[Federal Register Volume 77, Number 120 (Thursday, June 21, 2012)]
[Notices]
[Pages 37458-37470]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-15126]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-67208; File No. SR-FINRA-2011-058]
Self-Regulatory Organizations; Financial Industry Regulatory
Authority, Inc.; Notice of Filing of Amendment No. 2 and Order Granting
Accelerated Approval of a Proposed Rule Change, as Modified by
Amendment Nos. 1 and 2, To Amend FINRA Rule 6433 (Minimum Quotation
Size Requirements for OTC Equity Securities)
June 15, 2012.
I. Introduction
On October 6, 2011, the Financial Industry Regulatory Authority,
Inc. (``FINRA'') filed with the Securities and Exchange Commission
(``Commission''), pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a
proposed rule change to amend FINRA Rule 6433 (``Rule''), which governs
minimum quotation size requirements for OTC Equity Securities
(``Original Proposal'').\3\ The proposed rule change is intended to
simplify the Rule's price and size tiers; facilitate the display of
customer limit orders under FINRA Rule 6460 (Display of Customer Limit
Orders); \4\ and expand the scope of the Rule. The proposed rule change
was published for comment in the Federal Register on October 20,
2011.\5\ The Commission received seven comment letters on the Original
Proposal from four separate commenters,\6\ as well as
[[Page 37459]]
two responses to the comment letters from FINRA.\7\ On January 17,
2012, the Commission instituted proceedings pursuant to Section
19(b)(2)(B) of the Act \8\ to determine whether to approve or
disapprove the proposed rule change.\9\ The Order Instituting
Proceedings was published for comment in the Federal Register on
January 24, 2012.\10\ The Commission received one comment letter in
response to the Order Instituting Proceedings.\11\ On April 17, 2012,
FINRA filed Amendment No. 1 to the proposed rule change. The proposed
rule change, as modified by Amendment No. 1, was published for comment
in the Federal Register on April 20, 2012.\12\ The Commission received
two comment letters on the proposed rule change, as modified by
Amendment No. 1.\13\ On June 5, 2012, FINRA filed Amendment No. 2 to
the proposed rule change.\14\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ ``OTC Equity Security'' means ``any equity security that is
not an NMS stock as that term is defined in Rule 600(b)(47) of SEC
Regulation NMS; provided, however, that the term `OTC Equity
Security' shall not include any Restricted Equity Security.'' See
FINRA Rule 6420(e).
\4\ See Securities Exchange Act Release No. 62359 (June 22,
2010), 75 FR 37488 (June 29, 2010) (Order Approving NMS-Principled
Rules for OTC Equity Securities) (``NMS-Principled Rules Approval
Order''). FINRA Rule 6460 became operative on May 9, 2011.
\5\ See Securities Exchange Act Release No. 65568 (October 14,
2011), 76 FR 65307 (``Notice'') (publication of Original Proposal).
On November 17, 2011, FINRA consented to extending the time period
for the Commission to either approve or disapprove the proposed rule
change or to institute proceedings to determine whether to
disapprove the proposed rule change to January 18, 2012.
\6\ See Letter from Suzanne H. Shatto, dated October 20, 2011
(``Shatto Letter''); Letter from Naphtali M. Hamlet, dated October
21, 2011 (``Hamlet Letter); Letter from Daniel Zinn, General
Counsel, OTC Markets Group Inc. (``OTC Markets'') to Elizabeth M.
Murphy, Secretary, Commission, dated November 10, 2011 (``OTC
Markets Letter I''); Letter from Michael T. Corrao, Managing
Director, Knight Capital Group, Inc. (``Knight'') to Elizabeth M.
Murphy, Secretary, Commission, dated November 16, 2011 (``Knight
Letter I''); Letter from R. Cromwell Coulson, President & CEO, OTC
Markets to Craig Lewis and Kathleen Hanley, Commission, dated
November 18, 2011 (``OTC Markets Letter II''); Letter from Daniel
Zinn, General Counsel, OTC Markets Group Inc. to Elizabeth M.
Murphy, Secretary, Commission, dated December 29, 2011 (``OTC
Markets Letter III''); Letter from Michael T. Corrao, Managing
Director, Knight Capital Group, Inc. to Elizabeth M. Murphy,
Secretary, Commission, dated January 13, 2012 (``Knight Letter
II'').
\7\ See Email from Marc Menchel, FINRA to John Ramsay, David S.
Shillman, and Nancy J. Sanow, Division of Trading and Markets,
Commission, dated November 30, 2011 (``FINRA Response I'') and
Letter from Stephanie M. Dumont, Senior Vice President and Director
of Capital Markets Policy, FINRA to Elizabeth M. Murphy, Secretary,
Commission, dated December 23, 2011 (``FINRA Response II'').
\8\ 15 U.S.C. 78s(b)(2)(B).
\9\ See Securities Exchange Act Release No. 66168 (January 17,
2012) (``Order Instituting Proceedings''). On March 29, 2012, FINRA
consented to extend the time period for the proceedings for the
Commission to determine whether to approve or disapprove the
proposed rule change to June 15, 2012.
\10\ See Order Instituting Proceedings at 77 FR 3515. The
comment period closed on February 14, 2012, and FINRA's rebuttal
period closed on February 28, 2012.
\11\ See Letter from Daniel Zinn, General Counsel, OTC Markets
Group Inc. to Elizabeth M. Murphy, Secretary, Commission, dated
February 14, 2012 (``OTC Markets Letter IV'').
