transparency initiatives, such as the

adoption of real-time transaction and quotation

reporting, have resulted in increases in the

competitiveness and liquidity of both listed and

OTC equity markets despite market maker

protestations to the contrary prior to adoption of

these initiatives. See Id. at Study IV. See also

Simon & Colby, supra note 58. Even the creation

of Nasdaq itself was met with much opposition.

The result of this major structural change was far

from the predicted "death knell" of the OTC

market. Rather, OTC market strength and liquidity

have flourished since Nasdaq's inception. Based

on the Commission's experience with other market

structure initiatives, therefore, the Commission

believes that improvements in order handling,

market transparency, and efficiency will likely

improve market liquidity.



-[123]- Although the display requirement may decrease a

market maker's per trade profit due to narrowed

spreads, the Commission believes that this

decrease will be made up for in part by expected

increases in trading volume attributable to

enhanced liquidity and pricing efficiency. See

supra note 24. The Commission believes this

potential impact on market maker profits is

(continued...)

==========================================START OF PAGE 56======



It also may become feasible for market makers to charge



customers commissions for handling limit orders, even if that is



not the current practice today. As noted earlier, some



commenters claim that the Display Rule will have a disparate



impact on wholesale Nasdaq market makers in that such market



makers would not be able to offset the increased costs associated



with limit order display through charges or



commissions.-[124]- The Commission believes, however,



that the systems costs associated with the Display Rule should



not be overly burdensome,-[125]- nor should systems costs



or any reduced market maker profitability from declining spreads



be more extensive for wholesale market makers than for integrated



market makers. Although exchange specialists and integrated



firms may find it easier than wholesale firms to charge



commissions initially, the Commission notes that wholesale firms





---------FOOTNOTES----------

-[123]-(...continued)

justified in light of the benefits that will

accrue to investors and the markets as a whole.

Moreover, even if market makers' profits from

trading do decline, market makers may be able to

obtain increased revenues from commissions or

other fees charged directly to customers. Because

these other revenue sources are more transparent

to customers than are revenues from market maker

trading with customers on a proprietary basis,

increased reliance on these other revenue sources

will enable customers to make more informed

trading decisions.



-[124]- See, e.g., HHG Letter.



-[125]- See Memorandum from Stephen L. Williams, S.L.

Williams Co. to Richard R. Lindsey, Director,

Division of Market Regulation, SEC (July 29, 1996)

("Williams Study").

==========================================START OF PAGE 57======



are not prohibited from attempting to compensate for handling



limit orders, either through negotiated fee arrangements, or



reducing any payment made for order flow for limit



orders.-[126]-



iv. Discretion



Several commenters are concerned that the Display Rule would



eliminate their discretion to determine the best way in which to





---------FOOTNOTES----------

-[126]- The level of these fees, of course, would be

determined by competitive forces in the

marketplace. Any fees passed on to non-broker-

dealer customers would have to be disclosed in a

clear fashion to the customer, and otherwise

comply with applicable law. For example, NASD

Rule 2440 states, in part, that if a member acts

as agent for a customer in a transaction, the

customer shall not be charged more than a fair

commission or service charge, taking into

consideration all relevant circumstances. See

also NASD Regulatory & Compliance Alert Vol. 7,

No. 4 (December 1993). At least one commenter

argued that because spreads are ascertainable from

public quotations and commissions are not, a rule

that encourages charging commissions does not

satisfy the goal of increased transparency. See

Letter from Bruce C. Hackett, Managing Director,

Salomon Brothers Inc., to Jonathan G. Katz,

Secretary, SEC, dated January 25, 1996 ("Salomon

Letter"). The Commission notes, however, that

Rule 10b-10 under the Exchange Act requires

customer confirmations to disclose commissions

and, for listed and Nasdaq securities, the

difference between the reported price and the

price to the customer. Based on this disclosure,

execution costs could actually become better known

to customers if explicit fees are charged.

Therefore, the Commission believes that the

Display Rule will allow a customer to more easily

monitor the execution quality of its limit orders,

even if subject to fees for limit order

executions. In addition, this situation should

foster competition with respect to the amount, if

any, firms will charge for the execution of a

customer limit order.

==========================================START OF PAGE 58======



execute a customer's order. The commenters also claim that



customers rely on the judgment of a market professional in



choosing whether to display a limit order.-[127]- For



example, the NYSE believes that its current procedures allow



broker-dealers to achieve the best prices for their



customers.-[128]- Other commenters suggest that if the



rule were amended to require the display of representative size,



a dealer would retain some discretion on how best to execute the



order.-[129]- To preserve discretion, at least one



commenter argues that the rule should apply only when the



customer requests that its order be displayed.-[130]-



The Commission believes that the rule appropriately



establishes a presumption that limit orders should be displayed,



unless such orders are of block size, the customer requests that



its order not be displayed, or one of the exceptions to the rule



---------FOOTNOTES----------

-[127]- See, e.g., NYSE Letter; RPM Letter; Specialist

Assoc. Letter.



-[128]- See, e.g., NYSE Letter; Specialist Assoc. Letter.

According to the NYSE, a customer can choose to

benefit from the display of its order or to

benefit from relying on the specialist's

discretion, depending on whether the order is sent

to the post via SuperDOT, or is manually

submitted. The NYSE also notes that enabling a

specialist to use discretion in the handling of

limit orders is important in light of the fact

that the NYSE defines a limit order as an order to

buy or sell at a specified price, or at a better

price, if obtainable after the order is

represented in the trading crowd. See NYSE Rule

13.



-[129]- See, e.g., Madoff Letter; NASD Letter; SIA Letter.



-[130]- Jefferies Letter.

==========================================START OF PAGE 59======



applies. The exception allowing a customer to request that its



limit order not be displayed gives the customer ultimate control



in determining whether to trust the display of the limit order to



the discretion of a market professional, or to display the order



either in full, or in part, to other potential market



interest.-[131]-



v. Systems Burdens



Based on their belief that compliance with the Display Rule



would result in a large increase in quotation traffic, a number



of commenters maintain that the rule would require major



overhauls of the order handling systems used by brokers, market



makers and markets. For example, one commenter believes that it



would be impossible to comply with the rule without additional



automated systems.-[132]- The commenter concludes that



the costs associated with new systems and additional staff



necessary to monitor a more volatile market would contribute to













---------FOOTNOTES----------

-[131]- See discussion of the exceptions to the Display

Rule at section III.A.3.c., infra. See also

Section 240.11Ac1-4(c)(2); Section 240.11Ac1-

4(c)(4) (permitting a customer with a block size

limit order to request that the order be displayed

pursuant to the Display Rule). The Commission

does not mean to imply that a specialist or OTC

market maker that is not displaying a limit order

pursuant to the request of its customer may not

change its quotation in that security based on the

specialist's or market maker's own trading

interest.



-[132]- PaineWebber Letter.

==========================================START OF PAGE 60======



wider spreads and higher commissions.-[133]- In addition,



one SRO claims that quotation traffic must be kept at manageable



levels in order to allow entities to continue to manually process



limit orders, thus eliminating the need for entities to bear the



costs associated with automation of such orders.-[134]-



Other commenters also note their concern over the potential



operational costs associated with the rule.-[135]- The



STA states that an in-depth review is needed to determine the



costs for new equipment and technology necessary to comply with



the rule.-[136]-



A few commenters are concerned that the increased quotation



traffic that may be associated with the rule could pose a threat



to the integrity of the central quotation system.-[137]-



---------FOOTNOTES----------

-[133]- Id.; see also Bear Stearns Letter (noting that the

display rule would increase the volatility of

quotes and, as a result, market makers would have

a difficult time keeping up with the rapid changes

in bids, offers, and quote sizes).



-[134]- PSE Letter.



-[135]- See, e.g., Alex. Brown Letter; Bear Stearns

Letter; Jefferies Letter.



-[136]- STA Letter.



-[137]- See, e.g., Letter from Thomas J. Jordan, Financial

Information Forum, to Jonathan G. Katz, Secretary,

SEC, dated January 12, 1996 ("FIF Letter");

PaineWebber Letter; PSE Letter. This concern was

expressed with respect to the proposal that the

Commission adopt both the Display Rule and Price

Improvement Rule. The fact that the Commission

has deferred action on the Price Improvement Rule,

as discussed below, should substantially diminish

any system capacity concerns. Moreover, the

Commission's decision not to require display of de

(continued...)

==========================================START OF PAGE 61======



One commenter suggests that the rule be suspended for the first



30 minutes of trading.-[138]- Another commenter argues



that modifying the rule to require only the display of



representative size could act to alleviate some of the traffic



concerns.-[139]-



The Commission recognizes that achieving greater



transparency for limit orders depends upon the existence of



systems that are capable of the smooth and efficient display of



trading interest. The Commission believes that the Display Rule



will not substantially increase the quotation burden for exchange



markets, where systems currently exist for the display of



quotes.-[140]- In the OTC market, the Display Rule will



result in additional quotation entries for market makers that





---------FOOTNOTES----------

-[137]-(...continued)

minimis orders also should minimize system

capacity concerns.



-[138]- FIF Letter. According to FIF, the heaviest

traffic volume usually occurs within the first 30

minutes of trading.



-[139]- PSE Letter. The PSE notes, however, that the

rule, even if modified, still may result in an

increase in staffing costs. Id.



-[140]- For example, SuperDOT data indicates that 57% of

all customer trades originating from orders routed

through SuperDOT are limit orders. Of these limit

orders, 20% narrowed the NYSE quote. See supra

note 52. According to the NYSE, 93% of such

orders are reflected in the NYSE quote within two

minutes of receipt. See supra note 36 and

accompanying text (teleconference). See also CSE

Letter (costs associated with implementing such a

system are minimal, especially in light of the

benefits to the public); Paperwork Reduction Act

discussion at section VII, infra.

==========================================START OF PAGE 62======



display customer limit orders in their quotes. The Commission



believes, however, that current systems can handle the additional



volume, or can be expanded at moderate cost to handle the



additional volume.-[141]- Further, the Commission notes



that the Display Rule contains an exception to the display



requirement for limit orders of de minimis size priced at the



NBBO when the market maker's or specialist's quote matches the



NBBO.-[142]- The Display Rule also allows a specialist or



OTC market maker several ways to comply with the rule by routing



the order elsewhere without displaying the limit order in its own



quote by transmitting a customer limit order to an exchange- or



association-sponsored system or to a qualifying ECN.



Additionally, a few commenters believe that the Commission





---------FOOTNOTES----------

-[141]- The Commission notes that many small to medium

broker-dealers utilize shared trading systems that

enable such broker-dealers to streamline their OTC

market making and back office responsibilities.

Subscribers to such systems benefit by sharing

costs associated with the application of improved

technologies, rather than creating and updating

systems of their own. Therefore, it is assumed

that any changes deemed necessary to these shared

systems to facilitate efficient compliance with

the Display Rule also would be shared by all

subscribers.



In addition, the Commission specifically evaluated the costs

associated with implementation of the Display Rule. Based

on this evaluation, the Commission concluded that most

market makers will not be required to invest substantial

amounts of money in systems development in order to comply

with the Display Rule as adopted. See Williams Study, supra

note 125. See also CSE Letter (costs of implementing a

system for display of limit orders are minimal).



-[142]- See, Section 240.11Ac1-4(b)(1)(ii). See also

Section 240.11Ac1-4(b)(2)(ii).

==========================================START OF PAGE 63======



should give more consideration to the Display Rule's impact on



automatic execution systems.-[143]- These commenters



express concern that a market maker could be exposed to multiple



transactions from its own customers in the firm's automatic



execution system, which executes orders at the NBBO, even if the



NBBO represents a customer limit order as opposed to the price at



which a market maker is willing to trade. They claim this result



is unfair, especially if the automatic system has a minimum share



requirement that exceeds the customer limit order.



The Commission acknowledges the concern of some commenters



regarding the rule's interaction with automated execution



systems. However, because customer limit orders reflect actual



trading interest, it has been the Commission's intention to



enhance customer order executions throughout the markets by



requiring the display of these customer limit



orders.-[144]- Where a limit order represents the best





---------FOOTNOTES----------

-[143]- See, e.g., Dillon Letter; HHG Letter; Merrill

Letter; PaineWebber Letter; Schwab Letter.



-[144]- The Commission recognizes that SROs may have rules

regarding the minimum quotation sizes associated

with a specialist's or market maker's quote. The

Commission believes that SROs should consider

amending such rules and modifying certain systems

to allow a specialist or market maker to quote in

sizes smaller than the minimum quotation size when

such quote represents a customer limit order.

With these changes, a specialist or market maker

that displays a customer limit order in its quote

pursuant to the Display Rule would not be

responsible for executing as principal any

additional shares at the limit price where the

size of the customer limit order is less than the

minimum quotation size set by the SRO.

==========================================START OF PAGE 64======



quote, a market maker can respond by sending its customer order



to the market maker displaying the limit order at the NBBO,



thereby attempting to execute the limit order setting that price



and removing it as the NBBO.-[145]- Moreover, where the



size of a limit order represented in the best quote is smaller



than the size eligible for execution in an automated execution



system, the Commission believes that it is not inconsistent with



best execution principles for market makers and specialists using



automated execution systems to take into account the size of the



limit order quote in determining the price at which an order, or



portions thereof, should be automatically executed. The



Commission believes, however, that in such a case the market



maker or specialist should provide the customer order an



execution at the displayed price at least up to the displayed



size of the limit order.-[146]- For example, if customer



limit orders compose the NBBO of 10 1/4 - 10 1/2 (100 x 300), and





---------FOOTNOTES----------

-[145]- The Commission notes that the NASD's NAqcess

system, as proposed, would permit market makers to

send orders, including proprietary orders, to

other market makers through the system. See supra

note 45. See also ITS Plan. Moreover, the

Commission believes that the NASD should consider

modifying its SOES system to allow OTC market

makers to route customer orders for execution

against limit orders displayed by another market

maker in the same security.



-[146]- If the market maker or specialist attempted but

was unable to execute the displayed limit order

through a reasonable and efficient means, such as

sending an order through an automated system for

an OTC security, the market maker or specialist

would not be expected to give that limit order

price to its customer.

==========================================START OF PAGE 65======



a market maker receives a market order to sell 1,000 shares via



an automatic execution system, the market maker may automatically



execute 100 shares of the order at 10 1/4, and the remaining



portion of the order at the next best bid.



3. The Operation of the Rule As Adopted-[147]-



The rule as adopted applies to: (i) every member of an



exchange that is registered by that exchange as a specialist or



has been authorized by an exchange to perform functions



substantially similar to that of a specialist ("specialist"); and



(ii) OTC market makers.-[148]- The rule as adopted



applies to specialists that trade on the floor of an



exchange;-[149]- third market makers;-[150]-



members of a national securities association that are OTC market



makers;-[151]- and specialists that trade an OTC security



pursuant to unlisted trading privileges ("UTP").-[152]-



These market makers are required to reflect immediately in their



bid or offer the price and the full size of each customer limit



order they hold at a price that would improve their bid or offer



---------FOOTNOTES----------

-[147]- SRO rules that impose more stringent standards

would continue to apply.



-[148]- Although the Commission consolidated certain

sections of the proposed rule for clarity, the

rule as adopted applies to the same entities

identified in the proposed rule.



-[149]- Section 240.11Ac1-4(b)(1).



-[150]- Section 240.11Ac1-4(b)(2).



-[151]- Section 240.11Ac1-4(b)(2).



-[152]- Section 240.11Ac1-4(b)(1).

==========================================START OF PAGE 66======



in the security.-[153]- In addition, all market makers



covered by the rule are obligated to reflect in their quotes the



full size of a customer limit order that: (1) is priced equal to



their bid or offer; (2) is priced equal to the national best bid



or offer for the security; and (3) represents more than a de



minimis change in relation to the size associated with their bid



or offer.-[154]-



a. "Covered Securities" and "Customer Limit

Orders"



Rule 11Ac1-4 applies to "customer limit orders" in "covered



securities." A covered security is defined as any reported





---------FOOTNOTES----------

-[153]- Section 240.11Ac1-4(b)(1)(i) and (b)(2)(i). The

Commission wants to clarify that references to a

specialist's or OTC market maker's bid or offer

include instances where the bid or offer is a

proprietary quote, as well as instances where the

bid or offer represents a customer limit order.

Further, if a market maker is not quoting publicly

(e.g., a market maker that does not meet the 1%

threshold of the Quote Rule), it still must

publish a quotation that displays the limit order,

or avail itself of one of the exceptions.



Moreover, the Commission notes that some commenters suggest

that the rule should require broker-dealers that are not

specialists or OTC market makers to immediately transmit

limit orders they receive to an entity or system that will

display the orders in a manner consistent with the rule.

See, e.g., CSE Letter; Madoff Letter; Whitcomb Letter.

Also, at least one commenter believes that institutional

firms trading in block size should be considered "OTC market

makers" for purposes of the rule and subject to the display

requirement. Amex Letter. See generally infra notes 191 -

193 and accompanying text. The fact that the Commission has

not adopted these suggestions as part of the Display Rule

does not relieve broker-dealers which receive such orders

from compliance with their obligation to obtain best

execution for those orders.



-[154]- Section 240.11Ac1-4(b)(1)(ii) and (b)(2)(ii).

==========================================START OF PAGE 67======



security and any other security for which transaction reports,



last sale data or quotation information is disseminated through



an automated quotation system that is sponsored by a registered



securities association. This definition is designed to encompass



all exchange-listed securities, Nasdaq National Market securities



and Nasdaq SmallCap securities.-[155]-



The Commission received several comments regarding the



application of the rule to Nasdaq securities. Some commenters



believe that the rule should not extend to all Nasdaq securities,



and that some measure of liquidity should be used to determine



which Nasdaq securities should be subject to the



rule.-[156]- For example, one commenter suggests limiting



the rule's application to the top 250 Nasdaq National Market



securities with the highest average daily trading volume over the



previous calendar quarter.-[157]- In contrast, another



commenter favors the inclusion of Nasdaq SmallCap securities









---------FOOTNOTES----------

-[155]- Securities listed on regional exchanges that do

not substantially meet NYSE or Amex original

listing criteria do not satisfy the definition of

"covered security." Such securities are not

"reported securities" as that term is defined, nor

do they meet the other elements of the definition

of covered security. OTC Bulletin Board ("OTCBB")

securities also do not satisfy the definition of

covered security. The Commission has determined

not to extend the display requirement to any of

those securities at the present time.



-[156]- See, e.g., Bear Stearns Letter; Lehman Letter;

Merrill Letter; NASD Letter; SIA Letter.



-[157]- SIA Letter.

==========================================START OF PAGE 68======



within the definition of "covered security."-[158]-



Further, at least one commenter suggests that the rule apply not



only to all Nasdaq securities, but also to OTCBB



securities.-[159]-



As noted above, the Commission believes that the Display



Rule should apply equally to exchange-traded as well as non-



exchange-traded securities. In addition, the Commission believes



it is appropriate to include all Nasdaq securities within the



definition of "covered security." The Commission believes that,



regardless of the current trading volume of a particular



security, the investors in any security can benefit from the



uniform display of customer buying and selling interest if all



quotations in that security are required to be firm. As noted



previously,-[160]- data analyzed by the Commission shows



that limit orders are used frequently for transactions in NYSE



securities with ADTVs under $100,000. On average, 63% of



customer orders in such securities are limit orders. Of those



limit orders, 30% narrowed the NYSE quote and 32% matched the



quote. This data indicates that the display requirement may lead



to increased customer trading interest in securities that are



currently thinly traded.-[161]-



---------FOOTNOTES----------

-[158]- PSE Letter.



-[159]- Ricker Letter.



-[160]- See supra notes 50 and 52.



-[161]- As stated previously, because dealers are not

required to register as OTC market makers in OTCBB

(continued...)

==========================================START OF PAGE 69======



The Commission reiterates that limit order display is not



solely an issue of improved transparency. The Display Rule will



improve the handling of customer orders across all markets and



increase the probability that a customer limit order will be



executed. Therefore, the Commission believes that a uniform



limit order display requirement is closely related to a broker-



dealer's ability to obtain best execution for limit orders.



The Commission recognizes, however, that the rule represents



a significant change for the OTC market. The Commission,



therefore, has determined to provide a phase-in period for



application of the rule to customer limit orders in Nasdaq



securities.-[162]- The Commission believes that the



phase-in period will allow the Commission to monitor the effects



of the rule on the most liquid Nasdaq securities first, while



ensuring that customer limit orders in all Nasdaq securities will



receive the benefits of the rule within one year of its adoption.



This schedule also will provide OTC market makers with time to



adjust their systems to comply with the rule's



requirements.-[163]-



Under the rule, a customer limit order includes any order to



---------FOOTNOTES----------

-[161]-(...continued)

securities and are not required to enter and

maintain continuous firm two-sided quotations in

OTCBB securities, the Commission does not believe

that the Display Rule should be extended to such

securities at this time.



-[162]- See description of the phase-in at section

III.A.3.d., infra.



-[163]- See, e.g., Amex Letter.

==========================================START OF PAGE 70======



buy or sell a covered security at a specified price not for the



account of a broker or dealer. Customer limit orders transmitted



from one broker-dealer to another for execution are included in



the definition. Although some commenters believe that the rule



should be extended to orders for the account of a broker or



dealer, the Commission does not believe such extension is



appropriate at this time. The Commission acknowledges that the



display of all limit orders, including those of a broker or



dealer, would further enhance transparency.-[164]-



Requiring the display of broker-dealer limit orders, however,



would be a significant extension of the rule that could change



its impact on market maker participation and increase its



operational burdens. Therefore, the Commission believes that the



effects of the rule should be observed, and additional comment



should be solicited, before the rule is expanded.-[165]-



b. Size



As noted above, some commenters expressed concern regarding



the requirement that specialists and OTC market makers display





---------FOOTNOTES----------

-[164]- The Commission also is sensitive to the fact that

providing suitable opportunities for broker-

dealers, including options market makers, to lay

off risk is an important component of overall

market liquidity and efficiency. See Manning II,

supra note 24.



-[165]- The Commission notes that other actions recently

taken by the Commission address certain anti-

competitive behavior in the Nasdaq market that

heretofore may have negatively impacted the

ability of some broker-dealers, including options

market makers, to efficiently perform their market

making function. See 21(a) Report, supra note 28.

==========================================START OF PAGE 71======



the full size of a customer limit order. These commenters



suggest that the rule only require the display of representative



size.-[166]- They argue that the use of representative



size would preserve the ability of a specialist or OTC market



maker to exercise some discretion in determining the best



execution of the order.-[167]-



Other commenters, however, believe that the full size of a



customer limit order should be required to be



displayed.-[168]- Such commenters argue that the display



of full size is an important element in the Commission's effort



to improve transparency and, therefore, no dealer discretion



should be permitted unless a customer expressly requests that its



order not be displayed, or expressly grants discretion, pursuant



to the Display Rule.-[169]-



The Commission continues to believe that the display of full



size is important to improved transparency. The display of full



size will provide the most accurate picture of the depth of the







---------FOOTNOTES----------

-[166]- See, e.g., BSE Letter; CSE Letter; Madoff Letter;

NASD Letter; NYSE Letter; PSE Letter; SIA Letter;

Specialists Assoc. Letter; see also LJR Letter

(questioning whether the display of size, at least

with respect to institutional orders, would be

consistent with best execution obligations).



-[167]- See, e.g., Madoff Letter; NASD Letter; NYSE

Letter; SIA Letter; Specialists Assoc. Letter.



-[168]- See, e.g., Amex Letter; CHX Letter; D.E. Shaw

Letter.



-[169]- See, e.g., Amex Letter; CHX Letter; D.E. Shaw

Letter; ICI Letter.

==========================================START OF PAGE 72======



market at a particular price.-[170]- The Commission



believes that size, as well as price, is a factor in attracting



order flow and that the display of full size increases the



likelihood that a limit order will be executed. The Commission,



however, understands that there may be instances where a customer



would not want its order displayed, or does not want the full



size of its order displayed. The Display Rule, therefore, still



contains an exception for a customer that decides to rely on the



discretion of a broker-dealer rather than to take advantage of



the display requirement for its limit order.-[171]- The



Display Rule also permits a customer to state explicitly what



---------FOOTNOTES----------

-[170]- A few commenters believe that all customer limit

orders should be displayed, including the size of

those orders that equal the specialist's or OTC

market maker's bid or offer, but are not equal to

the NBBO. See, e.g., CHX Letter; Letter from

Edward J. Johnsen, Vice President and Counsel,

Morgan Stanley & Co., to Jonathan G. Katz,

Secretary, SEC, dated January 16, 1996 ("Morgan

Stanley Letter"); Peake Letter; Weaver Letter.

The Commission believes, however, that the burden

associated with the commenters' suggestion would

outweigh the corresponding benefit to market

transparency. Of course, the rule represents a

floor, rather than a ceiling. An exchange,

association, or broker-dealer may determine to

adopt more stringent display requirements.



Requiring display of size when the limit order is away from

the NBBO and equals the market maker's or specialist's quote

would provide some additional market information but also

would require market makers not quoting at the NBBO to

change their quote size on an ongoing basis. Although some

market makers or specialists may choose to do so to be

prepared if their quotation becomes the NBBO, on the whole

the Commission believes the increased transparency that

would result from this updating would not outweigh the

burdens imposed by a display requirement.



-[171]- Section 240.11Ac1-4(c)(2).

==========================================START OF PAGE 73======



portion, if any, the customer wants displayed.-[172]-



Furthermore, the Display Rule contains other exceptions to the



display requirement that will ease any potential operational



burdens associated with the display of full size.-[173]-



The following example illustrates the application of the



Display Rule where a customer limit order improves the price of a



specialist's or market maker's quote. Assume that a market maker



covered by the rule is quoting 10 - 10 1/2 (2,000 x 2,000) when



it receives a customer limit order in a covered security to buy



4,000 shares at 10 1/4. Under the rule, the market maker must



change the price and size associated with its quote to 10 1/4 -



10 1/2 (4,000 x 2,000). If this new quote represents the NBBO,



the Display Rule would require the market maker to increase the



size associated with the quote upon the receipt of additional



customer limit orders. For example, if the market maker



subsequently accepts another customer limit order to buy 4,000



shares at 10 1/4, the market maker must change its quote to 10



1/4 - 10 1/2 (8,000 x 2,000).



---------FOOTNOTES----------

-[172]- Id.



-[173]- As noted above, a specialist or OTC market maker

has the ability to execute a customer limit order

upon receipt; transmit the order to another

exchange member or OTC market maker that will

display the limit order in accordance with the

rule; or transmit the order to an exchange or

association sponsored system pursuant to the rule.

Additionally, a specialist or OTC market maker may

transmit an order to an ECN that provides for

public display of limit orders and provides access

to these orders. Moreover, the rule contains an

exception to the display requirement for certain

orders of de minimis size.

