[Federal Register Volume 75, Number 13 (Thursday, January 21, 2010)]
[Proposed Rules]
[Pages 3594-3614]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-1045]
[[Page 3593]]
-----------------------------------------------------------------------
Part III
Securities and Exchange Commission
-----------------------------------------------------------------------
17 CFR Part 242
Concept Release on Equity Market Structure; Proposed Rule
Federal Register / Vol. 75 , No. 13 / Thursday, January 21, 2010 /
Proposed Rules
[[Page 3594]]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-61358; File No. S7-02-10]
RIN 3235-AK47
Concept Release on Equity Market Structure
AGENCY: Securities and Exchange Commission.
ACTION: Concept release; request for comments.
-----------------------------------------------------------------------
SUMMARY: The Securities and Exchange Commission (``Commission'') is
conducting a broad review of the current equity market structure. The
review includes an evaluation of equity market structure performance in
recent years and an assessment of whether market structure rules have
kept pace with, among other things, changes in trading technology and
practices. To help further its review, the Commission is publishing
this concept release to invite public comment on a wide range of market
structure issues, including high frequency trading, order routing,
market data linkages, and undisplayed, or ``dark,'' liquidity. The
Commission intends to use the public's comments to help determine
whether regulatory initiatives to improve the current equity market
structure are needed and, if so, the specific nature of such
initiatives.
DATES: Comments should be received on or before April 21, 2010.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments:
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an e-mail to [email protected]. Please include
File No. S7-02-10 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments:
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File No. S7-02-10. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: Arisa Tinaves, Special Counsel, at
(202) 551-5676, Gary M. Rubin, Attorney, at (202) 551-5669, Division of
Trading and Markets, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-7010.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. Exchange Act Requirements for a National Market System
III. Overview of Current Market Structure
A. Trading Centers
1. Registered Exchanges
2. ECNs
3. Dark Pools
4. Broker-Dealer Internalization
B. Linkages
1. Consolidated Market Data
2. Trade-Through Protection
3. Broker Routing Services
IV. Request for Comments
A. Market Structure Performance
1. Long-Term Investors
a. Market Quality Metrics
b. Fairness of Market Structure
2. Other Measures
B. High Frequency Trading
1. Strategies
a. Passive Market Making
b. Arbitrage
c. Structural
d. Directional
2. Tools
a. Co-Location
b. Trading Center Data Feeds
3. Systemic Risks
C. Undisplayed Liquidity
1. Order Execution Quality
2. Public Price Discovery
3. Fair Access and Regulation of ATSs
D. General Request for Comments
I. Introduction
The secondary market for U.S.-listed equities has changed
dramatically in recent years. In large part, the change reflects the
culmination of a decades-long trend from a market structure with
primarily manual trading to a market structure with primarily automated
trading. When Congress mandated the establishment of a national market
system for securities in 1975, trading in U.S.-listed equities was
dominated by exchanges with manual trading floors. Trading equities
today is no longer as straightforward as sending an order to the floor
of a single exchange on which a stock is listed. As discussed in
section III below, the current market structure can be described as
dispersed and complex: (1) Trading volume is dispersed among many
highly automated trading centers that compete for order flow in the
same stocks; and (2) trading centers offer a wide range of services
that are designed to attract different types of market participants
with varying trading needs.
A primary driver and enabler of this transformation of equity
trading has been the continual evolution of technologies for
generating, routing, and executing orders. These technologies have
dramatically improved the speed, capacity, and sophistication of the
trading functions that are available to market participants. Changes in
market structure also reflect the markets' response to regulatory
actions such as Regulation NMS, adopted in 2005,\1\ the Order Handling
Rules, adopted in 1996,\2\ as well as enforcement actions, such as
those addressing anti-competitive behavior by market makers in NASDAQ
stocks.\3\
---------------------------------------------------------------------------
\1\ Securities Exchange Act Release No. 51808 (June 9, 2005), 70
FR 37496 (June 29, 2005) (``Regulation NMS Release'').
\2\ Securities Exchange Act Release No. 37619A (September 6,
1996), 61 FR 48290 (September 12, 1996) (``Order Handling Rules
Release'').
\3\ See, e.g., In the Matter of National Association of
Securities Dealers, Inc., Administrative Proceeding File No. 3-9056,
Securities Exchange Act Release No. 37538 (August 8, 1996).
---------------------------------------------------------------------------
The transformation of equity trading has encompassed all types of
U.S.-listed stocks. In recent years, however, it is perhaps most
apparent in stocks listed on the New York Stock Exchange (``NYSE''),
which constitute nearly 80% of the capitalization of the U.S. equity
markets.\4\ In contrast to stocks listed on the NASDAQ Stock Market LLC
(``NASDAQ''), which for more than a decade have been traded in a highly
automated fashion at many different trading centers,\5\ NYSE-listed
stocks were traded primarily on the floor of the NYSE in a manual
fashion until October 2006. At that time, NYSE began to offer
[[Page 3595]]
fully automated access to its displayed quotations.\6\ An important
impetus for this change was the Commission's adoption of Regulation NMS
in 2005, which eliminated the trade-through protection for manual
quotations that nearly all commenters believed was seriously
outdated.\7\
---------------------------------------------------------------------------
\4\ In November 2009, for example, NYSE-listed stocks
represented approximately 78% of the market capitalization of the
Wilshire 5000 Total Market Index. Wilshire Associates, http://wilshire.com/Indexes/Broad/Wilshire5000/Characteristics.html
(November 17, 2009).
\5\ NASDAQ itself offered limited automated execution
functionality until the introduction of SuperMontage in 2002. See
Securities Exchange Act Release No. 46429 (August 29, 2002), 67 FR
56862 (September 5, 2002) (Order with Respect to the Implementation
of NASDAQ's SuperMontage Facility). Prior to 2002, however, many
electronic communication networks (``ECNs'') and market makers
trading NASDAQ stocks provided predominantly automated executions.
\6\ See Securities Exchange Act Release No. 53539 (March 22,
2006), 71 FR 16353 (March 31, 2006) (File No. SR-NYSE-2004-05)
(approving proposal to create a ``Hybrid Market'' by, among other
things, increasing the availability of automated executions); Pierre
Paulden, Keep the Change, Institutional Investor (December 19, 2006)
(``Friday, October 6, was a momentous day for the New York Stock
Exchange. That morning the Big Board broke with 214 years of
tradition when it began phasing in a new hybrid market structure
that can execute trades electronically, bypassing face-to-face
auctions on its famed floor.''). Prior to the Hybrid Market, NYSE
offered limited automated executions.
\7\ Regulation NMS Release, 70 FR at 37505 n. 55 (``Nearly all
commenters, both those supporting and opposing the need for an
intermarket trade-through rule, agreed that the current ITS trade-
through provisions are seriously outdated and in need of reform.
They particularly focused on the problems created by affording equal
protection against trade-throughs to both automated and manual
quotations.'').
---------------------------------------------------------------------------
The changes in the nature of trading for NYSE-listed stocks have
been extraordinary, as indicated by the comparisons of trading in 2005
and 2009 in Figures 1 through 5 below:
BILLING CODE 8011-01-P
[GRAPHIC] [TIFF OMITTED] TP21JA10.001
BILLING CODE 8011-01-C
Figure 1--NYSE executed approximately 79.1% of the consolidated
share volume in its listed stocks in January 2005, compared to 25.1% in
October 2009.\8\
---------------------------------------------------------------------------
\8\ NYSE Euronext, ``NYSE Euronext Announces Trading Volumes for
October 2009 (November 6, 2009) (``Tape A matched market share for
NYSE was 25.1% in October 2009, above the 24.5% market share
reported in October 2008'') (available at http://www.nyse.com/press/125741917814.html); Securities Exchange Act Release No. 59039
(December 2, 2008), 73 FR 74770, 74782 (December 9, 2008) (File No.
SR-NYSEArca-2006-21) (``Given the competitive pressures that
currently characterize the U.S. equity markets, no exchange can
afford to take its market share percentages for granted--they can
change significantly over time, either up or down. * * * For
example, the NYSE's reported market share of trading in NYSE-listed
stocks declined from 79.1% in January 2005 to 30.6% in June 2008.'')
(citations omitted).
---------------------------------------------------------------------------
Figure 2--NYSE's average speed of execution for small, immediately
executable (marketable) orders was 10.1
[[Page 3596]]
seconds in January 2005, compared to 0.7 seconds in October 2009.\9\
---------------------------------------------------------------------------
\9\ NYSE Euronext, Rule 605 Reports for January 2005 and October
2009 (available at http://www.nyse.com/equities/nyseequities/1201780422054.html) (NYSE average speed of execution for small (100-
499 shares) market orders and marketable limit orders was 10.1
seconds in January 2005 and 0.7 seconds in October 2009).
---------------------------------------------------------------------------
Figure 3--Consolidated average daily share volume in NYSE-listed
stocks was 2.1 billion shares in 2005, compared to 5.9 billion shares
(an increase of 181%) in January through October 2009.\10\
---------------------------------------------------------------------------
\10\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues
2000-2009 (available at http://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).
---------------------------------------------------------------------------
Figure 4--Consolidated average daily trades in NYSE-listed stocks
was 2.9 million trades in 2005, compared to 22.1 million trades (an
increase of 662%) in January through October 2009.\11\
---------------------------------------------------------------------------
\11\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues
2000-2009 (available at http://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).
---------------------------------------------------------------------------
Figure 5--Consolidated average trade size in NYSE-listed stocks was
724 shares in 2005, compared to 268 shares in January through October
2009.\12\
---------------------------------------------------------------------------
\12\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues
2000-2009 (available at http://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).
---------------------------------------------------------------------------
The foregoing statistics for NYSE-listed stocks are intended solely
to illustrate the sweeping changes that are characteristic of trading
in all U.S.-listed equities, including NASDAQ-listed stocks and other
equities such as exchange-traded funds (``ETFs''). They are not
intended to indicate whether these changes have led to a market
structure that is better or worse for long-term investors--an important
issue on which comment is requested in section IV.A.1 below. Rather,
the statistics for NYSE-listed stocks provide a useful illustration
simply because the changes occurred both more rapidly and more recently
for NYSE-listed stocks than other types of U.S.-listed equities.
To more fully understand the effects of these and other changes in
equity trading, the Commission is conducting a comprehensive review of
equity market structure. It is assessing whether market structure rules
have kept pace with, among other things, changes in trading technology
and practices. The review already has led to several rulemaking
proposals that address particular issues and that are intended
primarily to preserve the integrity of longstanding market structure
principles. One proposal would eliminate the exception for flash orders
from the Securities Exchange Act of 1934 (``Exchange Act'') quoting
requirements.\13\ Another would address certain practices associated
with non-public trading interest, including dark pools of
liquidity.\14\ In addition, the Commission today is proposing for
public comment an additional market structure initiative to address the
risk management controls of broker-dealers with market access.\15\
---------------------------------------------------------------------------
\13\ Securities Exchange Act Release No. 60684 (September 18,
2009), 74 FR 48632 (September 23, 2009) (``Flash Order Release'').
\14\ Securities Exchange Act Release No. 60997 (November 13,
2009), 74 FR 61208 (November 23, 2009) (``Non-Public Trading
Interest Release'').
\15\ Securities Exchange Act Release No. [citation unavailable]
(``Market Access Release'').
---------------------------------------------------------------------------
The Commission is continuing its review. It recognizes that market
structure issues are complex and require a broad understanding of
statutory requirements, economic principles, and practical trading
considerations. Given this complexity, the Commission believes that its
review would be greatly assisted by receiving the benefit of public
comment on a broad range of market structure issues. It particularly is
interested in hearing the views of all types of investors and other
market participants and in receiving as much data and analysis as
possible in support of commenters' views.
Commenters' views on both the strengths and weaknesses of the
current market structure are sought. Views on both strengths and
weaknesses can help identify new initiatives that would enhance the
strengths or improve on the weaknesses, avoid changes that would
unintentionally cause more harm than good, and suggest whether any
current rules are no longer necessary or are counterproductive to the
objectives of the Exchange Act. As discussed in section II below,
Congress mandated that the national market system should achieve a
range of objectives--efficient execution of transactions, fair
competition among markets, price transparency, best execution of
investor orders, and the interaction of investor orders when consistent
with efficiency and best execution. Additionally, the Commission's
mission includes the protection of investors and the facilitation of
capital formation. Appropriately achieving each of these objectives
requires a balanced market structure that can accommodate a wide range
of participants and trading strategies.
This release is intended to facilitate public comment by first
giving a basic overview of the legal and factual elements of the
current equity market structure and then presenting a wide range of
issues for comment. The Commission cautions that it has not reached any
final conclusions on the issues presented for comment. The discussion
and questions in this release should not be interpreted as slanted in
any particular way on any particular issue. The Commission intends to
consider carefully all comments and to complete its review in a timely
fashion. At that point, it will determine whether there are any
problems that require a regulatory initiative and, if so, the nature of
that initiative. Moreover, a new regulatory requirement would first be
published in the form of a proposal that would give the public an
opportunity to comment on the specifics of the proposal prior to
adoption.
II. Exchange Act Requirements for a National Market System
In Section 11A of the Exchange Act,\16\ Congress directed the
Commission to facilitate the establishment of a national market system
in accordance with specified findings and objectives. The initial
Congressional findings were that the securities markets are an
important national asset that must be preserved and strengthened, and
that new data processing and communications techniques create the
opportunity for more efficient and effective market operations.
Congress then proceeded to mandate a national market system composed of
multiple competing markets that are linked through technology. In
particular, Congress found that it is in the public interest and
appropriate for the protection of investors and the maintenance of fair
and orderly markets to assure five objectives:
---------------------------------------------------------------------------
\16\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------
(1) Economically efficient execution of securities transactions;
(2) Fair competition among brokers and dealers, among exchange
markets, and between exchange markets and markets other than exchange
markets;
(3) The availability to brokers, dealers, and investors of
information with respect to quotations and transactions in securities;
(4) The practicability of brokers executing investors' orders in
the best market; and
(5) An opportunity, consistent with efficiency and best execution,
for investors' orders to be executed without the participation of a
dealer.
The final Congressional finding was that these five objectives
would be fostered by the linking of all markets for qualified
securities through communication and data processing facilities.
Specifically, Congress found that such linkages would foster
efficiency; enhance competition;
[[Page 3597]]
increase the information available to brokers, dealers, and investors;
facilitate the offsetting (matching) of investors' orders; and
contribute to the best execution of investors' orders.
Over the years, these findings and objectives have guided the
Commission as it has sought to keep market structure rules up-to-date
with continually changing economic conditions and technology advances.
This task has presented certain challenges because, as noted previously
by the Commission, the five objectives set forth in Section 11A can, at
times, be difficult to reconcile.\17\ In particular, the objective of
matching investor orders, or ``order interaction,'' can be difficult to
reconcile with the objective of promoting competition among markets.
Order interaction promotes a system that ``maximizes the opportunities
for the most willing seller to meet the most willing buyer.'' \18\ When
many trading centers compete for order flow in the same stock, however,
such competition can lead to the fragmentation of order flow in that
stock. Fragmentation can inhibit the interaction of investor orders and
thereby impair certain efficiencies and the best execution of
investors' orders. Competition among trading centers to provide
specialized services for investors also can lead to practices that may
detract from public price transparency. On the other hand, mandating
the consolidation of order flow in a single venue would create a
monopoly and thereby lose the important benefits of competition among
markets. The benefits of such competition include incentives for
trading centers to create new products, provide high quality trading
services that meet the needs of investors, and keep trading fees low.