\12\ See Securities Exchange Act Release No. 66819 (April 17,
2012), 77 FR 23770 (April 20, 2012). Amendment No. 1 revised the
Original Proposal's minimum quote size requirements and proposed
that the amended Rule operate as a pilot. The comment period for the
Notice of Amendment No. 1 closed on May 7, 2012.
\13\ See Letter from Daniel Zinn, General Counsel, OTC Markets
Group Inc. to Elizabeth M. Murphy, Secretary, Commission, dated May
7, 2012 (``OTC Markets Letter V''); Letter from Michael T. Corrao,
Managing Director, Knight Capital Group, Inc. to Elizabeth M.
Murphy, Secretary, Commission, dated May 7, 2012 (``Knight Letter
III'').
\14\ In Amendment No. 2, as further described below, FINRA
committed to provide specific data to allow the Commission to
evaluate the impact of the proposed pilot on the over-the-counter
(``OTC'') equity market; responded to comments received on Amendment
No. 1; and clarified certain statements in the Original Proposal and
Amendment No. 1. Amendment No. 2 also clarified that the
implementation date of the proposed rule change would be no sooner
than 120 days following Commission approval and no later than 180
days following Commission approval. A copy of Amendment No. 2 is
located in the Commission's public file for SR-FINRA-2011-058 at
http://www.sec.gov/comments/sr-finra-2011-058/finra2011058.shtml.
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The Commission is publishing this Notice and Order to solicit
comment on Amendment No. 2 and to approve the proposed rule change, as
modified by Amendments Nos. 1 and 2 thereto, on an accelerated basis.
II. Description of the Proposal
As described more fully in the Original Proposal, FINRA proposed
changes to the minimum quotation sizes in FINRA Rule 6433 to, among
other things, simplify the Rule's price and size tiers, facilitate the
display of customer limit orders under FINRA Rule 6460,\15\ and expand
the Rule's scope.
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\15\ See NMS-Principled Rules Approval Order, supra note 4.
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Currently, FINRA Rule 6433 requires every member functioning as an
OTC Market Maker \16\ that enters firm quotations into any inter-dealer
quotation system that permits quotation updates on a real-time basis to
honor those quotations for certain minimum sizes (``minimum quotation
sizes'').\17\ Rule 6433 sets forth the specific minimum quotation size
requirements in tiers that are based on the price of the OTC equity
security being quoted by the market maker. Further, FINRA Rule 6460
requires any OTC Market Maker displaying a priced quotation in an OTC
equity security in an inter-dealer quotation system to publish
immediately (subject to certain limited exceptions) a bid or offer that
reflects: (1) The price and full size of a customer limit order that
improves the market maker's bid or offer; and (2) the full size of a
customer limit order that: (a) Is priced equal to the market maker's
bid or offer; (b) is priced equal to the best bid or offer of the
inter-dealer quotation system in which the market maker is quoting; and
(c) is more than a de minimus amount in relation to the size of the
market maker's bid or offer.
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\16\ OTC Market Maker means ``a member of FINRA that holds
itself out as a market maker by entering proprietary quotations or
indications of interest for a particular OTC Equity Security in any
inter-dealer quotation system, including any system that the SEC has
qualified pursuant to Section 17B of the Act. A member is an OTC
Market Maker only in those OTC Equity Securities in which it
displays market making interest via an inter-dealer quotation
system.'' See FINRA Rule 6420(f).
\17\ See Original Proposal, supra note 5.
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In its Original Proposal, FINRA explained that OTC Market Makers
currently are not required to display a customer limit order unless
doing so would comply with the minimum quotation sizes applicable to
the display of quotations on an inter-dealer quotation system.\18\
FINRA stated that the proposed rule change would benefit investors by
facilitating the display of customer limit orders under Rule 6460,
which generally requires that OTC Market Makers fully display better-
priced customer limit orders (or same-priced customer limit orders that
are at the best bid or offer and that increase the OTC Market Maker's
size by more than a de minimus amount).\19\
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\18\ See Regulatory Notice 10-42 (September 2010).
\19\ FINRA Rule 6460 was adopted as part of an effort to extend
certain protections in place for NMS stocks to quoting and trading
of OTC Equity Securities. See NMS-Principled Rules Approval Order,
supra note 4. In approving FINRA Rule 6460, the Commission noted
that ``FINRA's limit order display proposal marks a positive step in
efforts to improve the transparency of OTC Equity Securities and the
handling of customer limit orders in this market sector.'' Id.
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Specifically, FINRA proposed that the minimum quotation size
required for display of a quotation in an OTC equity security would
fall into one of six tiers rather than the current nine tiers. Under
the current rule, there are nine tiers as follows:
$2500.01 per share and above, the minimum quotation size
is 1 share;
$1000.01 through $2500.00 per share, the minimum quotation
size is 5 shares;
$500.01 through $1000.00 per share, the minimum quotation
size is 10 shares;
$200.01 through $500.00 per share, the minimum quotation
size is 25 shares;
$100.01 through 200.00 per share, the minimum quotation
size is 100 shares;
$10.01 through $100.00 per share, the minimum quotation
size is 200 shares;
$1.01 through $10.00 per share, the minimum quotation size
is 500 shares;
$0.51 through $1.00 per share, the minimum quotation size
is 2,500 shares;
$0.0001 through $0.50 per share, the minimum quotation
size is 5,000 shares.