==========================================START OF PAGE 74======



The rule as adopted contains a de minimis standard



applicable in situations where a customer limit order equals a



specialist's or market maker's displayed price and that price is



equal to the NBBO. One commenter states that the use of



representative size would eliminate the Commission's need to rely



on a de minimis standard.-[174]- Another commenter



believes that the rationale underlying the de minimis standard



demonstrates that the display of size does not benefit public



customers.-[175]- Some commenters also believe that the



de minimis standard should be clarified or even



eliminated.-[176]-



The Commission proposed the de minimis standard to strike a



balance between the benefits of increased transparency and



operational burdens that might arise under the display



requirement in displaying limit orders irrespective of size. The



de minimis standard was intended to reduce the burdens of



displaying the smallest of limit orders where the frequent



updating of the quote for smaller orders would not result in



significant improvements in quotation size. The Commission



believes that the size of a customer limit order should be



considered de minimis if it is less than or equal to 10% of the



displayed size associated with a specialist's or OTC market







---------FOOTNOTES----------

-[174]- CSE Letter.



-[175]- Dean Witter Letter.



-[176]- See, e.g., Amex Letter; CHX Letter; Schwab Letter.

==========================================START OF PAGE 75======



maker's bid or offer.-[177]-



The Commission believes that this de minimis standard will



ease potential operational burdens associated with the display of



additional size in a specialist's or OTC market maker's quote.



The following example illustrates the application of the de



minimis standard.



Assume a market maker's quote is 10 - 10 1/2 (1,000 x



1,000), and the NBBO is 10 - 10 1/4 when the market maker



receives a customer limit order to buy 2,000 shares at 10. Under



the rule, the market maker is obligated to change the size of its



quote immediately to 10 - 10 1/2 (3,000 x 1,000).-[178]-



In this case, the 2,000 share order size is more than de minimis



in relation to the size associated with the market maker's quote.



If the limit order was for 100 shares, however, the market maker



would not be required to change its quotation size because the



order is de minimis in relation to its quote.-[179]-



---------FOOTNOTES----------

-[177]- Any SRO may set more stringent display

requirements through its own rules.



-[178]- If the original 1,000 shares displayed represents

the market maker's proprietary quote and,

consistent with Rule 11Ac1-1, the market maker no

longer wishes to trade for its own account at 10,

the market maker may quote at 10 - 10 1/2 (2,000 x

1,000).



-[179]- The Commission stresses that all other orders

previously considered de minimis and not displayed

must be added to the order under consideration for

purposes of the de minimis calculation.

Therefore, in the case of a 100 share limit order

to buy at 10, where the market maker had a

previous 100 share limit order to buy at 10 that

was not displayed pursuant to the de minimis

(continued...)

==========================================START OF PAGE 76======



Alternatively, the market maker could voluntarily display the



additional 100 shares.



c. Exceptions



The rule requires the "immediate" display of certain



customer limit orders. To satisfy this requirement, a specialist



or OTC market maker must display the limit order immediately upon



receipt unless there exists an applicable exception to the



display requirement. Some commenters have asked for



clarification of the "immediate" display



requirement.-[180]- The Commission is mindful that some



measure of time is needed for specialists or market makers to



display limit orders in the quote. Assuming that a specialist or



OTC market maker does not rely on one of the exceptions to the



Display Rule, however, such specialist or OTC market maker must



display the order as soon as is practicable after receipt which,





---------FOOTNOTES----------

-[179]-(...continued)

standard, both orders must be considered together

for purposes of making the de minimis calculation.

Because 200 shares is more than 10% of the

displayed size of 1,000, the market maker must

include the 200 shares in its quote.



The Commission notes that if an OTC market maker chooses not

to display a de minimis limit order, the NASD's

interpretation regarding limit orders would prohibit the

market maker from trading ahead of the limit order. See

Manning I & II, supra note 24. In addition, the NASD has

indicated that market makers must establish and consistently

follow policies regarding the priority in which limit orders

received from customers, which would include de minimis

orders, will be executed. See Special NASD Notice to

Members 95-43 (June 5, 1995).



-[180]- See, e.g., Amex Letter; D.E. Shaw Letter; NYSE

Letter; PSE Letter.

==========================================START OF PAGE 77======



under normal market conditions, would require display no later



than 30 seconds after receipt.-[181]-



There are seven exceptions to the general requirements of



the rule. The first exception applies to any customer limit



order that is executed upon receipt of the order.-[182]-



If the order is executed upon receipt, then no duty arises under



the rule.



The second exception applies to any limit order that is



placed by a customer who expressly requests that the order not be



displayed.-[183]- This request may take place on an order



by order basis, or may be agreed to prospectively. Most



commenters that addressed the issue were in favor of the



exception.-[184]- The Commission included this exception



because there could be instances in which a customer prefers to



exclude its order from public display. For example, a customer



with a large limit order could wish to let its broker work the





---------FOOTNOTES----------

-[181]- The Commission stresses that specialists and OTC

market makers still are under an obligation to

protect the customer limit order even during the

time the limit order is not displayed. See, e.g.,

Manning I & II, supra note 24 (prohibiting trading

ahead of customer limit orders). It should also

be noted that this standard would supersede SRO

rules that are less stringent with regard to the

time in which limit orders are to be displayed.

Those rules that impose more stringent standards

may continue to apply.



-[182]- Section 240.11Ac1-4(c)(1).



-[183]- Section 240.11Ac1-4(c)(2).



-[184]- But see, e.g., Madoff Letter; Morgan Stanley

Letter.

==========================================START OF PAGE 78======



order rather than display the entire order. This exception gives



the customer the right to decide if the order should be displayed



in its entirety, in part, or not at all.-[185]- The



Commission notes that under this exception, a customer may leave



the decision to display an order to the discretion of a broker-



dealer. Therefore, rather than instructing a broker-dealer not



to display an order, a customer, consistent with this exception,



may instruct the broker-dealer to use its discretion in



determining whether to display the order. Although allowing some



orders to not be displayed or to be displayed partially in the



system reduces transparency, the Commission believes this



exception is appropriate to give investors flexibility in



deciding how their orders should be handled.



The exception to the rule requires a customer to expressly



request that an order not be displayed.-[186]- A customer



request that an order be placed in a particular non-public



trading system would not, by itself, be deemed to be a non-



---------FOOTNOTES----------

-[185]- Any portion of a customer limit order that is not

displayed pursuant to this exception shall not be

included in the calculation for determining

whether any other limit order is de minimis. See

supra note 179.



-[186]- At least one commenter believes that documentation

of such customer requests should be required. CHX

Letter. Although the Commission does not believe

it necessary to mandate a particular method of

record keeping, the Commission expects the

compliance departments of individual firms to

discharge their responsibilities in such a manner

as to allow adequate supervision of compliance

with the customer's request not to display or to

display pursuant to discretionary authority

provided by the customer.

==========================================START OF PAGE 79======



display request. The Commission expects that most retail



customers will want their limit orders displayed pursuant to the



rule. Thus, the Commission has written the rule to require



specialists and OTC market makers to assume that retail customers



wish to have their orders displayed unless the customer



specifically requests that the order not be displayed.



The exception also permits any customer to negotiate with



its broker-dealer an individual agreement regarding the display



of its limit orders either on an order-by-order basis or



prospectively. Standardized disclaimers or contractual language



in broker-dealer new account agreements, however, would not be



deemed to be an individual request by a customer that its order



or orders not be displayed.



The third exception applies to odd-lot orders.-[187]-



The rule does not require the display of an order for less than a



unit of trading as established by the rules of the exchange or



association. In the event that a round-lot limit order



represented in the quote is partially filled and, as a result,



the remainder of the order would then be deemed an odd-lot order,



the remainder of the order may be treated as an odd-lot for



purposes of this exception. For example, assume a market maker



is quoting at the NBBO (10 1/4 -10 3/8 (200 x 1000)) and is



representing a 200 share customer limit order to buy when a



market order to sell 150 shares is received. Upon execution of



150 shares of the 200 share customer limit order, the market



---------FOOTNOTES----------

-[187]- Section 240.11Ac1-4(c)(3).

==========================================START OF PAGE 80======



maker is not required to display the remaining 50 shares of the



order at 10 1/4.-[188]-



The fourth exception applies to block size



orders.-[189]- Orders of at least 10,000 shares or for a



quantity of stock having a market value of at least $200,000 need



not be displayed in accordance with the rule, unless the customer



so requests.-[190]- The Commission recognizes that the



display of block size orders would add to market transparency.



In practice, however, the handling of block size orders differs



from other orders. For example, in the OTC market, market makers



often negotiate terms and conditions with respect to the handling



of block size orders, and display of block size orders may impact



market maker quotations in a security more than would smaller





---------FOOTNOTES----------

-[188]- The market maker still will have best execution

obligations with respect to the remaining odd-lot

portion of the customer limit order.



-[189]- Section 240.11Ac1-4(c)(4).



-[190]- This block definition is consistent with the

current definition used in NYSE Rule 127.10. Some

commenters, however, suggest that the parameters

for such orders be increased or made flexible

depending on the liquidity of a particular

security. See, e.g., D.E. Shaw Letter; PSE

Letter; Schwab Letter. Still others believe that

there should be no exception for orders of block

size. Instead, these commenters want such orders

to be included within the scope of the rule so as

to add to market transparency. See, e.g., Amex

Letter; ICI Letter; Lehman Letter; Peake Letter;

Ricker Letter. One commenter suggests the use of

a "block indicator" to give a specialist or OTC

market maker the option of displaying the full

size of the order or using the indicator to

identify the quote as representing a block size

order. Lehman Letter.

==========================================START OF PAGE 81======



limit orders.-[191]- Further, one of the major objectives



in proposing the Display Rule was to improve the handling and



execution opportunities afforded to customers that lack the power



to negotiate better terms. Because most investors that trade in



block size have such power, the Commission has chosen not to



mandate the display of block size orders, unless the customer so



requests.-[192]- The Commission is satisfied that the



current definition strikes an appropriate regulatory balance by



requiring a presumption in favor of display for those orders



requiring enhanced protection, while not extending the



presumption to those orders less likely to need such protection.



Of course, the Commission may reevaluate its treatment of block



size orders at a later date.



As proposed, the fifth exception would have applied to a



limit order that is delivered immediately to an exchange or



association sponsored system that displays limit orders and



complies with the requirements of the rule with respect to that



order.-[193]- This exception did not relieve a specialist



---------FOOTNOTES----------

-[191]- See, e.g., Manning II, supra note 24.



-[192]- Customers placing block orders, however, may

request that the order be displayed in accordance

with the requirements of the rule; a specialist or

OTC market maker that accepts the order will be

obligated to honor such a request. Section

240.11Ac1-4(c)(4). The Commission expects that

adequate procedures will be developed to ensure

compliance with a customer request. See supra note

186.



-[193]- Section 240.11Ac1-4(c)(5). A facility would not

be deemed to comply with the requirements of the

(continued...)

==========================================START OF PAGE 82======



or OTC market maker from its display obligation for orders it



received through exchange or association facilities, unless the



facility itself displayed the order.-[194]-



In the Proposing Release, the Commission requested comment



on whether to extend this exception from display to instances



where customer limit orders are sent to ECNs or PTSs by a



specialist or OTC market maker.-[195]- As discussed below



in connection with the amendments to the Quote Rule, the



Commission is amending the Quote Rule to require specialists and



---------FOOTNOTES----------

-[193]-(...continued)

Display Rule if the highest priced buy orders and

lowest priced sell orders entered by a specialist

or OTC market maker in the facility for a

particular security were not included in

calculating the best bid and offer for the market

and incorporated in the consolidated quote.



-[194]- One commenter argues that the exception permits

specialists and OTC market makers to become "fair

weather dealers," effectively allowing them to

selectively withdraw from the national market

system, which creates a misleading picture of

liquidity. Madoff Letter. The Commission

believes, however, that the exception provides a

specialist or OTC market maker with an appropriate

amount of discretion in handling a customer limit

order while ensuring that orders at the best price

are displayed to the marketplace.



-[195]- See, e.g., Letter from James Lynch, General

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

Secretary, SEC, dated, January 15, 1996 ("POSIT

Letter") (not supporting the extension of the

exception); PSE Letter (extension of exception

should be contingent on access provided by ECNs);

Whitcomb Letter (doubtful that exception could be

extended in today's environment); see also Madoff

Letter (market makers and specialists should be

able to represent a portion of the size of a

customer limit order in other markets or ECNs, but

the best price and some size should be reflected

in their quote).

==========================================START OF PAGE 83======



OTC market makers to include priced orders they enter into ECNs



in the bids and offers they communicate to their exchange or



association for reflection in their published quotations, when



such orders improve their published quotations.-[196]- In



recognition of the concerns raised by commenters, the Commission



also has included an alternative to the amendment designed to



preserve the anonymity of specialists and OTC market makers that



is currently provided by certain ECNs, while still publicizing in



the public quotation stream better prices entered into ECNs. The



ECN display alternative in the Quote Rule is available only if



the ECN provides for public dissemination of the price and full



size of the orders entered by specialists and OTC market makers



to an exchange or association and provides access to other



broker-dealers to trade at those prices which is equivalent to



that provided in the market where the prices are



disseminated.-[197]-



The Commission believes that ECNs that provide their best



specialist and market maker prices to the public quotation system



and provide ready access to their prices can provide an effective



---------FOOTNOTES----------

-[196]- See Section 240.11Ac1-1(c)(5)(i)(A); see also

Amendments to the Quote Rule discussion at section

III.B.2.c.ii., infra.



-[197]- As discussed, the Commission expects the SROs to

work expeditiously with ECNs that wish to avail

themselves of this alternative, and is prepared to

act if necessary to ensure the effectiveness of

the ECN display alternative, prior to the

effective date of the Quote Rule amendments. See

Introduction and Summary, supra; see also Section

240.11Ac1-1(c)(5)(ii); Amendments to the Quote

Rule discussion at section III.B.2.c.iii., infra.

==========================================START OF PAGE 84======



means for specialists and OTC market makers to ensure that



customer limit orders are handled in a manner consistent with the



Display Rule. In view of the ECN display alternative in the



Quote Rule, the Commission believes it is appropriate to extend



the exception in the Display Rule to orders entered into ECNs



that comply with the Quote Rule alternative.-[198]-



Accordingly, a specialist or OTC market maker that delivers a



customer limit order to an ECN will be deemed to have satisfied



its display obligation with regard to that order if the ECN



complies with the requirements of the new alternative in the



Quote Rule.-[199]- The proposed exception for limit



orders entered into exchange or association sponsored systems



contemplated that such orders would be transparent and



accessible. Therefore, expanding the exception to include the



use of ECNs that provide for the requisite transparency and



accessibility is consistent with the rule as proposed.



The Commission notes that this exception to the Display Rule



maintains the benefits, including increased transparency,





---------FOOTNOTES----------

-[198]- See Amendments to the Quote Rule discussion at

section III.B.2.c.i., infra, for a description of

the ECN definition; see also Section 240.11Ac1-

1(a)(8); Section 240.11Ac1-4(a)(8).



-[199]- Section 240.11Ac1-4(c)(5). See also, Amendments

to the Quote Rule discussion on accessibility at

section III.B.2.c.iii., infra. Additionally, a

specialist or OTC market maker may be relieved of

its display obligation if it delivers the customer

limit order to an exchange or association

sponsored system that complies with the new

alternative in the Quote Rule. Section 240.11Ac1-

4(c)(5).

==========================================START OF PAGE 85======



provided to customer limit orders under the rule. The exception



ensures that customer limit orders will have equivalent public



disclosure whether they are sent to an ECN that complies with the



alternative or displayed directly in a specialist's or OTC market



maker's quote.-[200]-



The sixth exception applies to a limit order that is



delivered to another exchange member or OTC market maker that



complies with the display requirements of the rule with respect



to that order.-[201]- For example, a market maker that



receives a limit order subject to the display requirement under



the rule may immediately send the order to another market maker



in the security if the other market maker will display the order



in accordance with this rule.-[202]-



The seventh exception applies to "all-or-none limit orders."



An "all-or-none limit order" is an order accompanied by the



customer's instruction that the order is to be executed in its





---------FOOTNOTES----------

-[200]- An OTC market maker or specialist choosing to

enter customer limit orders for display through an

ECN must still evaluate whether the customer order

is likely to obtain best execution through display

in that ECN. See section III.C.2., infra.



-[201]- Section 240.11Ac1-4(c)(6).



-[202]- One commenter believes that the rule should

require a specialist or OTC market maker to obtain

assurances that a customer's limit order will be

displayed in accordance with the rule before such

an order is sent. MJT Letter. But see PSE

Letter; Salomon Letter. As noted earlier, the

Commission believes that it is best left to a

firm's compliance department to decide on the

necessary assurances that the order will be

displayed in conformance with the rule.

==========================================START OF PAGE 86======



entirety or not at all.-[203]- Although this exception



was not included in the proposed rule, the Commission believes



that exempting all-or-none limit orders is necessary to avoid



operational difficulties regarding partial executions at the



public quote.-[204]- In this regard, all-or-none limit



orders typically are not displayed in the exchange markets



today.-[205]- The Commission believes, therefore, that



this exception is consistent with the goals and objectives of the



Display Rule.



Finally, a new provision has been included that enables the



Commission to exempt, conditionally or unconditionally, any



transactions that it may determine are not encompassed within the



purposes of the Display Rule. The Commission believes that this



exemptive authority provides flexibility in applying the Display



Rule.-[206]-



d. Effective Date and Phase-In



The Display Rule will become effective on [insert date 120



days from the date of publication in the Federal Register]. As



of this date, the Display Rule will apply to exchange-traded



securities. Moreover, this date will mark the beginning of the



---------FOOTNOTES----------

-[203]- See, e.g., NYSE Rule 13.



-[204]- For example, if an all or none order to buy 1,000

shares at 10 1/4 were displayed in the quote and

represented the NBBO, a subsequent market order to

sell 500 shares could not be matched against the

all or none order.



-[205]- See, e.g., NYSE Rule 13.



-[206]- Section 240.11Ac1-4(d).

==========================================START OF PAGE 87======



first phase-in for Nasdaq securities. As of this date, the



Display Rule will apply to the 1,000 Nasdaq securities with the



highest average daily trading volume in the previous quarter.



The second phase-in date will be on March 28, 1997. From



this date forward, the Display Rule will apply to the next 1,500



Nasdaq securities with the highest average daily trading volume



over the previous quarter.-[207]-



The third phase-in date will be on June 30, 1997. From this



date forward, the Display Rule will apply to the next 2,000



Nasdaq securities with the highest average daily trading volume



over the previous quarter.



The final phase-in date will be on August 28, 1997. From



this date forward, the Display Rule will apply to all remaining



Nasdaq securities.



Although the Commission believes that the Display Rule



should apply equally to exchange-traded and non-exchange-traded



securities, the Commission understands that the Display Rule will



more significantly impact current order handling procedures for



Nasdaq securities in light of existing practices in that market.



The phase-in period will allow the Commission to monitor the





---------FOOTNOTES----------

-[207]- Any security already covered by the rule will not

be included as part of the calculation of the

securities to be included in any subsequent group.

Therefore, if a security is included as one of the

1,000 securities in the first group, such security

will not be counted as one of the next 1,500

securities in the second group (even if such

security's average daily trading volume over the

previous calendar quarter would otherwise place it

in the second group).

==========================================START OF PAGE 88======



effects of the Display Rule on successive groups of Nasdaq



securities while ensuring that all covered securities receive the



benefits of the display requirement within one year of the



Display Rule's adoption.



B. Amendments to the Quote Rule



1. Background



Public quotation reporting for equity securities is governed



by the Commission's Quote Rule,-[208]- as well as by



exchange and NASD rules. These rules require registered



exchanges and securities associations to file quotation reporting



plans with the Commission that provide for the collection and



transmission of quotation information on a real-time basis for



securities covered by the Quote Rule.-[209]- Market



makers and exchange specialists communicate their quotes to the



NASD or to an exchange pursuant to these plans and the NASD and



exchanges in turn make this information available to vendors for



dissemination to the public.-[210]-



The Quote Rule requires the collection and public



dissemination of the best bid, best offer, and size for each



---------FOOTNOTES----------

-[208]- 17 CFR 240.11Ac1-1. See also Securities Exchange

Act Release No. 14415 (January 26, 1978), 43 FR

4342 (February 1, 1978) ("Quote Rule Adopting

Release").



-[209]- Rule 11Ac1-1(b)(1), 17 CFR 240.11Ac1-1(b)(1)

(dissemination requirements for exchanges and

associations).



-[210]- Rule 11Ac1-2, 17 CFR 240.11Ac1-2 ("Vendor Display

Rule") requires vendors of market information to

display quotation information in a non-

discriminatory manner.

==========================================START OF PAGE 89======



market quoting any security covered by the Quote Rule, as well as



the consolidation of those markets' quotations and public



dissemination of the national "consolidated" best bid and offer



("NBBO").-[211]- These quotations must be firm, and a



market maker or specialist generally is obligated to execute an



order at a price at least as favorable as its published bid or









---------FOOTNOTES----------

-[211]- Rule 11Ac1-1(b)(1), 17 CFR 240.11Ac1-1(b)(1).

Pursuant to the Quote Rule and the Joint

Consolidated Quotation Plan ("CQS Plan"), the

inside quotations collected and calculated by the

exchanges and Nasdaq for exchange-listed

securities are consolidated and disseminated to

vendors by SIAC, the exclusive processor for

consolidated quotations in listed securities.

Similarly, Nasdaq is the exclusive processor for

quotations in Nasdaq National Market ("Nasdaq

NMS") securities. Nasdaq collects and

consolidates inside quotations furnished by OTC

market makers and by exchanges pursuant to a Joint

Self-Regulatory Organization Plan that provides

for exchange trading of Nasdaq securities. Nasdaq

then disseminates to vendors the inside bid and

offer in Nasdaq NMS securities, and disseminates

to various subscribers more specific information

concerning the individual market maker and

exchange quotes in each Nasdaq security. The

terms "consolidated quote" and "publicly available

quotation," when used with respect to information

disseminated by exchanges and Nasdaq via their

exclusive processors, refer to the quotes that

SIAC or Nasdaq furnishes to vendors for

dissemination to the public. The terms "public

quote" or "publicly available quote," when used

with respect to a specialist or market maker,

refer to the bid and offer that the specialist or

market maker has furnished to its exchange or

association for inclusion in the consolidated

quote. The term "public quotation system" refers

to this entire structure through which SROs

collect quotations from market participants, and

the exclusive processors collect, process, and

disseminate those quotations to vendors.

==========================================START OF PAGE 90======



offer up to the size of its published bid or offer.-[212]-



Broker-dealers covered by the Quote Rule, including dealers



trading listed securities in the OTC market (i.e., third market



makers), must supply quotations to their exchange or association



for dissemination to quotation vendors.



The 1975 Amendments identified the need for a prompt,



accurate and reliable central quotation reporting



system.-[213]- The Quote Rule, in particular, was



designed to facilitate the NMS by requiring specialists and



market makers publishing quotes to provide these quotes to a



central system so they could be made available to the public.



Congress considered the public availability of quotation



information to be critical to fair and competitive markets



because published quotations provide investors, their brokers,



and other market participants with essential information about



the condition of the market. This information assists investors



in making investment decisions and in finding the best market for



a security, while making it possible for investors to evaluate



the quality of their executions.



Since the 1975 Amendments and the adoption of the Quote



Rule, there have been dramatic changes in the markets and the



---------FOOTNOTES----------

-[212]- Rule 11Ac1-1(c)(1), 17 CFR 240.11Ac1-1(c)(1).

This is referred to as the broker-dealer's

"firmness" requirement.



-[213]- Senate Report, supra note 31. Cf. H.R.Rep. No.

229, 94th Cong., 1st Sess. 29 (1975)("Conference

Report")(noting that the conference committee

adopted the Senate's provisions on the NMS with

minor revisions).

==========================================START OF PAGE 91======



technologies used by market participants. To ensure that the



Quote Rule keeps pace with the evolution of the securities



markets and continues to ensure the public availability of



accurate, reliable, and comprehensive quotation information, the



Commission has determined that certain amendments to the Quote



Rule are necessary and appropriate in furtherance of the



objectives of the Exchange Act.



The Commission proposed an amendment to the Quote Rule to



require specialists and market makers to reflect in their public



quotes any better priced orders they place in certain systems



that are not currently integrated into the NMS. In particular,



the ECN amendment is intended to incorporate within the public



quotes any better priced orders broadly displayed by market



makers and specialists through ECNs. This amendment is being



adopted with modifications to address concerns raised by some



commenters. Specifically, in order to provide specialists and



market makers with an alternative method to meet the ECN display



requirement, the Commission is adopting an alternative suggested



in the proposing release that deems a specialist or market maker



in compliance with the ECN amendment if the ECN provides the best



prices entered into the ECN by market makers or specialists for



each covered security to an exchange or association for inclusion



in the public quotation system and provides access to those



prices equivalent to the access currently available to other



quotes published by the exchange or association. In addition,



the Commission is amending the Quote Rule to expand the

==========================================START OF PAGE 92======



categories of securities covered by certain existing Quote Rule



provisions. The quotation requirements that previously applied



to substantial specialists and market makers in only certain



exchange-listed securities now will apply to substantial



specialists and market makers in all exchange-listed securities.



Further, certain Quote Rule provisions that previously applied to



market makers electing to quote particular Nasdaq securities now



will apply to market makers electing to quote any Nasdaq



security. The Commission is adopting these amendments



substantially as proposed, along with minor technical amendments



to the Quote Rule that are discussed more fully below.



2. Public Dissemination of Market Maker and

Specialist Prices in ECNs



a. Basis for the ECN amendment



Over 20 years ago, the Commission noted that an essential



purpose for the establishment of the NMS was "to make information



on prices, volume, and quotes for securities in all markets



available to all investors, so that buyers and sellers of



securities, wherever located, can make informed investment



decisions and not pay more than the lowest price at which someone



is willing to sell, or not sell for less than the highest price a



buyer is prepared to offer."-[214]- At the time, the lack



---------FOOTNOTES----------

-[214]- Securities and Exchange Commission, Statement of

the Securities and Exchange Commission on the

Future Structure of the Securities Markets

(February 2, 1972) ("Future Structure Statement")

at 9-10, 37 FR 5286, 5287 (February 4,

1972)(emphasis added). See also Securities and

Exchange Commission, Policy Statement of the

(continued...)

==========================================START OF PAGE 93======



of consolidated quote information made it difficult to ascertain



the different prices that were often available in the various



markets for a particular security. This lack of transparency as



to the best prices among competing markets was widely recognized



as preventing investors and their brokers from ascertaining



accurate trading interest for a security and obtaining the best



prices for their orders.-[215]- To address these



concerns, Congress directed the Commission to facilitate the



creation of a national market system that would link the various



markets trading a security. The price and quotation transparency



resulting from the Commission's ensuing NMS initiatives has



produced extremely liquid, successful, and, in most cases,



competitive markets.



As discussed in the Proposing Release, the Commission for



many years has been concerned that the development of so-called



"hidden markets," in which a market maker or specialist publishes



quotations at prices superior to the quotation information it



disseminates on a general basis, impedes these NMS



objectives.-[216]- Over the course of the last decade,



certain trading systems that allow market makers and specialists



to widely disseminate significant trading interest to certain





---------FOOTNOTES----------

-[214]-(...continued)

Securities and Exchange Commission on the

Structure of a Central Market System (1973) at 25-

28.