---------------------------------------------------------------------------
\17\ See, e.g., Securities Exchange Act Release No. 42450
(February 3, 2000), 65 FR 10577, 10580 (February 28, 2000)
(``Fragmentation Concept Release'') (``[A]lthough the objectives of
vigorous competition on price and fair market center competition may
not always be entirely congruous, they both serve to further the
interests of investors and therefore must be reconciled in the
structure of the national market system.'').
\18\ H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975).
---------------------------------------------------------------------------
The Commission's task has been to facilitate an appropriately
balanced market structure that promotes competition among markets,
while minimizing the potentially adverse effects of fragmentation on
efficiency, price transparency, best execution of investor orders, and
order interaction.\19\ An appropriately balanced market structure also
must provide for strong investor protection and enable businesses to
raise the capital they need to grow and to benefit the overall economy.
Given the complexity of this task, there clearly is room for reasonable
disagreement as to whether the market structure at any particular time
is, in fact, achieving an appropriate balance of these multiple
objectives. Accordingly, the Commission believes it is important to
monitor these issues and, periodically, give the public, including the
full range of investors and other market participants, an opportunity
to submit their views on the matter. This concept release is intended
to provide such an opportunity.
---------------------------------------------------------------------------
\19\ See S. Rep. 94-75, 94th Cong., 1st Sess. 2 (1975) (``S. 249
would lay the foundation for a new and more competitive market
system, vesting in the SEC power to eliminate all unnecessary or
inappropriate burdens on competition while at the same time granting
to that agency complete and effective powers to pursue the goal of
centralized trading of securities in the interest of both efficiency
and investor protection.''); Regulation NMS Release, 70 FR at 37499
(``Since Congress mandated the establishment of an NMS in 1975, the
Commission frequently has resisted suggestions that it adopt an
approach focusing on a single form of competition that, while
perhaps easier to administer, would forfeit the distinct, but
equally vital, benefits associated with both competition among
markets and competition among orders.'').
---------------------------------------------------------------------------
III. Overview of Current Market Structure
This section provides a brief overview of the current equity market
structure. It first describes the various types of trading centers that
compete for order flow in NMS stocks \20\ and among which liquidity is
dispersed. It then describes the primary types of linkages between or
involving these trading centers that are designed to enable market
participants to trade effectively. This section attempts to highlight
the features of the current equity market structure that may be most
salient in presenting issues for public comment and is not intended to
serve as a full description of the U.S. equity markets.
---------------------------------------------------------------------------
\20\ Rule 600(b)(47) of Regulation NMS defines ``NMS stock'' to
mean any NMS security other than an option. Rule 600(b)(46) defines
``NMS security'' to mean any security for which trade reports are
made available pursuant to an effective transaction reporting plan.
In general, NMS stocks are those that are listed on a national
securities exchange.
---------------------------------------------------------------------------
A. Trading Centers
A good place to start in describing the current market structure is
by identifying the major types of trading centers and giving a sense of
their current share of trading volume in NMS stocks. Figure 6 below
provides this information with estimates of trading volume in September
2009: \21\
---------------------------------------------------------------------------
\21\ Sources of estimated trading volume percentages: NASDAQ;
NYSE Group; BATS; Direct Edge; data compiled from Forms ATS for 3d
quarter 2009.
---------------------------------------------------------------------------
Figure 6
Trading Centers and Estimated % of Share Volume in NMS Stocks September
2009
[[Page 3598]]
[GRAPHIC] [TIFF OMITTED] TP21JA10.002
------------------------------------------------------------------------
Percent
------------------------------------------------------------------------
Registered Exchanges
------------------------------------------------------------------------
NASDAQ....................................................... 19.4
NYSE......................................................... 14.7
NYSE Arca.................................................... 13.2
BATS......................................................... 9.5
NASDAQ OMX BX................................................ 3.3
Other........................................................ 3.7
----------
Total Exchange........................................... 63.8
------------------------------------------------------------------------
ECNs
------------------------------------------------------------------------
2 Direct Edge................................................ 9.8
3 Others..................................................... 1.0
----------
Total ECN................................................ 10.8
----------
Total Displayed Trading Center........................... 74.6
------------------------------------------------------------------------
Dark Pools
------------------------------------------------------------------------
Approximately 32 \22\........................................ 7.9
------------------------------------------------------------------------
Broker-Dealer Internalization
------------------------------------------------------------------------
More than 200 \23\........................................... 17.5
----------
Total Undisplayed Trading Center......................... 25.4
------------------------------------------------------------------------
Figure 6 identifies two types of trading centers that display
quotations in the consolidated quotation data that is widely
distributed to the public--registered exchanges and ECNs.\24\ These
displayed trading centers execute approximately 74.6% of share volume.
Figure 6 also identifies two types of undisplayed trading centers--dark
pools and broker-dealers that execute trades internally--that execute
approximately 25.4% of share volume. These four types of trading
centers are described below.
---------------------------------------------------------------------------
\22\ Data compiled from Forms ATS submitted to Commission for 3d
quarter 2009.
\23\ More than 200 broker-dealers (excluding ATSs) have
identified themselves to FINRA as market centers that must provide
monthly reports on order execution quality under Rule 605 of
Regulation NMS (list available at http://apps.finra.org/datadirectory/1/marketmaker.aspx).
\24\ Consolidated quotation data is described in section
III.B.1. below.
---------------------------------------------------------------------------
1. Registered Exchanges
Registered exchanges collectively execute approximately 63.8% of
share volume in NMS stocks, with no single exchange executing more than
19.4%. Registered exchanges must undertake self-regulatory
responsibility for their members and file their proposed rule changes
for approval with the Commission. These proposed rule changes publicly
disclose, among other things, the trading services and fees of
exchanges.
The registered exchanges all have adopted highly automated trading
systems that can offer extremely high-speed, or ``low-latency,'' order
responses and executions. Published average response times at some
exchanges, for example, have been reduced to less than 1
millisecond.\25\ Many exchanges offer individual data feeds that
deliver information concerning their orders and trades directly to
customers. To further reduce latency in transmitting market data and
order messages, many exchanges also offer co-location services that
enable exchange customers to place their servers in close proximity to
the exchange's matching engine. Exchange data feeds and co-location
services are discussed further in section IV.B.2. below.
---------------------------------------------------------------------------
\25\ See, e.g., BATS Exchange, Inc., http://batstrading.com/resources/features/bats_exchange_Latency.pdf (June 2009) (average
latency (time to accept, process, and acknowledge or fill order) of
320 microseconds; NASDAQ, http://www.nasdaqtrader.com/trader.aspx?id=inet (December 12, 2009) (average latency (time to
accept, process, and acknowledge or fill order) of 294
microseconds).
---------------------------------------------------------------------------
Registered exchanges typically offer a wide range of order types
for trading on their automated systems. Some of their order types are
displayable in full if they are not executed immediately. Others are
undisplayed, in full or in part. For example, a reserve order type will
display part of the size of an order at a particular price, while
holding the balance of the order in reserve and refreshing the
displayed size as needed. In general, displayed orders are given
execution priority at any given price over fully undisplayed orders and
the undisplayed size of reserve orders.\26\
---------------------------------------------------------------------------
\26\ See, e.g., BATS Exchange, Inc., Rule 11.12 (equally priced
trading interest executed in time priority in the following order:
(1) Displayed size of limit orders; (2) non-displayed limit orders;
(3) pegged orders; (4) mid-point peg orders; (5) reserve size of
orders; and (6) discretionary portion of discretionary orders);
NASDAQ Rule 4757(a)(1) (book processing algorithm executes trading
interest in the following order: (1) Displayed orders; (2) non-
displayed orders and the reserve portion of quotes and reserve
orders (in price/time priority among such interest); and (3) the
discretionary portion of discretionary orders.
---------------------------------------------------------------------------
In addition, many exchanges have adopted a ``maker-taker'' pricing
model in an effort to attract liquidity providers. Under this model,
non-marketable,
[[Page 3599]]
resting orders that offer (make) liquidity at a particular price
receive a liquidity rebate if they are executed, while incoming orders
that execute against (take) the liquidity of resting orders are charged
an access fee. Rule 610(c) of Regulation NMS caps the amount of the
access fee for executions against the best displayed prices of an
exchange at 0.3 cents per share. Exchanges typically charge a somewhat
higher access fee than the amount of their liquidity rebates, and
retain the difference as compensation. Sometimes, however, exchanges
have offered ``inverted'' pricing and pay a liquidity rebate that
exceeds the access fee.
Highly automated exchange systems and liquidity rebates have helped
establish a business model for a new type of professional liquidity
provider that is distinct from the more traditional exchange specialist
and over-the-counter (``OTC'') market maker. In particular, proprietary
trading firms and the proprietary trading desks of multi-service
broker-dealers now take advantage of low-latency systems and liquidity
rebates by submitting large numbers of non-marketable orders (often
cancelling a very high percentage of them), which provide liquidity to
the market electronically. As discussed in section IV.B. below, these
proprietary traders often are labeled high-frequency traders, though
the term does not have a settled definition and may encompass a variety
of strategies in addition to passive market making.
2. ECNs
The five ECNs that actively trade NMS stocks collectively execute
approximately 10.8% of share volume. Almost all ECN volume is executed
by two ECNs operated by Direct Edge, which has submitted applications
for registration of its two trading platforms as exchanges.\27\ ECNs
are regulated as alternative trading systems (``ATSs''). Regulation of
ATSs is discussed in the next section below in connection with dark
pools, which also are ATSs. The key characteristic of an ECN is that it
provides its best-priced orders for inclusion in the consolidated
quotation data, whether voluntarily or as required by Rule 301(b)(3) of
Regulation ATS. In general, ECNs offer trading services (such as
displayed and undisplayed order types, maker-taker pricing, and data
feeds) that are analogous to those of registered exchanges.
---------------------------------------------------------------------------
\27\ Securities Exchange Act Release No. 60651 (September 11,
2009), 74 FR 47827 (September 17, 2009) (Notice of filing of
applications for registration as national securities exchanges by
EDGX Exchange, Inc. and EDGA Exchange, Inc.).
---------------------------------------------------------------------------
3. Dark Pools
Dark pools are ATSs that, in contrast to ECNs, do not provide their
best-priced orders for inclusion in the consolidated quotation data. In
general, dark pools offer trading services to institutional investors
and others that seek to execute large trading interest in a manner that
will minimize the movement of prices against the trading interest and
thereby reduce trading costs.\28\ There are approximately 32 dark pools
that actively trade NMS stocks, and they executed approximately 7.9% of
share volume in NMS stocks in the third quarter of 2009.\29\ ATSs, both
dark pools and ECNs, fall within the statutory definition of an
exchange, but are exempted if they comply with Regulation ATS.
Regulation ATS requires ATSs to be registered as broker-dealers with
the Commission, which entails becoming a member of the Financial
Industry Regulatory Authority (``FINRA'') and fully complying with the
broker-dealer regulatory regime. Unlike a registered exchange, an ATS
is not required to file proposed rule changes with the Commission or
otherwise publicly disclose its trading services and fees. ATSs also do
not have any self-regulatory responsibilities, such as market
surveillance. The regulatory differences between registered exchanges
and ATSs are addressed further in section IV.C.3. below.
---------------------------------------------------------------------------
\28\ See Non-Public Trading Interest Release, 74 FR at 61208-
61209.
\29\ Data compiled from Forms ATS submitted to Commission for 3d
quarter 2009. Some OTC market makers offer dark liquidity primarily
in a principal capacity and do not operate as ATSs. For purposes of
this release, these trading centers are not defined as dark pools
because they are not ATSs. These trading centers may, however, offer
electronic dark liquidity services that are analogous to those
offered by dark pools.
---------------------------------------------------------------------------
Dark pools can vary quite widely in the services they offer their
customers. For example, some dark pools, such as block crossing
networks, offer specialized size discovery mechanisms that attempt to
bring large buyers and sellers in the same NMS stock together
anonymously and to facilitate a trade between them. The average trade
size of these block crossing networks can be as high as 50,000
shares.\30\ Most dark pools, though they may handle large orders,
primarily execute trades with small sizes that are more comparable to
the average size of trades in the public markets, which was less than
300 shares in July 2009.\31\ These dark pools that primarily match
smaller orders (though the matched orders may be ``child'' orders of
much larger ``parent'' orders) execute more than 90% of dark pool
trading volume.\32\ The majority of this volume is executed by dark
pools that are sponsored by multi-service broker-dealers. These broker-
dealers also offer order routing services, trade as principal in the
sponsored ATS, or both.
---------------------------------------------------------------------------
\30\ See, e.g., http://www.liquidnet.com/about/liquidStats.html
(average U.S. execution size in July 2009 was 49,638 shares for
manually negotiated trades via Liquidnet's negotiation product);
http://www.pipelinetrading.com/AboutPipeline/CompanyInfo.aspx
(average trade size of 50,000 shares in Pipeline).
\31\ See, e.g., http://www.nasdaqtrader.com/trader/aspx?id=marketshare (average size of NASDAQ matched trades in July
2009 was 228 shares); http://nyxdata.com/nysedata/asp/factbook (NYSE
Group average trade size in all stocks traded in July 2009 was 267
shares).
\32\ Data compiled from Forms ATS submitted to Commission for 3d
quarter 2009.
---------------------------------------------------------------------------
4. Broker-Dealer Internalization
The other type of undisplayed trading center is a non-ATS broker-
dealer that internally executes trades, whether as agent or principal.
Notably, many broker-dealers may submit orders to exchanges or ECNs,
which then are included in the consolidated quotation data. The
internalized executions of broker-dealers, however, primarily reflect
liquidity that is not included in the consolidated quotation data.
Broker-dealer internalization accordingly should be classified as
undisplayed liquidity. There are a large number of broker-dealers that
execute trades internally in NMS stocks--more than 200 publish
execution quality statistics under Rule 605 of Regulation NMS.\33\
Broker-dealer internalization accounts for approximately 17.5% of share
volume in NMS stocks.
---------------------------------------------------------------------------
\33\ See supra note 23.
---------------------------------------------------------------------------
Broker-dealers that internalize executions generally fall into two
categories--OTC market makers and block positioners. An OTC market
maker is defined in Rule 600(b)(52) of Regulation NMS as ``any dealer
that holds itself out as being willing to buy and sell to its
customers, or others, in the United States, an NMS stock for its own
account on a regular or continuous basis otherwise than on a national
securities exchange in amounts of less than block size.'' ``Block
size'' is defined in Rule 600(b)(9) as an order of at least 10,000
shares or for a quantity of stock having a market value of at least
$200,000. A block positioner generally means any broker-dealer in the
business of executing, as principal or agent, block size trades for its
customers. To facilitate trades, block positioners often commit their
own capital to trade as principal with at least some part of the
customer's block order.