Under FINRA's Original Proposal, the proposed six tiers would be as
follows:
$175.00 per share and above, the minimum quotation size
would be 1 share;
$1.00 through $174.99 per share, the minimum quotation
size would be 100 shares;
[[Page 37460]]
$0.51 through $0.9999 per share, the minimum quotation
size would be 200 shares;
$0.26 through $0.5099 per share, the minimum quotation
size would be 500 shares;
$0.02 through $0.2599 per share, the minimum quotation
size would be 1,000 shares;
$0.0001 through $0.0199 per share, the minimum quotation
size would be 10,000 shares.
Under Amendment No. 1, the proposed six tiers would be as follows:
$175.00 per share and above, the minimum quotation size
would be 1 share;
$1.00 through $174.99 per share, the minimum quotation
size would be 100 shares;
$0.51 through $0.9999 per share, the minimum quotation
size would be 1,000 shares;
$0.20 through $0.5099 per share, the minimum quotation
size would be 2,500 shares;
$0.10 through $0.1999 per share, the minimum quotation
size would be 5,000 shares;
$0.0001 through $0.0999 per share, the minimum quotation
size would be 10,000 shares.
Amendment No. 1 would increase the minimum quotation sizes for most
price points between $0.02 and $1.00 in comparison to the Original
Proposal. Under Amendment No. 1, the proposed minimum quotation size
for securities priced between $0.02 and $0.0999 would be increased from
1,000 shares to 10,000 shares; between $0.10 and $0.1999 would be
increased from 1,000 shares to 5,000 shares; between $0.26 and $0.5099
would be increased from 500 shares to 2,500 shares; and between $0.51
and $0.9999 from 200 shares to 1,000 shares, when compared to the
Original Proposal. The proposed minimum quotation size for securities
priced below $0.02 would be 10,000 shares, which remains unchanged from
the Original Proposal.
Based on its study of the Order Audit Trail System (``OATS'') data
for OTC Equity Securities in connection with its Original Proposal,
FINRA in its Original Proposal stated that the changes to the current
tier sizes set forth in the Original Proposal would result in the
display of a larger number of customer limit orders, potentially
increasing from 50% to 90% the number of customer limit orders eligible
for display, particularly for securities quoted between $0.51 and
$0.9999 per share.\20\ In Amendment No. 2, FINRA clarified that the
sample it had referred to in the Original Proposal pertained only to
securities priced between $0.51 and $1.00 per share.\21\ In its
Original Proposal, FINRA stated that, for securities priced at or above
$0.02 per share, the reduction in minimum quotation size requirements
would cause a greater percentage of customer limit orders to be
displayed.\22\
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\20\ See Original Proposal, supra note 5.
\21\ See Amendment No. 2, supra note 14.
\22\ See Original Proposal, supra note 5. For securities priced
under $0.02 per share, FINRA recognized that more substantive
dollar-value commitments to the market would be required.
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Based on a later study, as described in Amendment No. 1, FINRA
stated that the revised tier sizes proposed in Amendment No. 1 would
facilitate the display of additional liquidity by market makers in
comparison to the Original Proposal and of a total of approximately 95%
of all customer limit orders.\23\ In addition, under the revised tiers
described in Amendment No. 1, for securities priced from $0.10 up to
$1.00, FINRA noted that the required minimum dollar value of displayed
liquidity would range from $500.00 to $1,274.75, which are dollar
amounts that, in FINRA's view, represent both the appropriate minimum
dollar value of displayed liquidity for members and reasonable dollar
values for customer orders to be eligible for display on an inter-
dealer quotation system. In Amendment No. 2, FINRA stated that although
its analysis of sample data showed that improved display of customer
limit orders is most dramatic for those securities priced between $0.51
and $1.00 per share, it also found that, in the aggregate, a material
increase in the number of displayable customer limit orders would be
achieved with the new tier sizes.\24\
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\23\ In Amendment No. 1, FINRA stated that it had analyzed a
random sample of over 100 million customer limit orders in OTC
Equity Securities that were reported to FINRA during a six-month
period.
\24\ Specifically, FINRA looked at a random sample of 32 trading
days between May and December 2011 and found that the number of
customer limit orders at or above the minimum tier size increased
from approximately 85% of customer limit orders being at or above
the minimum size to be eligible for display under the current tiers
to 96% of customer limit orders being eligible for display under the
tiers proposed in Amendment No. 1.
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In the Original Proposal, FINRA stated that the proposed revisions
to Rule 6433 were appropriate because they would simplify the price and
size tier structure of the Rule and would facilitate the display of
customer limit orders consistent with Rule 6460, while still
recognizing the utility of requiring that quotes in lower-priced
securities represent a minimum dollar-value commitment to the market.
FINRA remarked that the revised proposed tiers, as described in
Amendment No. 1, would increase the minimum quotation size requirements
for OTC equity securities in comparison to the Original Proposal. In
FINRA's view, the proposed tier sizes in Amendment No. 1 would increase
the minimum dollar commitment to the market overall in comparison to
the Original Proposal, while still facilitating investor protection by
providing for greater display of customer limit orders than occurs
under the current Rule. FINRA contended that the revised tiers
described in Amendment No. 1 would continue to yield the benefits
discussed in its Original Proposal, including the simplification of the
existing Rule by reducing the number of minimum quotation tiers and
incorporating a minimum of quotation size of 100 shares for all
securities priced at or above $1.00, other than those priced at or
above $175.