-[215]- See Senate Report, supra note 31.



-[216]- See Proposing Release at 4.

==========================================START OF PAGE 94======



market participants without making this trading interest



available to the public market at large have become significant



markets in their own right. Although offering benefits to some



market participants, widespread participation in these hidden



markets has reduced the completeness and value of publicly



available quotations contrary to the purposes of the NMS.



Because these systems are not registered as exchanges or



associations, they are currently not required to integrate into



the public quote the prices at which their subscribers, including



subscribing market makers and specialists, are willing to



trade.-[217]- The use of these systems by market makers



and specialists to quote prices not incorporated into the NMS has



resulted in fragmented and incomplete dissemination of quotation



information.



Certain markets, in particular ECNs that allow



subscribers-[218]- to enter priced orders that are widely











---------FOOTNOTES----------

-[217]- Certain ECNs may be registered with the Commission

as broker-dealers and indeed perform various

brokerage functions. Nevertheless, the Commission

recognizes that in providing a mechanism by which

system subscribers can (1) broadcast prices to

other system subscribers and (2) trade with one

another at those prices, these systems also

function as securities markets.



-[218]- ECN subscribers may include institutional

investors, broker-dealers, and market makers.

ECNs provide their services to subscribers for a

fee or commission equivalent. Some ECNs (such as

SelectNet) have been available only to broker-

dealers and not to investors generally.

==========================================START OF PAGE 95======



disseminated to third parties-[219]- and permit such



orders to be executed in whole or in part through the system,



communicate orders that are closely analogous to quotations.



These ECNs, in effect, allow market makers and specialists to



display different prices to different market participants.



Although these ECNs can facilitate the execution of their



subscribers' orders and allow institutions to participate



directly in price discovery, the display of better prices



privately in ECNs reduces the reliability and completeness of



consolidated quotations, the accuracy of which continues to be an



essential element of the NMS. These private markets have



resulted in fragmented quotations and a reduction in the



reliability of public quotations as an accurate indicator of



market makers' and specialists' best prices, the identical



situation that prompted Congress to adopt the NMS amendments in



1975. The unavailability of full market maker and specialist



quotation information prevents investors and their brokers from



ascertaining the true trading interest for a security, and



obtaining the best price for market orders, and prevents



investors from monitoring the efforts of their brokerage firms to



obtain best execution for their orders.



The Commission's analysis of the trading activity in these



ECNs has produced clear evidence of the existence of a two-tiered



---------FOOTNOTES----------

-[219]- "Third parties" in this context refers to

subscribers or any other entities (such as

customers of subscribers) that receive information

from the ECN concerning any priced order entered

into the ECN by another subscriber.

==========================================START OF PAGE 96======



market in which market makers routinely trade at one price with



retail customers and at better prices with ECN



subscribers.-[220]- For example, analysis of trading



activity in the two most significant ECNs in the Nasdaq market,



Instinet and SelectNet, reveals that approximately 85% of the



bids and offers displayed by market makers in Instinet and 90% of



the bids and offers displayed on SelectNet were at better prices



than those posted publicly on Nasdaq.-[221]- Furthermore,



approximately 77% of the trades executed on Instinet and 60% of



the trades executed on SelectNet occurred at prices between the



Nasdaq best bid and offer. Market makers participated on at



least one side of approximately 90% of the trades in these ECNs.



The trading activity in Instinet, which comprised approximately



17% of trades and 15% of the volume in Nasdaq securities,



represents a significant portion of the overall market for Nasdaq



securities.-[222]-



---------FOOTNOTES----------

-[220]- For example, a market maker with a public offer

constituting the best public offer of 20 3/4 might

offer to sell shares in an ECN at 20 5/8. If the

market maker did not change its public offer to

reflect this improved selling price, public

customers buying from the market maker would pay

the higher price of 20 3/4 for the security

because they do not have access to the market

maker's price in the ECN.



-[221]- The Commission's analysis is based on Instinet and

SelectNet data for the months April through June

1994. See 21(a) Report at notes 48-52 and

accompanying text and Appendix at notes 18-28 and

accompanying text.



-[222]- More trading volume now occurs on Instinet than on

any of the organized U.S. stock markets other than

(continued...)

==========================================START OF PAGE 97======



The Commission's recent investigation into various trading



practices in Nasdaq stocks revealed that the existence of this



two-tiered market facilitated the maintenance of wide spreads on



Nasdaq. As discussed in the 21(a) Report, Nasdaq market makers



engaged in a widespread course of conduct that resulted in



artificially wide spreads in a large percentage of Nasdaq stocks.



The maintenance of wide spreads was made possible at least in



part by the fact that ECNs like Instinet and SelectNet did not



affect the prices at which market makers traded with the general



public, thus allowing market makers to attract trading interest



at prices inside the spread without adjusting their Nasdaq



quotes. Integrating the better prices market makers quote in



ECNs should significantly limit the types of uncompetitive



practices identified in the investigation without limiting the



usefulness of these systems as efficient alternative mechanisms



for negotiating transactions.



The Commission firmly believes that all investors should



have an opportunity to have their orders filled at the best



prices made available by market makers. Consistent with



Congress's goals for a NMS, these opportunities must be made



available to all customers, not just those customers who, due to





---------FOOTNOTES----------

-[222]-(...continued)

the NYSE and Nasdaq. In 1994, trading volume on

Instinet totalled approximately 10.8 billion

shares with an approximate dollar volume of $282

billion. In comparison, Nasdaq traded

approximately 74 billion shares, with an

approximate dollar volume of $1,449 billion. Id.

at note 50 and accompanying text.

==========================================START OF PAGE 98======



size or sophistication, may avail themselves of prices in ECNs



not currently linked with the public quotation system. The vast



majority of investors may not be aware of the better prices



widely disseminated by market makers or specialists through ECNs



and many do not have the ability to route their orders directly



or indirectly to such systems. As a result, many customers, both



institutional and retail, do not always obtain the benefit of the



better prices entered by a market maker or a specialist into an



ECN.



Brokers frequently use the consolidated quote as the



benchmark for automated execution of customer orders and for the



starting point in negotiating execution prices with institutional



investors.-[223]- Consolidated quotations in listed



---------FOOTNOTES----------

-[223]- Some commenters argue that the ECN amendment

focuses on expanding the availability of these

systems to small investors, and ignores the fact

that small investors already benefit from these

systems in that institutional subscribers in ECNs

primarily represent the collective interests of

small investors, e.g., through mutual funds and

401(k) plans. See, e.g., CALpers Letter; Dillon

Letter; Instinet Letter; LJR Letter; Northern

Trust Letter; SIA Letter; STAIC Letter. The

objectives of the ECN amendment, however, are not

limited to improving market transparency and

accessibility for small investors. Comprehensive

and transparent information about market

conditions is critical to efficient and

competitive markets for all investors, whether

retail or institutional. Indeed, while large

institutional investors often have access to ECNs,

the public quotes nevertheless frequently serve as

a benchmark for their negotiations with market

makers. In any event, while retail investors

directly account for a significantly smaller

percentage of trading volume than institutional

investors, they still account for half of the

(continued...)

==========================================START OF PAGE 99======



stocks are provided by CQS to vendors, who then provide this



information to the public. In approving the CQS as the mechanism



to serve this vital function, the Commission stressed that it



would expect broker-dealers to take into account pricing



information made available through the CQS in fulfilling their



best execution obligations.-[224]- Similarly, for OTC



securities, Nasdaq disseminates to market makers, vendors, and



investors multiple market maker quotations, and a "best" bid and



offer derived from these quotations. As broker-dealers and



markets have developed automated order-routing and order



execution systems, they have relied on these consolidated quotes



in pricing and executing customer orders routed through their



systems.-[225]- Including the prices entered into ECNs by market



makers and specialists in the consolidated quotation will help



broker-dealers using these automated systems to provide their



customers' orders with improved executions, and will improve



institutions' ability to ascertain true market prices.



---------FOOTNOTES----------

-[223]-(...continued)

direct equity investment in U.S. markets. NYSE

1995 Fact Book at 57. The Commission recognizes

that direct retail participation provides critical

liquidity and therefore limited access and

transparency to the best prices available

undermines the efficiency of our markets and

jeopardizes public confidence in their fairness.



-[224]- See Securities Exchange Act Release No. 15009

(July 28, 1978), 43 FR 34851 (declaring the CQS

Plan temporarily effective); Securities Exchange

Act Release No. 16518 (Jan. 22, 1980), 45 FR 6521

(permanently approving the CQS Plan).



-[225]- See discussion of best execution principles, infra

section III.C.2.

==========================================START OF PAGE 100======



In light of the stated fundamental purposes of the 1975



Amendments and clear evidence of a two-tiered market, the



Commission believes it is imperative to amend the Quote Rule to



ensure the public dissemination of accurate quotes that represent



the best prices that market makers and specialists widely



disseminate. Thus, the ECN amendment is intended to integrate



into the public quote the prices of market makers and specialists



that are now widely disseminated to ECN subscribers but are not



available to the rest of the market.-[226]-



Most commenters support the Commission's goal of improving



the quality of quotation information made available to the



public, although many raise questions, discussed below, about the



proposal. In particular, and as discussed below, some commenters



expressed concern about the potential impact of the rule on



benefits provided to the market as a whole by ECNs. Upon review



of the comments received, the Commission has determined that it



is appropriate to adopt the proposed ECN amendment. Furthermore,



in response to the concerns noted, and to facilitate compliance



with the ECN amendment, the Commission has included the ECN



display alternative that permits a market maker or specialist to



---------FOOTNOTES----------

-[226]- Several commenters characterize ECNs as

"wholesale" markets, and argue that the ECN rule

would require market makers to trade with retail

customers at wholesale prices. See, e.g., Davis

Letter; Instinet Letter; LJR Letter; Merrill

Letter. The Commission notes that market makers

are compensated by the spread between their bid

and offer prices, and nothing in the ECN rule

prevents market makers from buying at the bid from

one customer and selling at the offer to another.

==========================================START OF PAGE 101======



comply with the amendment through an ECN that meets two



conditions. First, the ECN into which the market maker or



specialist enters its order must ensure that the best prices



market makers and specialists have entered therein are



communicated to the public quotation system. Second, the ECN



must provide brokers and dealers access to orders entered by



market makers and specialists into the ECN, so brokers and



dealers that do not subscribe to the ECN can trade with those



orders. The ECN display alternative therefore allows a market



maker or specialist to comply with the ECN amendment directly by



changing its quote, or alternatively by using an ECN that meets



the above two conditions.



As discussed above, the Commission expects the SROs to work



expeditiously with ECNs that wish to avail themselves of the ECN



display alternative to develop rules or understandings of general



applicability. The Commission is prepared to act as necessary to



ensure implementation of the ECN display alternative prior to the



effective date of the Quote Rule.



b. Response to Comments-[227]-



The Commission solicited comment on whether the proposed



amendment achieves the goals of deterring fragmented markets and



promoting improved quotations. The Commission also invited



comment on whether there are any feasible alternatives to the





---------FOOTNOTES----------

-[227]- This section includes a discussion of the

principal arguments advanced by the commenters. A

more detailed discussion of the comments is

provided in the Summary of Comments.

==========================================START OF PAGE 102======



rule, and on possible business or economic justifications for



permitting market makers and specialists to publish prices in



ECNs that differ from their public quotations. The Commission



requested comment on the competitive effects of the proposal on



existing ECNs, subscribers, and users.-[228]- In



addition, the Commission solicited comment on alternatives to the



proposal that would minimize any negative effects, yet still



achieve the Commission's goals. The Commission specifically



asked whether ECNs should, as an alternative, furnish market



makers' and specialists' best prices to the applicable exchange



or association for further dissemination, and provide access to



those prices through some form of linkage.-[229]-



i. General Comments



The Commission received numerous comments on the ECN



proposal. Many commenters support the proposal as an important



initiative designed to further investor protection by improving



publicly available quotation information and assuring best



execution of customer orders.-[230]- Some commenters



---------FOOTNOTES----------

-[228]- The Commission also specifically solicited comment

on whether exceptions to the rule would be

appropriate, particularly if a customer requests

that the market maker refrain from publicly

disseminating its order. The Commission also

solicited comment on whether market makers should

be required to disseminate publicly the full size

of orders placed in ECNs. The Commission received

only minimal response to these questions, which is

discussed in the Summary of Comments.



-[229]- See Proposing Release at 28-29.



-[230]- See, e.g., DOJ Letter; Lehman Letter; Madoff

Letter; Amex Letter; NASD Letter.

==========================================START OF PAGE 103======



recognize that a number of brokers and dealers have adopted the



practice of placing superior priced orders in ECNs without



including these better prices in their public



quotes.-[231]- These commenters agree that the Commission



should be concerned that some retail investors may have neither



knowledge nor access to the best available prices under these



circumstances.-[232]- They voice general support for the



rule, and recommend one or more mechanisms-[233]- by which



the Commission could ensure that public quotes contain the best



prices otherwise widely disseminated by market makers and



specialists.



ii. Impact on ECNs, Market Makers and

Specialists, and Institutions



Some commenters express concern that the amendment could



negatively impact services provided by ECNs and caution the



Commission not to diminish the benefits provided by ECNs to the



market as a whole. Some commenters argue that, under the



proposal, market makers and specialists that use ECNs would lose



the anonymity that these commenters believe is crucial to







---------FOOTNOTES----------

-[231]- See, e.g., Amex Letter; DOJ Letter; Madoff Letter;

RPM Letter.



-[232]- See, e.g., Letter from Gerri Detweiler, Policy

Director, National Counsel of Individual

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

dated January 22, 1996 ("NCII Letter"); Goldman

Sachs Letter; PaineWebber Letter; SIA Letter;

Madoff Letter; Lehman Letter; DOJ Letter.



-[233]- See discussion of alternative approaches, infra at

section III.B.2.b.iv.

==========================================START OF PAGE 104======



successfully execute large trades for institutional



investors.-[234]- Some commenters anticipate the adoption



of the ECN amendment prompting a potential decline in the use of



certain ECNs.-[235]- In addition, some commenters contend



that this amendment, because of the impact on ECNs and their



subscribers, will lead to a loss of liquidity in both ECNs and



the public markets-[236]- and to a decline in the variety



of available trading options which could be detrimental to all



investors.-[237]- Other commenters argue that the



proposal would effectively double the risk of a specialist or



market maker that enters orders into an ECN because the



---------FOOTNOTES----------

-[234]- See AZX Letter; Instinet Letter; ICI Letter;

Investors Research Letter; NASD Letter; Ruane

Letter; STAIC Letter; Letter from Edward G.

Shufro, Partner, Shufro, Rose & Ehrman, to

Jonathan G. Katz, Secretary, SEC ("Shufro

Letter"); Sutro Letter.



-[235]- See Goldman Sachs Letter; STA Letter; AZX Letter;

Instinet Letter; Schwartz and Wood Letter; Ruane

Letter.



-[236]- See DOJ Letter; STA Letter; Alex. Brown Letter;

Letter from Jeffrey L. Davis, Economists

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

dated October 25, 1995 ("Davis Letter"); Dillon

Letter; Instinet Letter; Merrill Letter. (citing

the "deleterious effects concerning liquidating

inventory and replacing necessary capital" at pp.

7-8); Schwartz and Wood Letter; Letter from Mary

Kay Wright, Second Vice President and Senior

Equity Trader, The Northern Trust Company, to

Jonathan G. Katz, Secretary, SEC, dated February

28, 1996 ("Northern Trust Letter").



-[237]- See Letter from Anthony R. Gray, Chairman and CIO,

STI Capital Management, to Jonathan G. Katz,

Secretary, SEC, dated February 12, 1996 ("STI

Capital Letter"); Ruane Letter; DOJ Letter; and

LJR Letter.

==========================================START OF PAGE 105======



specialist or market maker could be simultaneously responsible



for multiple executions based on its disseminated quote as well



as its ECN order.-[238]- Moreover, at least one commenter



argues that quotes, bids, offers, and orders have historically



had different meanings and that the proposal's treatment of



priced orders as quotes confuses the essence of the terms,



thereby resulting in inadvertent anti-competitive



effects.-[239]- Some commenters also argue that the



better prices frequently available in ECNs reflect the lower



costs of doing business in those systems, and therefore, it would



be inappropriate to require market makers and specialists to



match their ECN prices in their public quotes.-[240]-



---------FOOTNOTES----------

-[238]- See, e.g., Merrill Letter.



-[239]- See Instinet Letter. Instinet also bases much of

its arguments on its regulatory identification as

a broker-dealer. Instinet argues that the

proposal targets its ECN operations for treatment

different from other broker-dealers. The

Commission notes that Instinet (and similar

systems) provides to its customers ECN services

that are significantly different from the services

provided by other broker-dealers to their

customers. Specifically, Instinet, without

discretion, publicizes subscriber orders and

enables other subscribers to trade with these

orders at their stated price.



-[240]- See, e.g., Dillon Letter; HHG Letter; LJR Letter;

Merrill Letter; STA Letter; Goldman Sachs Letter.





There appear to be counter arguments. For example, there is

no reason to suppose that adverse selection costs � that is,

the risks of trading with an informed trader � are any lower

in ECNs, whose subscribers typically can include market

makers, other broker-dealers, institutional money managers,

hedge funds, momentum traders, and options market makers.

(continued...)

==========================================START OF PAGE 106======



The Commission agrees with commenters that ECNs provide



certain valuable benefits to their subscribers. It also



recognizes the benefits competing systems bring to the market as



a whole, particularly systems that take advantage of new



technologies to offer improved trading opportunities. The



Commission, therefore, has adopted an alternative method of



compliance with the ECN requirement discussed in the proposing



release to reduce the amendment's potential impact on existing



ECNs and their subscribers, and to maintain incentives and



opportunities for new ECNs to enter the



marketplace.-[241]- The Commission continues to believe



---------FOOTNOTES----------

-[240]-(...continued)

Second, because traders can more easily mask their

identities and thus their trading motives in ECNs than in

the primary market, informed traders may prefer to trade in

ECNs. These higher information asymmetries would be

expected to lead to higher, rather than lower, trading

costs. Finally, ECNs often impose transactions charges that

may not otherwise be incurred by dealers trading in the

primary market.



Furthermore, it does not appear that the better prices

available in ECNs can be explained by differences in the

size of orders and transactions given that the average order

size and trade size in one ECN (Instinet) is substantially

similar to the average size of quotes and trades in the

primary market. In any event, the Commission generally

would not expect larger size orders to receive better prices

in view of the considerable literature suggesting that in

equities markets, larger orders tend to get worse prices

because of the risk of trading with an informed trader.

See, e.g., David Easley and Maureen O'Hara, 19 J. Fin. Econ.

69, (No. 1, September 1987).



-[241]- The Commission believes that although the ECN

amendment may marginally reduce the incentive of

some subscribers to participate in an ECN, on the

whole the effect on ECNs should not be so

significant as to affect their viability.

(continued...)

==========================================START OF PAGE 107======



it is important that the best prices of orders entered into these



markets by market makers and specialists are properly integrated



into the public market so that all market participants can



benefit from the price discovery taking place within these



markets.



In its comment letter, the NASD stated its view that the



proposal could discourage market makers' use of ECNs because a



market maker placing an order in an ECN at a better price would



have to simultaneously change its quote, thereby telegraphing its



interest. In proposing a solution to this situation, the NASD



specifically referred to the ECN alternative noting "...this



problem can be addressed without discouraging market maker use of



ECNs through the approach suggested by the Commission as a



possible alternative, i.e., by reflecting the better ECN prices



in the inside market display, rather than in individual



quotes."-[242]-



In response to the concerns raised by the NASD and other





---------FOOTNOTES----------

-[241]-(...continued)

Moreover, given the availability of the ECN

display alternative, which is designed to minimize

any potentially detrimental effects of the rule on

ECNs, the Commission believes that the benefits of

the amendment to investors of publicizing the

better prices entered by market makers and

specialists outweigh the limited likely costs to

ECNs. Many of the comments received that

addressed the ECN proposal raised concern about

the importance of preserving the anonymity offered

by these systems. See, e.g., Alex. Brown Letter;

AZX Letter; Dillon Letter; Estep Letter; ICI

Letter; Instinet Letter; NASD Letter.



-[242]- NASD Letter at 14.

==========================================START OF PAGE 108======



commenters, the ECN display alternative is designed to preserve



the benefits associated with the anonymity that some ECNs



currently offer to subscribing market makers and specialists and



their customers.-[243]- This alternative will ensure that



the best prices of market makers and specialists are publicly



disseminated and that non-ECN-subscribing brokers and dealers can



trade with the ECN orders represented by those prices. Under the



display alternative, the best prices and sizes of orders entered



into an ECN by specialists and market makers would be publicly



disseminated while the specialists and market makers themselves



would remain anonymous. This alternative not only preserves



anonymity, but also eliminates the risk that a market maker or



specialist could be exposed to multiple executions at the ECN



price.-[244]-



---------FOOTNOTES----------

-[243]- The Commission recognizes that in certain

securities, specific market makers or specialists

may be viewed as price leaders for those

securities. Therefore, if the market knows that

one of those firms has changed its quote, other

market makers or specialists are likely to follow

that price change and frustrate the first's firms

ability to obtain an execution at the improved

price. The ability to place an anonymous order in

an ECN allows the firm to change its price without

triggering corresponding price changes from other

market makers or specialists and thereby increases

its potential to obtain an execution at the

improved price.





-[244]- Certain commenters fear that, as originally

proposed, the amendment would have an adverse

impact on institutional investors which currently

subscribe to ECNs. These commenters appeared to

believe that the ECN amendment would seriously

harm ECNs, and thus harm institutional users. See,

(continued...)

==========================================START OF PAGE 109======



The ECN amendment, as proposed, sought to minimize the



potential impact on market makers, specialists, and ECNs by



requiring a market maker or specialist to display in its public



quote only the size required by its exchange or association,



rather than the actual size of any order the firm places into an



ECN. This part of the amendment is being adopted as proposed for



orders for the accounts of market makers and specialists.



However, for customers' orders entered into an ECN by a market



maker or specialist that are smaller than the quote size required



by the market maker's or specialist's exchange or association,



the Commission has amended the rule to allow market makers and



specialists to display only the customer's order



size.-[245]- The requirement to display no more than the



required size for market makers' and specialists' own orders



should reduce any disincentives to use ECNs that could otherwise



result from the ECN amendment, and responds to the concern that



---------FOOTNOTES----------

-[244]-(...continued)

e.g., ICI Letter; Ruane Letter. The Commission

does not believe that the amendments will

significantly interfere with the operations of

ECNs. Moreover, the Commission believes that as

adopted, particularly with the addition of the ECN

display alternative, ECNs will continue to be able

to provide services to institutional investors of

similar value to those they provide today. The

Commission also believes that the benefits of the

amendments, including increased market maker

competition and decreased fragmentation, will flow

to all investors, institutional as well as retail.

See 21(a) Report.



-[245]- As discussed supra in footnote 144, SROs may wish

to allow market makers or specialists to quote in

sizes smaller than the minimum quotation increment

when the quote represents a customer limit order.

==========================================START OF PAGE 110======



disclosure of the full size of the order in the market maker's or



specialist's quote could impede its ability to execute the



order.-[246]- Moreover, permitting the display of



customer orders of less then the minimum quote size should reduce



the potential burden on a specialist or market maker of having to



publish a public quote for more than the customer's order size



when the customer's order is for less than the minimum quotation



size required by the specialist's or market maker's exchange or



association.



Market makers and specialists who avail themselves of the



ECN display alternative will be required to furnish to the public



quotation system the full size of the best buy and sell orders



they enter into the ECN. The Commission believes that the



display of full size by the ECN will help inform the public



market of the true trading interest entered by specialists and



market makers, without impeding the execution of these orders by



disclosing the identity of the specialist or market maker placing



the order. Under the ECN display alternative, the market maker



or specialist will be able to continue to represent the order on



an anonymous basis both in the ECN and in the public quote,



substantially reducing any negative impact of the amendment on





---------FOOTNOTES----------

-[246]- The Commission received several comments that

support this aspect of the proposal. See, e.g.,

Lehman Letter; and Smith Barney Letter. These

commenters believe that display of full size in a

market maker's quote could impair the quality of

an execution obtained for a customer because the

display in the public quotation system is broader

than the display in the ECN.

==========================================START OF PAGE 111======



ECN users.



Where the order entered by the market maker or specialist is



on behalf of a customer, the display of full size under the ECN



display alternative is consistent with the requirement under the



Display Rule, which requires market makers and specialists to



display the full size of their customer limit orders. Therefore,



the full size of customer limit orders will be displayed whether



the specialist or market maker displays the order itself or



enters the order into an ECN complying with the ECN display



alternative.-[247]-



The Commission believes that the concerns expressed by some



commenters about a potential loss of liquidity resulting from the





---------FOOTNOTES----------

-[247]- The Commission notes that the exceptions under the

Display Rule for limit orders of block size and

for limit orders that a customer has asked not to

be displayed will not apply to customer limit

orders entered by a market maker or specialist

into an ECN. If entered into an ECN, these orders

must either be reflected in the market maker's or

specialist's own quote or displayed via the ECN

alternative. As discussed previously, the

Commission believes that a customer should have

discretion to permit a market maker or specialist

to handle its limit order without public display,

and large limit orders should not be required to

be displayed unless the customer makes a request.

However, the Commission does not believe these

orders should be withheld from public display if

they are being displayed in an ECN. The

Commission believes that if these orders, when

handled by market makers or specialists, are

displayed widely through an ECN to the ECN's

subscribers, then they should also be displayed to

the public generally. Moreover, limiting display

to only one market would be inconsistent with

Congress's goal for a NMS in which trading

interest in disparate markets would be

consolidated and publicly disseminated.

==========================================START OF PAGE 112======



proposal have been substantially addressed by the alternative



adopted today. Because this alternative preserves the anonymity



some ECNs afford to the users of their systems, the proposal



maintains incentives for subscribers to continue participating in



such systems. In fact, a market maker or specialist, who



presumably wants its orders executed at prices it is widely



displaying through the ECN, should benefit from attracting



greater trading interest by having the prices of its orders



displayed to the entire market.



Finally, under the proposal, priced orders of institutions



and other non-market makers entered directly into ECNs would not



be required to be reflected in the public quote. Some commenters



criticized the proposal because it did not require the inclusion



of all better priced orders in the public quote. This result,



however, is consistent with existing quotation principles.



Institutional bids, offers, and orders handled independent of a



market maker historically have been outside the scope of the



Quote Rule, and the Commission's proposal was not intended to



expand the scope of the Quote Rule in this respect.-[248]-



Furthermore, the Commission believes that, although institutional



investors' direct orders in ECNs provide valuable liquidity, the



amendments will substantially strengthen the public quotation



system by publishing orders entered by market makers and



---------FOOTNOTES----------

-[248]- The fact that ECNs will continue to contain

institutional investors' orders priced better than

the public quotes will provide another incentive

for market participants to continue to participate

in those systems.