Broker-dealers that act as OTC market makers and block positioners
conduct
[[Page 3600]]
their business primarily by directly negotiating with customers or with
other broker-dealers representing customer orders. OTC market makers,
for example, appear to handle a very large percentage of marketable
(immediately executable) order flow of individual investors that is
routed by retail brokerage firms. A review of the order routing
disclosures required by Rule 606 of Regulation NMS of eight broker-
dealers with significant retail customer accounts reveals that nearly
100% of their customer market orders are routed to OTC market
makers.\34\ The review also indicates that most of these retail brokers
either receive payment for order flow in connection with the routing of
orders or are affiliated with an OTC market maker that executes the
orders. The Rule 606 Reports disclose that the amount of payment for
order flow generally is 0.1 cent per share or less.\35\
---------------------------------------------------------------------------
\34\ Review of Rule 606 Reports for 2d quarter 2009 of eight
broker-dealers with substantial number of retail customer accounts.
\35\ Id.
---------------------------------------------------------------------------
B. Linkages
Given the dispersal of liquidity across a large number of trading
centers of different types, an important question is whether trading
centers are sufficiently linked together in a unified national market
system. Thus far in this release, the term ``dispersed'' has been used
to describe the current market structure rather than ``fragmented.''
The term ``fragmentation'' connotes a negative judgment that the
linkages among competing trading centers are insufficient to achieve
the Exchange Act objectives of efficiency, price transparency, best
execution, and order interaction. Whether fragmentation is in fact a
problem in the current market structure is a critically important issue
on which comment is requested in section IV below in a variety of
contexts. This section will give an overview of the primary types of
linkages that operate in the current market structure--consolidated
market data, trade-through protection, and broker routing services.
1. Consolidated Market Data
When Congress mandated a national market system in 1975, it
emphasized that the systems for collecting and distributing
consolidated market data would ``form the heart of the national market
system.'' \36\ As described further below, consolidated market data
includes both: (1) Pre-trade transparency--real-time information on the
best-priced quotations at which trades may be executed in the future
(``consolidated quotation data''); and (2) post-trade transparency--
real-time reports of trades as they are executed (``consolidated trade
data''). As a result, the public has ready access to a comprehensive,
accurate, and reliable source of information for the prices and volume
of any NMS stock at any time during the trading day. This information
serves an essential linkage function by helping assure that the public
is aware of the best displayed prices for a stock, no matter where they
may arise in the national market system. It also enables investors to
monitor the prices at which their orders are executed and assess
whether their orders received best execution.
---------------------------------------------------------------------------
\36\ H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975).
---------------------------------------------------------------------------
Consolidated market data is collected and distributed pursuant to a
variety of Exchange Act rules and joint-industry plans. With respect to
pre-trade transparency, Rule 602 of Regulation NMS requires exchange
members and certain OTC market makers that exceed a 1% trading volume
threshold to provide their best-priced quotations to their respective
exchanges or FINRA, and these self-regulatory organizations (``SROs''),
in turn, are required to make this information available to vendors.
Rule 604 of Regulation NMS requires exchange specialists and OTC market
makers to display certain customer limit orders in their best-priced
quotations provided under Rule 602. In addition, Rule 301(b)(3) of
Regulation ATS requires an ATS that displays orders to more than one
person in the ATS and exceeds a 5% trading volume threshold to provide
its best-priced orders for inclusion in the quotation data made
available under Rule 602.\37\
---------------------------------------------------------------------------
\37\ The Commission has proposed lowering the trading volume
threshold for order display obligations from 5% to 0.25%. Non-Public
Trading Interest Release, 74 FR at 61213.
---------------------------------------------------------------------------
Importantly, the Commission's rules do not require the display of a
customer limit order if the customer does not wish the order to be
displayed.\38\ Customers have the freedom to display or not display
depending on their trading objectives. On the other hand, the selective
display of orders generally is prohibited in order to prevent the
creation of significant private markets and two-tiered access to
pricing information.\39\ Accordingly, the display of orders to some
market participants generally will require that the order be included
in the consolidated quotation data that is widely available to the
public.
---------------------------------------------------------------------------
\38\ Rule 604 of Regulation NMS, for example, explicitly
recognizes the ability of customers to control whether their limit
orders are displayed to the public. Rule 604(b)(2) provides an
exception from the limit order display requirement for orders that
are placed by customers who expressly request that the order not be
displayed. Rule 604(b)(4) provides an exception for all block size
orders unless the customer requests that the order be displayed.
\39\ See, e.g., Rule 301(b)(3) of Regulation ATS; Rule 602(a)(1)
of Regulation NMS; Order Handling Rules Release, 61 FR at 48307
(``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.'').
---------------------------------------------------------------------------
With respect to post-trade transparency, Rule 601 of Regulation NMS
requires the equity exchanges and FINRA to file a transaction reporting
plan regarding transactions in listed equity securities. The members of
these SROs are required to comply with the relevant SRO rules for trade
reporting. FINRA's trade reporting requirements apply to all ATSs that
trade NMS stocks, both ECNs and dark pools, as well as to broker-
dealers that internalize. FINRA currently requires members to report
their trades as soon as practicable, but no later than 90 seconds.\40\
FINRA has proposed to reduce the reporting time period to 30 seconds,
noting that more than 99.9% of transactions are reported to FINRA in 30
seconds or less.\41\
---------------------------------------------------------------------------
\40\ Securities Exchange Act Release No. 60960 (November 6,
2009), 74 FR 59272, 59273 (November 17, 2009) (File No. SR-FINRA-
2009-061) (in its description of the proposed rule change, FINRA
stated that ``[a]lthough members would have 30 seconds to report,
FINRA reiterates that--as is the case today--members must report
trades as soon as practical and cannot withhold trade reports, e.g.,
by programming their systems to delay reporting until the last
permissible second'').
\41\ Id. (from February 23, 2009 through February 27, 2009,
99.90% of trades submitted to a FINRA Facility for public reporting
were reported in 30 seconds or less).
---------------------------------------------------------------------------
Finally, Rule 603(b) of Regulation NMS requires the equity
exchanges and FINRA to act jointly pursuant to one or more effective
national market system plans to disseminate consolidated information,
including an NBBO, on quotations for and transactions in NMS stocks. It
also requires that consolidated information for each NMS stock be
disseminated through a single plan processor.
To comply with these requirements, the equity exchanges and FINRA
participate in three joint-industry plans (``Plans'').\42\ Pursuant to
the Plans, three
[[Page 3601]]
separate networks distribute consolidated market data for NMS stocks:
(1) Network A for securities with their primary listing on the NYSE;
(2) Network B for securities with their primary listing on exchanges
other than the NYSE or NASDAQ; and (3) Network C for securities with
their primary listing on NASDAQ. The three Networks establish fees for
the data, which must be filed for Commission approval. The three
Networks collect the applicable fees and, after deduction of Network
expenses (which do not include the costs incurred by SROs to generate
market data and provide such data to the Networks), allocate the
remaining revenues to the SROs. The revenues, expenses, and allocations
for each of the three Networks are set forth in Table 1 below:\43\
---------------------------------------------------------------------------
\42\ The three joint-industry plans are: (1) The CTA Plan, which
is operated by the Consolidated Tape Association and disseminates
transaction information for securities with their primary listing on
exchanges other than NASDAQ; (2) the CQ Plan, which disseminates
consolidated quotation information for securities with their primary
listing on exchanges other than NASDAQ; and (3) the NASDAQ UTP Plan,
which disseminates consolidated transaction and quotation
information for securities with their primary listing on NASDAQ. The
CTA Plan and CQ Plan are available at http://www.nyxdata.com/nysedata/default.aspx?tabid=227. The NASDAQ UTP Plan is available at
http://www.utpplan.com.
\43\ The Network financial information for 2008 is preliminary
and unaudited.
Table 1--2008 Financial Information for Networks A, B, and C
----------------------------------------------------------------------------------------------------------------
Network A Network B Network C Total
----------------------------------------------------------------------------------------------------------------
Revenues............................ $209,218,000 $119,876,000 $134,861,000 $463,955,000
Expenses............................ 6,078,000 3,066,000 5,729,000 14,873,000
Net Income.......................... 203,140,000 116,810,000 129,132,000 449,082,000
Allocations:
NASDAQ.......................... 47,845,000 34,885,000 60,614,000 143,343,000
NYSE Arca....................... 37,080,000 38,235,000 26,307,000 101,622,000
NYSE............................ 68,391,000 0 0 68,391,000
FINRA........................... 24,325,000 16,458,000 20,772,000 61,555,000
NSX............................. 7,100,000 11,575,000 17,123,000 35,798,000
ISE............................. 15,260,000 1,477,000 1,883,000 18,620,000
NYSE Amex....................... 1,000 9,760,000 14,000 9,775,000
BATS............................ 2,356,000 2,770,000 1,538,000 6,664,000
CBOE............................ 80,000 1,046,000 433,000 1,559,000
CHX............................. 565,000 574,000 298,000 1,437,000
Phlx............................ 134,000 30,000 146,000 310,000
BSE............................. 3,000 ................. 4,000 7,000
----------------------------------------------------------------------------------------------------------------
In addition to providing quotation and trade information to the
three Networks for distribution in consolidated data, many exchanges
and ECNs offer individual data feeds directly to customers that include
information that is provided in consolidated data. The individual data
feeds of exchanges and ECNs also can include a variety of other types
of information, such as ``depth-of-book'' quotations at prices inferior
to their best-priced quotations. Rule 603(a) of Regulation NMS requires
all exchanges, ATSs, and other broker-dealers that offer individual
data feeds to make the data available on terms that are fair and
reasonable and not unreasonably discriminatory. Exchanges, ATSs, and
other broker-dealers are prohibited from providing their data directly
to customers any sooner than they provide their data to the plan
processors for the Networks.\44\ The fact that trading center data
feeds do not need to go through the extra step of consolidation at a
plan processor, however, means that such data feeds can reach end-users
faster than the consolidated data feeds. The average latencies of the
consolidation function at plan processors (from the time the processor
receives information from the SROs to the time it distributes
consolidated information to the public) are as follows: (1) Network A
and Network B--less than 5 milliseconds for quotation data and less
than 10 milliseconds for trade data; and (2) Network C--5.892
milliseconds for quotation data and 6.680 milliseconds for trade
data.\45\ The individual trading center data feeds are discussed below
in section IV.B.2.b.
---------------------------------------------------------------------------
\44\ Regulation NMS Release, 70 FR at 37567 (``Adopted Rule
603(a) will not require a market center to synchronize the delivery
of its data to end-users with delivery of data by a Network
processor to end-users. Rather independently distributed data could
not be made available on a more timely basis than core data is made
available to a Network processor. Stated another way, adopted Rule
603(a) prohibits an SRO or broker-dealer from transmitting data to a
vendor or user any sooner than it transmits the data to a Network
processor.''). The plan processor for the CTA Plan and CQ Plan is
the Securities Industry Automation Corporation (``SIAC''). The plan
processor for the NASDAQ UTP Plan is NASDAQ.
\45\ Sources: SIAC for Network A and Network B; NASDAQ for
Network C.
---------------------------------------------------------------------------
2. Trade-Through Protection
Another important type of linkage in the current market structure
is the protection against trade-throughs provided by Rule 611 of
Regulation NMS. A trade-through is the execution of a trade at a price
inferior to a protected quotation for an NMS stock. A protected
quotation must be displayed by an automated trading center, must be
disseminated in the consolidated quotation data, and must be an
automated quotation that is the best bid or best offer of an exchange
or FINRA. Importantly, Rule 611 applies to all trading centers, not
just those that display protected quotations. Trading center is defined
broadly in Rule 600(b)(78) to include, among others, all exchanges, all
ATSs (including ECNs and dark pools), all OTC market makers, and any
other broker-dealer that executes orders internally, whether as agent
or principal.
Rule 611(a)(1) requires all trading centers to establish, maintain,
and enforce written policies and procedures that are reasonably
designed to prevent trade-throughs of protected quotations, subject to
the exceptions set forth in Rule 611(b). Protection against trade-
throughs is an important linkage among trading centers because it
provides a baseline assurance that: (1) Marketable orders will receive
at least the best displayed price, regardless of the particular trading
center that executes the order or where the best price is displayed in
the national market system; and (2) quotations that are displayed at
one trading center will not be bypassed by trades with inferior prices
at any trading center in the national market system.
Rule 611 also helps promote linkages among trading centers by
encouraging them, when they do not have available trading interest at
the best price, to route marketable orders to a trading center that is
displaying the best price. Although Rule 611 does not directly require
such routing services (a trading center can, for example, cancel and
return an order when it does not have the best price), competitive
factors have
[[Page 3602]]
led many trading centers to offer routing services to their customers.
Prior to Rule 611, exchanges routed orders through an inflexible,
partially manual system called the Intermarket Trading System
(``ITS'').\46\ With Regulation NMS, however, the Commission adopted a
``private linkages'' approach that relies exclusively on brokers to
provide routing services, both among exchanges and between customers
and exchanges. These broker routing services are discussed next.
---------------------------------------------------------------------------
\46\ See Regulation NMS Release, 70 FR at 37538-37539
(``Although ITS promotes access among participants that is uniform
and free, it also is often slow and limited.'').
---------------------------------------------------------------------------
3. Broker Routing Services
In a dispersed and complex market structure with many different
trading centers offering a wide spectrum of services, brokers play a
significant role in linking trading centers together into a unified
national market system. Brokers compete to offer the sophisticated
technology tools that are needed to monitor liquidity at many different
venues and to implement order routing strategies. To perform this
function, brokers may monitor the execution of orders at both displayed
and undisplayed trading centers to assess the availability of
undisplayed trading interest. Brokers may, for example, construct real-
time ``heat maps'' in an effort to discern and access both displayed
and undisplayed liquidity at trading centers throughout the national
market system.
Using their knowledge of available liquidity, many brokers offer
smart order routing technology to access such liquidity. Many brokers
also offer sophisticated algorithms that will take the large orders of
institutional investors and others, divide a large ``parent'' order
into many smaller ``child'' orders, and route the child orders over
time to different trading centers in accordance with the particular
trading strategy chosen by the customer. Such algorithms may be
``aggressive,'' for example, and seek to take liquidity quickly at many
different trading centers, or they may be ``passive,'' and submit
resting orders at one or more trading centers and await executions at
favorable prices.
To the extent they help customers cope with the dispersal of
liquidity among a large number of trading centers of different types
and achieve the best execution of their customers' orders, the routing
services of brokers can contribute to the broader policy goal of
promoting efficient markets.
Under the private linkages approach adopted by Regulation NMS,
market participants obtain access to the various trading centers
through broker-dealers that are members or subscribers of the
particular trading center.\47\ Rule 610(a) of Regulation NMS, for
example, prohibits an SRO trading facility from imposing unfairly
discriminatory terms that would prevent or inhibit any person from
obtaining efficient access through an SRO member to the displayed
quotations of the SRO trading facility. Rule 610(c) limits the fees
that a trading center can charge for access to its displayed quotations
at the best prices. Rule 611(d) requires SROs to establish, maintain,
and enforce rules that restrict their members from displaying
quotations that lock or cross previously displayed quotations.
---------------------------------------------------------------------------
\47\ See Regulation NMS Release, 70 FR at 37540 (``[M]any
different private firms have entered the business of linking with a
wide range of trading centers and then offering their customers
access to those trading centers through the private firms' linkages.
Competitive forces determine the types and costs of these private
linkages.'').