FINRA also believed that the minimum quotation size requirements
contained in its Original Proposal and the proposed revisions contained
in Amendment No. 1 would benefit investors by increasing the percentage
of customer limit orders that would be eligible for display under Rule
6460, thereby improving transparency and enhancing execution
opportunities for customer limit orders. In Amendment No. 1, FINRA
noted its view that the resulting increased display of customer limit
orders would enhance competition and pricing efficiency in the market
for OTC equity securities, which also should have a positive impact on
capital formation.\25\ In Amendment No. 1, FINRA further stated that
the resulting increased display of customer limit orders would improve
the public availability of quotation information, and increase quote
competition, market efficiency, best execution and
disintermediation.\26\
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\25\ See Amendment No. 1, supra note 12.
\26\ Id.
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Currently, Rule 6433 applies to those member firms that function as
market makers in OTC equity securities. In the Original Proposal, FINRA
proposed to expand the scope of the Rule to apply to all quotations or
orders displayed in an inter-dealer quotation system, including
quotations displayed by alternative trading systems (``ATSs'') or by
non-market maker members representing customer trading interest.\27\
FINRA noted that ATSs have become increasingly active in the OTC market
and believed that the proposed expansion of the scope of the Rule would
ensure that minimum quotation
[[Page 37461]]
sizes were observed consistently by all members displaying quotations
on an inter-dealer quotation system.
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\27\ The Commission notes that this proposal was not modified by
Amendment No. 1.
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FINRA remarked that other existing requirements and obligations
would not be altered by its proposed rule change, as amended. According
to FINRA, each member would continue to be required to honor its
quotations for the full quantity displayed in accordance with FINRA
Rule 5220 (Offers at Stated Prices), which generally provides that no
member shall make an offer to buy or sell any security at a stated
price unless such member is prepared to purchase or sell the security
at such price and under such conditions as are stated at the time of
such offer to buy or sell.\28\ Likewise, member obligations pursuant to
FINRA Rule 5210 (Publication of Transactions and Quotations) would
continue to apply. Among other things, FINRA Rule 5210 generally
prohibits members from publishing, circulating, or causing to be
published or circulated, any quotation which purports to quote the bid
price or asked price for any security, unless such member believes that
such quotation represents a bona fide bid for, or offer of, such
security.\29\
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\28\ See also Rule 5220.01 (Firmness of Quotations).
\29\ See also Rule 5210.01 (Manipulative and Deceptive
Quotations).
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Under Amendment No. 1, the proposed rule change would be
implemented for all OTC equity securities displayed on an inter-dealer
quotation system on a pilot basis for a period of one year from the
operative date of the proposed rule change. In the Original Proposal,
FINRA stated that it would announce in a Regulatory Notice the
operative date of the proposed rule change, which would be no later
than 180 days following Commission approval of the proposed rule
change. In Amendment No. 1, FINRA clarified that the operative date for
the pilot would be 120 days following the date of Commission approval
of the proposed rule change, as amended. In Amendment No. 2, FINRA
further clarified that the operative date for the pilot would be no
sooner than 120 days, and no later than 180 days, following the date of
Commission approval of the proposed rule change, as amended. FINRA also
has committed to provide the Commission with data to allow the
Commission to evaluate the impact of the pilot program to revise the
Rule's minimum quotation size requirements.\30\
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\30\ See Amendment No. 2, supra note 14.
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III. Comment Letters and FINRA's Responses
A. Comment Letters Received on the Original Proposal and FINRA's
Responses Thereto
The Commission received seven comment letters from four commenters
on the Original Proposal.\31\ FINRA submitted two responses to those
comment letters.\32\
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\31\ See supra note 6.
\32\ See supra note 7.
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The commenters on the Original Proposal generally were supportive
of the goal of having additional limit orders eligible for display.
However, OTC Markets and Knight objected to the proposed revisions to
the minimum quotation size requirements of Rule 6433.\33\ Specifically,
these commenters expressed concern that FINRA's proposal lacked
sufficient economic analysis to demonstrate that the proposed revisions
to the minimum quotation size requirements would improve liquidity or
lower transaction costs for investors.\34\ A third commenter suggested
that the minimum dollar value of each tier size should be $100 as a
means to provide greater transparency to all market participants.\35\ A
fourth commenter supported the proposal to the extent that it would
help prevent manipulative practices, but otherwise addressed topics
unrelated to the proposal.\36\
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\33\ See OTC Markets Letter I, Knight Letter I, OTC Markets
Letter II, OTC Markets Letter III, and Knight Letter II.
\34\ Id.
\35\ See Shatto Letter.
\36\ See Hamlet Letter.
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Knight expressed the view that the proposal could have the
unintended consequence of negatively impacting the market by removing
meaningful minimum required dollar value levels of displayed liquidity
by market makers.\37\ According to this commenter, because the proposed
levels are significantly lower than currently required levels, the
proposal potentially could cause a severe degradation in trading
efficiency, particularly in less liquid securities, and thereby fail to
meet the proposal's desired goal.\38\ Knight provided a table to detail
the change to the minimum dollar value required to be displayed by
market makers under the proposal.\39\ According to Knight, its table
illustrated a significant decrease in dollar value of liquidity that
market makers would be required to offer at each tier level.
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\37\ See Knight Letter I.
\38\ See Knight Letter I at p. 1.
\39\ See Knight Letter I at p. 2.