==========================================START OF PAGE 113======



specialists without creating new requirements for orders not



controlled by market makers or specialists.-[249]-



Nevertheless, the Commission will continue to monitor closely



issues involving the display of prices published by institutions



in light of the Quote Rule and its objectives.



iii. Technology and Innovation



Some commenters predict that the proposal may have a



chilling effect on technological innovation, primarily because



the proposal applies only to ECNs and not to all available



communication technologies that may be used for disseminating



interest to buy and sell a particular number of shares at a



specified price.-[250]- Some commenters argue that the



proposal is anti-competitive and otherwise antithetical to the



purposes of the Exchange Act because it will deter future



technological advances in automated trading environments by



favoring less automated trading methods (e.g., telephone



transactions).-[251]-



The Commission is cognizant of the importance of the



continued development of innovative trading systems and services.



New technologies have expanded the ways in which investors'





---------FOOTNOTES----------

-[249]- The Commission notes that, as described in the

Commission's 21(a) Report, institutions trading

with dealers or others accounted for less than 20%

of trades in one ECN (Instinet). See Appendix to

the 21(a) Report at A-11.



-[250]- See DOJ Letter; SIA Letter; Instinet Letter;

Schwab Letter; STI Capital Letter; Sutro Letter.



-[251]- See, e.g., Instinet letter.

==========================================START OF PAGE 114======



buying and selling interest can be brought together and have



fostered additional competition in the securities markets. The



Commission believes that this competition should be encouraged.



Nonetheless, to promote competition, efficiency, and transparency



in the securities markets, and insure the integrity of publicly



available information, the Commission believes it is appropriate



to set minimum standards that apply to the entry of the



functional equivalent of quotations by market makers and



specialists in trading systems.-[252]- Indeed, consistent



with the Commission's experience with previous NMS



initiatives,-[253]- these minimum standards will permit



and foster the development of new technologies that improve the



public availability of trading information, while discouraging



practices that are inconsistent with the purposes of the 1975



Amendments. The Commission believes that the Quote Rule as



amended will not unduly diminish the beneficial services provided



by existing ECNs, nor will it stifle the development of new





---------FOOTNOTES----------

-[252]- The Commission notes that the focus of the

proposal is not on any particular system or

systems but, rather, on the types of orders that

are the fundamental equivalent of quotations, and

the fragmented market that results when the prices

of these orders are not integrated into publicly

available quotations.



-[253]- See Simon and Colby, supra note 58. The

Commission also notes the growth in technologies

over the past twenty years, including broker-

dealer and exchange automated execution systems,

that clearly rely on, and were facilitated by,

successful operation of NMS and joint industry

initiatives such as the Quote Rule, CTA, and the

ITS Plan.

==========================================START OF PAGE 115======



trading technologies or new ECNs.



iv. Alternative Approaches



In the Proposing Release, the Commission suggested



alternatives to the proposal, and solicited comment on these



alternatives. The Commission also invited commenters to suggest



possible alternatives. The Commission specifically asked whether



it should require ECNs to furnish prices to the applicable



exchange or association for public dissemination and to provide



some access, such as a linkage, to the prices in the



ECN.-[254]- A number of commenters supported this



approach.



The NASD recommended, as an alternative to the proposed



rule, that the better ECN price be reflected in the inside



market, rather than in individual quotes. Under the alternative



described by the NASD, an ECN would report its best market maker



or specialist inside prices to the SRO that is the primary market



in the security. The NASD also recognizes that more assured



access to orders in the ECNs would be necessary under this



option.-[255]- Similarly, one commenter agreed that the



inside market available to the public should reflect the best bid



and offer prices whether in a market maker's quote or in a market



maker's order on an ECN. The Commenter suggested that this could



be accomplished by requiring quotations in ECNs to be made part



of the public quotation and by separately identifying the ECN



---------FOOTNOTES----------

-[254]- See Proposing Release and e.g., NASD Letter.



-[255]- See NASD Letter.

==========================================START OF PAGE 116======



into which the order is entered rather than the market maker that



placed the order.-[256]- Finally, certain commenters



state that expanding ITS to include orders entered into ECNs



would be a better alternative to the proposal.-[257]-



The Commission believes that the ECN display alternative



adopted today is consistent with these suggested alternatives and



will minimize many of the asserted negative effects of the rule.



The adopted provision provides an alternative to an ECN that



disseminates specialists' and market makers' best prices to the



public quotation system. Thus, the amendment enables a market



maker or specialist to comply with the Quote Rule either directly



by sending to its exchange or association the prices of orders it



places into ECNs that improve the market maker's or specialist's



public quote, or indirectly by using an ECN that transmits the



best prices entered therein by market makers and specialists for



publication in the public quotation system.



The ECN display alternative is consistent with the



alternative recommended by the NASD because the adopted provision



enables the specialists' or market makers' best prices in ECNs to



be consolidated with the exchange's or association's best prices



for dissemination within the consolidated quotes. In addition,



the adopted amendment requires the ECNs to provide an equivalent



means of access to those best prices.



---------FOOTNOTES----------

-[256]- Morgan Stanley Letter. See also, PaineWebber

Letter (recommending that priced orders in ECNs be

included in the NBBO).



-[257]- See, e.g., STAIC Letter; ICI Letter.

==========================================START OF PAGE 117======



The Commission recognizes that this alternative may reduce



the content of information that is publicly available because



under the ECN display alternative, the identity of the market



maker or specialist that entered the better priced order in the



ECN will be withheld.-[258]- The Commission believes this



result is justified because the inside prices and full sizes of



orders entered by market makers and specialists will be in the



public quotation system to inform the entire market of these



prices and ECNs will provide equivalent access to those prices.



Moreover, the Commission believes the benefits of facilitating



the use of ECNs, by permitting the continued anonymity of market



makers and specialists, more than offset the reduced information



available on the identity of a particular market maker or



specialist.



As an alternative to the ECN amendment, certain commenters



suggested that enforcement of best execution principles would be



sufficient to protect public investors.-[259]- As



discussed in more detail in section III.C.2., the Commission does





---------FOOTNOTES----------

-[258]- The Commission also notes that under the

alternative, a specialist or market maker that

puts an order into an ECN that is priced better

than that specialist's or market maker's public

quote, but is not the best priced quote from any

specialist or market maker in the ECN, will not

have its better priced order reflected in the

public quote. The prices will be displayed,

however, if the better price in the ECN is

executed or withdrawn and the lower specialist's

or market maker's priced quote then becomes the

best priced quote.



-[259]- See, e.g., Instinet Letter.

==========================================START OF PAGE 118======



not believe this is a practical alternative because ECNs do not



provide broker-dealers with automated links and thus may not be



reasonably available for the handling of retail orders on an



automated basis. Furthermore, investors and their brokers cannot



efficiently ascertain if they have received the best prices for



their orders if publicly available prices do not reflect the best



prices at which specialists and market makers are willing to



trade. Under these circumstances, providing customers the best



executions available can be achieved most effectively by ensuring



that the consolidated quotes systematically include the better



prices that market makers and specialists have entered into an



ECN.



Finally, certain commenters argue that, as an alternative to



adopting the ECN proposal, the Commission should defer any action



until further study is completed on the use of ECNs because the



Proposing Release provides insufficient data regarding whether



customers currently get the best available price, or market maker



and specialist use of ECNs results in harm to



customers.-[260]- The Commission has determined to go



forward with the amendments now because of compelling concerns



presented by two-tiered markets. Many of the commenters to the



proposed rules also recognize these concerns. Furthermore, as



part of its recently concluded Nasdaq investigation, the





---------FOOTNOTES----------

-[260]- See, e.g., Instinet Letter, asserting that the

Commission should obtain and study data on this

matter and that, absent such data, adoption of the

proposed amendment is unwarranted.

==========================================START OF PAGE 119======



Commission has conducted an extensive analysis since the



proposals were published that supports the Commission's proposal



and clearly evidences the existence of a "two-tiered" market in



which customer orders are executed at publicly available prices



inferior to prices contemporaneously available in existing



ECNs.-[261]- Moreover, Commission data shows that the



pricing opportunities available in at least two ECNs (Instinet



and SelectNet) are not limited to block trades, but extend to



smaller orders executed in the system.-[262]- The



Commission believes, therefore, that further study is not



necessary to address a structural disparity in market information



that disadvantages investors who lack access to ECNs.



c. Operation of the Rule Amendment



i. Definition of the term "Electronic

Communications Network"



The proposed amendment did not specifically define the term



"electronic communications network." The Commission did state,



---------FOOTNOTES----------

-[261]- As discussed previously, the Commission believes

the data it has reviewed supports the need for

prompt adoption of the ECN amendment to the Quote

Rule. See supra notes 222 and 223, and

accompanying text. Given the strong evidence that

investors would benefit from public dissemination

of the hidden prices that are broadly disseminated

to subscribers in these systems, the Commission

believes that it is appropriate to adopt the

amendments to the Quote Rule.



-[262]- As noted above, the Appendix to the 21(a) Report

states that average trade size for Nasdaq NMS

securities on Instinet was approximately 1,600

shares for the period studied, while the average

trade size generally in the securities was

approximately 1,900 shares. See Appendix to the

21(a) Report at A-8.

==========================================START OF PAGE 120======



however, that priced orders that market makers and specialists



enter into certain ECNs are bids and offers for the purposes of



the Quote Rule.-[263]- The proposal applied to systems



that widely disseminate priced orders to third parties and permit



such orders to be executed against in whole or in part. The



Commission further explained that the term "electronic



communications network" was intended to include continuous



auction trading systems, but was not intended to include crossing



systems or broker-dealer internal order routing systems.



Several commenters suggested the need for a definition of



the term "electronic communications network."-[264]- The



Commission agrees that it is appropriate to define the term in



the Quote Rule and has decided to adopt a definition that



reflects the fundamental characteristics of an ECN as discussed



in the Proposing Release.



As discussed earlier, the objective of the ECN amendment is



to incorporate within the consolidated public quote firm prices



quoted by market makers and specialists in securities markets





---------FOOTNOTES----------

-[263]- As a result, relevant provisions of the Quote

Rule, such as the obligation on exchanges and

associations to disseminate quotes, and the

firmness requirement placed on a market maker or

specialist who furnishes the quotes, become

operative with respect to a security when a market

maker or specialist enters an order for that

security into an ECN. See section III.B.2.c.v.,

infra.



-[264]- See Goldman Sachs Letter; Instinet Letter; Schwab

Letter. In addition, one commenter argues that

ECNs should include SRO stock crossing systems and

all non-market-maker broker-dealers. NYSE Letter.

==========================================START OF PAGE 121======



that widely disseminate those prices but are not registered as



exchanges or associations and thus are not integrated into the



NMS. Therefore, the Commission has defined the term "ECN" as an



electronic system that widely disseminates to third



parties-[265]- orders entered therein by a market maker or



specialist, and permits such orders to be executed against in



whole or in part. The definition specifically excludes any



system that crosses multiple orders at one or more specified



times at a single price set by the system and that does not allow



orders to be crossed or executed against directly by participants



outside of such times. This exclusion is consistent with



statements made in the Proposing Release that it was not the



Commission's intention to cover crossing systems because these



systems do not communicate to multiple market participants the



prices at which system subscribers are willing to trade. Rather,



the excluded crossing systems themselves establish an internal



trading price for subscribers on an episodic basis.-[266]-



The ECN definition also excludes any system operated by, or



on behalf of, a market maker or specialist that executes customer



orders primarily for its own account as principal, other than as





---------FOOTNOTES----------

-[265]- The Commission intends the term "third parties" to

refer to subscribers to the ECN, other than the

ECN and the market maker or specialist that is

entering its priced order into the ECN. The ECN

also may disseminate to others, including non-

subscribers.



-[266]- The Commission notes that broker-dealers that

publish quotes through a vendor are already

covered by the rule.

==========================================START OF PAGE 122======



riskless principal. This exclusion is intended to ensure that,



as discussed in the Proposing Release, internal broker-dealer



order routing systems in which the market maker trades primarily



with customer orders on a principal basis are not ECNs within the



scope of the amendment. The exclusion would not except from the



ECN definition systems that involve multiple market makers or



specialists competing as principal in a security or that cross



multiple market maker and customer orders.



Furthermore, the Commission believes the definition should



be read broadly to include systems that match orders internally



and deliver the matched order to some other market for execution.



Thus, the term "permits such orders to be executed against"



should not be read to exclude systems where a narrow technical



reading of "executed" is the only reason that the system would



not fall within the ECN definition. For example, if a system



puts buy orders and sell orders together for execution, completes



all necessary elements of the trade, and then sends the matched



pair to an exchange or association merely to print the terms of



the trade on the Consolidated Tape, the system would be an ECN.



ii. "Priced orders" in ECNs



Under this definition, the Commission intends to include in



the public quotation system firm prices for securities entered by



market makers or specialists, whether such firm prices are



labeled as "quotes" or "orders." The Commission believes that



priced orders entered by market makers or specialists into ECNs



where the orders are widely disseminated and executable are the

==========================================START OF PAGE 123======



functional equivalent of market maker or specialist quotations,



and like quotations, play a key role in the price discovery



process. The Commission thus believes that these "quotation-



equivalents" should be made part of the public quote.



Although some commenters argue that priced orders entered



into ECNs are more closely parallel to prices communicated over



the telephone to other market makers than to market quotes, the



Commission recognizes a fundamental distinction between limited



communication of price in bilateral telephone negotiations and



broad exposure of firm prices to multiple participants in a



market.-[267]- Accordingly, prices communicated by



telephone are excluded because these prices generally are not



widely disseminated to other parties for execution. The rule



also would not cover indications of interest that do not



constitute firm prices.



In this connection, the Commission intended the term "priced



order," which is deemed under the ECN amendment to be a bid or



offer, to encompass commitments to buy or sell a security at a



particular price for a particular number of shares. The





---------FOOTNOTES----------

-[267]- The Commission recognizes that market makers and

specialists may be willing to trade with certain

customers at better, negotiated prices, such as

when market makers negotiate with customers over

the telephone. In contrast, however, the prices

quoted by market makers and specialists in ECNs

are widely disseminated to market participants.

In adopting the ECN amendment, the Commission is

reaffirming the NMS principle that prices

advertised in one market must be integrated into

the national market -- that is, the consolidated

public quote.

==========================================START OF PAGE 124======



Commission also does not intend the term "priced orders" to



include interest to buy or sell a security where price or the



number of shares is not specified to system subscribers, unless



the price or size is otherwise understood as part of the system's



operation.-[268]- The ECN amendment would, however,



include priced orders entered into an ECN by a market maker or



specialist that are visible only to some system subscribers if



these orders can be executed against in the ECN. The ECN



amendment is intended to require the public display of priced



orders entered into ECNs by market makers and specialists where



these priced orders are similar to quotations. Accordingly, the



Commission does not intend the ECN amendment to apply to a priced



order that is entered into an ECN by a market maker or specialist



merely in order to execute against an existing order visible in



the ECN, and not entered to elicit other buying or selling



interest. If, however, the order entered by the market maker or



specialist does not in fact execute immediately in full against



an existing order but rather is itself disseminated as an open



order in the ECN, the market maker or specialist must comply with



the requirements of the ECN amendment with respect to the order.



In order to ensure that customers consistently receive the



benefit of better prices entered into ECNs, a market maker or



---------FOOTNOTES----------

-[268]- The definition of an ECN specifically excludes any

system that crosses multiple orders at one or more

specified times at a single price set by the ECN

(by algorithm or by any derivative pricing

mechanism) and does not allow orders to be crossed

or executed against directly by subscribers

outside of such times. See 11Ac1-1(a)(8).

==========================================START OF PAGE 125======



specialist entering an all-or-none or minimum size order for its



own account into an ECN would be required to include this price



in its public quote, or disseminate the price via the ECN display



alternative, and thereby publicly display the order for the full



number of shares for execution in whole or in part. Although the



execution of an all-or-none order is typically conditioned on



execution of the entire size of the order, the Commission



believes that allowing market makers to avoid public display of



an unconditional quote when using this type of order could



seriously undermine the purposes of the rule.-[269]- The



rule will permit, however, a market maker or specialist to enter



an all-or-none customer order into an ECN without requiring



public display of the quote for that order where the customer



specifically requests that the order be executed on an all-or-



none basis. This latter provision accommodates the desire of



some customers to trade only at a specific size associated with a



specific price.



iii. ECN Display Alternative



Pursuant to the amendment as adopted, a priced order entered



by a market maker or specialist into an ECN that widely



disseminates the order is deemed to be a bid or offer for the



purposes of the market maker's or specialist's quotation



reporting obligations under the Quote Rule. As a result,





---------FOOTNOTES----------

-[269]- All-or-none and minimum size orders are rarely

used by market makers and specialists in ECNs and

are prohibited from being included in the public

quotes by the registered exchanges and Nasdaq.

==========================================START OF PAGE 126======



specialists and market makers are required to include such orders



in the bids and offers they communicate to their exchange or



association for inclusion in the published quotations made



available by the exchange or association.-[270]-



As discussed above, in response to the concerns of some



commenters, the adopted amendment includes an alternative to the



specialist or market maker itself revising its public quotation



to reflect its better priced order entered in an ECN. This



alternative allows the ECN to act as an intermediary in



communicating to the public quotation system the best price and



size of orders for each security that have been entered into the



ECN by a specialist or market maker. To communicate the



quotations publicly, the ECN must submit the best price entered



by a specialist or market maker to an exchange or association, or



to a securities information processor acting on behalf of one or



more exchanges or associations.



The alternative reduces the impact of the amendment on



specialists and market makers because they have a choice



regarding how to comply with their obligation. This alternative



also reduces the impact of the amendment on ECNs by offering



these systems an opportunity to provide additional services to



their subscribers, and creating an opportunity to generate



additional order flow from non-subscribers. At the same time,



---------FOOTNOTES----------

-[270]- An OTC market maker that places priced orders for

execution into any ECN will in effect be making an

election to communicate quotations to its

association bids, offers and quotation sizes in

the security. See 11Ac1-1(a)(25)(ii)(B).

==========================================START OF PAGE 127======



more accurate prices are provided through public quotation



systems than are currently available.



Under this alternative, consistent with the goals of the



initial proposal, the ECN must comply with two conditions.



First, the ECN must provide the best prices and sizes that market



makers or specialists have entered in the ECN to the public



quotation system for inclusion in the consolidated quotation.



The market maker or specialist responsible for the price does not



have to be identified.-[271]- The ECN must, however, at a



minimum, publicly identify itself as the originating system for



these prices. Accordingly, if a market maker puts an order that



improves the NBBO into an ECN and the ECN disseminates that price



to the public quotation system, the disseminated price must



either be identified as originating from the market maker or from



the ECN.



Second, the ECN must provide non-subscriber brokers and



dealers with a means of access to those prices entered in the ECN



by market makers and specialists. This access must be equivalent



to the access that would have been available for the relevant



security if these prices had been published in the market makers'













---------FOOTNOTES----------

-[271]- An ECN that does not offer the option of anonymity

to its subscribers could choose to include the

identity of the market maker or specialist with

the prices furnished to the SRO for public

dissemination. As discussed below, the ECN also

must provide access to these prices.

==========================================START OF PAGE 128======



or specialists' quotation.-[272]- The extent and form of



this access will depend on the form(s) of access available in the



market to which the ECN supplies the bids and offers for public



dissemination.-[273]-



For example, market makers in Nasdaq NMS and SmallCap



securities typically can be reached through the telephone and



through the NASD's Small Order Execution System. Therefore, an



ECN that chooses, pursuant to the alternative, to act as an



intermediary for its market maker and specialist subscribers for



Nasdaq NMS and Smallcap securities would have to be prepared to



receive and execute telephone orders from broker-dealers against



those market makers' and specialists' orders entered in the ECN.



The ECN will have to execute these orders promptly at the prices



the market makers and specialists have entered into the ECN. In



addition, because a market maker with the best price in a Nasdaq



NMS security is subject to SOES executions, this equivalent



access condition would require the ECN to provide broker-dealers



who use SOES with equivalent automated access to the best priced



---------FOOTNOTES----------

-[272]- For access to be "equivalent", the ECN must enable

non-subscribing broker-dealers to execute against

the ECN's published best price to the same extent

as would be possible had that best price been

reflected in the public quote of a specialist or

market maker. The ECN, however, may impose

charges for access to its system, similar to the

communications and systems charges imposed by

various markets, if not structured to discourage

access by non-subscriber broker-dealers.



-[273]- The extent and form of the access will not

necessarily be the same as the access available in

the market to which the specialist or market maker

would otherwise supply its bid and offers.

==========================================START OF PAGE 129======



market maker orders in the ECN. This could be accomplished



either through an electronic linkage to SOES or by other means



agreed upon with the NASD. For example, the ECN could supply the



NASD with an identifier for the market maker who entered the best



priced order, which the NASD could use in assigning SOES



executions to that market maker.-[274]-



Similarly, in exchange-listed securities, the degree of



access that the ECN must offer would depend on the current access



that the market receiving the information from the ECN offers to





---------FOOTNOTES----------

-[274]- As discussed supra section II., the NASD has

proposed a new facility, NAqcess, which, as part

of its proposed services, would widely disseminate

priced orders for execution in whole or in part.

Supra note 45. As proposed, Naqcess would publish

its best prices in the Nasdaq quotation system

stream and would be accessible to all NASD members

for order entry and execution against those

orders. Thus, NAqcess, as proposed, would appear

to make prices entered by market makers into

NAqcess available, and provide equivalent access

under the alternative. Therefore, a market maker

that entered its best priced order into NAqcess

would comply with the requirements of the ECN

amendment without reflecting the order in the

market maker's own quote. Moreover, a market

maker that entered an order into another ECN at a

price better than its quote could satisfy the

requirements of the ECN amendment by entering an

order reflecting this price into NAqcess, even if

the other ECN does not directly provide the price

to the public quotation system, because this use

of NAqcess, as proposed, would meet the

requirements of the amendment. Similarly, an ECN

availing itself of the ECN display alternative

could provide prices directly to NAqcess. The ECN

and the NASD also could develop mechanisms to

ensure public anonymity of market makers that use

ECNs, while providing to the NASD the identity of

the market makers that are at the inside quote

solely for the purpose of direct order-routing

between NAqcess and the market maker.

==========================================START OF PAGE 130======



broker-dealers in the relevant type of security. If the ECN



communicates prices for exchange-listed securities to an



exchange, the specialist or market maker orders in the ECN must



be accessible to broker-dealers in the same manner as quotes on



that exchange. This access would include any automated execution



features offered to broker-dealers by the exchange. The ECN must



provide to the exchange, or to the exchange specialist in each



security, access to the market maker or specialist orders in the



ECN. Such access must provide broker-dealers with the ability to



enter and obtain executions for their orders at least as promptly



as that exchange offers to its own members through its order-



routing and execution systems. Because the ITS Plan applies to



exchange-trading of listed securities, orders received from other



markets through ITS must have the same ability to trade with ECN



orders whose prices are displayed through the exchange as they



have with the exchange's own quotations. For instance, if the



exchange specialist typically receives incoming ITS commitments



and executes them manually, the ECN must at a minimum enable the



incoming ITS commitment to be manually entered into the ECN for



execution.



If the ECN instead provides orders in exchange-listed



securities to the NASD for inclusion in the public quotation



system, the orders must be as accessible to broker-dealers as the



quotes published by third market makers in exchange-listed



securities. At a minimum, these prices must be included as part



of the third market quotation display and identified as

==========================================START OF PAGE 131======



originating from a named market maker or from a named ECN. For



non-Rule 19c-3 securities, broker-dealers must be able to contact



the ECN by telephone and have an order promptly entered into the



ECN for execution. For Rule 19c-3 securities, the ECN also must



be accessible through the ITS/CAES linkage, operated by the NASD,



in the same manner as other third market maker quotes in those



securities.-[275]-



Under the ECN display alternative, the ECN must furnish to



an exchange or association the full size associated with the best



priced orders placed in the ECN by market makers and specialists



to buy and to sell a security. This full size requirement under



the alternative is intended to give the public information about



the depth of the market at the ECN prices, while maintaining the



anonymity of market makers and specialists. For example, if an



ECN is furnishing quotation information to Nasdaq under this



alternative, and a market maker enters a 4,000-share order into



the ECN at a price that is better than other market maker or



specialist prices for that security in the ECN, the ECN will be



required to provide Nasdaq that price and size of 4,000 shares as



a quotation for public dissemination. If 2,500 shares of this



order is executed, the ECN must display the remaining 1,500



shares. If two market makers enter 4,000-share orders for a



security at the same price, which is the best price in the ECN





---------FOOTNOTES----------

-[275]- As discussed below concerning expansion of the

ITS/CAES linkage, currently non-Rule 19c-3

securities may not be traded via the ITS/CAES

linkage.

==========================================START OF PAGE 132======



for that security, the ECN is required to show all 8,000 shares



publicly. In contrast, if a market maker enters a 100-share



order for a Nasdaq security at the best price in the ECN for that



security, the alternative requires the ECN to furnish the price



for only 100 shares, even though NASD rules require Nasdaq market



makers to display no less than 1000, 500, or 200 shares in



Nasdaq, depending on the characteristics of that security.



The Commission recognizes that the means of providing



equivalent access will vary for different markets, and that ECNs



operating under the ECN display alternative that currently do not



provide access to their systems to non-subscribers will have to



develop methods to provide this access. Meeting this requirement



may be achieved in a variety of ways, including a linkage between



ECNs and one or more of the SROs. The Commission believes an SRO



that accepts the prices provided by an ECN for publication should



be authorized to impose reasonable rules related to the public



dissemination of those prices upon market makers and specialists



who avail themselves of this alternative. The rules an SRO



imposes in this regard, however, may not establish standards for



the dissemination of these prices that are more burdensome for



market makers and specialists using ECNs than the SRO rules that



apply to quotations delivered directly to the SRO by specialists



and market makers.



The Commission looks forward to working closely with all



market participants to effect the necessary market developments



to ensure that this alternative method of compliance with the

==========================================START OF PAGE 133======



Quote Rule is made possible. In order to ensure prompt



implementation of the necessary changes before the effective date



of the rule amendments, the Commission requests each SRO,



individually or jointly as signatories to the CQS Plan, to notify



the Commission in writing by [insert date 45 days from the date



of publication in the Federal Register] regarding its willingness



and its plan to afford ECNs the opportunity to communicate, for



inclusion in the public quotation system, the prices of market



makers and specialists.



In order to implement the changes to the Quote Rule under



new subsection (c)(5), the prices sent to an ECN by market makers



and specialists will have to be displayed in the public



quotations disseminated by SROs, and order routing or access



linkages will have to be in place. After hearing from the SROs,



the Commission will determine whether it will be necessary to use



its authority under Section 11A(a)(3)(B) of the Exchange Act to



require the SROs to act jointly to provide means to accomplish



these objectives.



iv. Minimum Price Variations



In the Proposing Release the Commission recognized that



there may be different minimum price variations in any given



security between the SROs providing a market for the security and



ECNs through which the security is also traded. Currently most



exchange-listed securities tend to be quoted and traded with a

==========================================START OF PAGE 134======



minimum price variation of 1/8 point or 1/16 point.-[276]-



Nasdaq securities can be publicly reported in variations as low



as 1/64, and can be quoted in minimum variations as low as 1/32,



depending on the price at which the security



trades.-[277]- Some ECNs allow priced orders in



variations as low as 1/256; other systems provide for orders



priced in decimals as small as one cent.