---------------------------------------------------------------------------
Section 6(a)(2) of the Exchange Act requires registered exchanges
to allow any qualified and registered broker-dealer to become a member
of the exchange--a key element in assuring fair access to exchange
services. In contrast, the access requirements that apply to ATSs are
much more limited. Regulation ATS includes two distinct types of access
requirements: (1) order display and execution access in Rule 301(b)(3);
and (2) fair access to ATS services in general in Rule 301(b)(5). An
ATS must meet order display and execution access requirements if it
displays orders to more than one person in the ATS and exceeds a 5%
trading volume threshold.\48\ An ATS must meet the general fair access
requirement if it exceeds a 5% trading volume threshold. If an ATS
neither displays orders to more than one person in the ATS nor exceeds
a 5% trading volume threshold, Regulation ATS does not impose access
requirements on the ATS.
---------------------------------------------------------------------------
\48\ The Commission has proposed reducing the threshold for
order display and execution access to 0.25%. Non-Public Trading
Interest Release, 74 FR at 61213. It has not proposed to change the
threshold for fair access in general.
---------------------------------------------------------------------------
An essential type of access that should not be overlooked is the
fair access to clearance and settlement systems required by Section 17A
of the Exchange Act. If brokers cannot efficiently clear and settle
transactions at the full range of trading centers, they will not be
able to perform their linkage function properly.
The linkage function of brokers also is supported by a broker's
legal duty of best execution. This duty requires a broker to obtain the
most favorable terms reasonably available when executing a customer
order.\49\ Of course, this legal duty is not the only pressure on
brokers to obtain best execution. The existence of strong competitive
pressure to attract and retain customers encourages brokers to provide
high quality routing services to their customers. In this regard, Rules
605 and 606 of Regulation NMS are designed to support competition by
enhancing the transparency of order execution and routing practices.
Rule 605 requires market centers to publish monthly reports of
statistics on their order execution quality. Rule 606 requires brokers
to publish quarterly reports on their routing practices, including the
venues to which they route orders for execution. As the Commission
emphasized when it adopted the rules in 2000, ``[b]y increasing the
visibility of order execution and routing practices, the rules adopted
today are intended to empower market forces with the means to achieve a
more competitive and efficient national market system for public
investors.'' \50\ In section IV.A.1.b. below, comment is requested on
whether Rules 605 and 606 should be updated for the current market
structure.
---------------------------------------------------------------------------
\49\ See, e.g., Regulation NMS Release, 70 FR at 37537-37538
(discussion of duty of best execution).
\50\ Securities Exchange Act Release No. 43590 (November 17,
2000), 65 FR 75414, 75415 (December 1, 2000) (Disclosure of Order
Execution and Routing Practices).
---------------------------------------------------------------------------
IV. Request for Comments
This section will focus on three categories of issues that the
Commission particularly wishes to present for comment--the performance
of the current market structure, high frequency trading, and
undisplayed liquidity. The Commission emphasizes, however, that it is
interested in receiving comments on all aspects of the equity market
structure that the public believes are important. The discussion in
this release should not be construed as in any way limiting the scope
of comments that will be considered.
This concept release focuses on the structure of the equity markets
and does not discuss the markets for other types of instruments that
are related to equities, such as options and OTC derivatives. The
limited scope of this release is designed to focus on a discrete set of
issues that have gained increased prominence in the equity markets.
Comment is requested, however, on the extent to which the issues
identified in this release are intertwined with other markets. For
example, market participants may look to alternative instruments if
they believe the equity markets are not optimal for their trading
[[Page 3603]]
objectives. Should the Commission consider the extent to which
instruments substitute for one another in evaluating equity market
structure?
In addition, comment is requested on the impact of globalization on
market structure. How does global competition for trading activity
impact the U.S. market structure? Should global competition affect the
approach to regulation in the U.S.? Will trading activity and capital
tend to move either to the U.S. or overseas in response to different
regulation in the U.S.? How should the Commission consider these
globalization issues in its review of market structure?
A. Market Structure Performance
The secondary markets for NMS stocks are essential to the economic
success of the country and to the financial well-being of individual
Americans. High quality trading markets promote capital raising and
capital allocation by establishing prices for securities and by
enabling investors to enter and exit their positions in securities when
they wish to do so.\51\ The Commission wishes to request comment
broadly on how well or poorly the current market structure is
performing its vital economic functions.
---------------------------------------------------------------------------
\51\ See, e.g., S. Report 94-75 at 3 (``The rapid attainment of
a national market system as envisaged by this bill is important,
therefore, not simply to provide greater investor protection and
bolster sagging investor confidence but also to assure that the
country maintains a strong, effective and efficient capital raising
and capital allocating system in the years ahead. The basic goals of
the Exchange Act remain salutary and unchallenged: to provide fair
and honest mechanisms for the pricing of securities, to assure that
dealing in securities is fair and without undue preferences or
advantages among investors, to ensure that securities can be
purchased and sold at economically efficient transaction costs, and
to provide, to the maximum degree practicable, markets that are open
and orderly.'').
---------------------------------------------------------------------------
In recent months, the Commission has heard a variety of concerns
about particular aspects of the current market structure, as well as
the view that recent improvements to the equity markets have benefitted
both individual and institutional investors. The concerns about market
structure often have related to high frequency trading and various
types of undisplayed liquidity. Prior to discussing these particular
areas of concern in this release, the Commission believes it is
important to assess more broadly the performance of the market
structure, particularly for long-term investors and for businesses
seeking to raise capital. Assessing overall market structure
performance should help provide context for particular concerns, as
well as the nature of any regulatory response that may be appropriate
to address concerns.
1. Long-Term Investors
In assessing the performance of the current equity market structure
and whether it is meeting the relevant Exchange Act objectives, the
Commission is particularly focused on the interests of long-term
investors. These are the market participants who provide capital
investment and are willing to accept the risk of ownership in listed
companies for an extended period of time. Unlike long-term investors,
professional traders generally seek to establish and liquidate
positions in a shorter time frame. Professional traders with these
short time frames often have different interests than investors
concerned about the long-term prospects of a company.\52\ For example,
short-term professional traders may like short-term volatility to the
extent it offers more trading opportunities, while long-term investors
do not. The net effect of trading strategies pursued by various short-
term professional traders, however, may not increase volatility and may
work to dampen volatility.
---------------------------------------------------------------------------
\52\ See Regulation NMS Release, 70 FR at 37500 (``The
Commission recognizes that it is important to avoid false
dichotomies between the interests of short-term traders and long-
term investors, and that many difficult line-drawing exercises can
arise in precisely defining the difference between the two terms.
For present purposes, however, these issues can be handled by simply
noting that it makes little sense to refer to someone as `investing'
in a company for a few seconds, minutes, or hours.'') (citation
omitted).
---------------------------------------------------------------------------
Nevertheless, the interests of investors and professional traders
may at times be aligned. Indeed, the collective effect of professional
traders competing to profit from short-term trading strategies can work
to the advantage of long-term investors. For example, as just noted,
short-term trading strategies may work to dampen short-term volatility.
Professional traders with an informed view of prices can promote
efficient pricing. Professional traders competing to provide liquidity
may narrow spreads and give investors the benefit of better prices when
they simply want to trade immediately at the best available price.
Given the difference in time horizons, however, the trading needs
of long-term investors and short-term professional traders often may
diverge. Professional trading is a highly competitive endeavor in which
success or failure may depend on employing the fastest systems and the
most sophisticated trading strategies that require major expenditures
to develop and operate. Such systems and strategies may not be
particularly useful, in contrast, for investors seeking to establish a
long-term position rather than profit from fleeting price movements.
Where the interests of long-term investors and short-term professional
traders diverge, the Commission repeatedly has emphasized that its duty
is to uphold the interests of long-term investors.\53\
---------------------------------------------------------------------------
\53\ See, e.g., Flash Order Release, 74 FR at 48635-48636;
Regulation NMS Release, 70 FR at 37499-37501; Fragmentation Concept
Release, 65 FR at 10581 n. 26; see also S. Rep. No. 73-1455, 73rd
Cong., 2d Sess. 5 (1934) (``Transactions in securities on organized
exchanges and over-the-counter are affected with the national public
interest. * * * In former years transactions in securities were
carried on by a relatively small portion of the American people.
During the last decade, however, due largely to the development of
means of communication * * * the entire Nation has become acutely
sensitive to the activities on the securities exchanges. While only
a fraction of the multitude who now own securities can be regarded
as actively trading on the exchanges, the operations of these few
profoundly affect the holdings of all.'').
---------------------------------------------------------------------------
Comment is requested on the practicality of distinguishing the
interests of long-term investors from those of short-term professional
traders when assessing market structure issues. In what circumstances
should an investor be considered a ``long-term investor''? If a time
component is needed to define this class of investor, how should the
Commission determine the length of expected ownership that renders an
investor ``long-term''? Under what circumstances would a distinction
between a long-term investor and a short-term professional trader
become unclear, and how prevalent are these circumstances? To the
extent that improved market liquidity and depth promote the interests
of long-term investors by leading to reduced transaction costs, what
steps should the Commission consider taking to promote market liquidity
and depth?
Long-term investors include individuals that invest directly in
equities and institutions that invest on behalf of many individuals.
The Commission is interested in hearing how all types of individual
investors and all sizes of institutional investors--small, medium, and
large--are faring in the current market structure. For example, has the
current market structure become so dispersed and complex that only the
largest institutions can afford to deploy their own highly
sophisticated trading tools? If so, are smaller institutions able to
trade effectively? Some broker-dealers offer sophisticated trading
tools, such as smart routing and algorithmic trading. How accessible
are these trading tools to smaller institutions? Are the costs of
paying for these tools so high that they are effectively inaccessible?
Moreover, to the extent that a competitive advantage flows from these
trading
[[Page 3604]]
tools, does that competitive advantage help to promote and enable
competition, beneficial innovation, and, ultimately, enhanced market
quality? Is there a risk that certain competitive advantages may reduce
competition or lead to detrimental innovations? To what extent is it
important for market participants to be allowed to gain competitive
advantages, such as by using more sophisticated trading tools?
In addition, the Commission recognizes that there is wide variation
in types of equity securities and that there may be important
differences in market performance among the different types. With
respect to corporate equities, for example, the Commission is
interested in how market structure impacts stocks of varying levels of
market capitalization (for example, top tier, large, middle, and
small). A vital function of the equity markets is to support the
capital raising function, including capital raising by small companies.
The Commission recognizes that small company stocks may trade
differently than large company stocks and requests comment specifically
on how the market structure performs for smaller companies and whether
it supports the capital raising function for them.
a. Market Quality Metrics
Given these broad concerns for all types of long-term investors and
the full range of equities, what are useful metrics for assessing the
performance of the current market structure? In the past, the
Commission and its staff have considered a wide variety of metrics,
most of which have applied to smaller orders (such as 10,000 shares or
less).\54\ These metrics have included measures of spreads--the
difference between the prices that buyers pay and sellers receive when
they are seeking to trade immediately at the best prices. Spread
measures include quoted spreads, effective spreads (which reflects
whether investors receive prices that are better than, equal to, or
worse than quoted spreads), and realized spreads (which reflects how
investors are affected by subsequent price movements in a stock).
Another often used metric has been speed of execution.\55\
---------------------------------------------------------------------------
\54\ See, e.g., Memorandum to File from Office of Economic
Analysis dated December 15, 2004 regarding comparative analysis of
execution quality on NYSE and NASDAQ based on a matched sample of
stocks (``Comparative Analysis of Execution Quality'') (available at
http://www.sec.gov/spotlight/regnms.htm); Memorandum to File from
Office of Economic Analysis dated December 15, 2004 regarding
Analysis of Volatility for Stocks Switching from Nasdaq to NYSE
(available at http://www.sec.gov/spotlight/regnms.htm); Office of
Economic Analysis, Report on Comparison of Order Executions Across
Equity Market Structures (January 8, 2001) (``Report on Comparison
of Order Executions'') (available at http://www.sec.gov/news/studies/ordrxmkt.htm); Commission, Report on the Practice of
Preferencing (April 15, 1997) (available at http://www.sec.gov/news/studies/studiesarchive/1997archive.shtml).
\55\ When assessing market structure during the development of
Regulation NMS, for example, Commission staff used Rule 605 data to
measure quoted spreads, effective spreads, realized spreads, price
impact, net price improvement, execution speed, and fill rates. All
of the cost values were calculated both in terms of absolute value
(cents) and in terms of proportional costs as a percentage of stock
prices. Comparative Analysis of Execution Quality at 8-9.
---------------------------------------------------------------------------
Short-Term Volatility. Spreads and speed of execution may not,
however, give a full picture of execution quality, even for the small
orders of individual investors that generally will be fully executed in
one transaction (unlike the large orders of institutional investors
that may require many smaller executions). For example, short-term
price volatility may harm individual investors if they are persistently
unable to react to changing prices as fast as high frequency traders.
As the Commission previously has noted, long-term investors may not be
in a position to assess and take advantage of short-term price
movements.\56\ Excessive short-term volatility may indicate that long-
term investors, even when they initially pay a narrow spread, are being
harmed by short-term price movements that could be many times the
amount of the spread.
---------------------------------------------------------------------------
\56\ Fragmentation Concept Release, 65 FR at 10581 n. 26 (``In
theory, short-term price swings that hurt investors on one side of
the market can benefit investors on the other side of the market. In
practice, professional traders, who have the time and resources to
monitor market dynamics closely, are far more likely than investors
to be on the profitable side of short-term price swings (for
example, by buying early in a short-term price rise and selling
early before the price decline).'').
---------------------------------------------------------------------------
The Commission has used a variety of measures of short-term
volatility, including variance ratios (for example, 5 minute return
variance to 60 minute return variance, 1 day return variance to 1 week
return variance, and 1 day return variance to 4 week return
variance).\57\ Variance ratios are useful because they focus on short-
term volatility that may be directly related to market structure
quality, as opposed to long-term volatility that may be much more
affected by fundamental economic forces that are independent of market
structure quality. Another possible metric for assessing whether
investors are harmed by short-term volatility is realized spread, which
indicates whether prices moved for or against the submitter of the
order after the order was executed. Rule 605, for example, measures
realized spreads based on quotations 5 minutes after the time of order
execution.
---------------------------------------------------------------------------
\57\ Variance ratios are calculated by comparing return
variances for a short time period with return variances for a longer
time period. One of the advantages of this measure of volatility is
that ``there is a built-in control for the underlying uncertainty as
to the `true' value of the stock. For example, the high variance of
returns on technology stocks is to be expected given the high
uncertainty as to their future cash flows. The point is that this
uncertainty will manifest itself in both the daily and weekly return
variances. When [Commission staff] divide the weekly return by the
daily return, the natural uncertainty associated with the stock
`washes out' and [Commission staff] are left with a measure
associated with transaction costs or some other form of
inefficiency.'' Report on Comparison of Order Executions, supra note
54, at 18.
---------------------------------------------------------------------------
Finally, the Commission has evaluated various measures of the depth
that is immediately available to fill orders. These metrics include
fill rates for limit orders, quoted size at the inside prices, the
effect of reserve size and undisplayed size at the inside prices or
better, and quoted depth at prices away from the inside.
Metrics for Smaller Orders. Comment is requested on whether these
metrics that focus on the execution of smaller orders continue to be
useful. Which metrics are most useful in today's market structure? Are
there other useful metrics not listed above? Are there other relevant
metrics that reflect how individual investors are likely to trade? For
example, a significant number of individual investor orders are
submitted after regular trading hours when such investors have an
opportunity to evaluate their portfolios. These orders typically are
executed at opening prices. What are the best metrics for assessing
whether individual investor orders are executed fairly and efficiently
at the opening? Are there other particular times or contexts in which
retail investors often trade and, if so, what are the best metrics for
determining whether they are treated fairly and efficiently in those
contexts as well?