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In addition, Knight believed that, under the proposal, market
makers would be required to quote insignificant dollar values, thereby
creating additional operational and trading risks, without providing
real value to the market.\40\ Knight further expressed concern that any
increase in costs to liquidity providers could result in the departure
of market makers and thereby could cause an erosion of liquidity.\41\
Knight recommended further economic analysis to study the expected
impact of the proposed tier sizes on market liquidity, and requested
that the Commission conduct an analysis of the data.\42\ Knight
suggested that, if the Commission were inclined to move forward after
such analysis, a limited pilot would allow for the assessment of the
proposal's impact on market quality while minimizing the effects of any
unintended consequences.\43\
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\40\ See id.
\41\ See id.
\42\ See id.
\43\ See id.
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In another communication, Knight reiterated its belief that the
proposal would have serious negative consequences to the OTC
marketplace and investors, including a significant reduction in
liquidity, inferior pricing and increased vulnerability to gaming and
frontrunning.\44\ Knight expressed concern about the consequences
likely to result when concepts and rules from the market for NMS
securities were applied to the OTC equity market, despite differing
trading characteristics between NMS securities and OTC equity
securities.\45\ Knight again requested that the Commission conduct a
comprehensive analysis of empirical data to assess whether the proposal
has a sound basis and evaluate the costs and benefits associated with
the proposal.\46\ Knight questioned how FINRA could evaluate its
obligations under Section 15A(b)(9) of the Act \47\ without performing
a fundamental analysis of the proposal.\48\ Knight pointed to the prior
analysis performed by the National Association of Securities Dealers,
Inc., FINRA's predecessor, in connection with tier size reductions in
Nasdaq securities and suggested that FINRA consider a similar approach
for its current proposal.\49\
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\44\ See Knight Letter II at p. 1. Knight noted its agreement
with the views expressed in OTC Markets Letter III. Id. Knight also
included a modified version of the table that was included in its
prior letter. See Knight Letter II at p. 3.
\45\ See id.
\46\ See Knight Letter II at p. 2.
\47\ 15 U.S.C. 78o-3(b)(9).
\48\ Id.
\49\ See id. (citing Securities Exchange Act Release No. 40211
(July 15, 1998), 63 FR 39322 (July 22, 1998) (Order Approving a
Proposed Rule Change to Permanently Expand the NASD's Rule
Permitting Market Makers to Display Their Actual Quotation Size)).
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[[Page 37462]]
Knight expressed the view that non-NMS securities are significantly
less liquid than NMS securities and that the proposed rule change would
have an adverse impact on both dealers and investors.\50\ In Knight's
opinion, the only possible benefits resulting from the proposal would
accrue to firms that provide little or no liquidity, as those firms
would ``pick-off'' dealer liquidity at the expense of investors.\51\
Knight further noted that market makers like itself generally do not
charge commissions or mark-up/mark-downs to competitors or broker-
dealer clients.\52\ Knight indicated that market makers would continue
to incur costs to access liquidity under the proposal and that there
was a likelihood that market participants would gravitate to posting
quotations at the minimum tier size as they currently do today.\53\
Finally, Knight reiterated its concern that costs could increase for
self-clearing firms under the proposal and that costs would be more
burdensome in the case of non-DTCC eligible securities (i.e.,
physically settled securities) because those costs were driven by the
number of settlements as opposed to the number of trades.\54\
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\50\ See Knight Letter II at pp. 2-3.
\51\ See Knight Letter II at p. 3.
\52\ See id.
\53\ See id.
\54\ See Knight Letter II at pp. 3-4.
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OTC Markets expressed the view that the reduction of minimum quote
size requirements ``has not been shown by FINRA to benefit investors
and has a significant risk that it will degrade market quality.'' \55\
OTC Markets further suggested that Regulation NMS-type rules are not
appropriate in the context of smaller issuers.\56\ In OTC Market's
view, the immediate effect of the proposal would be less displayed
liquidity, even if the actual liquidity were larger, because quotations
typically are submitted at the minimum size.\57\ OTC Markets believed
that this potential effect would lead to more volatility and would
increase realized spreads because orders ultimately would be filled
away from the inside quote, thereby raising the cost of trading.\58\
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\55\ See OTC Markets Letter I at p. 1.
\56\ See id.
\57\ See OTC Markets Letter I at p. 3.
\58\ See id.
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OTC Markets stated that the analysis provided by FINRA was not
compelling, and cited to public commentators and academics that
generally have suggested that Regulation NMS-type rules are harmful to
the market for smaller companies' securities.\59\ OTC Markets asserted
that FINRA's statistical analysis concerning the additional percentage
of customer orders that would be displayed under the proposed rule
change was flawed because, among other things, FINRA did not consider
the impact of its own quote aggregation rules.\60\ OTC Markets
believed, at a minimum, FINRA's analysis required further study,\61\
and recommended that the Commission's staff review the actual effect of
the proposed rule change on the display of limit orders.\62\
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\59\ See OTC Markets Letter I at p. 2.
\60\ See id.
\61\ See id.
\62\ See OTC Markets Letter I at p. 3.
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In another communication, OTC Markets again expressed the view that
FINRA's analysis was flawed.\63\ OTC Markets suggested that the
proposal represented a large change in OTC market structure and could
negatively impact capital formation for small businesses. Again, OTC
Markets requested that the Commission's staff conduct its own economic
analysis of the proposed rule change.
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\63\ See OTC Markets Letter II.