Most commenters did not address the issue of ECN minimum



price variations. Some commenters that did address the issue,



however, recommended that the ECN quote be rounded for public



dissemination either downward from or upward to better prices in



increments of 1/16 or smaller.-[278]- Other commenters



recommended rounding in decimals,-[279]- while still





---------FOOTNOTES----------

-[276]- NYSE Rule 62 provides that bids or offers in

stocks selling above one dollar per share may not

be made at a variation of less than one-eighth of

a dollar or twelve and a half cents; Amex Rule 127

allows for one-sixteenth spreads for stocks priced

under ten dollars, and one-eighth spreads for

stocks priced ten dollars and over.



-[277]- The NASD does not have a minimum variation policy

for Nasdaq stocks. Nasdaq, however, is designed

to process quotes and trades in particular minimum

variations.



-[278]- See, e.g., NASD Letter; Lehman Letter; Instinet

Letter.



-[279]- See, e.g., Letter from Leslie M. Marx, Assistant

Professor of Economics and Management, and Eugene

Kandel, William E. Simon Graduate School of

Business Administration, University of Rochester,

to Commissioner Steven Wallman, SEC, dated

November 27, 1995 ("Marx and Kandel Letter"),

concluding that the markets should move toward

decimal pricing.

==========================================START OF PAGE 135======



others strongly opposed the use of decimals.-[280]- One



commenter asserted that non-standard increments (i.e., increments



not approved by the primary market for the relevant security)



should be prohibited in non-primary markets.-[281]- To



address situations where the priced order in an ECN is at a non-



standard increment, the Commission has determined that it is



appropriate to interpret the ECN amendment to allow market makers



and specialists to comply with the amendment (either individually



or through the ECN) by rounding up or down to the nearest



fraction accepted by the market disseminating the quote provided



by the ECN.-[282]- The Commission believes, however, that



rounding is appropriate only if the rounded public quotes are



accompanied by an identifier that marks the quote as



rounded.-[283]- Market makers, specialists, and ECNs will



---------FOOTNOTES----------

-[280]- See CHX Letter.



-[281]- See Madoff Letter.



-[282]- The Commission believes this alternative is

preferable to imposing particular trading

increments on the markets. At the same time,

however, this alternative will provide the markets

with an incentive to voluntarily move towards

finer trading increments.



-[283]- In order to facilitate compliance with the rule,

it will be necessary for SROs to provide a means

for rounded prices to include a "rounded"

identifier that makes clear that a better price is

available in the ECN. The Commission notes that

SROs, and the public quotation system, may not

currently have such a field available for

identifying quotations as rounded. The

Commission, therefore, requests that the SROs work

jointly to modify the public quotation system to

ensure that specialists, market makers, and ECNs

(continued...)

==========================================START OF PAGE 136======



be permitted to round the prices of ECN buy orders down to the



nearest quote increment, and round the prices of ECN sell orders



up to the nearest increment. For example, under this



interpretation, if a market maker or specialist enters a priced



buy order into an ECN at 10 5/16 and the market receiving the



price from the ECN for dissemination has a minimum quote



increment of 1/8, a bid of 10 1/4 will be displayed in the public



market and identified as a rounded price. This result reflects



an SRO rule that prohibits dissemination of quotes in 1/16



variations. If the market maker or specialist already is bidding



publicly at 10 1/4 when it enters the 10 5/16 buy order in an



ECN, the market maker or specialist publishing a quote must



reflect the ECN order by identifying its 10 1/4 bid as rounded.



In addition, market makers and specialists entering orders



into ECNs that are reflected at rounded prices in the public



quote will be expected to give their customers an execution at



the superior non-rounded price. Thus, the market maker or



specialist quoting a rounded price of 10 1/4 to reflect a 10 5/16



buy order must give a customer sell order an execution at 10 5/16



up to the published size. Similarly, an ECN providing market



maker or specialist prices pursuant to the rounding alternative



must execute an incoming order at the non-rounded price. The



Commission recognizes that it may not be feasible for market



makers or specialists that have not entered the rounded order



---------FOOTNOTES----------

-[283]-(...continued)

that are disseminating rounded prices have the

ability to distinguish those rounded quotes.

==========================================START OF PAGE 137======



into an ECN to determine, in an efficient manner, the actual



price of the better order in the ECN. This may particularly be



true with respect to market makers or specialists operating



automated execution systems. The Commission believes that it is



appropriate in such instances for such market makers and



specialists that did not enter the rounded order to execute



orders at the displayed rounded price.-[284]-



The Commission recognizes that this interpretation will



allow prices in ECNs that are denominated in non-standard



quotation increments not to be fully displayed, but believes this



interpretation is appropriate to accommodate ECN prices in the



existing public quotation system without imposing uniform trading



increments.-[285]- The rounding identifier will inform



investors that a better price is behind the rounded quote. Thus,



even though the actual price cannot be readily displayed,



investors will be aware of, and will be able to obtain, the



better price in the ECN or from the market maker or specialist.



v. Effect on the Voluntary Aspect of the

Quote Rule



If an OTC market maker uses an ECN that does not rely on the



alternative of communicating that market maker's best prices to



the public quotation system, then the market maker must publish





---------FOOTNOTES----------

-[284]- See also, section III.C.2. for a discussion of

best execution, infra.



-[285]- If primary markets in the future allow narrower

quotation increments, these ECN prices between the

existing quotation increments could be more

accurately displayed in the public quote.

==========================================START OF PAGE 138======



in its own quote that better priced order entered into the ECN.



Once a market maker publishes a quote through its association to



reflect a priced order it entered into an ECN, pursuant to Rule



11Ac-1(c)(5)(i)(A), it will be deemed to have elected to publish



quotations in that security,-[286]- and will therefore be



subject to the quotation provisions of the Quote Rule. Moreover,



pursuant to certain existing SRO rules,-[287]- withdrawal



of that quotation after the ECN order has been executed or



withdrawn prevents the market maker from immediately reinstating



quotes in that security.-[288]- As a practical matter,



once electing to quote, a withdrawal then precludes the market





---------FOOTNOTES----------

-[286]- 17 CFR 240.11Ac1-1(b)(5), as amended. See also,

17 CFR 240.11Ac1-1(a)(25), 17 CFR 240.11Ac1-

1(c)(4)(ii), and 11Ac1-1(c)(5)(ii), as amended,

acting jointly to ensure that OTC market makers

publish quotations pursuant to the Quote Rule in

securities they trade via ECNs.



-[287]- See NASD Manual, Marketplace Rules, Rule 4600 et.

seq., Nasdaq Market Maker Requirements (requiring

members to maintain continuous two-sided

quotations in the Nasdaq securities for which they

are registered as market makers). See also, ITS

Plan, Section 6(A)(i)(B), Furnishing Quotations

(requiring each ITS Participant to furnish the

current bid-asked quotation emanating from its

floor or, in the case of the NASD, the best bid

and offer emanating from ITS/CAES market makers in

eligible securities). Unexcused withdrawal of

quotations violates these NASD rules and ITS

provisions.



-[288]- This will be true even if the market maker traded

less than 1% of the share volume in the security

in the previous quarter because the 1% threshold

of the Quote Rule for mandatory quotes would not

exempt the market maker from disseminating quotes

once the market maker has "elected" to quote the

security by using the ECN.

==========================================START OF PAGE 139======



maker from continuing to enter priced orders for the security in



an ECN because of the SRO prohibition on re-entering quotes after



withdrawal.



The Commission solicited comment on this aspect of the ECN



proposal. Although most commenters were silent concerning this



issue, certain comments indicate confusion as to the effect on



market makers who currently use ECNs but who do not voluntarily



quote under the existing Quote Rule.-[289]- The



Commission, therefore, reiterates that the combined operation of



the ECN amendment and SRO rules may require a market maker or



specialist who enters an order into an ECN that does not rely on



the ECN display alternative, and publishes a quote reflecting



that price, to continue to publish quotes in the public market



regardless of the number of shares traded by the market maker or



specialist in the security during the previous quarter.



In determining whether a market participant will be required



to publish quotes after entering orders in an ECN, the Commission



notes that, with respect to any given security, the quote rule



requirements only apply if the market participant falls within



---------FOOTNOTES----------

-[289]- See, e.g., Madoff Letter; Instinet Letter. In its

comment letter, Instinet notes that some market

makers that make a continuous market in a

security, but do not normally publish quotations

in that security, will now be required to

disseminate quotations for that security if the

market maker places a priced order for that

security on an ECN. The Commission recognizes

this result, but notes the ECN display alternative

of allowing such market makers to continue to

place orders in a security into an ECN without

having to directly publish quotes in that

security.

==========================================START OF PAGE 140======



the definition of the term "OTC market maker" for that security.



To be an OTC market maker, the participant must hold itself out



as willing both to buy and sell on a regular or continuous



basis.-[290]-



The "OTC market maker" definition is not intended to capture



subscribers who enter orders into ECNs on one side of the market



to limit or offset their risk, such as options market makers who



use ECNs to hedge their positions in the securities underlying



the options they trade. They would not be required to publish



public quotes in a security simply because they had entered an



order for the security into an ECN, unless they regularly or



continuously hold themselves out as willing to buy and sell the



security. An entity that holds itself out via contract,



marketing, or other communications with its customers, as being



willing both to buy and sell a specific security on a regular or



continuous basis would be an "OTC market maker" for the security.



This latter market maker's entry of a superior priced order into



an ECN for a security that itself does not publish quotes would



compel the market maker to publish a quote and potentially,



depending on SRO rules, trigger on-going quotation obligations.



vi. Exemptive Relief



Finally, the Commission is amending Section (d) of the Quote



Rule concerning exemptive relief. Under that section, the



Commission previously could exempt from the provisions of the



Quote Rule, either conditionally or on specified terms and



---------FOOTNOTES----------

-[290]- Rule 11Ac1-1(a)(8), as amended.

==========================================START OF PAGE 141======



conditions, any responsible broker or dealer (which now will



include a specialist or market maker under the ECN amendment),



exchange, or association if the Commission determined that such



an exemption was consistent with the public interest, the



protection of investors and the removal of impediments to and



perfection of an NMS. The Commission is adding a provision



allowing it to exempt an ECN from the definition in the rule.



The Commission did not solicit comment on expanding its authority



to grant exemptive relief in this manner. The Commission



believes, however, that the added exemptive authority is



appropriate because it provides flexibility in applying the ECN



amendment.



3. Amendments to the Quote Rule Concerning

Definitions



a. Introduction



In the Proposing Release the Commission proposed to expand



the Quote Rule's existing requirements to include quotation



information from broker-dealers that, while internalizing order



flow, hold themselves out as willing to buy and sell on a regular



or continuous basis. This expansion of the Quote Rule would be



accomplished by amending the definition of OTC market maker. The



Proposing Release also recommended that quotation requirements be



imposed on substantial broker-dealers in non-Rule 19c-3



securities by amending the definition of subject security, and on



broker-dealers in Nasdaq SmallCap securities by amending the

==========================================START OF PAGE 142======



definition of covered security.-[291]- In putting forward



this proposal, the Commission noted that some dealers quote on a



selective basis, choosing not to display quotes for securities



that they actively trade because these securities are subject



only to the voluntary quote provisions of the Quote Rule.



The amendments adopted by the Commission today are



substantially the same as those proposed.-[292]- The



---------FOOTNOTES----------

-[291]- OTC market makers and specialists are not required

by the Quote Rule to provide continuous two-sided

quotations for any Nasdaq security. As amended,

an OTC market maker or specialist may make an

election, pursuant to paragraph (b)(5)(i) of the

Quote Rule, to collect, process, and make

available quotations for Nasdaq NMS or Nasdaq

SmallCap securities. The Commission is soliciting

comment on a proposed amendment which would

require continuous two-sided quotations from OTC

market makers and specialists responsible for more

than 1% of the aggregate transaction volume for a

Nasdaq security. See Companion Release.



-[292]- The only substantive difference between the

amendments as adopted today and as proposed is the

definition of the term "OTC market maker." The

definition as proposed read "...sell to a

customer...." but has been modified to read

"... sell to its customers...." Rule 11Ac1-

1(a)(13), 17 CFR 140.11Ac1-1(a)(13). See infra

note 308.



In addition to the amendments discussed in detail herein,

the Commission is making technical, non-substantive

amendments to the Quote Rule. The terms "association",

"revised bid or offer", and "revised quotation size" will be

separately defined in the rule. The definition of

"exchange-traded security" has been revised to exclude OTC

securities traded on an exchange pursuant to unlisted

trading privileges. The definition of "plan processor" has

been amended to reflect the appropriate cross-reference.

The definition of "principal market" has been removed from

the Quote Rule because it is no longer applicable. In

addition, the definitions have been arranged in alphabetical

order.

(continued...)

==========================================START OF PAGE 143======



Commission believes these amendments will benefit investors by



improving price discovery and liquidity, and increasing



competition between OTC market makers and specialists. The



Commission further believes that these amendments are in keeping



with Congress's directive that the Commission use its rulemaking



authority to remove impediments to competition.











b. Basis for Amendments to Rule 11Ac1-1(a)



i. Amendment to 11Ac1-1(a)(25) (definition

of a "subject security")



The Commission is amending the Quote Rule's definition of



subject security to require continuous two-sided quotations from





---------FOOTNOTES----------

-[292]-(...continued)



Paragraph (b)(1)(i) of the rule has been reorganized to

separately set forth the exclusions in subparagraphs (A) and

(B). Paragraph (b)(1)(iii) has been eliminated and the

substance of the provision has been incorporated into

paragraphs (b)(1)(i) and (b)(1)(ii).



The Commission is also amending the definition of the term

"reported security" as it appears in Rule 11A3-1(a)(4). The

amendment alters the form but not the meaning of the term or

its application. The amendment will make the term

consistent with the definition of "reported security" in the

Quote Rule.



The amendments to Rule 11Ac1-1(a) are being adopted

prospectively. Outstanding Quote Rule interpretations and

no-action letters continue to be operative, to the extent

that the positions taken therein are not materially in

conflict with the amendments adopted today. Persons seeking

clarification regarding the status of outstanding no-action

letters should contact the Office of Market Supervision,

Division of Market Regulation, Securities and Exchange

Commission.



==========================================START OF PAGE 144======



OTC market makers and exchanges that are responsible for more



than 1% of the volume in a non-Rule 19c-3 security. The



Commission believes that this amendment removes an impediment to



competition that exists under the current rule. Broker-dealers



that held themselves out as willing to buy and sell non-Rule 19c-



3 securities on a regular or continuous basis were not previously



required to disseminate quotation information unless they



transacted the largest percentage of the aggregate trading volume



in a particular security. Consequently, regardless of the volume



transacted by other exchanges or OTC market makers, the primary



market, which was the market responsible for transacting the



largest percentage of the aggregate trading volume, was the only



market participant required to disseminate quotations in these



securities.-[293]-



As noted in the Proposing Release, third market trading in



non-Rule 19c-3 securities has increased considerably since the



Quote Rule was last amended.-[294]- Third market trading



---------FOOTNOTES----------

-[293]- An OTC market maker or specialist, although not

the principal market for a listed security, could

elect to disseminate quotes for the security.

Under the amended 11Ac1-1(a)(25) an OTC market

maker or specialist may still elect to disseminate

quotations if it is responsible for 1% or less of

the volume in that security.



-[294]- Third market maker trading interest is more

concentrated in non-Rule 19c-3 securities, as

evidenced by the fact that the percentage of third

market quotes in non-Rule 19c-3 securities (36%)

is greater than that for Rule 19c-3 securities

(28%). See Fragmentation vs. Consolidation of

Securities Trading: Evidence of the Operation of

Rule 19c-3, Office of Economic Analysis, SEC, at 5

(continued...)

==========================================START OF PAGE 145======



in Rule 19c-3 securities now accounts for a greater number of



stocks and a more substantial percentage of U.S. trading volume



than it did when the Commission initially established disparate



regulatory treatment under the Quote Rule for Rule 19c-3



securities and non-Rule 19c-3 securities.-[295]- In view



of the growth of third market trading volume, the Commission



believes that requiring all broker-dealers trading more than 1%



of the volume in a listed security to publish quotations will



provide more accurate and comprehensive quotation information for



non-Rule 19c-3 securities.



The Commission believes that disparate regulatory



requirements for Rule 19c-3 and non-Rule 19c-3 securities can no



longer be justified by differences in the trading of the two



types of securities. Moreover, the Commission finds that



differences in regulatory treatment have impaired transparency.



Because of the growth of third market trading in non-Rule 19c-3



securities, the absence of quotes revealing the substantial third



market makers in a security and the prices they are prepared to



publicly quote results in the consolidated quotations in the







---------FOOTNOTES----------

-[294]-(...continued)

(March 29, 1995)("Fragmentation vs.

Consolidation").



-[295]- Third market trading volume has grown, at least in

part, because the universe of securities subject

to Rule 19c-3 has increased considerably. For

example, nearly 60% of the stocks listed on the

NYSE are subject to Rule 19c-3, accounting for

approximately 48% of the total NYSE volume. See

Fragmentation vs. Consolidation at 4-5.

==========================================START OF PAGE 146======



security being incomplete.-[296]- The Commission



therefore believes that significant dealers in non-Rule 19c-3



securities should become subject to the same standards required



for trading Rule 19c-3 securities.-[297]- As a result of



this amendment, market participants will have more complete



information about significant OTC market makers and specialists



in a security and the prices at which they are willing to trade.



The majority of commenters who addressed the amendment to Rule



11Ac1-1(a)(25) endorse the Commission's proposal to end the



disparity between Rule 19c-3 securities and non-Rule 19c-3



securities, noting that there is no basis for continuing to draw



a regulatory distinction between Rule 19c-3 and non-Rule 19c-3



securities, and that the extension of the Quote Rule will provide



meaningful information about significant market makers in listed



securities.-[298]- One commenter asserts that requiring



---------FOOTNOTES----------

-[296]- See, e.g., supra note 294.



-[297]- OTC market makers that trade a significant volume

in non-Rule 19c-3 securities have not been subject

to the same requirements as third market makers

that meet the 1% threshold for Rule 19c-3

securities. For example, an OTC market maker

meeting the 1% threshold is required to quote in a

Rule 19c-3 security and therefore must register as

a CQS market maker with the NASD. NASD Manual,

Rule 6320. CQS market makers are subject to the

NASD's CQS market maker rules, which include firm

and continuous two-sided quote obligations and

mandatory participation in the ITS through

Nasdaq's Computer Assisted Execution System. NASD

Manual, Rules 6320 and 6330.



-[298]- See, e.g., Amex Letter; Blume Letter; BSE Letter;

CHX Letter; CSE Letter; NASD Letter; PSE Letter;

Alex. Brown Letter; Schwab Letter; D.E. Shaw

(continued...)

==========================================START OF PAGE 147======



quotations from all significant OTC market makers will succeed in



improving the quality of the NMS for all listed securities while



at the same time leveling the playing field for all market



makers.-[299]-



Nevertheless, many commenters suggest modifications to the



1% volume threshold. Some commenters suggest that Nasdaq, on



behalf of all third market makers, should be viewed as one market



participant, and that once its volume exceeds 1% for a listed



security, all OTC market makers in that security should be



required to maintain continuous two-sided



quotations.-[300]- Other commenters believe that the



---------FOOTNOTES----------

-[298]-(...continued)

Letter; Dean Witter Letter; Lehman Letter; Madoff

Letter; Merrill Letter; PaineWebber Letter;

Salomon Letter; Smith Barney Letter; STA Letter.



There were some commenters who did not support the extension

of the Quote Rule's requirements to non-Rule 19c-3

securities. See, e.g., NYSE Letter; and Specialists Assoc.

Letter, which note that the Commission, rather than

expanding the Quote Rule to include non-Rule 19c-3

securities, should re-examine the validity of Rule 19c-3.

See, e.g., Letter from Alexander H. Slivka, Executive Vice-

President, National Securities Corporation, to Jonathan G.

Katz, Secretary, SEC, dated October 25, 1995 ("NSC Letter");

Fahnestock Letter; Letter from Samuel Lieberman, President,

Rothschild Lieberman Ltd., to Jonathan G. Katz, Secretary,

SEC ("Rothschild Letter"); Letter from Mark T. DeFelice,

Vice President, Roosevelt & Cross, Inc., to Jonathan G.

Katz, SEC, dated January 24, 1996 ("Roosevelt Letter"),

which note that the extension of the quotation requirements

to include non-Rule 19c-3, will have an impact on small

firms. See infra note 307.



-[299]- Madoff Letter.



-[300]- See PSE Letter; Specialists Assoc. Letter.



A comparable alternative is to require quotations from all

(continued...)

==========================================START OF PAGE 148======



Commission should adopt a "continuousness of execution" standard



rather than a rigid 1% volume threshold.-[301]- This



suggestion would require a dealer to quote if it executes orders



on a regular or continuous basis, even if it accounts for less



than 1% of the volume, while excluding from quotation



requirements a dealer that executes a few large trades that



account for more than 1% of the volume. The NYSE suggests an



additional threshold, to be used in the alternative with the 1%



of volume threshold.-[302]- This alternative would have



the effect of requiring public quotations from market makers who,



while not accounting for more than 1% of the aggregate



transaction volume, have an active retail business in small-sized



trades.



The Commission believes that extending the 1% threshold



based on quarterly aggregate trading volume to non-Rule 19c-3





---------FOOTNOTES----------

-[300]-(...continued)

OTC market makers who account for more than 1% of the

Nasdaq-reported volume in a security. See Investors Research

Letter.



In the same vein, two commenters suggest that once an OTC

market maker or specialist displays a quotation in a listed

security, it should be subject to the requirements of the

rule. See BSE Letter; CSE Letter.



The NYSE and CSE suggest further application of the rule to

include brokers and their private trading systems. See NYSE

Letter; CSE Letter.



-[301]- See CHX Letter; Fahnestock Letter; Jefferies

Letter; Salomon Brothers Letter; STA Letter. See

also Rothschild Letter.



-[302]- NYSE Letter. See also RPM Letter; Specialists

Assoc. Letter.

==========================================START OF PAGE 149======



securities is a reasonable method to improve the scope of



quotation information to include significant OTC market makers



and specialists. This 1% threshold, currently in effect for Rule



19c-3 securities, has proved effective in supplying comprehensive



quotation information to the market at large. Moreover, based on



the increase in third market trading volume for these securities,



the Commission does not believe this standard is unduly



burdensome on OTC market makers or specialists.-[303]-



Rather, the Commission believes this threshold strikes a balance



between requiring the dissemination of all quotation interest and



accommodating those specialists and OTC market makers that are



small entities. The Commission believes that OTC market makers



and specialists that account for 1% or less of the aggregate



volume are not active enough to justify the additional expense of



providing continuous quotation display.-[304]-



---------FOOTNOTES----------

-[303]- The Commission seeks to avoid imposing burdens on

market participants that are not necessary to

achieve the Quote Rule's objective of reliable

public quotations from all significant markets in

a security. The Commission notes that the 1%

threshold for quotations in Rule 19c-3 securities

has not impaired trading in these securities.

Since the Quote Rule was amended, OTC market

makers' volume in Rule 19c-3 securities has

increased. See Fragmentation vs. Consolidation at

4-5. The Commission has no reason to believe that

imposing mandatory quotations on specialists and

OTC market makers that are responsible for more

than 1% of the volume in a non-Rule 19c-3 security

will affect market making in these securities.



-[304]- A few commenters expressed concern that the

amendment to the Quote Rule would have a

detrimental impact on small firms. See Fahnestock

Letter; NSC Letter; Roosevelt Letter; Rothschild

(continued...)

==========================================START OF PAGE 150======



Similarly, the Commission believes that applying the 1%



threshold to the total over-the-counter volume in a listed



security would extend the quotation requirements to inactive



market makers. The Commission questions whether the added



quotation information would justify the added



burden.-[305]- The Commission also believes that reliance



on something other than a numerical standard in this circumstance



would lead to confusion in the marketplace. Accordingly, the



Commission believes the "greater than 1% aggregate trading



volume" threshold for mandatory quotations continues to be



appropriate.



ii. Amendment to 11Ac1-1(a)(13) (definition

of an "OTC market maker")



Amended Rule 11Ac1-1(a)(13)-[306]- revises the





---------FOOTNOTES----------

-[304]-(...continued)

Letter. The Commission believes the requirement

that a dealer must transact greater than 1% of the

volume in a security before quotations are

mandated prevents the rule from becoming

unnecessarily burdensome on small firms. For

example, a firm would not have to publish

continuous two-sided quotations in AT&T unless it

transacted more than 1% of the aggregate

transaction volume, which the Commission considers

more than modest volume.



-[305]- In a related release issued today, the Commission

is proposing an amendment that would require

continuous two-sided quotations from OTC market

makers and specialists provided that the OTC

market maker or specialist is responsible for more

than 1% of the aggregate transaction volume for a

security included on the Nasdaq Stock Market. See

Companion Release for a detailed discussion on the

proposed amendment to the Quote Rule.



-[306]- 17 CFR 240.11Ac1-1(a)(13).

==========================================START OF PAGE 151======



definition of "OTC market maker" to include any dealer who holds



itself out as willing to buy from and sell to its customers, or



otherwise, a covered security for its own account on a regular or



continuous basis otherwise than on an exchange in amounts of less



than block size.-[307]- Accordingly, dealers that



internalize customer order flow in particular stocks, by holding



themselves out to customers as willing to buy and sell on an



ongoing basis, would fall within the definition even though they



may not hold themselves out to all other market participants. In



addition, dealers that hold themselves out to particular firms as



willing to receive customer order flow, and execute those orders



on a regular or continuous basis, also would fall within the



definition of an OTC market maker.



Most commenters addressing this issue assert that it is



appropriate to include in the definition of OTC market maker



those dealers who internalize customer order flow because they



believe that dealers that hold themselves out to their customers





---------FOOTNOTES----------

-[307]- The definition, as proposed, read "...sell to a

customer..." but has been modified to read

"...sell to its customers...." This change was in

response to the requests of commenters for

consistency in the definition of OTC market maker

between proposed Rule 11Ac1-1(a)(13) and proposed

Rule 11Ac1-4(a)(9). See, e.g., NASD Letter.

Additionally, the Commission stated in the

Proposing Release that "[a]s in the past, broker-

dealers will not be considered to be holding

themselves out as regularly or continuously

willing to buy or sell a security if they

occasionally execute a trade as principal to

accommodate a customer's request." Proposing

Release at 24. The Commission believes the new

language more accurately reflects that premise.

==========================================START OF PAGE 152======



as willing to buy and sell securities on a continuous basis



should be required to publish quotations.-[308]- One



commenter asserts that the amendment will broaden the definition



of who should be required to provide transparency and liquidity



to the NMS to include dealers that transact business with other



firms' order flow and with their own customers, thus ensuring a



minimum level of quotation commitment from those NMS participants



vying for public order flow.-[309]- Some commenters,



however, advocate that more than internalization of order flow



should be required before a dealer is deemed an OTC market maker.