Measuring Institutional Investor Transaction Costs. Most of the
Commission's past analyses of market performance have focused on the
execution of smaller orders (for example, less than 10,000 shares),
rather than attempting to measure the overall transaction costs of
institutional investors to execute large orders (for example, greater
than 100,000 shares). Measuring the transaction costs of institutional
investors that need to trade in large size can be extremely
complex.\58\ These large orders often are
[[Page 3605]]
broken up into smaller child orders and executed in a series of
transactions. Metrics that apply to small order executions may miss how
well or poorly the large order traded overall. Direct measures of large
order transaction costs typically require access to institutional order
data that is not publicly available. In this regard, a few trading
analytics firms with access to institutional order data publish
periodic analyses of institutional investor transaction costs.\59\
These analyses allow such costs to be tracked over time to determine
whether they are improving or worsening. Comment is requested on these
published analyses generally and whether they accurately reflect the
transaction costs experienced by institutional investors. Are there
other studies or analyses of institutional trading costs that the
Commission should consider? Comment is requested in general on other
means for assessing the transaction costs of institutional investors in
the current market structure. For example, are any of the measures of
short-term volatility discussed above useful for assessing the
transactions costs of larger orders and, if so, how?
---------------------------------------------------------------------------
\58\ See generally Investment Company Act Release No. 26313
(December 18, 2003), 68 FR 74820, 74821 (December 24, 2003) (Request
for Comments on Measures to Improve Disclosure of Mutual Fund
Transaction Costs) (``The Commission is aware of the need for
transparency of mutual fund fees and expenses and committed to
improving disclosure of the costs that are borne by mutual fund
investors; but it is mindful of the complexities associated with
identifying, measuring, and accounting for transaction costs.'').
\59\ See, e.g., U.S. Government Accountability Office,
``Securities Markets: Decimal Pricing Has Contributed to Lower
Trading Costs and a More Challenging Trading Environment,'' at 96
(May 2005) (``We obtained data from three leading firms that collect
and analyze information about institutional investors' trading
costs. These trade analytics firms * * * obtain trade data directly
from institutional investors and brokerage firms and calculate
trading costs, including market impact costs (the extent to which
the security changes in price after the investor begins trading),
typically for the purpose of helping investors and traders limit
costs of trading. These firms also aggregate client data so as to
approximate total average trading costs for all institutional
investors. Generally, the client base represented in aggregate cost
data can be used to make generalizations about the institutional
investor industry.''); see also Pam Abramowitz, Technology Drives
Trading Costs, Institutional Investor (November 4, 2009) (13th
annual survey of transaction costs conducted for Institutional
Investor Magazine by Elkins/McSherry); Elkins McSherry LLC,
``Trading Cost Averages and Volatility Continued to Decline in
3Q09'' (November 2009) (available at https://www.elkinsmcsherry.com/em/pdfs/Newsletters/Nov_2009_newsletter.pdf); Investment
Technology Group, Inc., ``ITG Global Trading Cost Review: 2009 Q2''
(September 15, 2009) (available at http://www.itg.com/news_events/papers/ITGGlobalTradingCostReview_2009Q2.pdf).
---------------------------------------------------------------------------
Trend of Market Quality Metrics. With respect to all of the metrics
that are useful for assessing market structure performance for long-
term investors, the Commission is interested in whether commenters
believe they show improvement or worsening in recent years. For
example, do the relevant metrics indicate that market quality has
improved or worsened over the last ten years and the last five years?
Have markets improved or worsened more recently, since January 2009?
Which of the recent developments in market structure do you consider to
have the greatest effect on market quality? The Commission wishes to
hear about any current regulations that may be harming, rather than
improving, market quality. Specifically, how could any current
regulations be modified to fit more properly with the current market?
Recognizing that there is no such thing as a perfect market
structure that entirely eliminates transaction costs, the Commission
believes that an understanding of trends is important because they
provide a useful, pragmatic touchstone for assessing the goals with
respect to market structure performance.\60\
---------------------------------------------------------------------------
\60\ A very recent study, for example, examined trading activity
trends through the end of 2008. Chordia, Tarun, Richard Roll, &
Avanidar Subrahmanyam, Why Has Trading Volume Increased? (January 6,
2010). It focused on comparisons of pre- and post-decimal trading in
NYSE-listed stocks (subperiods from 1993-2000 and 2001-2008). Among
the study's findings are that average effective spreads decreased
significantly (from 10.2 cents to 2.2 cents for small trades
(<$10,000) and from 10.7 cents to 2.7 cents for large trades
(>$10,000)), while average depth available at the inside bid and
offer declined significantly (from 11,130 shares to 2797 shares).
---------------------------------------------------------------------------
Effect of Broad Economic Forces. The Commission notes that many
metrics of market performance may be affected by broad economic forces,
such as the global financial crisis during the Autumn of 2008, that
operate independently of market structure. Periods of high volatility
may be associated with high intermediation costs. This may reflect both
compensation for risk assumed by liquidity providers and the higher
demand for immediacy by long-term investors. How should the effect of
these economic forces be adjusted for in assessing the performance of
market structure over the last ten years, five years, and the last
year? For example, the CBOE Volatility Index (``VIX'') reached record
levels during 2008.\61\ The VIX is sometimes referred to as the ``fear
index'' because it measures expected volatility of the S&P 500 Index
over the next 30 calendar days.\62\ To what extent are metrics of
market structure performance correlated with the VIX or other analogous
measures of volatility? Is the level of the VIX largely independent of
market structure quality or are the level of the VIX and market
structure quality interdependent? Given that the VIX measures expected
volatility over the next 30 days, how important is the VIX to long-term
investors?
---------------------------------------------------------------------------
\61\ See infra note 81 and accompanying text.
\62\ See Chicago Board Options Exchange, ``The CBOE Volatility
Index--VIX,'' at 1, 4 (``VIX measures 30-day expected volatility of
the S&P 500 Index. The components of VIX are near- and next-term put
and call options, usually in the first and second SPX contract
months.'') (available at http://www.cboe.com/micro/vix/vixwhite.pdf).
---------------------------------------------------------------------------
b. Fairness of Market Structure
The Commission requests comment on whether the current market
structure is fair for long-term investors. For example, the speed of
trading has increased to the point that the fastest traders now measure
their latencies in microseconds. Is it necessary or economically
feasible for long-term investors to expend resources on the very
fastest and most highly sophisticated systems or otherwise obtain
access to these systems? If not, does the fact that professional
traders likely always will be able to trade faster than long-term
investors render the equity markets unfair for these investors? Or do
the different trading needs and objectives of long-term investors mean
that the disparities in speed in today's market structure are not
significant to the interests of such investors? In addition, what
standards should the Commission apply in assessing the fairness of the
equity markets? For example, is it unfair for market participants to
obtain a competitive advantage by investing in technology and human
resources that enable them to trade more effectively and profitably
than others?
Rules 605 and 606 and Other Tools to Protect Investor Interests. In
assessing the fairness of the current market structure, the Commission
is interested in whether long-term investors and their brokers have the
tools they need to protect their own interests in a dispersed and
complex market structure. Do, for example, broker-dealers provide
routing tools to their agency customers that are as powerful and
effective as the routing tools they may use for their proprietary
trading? If not, is this difference in access to technology unfair to
long-term investors? Or is a broker-dealer's ability to develop and use
more powerful and effective trading tools a competitive advantage that
spurs competition and beneficial innovation?
In addition, comment is requested on Rules 605 and 606, which were
adopted in 2000. Do these rules need to be updated and, if so, in what
respects? Do Rule 605 and Rule 606 reports continue to provide useful
information for investors and their brokers in assessing the quality of
order execution and routing practices? The Commission
[[Page 3606]]
notes that Rule 606 statistics reveal that brokers with significant
retail customer accounts send the great majority of non-directed
marketable orders to OTC market makers that internalize executions,
often pursuant to payment for order flow arrangements.\63\ Do
individual investors understand and pay attention to Rule 605 and 606
statistics? If not, what market participants, if any, make decisions
based on this data? Are those decisions beneficial to individual
investors?
---------------------------------------------------------------------------
\63\ See supra note 34 and accompanying text.
---------------------------------------------------------------------------
Rule 605 currently requires that the speed of execution for
immediately executable orders (market orders and marketable limit
orders) be disclosed to the tenth of a second. Do investors and brokers
need more finely tuned statistics, such as hundredths or thousandths of
a second? For non-marketable limit orders with prices that render them
not immediately executable at the best displayed prices, the shortest
time category is 0-9 seconds. Would a shorter time period be useful for
investors that use non-marketable limit orders? In addition, Rule 605
does not include any statistics measuring the execution quality of
orders submitted for execution at opening or closing prices. Would such
statistics be helpful to investors? Rule 605 also does not include any
statistics measuring commission costs of orders, access fees, or
liquidity rebates. Would such statistics be helpful to investors?
Rule 605 does not require disclosure of the amount of time that
canceled non-marketable orders are displayed in the order book of
trading center before cancellation. Considering the high cancellation
percentage of non-marketable orders, should Rule 605 require the
disclosure of the average time that canceled orders were displayed in
the order book? Conversely, should Rule 605 exclude or otherwise
distinguish canceled orders with a very limited duration (such as less
than one second)?
Moreover, Rules 605 and 606 were drafted primarily with the
interests of individual investors in mind and are focused on the
execution of smaller orders. Orders with large sizes, for example, are
excluded from both rules.\64\ Should the rules be updated to address
the interests of institutional investors in efficiently executing large
orders (whether in one large trade or many smaller trades)? If so, what
metrics would be useful for institutional investors?
---------------------------------------------------------------------------
\64\ Orders with a size of 10,000 shares or greater are exempt
from Rule 605 reporting. See generally Staff Legal Bulletin 12R:
Frequently Asked Questions About Rule 11Ac1-5 (Revised), now
Regulation NMS Rule 605, Question 26: Exemption of Block Orders
(available at http://www.sec.gov/divisions/marketreg/disclosure.htm). Rule 606 requires broker-dealers to report on their
routing of ``non-directed orders,'' which is defined in Rule
600(b)(48) as limited to customer orders. ``Customer order'' is
defined in Rule 600(b)(18) of Regulation NMS to exclude an order in
NMS stocks with a market value of at least $200,000. See generally
Staff Legal Bulletin 13A: Frequently Asked Questions About Rule
11Ac1-6, now Regulation NMS Rule 606, Question 6: Definition of
Customer Orders--Large Order Exclusion (available at http://www.sec.gov/divisions/marketreg/disclosure.htm).
---------------------------------------------------------------------------
Intermarket sweep orders (``ISOs'') are mostly used by
institutional traders.\65\ Rule 605 disclosures do not report regular
orders and ISOs separately.\66\ Would a distinction between ISO and
non-ISO marketable orders benefit individual and/or institutional
investors? Should any other order types be treated differently in Rule
605 reports?
---------------------------------------------------------------------------
\65\ Intermarket sweep orders are exceptions provided in Rule
611(b)(5) and (6) that enable an order router to sweep one or more
price levels simultaneously at multiple trading centers without
violating trade-through restrictions. As defined in Rule 600(b)(30)
of Regulation NMS, intermarket sweep orders must be routed to
execute against the full displayed size of any protected quotation
that otherwise would be traded through by the orders. In addition, a
single ISO can be routed to the best displayed price at the time of
routing to help assure an execution even if quotations change after
the order is routed. See Responses to Frequently Asked Questions
Concerning Rule 611 and Rule 610 of Regulation NMS, Question 4.04
(April 4, 2008 Update) (available at http://www.sec.gov/divisions/marketreg/nmsfaq610-11.htm).
\66\ An ISO is excluded from a Rule 605 report as requiring
special handling if it has a limit price that is inferior to the
NBBO at the time of order receipt. All other ISOs should be included
in a Rule 605 report, absent another applicable exclusion. Id. at
Question 7.06.
---------------------------------------------------------------------------
More broadly, are there any approaches to improving the
transparency of the order routing and order execution practices for
institutional investors that the Commission should consider? For
example, do institutional investors currently have sufficient
information about the smart order routing services and order algorithms
offered by their brokers? Would a regulatory initiative to improve
disclosure of these broker services be useful and, if so, what type of
initiative should the Commission pursue?
2. Other Measures
The Commission requests comment on any other measures of market
structure performance that the public believes the Commission should
consider. For example, are there useful metrics for assessing the
quality of price discovery in equity markets, such as how efficiently
prices respond to new information? In addition, what is the best
approach for assessing whether the secondary markets are appropriately
supporting the capital-raising function for companies of all sizes?
B. High Frequency Trading
One of the most significant market structure developments in recent
years is high frequency trading (``HFT''). The term is relatively new
and is not yet clearly defined. It typically is used to refer to
professional traders acting in a proprietary capacity that engage in
strategies that generate a large number of trades on a daily basis.
These traders could be organized in a variety of ways, including as a
proprietary trading firm (which may or may not be a registered broker-
dealer and member of FINRA), as the proprietary trading desk of a
multi-service broker-dealer, or as a hedge fund (all of which are
referred to hereinafter collectively as a ``proprietary firm''). Other
characteristics often attributed to proprietary firms engaged in HFT
are: (1) The use of extraordinarily high-speed and sophisticated
computer programs for generating, routing, and executing orders; (2)
use of co-location services and individual data feeds offered by
exchanges and others to minimize network and other types of latencies;
(3) very short time-frames for establishing and liquidating positions;
(4) the submission of numerous orders that are cancelled shortly after
submission; and (5) ending the trading day in as close to a flat
position as possible (that is, not carrying significant, unhedged
positions over-night). Estimates of HFT volume in the equity markets
vary widely, though they typically are 50% of total volume or
higher.\67\ By any measure, HFT is a dominant component of the current
market structure and is likely to affect nearly all aspects of its
performance.
---------------------------------------------------------------------------
\67\ See, e.g., Jonathan Spicer and Herbert Lash, Who's Afraid
of High-Frequency Trading?, Reuters.com, December 2, 2009 (available
at http://www.reuters.com/article/idUSN173583920091202) (``High-
frequency trading now accounts for 60 percent of total U.S. equity
volume, and is spreading overseas and into other markets.''); Scott
Patterson and Geoffrey Rogow, What's Behind High-Frequency Trading,
Wall Street Journal, August 1, 2009 (``High frequency trading now
accounts for more than half of all stock-trading volume in the
U.S.'');
---------------------------------------------------------------------------
The Commission today is proposing an initiative to address a
discrete HFT concern that the Commission already has identified. It
would address the use of various types of arrangements to obtain the
fastest possible market access.\68\ This concept release is intended to
request comment on the full range of concerns with respect to HFT,
[[Page 3607]]
in contrast to the discrete concerns the Commission already has
identified.
---------------------------------------------------------------------------
\68\ Market Access Release, supra note 15.
---------------------------------------------------------------------------
The lack of a clear definition of HFT, however, complicates the
Commission's broader review of market structure issues. The lack of
clarity may, for example, contribute to the widely varying estimates of
HFT volume in today's equity markets. Although the term itself clearly
implies a large volume of trades, some concerns that have been raised
about particular strategies used by proprietary firms may not
necessarily involve a large number of trades. Indeed, any particular
proprietary firm may simultaneously be employing many different
strategies, some of which generate a large number of trades and some
that do not. Conceivably, some of these strategies may benefit market
quality and long-term investors and others could be harmful.