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FINRA provided two response letters addressing issues raised by the
commenters on the Original Proposal.\64\ In both of its responses,
FINRA noted that the purpose of allowing smaller displayed quotes was
to allow for the greater use of limit orders by investors.\65\ In FINRA
Response II, FINRA reiterated that the Original Proposal was associated
with the FINRA limit order display rule, which recently had provided a
fundamental investor protection with respect to OTC equity
securities.\66\ FINRA explained that the existing minimum quotation
sizes reduced the benefit of its limit order display rule because the
higher existing levels ``act to restrict transparency of a large number
of customer limit orders.'' \67\ Addressing commenters' concerns about
reduced liquidity, FINRA noted that the lower minimum quote sizes
described in the Original Proposal would allow for the display of a
greater number of limit orders. FINRA believed that the larger number
of quotes would increase competition, and increased competition would
improve liquidity.\68\ FINRA noted that, although the role of the
market maker had been reduced in the trading of NMS securities,
liquidity in those securities appeared intact.\69\ FINRA remarked that,
to the extent that commenters were concerned that the processing of
smaller quotes would be uneconomical, the proposed rule change would
not mandate the use of smaller quote sizes.\70\
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\64\ See supra note 7.
\65\ See FINRA Response I at p. 1.
\66\ See FINRA Response II at p. 1.
\67\ Id.
\68\ See FINRA Response I at p. 1 and FINRA Response II at p. 5,
n. 17. Knight and OTC Markets stated that market makers might react
to the proposed rule change by reducing their quote sizes. See
Knight Letter I at pp. 1-2 and OTC Markets Letter I at p. 3.
\69\ See FINRA Response I at p. 1.
\70\ See FINRA Response I at p. 1 and FINRA Response II at p. 5,
n. 17. Knight believed that there would be costs associated with the
operational complexity of clearing increased volumes of smaller
trades in non-DTC eligible securities. See Knight Letter I at p. 2.
OTC Markets believed that the proposed rule change would increase
transaction costs for investors. See OTC Markets Letter I at p. 3.
---------------------------------------------------------------------------
In FINRA Response II, FINRA disagreed with OTC Markets' suggestion
that the percentage of customer limit orders currently displayed under
Rule 6460 already was in line with FINRA's estimate of the number of
customer limit orders that would be displayed under the proposal.\71\
FINRA believed that, contrary to the commenter's assertion, broker-
dealers were unlikely to be in a position to aggregate multiple
customer orders to reach the existing display thresholds, because OTC
equity securities trade infrequently and at widely varying volume each
day.\72\ FINRA also noted that, in any event, price transparency should
not depend upon the expectation that other orders for OTC equity
securities might be placed at the same price and at around the same
time.\73\ Finally, FINRA noted that a more recent sample of relevant
data further supported its position that the proposed rule change would
increase the display of customer limit orders from 50% under the
existing minimum quotation size requirements to 90% under the Original
Proposal in the case of OTC equity securities priced between $0.51 and
$1.00.\74\
---------------------------------------------------------------------------
\71\ See FINRA Response II at p. 3. OTC Markets believed that
the FINRA analysis failed to take into account aggregation
requirements. See OTC Markets Letter I at p. 2.
\72\ See FINRA Response II at p. 3.
\73\ See id.
\74\ See id.
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In FINRA Response II, FINRA stated its view that the chart
contained in Knight Letter I did not accurately align tier and price
points and therefore did not allow for an appropriate comparison of the
current and proposed rules.\75\ FINRA provided a comparison of similar
price points and ranges to demonstrate that the Original Proposal would
increase the dollar values for two proposed lower price point tiers and
decrease dollar values for three proposed higher price point tiers,
while
[[Page 37463]]
the dollar values of one proposed price point tier would remain
unchanged.\76\ FINRA believed that its proposed structure was better
for investors; was more consistent with the national market system; and
represented more meaningful minimum displayed liquidity at the lowest
tiers.\77\ FINRA disputed the suggestion in Knight Letter I that its
proposal would degrade market quality or have far reaching effects on
liquidity and efficiency in the OTC markets, noting again that the
``opposing commenters have provided no analysis or clear explanation
that would indicate the likelihood of a nexus between such harms and
the proposal.'' \78\ FINRA reiterated that the likely impact of the
proposed rule change would be greater displayed customer limit orders,
as customer orders may be smaller than market maker orders, and that
this increased display would result in increased price
transparency.\79\ FINRA noted that the Rule only prescribes the minimum
sizes required for display, and that market makers may choose to
display a quotation at the proposed minimum or in excess of the
proposed minimum, as they do today.\80\
---------------------------------------------------------------------------
\75\ See FINRA Response II at pp. 3-4.
\76\ See FINRA Response II at p. 4.
\77\ See id.
\78\ See FINRA Response II at pp. 4-5.
\79\ See FINRA Response II at pp. 5-6.
\80\ See FINRA Response II at p. 6; see also FINRA Response I at
p. 1.
---------------------------------------------------------------------------
In FINRA Response II, FINRA further noted that several comments
were not germane to the consideration of the merits of its proposal.
For example, FINRA did not believe that there was a nexus between the
proposal and the extension of certain other NMS protections to OTC
markets, as stated in the OTC Markets comments,\81\ or between the
proposal and issues such as locked or crossed markets and access fees,
as suggested by Knight Letter I.\82\
---------------------------------------------------------------------------
\81\ See FINRA Response II at p. 6. OTC Markets believed ``NMS-
type rules are harmful when applied to smaller companies.'' See OTC
Markets Letter I at pp. 1-2.