These commenters suggest the Commission adopt some form of a



"holding itself out" standard, so that the rule would capture the



quotations of professional liquidity providers but not dealers



that occasionally accommodate a customer's request.-[310]-



Other commenters, deeming the definition too inclusive, suggest



the Commission add an exception for broker-dealers that act











---------FOOTNOTES----------

-[308]- See Amex Letter; BSE Letter; CHX Letter; CSE

Letter; D.E. Shaw Letter; Madoff Letter; NYSE

Letter; PSE Letter; RPM Letter; SIA Letter; STA

Letter.





-[309]- Madoff Letter.



-[310]- See NASD Letter; Jefferies Letter; SIA Letter;

PaineWebber Letter; STA Letter. It should be

noted that the amended definition includes a

requirement that the broker-dealer hold itself out

to, at a minimum, its customers on a regular and

continuous basis in order to be an OTC market

maker.

==========================================START OF PAGE 153======



solely as agents.-[311]-



One commenter believes that excluding firms that transact



primarily block size orders and therefore account for significant



volume is inconsistent with the Commission's goals for increased



transparency.-[312]- However, several commenters note



that block size orders are excluded from the existing definition



of OTC market maker and argue strongly that it is consistent with



the purposes of the rule to continue to exclude



them.-[313]-



The Commission believes that adoption of the amendment is



warranted to ensure the availability of quotation information



that accurately reflects the interests of all significant market



participants. Increased transparency is fundamental to the



fairness and efficiency of the securities markets. As noted in



the Market 2000 Study, enhanced transparency helps link various



market segments.-[314]- Currently, a dealer can receive



order flow from internalization or pre-existing order routing



arrangements but avoid publishing quotations, even when it



accounts for more than 1% of the volume in a non-Rule 19c-3



security, because it is not currently deemed to be an OTC market





---------FOOTNOTES----------

-[311]- See Fahnestock Letter; Salomon Brothers Letter;

Rothschild Letter; Investors Research Letter.



-[312]- Amex Letter.



-[313]- See Fahnestock Letter; Dillon Letter; Goldman

Sachs Letter; Merrill Letter; Salomon Brothers

Letter.



-[314]- See Market 2000 Study at III - 7.

==========================================START OF PAGE 154======



maker.-[315]- Allowing significant market makers that



deal actively in securities without publicizing their activity or



making available their prices undermines the NMS goal of



transparency. The Commission believes that those dealers should



be classified under the rule as market makers and be required to



publicize their quotations so that investors may know of, and



trade on similar terms with, those market makers.



The Commission has considered commenters' suggestions



regarding alternative definitions. In fact, in response to the



suggestions of some commenters, the Commission has modified the



proposed amendment to make clear that more than an isolated



transaction is necessary before a dealer is designated an OTC



market maker.



The Commission, in regard to orders of block size, has



determined to continue to exclude dealers that hold themselves



out as only willing to deal in orders equal to or greater than



10,000 shares. Orders of block size are generally negotiated



with the dealer and exposed upon execution. Block positioners



usually do not maintain prices at which they are willing to buy



and sell a particular security; rather, they make known their



role of assisting in the purchase and sale of large positions in



---------FOOTNOTES----------

-[315]- Although NASD rules require dealers who are

registered as CQS market makers to provide

quotations, registration is not mandated. A

dealer in reported securities may elect to

disseminate quotations by registering as a NASD

market maker and "communicating" its best bids and

offers to the association by entering two-sided

quotations in the Nasdaq System. See NASD Manual,

Rule 4611.

==========================================START OF PAGE 155======



securities at some price. Consequently, these dealers do not



function as typical dealers that maintain a regular or continuous



price quote. The Commission has concluded that requiring



quotations from these dealers would not provide useful price



information and therefore a dealer that acts solely as a block



positioner should remain excluded from the definition.



iii. Amendment to 11Ac1-1(a)(6) (definition

of a "covered security")



As amended, Rule 11Ac1-1(a)(6)-[316]- defines



"covered security" to include any security for which a



transaction report, last sale data or quotation information is



disseminated through an automated quotation system as described



in Section 3(a)(51)(A)(ii) of the Exchange Act.-[317]-



This amendment would extend the Quote Rule provisions to OTC



market makers and exchange specialists quoting in Nasdaq SmallCap



securities.



The Proposing Release noted that the Quote Rule presently



does not reflect certain developments in the Nasdaq market,



including the large number of securities included on the Nasdaq



SmallCap market. Only one commenter addressed this amendment.



That commenter, MJT, expressed strong support for the proposal,



noting that it is both fair and equitable to apply the Quote Rule



to Nasdaq SmallCap securities.-[318]- The Commission





---------FOOTNOTES----------

-[316]- Rule 11Ac1-1(a)(6), 17 CFR 240.11Ac1-1(a)(6).



-[317]- 15 U.S.C. 78c(a)(51)(A)(ii).



-[318]- MJT Letter.

==========================================START OF PAGE 156======



believes it is appropriate to extend coverage of the Quote Rule



to these securities in recognition of the development of a liquid



trading market and increased investor demand for these



securities. NASD rules concerning quotations already require



firm quotations for both Nasdaq SmallCap securities and



Nasdaq/National Market securities.-[319]- Thus, the



amendment simply extends coverage of the Quote Rule requirements



to the same range of securities as existing NASD firm quote



requirements.-[320]-







c. Response to Other Specific Requests for

Comments



In addition to the Quote Rule amendments discussed above,



the Proposing Release solicited comment on whether: (1) revisions



are necessary to an NASD rule that restricts certain computer



generated quotations;-[321]- and (2) whether the ITS



---------FOOTNOTES----------

-[319]- See NASD Manual, Rule 4613.



-[320]- Section 11A(c)(1) of the Exchange Act grants the

Commission the authority to prescribe, among other

matters, rules and regulations to assure accurate

and reliable quotations "with respect to any

security other than an exempted security." The

Commission believes that extending the

requirements of the Quote Rule to Nasdaq SmallCap

securities will further these interests. No new

costs should be imposed on market participants

because the NASD rules concerning quotations

already treat Nasdaq/National Market and SmallCap

securities similarly.



-[321]- NASD Manual, Rule 6330. The NASD, however,

provides an automated quotation update capability

("auto-refresh") as part of the Small Order

Execution System which market makers may elect to

(continued...)

==========================================START OF PAGE 157======



linkage should be expanded to allow NASD CAES members access to



the linkage in non-Rule 19c-3 securities.



i. Automatic Generation of Quotations



Requiring active third market makers in non-Rule 19c-3



securities to quote also raises the issue of whether NASD members



should continue to be prohibited from using computer systems to



generate quotations automatically.-[322]- Currently,



exchange specialists may use automated mechanisms to track the



NBBO in a security if they maintain a quotation size of no more



than 100 shares.-[323]- OTC market makers, however, are



prohibited by NASD requirements from using automated quotation



tracking systems.



The Commission requested comment on whether computer



generated quotations should be permitted if active third market



makers are required to quote in non-Rule 19c-3 securities, and if



so, under what conditions. Commenters in favor of lifting the



NASD's automated quotation ban believe that worthwhile computer









---------FOOTNOTES----------

-[321]-(...continued)

use. Specifically, the quote of a market maker

using auto-refresh will be automatically updated

when the market maker exhausts its exposure limit

in the NASD's Small Order Execution System.



-[322]- See supra note 288, concerning the impact of the

ECN amendment to the 1% rule.



-[323]- The 100-share limitation follows the ITS Plan

requirement that no ITS Participant may use an

automated computer tracking system to generate

quotes for more than 100 shares in any security

the Participant trades through the ITS system.

==========================================START OF PAGE 158======



generated quotes should be permitted.-[324]- For example,



one commenter stresses that a ban on all computer generated



quotations impedes technological innovation, protecting the



franchise of inefficient market makers at the expense of the



investing public. Moreover, the commenter asserts, given the



same regulatory environment, there is no reason to believe that



firms that make automated markets will quote away from the market



any more than firms posting quotes manually.-[325]-



Certain commenters, including the NASD, believe that the ban



should continue in effect. In general, these commenters believe



that lifting the ban could create systems capacity and data



traffic problems, and result in useless quotations that are



automatically maintained away from current market



prices.-[326]-



Even commenters in favor of lifting the ban tend to believe



that, while some types of computer generated quotes are



appropriate, others, such as quotations automatically maintained



away from the best market quotation, should not be permitted.



The NASD, which generally favors the ban on automated quotes,



believes it may be appropriate to revise its autoquote policy to



permit a market maker to automatically update its quote to match



---------FOOTNOTES----------

-[324]- See, e.g., BSE Letter; CSE Letter; D.E. Shaw

Letter; Investors Research Letters; Lehman Letter;

Madoff Letter; Merrill Letter; NSC Letter; NYSE

Letter; Smith Barney Letter.



-[325]- D.E. Shaw Letter.



-[326]- See, e.g., Dean Witter Letter; NASD Letter; PSE

Letter; RPM Specialist Letter.

==========================================START OF PAGE 159======



either the best bid or best offer, provided liquidity is not



withdrawn from the contra-side of the quotation. In this



situation, the NASD believes a market maker will be exposed to an



execution and will be genuinely contributing to market liquidity.



The Commission believes that a total prohibition on the use



of computer generated quotes is not appropriate. Such an



approach excessively limits the use of sophisticated trading



strategies that rely on automation in the quotation process for



their success, and it also may act as a competitive disadvantage



to market makers and specialists that would otherwise rely on



technology to meet their quotation obligations more efficiently.



In the latter instance, broad prohibitions on the use of computer



generated quotes may cause some market makers and specialists to



restrict the number of stocks in which they are willing to make



markets.



While the Commission recognizes traditional concerns related



to the accessibility of computer generated quotes and the impact



of such quotes on systems capacity, it believes that more can and



should be done in this area. This is particularly true given the



enhanced quotation obligations that will be imposed on some



market participants under the revised Quote Rule. The Commission



urges the NASD, ITS Participants,-[327]- and other



---------FOOTNOTES----------

-[327]- The ITS Plan also places certain restrictions on

the use of computer generated quotes. See supra

note 323. Given the technologies that have

developed during the nearly 20 years that these

ITS Plan restrictions have been in place, the

Commission requests that the ITS Participants

(continued...)

==========================================START OF PAGE 160======



interested market participants to develop revised standards that



would permit the use of computer generated quotes that contribute



value to the market. Specifically, the Commission requests that



the NASD and ITS Participants resolve this issue before the



effective date of the Quote Rule amendments. In the absence of



such progress, the Commission recognizes that it will consider



invoking its own authority to address this issue.



ii. Expansion of ITS/CAES Access



As discussed in the Proposing Release, the uniform



application of the Quote Rule to all exchange-listed securities



raises the issue of the disparate treatment of Rule 19c-3 and



non-Rule 19c-3 securities under the ITS Plan. The Commission



solicited comment on this disparate treatment. The same issue



arises with the provision allowing the use of an ECN as an



intermediary in communicating quotes to the public quotation



system if equivalent access is provided.



Currently, the ITS Plan provides access to the ITS System to



any Participant in any Rule 19c-3 security in which the



Participant disseminates continuous two-sided quotations, but



excludes OTC market makers from ITS access for non-Rule 19c-3



securities. In the past, market makers in non-Rule 19c-3



securities were not subject to mandatory quote requirements. The





---------FOOTNOTES----------

-[327]-(...continued)

review these limitations and whether they continue

to be appropriate, in whole or in part, and

whether new limitations should replace the

existing provisions or whether there should be any

ITS Plan limitations on automated quotes.

==========================================START OF PAGE 161======



amendments to the Quote Rule adopted today will subject OTC



market makers and exchange specialists to the same quotation



requirements for all exchange-listed securities.



The Commission requested comment on whether the Quote Rule



amendments justify an expansion of the linkage between ITS and



the NASD's CAES interface to provide ITS access to and from any



market maker for any exchange-listed security in which that



market maker disseminates continuous two-sided quotations.



Numerous commenters support expanding the linkage in this manner



because they believe an expansion will enhance fair competition



and increase opportunities for best execution.-[328]-



Several commenters also assert that arguments previously made to



exclude OTC market maker quotes in non-Rule 19c-3 securities from



ITS are no longer valid.-[329]-



One commenter specifically argues that adoption of the



Commission's proposals should end any objection to the NASD's



full participation in ITS because the operation of the Quote Rule



will reduce opportunities for OTC market makers to trade in ECNs



while simultaneously availing themselves of the voluntary aspect



of the Quote Rule, and therefore, will expand the imposition of



NASD quotation requirements upon OTC market makers. These



requirements, according to the commenter, are equal to those of





---------FOOTNOTES----------

-[328]- See, e.g. D.E. Shaw Letter; Investors Research

Letter; Lehman Letter; NASD Letter; NSC Letter;

Madoff Letter; Rothschild Letter; Schwab Letter;

STA Letter.



-[329]- See, e.g., Madoff Letter.

==========================================START OF PAGE 162======



any other market and add greater transparency and liquidity to



the markets for exchange-listed securities as well as the



NMS.-[330]-



Those commenters opposed to the expansion generally believe



that the existing limitation on ITS access is justified in view



of disparities in customer protections afforded by exchanges and



exchange members when compared to customer protections mandated



by NASD rules.-[331]-



The Commission recognizes that the expansion of ITS/CAES is



a significant issue of concern to many market participants. The



Commission therefore encourages a continuing dialogue among the



ITS Participants to solve this issue on a timely basis and in a



manner beneficial to the market as a whole.





d. Operation of the Rule with Amended

Definitions



i. Amendment to 11Ac1-1(a)(25) (definition

of a "subject security")



As a result of the amendment adopted today, OTC market



makers and exchange specialists who hold themselves out as



willing to buy and sell non-Rule 19c-3 securities on a regular or





---------FOOTNOTES----------

-[330]- Id. Madoff states that the NASD now requires

every OTC market maker to conform with NMS

principles, respect all other NMS quotations in

listed securities, and not trade through better

quotes in the NMS. Madoff further notes that, in

contrast, exchanges do not impose similar

restrictions with respect to trading through off-

exchange quotations.



-[331]- See Amex Letter; BSE Letter; CHX Letter; CSE

Letter; PSE Letter; Specialists Assoc. Letter.

==========================================START OF PAGE 163======



continuous basis, and that account for more than 1% of the



quarterly aggregate trading volume, will be subject to the Quote



Rule and required to make continuous two-sided quotations



available to the public, even if they have not previously elected



to register as CQS market makers with the NASD. This amendment



will close a significant gap in the quotation information that



has been available heretofore to market participants and



investors. In a parallel action, the Commission is proposing for



comment an additional amendment to the Quote Rule.-[332]-



The Commission believes that the additional proposal, if adopted,



would further improve transparency by providing investors with



quotation information on Nasdaq securities from significant OTC



market makers and specialists.



ii. Amendment to 11Ac1-1(a)(13) (definition

of an "OTC market maker")



The definition of OTC market maker now includes any dealer



holding itself out as willing to transact business for its own



account on a regular or continuous basis, whether it transacts



exclusively with its own customers or with the customers of other



dealers. Those dealers that hold themselves out to customers as



willing to execute orders on a regular or continuous basis,



whether by the internalization of customer order flow in



particular stocks or through arrangements with particular firms



to execute their customer order flow, now fall within the



definition of OTC market maker. Therefore, obligations under the





---------FOOTNOTES----------

-[332]- See Companion Release.

==========================================START OF PAGE 164======



Quote Rule will now apply to dealers that internalize customer



order flow or hold themselves out to particular firms as willing



to execute their customer order flow, and that execute those



orders on a regular or continuous basis. As in the past, broker-



dealers will not be considered to be holding themselves out as



regularly or continuously willing to buy or sell a security if



they occasionally execute a trade as principal to accommodate a



customer's request.



iii. Amendment to 11Ac1-1(a)(6) (definition

of a "covered security")



The amendment extends the coverage of the Quote Rule to all



Nasdaq securities where the rule had previously applied only to



Nasdaq/National Market securities. As noted previously, NASD



rules already require a dealer that makes a market in a Nasdaq



SmallCap security to provide quotations.-[333]- The



Commission, therefore, does not believe extending the Quote Rule



to include securities covered by an existing NASD rule will



result in additional burdens on OTC market makers. Although the



definition of covered security has been amended to include Nasdaq



SmallCap securities, an exchange specialist or OTC market maker



still must make an election, pursuant to paragraphs (b)(5)(i) and



(ii), respectively, of the Quote Rule.-[334]-



Accordingly, although the definition has been amended, an OTC



market maker or specialist is not mandated by the Quote Rule to





---------FOOTNOTES----------

-[333]- See NASD Rule 4613.



-[334]- 17 CFR 240.11Ac1-1(b)(5)(i)

==========================================START OF PAGE 165======



provide quotations on Nasdaq SmallCap securities. If, however,



an exchange specialist or OTC market maker makes an election to



make available quotations, the firmness obligations under



paragraph (c) of the Quote Rule become operative.



e. Effective Date



The amendments to Rule 11Ac1-1 adopted by the Commission



today will become effective on [insert date 120 days from the



date of publication in the Federal Register].



C. Price Improvement for Customer Market Orders



1. Proposed Rule



In the Proposing Release, the Commission sought comment on a



market-wide Price Improvement Rule for customer market orders.



The proposed rule was designed to apply across exchange and OTC



markets to promote the execution quality of orders by providing



increased opportunities for customer orders to interact at better



prices without the intervention of a dealer. The proposal



included a non-exclusive safe harbor as one means by which a



specialist or OTC market maker could be assured that an order



received a sufficient opportunity for price improvement for



purposes of the rule.



The proposed rule was intended to encourage market



participants to take advantage of current technologies and



provide customer market orders with improved access to price



improvement opportunities, regardless of where such orders are



routed for execution. Although the proposed rule would have



required specialists and OTC market makers to provide price

==========================================START OF PAGE 166======



improvement opportunities for customer orders, the Commission did



not prescribe any particular method of achieving price



improvement in recognition of the fact that competition can



produce innovative price improvement mechanisms. The Commission



proposed a non-exclusive safe harbor, however, to provide



certainty regarding one alternative by which a specialist or OTC



market maker would be deemed to have satisfied its price



improvement obligation.



Under the safe harbor, a specialist or OTC market maker



would have been deemed in compliance with the proposed price



improvement rule if it exposed, in its quote, a customer market



order at an improved price and provided the customer with a



guaranteed execution at the "stop" price.-[335]- This



procedure was designed to promote the interaction of exposed



orders at prices better than the NBBO with orders or trading



interest in other markets. The safe harbor also was intended to



lead to increased competition by encouraging specialists and OTC



market makers to compete more actively for order flow on the



basis of their published quotations. The Commission made clear,



however, that the order exposure procedures set out in the



proposed safe harbor neither would be mandatory, nor the



exclusive means by which to satisfy the obligation to provide an





---------FOOTNOTES----------

-[335]- The proposed safe harbor provided for an order to

be "stopped" at the national best bid (for a sell

order) or offer (for a buy order) for the lesser

of either the full size of the order, or the size

associated with the national best bid (for a sell

order) or offer (for a buy order).

==========================================START OF PAGE 167======



opportunity for price improvement.



Many of the 145 commenters discussed the proposed Price



Improvement Rule. The commenters raise numerous questions and



concerns regarding the proposed rule. For example, some



commenters claim that an absolute rule would reduce the broker-



dealer's fiduciary obligation of best execution to an algorithm,



eliminating the exercise of professional judgment in identifying



price improvement opportunities.-[336]- Instead, the



commenters argue that customers and market professionals should



be able to use discretion in deciding when and how price



improvement should be sought.-[337]-



In addition, several commenters are concerned that the



proposed safe harbor would become the industry standard. These



commenters believe that, although non-exclusive, the proposed



safe harbor would dictate the minimum acceptable standard to



follow, thereby stifling innovation and



competition.-[338]- Many commenters also are troubled by



---------FOOTNOTES----------

-[336]- See, e.g., Goldman Sachs Letter; Jefferies Letter;

Madoff Letter; Merrill Letter; NYSE Letter;

PaineWebber Letter; PSE Letter.



-[337]- See, e.g., CSE Letter; Goldman Sachs Letter;

Madoff Letter; Merrill Letter; NSC Letter; NYSE

Letter; PSE Letter.



-[338]- See, e.g., AZX Letter; Blume Letter; HHG Letter;

Lehman Letter; Merrill Letter; Morgan Stanley

Letter; NASD Letter; Salomon Letter; Schwab

Letter; Smith Barney Letter; PaineWebber Letter;

Ruane Letter.



Some commenters believe their current operations would

satisfy the rule and, therefore, they would not need to

(continued...)

==========================================START OF PAGE 168======



various technical aspects regarding the application of the safe



harbor. For example, some commenters believe the 30-second



exposure period would be insufficient to allow other market



participants to respond to the exposed order, even with today's



technology.-[339]- Other commenters are concerned with



the mechanics of the "stopping" procedures.-[340]- At



least one commenter argues that the requirement to stop stock



blurs the distinction between price guarantees and price



improvement opportunities.-[341]-



The potential costs associated with the proposed rule also



concern many commenters. They claim that necessary systems



upgrades would be expensive.-[342]- In addition, several



commenters claim that the number of quotes generated as a result



of the safe harbor would pose a serious threat to system





---------FOOTNOTES----------

-[338]-(...continued)

utilize the safe harbor procedures. See, e.g., Amex Letter;

BSE Letter; CHX Letter; NYSE Letter; PSE Letter.



-[339]- See, e.g., Amex Letter; Blume Letter; BSE Letter;

CHX Letter; CSE Letter; NYSE Letter; PSE Letter;

Schwab Letter;. But see, e.g., Letter from

Raymond E. Wooldridge, Chief Executive Officer,

Southwest Securities, to Mr. Jonathan G. Katz,

Secretary, SEC, dated January 9, 1996 ("Southwest

Letter"); STANY Letter.



-[340]- See, e.g., Madoff Letter; MJT Letter; Smith Barney

Letter.



-[341]- See Sutro Letter.



-[342]- See, e.g., Blume Letter; Dean Witter Letter;

Fahnestock Letter; Goldman Sachs Letter; LJR

Letter; NASD Letter; PaineWebber Letter; Ruane

Letter; Salomon Letter; Schwab II Letter; SIA

Letter.

==========================================START OF PAGE 169======



capacity.-[343]- Many commenters warn that the increased



traffic would reduce trading efficiency, decrease transparency



and increase overall risk.-[344]- Some commenters also



state that market price integrity would be reduced due to the



proliferation of flickering, ephemeral quotations.-[345]-



A common suggestion from the commenters is that the



Commission not adopt the proposed rule prior to evaluating the



effects of the other initiatives contained in the



proposal.-[346]- Some commenters believe that the



amendments to the Quote Rule and the proposed Limit Order Display



Rule should act to narrow spreads by eliciting the true market



for a given security, thereby decreasing the utility and



necessity of seeking better prices for customer orders.



According to these commenters, if such results are achieved



through the other initiatives, the potential costs and



significant market operations changes associated with the



---------FOOTNOTES----------

-[343]- See, e.g., Bear Stearns Letter; FIF Letter;

Merrill Letter; PSE Letter; STANY Letter.



-[344]- See, e.g., Amex Letter; Bear Stearns Letter; Blume

Letter; FIF Letter; LJR Letter; Madoff Letter;

Merrill Letter; Morgan Stanley Letter; NASD

Letter; PSE Letter; Salomon Letter; STA Letter;

STANY Letter; Specialist Assoc. Letter.



-[345]- See, e.g., Dean Witter Letter; ICI Letter; Merrill

Letter; Morgan Stanley Letter; NASD Letter; NYSE

Letter; PSE Letter; Salomon Letter; Schwab II

Letter; Specialist Assoc. Letter; STANY Letter.



-[346]- See, e.g., Bear Stearns Letter; Dean Witter

Letter; DOJ Letter; Goldman Sachs Letter; Lehman

Letter; Madoff Letter; Morgan Stanley Letter; NASD

Letter; NSC Letter; Schwab II Letter; SIA Letter;

Sutro Letter.

==========================================START OF PAGE 170======



proposed Price Improvement Rule would far outweigh any potential



benefit.



Although the Commission continues to believe that the



opportunity for price improvement can contribute to providing



customer orders with enhanced executions, the Commission has



determined to defer action on the proposed Price Improvement Rule



for the present time. The Commission believes that the other



initiatives adopted today will greatly improve the price



discovery process and the opportunity for customer orders to



receive enhanced execution prices. These initiatives should act



to narrow spreads by making available to all market participants



the true buying and selling interest in a given security. The



Commission believes, therefore, that the most appropriate course



of action is to monitor the operation of the initiatives adopted



today, and assess their impact on spreads, the quality of



markets, and the quality of executions. This assessment will



enable the Commission to better determine the need for further



Commission action regarding specific price improvement



obligations.



2. Best Execution Obligations



The proposed Price Improvement Rule was designed to



complement the long-standing duties of broker-dealers to seek to



obtain best execution of their customer orders; the Commission



did not intend for the proposed rule to modify this existing best



execution obligation.-[347]- Therefore, the Commission's



---------FOOTNOTES----------

-[347]- Proposing Release at 49.

==========================================START OF PAGE 171======



decision to defer consideration of the proposed rule in no way



should be taken as an indication that the duty of best execution



has been altered.



A broker-dealer's duty of best execution derives from common



law agency principles and fiduciary obligations, and is



incorporated both in SRO rules and, through judicial and



Commission decisions, in the antifraud provisions of the federal



securities laws.-[348]- This duty of best execution



requires a broker-dealer to seek the most favorable terms



reasonably available under the circumstances for a customer's



transaction.-[349]- The scope of this duty of best



execution must evolve as changes occur in the market that give



rise to improved executions for customer orders, including



opportunities to trade at more advantageous prices. As these



changes occur, broker-dealers' procedures for seeking to obtain



best execution for customer orders also must be modified to



consider price opportunities that become "reasonably



available."-[350]-



In the past the Commission has recognized the practical



necessity of automating the handling of small orders, and has



indicated that automated routing or execution of customer orders







---------FOOTNOTES----------

-[348]- See Market 2000 Study, Study V at V-1, 2 and

sources cited therein.



-[349]- See Market 2000 Concept Release, supra note 10;

Market 2000 Study, Study V.



-[350]- Proposing Release at 7-10.

==========================================START OF PAGE 172======



is not necessarily inconsistent with best



execution.-[351]- At the same time, the Commission has



emphasized that best execution obligations require that broker-



dealers routing orders for automatic execution must periodically



assess the quality of competing markets to assure that order flow



is directed to markets providing the most beneficial terms for



their customers' orders.-[352]- While in the past quote-



based executions in OTC securities were generally recognized as



satisfying best execution obligations, the development of



efficient new facilities has altered what broker dealers must



consider in seeking best execution of customer



orders.-[353]- The Commission thus noted the importance



of the opportunity for price improvement as a factor in best



execution, speaking in the context of aggregate order handling



decisions for both listed and OTC stocks.-[354]-



Therefore, the Commission believes that routing order flow for



automated execution, or internally executing order flow on an





---------FOOTNOTES----------

-[351]- Id. at 8.