In sum, the types of firms engaged in professional trading and the
types of strategies they employ can vary considerably. Rather than
attempt any single, precise definition of HFT, this release will focus
on particular strategies and tools that may be used by proprietary
firms and inquire whether these strategies and tools raise concerns
that the Commission should address.
1. Strategies
Comment generally is requested on the strategies employed by
proprietary firms in the current market structure. What are the most
frequently used strategies? What are the key features of each strategy?
What technology tools and other market structure components (such as
exchange fee structures) are necessary to implement each strategy? Have
any of these strategies been a competitive response to particular
market structure components or to particular problems or challenges in
the current market structure? Does implementation of a specific
strategy benefit or harm market structure performance and the interests
of long-term investors? Is it possible to reliably identify harmful
strategies through, for example, such metrics as adding or taking
liquidity, or trading with (momentum) or against (contrarian)
prevailing price movements? Are there regulatory tools that would
address harmful strategies while at the same time have a minimal impact
on beneficial strategies?
Do commenters believe that the overall use of harmful strategies by
proprietary firms is sufficiently widespread that the Commission should
consider a regulatory initiative to address the problem? What type of
regulatory initiative would be most effective? For example, should
there be a minimum requirement on the duration of orders (such as one
second) before they can be cancelled, whether across the board, in
particular contexts, or when used by particular types of traders? If
so, what would be an appropriate time period? Should the use of
``pinging'' orders by all or some traders to assess undisplayed
liquidity be prohibited or restricted in all or some contexts? \69\
---------------------------------------------------------------------------
\69\ A ``pinging'' order is an immediate-or-cancel order that
can be used to search for and access all types of undisplayed
liquidity, including dark pools and undisplayed order types at
exchanges and ECNs. The trading center that receives an immediate-
or-cancel order will execute the order immediately if it has
available liquidity at or better than the limit price of the order
and otherwise will immediately respond to the order with a
cancellation. As noted in section IV.B.1.d. below, there is an
important distinction between using tools such as pinging orders as
part of a normal search for liquidity with which to trade and using
such tools to detect and trade in front of large trading interest as
part of an ``order anticipation'' trading strategy.
---------------------------------------------------------------------------
The use of certain strategies by some proprietary firms has, in
many trading centers, largely replaced the role of specialists and
market makers with affirmative and negative obligations.\70\ Has market
quality improved or suffered from this development? How important are
affirmative and negative obligations to market quality in today's
market structure? Are they more important for any particular equity
type or during certain periods, such as times of stress? Should some or
all proprietary firms be subject to affirmative or negative trading
obligations that are designed to promote market quality and prevent
harmful conduct? Is there any evidence that proprietary firms increase
or reduce the amount of liquidity they provide to the market during
times of stress?
---------------------------------------------------------------------------
\70\ Affirmative and negative obligations generally are intended
to promote market quality. Affirmative obligations might include a
requirement to consistently display high quality, two-sided
quotations that help dampen price moves, while negative obligations
might include a restriction on ``reaching across the market'' to
execute against displayed quotations and thereby cause price moves.
---------------------------------------------------------------------------
As noted above, the Commission wishes to request comment broadly on
all strategies used by proprietary firms. To help present issues for
comment, but without limiting the broad request, this release next will
briefly discuss four broad types of trading strategies that often are
associated with proprietary firms--passive market making, arbitrage,
structural, and directional. The discussion of directional strategies
will focus on two directional strategies that may pose particular
problems for long-term investors--order anticipation and momentum
ignition. The Commission notes that many of the trading strategies
discussed below are not new. What is new is the technology that allows
proprietary firms to better identify and execute trading strategies.
a. Passive Market Making
Passive market making primarily involves the submission of non-
marketable resting orders (bids and offers) that provide liquidity to
the marketplace at specified prices. While the proprietary firm
engaging in passive market making may sometimes take liquidity if
necessary to liquidate a position rapidly, the primary sources of
profits are from earning the spread by buying at the bid and selling at
the offer and capturing any liquidity rebates offered by trading
centers to liquidity-supplying orders. If the proprietary firm is
layering the book with multiple bids and offers at different prices and
sizes, this strategy can generate an enormous volume of orders and high
cancellation rates of 90% of more. The orders also may have an
extremely short duration before they are cancelled if not executed,
often of a second or less.
Although proprietary firms that employ passive market making
strategies are a new type of market participant, the liquidity
providing function they perform is not new. Professional traders with a
permanent presence in the marketplace, standing ready to buy and sell
on an ongoing basis, are a perennial type of participant in financial
markets. Proprietary firms largely have replaced more traditional types
of liquidity providers in the equity markets, such as exchange
specialists on manual trading floors and OTC market makers that trade
directly with customers. In contrast, proprietary firms generally are
not given special time and place privileges in exchange trading (nor
are they subject to the affirmative and negative trading obligations
that have accompanied such privileges). In addition, proprietary firms
typically do not trade directly with customer order flow, but rather
trade by submitting orders to external trading venues such as exchanges
and ATSs.\71\
---------------------------------------------------------------------------
\71\ It is possible for a single firm to provide liquidity in a
variety of different forms. Some firms, for example, may blur the
distinction between proprietary firms and OTC market makers by both
trading actively in external trading centers and operating trading
centers themselves that offer customers direct electronic access to
their liquidity.
---------------------------------------------------------------------------
Proprietary firms participate in the marketplace in some ways that
are similar to both exchange specialists and OTC market makers. Indeed,
a single firm or its affiliates may operate simultaneously in all three
capacities. For example, proprietary traders are like
[[Page 3608]]
exchange specialists in the sense that they transact most of their
volume in public markets where their orders will trade with all comers.
Unlike the traditional floor specialists, however, they do not have
time and place advantages, except insofar as their sophistication and
size enables them to employ the fastest, most powerful systems for
generating, routing, and cancelling orders and thereby most take
advantage of the current highly automated market structure (including
such tools as individual trading center data feeds and co-location
discussed below in section IV.B.2.). Proprietary traders are analogous
to OTC market makers in that they have considerable flexibility in
trading without significant negative or affirmative obligations for
overall market quality. But unlike an OTC market maker, a proprietary
firm typically does not trade directly with customers. The proprietary
firm therefore may not have ongoing relationships with customers that
can pressure the proprietary trader to provide liquidity in tough
trading conditions or less actively traded stocks.
Quality of Liquidity. The Commission requests comment on the
passive market making strategies of proprietary firms. To what extent
do proprietary firms engage in the types of strategies described above?
Do they provide valuable liquidity to the market for top-tier, large,
medium, and small capitalization stocks? Has market quality improved or
worsened as traditional types of liquidity providers have been replaced
by proprietary firms? Does the very brief duration of many of their
orders significantly detract from the quality of liquidity in the
current market structure? For example, are their orders accurately
characterized as phantom liquidity that disappears when most needed by
long-term investors and other market participants? Or, is the
collective result of many different proprietary firms engaging in
passive market making a relatively stable quoted market in which there
are many quotation updates (primarily updates to size of the NBBO), but
relatively few changes in the price of the NBBO? What types of data are
most useful in assessing the quality of liquidity provided by
proprietary firms?
Liquidity Rebates. One important aspect of passive market making is
the liquidity rebates offered by many exchanges and ECNs when resting
orders that add liquidity are accessed by those seeking to trade
immediately by taking liquidity. The Commission requests comment on the
volume of high frequency trading geared toward earning liquidity
rebates and on the benefits or drawbacks of such trading. Are liquidity
rebates unfair to long-term investors because they necessarily will be
paid primarily to proprietary firms engaging in passive market making
strategies? Or do they generally benefit long-term investors by
promoting narrower spreads and more immediately accessible liquidity?
Do liquidity rebates reward proprietary firms for any particular types
of trading that do not benefit long-term investors or market quality?
For example, are there risk-free trading strategies driven solely by
the ability to recoup a rebate that offer little or no utility to the
marketplace? Are these strategies most likely when a trading center
offers inverted pricing and pays a liquidity rebate that is higher than
its access fee for taking liquidity? Does the distribution of
consolidated market data revenues pursuant to the Plans lead to the
current trading center pricing schedules? If so, would there be any
benefits to restructuring the Plans and, if so, how?
b. Arbitrage
An arbitrage strategy seeks to capture pricing inefficiencies
between related products or markets. For example, the strategy may seek
to identify discrepancies between the price of an ETF and the
underlying basket of stocks and buy (sell) the ETF and simultaneously
sell (buy) the underlying basket to capture the price difference. Many
of the trades necessary to execute an arbitrage strategy are likely to
involve taking liquidity, in contrast to the passive market making
strategy that primarily involves providing liquidity. In this respect,
it is quite possible for a proprietary firm using an arbitrage strategy
to trade with a proprietary firm using a passive market making
strategy, and for both firms to end up profiting from the trade.
Arbitrage strategies also generally will involve positions that are
substantially hedged across different products or markets, though the
hedged positions may last for several days or more.
The Commission requests comment on arbitrage strategies and whether
they benefit or harm the interests of long-term investors and market
quality in general. To what extent do proprietary firms engage in the
types of strategies described above? For example, what is the volume of
trading attributable to arbitrage involving ETFs (both in the ETF
itself and in any underlying securities) and has the increasing
popularity of ETFs in recent years significantly affected volume and
trading patterns in the equity markets? If so, has the impact of ETF
trading been positive or negative for long-term investors and overall
market quality?
In addition, to what extent are arbitrage strategies focused on
capturing pricing differences among the many different trading centers
in NMS stocks? For example, do these arbitrage strategies significantly
depend on latencies among trading center data feeds and the
consolidated market data feeds? Are these strategies beneficial for
long-term investors and market structure quality? If not, how should
such strategies be addressed?
c. Structural
Some proprietary firm strategies may exploit structural
vulnerabilities in the market or in certain market participants. For
example, by obtaining the fastest delivery of market data through co-
location arrangements and individual trading center data feeds
(discussed below in section IV.B.2.), proprietary firms theoretically
could profit by identifying market participants who are offering
executions at stale prices. In addition, some market participants offer
guarantee match features to guarantee the NBBO up to a certain limit. A
proprietary firm could enter a small limit order in one part of the
market to set up a new NBBO, after which the same proprietary firm
triggers guaranteed match trades in the opposite direction.\72\ Are
proprietary firms able to profitably exploit these structural
vulnerabilities? To what extent do proprietary firms engage in the
types of strategies described above? What is the effect of this trading
on market quality?
---------------------------------------------------------------------------
\72\ The Commission has found that similar conduct is
manipulative, in violation of Section 10(b) of the Exchange Act and
Rule 10b-5 thereunder. See Terrance Yoshikawa, Securities Exchange
Act Release No. 53731 (April 26, 2006) (Commission opinion affirming
NASD disciplinary action).
---------------------------------------------------------------------------
d. Directional
Neither passive market making nor arbitrage strategies generally
involve a proprietary firm taking a significant, unhedged position
based on an anticipation of an intra-day price movement of a particular
direction. There may, however, be a wide variety of short-term
strategies that anticipate such a movement in prices. Some
``directional'' strategies may be as straightforward as concluding that
a stock price temporarily has moved away from its ``fundamental value''
and establishing a position in anticipation that the price will return
to such value. These speculative strategies often may contribute to the
quality of price discovery in a stock.\73\
---------------------------------------------------------------------------
\73\ See, e.g., Sanford Grossman & Joseph Stiglitz, On the
Impossibility of Informationally Efficient Markets, American
Economic Review (June 1980) (``We propose here a model in which
there is an equilibrium degree of disequilibrium: prices reflect the
information of informed individuals (arbitrageurs) but only
partially, so that those who expend resources do receive
compensation. How informed the price system is depends on the number
of individuals who are informed, but the number of individuals who
are informed is itself an endogenous variable in the model.'').
---------------------------------------------------------------------------
[[Page 3609]]
The Commission requests comment on two types of directional
strategies that may present serious problems in today's market
structure--order anticipation and momentum ignition.
Order Anticipation Strategies. One example of an order anticipation
strategy is when a proprietary firm seeks to ascertain the existence of
one or more large buyers (sellers) in the market and to buy (sell)
ahead of the large orders with the goal of capturing a price movement
in the direction of the large trading interest (a price rise for buyers
and a price decline for sellers).\74\ After a profitable price
movement, the proprietary firm then may attempt to sell to (buy from)
the large buyer (seller) or be the counterparty to the large buyer's
(seller's) trading. In addition, the proprietary firm may view the
trading interest of the large buyer (seller) as a free option to trade
against if the price moves contrary to the proprietary firm's position.
---------------------------------------------------------------------------
\74\ See Larry Harris, Trading and Exchanges: Market
Microstructure for Practitioners (2003) at 222, 245 (``Harris
Treatise'') (``Order anticipators are speculators who try to profit
by trading before others trade. They make money when they correctly
anticipate how other traders will affect prices or when they can
extract option values from the orders that other traders offer to
the market.'') (emphasis in original).
---------------------------------------------------------------------------
Of course, any proprietary firm or other person that violates a
duty to a large buyer or seller or misappropriates their order
information and then uses the information for its own trading to the
detriment of the large buyer and seller has engaged in misconduct that
already is prohibited, such as forms of front running. Regulatory
authorities currently examine for, investigate, and prosecute this type
of misconduct and will continue to do so. The Commission requests
comment on any regulatory change that would limit the potential for
proprietary firms to profit from misconduct with respect to the trading
activities of large buyers and sellers.
The type of order anticipation strategy referred to in this release
involves any means to ascertain the existence of a large buyer (seller)
that does not involve violation of a duty, misappropriation of
information, or other misconduct. Examples include the employment of
sophisticated pattern recognition software to ascertain from publicly
available information the existence of a large buyer (seller), or the
sophisticated use of orders to ``ping'' different market centers in an
attempt to locate and trade in front of large buyers and sellers.
It is important to recognize the distinction between order
anticipation and a normal search for liquidity to implement a trading
strategy. When a proprietary firm employs an order anticipation
strategy and detects a large buyer (seller), it will first attempt to
buy (sell), and the proprietary firm largely will be indifferent to
whether the party is a buyer or a seller. In contrast, long-term
investors searching for liquidity to trade against will be seeking
specifically either to establish a position or to liquidate a position.
If buying, the long-term investor will attempt to find large selling
interest and buy from it or, if selling, will attempt to find large
buying interest and sell to it. Both the long-term investor and the
large buyer (seller) benefit from the liquidity seeking strategy, in
contrast to the order anticipation strategy where the large buyer
(seller) is harmed when the proprietary firm initially trades in front
of the large buyer (seller).
Order anticipation is a not a new strategy. Indeed, a 2003 treatise
on market structure described order anticipation as follows: ``Order
anticipators are parasitic traders. They profit only when they can prey
on other traders. They do not make prices more informative, and they do
not make markets more liquid. * * * Large traders are especially
vulnerable to order anticipators.''\75\ An important issue for purposes
of this release is whether the current market structure and the
availability of sophisticated, high-speed trading tools enable
proprietary firms to engage in order anticipation strategies on a
greater scale than in the past. Alternatively, is it possible that the
widespread use of high-speed trading tools by a variety of proprietary
firms and institutions limits the ability of market participants to
engage in profitable order anticipation strategies? Does your answer
depend on whether top tier, large, medium, or small market
capitalization stocks are considered?