\82\ See FINRA Response II at p. 6. As noted above, Knight
requested that the Commission examine the impact on trading,
clearing (e.g., the operational complexity of clearing increased
volumes of smaller trades in non-DTC eligible securities), related
costs, locked markets, access fees, trading efficiency and market
participant behavior under the proposed reduced tier sizes. See text
accompanying note 42 supra.
---------------------------------------------------------------------------
OTC Markets reiterated its views regarding the proposal in its
third comment letter, which was submitted following FINRA's responses
to the comment letters.\83\ The commenter again stated its view that
Regulation NMS-type rules were not appropriate for the OTC market.\84\
In addition, OTC Markets once more raised issues regarding FINRA's
analysis. According to OTC Markets, FINRA's analysis did not reflect
existing customer order aggregation requirements; \85\ did not provide
information regarding dollar and share volume relative to tier sizes;
\86\ and did not analyze the proposal's potential impact on market
orders or proprietary quotes.\87\
---------------------------------------------------------------------------
\83\ See OTC Markets Letter III.
\84\ See OTC Markets Letter III at p. 5.
\85\ See OTC Markets Letter III at p. 7.
\86\ See OTC Markets Letter III at p. 8.
\87\ See OTC Markets Letter III at pp. 2-3.
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OTC Markets remarked that FINRA's response letters failed to
address Section 3(f) of the Act,\88\ which requires that whenever,
pursuant to the Act, the Commission is engaged in rulemaking, or in the
review of a rule of a self-regulatory organization (``SRO''), and is
required to consider or determine whether an action is necessary or
appropriate in the public interest, the Commission shall also consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation.\89\ OTC Markets
believed that FINRA's proposed revisions potentially could have various
dynamic effects on the OTC market.\90\ OTC Markets stated that it
reviewed data relating to all trades in OTC equity securities that
occurred on October 27, 2011, with respect to share volume, dollar
volume and number of trades in relation to the existing and proposed
tier sizes.\91\ Based on its review, OTC Markets believed that the
proposal would not significantly increase liquidity but would impose a
direct cost on investors, particularly investors placing marketable
orders.\92\ OTC Markets believed that the proposed rule change would
lead most market makers to reduce their quote sizes and display less
liquidity.\93\ OTC Markets further believed that an extensive decrease
in displayed proprietary liquidity would ``overwhelmingly offset the
benefit of the increased number of customer limit orders displayed.''
\94\
---------------------------------------------------------------------------
\88\ 15 U.S.C. 78c(f).
\89\ See OTC Markets Letter III at pp. 2-3.
\90\ See OTC Markets Letter III at p. 4.
\91\ See OTC Markets Letter III at p. 5. OTC Markets stated that
it had selected October 27, 2011 for its review because that day had
the highest trading volume of any day that month and, according to
the commenter, presumably also had the highest amount of investor
liquidity for that month.
\92\ See OTC Markets Letter III at p. 6.
\93\ See id.
\94\ See OTC Markets Letter III at p. 7.
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B. Comment Letter Received on the Order Instituting Proceedings
Following publication by the Commission of the Order Instituting
Proceedings, the Commission received another comment letter from OTC
Markets, which reiterated its prior statements and provided additional
data for consideration.\95\ OTC Markets contended that, as part of the
proceedings, the Original Proposal should be evaluated in the context
of Section 3(f) of the Act.\96\ OTC Market stated that the proposal
would contravene the requirements of Section 15A(b)(6) of the Act \97\
because of the potential negative impact on the operation of the OTC
market.\98\ OTC Markets also stated that the proposal would contravene
Section 15A(b)(11) of the Act \99\ because of the potential decrease in
displayed liquidity at the inside price.\100\ OTC Markets submitted a
DVD containing data for the month of October 2011 and noted that its
data would be available to others who want to conduct a similar
analysis.\101\ Finally, OTC Markets reiterated its request that FINRA
or the Commission provide additional data for a panel of independent
academics to evaluate the appropriate tier size levels for OTC equity
securities.\102\
---------------------------------------------------------------------------
\95\ See OTC Markets Letter IV, supra note 11.
\96\ See OTC Markets Letter IV at p. 2. See text accompanying
note 88 supra for a description of Section 3(f) of the Exchange Act.
\97\ 15 U.S.C. 78o-3(b)(6).
\98\ See OTC Markets Letter IV at p. 2.
\99\ 15 U.S.C. 78o-3(b)(11).
\100\ Id.
\101\ See OTC Markets Letter IV at p. 3.
\102\ See OTC Markets Letter IV at p. 4.