-[352]- Payment for Order Flow Release, supra note 23, at

n. 30 and accompanying text; See Securities

Exchange Act Release No. 37046 (March 29, 1996),

61 FR 15322 (April 5, 1996) ("CSE Approval

Order"); Securities Exchange Act Release No. 37045

(March 29, 1996), 61 FR 15318 (April 5, 1996)

("BSE Approval Order").



-[353]- Proposing Release at 10.



-[354]- Id.; see also Payment for Order Flow Release,

supra note 23 at text accompanying notes 31-33.

See CSE Approval Order, supra note 352; BSE

Approval Order, supra note 352.

==========================================START OF PAGE 173======



automated basis, at the best bid or offer quotation, would not



necessarily satisfy a broker-dealer's duty of best execution for



small orders in listed and OTC securities.-[355]-



Both the rule and the amendments adopted today should



further improve a broker-dealer's ability to obtain improved



executions for customer orders. These changes will enhance the



public quote by including in the public quotation system many



superior prices not currently reflected there. The ECN amendment



is intended to publicize superior market maker ECN prices in the



public quote, which should make these prices more easily



accessible. Similarly, the Display Rule will include more



customer prices in the public quote through requiring the display



of customer limit orders.



Nonetheless, various markets and market makers may continue



to provide opportunities for executions at prices superior to the



enhanced national best bid and offer for their customer



orders.-[356]- For example, some markets or market makers



may continue to offer price improvement opportunities, based on



internal order flow or execution algorithms. The Commission



believes that broker-dealers deciding where to route or execute



small customer orders in listed or OTC securities must carefully



evaluate the extent to which this order flow would be afforded



better terms if executed in a market or with a market maker



---------FOOTNOTES----------

-[355]- Proposing Release at 9-10; see also note 360 and

accompanying text (factors relevant to best

execution).



-[356]- Id.

==========================================START OF PAGE 174======



offering price improvement opportunities. In conducting the



requisite evaluation of its internal order handling procedures, a



broker-dealer must regularly and rigorously examine execution



quality likely to be obtained from the different markets or



market makers trading a security.-[357]- If different



markets may be more suitable for different types of orders or



particular securities, the broker-dealer will also need to



consider such factors.



Where material differences exist between the price



improvement opportunities offered by markets or market makers,



these differences must be taken into account by the broker-



dealer. Similarly, in evaluating its procedures for handling



limit orders, the broker-dealer must take into account any



material differences in execution quality ( e.g., the likelihood



of execution) among the various markets or market centers to



which limit orders may be routed. The traditional non-price



factors affecting the cost or efficiency of executions also



should continue to be considered;-[358]- however, broker-



dealers must not allow an order routing inducement, such as





---------FOOTNOTES----------

-[357]- CSE Approval Order, 61 FR at 15329. "Price

improvement" in this context is defined as the

difference between execution price and the best

quotes prevailing in the market at the time the

order arrived at the market or market maker. Any

evaluation of price improvement opportunities

would have to consider not only the extent to

which orders are executed at prices better than

the prevailing quotes, but also the extent to

which orders are executed at inferior prices.



-[358]- See Market 2000 Study, Study V at V-2, 3.

==========================================START OF PAGE 175======



payment for order flow or the opportunity to trade with that



order as principal, to interfere with its duty of best



execution.-[359]- Of course, as the Commission has



previously noted, in light of a broker-dealer's obligation to



assess the quality of the markets to which it routes packaged



order flow absent specific instructions from customers, the



Commission does not believe that a broker-dealer violates its



best execution obligation merely because it receives payment for



order flow or trades as principal with customer orders.



-[360]-



Prices superior to the public quote may at times be



available in ECNs, even after adoption of the ECN amendment,



based, for example, on orders of institutional participants and



others not covered by the ECN amendment. Superior prices also



may be available in other systems not classified as ECNs. As the



Commission noted in the Proposing Release in September, 1995, and



reiterates today, where reliable, superior prices are readily



accessible in such systems, broker-dealers should consider these



prices in making decisions regarding the routing of customer



orders.-[361]- The Commission recognizes that many of



these systems are less accessible and involve higher costs for



broker-dealers than the public markets. In addition, in many



cases it is not currently feasible to efficiently obtain price



---------FOOTNOTES----------

-[359]- Payment for Order Flow Release, supra note 23.



-[360]- Id.



-[361]- Proposing Release at 10.

==========================================START OF PAGE 176======



information from these systems or link to these systems on an



automated basis. The Commission is not suggesting that broker-



dealers must engage in manual handling of small orders if



necessary to access these systems.-[362]- Nonetheless, the



Commission believes that because technology is rapidly making



these systems more accessible, broker-dealers must regularly



evaluate whether prices or other benefits offered by these



systems are reasonably available for purposes of seeking best



execution of these customer orders. For example, if an ECN



provides an automated link that makes it cost effective for a



broker-dealer to access these systems for its retail orders on an



automated basis, the broker-dealer must take the prices and other



relevant costs in that system into account in handling these



customer orders.



Pursuant to the Display Rule, most customer limit orders at



superior prices will be required to be displayed and included in



the public quote.-[363]- The display of a limit order by



a market maker directly affects its responsibilities in handling



other customer orders. The Commission has long said that broker-



---------FOOTNOTES----------

-[362]- The Commission has recognized that it may be

impractical, both in terms of time and expense,

for a broker that handles a large volume of orders

to determine individually where to route each

order it received. Proposing Release at 8.



-[363]- The Commission notes that the NASD's

interpretation prohibiting market makers from

trading ahead of customer limit orders applies

both to displayed and nondisplayed customer limit

orders held by the market maker. See NASD Conduct

Rule IM 2110-2 (Trading Ahead of Customer Limit

Orders).

==========================================START OF PAGE 177======



dealers must consider quotation information contained in the



public quotation system in seeking best execution of customer



orders.-[364]- In executing customer market orders, a



market maker must give no less consideration to the price of its



own displayed customer limit order than any other public



quotation price. Therefore, under the new Display Rule, a market



maker that has displayed a customer limit order would be expected



to provide an offsetting customer market order an execution at



that limit price at least up to the size of the limit order.



In addition, the Commission notes that currently, some



market makers that hold a customer limit order on one side of the



market, priced better than the market maker's own quote, and a



customer market order on the other side of the market, will



execute both orders as principal rather than crossing the two



orders. As a result, the market order customer receives the best



bid and offer rather than receiving the benefit of a better limit



order price. In light of the increased opportunities for price



improvement now available and the rules the Commission is



adopting today, the Commission believes that going forward this



practice is no longer appropriate given the broker-dealer's



obligation, as part of its duty of best execution, to its market



order customer.-[365]-





---------FOOTNOTES----------

-[364]- See Quote Rule Adopting Release, supra note 208.



-[365]- Cf., NASD Notice to Members 96-10 (February, 1996)

at 43; NASD Notice to Members 95-67 (August, 1995)

at 417.

==========================================START OF PAGE 178======



In conclusion, although the Commission has determined for



the present to defer final action on the proposed Price



Improvement Rule, the Commission's adoption of the Display Rule



and the Quote Rule amendments should substantially improve public



quotations. Moreover, the Commission firmly believes that



broker-dealers, when deciding where to route or execute customer



orders, must carefully consider and evaluate opportunities for



obtaining improved executions.



IV. Authority



As discussed above, the 1975 Act Amendments to the Exchange



Act set forth Congress' goals for a national market system.



Several commenters argue that the proposed rules violate



Congress's direction that the Commission facilitate the



establishment of, rather than design, a national market



system.-[366]- Many of these comments were directed at



the proposed Price Improvement Rule and in particular the



proposed price improvement safe harbor. The Commission today is



deferring action on that rule proposal. To the extent that the



comments relate to the rule and amendments adopted today,



however, they reflect a fundamental misunderstanding regarding



the purpose of the rules and the Commission's role in



facilitating a national market system.



The Commission's adoption of these rules is fully consistent



with the role that Congress envisioned in 1975 for the



---------FOOTNOTES----------

-[366]- See, e.g., ABA Letter; Fahnestock Letter; HHG

Letter; LJR Letter; NSC Letter; PaineWebber

Letter; RPM Letter; Ruane Letter; SIA Letter.

==========================================START OF PAGE 179======



Commission. Congress's direction to the Commission to



"facilitate" the establishment of a national market system for



securities that implemented Congressionally enumerated objectives



was not intended as a limitation on the Commission's authority



but rather was "designed to provide maximum flexibility to the



Commission and the securities industry in giving specific content



to the general concept of the national market system."



-[367]- Congress granted the Commission broad rulemaking



authority over the national market system and market participants



and this grant of specific rulemaking authority was not



conditioned on the expectation that the Commission refrain from



using it.



Although Congress expressed a preference that where possible



the national market system evolve through the interplay of



competitive forces, it recognized that "competition may not be



sufficient" and that in such cases, the Commission should act



"promptly and effectively to insure that the essential mechanisms



of an integrated secondary trading system [be] put into place * *



---------FOOTNOTES----------

-[367]- Conference Report, supra note 213, at 92. See

Senate Report, supra note 31, at 8-9 ("the sounder

approach appeared * * * 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

Congressional determined goals and objectives.").

The Conference Committee report on the 1975 Act

Amendments indicates that the conferees adopted

with minor revisions the Senate's provisions

concerning the national market system. Conference

Report, supra note 213, at 92.

==========================================START OF PAGE 180======



*." -[368]- Congress specifically identified in 1975 some



of the concerns addressed today and the Commission has examined



these issues on several occasions over the intervening years in



response to evolving market conditions and technologies. In view



of the caution and deliberation with which the Commission has



proceeded over the past 21 years, its actions today cannot fairly



be viewed as arresting natural competitive forces, but rather



should be regarded as an attempt to foster efficiency and redress



shortcomings in the national market system that have developed



since then, or that the securities industry on its own has been



unable to resolve over this time.



The subject matter of these rule and rule amendments is an



area of the national market system in which Congress itself



recognized that the Commission's expertise and authority were



paramount. Indeed, Section 11A was specifically enacted to



eliminate "arguments about the SEC's authority" in this area.



For that reason, the Commission was given "pervasive rulemaking



power" with respect to the business of collecting, processing, or



publishing information relating to quotations for and



transactions in securities. -[369]- The rules adopted



today implement Congress' goals as to dissemination of trading



information: "to insure the availability of prompt and accurate



trading information, to assure that these communications networks



are not controlled or dominated by any particular market center,



---------FOOTNOTES----------

-[368]- Conference Report, supra note 213 at 92.



-[369]- Conference Report, supra note 213, at 93.

==========================================START OF PAGE 181======



to guarantee fair access to such systems by all brokers, dealers



and investors, and to prevent any competitive restriction on



their operation not justified by the purposes of the Exchange



Act." -[370]-



It bears noting that the standards adopted by the Commission



today are intended to allow markets to adapt and evolve in



meeting the objectives of the national market system; the rules



establish performance standards but do not dictate market



structure. With regard to the Quote Rule, the rules do not



determine how non-Rule 19c-3 market makers may make markets or



how electronic communications networks may operate. Non-Rule



19c-3 market makers are free to operate as they please so long as



they report their quotations to the extent they execute a certain



level of volume in a security. Likewise, market makers and



specialists may place priced orders in ECNs of many different



designs as long as they change their quotes to reflect the orders



in the ECN or the ECNs publicly report the quotes and provide



access to such priced orders. With regard to the Limit Order



Display Rule, the rule does not seek to create a central limit



order book or central limit order file. Broker-dealers are free



to satisfy the rule in several different ways, so long as the



result is that customer limit orders priced at or better than the



NBBO are publicly displayed.



Some commenters also argue that the proposed rules are



contrary to Congress' direction to assure fair competition



---------FOOTNOTES----------

-[370]- Senate Report, supra note 31.

==========================================START OF PAGE 182======



between auction and dealer markets as structures for the trading



of securities-[371]- and inappropriately introduce auction



market principles into dealer markets. Although requiring



display of superior-priced customer limit orders could be viewed



as an auction market principle, such a requirement does not



supplant the basic features of a dealer market or undermine



competition between the exchange and OTC markets. Congress



clearly intended that dealer markets would benefit from use of



some auction market principles -[372]- and the 1975



Amendments specifically announce as a goal of the national market



system that customer orders be able to interact without the



intervention of a dealer to the extent that such a goal is



consistent with other national market system



objectives.-[373]- At a minimum, where feasible, customer



limit orders should have a meaningful opportunity to interact



with customer market orders.-[374]-



One of the main benefits contemplated by Congress was that



the national market system would enable investors in dealer



markets to execute against another limit order or market order at



a better price than currently being quoted by a dealer for his



---------FOOTNOTES----------

-[371]- See, e.g., Goldman Sachs Letter; Jefferies Letter;

Merrill Lynch Letter; RPM Letter; Schwab I Letter;

Schwartz & Wood Letter; SIA Letter; Specialist

Assoc. Letter; see also Exchange Act Section

11A(a)(1)(C)(ii), 15 U.S.C. 78k-1(a)(1)(C)(ii).



-[372]- Senate Report, supra note 31, at 16.



-[373]- Exchange Act Section 11A(a)(1)(C)(v).



-[374]- Exchange Act Section 11A(a)(1)(C)(v).

==========================================START OF PAGE 183======



own account.-[375]- Display of superior-priced limit



orders would permit investors to compete in some cases with



market makers and specialists, thereby increasing the



competitiveness of dealer markets in these securities and



enhancing the quality of customer limit order execution. Display



of customer limit orders, however, would not compromise the



essential features of dealer markets. In the absence of any



superior-priced customer limit orders, dealers would continue to



compete for market orders at their published quotations and would



be able to execute against customer limit orders that would



otherwise prevent the market maker from trading with a market



order. Further, the widespread use by OTC dealers of ECNs to



trade at prices better than the dealers' published quotes is of



such recent vintage that it can hardly be viewed as a necessary



part of a dealer market structure.-[376]-



V. Summary of Final Regulatory Flexibility Act Analysis



This following discussion summarizes the Commission's



analysis of the rules adopted today under the Regulatory



Flexibility Act. A complete final copy of the Final Regulatory



Flexibility Act is available in the Public File.





---------FOOTNOTES----------

-[375]- Senate Report supra note 31, at 16.



-[376]- While the rule and rule amendments adopted today

function as an integrated response to the problems

the Commission has identified in the

implementation of a NMS, each separately advances

the Congressional goals of market efficiency, fair

competition, transparency, and best execution, and

accordingly the Commission intends that they be

treated as severable for purposes of review.

==========================================START OF PAGE 184======



The rules adopted today by the Commission are intended to



allow markets to adapt and evolve in meeting the objectives of



the national market system. In this regard, the rules establish



performance standards but do not dictate market structure. The



Quote Rule does not dictate how market makers or specialists that



trade non-Rule 19c-3 securities may conduct their market making



activities or how ECNs may service their subscribers. Market



makers will be able to continue their regular market making



activities so long as they report their quotations if they trade



more than 1% of the transaction volume in a security. Likewise,



market makers and specialists may place priced orders in ECNs of



many different designs as long as they change their quotes to



reflect better priced orders they have entered in ECNs or,



alternatively, such ECNs provide for the public reporting of



these prices and provide access to such priced orders. Moreover,



broker-dealers are free to satisfy the Display Rule in several



different ways, so long as the result is that customer limit



orders priced at or better than the NBBO are publicly displayed



in accordance with the rule.



A. Display Rule



The Commission considered several significant alternatives



to Rule 11Ac1-4 consistent with the Rule s objectives and



designed to minimize the impact of the rule on small entities.



The Commission solicited comment on, among other things: (i)



whether the display requirement should be based on a de minimis



threshold; (ii) the classes of securities to which the Rule

==========================================START OF PAGE 185======



should apply; (iii) whether to permit limit orders to be



delivered to an exchange- or association-sponsored system that



displays limit orders in accordance with the rule; and (iv)



whether to permit limit orders to be delivered to an ECN or a



PTS. The Commission believes that the rule as adopted imposes a



smaller burden upon small brokers and dealers than do other



alternatives considered.



The Commission believes that the ability of brokers and



dealers to send a limit order to another party or system that



will display that order provides all brokers and dealers,



including small brokers and dealers, with the greatest possible



flexibility to satisfy the NMS objectives embodied in the rule in



the most economical manner. In this regard, the Commission



decided to expand one of the exceptions to the display



requirement that will permit market makers to comply with the



rule by delivering customer limit orders to an ECN that complies



with the ECN amendment to the Quote Rule. Furthermore, the



Commission added a new exemptive provision that enables the



Commission to exempt any responsible broker or dealer, ECN,



exchange, or association from the requirements of the Display



Rule.



The Commission considered allowing display of a



representative size of a limit order rather than the full size,



but concluded that display of the full size will provide the most



accurate picture of the depth of the market at a particular



price. The Commission does not believe that it is practicable to

==========================================START OF PAGE 186======



exempt small entities from the Display Rule because to do so



would be inconsistent with the Commission's statutory mandate to



protect investors. In that regard, the Commission believes that



the pricing and size conventions documented in the 21(a) Report



referenced above make it imperative that the requirements of the



Display Rule apply to all market participants with equal force.



The Commission notes that any exception for small brokers and



dealers could create an incentive for Nasdaq market makers to



create special market making subsidiaries qualifying as small



broker-dealers which would be free to engage in the anti-



competitive practices identified in the 21(a) Report.



B. Quote Rule



Allowing market makers that deal actively in securities



without publicizing their activity or making available their



prices undermines the NMS goal of transparency. The Commission



believes that those dealers should be recognized as market makers



and their quotations publicized so that investors may know of,



and trade on similar terms with, those market makers. Therefore,



the definition of OTC market maker now includes any dealer



holding itself out as willing to transact business for its own



account on a regular or continuous basis, whether it transacts



exclusively with its own customers or with the customers of other



dealers. Thus, those dealers that internalize customer order



flow in particular stocks or through arrangements with other



firms to execute that order flow, now fall within the definition



of OTC market maker and are subject to the obligations under the

==========================================START OF PAGE 187======



Quote Rule. As in the past, broker-dealers will not be



considered to be holding themselves out as regularly or



continuously willing to buy or sell a security if they



occasionally execute a trade as principal to accommodate a



customer's request. In response to the suggestions of some



commenters, the Commission has modified the amendment to make



clear that more than one isolated transaction is necessary before



a dealer is designated an OTC market maker.



In addition, the Commission believes that extending the 1%



threshold based on quarterly aggregate trading volume to non-Rule



19c-3 securities is a reasonable method to improve the scope of



quotation information to include significant OTC market makers



and specialists. This 1% threshold, currently in effect for Rule



19c-3 securities, has proved effective in supplying comprehensive



quotation information to the market at large. Moreover, based on



the increase in third market trading volume for these securities,



the Commission does not believe this standard is unduly



burdensome on OTC market makers. Rather, the Commission believes



this threshold strikes a balance between requiring the



dissemination of all quotation interest and accommodating those



specialists and OTC market makers that may be small entities.



The Commission believes that OTC market makers and specialists



that account for 1% or less of the aggregate volume are not



active enough to justify the additional expense of providing



continuous quotation display. Accordingly, the Commission



believes the "greater than 1% aggregate trading volume" threshold

==========================================START OF PAGE 188======



for mandatory quotations continues to be appropriate. To limit a



possible inconsistency in the treatment of exchange-listed and



Nasdaq securities, the Commission today is proposing that the 1%



test be extended from all exchange-listed securities to all



Nasdaq-listed securities.



The Commission considered several significant alternatives



to the proposed amendments to the Quote Rule consistent with the



Rule's objectives and designed to minimize the impact of the



amendments on small entities. The Commission solicited comment



on numerous alternatives to the amendments proposed to ensure



that investors receive consolidated quotations that truly reflect



the best prices available for a security. The Commission



solicited comment on, among other issues: (i) whether the



Commission should require SROs to amend their rules to permit



computer-generated quotations; (ii) whether there existed



alternatives to the ECN proposal that minimized certain



consequences of the rule while assuring public dissemination of



the best priced orders in such systems; (iii) whether there



should be exceptions to the ECN proposal and under what



circumstances; and (iv) whether the objectives of the Quote Rule



and the ECN amendment could be achieved by allowing ECNs to



furnish prices to the applicable SRO, while providing access to



the prices in their ECN. The Commission believes that the



amendments as adopted impose a smaller burden upon small brokers



and dealers than does any other alternative considered.



In recognition of the concerns raised by some commenters,

==========================================START OF PAGE 189======



the ECN display alternative is designed to preserve the benefits



associated with the anonymity that certain ECNs currently offer



to subscribing market makers and specialists. This alternative



also ensures that the best market maker and specialist prices in



the ECN are publicly disseminated and that non-subscribing



brokers and dealers may trade with the orders represented by



those prices. Under the display alternative, the price of a



specialist's or market maker's order entered into an ECN would be



publicly disseminated while the specialist or market maker



remains anonymous. This alternative not only preserves



anonymity, but also eliminates the risk that a market maker or



specialist may be exposed to multiple executions at the ECN



price. With the addition of the alternative, the ECN amendment



permits the display of the best price either in the specialist's



or market maker's quote or through an ECN that provides for the



dissemination of the best market maker and specialist prices



entered into the ECN.



The Commission also notes that the ECN display alternative



reduces the compliance burden on broker-dealers, including small



entities, by permitting specialists and market makers to comply



with the ECN amendment if the ECN into which the market maker s



order is entered ensures that the best market maker prices



entered therein are communicated to an exchange, association or



securities information processor and the ECN provides a means for



brokers and dealers to trade with the orders market makers and



specialists put in the ECN.

==========================================START OF PAGE 190======



The Commission recognizes that the ECN display alternative



may reduce the content of information that is publicly available



because under this alternative, the identity of the market maker



or specialist that entered the better priced order in the ECN



will be withheld. The Commission believes this result is



justified because the inside prices and full sizes of orders



entered by market makers and specialists will be in the public



quotation system to inform the entire market of these prices and



ECNs will provide equivalent access to those prices. Moreover,



the Commission believes the benefits of facilitating the use of



ECNs, by permitting the continued anonymity of market makers and



specialists, more than offset the reduced information available



on the identity of a particular market maker or specialist.



The Commission believes the data it has reviewed supports



the need for prompt adoption of the ECN amendment to the Quote



Rule. As discussed more fully in the Appendix to the 21(a)



Report, an analysis of data for April through June 1994 shows



that approximately 85% of bids and offers displayed by market



makers on Instinet and 90% of bids and offers displayed on



SelectNet (an ECN sponsored by the NASD) were at better prices



than those disseminated to the public via Nasdaq. In addition,



approximately 77% of trades executed on Instinet and 60% of



trades executed on SelectNet were at prices superior to the



Nasdaq inside spread. Given this strong evidence that investors



would benefit from public dissemination of these hidden prices



that are broadly disseminated to subscribers in these systems,

==========================================START OF PAGE 191======



the Commission believes that it is appropriate to adopt the



amendments to the Quote Rule.



The Commission does not believe that it is practicable to



exempt small entities from the Quote Rule amendments because to



do so would be inconsistent with the Commission's statutory



mandate to protect investors. In this regard, the Commission



notes the clear evidence of a two-tiered market, in which market



makers routinely trade at one price with customers and at better



prices with ECN participants. The Commission believes that it is



imperative to further the long-standing objectives of the 1975



Amendments to ensure reliable and accurate quotes by making these



prices available to the public. The Commission believes that any



exception for small brokers and dealers could create an incentive



for Nasdaq market makers to create special market making



subsidiaries qualifying as small broker-dealers which would be



free to engage in the anti-competitive practices identified in



the 21(a) Report.



A final copy of the Final Regulatory Flexibility Act



analysis is available in the Public File.



VI. Paperwork Reduction Act



As set forth in the Proposing Release,-[377]- the



proposed amendments to Rule 11Ac1-1 and proposed Rule 11Ac1-4



contain collections of information within the meaning of the



Paperwork Reduction Act ("PRA"). Accordingly, proposed



amendments to Rule 11Ac1-1 and proposed Rule 11Ac1-4 were



---------FOOTNOTES----------

-[377]- Proposing Release at 70.

==========================================START OF PAGE 192======



submitted to the Office of Management and Budget ("OMB") for



review pursuant to Section 3507 of the PRA (44 U.S.C. 3507), and



were approved by OMB which assigned the following control



numbers: Amendments to Rule 11Ac1-1, control number 3235-0461;



Rule 11Ac1-4, control number 3235-0462. An agency may not



conduct or sponsor, and a person is not required to respond to, a



collection of information unless it displays a valid OMB control



number. This is the final notice regarding the collection of



information under Rule 11Ac1-4, the Display Rule. A new notice



regarding the collections of information under Rule 11Ac1-1, the



Quote Rule, may be found in the Companion Release (published



elsewhere in the Federal Register today) which proposes an



additional amendment to the Quote Rule. The PRA section in the



preamble of the Companion Release provides new estimates of the



burden in responding to the collections of information under the



Quote Rule as a whole.



The reporting requirement in Rule 11Ac1-4 is found in 17 CFR



240.11Ac1-4. The collection of information is mandatory and



responses are not confidential. The respondents are OTC market



makers, as defined under the rule. (Although exchange



specialists are also required to follow the rule, as noted in the



Proposing Release the Commission does not anticipate any



significant additional burden on exchange specialists in light of



current exchange order handling practices.) The Rule requires



market makers to change their published quotation to reflect the



price and/or size of a customer limit order that would improve

==========================================START OF PAGE 193======



their published bid or offer or otherwise ensure that such limit



order is displayed. The burden on market makers will depend on



the extent and variety of their market-making activities and



their choice of the various compliance options offered by the



regulations. The ability of market makers to utilize facilities



of national securities exchanges, registered national securities



associations, and ECNs to comply with the reporting requirement



should ease the compliance burden. The proposed rule would have



permitted market makers to execute a limit order or send a limit



order to another market maker or exchange or association facility



that would ensure display of such orders in lieu of the market



makers' own display. Rule 11Ac1-4 as adopted maintains these



alternatives and also permits respondents to send a limit order



to an ECN meeting certain criteria. The information reported



will be displayed to all persons who have access to a quotation



montage as that term is defined in 17 CFR 240.11Ac1-2(a)(16).



The Commission carefully considered comments received from



the NASD and SIA concerning the Commission's burden



estimates.-[378]- The NASD stated that the Commission



underestimated the number of limit orders to be displayed per



trading day, given the NASD's view that Rule 11Ac1-4 will lead to



increased limit order exposure. After considering the NASD's



---------FOOTNOTES----------

-[378]- The SIA noted that they join in the concerns

expressed by the NASD that the Commission's

estimates under the PRA are too low, and need to

be revised and extended to include the proposed

safe harbor under Rule 11Ac1-5. SIA Letter at 4.

As noted above, the Commission is not adopting the

Price Improvement Rule at this time.