---------------------------------------------------------------------------
\75\ Harris Treatise at 251 (emphasis in original).
---------------------------------------------------------------------------
The Commission requests comment on all aspects of order
anticipation strategies. Do commenters believe that order anticipation
significantly detracts from market quality and harms institutional
investors (for example, does it represent a substantial transfer of
wealth from the individuals represented by institutional investors to
proprietary firms)? Do commenters believe that order anticipation has
become more or less prevalent in recent years? If more prevalent, is
the use of proprietary firm strategies an important factor in this
development? If commenters believe order anticipation has become more
prevalent, are there ways to distinguish order anticipation from other
beneficial trading strategies? Are there regulatory tools that would
effectively address concerns about order anticipation, without
unintentionally interfering with other strategies that may be
beneficial for long-term investors and market quality?
Momentum Ignition Strategies. Another type of directional strategy
that may raise concerns in the current market structure is momentum
ignition. With this strategy, the proprietary firm may initiate a
series of orders and trades (along with perhaps spreading false rumors
in the marketplace) in an attempt to ignite a rapid price move either
up or down. For example, the trader may intend that the rapid
submission and cancellation of many orders, along with the execution of
some trades, will ``spoof'' the algorithms of other traders into action
and cause them to buy (sell) more aggressively. Or the trader may
intend to trigger standing stop loss orders that would help cause a
price decline. By establishing a position early, the proprietary firm
will attempt to profit by subsequently liquidating the position if
successful in igniting a price movement. This type of strategy may be
most harmful in less actively traded stocks, which may receive little
analyst or other public attention and be vulnerable to price movements
sparked by a relatively small amount of volume.
Of course, any market participant that manipulates the market has
engaged in misconduct that already is prohibited. The Commission and
other regulatory authorities already employ their examination and
enforcement resources to detect violations and bring appropriate
proceedings against the perpetrators. This concept release is focused
on the issue of whether additional regulatory tools are needed to
address illegal practices, as well as any other practices associated
with momentum ignition strategies. For example, while spreading false
rumors to cause price moves is illegal, such rumors can be hard to find
(if not spread in writing), and it can be difficult to ascertain the
identity of those who spread rumors to cause price moves.
The Commission requests comment on whether momentum ignition
strategies are a significant problem in the current market structure.
To what extent do proprietary firms engage in the types of strategies
described above?
[[Page 3610]]
Does, for example, the speed of trading and ability to generate a large
amount of orders across multiple trading centers render this type of
strategy more of a problem today? If momentum ignition strategies have
caused harm, are there objective indicia that would reliably identify
problematic strategies? Are there regulatory tools (beyond the
currently applicable anti-fraud and anti-manipulation provisions) that
would effectively reduce or eliminate the use of momentum ignition
strategies while at the same time have a minimal impact on other
strategies that are beneficial to long-term investors and market
quality?
2. Tools
This section will focus on two important tools that often are used
by proprietary firms to implement their short-term trading strategies--
co-location and trading center data feeds.
a. Co-Location
Many proprietary firm strategies are highly dependent upon speed--
speed of market data delivery from trading center servers to servers of
the proprietary firm; speed of decision processing of trading engines
of the proprietary firm; speed of access to trading center servers by
servers of the proprietary firm; and speed of order execution and
response by trading centers. Speed matters both in the absolute sense
of achieving very small latencies and in the relative sense of being
faster than competitors, even if only by a microsecond. Co-location is
one means to save micro-seconds of latency.
Co-location is a service offered by trading centers that operate
their own data centers and by third parties that host the matching
engines of trading centers. The trading center or third party rents
rack space to market participants that enables them to place their
servers in close physical proximity to a trading center's matching
engine. Co-location helps minimize network and other types of latencies
between the matching engine of trading centers and the servers of
market participants.
The Commission believes that the co-location services offered by
registered exchanges are subject to the Exchange Act. Exchanges that
intend to offer co-location services must file proposed rule changes
and receive approval of such rule changes in advance of offering the
services to customers.\76\ The terms of co-location services must not
be unfairly discriminatory, and the fees must be equitably allocated
and reasonable.\77\
---------------------------------------------------------------------------
\76\ Section 3(a)(27) of the Exchange Act defines ``rules of an
exchange'' as, among other things, a stated policy, practice, or
interpretation of the exchange that the Commission has by rule
determined to be rules of the exchange. Rule 19b-4(b) under the
Exchange Act defines ``stated policy, practice, or interpretation''
to mean, in part, [a]ny material aspect of the operation of the
facilities of the self-regulatory organization.'' The Commission
views co-location services as being a material aspect of the
operation of the facilities of an exchange.
\77\ Section 6(b)(4) and (5) of the Exchange Act.
---------------------------------------------------------------------------
Fairness of Co-Location Services. Beyond these basic statutory
requirements, the Commission broadly requests comment on co-location
and whether it benefits or harms long-term investors and market
quality. For example, does co-location provide proprietary firms an
unfair advantage because they generally will have greater resources and
sophistication to take advantage of co-location services than other
market participants, including long-term investors? If so, specify how
this disparity harms long-term investors. Conversely, does co-location
offer benefits to long-term investors? For example, do co-location
services enable liquidity providers to operate more efficiently and
thereby increase the quality of liquidity they provide to the markets?
Please quantify any harm or benefits, if possible. Is it fair for some
market participants to pay to obtain better access to the markets than
is available to those not in a position to pay for or otherwise obtain
co-location services? Aside from physical proximity, are there other
aspects of services offered by exchanges to co-location participants
that may lead to unfair access concerns?
In addition, are brokers generally able to obtain and use co-
location services on behalf of their customers? If so, are long-term
investors harmed by not being able to use co-location directly? Are co-
location fees so high that they effectively create a barrier for
smaller firms? Do commenters believe that co-location services
fundamentally differ from other respects in which market participants
can obtain latency advantages, particularly if co-location services are
not in short supply and are available to anyone on terms that are fair
and reasonable and not unreasonably discriminatory?
If commenters believe that co-location services create unfair
access to trading, should the Commission prohibit or restrict
exchanges, and other trading centers, such as ATSs, from offering co-
location services? If exchanges and other trading centers were no
longer permitted to provide the services, would third parties, who may
be outside the Commission's regulatory authority, be encouraged to
obtain space close to an exchange's data center and rent such space to
market participants? Alternatively, could exchanges and other trading
centers batch process all orders each second and, if so, what would be
the effect of such a policy on market quality?
The Commission also requests comment on exchanges and other trading
centers that place their trading engines in data facilities operated by
third parties. Such parties are not regulated entities subject to the
access and other requirements of the Exchange Act and Commission rules.
Could this disparity create competitive disadvantages among trading
centers? Should the third party data centers be considered facilities
of the exchange or trading center? Alternatively, should the Commission
require trading centers to obtain contractual commitments from third
parties to provide any co-location services on terms consistent with
the Exchange Act and Commission rules?
With respect to those market participants that purchase co-location
services, should exchanges and other trading centers be subject to
specific requirements to help assure that all participants are treated
in a manner that is not unfairly discriminatory? Latency can arise from
a variety of sources, such as cable length and capacity, processing
capabilities, and queuing. Is it possible for trading centers to
guarantee equal latency across all market participants that use
comparable co-location services? Should the Commission require latency
transparency--the disclosure of information that would enable market
participants to make informed decisions about their speed of access to
an exchange or other trading center? Such disclosures could include,
for example, periodic public reports on the latencies of the fastest
market participants (on an anonymous basis), as well as private reports
directly to individual market participants of their specific latencies.
If latency disclosure should be required, what information should be
disclosed and in what manner?
Affirmative or Negative Trading Obligations. Finally, the
Commission requests comment on whether all or some market participants
(such as proprietary firms) that obtain co-location services should be
subject to any affirmative or negative obligations with respect to
their trading behavior. Such obligations historically were applied to
exchange specialists that enjoyed a unique time and place advantage on
the floor of an exchange. Are co-location services analogous to the
specialist advantages? Or does the wider availability of co-location
services to many market participants distinguish co-located market
participants from
[[Page 3611]]
exchange specialists? If all or some co-location participants should be
subject to trading obligations, what should be the nature of such
obligations? For example, should some or all co-location participants
be prohibited from aggressively taking liquidity and moving prices
always or only under specified circumstances? If only under specified
circumstances, what should those include or exclude? Should some or all
co-location participants ever be required to provide liquidity on an
ongoing basis or in certain contexts?
b. Trading Center Data Feeds
Another important tool widely used by proprietary firms is the
individual data feeds offered by many exchanges and ECNs. As discussed
in section III.B.1. above, the consolidated data feeds include the
best-priced quotations of all exchanges and certain ATSs and all
reported trades. The individual data feeds of exchanges and ECNs
generally will include their own best-priced quotations and trades, as
well as other information, such as inferior-priced orders included in
their depth-of-book. When it adopted Regulation NMS in 2005, the
Commission did not require exchanges, ATSs, and other broker-dealers to
delay their individual data feeds to synchronize with the distribution
of consolidated data, but prohibited them from independently
transmitting their own data any sooner than they transmitted the data
to the plan processors.\78\
---------------------------------------------------------------------------
\78\ Regulation NMS Release, 70 FR at 37567.
---------------------------------------------------------------------------
Given the extra step required for SROs to transmit market data to
plan processors, and for plan processors to consolidate the information
and distribute it the public, the information in the individual data
feeds of exchanges and ECNs generally reaches market participants
faster than the same information in the consolidated data feeds. The
extent of the latency depends, among other things, on the speed of the
systems used by the plan processors to transmit and process
consolidated data and on the distances between the trading centers, the
plan processors, and the recipients. As noted above,\79\ the Commission
understands that the average latency of plan processors for the
consolidated data feeds generally is less than 10 milliseconds. This
latency captures the difference in time between receipt of data by the
plan processors from the SROs and distribution of the data by the plan
processors to the public.
---------------------------------------------------------------------------
\79\ See supra note 45 and accompanying text.
---------------------------------------------------------------------------
Latency of Consolidated Data. The Commission requests comment on
all aspects of the latency between consolidated data feeds and
individual trading center data feeds. What have market participants
experienced in terms of the degree of latency between trading center
and consolidated data? Is the latency as small as possible given the
necessity of the consolidation function, or could plan processor
systems be improved to significantly reduce the latency from current
levels, while still retaining the high level of reliability required of
plan processors?
More broadly, is the existence of any latency, or the disparity in
information transmitted, fair to investors or other market participants
that rely on the consolidated market data feeds and do not use
individual trading center data feeds? If so, should the unfairness be
addressed by a requirement that trading center data be delayed for a
sufficient period of time to assure that consolidated data reaches
users first? Would such a mandated delay adequately address unfairness?
Would a mandatory delay seriously detract from the efficiency of
trading and harm long-term investors and market quality? Should the
Commission require that additional information be included in the
consolidated market data feeds?
Odd-Lot Transactions. Finally, the consolidated trade data
currently does not include reports of odd lot orders or odd lot
transactions (transactions with sizes of less than 1 round lot, which
generally is 100 shares). It appears that a substantial volume of
trading (approximately 4%) may be attributable to odd lot transactions.
Why is the volume of odd lots so high? Should the Commission be
concerned about this level of activity not appearing in the
consolidated trade data? Has there been an increase in the volume of
odd lots recently? If so, why? Do market participants have incentives
to strategically trade in odd lots to circumvent the trade disclosure
or other regulatory requirements? Would these trades be important for
price discovery if they were included in the consolidated trade data?
Should these transactions be required to be reported in the
consolidated trade data? Why?
3. Systemic Risks
Stepping back from the particular strategies and tools used by
proprietary traders, comment is requested more broadly on whether HFT
poses significant risks to the integrity of the current equity market
structure. For example, do the high speed and enormous message traffic
of automated trading systems threaten the integrity of trading center
operations? Also, many proprietary firms potentially could engage in
similar or connected trading strategies that, if such strategies
generated significant losses at the same time, could cause many
proprietary firms to become financially distressed and lead to large
fluctuations in market prices. To the extent that proprietary firms
obtain financing for their trading activity from broker-dealers or
other types of financial institutions, the significant losses of many
proprietary firms at the same time also could lead to more widespread
financial distress.\80\
---------------------------------------------------------------------------
\80\ A broker-dealer conducting a general securities business
that is required to register with the Commission under Section 15(b)
of the Exchange Act must comply with the Commission's net capital
rule, Exchange Act Rule 15c3-1. Under Rule 15c3-1, broker-dealers
are required to maintain, at all times, a minimum amount of net
capital. This means that firms must be able to demonstrate that they
have sufficient net capital for intra-day positions. In addition, if
a broker-dealer is engaged in proprietary trading on margin, it may
be subject to certain provisions of Regulation T, 12 CFR 220.1, et
seq., as well as SRO margin rules applicable to broker-dealers. See,
e.g., NYSE Rule 431(e)(5) (specialists' and market makers'
accounts), (e)(6)(A) (broker/dealer accounts), (e)(6)(B) (Joint Back
Office Arrangements) and NASD Rule 2520(e)(5), (e)(6)(A) and
(e)(6)(B). Moreover, high frequency traders who are not broker-
dealers must comply with the SRO day trading rules if they meet the
definition of ``pattern day trader.'' NYSE Rule 431(f)(8)(B) and
NASD Rule 2520(f)(8)(B).
---------------------------------------------------------------------------
Comment also is requested on whether proprietary traders help
promote market integrity by providing an important source of liquidity
in difficult trading conditions. The Commission notes that, from an
operational standpoint, the equity markets performed well during the
world-wide financial crisis in the Autumn of 2008 when volume and
volatility spiked to record highs.\81\ Unlike some financial crises in
the past, the equity markets continued to operate smoothly and
participants generally were able to trade at currently displayed prices
(though most investors likely suffered significant losses from the
general decline of market prices). Does
[[Page 3612]]
the 2008 experience indicate that systemic risk is appropriately
minimized in the current market structure? If not, what further steps
should the Commission take to address systemic risk? Should, for
example, all proprietary firms be required to register as broker-
dealers and become members of FINRA to help assure that their
operations are subject to full regulatory oversight? Moreover, does the
current regulatory regime adequately address the particular concerns
raised by proprietary firms and their trading strategies and tools?
---------------------------------------------------------------------------
\81\ See, e.g., NYSE Euronext, Consolidated Volume in NYSE
Listed Issues 2000-2009 (available at http://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx) (consolidated
average daily volume in NYSE-listed stocks reached a then-record
high of 7.1 billion shares in October 2008, compared to an average
of 3.4 billion shares for the year 2007); Pam Abramowitz, Technology
Drives Trading Costs, Institutional Investor (November 4, 2009)
(``[V]olatility has fallen substantially over the past six to nine
months as equity markets have rallied. * * * [The] VIX, which hit an
all-time high of 89.53 in October 2008, averaged 25.49 in the third
quarter of 2009, close to its precrisis historical average of
20.3''); Tom Lauricella, Volatility Requires New Strategies, Wall
Street Journal (October 20, 2008) (``The stock market's collapse and
unprecedented daily price swings are forcing investors of all
stripes to rethink their strategies, all the while looking for any
hints that the financial markets will stabilize. * * * So far this
month, there have been 10 days where the Dow Jones Industrial
Average ricocheted in a range of more than 5% * * *'').