==========================================START OF PAGE 194======



comment, and based upon further review of the market data, the



Commission is revising its burden estimate for Rule 11Ac1-4 as



follows. There are approximately 570 respondents. Each



respondent on average will respond to the collection of



information 42,000 times per year, based on a 252 trading day



year. The total time burden for each respondent per year is



estimated to be 35 hours, based on an estimate of 3 seconds per



response (i.e., the time it takes to update a quote to reflect a



limit order, or to transmit the order for display



elsewhere).-[379]- The total annual aggregate burden for



all respondents is estimated to be 19,950 hours.







VII. Effects on Competition



Section 23(a)(2) of the Exchange Act-[380]- requires



the Commission to consider the anti-competitive effects of any



rules it adopts thereunder, and to balance them against the



benefits that further the purposes of the Act. As discussed



above, several commenters raised concerns regarding the







---------FOOTNOTES----------

-[379]- The NASD commented that it believes the PRA burden

estimate should include the time market makers

spend analyzing market trends and following

quotation and last sale information. The

Commission has determined not to revise its burden

estimate based on this comment, because market

makers otherwise engage in such activities apart

from the collection of information requirement.

For example, market makers are already required to

monitor the markets to ensure that they do not

trade ahead of customer limit orders.



-[380]- 15 U.S.C. 78w(a)(2).

==========================================START OF PAGE 195======



competitive implications of the order handling



proposals.-[381]- The foregoing discussion contains



extensive analysis of the competitive effects of both the rule



and rule amendments; this section summarizes the Commission's



conclusions. The Commission has considered the proposals in



light of the comments and the standard embodied in Section



23(a)(2) and has concluded any burdens on competition imposed by



the Display Rule and the amendments to the Quote Rule are



necessary and appropriate in furtherance of the purposes of the



Exchange Act, in particular, the purposes of Section 11A.



The Commission notes that the primary burden imposed by the



Display Rule will be to require exchange specialists and OTC



market makers to ensure that customer limit orders improving



their quotes are displayed. The Commission believes that if



systems upgrades are necessary, those systems upgrades reflect



one-time charges. The Commission also notes that ensuring public



dissemination of limit orders enhances market transparency,



increases pricing efficiency, and quote-based competition, and



permits investors' orders to interact with all available market



interest. Moreover, the limit order display rule will provide an



opportunity for investors to compete directly in the market.



This additional competition should limit certain anticompetitive



practices identified in the 21(a) Report and discussed supra. For



the reasons discussed above, the Commission does not believe the



Display Rule will have a significantly different effect on



---------FOOTNOTES----------

-[381]- See ABA Letter; HHG Letter; NASD Letter.

==========================================START OF PAGE 196======



wholesale and retail market makers.-[382]- The Commission



notes that the Antitrust Division of the U.S. Department of



Justice similarly concluded that the Display Rule will promote



competition and will thereby benefit the investing public.



Similarly, the Commission notes that the primary burden



imposed by the ECN Amendment to the Quote Rule will be to require



exchange specialists and OTC market makers to add personnel or



upgrade systems to ensure that their quotes reflect priced orders



entered into those ECNs that do not disseminate order information



to the relevant exchange or association. The Commission believes



that such systems upgrades reflect one-time charges. The



Commission believes that the ECN amendment to the Quote Rule will



impose only limited competitive burdens on ECNs. ECNs which have



attributes that differentiate them from other types of electronic



order routing and order execution systems, will have a choice



whether to disseminate order information to the relevant



exchanges or association. While choosing this alternative will



result in some system costs, the Commission believes that the



alternative will provide ECNs with additional business



opportunities, including increased order flow. The ECN amendment



should allow ECNs to function as valuable facilities for their



subscribers, and should not harm ECNs significantly in their



competition with other order execution systems.-[383]-



---------FOOTNOTES----------

-[382]- See supra note 124 and accompanying text.



-[383]- Although the Antitrust Division of the U.S.

Department of Justice expressed concerns about the

(continued...)

==========================================START OF PAGE 197======



The Commission also notes that ensuring public dissemination of



market makers' and specialists' priced orders entered into ECNs



enhances market transparency, pricing efficiency, price



competition, and allows investors' orders to interact with all



available market interest.



Finally, with respect to the amendments extending the



Mandatory Quote Rule to non-Rule 19c-3 securities, the primary



burden imposed will be to require certain brokers and dealers to



register as CQS market makers and make continuous two-sided



quotes available to the public. The Commission believes that the



benefit to the investing public of ensuring that available market



interest is disseminated to the public will enhance competition



by facilitating the routing of investor orders to the market



center displaying the best quotation for a security. The



Commission believes that the added transparency resulting from



the amendment outweighs any burden to competition that may be



imposed.

























---------FOOTNOTES----------

-[383]-(...continued)

effects of the ECN amendment as originally

proposed, the Commission believes that with the

quote dissemination alternative, the amendment

will not impose any unnecessary or inappropriate

burdens on competition.

==========================================START OF PAGE 198======



List of Subjects in 17 CFR Part 240



Broker-dealers, Confidential business information, Reporting



and recordkeeping requirements, and Securities.



TEXT OF THE RULES



For the reasons set out in the preamble, the Commission



amends Part 240 of Chapter II of Title 17 of the Code of Federal



Regulation as follows:



PART 240 -- GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE



ACT OF 1934



1. The general authority citation for Part 240 is revised



to read as follows:



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



77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78k, 78k-1, 78l,



78m, 78n, 78o, 78p, 78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-



20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless



otherwise noted.



*****



2. Section 240.11Aa3-1 is amended by revising paragraph



(a)(4) to read as follows:



240.11Aa3-1 Dissemination of transaction reports and last sale



data with respect to transactions in reported securities



(a) Definitions. ***



(4) The term reported security shall mean any security or



class of securities for which transaction reports are collected,



processed and made available pursuant to an effective transaction



reporting plan.

==========================================START OF PAGE 199======



*****



3. Section 240.11Ac1-1 is revised to read as follows:



240.11Ac1-1 Dissemination of quotations.



(a) Definitions. For the purposes of this section:



(1) The term aggregate quotation size shall mean the sum of



the quotation sizes of all responsible brokers or dealers who



have communicated on any exchange bids or offers for a covered



security at the same price.



(2) The term association shall mean any association of



brokers and dealers registered pursuant to Section 15A of the Act



(15 U.S.C. 78o-3).



(3) The terms best bid and best offer shall mean the highest



priced bid and the lowest priced offer.



(4) The terms bid and offer shall mean the bid price and the



offer price communicated by an exchange member or OTC market



maker to any broker or dealer, or to any customer, at which it is



willing to buy or sell one or more round lots of a covered



security, as either principal or agent, but shall not include



indications of interest.



(5) The term consolidated system shall mean the consolidated



transaction reporting system.



(6) The term covered security shall mean any reported



security and any other security for which a transaction report,



last sale data or quotation information is disseminated through



an automated quotation system as described in Section



3(a)(51)(A)(ii) of the Act (15 U.S.C. 78c(a)(51)(A)(ii)).

==========================================START OF PAGE 200======



(7) The term effective transaction reporting plan shall have



the meaning provided in 240.11Aa3-1(a)(3).



(8) The term electronic communications network, for the



purposes of 240.11Ac1-1(c)(5), shall mean any electronic system



that widely disseminates to third parties orders entered therein



by an exchange market maker or OTC market maker, and permits such



orders to be executed against in whole or in part; except that



the term electronic communications network shall not include:



(i) Any system that crosses multiple orders at one or more



specified times at a single price set by the ECN (by algorithm or



by any derivative pricing mechanism) and does not allow orders to



be crossed or executed against directly by participants outside



of such times; or



(ii) Any system operated by, or on behalf of, an OTC market



maker or exchange market maker that executes customer orders



primarily against the account of such market maker as principal,



other than riskless principal.



(9) The term exchange market maker shall mean any member of



a national securities exchange ("exchange") who is registered as



a specialist or market maker pursuant to the rules of such



exchange.



(10) The term exchange-traded security shall mean any



covered security or class of covered securities listed and



registered, or admitted to unlisted trading privileges, on an



exchange; provided, however, That securities not listed on any



exchange that are traded pursuant to unlisted trading privileges

==========================================START OF PAGE 201======



are excluded.



(11) The term make available, when used with respect to



bids, offers, quotation sizes and aggregate quotation sizes



supplied to quotation vendors by an exchange or association,



shall mean to provide circuit connections at the premises of the



exchange or association supplying such data, or at a common



location determined by mutual agreement of the exchanges and



associations, for the delivery of such data to quotation vendors.



(12) The term odd-lot shall mean an order for the purchase



or sale of a covered security in an amount less than a round lot.



(13) The term OTC market maker shall mean any dealer who



holds itself out as being willing to buy from and sell to its



customers, or otherwise, a covered security for its own account



on a regular or continuous basis otherwise than on an exchange in



amounts of less than block size.



(14) The term plan processor shall have the meaning provided



in 240.11Aa3-2(a)(7).



(15) The term published aggregate quotation size shall mean



the aggregate quotation size calculated by an exchange and



displayed by a quotation vendor on a terminal or other display



device at the time an order is presented for execution to a



responsible broker or dealer.



(16) The terms published bid and published offer shall mean



the bid or offer of a responsible broker or dealer for a covered



security communicated by it to its exchange or association



pursuant to this section and displayed by a quotation vendor on a

==========================================START OF PAGE 202======



terminal or other display device at the time an order is



presented for execution to such responsible broker or dealer.



(17) The term published quotation size shall mean the



quotation size of a responsible broker or dealer communicated by



it to its exchange or association pursuant to this section and



displayed by a quotation vendor on a terminal or other display



device at the time an order is presented for execution to such



responsible broker or dealer.



(18) The term quotation size, when used with respect to a



responsible broker's or dealer's bid or offer for a covered



security, shall mean:



(i) The number of shares (or units of trading) of that



covered security which such responsible broker or dealer has



specified, for purposes of dissemination to quotation vendors,



that it is willing to buy at the bid price or sell at the offer



price comprising its bid or offer, as either principal or agent;



or



(ii) In the event such responsible broker or dealer has not



so specified, a normal unit of trading for that covered security.



(19) The term quotation vendor shall mean any securities



information processor engaged in the business of disseminating to



brokers, dealers or investors on a real-time basis, bids and



offers made available pursuant to this section, whether



distributed through an electronic communications network or



displayed on a terminal or other display device.



(20) The term reported security shall mean any security or

==========================================START OF PAGE 203======



class of securities for which transaction reports are collected,



processed and made available pursuant to an effective transaction



reporting plan.



(21) The term responsible broker or dealer shall mean:



(i) When used with respect to bids or offers communicated on



an exchange, any member of such exchange who communicates to



another member on such exchange, at the location (or locations)



designated by such exchange for trading in a covered security, a



bid or offer for such covered security, as either principal or



agent; provided, however, That, in the event two or more members



of an exchange have communicated on such exchange bids or offers



for a covered security at the same price, each such member shall



be considered a "responsible broker or dealer" for that bid or



offer, subject to the rules of priority and precedence then in



effect on that exchange; and further provided, That for a bid or



offer which is transmitted from one member of an exchange to



another member who undertakes to represent such bid or offer on



such exchange as agent, only the last member who undertakes to



represent such bid or offer as agent shall be considered the



"responsible broker or dealer" for that bid or offer; and



(ii) When used with respect to bids and offers communicated



by a member of an association to another broker or dealer or to a



customer otherwise than on an exchange, the member communicating



the bid or offer (regardless of whether such bid or offer is for



its own account or on behalf of another person).



(22) The term revised bid or offer shall mean a market

==========================================START OF PAGE 204======



maker's bid or offer which supersedes its published bid or



published offer.



(23) The term revised quotation size shall mean a market



maker's quotation size which supersedes its published quotation



size.



(24) The term specified persons, when used in connection



with any notification required to be provided pursuant to



paragraph (b)(3) of this section and any election (or withdrawal



thereof) permitted under paragraph (b)(5) of this section, shall



mean:



(i) Each quotation vendor;



(ii) Each plan processor; and



(iii) The processor for the Options Price Reporting



Authority (in the case of a notification for a subject security



which is a class of securities underlying options admitted to



trading on any exchange).



(25) The term subject security shall mean:



(i) With respect to an exchange:



(A) Any exchange-traded security other than a security for



which the executed volume of such exchange, during the most



recent calendar quarter, comprised one percent or less of the



aggregate trading volume for such security as reported in the



consolidated system; and



(B) Any other covered security for which such exchange has



in effect an election, pursuant to paragraph (b)(5)(i) of this



section, to collect, process, and make available to quotation

==========================================START OF PAGE 205======



vendors, bids, offers, quotation sizes, and aggregate quotation



sizes communicated on such exchange; and



(ii) With respect to a member of an association:



(A) Any exchange-traded security for which such member acts



in the capacity of an OTC market maker unless the executed volume



of such member, during the most recent calendar quarter,



comprised one percent or less of the aggregate trading volume for



such security as reported in the consolidated system; and



(B) Any other covered security for which such member acts in



the capacity of an OTC market maker and has in effect an



election, pursuant to paragraph (b)(5)(ii) of this section, to



communicate to its association bids, offers and quotation sizes



for the purpose of making such bids, offers and quotation sizes



available to quotation vendors.



(b) Dissemination requirements for exchanges and



associations.



(1) Every exchange and association shall establish and



maintain procedures and mechanisms for collecting bids, offers,



quotation sizes and aggregate quotation sizes from responsible



brokers or dealers who are members of such exchange or



association, processing such bids, offers and sizes, and making



such bids, offers and sizes available to quotation vendors, as



follows:



(i) Each exchange shall at all times such exchange is open



for trading, collect, process and make available to quotation



vendors the best bid, the best offer, and aggregate quotation

==========================================START OF PAGE 206======



sizes for each subject security listed or admitted to unlisted



trading privileges which is communicated on any exchange by any



responsible broker or dealer, but shall not include:



(A) Any bid or offer executed immediately after



communication and any bid or offer communicated by a responsible



broker or dealer other than an exchange market maker which is



cancelled or withdrawn if not executed immediately after



communication; and



(B) Any bid or offer communicated during a period when



trading in that security has been suspended or halted, or prior



to the commencement of trading in that security on any trading



day, on that exchange.



(ii) Each association shall, at all times that last sale



information with respect to reported securities is reported



pursuant to an effective transaction reporting plan, collect,



process and make available to quotation vendors the best bid,



best offer, and quotation sizes communicated otherwise than on an



exchange by each member of such association acting in the



capacity of an OTC market maker for each subject security and the



identity of that member (excluding any bid or offer executed



immediately after communication), except during any period when



over-the-counter trading in that security has been suspended.



(2) Each exchange shall, with respect to each published bid



and published offer representing a bid or offer of a member for a



subject security, establish and maintain procedures for



ascertaining and disclosing to other members of that exchange,

==========================================START OF PAGE 207======



upon presentation of orders sought to be executed by them in



reliance upon paragraph (c)(2) of this section, the identity of



the responsible broker or dealer who made such bid or offer and



the quotation size associated with it.



(3)(i) If, at any time an exchange is open for trading, such



exchange determines, pursuant to rules approved by the Securities



and Exchange Commission pursuant to section 19(b)(2) of the Act



(15 U.S.C. 78s(b)(2)), that the level of trading activities or



the existence of unusual market conditions is such that the



exchange is incapable of collecting, processing, and making



available to quotation vendors the data for a subject security



required to be made available pursuant to paragraph (b)(1) of



this section in a manner that accurately reflects the current



state of the market on such exchange, such exchange shall



immediately notify all specified persons of that determination.



Upon such notification, responsible brokers or dealers that are



members of that exchange shall be relieved of their obligation



under paragraph (c)(2) of this section and such exchange shall be



relieved of its obligations under paragraphs (b)(1) and (2) of



this section for that security: provided, however, That such



exchange will continue, to the maximum extent practicable under



the circumstances, to collect, process, and make available to



quotation vendors data for that security in accordance with



paragraph (b)(1) of this section.



(ii) During any period an exchange, or any responsible



broker or dealer that is a member of that exchange, is relieved

==========================================START OF PAGE 208======



of any obligation imposed by this section for any subject



security by virtue of a notification made pursuant to paragraph



(b)(3)(i) of this section, such exchange shall monitor the



activity or conditions which formed the basis for such



notification and shall immediately renotify all specified persons



when that exchange is once again capable of collecting,



processing, and making available to quotation vendors the data



for that security required to be made available pursuant to



paragraph (b)(1) of this section in a manner that accurately



reflects the current state of the market on such exchange. Upon



such renotification, any exchange or responsible broker or dealer



which had been relieved of any obligation imposed by this section



as a consequence of the prior notification shall again be subject



to such obligation.



(4) Nothing in this section shall preclude any exchange or



association from making available to quotation vendors



indications of interest or bids and offers for a subject security



at any time such exchange or association is not required to do so



pursuant to paragraph (b)(1) of this section.



(5)(i) Any exchange may make an election for purposes of



paragraph (a)(25)(i)(B) of this section for any covered security,



by collecting, processing, and making available bids, offers,



quotation sizes, and aggregate quotation sizes in that security;



except that for any covered security previously listed or



admitted to unlisted trading privileges on only one exchange and



not traded by any OTC market maker, such election shall be made

==========================================START OF PAGE 209======



by notifying all specified persons, and shall be effective at the



opening of trading on the business day following notification.



(ii) Any member of an association acting in the capacity of



an OTC market maker may make an election for purposes of



paragraph (a)(25)(ii)(B) of this section for any covered



security, by communicating to its association bids, offers, and



quotation sizes in that security; except that for any other



covered security listed or admitted to unlisted trading



privileges on only one exchange and not traded by any other OTC



market maker, such election shall be made by notifying its



association and all specified persons, and shall be effective at



the opening of trading on the business day following



notification.



(iii) The election of an exchange or member of an



association for any covered security pursuant to this paragraph



(b)(5) shall cease to be in effect if such exchange or member



ceases to make available or communicate bids, offers, and



quotation sizes in such security.



(c) Obligations of responsible brokers and dealers.



(1) Each responsible broker or dealer shall promptly



communicate to its exchange or association, pursuant to the



procedures established by that exchange or association, its best



bids, best offers, and quotation sizes for any subject security.



(2) Subject to the provisions of paragraph (c)(3) of this



section, each responsible broker or dealer shall be obligated to



execute any order to buy or sell a subject security, other than

==========================================START OF PAGE 210======



an odd-lot order, presented to it by another broker or dealer, or



any other person belonging to a category of persons with whom



such responsible broker or dealer customarily deals, at a price



at least as favorable to such buyer or seller as the responsible



broker's or dealer's published bid or published offer (exclusive



of any commission, commission equivalent or differential



customarily charged by such responsible broker or dealer in



connection with execution of any such order) in any amount up to



its published quotation size.



(3)(i) No responsible broker or dealer shall be obligated to



execute a transaction for any subject security as provided in



paragraph (c)(2) of this section to purchase or sell that subject



security in an amount greater than such revised quotation if:



(A) Prior to the presentation of an order for the purchase



or sale of a subject security, a responsible broker or dealer has



communicated to its exchange or association, pursuant to



paragraph (c)(1) of this section, a revised quotation size; or



(B) At the time an order for the purchase or sale of a



subject security is presented, a responsible broker or dealer is



in the process of effecting a transaction in such subject



security, and immediately after the completion of such



transaction, it communicates to its exchange or association a



revised quotation size, such responsible broker or dealer shall



not be obligated by paragraph (c)(2) of this section to purchase



or sell that subject security in an amount greater than such



revised quotation size.

==========================================START OF PAGE 211======



(ii) No responsible broker or dealer shall be obligated to



execute a transaction for any subject security as provided in



paragraph (c)(2) of this section if:



(A) Before the order sought to be executed is presented,



such responsible broker or dealer has communicated to its



exchange or association pursuant to paragraph (c)(1) of this



section, a revised bid or offer; or



(B) At the time the order sought to be executed is



presented, such responsible broker or dealer is in the process of



effecting a transaction in such subject security, and,



immediately after the completion of such transaction, such



responsible broker or dealer communicates to its exchange or



association pursuant to paragraph (c)(1) of this section, a



revised bid or offer; provided, however, That such responsible



broker or dealer shall nonetheless be obligated to execute any



such order in such subject security as provided in paragraph



(c)(2) of this section at its revised bid or offer in any amount



up to its published quotation size or revised quotation size.



(4) Subject to the provisions of paragraph (b)(4) of this



section:



(i) No exchange or OTC market maker may make available,



disseminate or otherwise communicate to any quotation vendor,



directly or indirectly, for display on a terminal or other



display device any bid, offer, quotation size, or aggregate



quotation size for any covered security which is not a subject



security with respect to such exchange or OTC market maker; and

==========================================START OF PAGE 212======



(ii) No quotation vendor may disseminate or display on a



terminal or other display device any bid, offer, quotation size,



or aggregate quotation size from any exchange or OTC market maker



for any covered security which is not a subject security with



respect to such exchange or OTC market maker.



(5)(i) Entry of any priced order for a covered security by



an exchange market maker or OTC market maker in that security



into an electronic communications network that widely



disseminates such order shall be deemed to be:



(A) A bid or offer under this section, to be communicated to



the market maker's exchange or association pursuant to paragraph



(c) of this section for at least the minimum quotation size that



is required by the rules of the market maker's exchange or



association if the priced order is for the account of a market



maker, or the actual size of the order up to the minimum



quotation size required if the priced order is for the account of



a customer; and



(B) A communication of a bid or offer to a quotation vendor



for display on a display device for purposes of paragraph (c)(4)



of this section.



(ii) An exchange market maker or OTC market maker that has



entered a priced order for a covered security into an electronic



communications network that widely disseminates such order shall



be deemed to be in compliance with paragraph (c)(5)(i)(A) of this



section if the electronic communications network:



(A) Provides to an exchange or association (or an exclusive

==========================================START OF PAGE 213======



processor acting on behalf of one or more exchanges or



associations) the prices and sizes of the orders at the highest



buy price and the lowest sell price for such security entered in,



and widely disseminated by, the electronic communications network



by exchange market makers and OTC market makers for the covered



security, and such prices and sizes are included in the quotation



data made available by the exchange, association, or exclusive



processor to quotation vendors pursuant to this section; and



(B) Provides, to any broker or dealer, the ability to effect



a transaction with a priced order widely disseminated by the



electronic communications network entered therein by an exchange



market maker or OTC market maker that is:



(1) Equivalent to the ability of any broker or dealer to



effect a transaction with an exchange market maker or OTC market



maker pursuant to the rules of the exchange or association to



which the electronic communications network supplies such bids



and offers; and



(2) At the price of the highest priced buy order or lowest



priced sell order, or better, for the lesser of the cumulative



size of such priced orders entered therein by exchange market



makers or OTC market makers at such price, or the size of the



execution sought by the broker or dealer, for the covered



security.



(d) Exemptions. The Commission may exempt from the



provisions of this section, either unconditionally or on



specified terms and conditions, any responsible broker or dealer,

==========================================START OF PAGE 214======



electronic communications network, exchange, or association if



the Commission determines that such exemption is consistent with



the public interest, the protection of investors and the removal



of impediments to and perfection of the mechanism of a national



market system.



4. Section 240.11Ac1-4 is added to read as follows:



240.11Ac1-4 Display of customer limit orders.



(a) Definitions. For purposes of this section:



(1) The term association shall mean any association of



brokers and dealers registered pursuant to Section 15A of the Act



(15 U.S.C. 78o-3).



(2) The terms best bid and best offer shall have the



meaning provided in 240.11Ac1-1(a)(3).



(3) The terms bid and offer shall have the meaning provided



in 240.11Ac1-1(a)(4).



(4) The term block size shall mean any order:



(i) Of at least 10,000 shares; or



(ii) For a quantity of stock having a market value of at



least $200,000.



(5) The term covered security shall mean any "reported



security" and any other security for which a transaction report,



last sale data or quotation information is disseminated through



an automated quotation system as described in Section



3(a)(51)(A)(ii) of the Act (15 U.S.C. 78c(a)(51)(A)(ii)).



(6) The term customer limit order shall mean an order to



buy or sell a covered security at a specified price that is not

==========================================START OF PAGE 215======



for the account of either a broker or dealer; provided, however,



That the term customer limit order shall include an order



transmitted by a broker or dealer on behalf of a customer.



(7) The term electronic communications network shall have



the meaning provided in 240.11Ac1-1(a)(8).



(8) The term exchange-traded security shall have the



meaning provided in 240.11Ac1-1(a)(10).



(9) The term OTC market maker shall mean any dealer who



holds itself out as being willing to buy from and sell to its



customers, or otherwise, a covered security for its own account



on a regular or continuous basis otherwise than on a national



securities exchange in amounts of less than block size.



(10) The term reported security shall have the meaning



provided in 240.11Ac1-1(a)(20).



(b) Specialists and OTC market makers. For all covered



securities:



(1) Each member of an exchange that is registered by that



exchange as a specialist, or is authorized by that exchange to



perform functions substantially similar to that of a specialist,



shall publish immediately a bid or offer that reflects:



(i) The price and the full size of each customer limit



order held by the specialist that is at a price that would



improve the bid or offer of such specialist in such security; and



(ii) The full size of each customer limit order held by the



specialist that:



(A) Is priced equal to the bid or offer of such specialist

==========================================START OF PAGE 216======



for such security;



(B) Is priced equal to the national best bid or offer; and



(C) Represents more than a de minimis change in relation to



the size associated with the specialist's bid or offer.



(2) Each registered broker or dealer that acts as an OTC



market maker shall publish immediately a bid or offer that



reflects:



(i) The price and the full size of each customer limit



order held by the OTC market maker that is at a price that would



improve the bid or offer of such OTC market maker in such



security; and



(ii) The full size of each customer limit order held by the



OTC market maker that:



(A) Is priced equal to the bid or offer of such OTC market



maker for such security;



(B) Is priced equal to the national best bid or offer; and



(C) Represents more than a de minimis change in relation to



the size associated with the OTC market maker's bid or offer.



(c) Exceptions. The requirements in paragraph (b) of this



section shall not apply to any customer limit order:



(1) That is executed upon receipt of the order.



(2) That is placed by a customer who expressly requests,



either at the time that the order is placed or prior thereto



pursuant to an individually negotiated agreement with respect to



such customer's orders, that the order not be displayed.



(3) That is an odd-lot order.

==========================================START OF PAGE 217======



(4) That is a block size order, unless a customer placing



such order requests that the order be displayed.



(5) That is delivered immediately upon receipt to an



exchange or association-sponsored system, or an electronic



communications network that complies with the requirements of



240.11Ac1-1(c)(5)(ii) with respect to that order.



(6) That is delivered immediately upon receipt to another



exchange member or OTC market maker that complies with the



requirements of this section with respect to that order.



(7) That is an "all or none" order.



(d) Exemptions.



The Commission may exempt from the provisions of this



section, either unconditionally or on specified terms and



conditions, any responsible broker or dealer, electronic



communications network, exchange, or association if the



Commission determines that such exemption is consistent with the



public interest, the protection of investors and the removal of



impediments to and perfection of the mechanism of a national



market system.









By the Commission.







Jonathan G. Katz

Secretary







Date: September 6, 1996

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