---------------------------------------------------------------------------
C. Undisplayed Liquidity
As noted in section III.A. above, undisplayed liquidity is trading
interest that is available for execution at a trading center, but is
not included in the consolidated quotation data that is widely
disseminated to the public. Undisplayed liquidity also is commonly
known as ``dark'' liquidity. The Commission recently published
proposals to address certain practices with respect to undisplayed
liquidity. These include the use of actionable indications of interest,
or ``IOIs,'' to attract order flow, the lowering of the trading volume
threshold that would trigger ATS order display obligations, and the
real-time disclosure of the identity of ATSs on the public reports of
their executed trades.\82\ This release is intended to request comment
on a wide range of issues with respect to undisplayed liquidity in all
of its forms.
---------------------------------------------------------------------------
\82\ See Non-Public Trading Interest Release, 74 FR at 61209-
61210.
---------------------------------------------------------------------------
Undisplayed liquidity in general is not a new phenomenon. Market
participants that need to trade in large size, such as institutional
investors, always have faced a difficult trading dilemma. On the one
hand, if they prematurely reveal the full extent of their large trading
interest to the market, then market prices are likely to run away from
them (a price rise for those seeking to buy and a price decline for
those seeking to sell), which would greatly increase their transaction
costs and reduce their overall investment returns. On the other hand,
if an institutional investor that wants to trade in large size does
nothing, then it will not trade at all. Finding effective and
innovative ways to trade in large size with minimized transaction costs
is a perennial challenge for institutional investors, the brokers that
represent their orders in the marketplace, and the trading centers that
seek to execute their orders.
A primary source of dark liquidity for many years was found on the
manual trading floors of exchanges. The floor brokers ``worked'' the
large orders of their customers by executing such orders in a number of
smaller transactions without revealing to potential counterparties the
total size of the order. One consequence of the decline in market share
of the NYSE floor in recent years is that this historically large
undisplayed liquidity pool in NYSE-listed stocks appears to have
largely migrated to other types of venues. As discussed in section
III.A.3. above, a recent form of undisplayed liquidity is the dark
pool--an ATS that does not display quotations in the consolidated
quotation data. Other sources of undisplayed liquidity are broker-
dealers that internalize orders \83\ and undisplayed order types of
exchanges and ECNs.
---------------------------------------------------------------------------
\83\ As noted in section III.A.2. above, many broker-dealers may
submit orders to exchanges or ECNs, which then are included in the
consolidated quotation data. The internalized executions of broker-
dealers, however, primarily reflect liquidity that is not included
in the consolidated quotation data and are appropriately classified
as undisplayed liquidity.
---------------------------------------------------------------------------
Although they offer liquidity that is not included in the
consolidated quotation data, dark pools and OTC market makers generally
trade with reference to the best displayed quotations and execute
orders at prices that are equal to or better than the NBBO. Indeed, all
dark pools and OTC market makers are covered by the trade-through
restrictions of Rule 611 and, subject to limited exceptions, cannot
execute transactions at prices that are inferior to the best displayed
prices.
The Commission requests comment on all forms of undisplayed
liquidity in the current market structure. It particularly wants to
present three issues for comment--the effect of undisplayed liquidity
on order execution quality, the effect of undisplayed liquidity on
public price discovery, and fair access to sources of undisplayed
liquidity.
1. Order Execution Quality
It appears that a significant percentage of the orders of
individual investors are executed at OTC market makers, and that a
significant percentage of the orders of institutional investors are
executed in dark pools. Comment is requested on the order execution
quality provided to these long-term investors. Given the strong
Exchange Act policy preference in favor of price transparency and
displayed markets, do dark pools and OTC market makers offer
substantial advantages in order execution quality to long-term
investors? If so, do these advantages justify the diversion of a large
percentage of investor order flow away from the displayed markets that
play a more prominent role in providing public price discovery? If
investors were limited in their ability to use undisplayed liquidity,
how would trading behavior change, if at all? What types of activity
might evolve to replace undisplayed liquidity if its use were
constrained?
Individual Investors. Liquidity providers generally consider the
orders of individual investors very attractive to trade with because
such investors are presumed on average to not be as informed about
short-term price movements as are professional traders. Do individual
investor orders receive high quality executions when routed to OTC
market makers? For example, does competition among OTC market makers to
attract order flow lead to significantly better prices for individual
investor orders than they could obtain in the public markets? Do OTC
market makers charge access fees comparable to those charged by public
markets? Does the existence of payment for order flow arrangements
between routing brokers and OTC market makers (and internalization
arrangements when the routing broker and OTC market maker are
affiliated) detract from the quality of executions for investor orders?
If more individual investor orders were routed to public markets, would
it promote quote competition in the public markets, lead to narrower
spreads, and ultimately improve order execution quality for individual
investors beyond current levels? Finally, are a significant number of
individual investor orders executed in dark pools and, if so, what is
the execution quality for these orders?
Institutional Investors. An important objective of many dark pools
is to offer institutional investors an efficient venue in which to
trade in large size (often by splitting a large parent order into many
child orders) with minimized market impact. To what extent do dark
pools meet this objective of improving execution quality for the large
orders of institutional investors? Does execution quality vary across
different types of dark pools and, if so, which types? If so, does this
difference depend on the characteristics of particular securities (such
as market capitalization and security price)?
As noted above in section IV.C., many dark pools execute orders
with reference to the displayed prices in public markets. Does this
reference pricing create opportunities for institutional investors to
be treated unfairly by improper behavior (such as placing a small order
to change the NBBO for a
[[Page 3613]]
very short period and quickly submitting orders to dark pools for
execution at prices affected by the new NBBO)? \84\ If so, to what
extent does gaming occur? Do all types of dark pools employ anti-gaming
tools? How effective are such tools?
---------------------------------------------------------------------------
\84\ The Commission has found that similar conduct is
manipulative. See supra note 72.
---------------------------------------------------------------------------
Finally, are institutional investors able to trade more efficiently
using undisplayed liquidity at dark pools and broker-dealers than they
are using the undisplayed liquidity at exchanges and ECNs? What are the
advantages and disadvantages of each form of undisplayed liquidity? If
the use of undisplayed liquidity at dark pools and broker-dealers were
curtailed in any way, could institutional investors adjust by using
undisplayed liquidity on exchanges and ECNs without incurring higher
transaction costs?
2. Public Price Discovery
Comment is requested on whether the trading volume of undisplayed
liquidity has reached a sufficiently significant level that it has
detracted from the quality of public price discovery and execution
quality. For example, has the level of undisplayed liquidity led to
increased spreads, reduced depth, or increased short-term volatility in
the displayed trading centers? If so, has such harm to public price
discovery led to a general worsening of execution quality for investors
in undisplayed markets that execute trades with reference to prices in
the displayed markets?
It appears that a significant percentage of the orders of long-term
investors are executed either in dark pools or at OTC market makers,
while a large percentage of the trading volume in displayed trading
centers is attributable to proprietary firms executing short-term
trading strategies. Has there in fact been an increase in the
proportion of long-term investor orders executed in undisplayed trading
centers? If so, what is the reason for this tendency and is the
practice beneficial or harmful to long-term investors and to market
quality? With respect to undisplayed order types on exchanges and ECNs,
do commenters believe that these order types raise similar concerns
about public price discovery as undisplayed liquidity at dark pools and
broker-dealers?
If commenters do not believe the current level of undisplayed
liquidity has detracted from the quality of public price discovery, is
there any level at which they believe the Commission should be
concerned? In this regard, it appears that the overall percentage of
trading volume between undisplayed trading centers and displayed
trading centers has remained fairly steady for many years between 70%
and 80%.\85\ Does this overall percentage accurately reflect the effect
of undisplayed liquidity on public price discovery or does it mask
potentially important changes in the routing of underlying types of
order flow? For example, the NYSE captures a smaller percentage of
trading in NYSE-listed stocks, while the overall volume in NYSE stocks
has increased dramatically.\86\ Should this change in market share be
interpreted to mean that a greater percentage of long-term individual
investor and long-term institutional investor order flow in NYSE-listed
stocks has shifted to dark pools and OTC market makers, while the
public markets are executing an expanding volume of trading that is
primarily attributable to HFT strategies? If so, does this underlying
shift in order flow affect the quality of public price discovery in
NYSE-listed stocks and what are the reasons for this development? Do
similar order flow patterns affect the quality of public price
discovery in stocks listed on other exchanges as well?
---------------------------------------------------------------------------
\85\ See supra note 21 and accompanying text (estimated 25.4% of
share volume in NMS stocks executed in undisplayed trading centers
in September 2009).
\86\ See supra notes 8 and 10 and accompanying text.
---------------------------------------------------------------------------
Trade-At Rule. If commenters believe that the quality of public
price discovery has been harmed by undisplayed liquidity, are there
regulatory tools that the Commission should consider to address the
problem? Should the Commission consider a ``trade-at'' rule that would
prohibit any trading center from executing a trade at the price of the
NBBO unless the trading center was displaying that price at the time it
received the incoming contra-side order? Under this type of rule, for
example, a trading center that was not displaying the NBBO at the time
it received an incoming marketable order could either: (1) Execute the
order with significant price improvement (such as the minimum allowable
quoting increment (generally one cent)); or (2) route ISOs to full
displayed size of NBBO quotations and then execute the balance of the
order at the NBBO price.
The Commission requests comment on all aspects of a trade-at rule.
Would it help promote pre-trade public price discovery by preventing
the diversion of a significant volume of highly valuable marketable
order flow away from the displayed trading centers and to undisplayed
trading centers? If so, to what extent would the increased routing of
this marketable order flow to displayed trading centers create
significantly greater incentives for market participants to display
quotations in greater size or with more aggressive prices?
Given the order-routing and trading system technologies currently
in place to prevent trade-throughs, would it be feasible for market
participants to comply with a trade-at rule at reasonable cost? Should
a trade-at rule apply to all types of trading centers (e.g., exchanges,
ECNs, OTC market makers, and dark pools) or only to some of them? If
so, which ones and why? In addition, if the Commission were to consider
such a rule, how should it treat the issue of displayed markets that
charge access fees? Should it, for example, condition the ``trade-at''
protection of a displayed quotation on there being no access fee or an
access fee that is much smaller than the current 0.3 cent per share cap
in Rule 610(c) of Regulation NMS?
Depth-of-Book Protection. Rule 611 currently provides trade-through
protection only to quotations that reflect the best, ``top-of-book,''
prices of a trading center.\87\ Should Rule 611 be expanded to provide
trade-through protection to the displayed ``depth-of-book'' quotations
of a trading center? Would depth-of-book protection significantly
promote the greater display of trading interest? Is depth-of-book
protection feasible under current trading conditions and could the
securities industry implement depth-of-book protection at reasonable
cost?
---------------------------------------------------------------------------
\87\ See Regulation NMS Release, 70 FR at 37529-37530
(discussion of decision not to adopt a ``Voluntary Depth
Alternative'' that would have provided trade-through protection to
depth-of-book quotations that a market voluntarily included in the
consolidated quotation data).
---------------------------------------------------------------------------
Low-Priced Stocks. There may be greater incentives for broker-
dealer internalization in low-priced stocks than in higher priced
stocks. In low-priced stocks, the minimum one cent per share pricing
increment of Rule 612 of Regulation NMS is much larger on a percentage
basis than it is in higher-priced stocks. For example, a one cent
spread in a $20 stock is 5 basis points, while a one cent spread in a
$2 stock is 50 basis points--10 times as wide on a percentage basis.
Does the larger percentage spread in low-price stocks lead to greater
internalization by OTC market makers or more trading volume in dark
pools? If so, why? Should the Commission consider reducing the minimum
pricing increment in Rule 612 for lower priced stocks?
[[Page 3614]]
3. Fair Access and Regulation of ATSs
A significant difference between the undisplayed liquidity offered
by exchanges and the undisplayed liquidity offered by dark pools and
broker-dealers is the extent of access they allow to such liquidity. As
noted in section III.B.3. above, registered exchanges are required to
offer broad access to broker-dealers. As ATSs that are exempt from
exchange registration, dark pools are not required to provide fair
access unless they reach a 5% trading volume threshold in a stock,
which none currently do.\88\ Broker-dealers that internalize also are
not subject to fair access requirements. As a result, access to the
undisplayed liquidity of dark pools and broker-dealers is determined
primarily by private negotiation.
---------------------------------------------------------------------------
\88\ The Commission understands that ECNs, unlike most dark
pools, generally offer wide access to their services, including
undisplayed liquidity, even if not subject to the fair access
requirement of Rule 301(b)(5) of Regulation ATS.
---------------------------------------------------------------------------
The Commission requests comment on whether trading centers offering
undisplayed liquidity are subject to appropriate regulatory
requirements for the type of business they conduct. For example, should
the trading volume threshold in Regulation ATS that triggers the fair
access requirement be lowered from its current 5%? If so, what is the
appropriate threshold?
If an ATS exceeds the trading volume threshold, Regulation ATS
requires that the ATS have access standards that do not unreasonably
prohibit or limit any person in respect to access services, and
prohibits the ATS from applying such standards in an unfair or
discriminatory manner. Do commenters believe that all types of dark
pools can comply with this fair access requirement, yet still achieve
the objective of enabling institutional investors to trade in large
size with minimized price impact? Can dark pool restrictions designed
to prevent predatory trading behavior \89\ be drafted in an objective
fashion that would comply with the Regulation ATS fair access
requirement?
---------------------------------------------------------------------------
\89\ See, e.g., section IV.B.1.d. supra (discussion of order
anticipation strategies that seek to ascertain the existence of
large buyers and sellers).
---------------------------------------------------------------------------
The majority of dark pool volume is executed in ATSs that are
sponsored by multi-service broker-dealers.\90\ Can a broker-dealer
sponsored dark pool apply objective fair access standards reasonably to
prevent predatory trading, but without using such standards as a
pretext to discriminate based on the competitive self interest of the
sponsoring broker?
---------------------------------------------------------------------------
\90\ Data compiled from Forms ATS submitted to Commission for 3d
quarter 2009.
---------------------------------------------------------------------------
Finally, do investors have sufficient information about dark pools
to make informed decisions about whether in fact they should seek
access to dark pools? Should dark pools be required to provide improved
transparency on their trading services and the nature of their
participants? If so, what disclosure should be required and in what
manner should ATSs provide such disclosures?
More broadly, are there any other aspects of ATS regulation that
should be enhanced for dark pools or for all ATSs, including ECNs? For
example, do ATSs contribute appropriately to the costs of consolidated
market surveillance? Currently, FINRA is the SRO for ATSs, and ATSs
must pay the applicable FINRA regulatory fees. Do these FINRA fees
adequately reflect the significant volume currently executed by ATSs?
Should ATSs be required to contribute more directly to the cost of
market surveillance? Finally, are there any ways in which Regulation
ATS should be modified or supplemented to appropriately reflect the
significant role of ATSs in the current market structure?
D. General Request for Comments
The Commission requests and encourages all interested persons to
submit their views on any aspect of the current equity market
structure. While this release was intended to present particular issues
for comment, it was not intended in any way to limit the scope of
comments or issues to be considered. In addition, the views of
commenters are of greater assistance when they are accompanied by
supporting data and analysis.
Dated: January 14, 2010.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010-1045 Filed 1-20-10; 8:45 am]
BILLING CODE 8011-01-P