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C. Comment Letters Received on Amendment No. 1
Following the publication by the Commission of Amendment No. 1, the
Commission received two more comment letters from Knight and OTC
Markets, respectively.\103\ As noted above, these commenters previously
raised concerns relating to the portion of the Original Proposal that
would revise the minimum quotation size requirements.\104\ In providing
comments on the proposal, as amended, Knight stated that ``the changes
FINRA made to the tier sizes address many of the points made in the
comment letters. More specifically, FINRA's revised proposal appears to
strike an appropriate balance between displayed liquidity from retail
limit orders and a tier size requirement for market makers.'' \105\
Knight also indicated support for FINRA's proposed pilot program so
that the impact of the changes to the Rule could be evaluated. Knight,
however, suggested that the proposed one-year length of the pilot
[[Page 37464]]
was too long and that a three- or four-month period would be sufficient
to gather the necessary data for the analysis.\106\ Finally, Knight
noted that the recent Jumpstart Our Business Startups Act (``JOBS
Act''), which requires the Commission to conduct a study and provide a
report to Congress on the impact of changes to the minimum tick size
requirements in light of decimalization, likely would have some
relationship to FINRA's proposed rule change.\107\ Knight suggested
that the Commission not approve FINRA's proposal until the Commission
completed the required JOBS Act study on tick sizes.\108\ OTC Markets,
who submitted four prior letters, stated that the amended proposal
``improves on some facets of the original Proposed Rule, however the
Amended Proposed Rule does not go far enough to protect liquidity and
reduce volatility in the OTC market.'' \109\ OTC Markets also pointed
to the recently enacted JOBS Act, and recommended that the new law's
required study should be combined with a study of the potential effects
of FINRA's proposal.\110\ OTC Markets further suggested that it would
not be appropriate to introduce the proposed pilot program until such
study was completed.\111\ OTC Markets stated that, without further
study, the amended proposal's potential risks would outweigh its
potential benefits, and that the length and breadth of the proposed
pilot would pose unwarranted risk to the OTC equity market.\112\ In
addition to recommending that the Commission first conduct a study on
liquidity and volatility using currently available data before
approving the pilot program, OTC Markets suggested that FINRA remove a
prohibition on broker-dealer proprietary trading in a security at a
price equal to or better than an unexecuted customer limit order and
allow the two orders to trade in parity and in proportion to their
displayed liquidity. OTC Markets posited that this change would
incentivize proprietary liquidity and protect customer limit orders.
---------------------------------------------------------------------------
\103\ See supra note 13.
\104\ See, e.g., OTC Markets Letter I, Knight Letter I, OTC
Markets Letter II, OTC Markets Letter III, and Knight Letter II.
\105\ See Knight Letter III at p. 2.
\106\ See id.
\107\ See Knight Letter III at pp. 2-3.
\108\ See Knight Letter III at p. 3. See 15 U.S.C. 78l-
1(c)(6)(A) (``The Commission shall conduct a study examining the
transition to trading and quoting securities in one penny
increments, also known as decimalization. The study shall examine
the impact that decimalization has had on the number of initial
public offerings since its implementation relative to the period
before its implementation. The study shall also examine the impact
that this change has had on liquidity for small and middle
capitalization company securities and whether there is sufficient
economic incentive to support trading operations in these securities
in penny increments. Not later than 90 days after the date of
enactment of this paragraph, the Commission shall submit to Congress
a report on the findings of the study.'').
\109\ See OTC Markets Letter V at p. 7.
\110\ See OTC Markets Letter V at pp. 1-2.
\111\ See OTC Markets Letter V at p. 2.
\112\ See OTC Markets Letter V at pp. 2-3.
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IV. Amendment No. 2
FINRA stated that its purpose in filing Amendment No. 2 was to
address comments made by Knight and OTC Markets on the revised
proposal, as set forth in Amendment No. 1; outline the steps FINRA
intends to take to review and assess the effects of the amended Rule
during the pilot period; and clarify certain issues raised in the
Original Proposal and Amendment No. 1.\113\ FINRA noted that it filed
Amendment No. 1 to modify the proposed tiers in response to the
comments received by the Commission and to propose that the revised
Rule be implemented as a one-year pilot to allow FINRA and the
Commission to assess its impact.\114\ FINRA remarked that, although
commenters had suggested reducing the proposed one-year length of the
pilot, FINRA did not believe that a three- or four-month pilot period
would provide sufficient time to gather data and to evaluate fully the
impact of the proposed rule change. FINRA stated, however, that it
would regularly monitor the results of the pilot and, if FINRA
concluded that there had been a significant negative impact (including
on liquidity) on the OTC market, FINRA would consider rescinding the
pilot prior to the end of its one-year period.
---------------------------------------------------------------------------
\113\ See Amendment No. 2, supra note 14.
\114\ See infra note 150 for a description of the data FINRA has
committed to provide on a monthly basis to the Commission.
---------------------------------------------------------------------------
FINRA also discussed the suggestion by Knight and OTC Markets that
the Commission review minimum quotation sizes and minimum tick sizes
for OTC equities concurrently, in light of the directive set forth in
the JOBS Act that the Commission study the impact of decimalization. In
responding to this suggestion, FINRA stated its view that the
amendments to the Rule should not be delayed in light of the potential
benefits of increased limit order display for the market and for
investors. FINRA stated that, if minimum tick sizes were to change as a
result of the JOBS Act study, it would consider whether additional
revisions are necessary for OTC equity securities.
FINRA noted that it had worked closely with OTC liquidity
providers, including Knight, in revising the Original Proposal to best
achieve a balance that would facilitate both the goal of providing
meaningful liquidity commitments by market makers and the display of
competitively priced customer limit orders. With regard to Knight's
concerns about the clearing costs that potentially could result if
reduced quote sizes resulted in a more fragmented market, particularly
for non-DTCC eligible securities, FINRA stated that it would monitor
for this issue during the pilot period, although it believed that such
securities accounted for a very small percentage of securities that
would be subject to the Rule.
FINRA pointed out that OTC Markets took issue with the amended
proposal because the commenter believed that it would harm markets by
reducing displayed liquidity. According to FINRA, OTC Markets appeared
to have formed its views based on an internal analysis of one day's
trading activity and on a comparison of the existing and proposed tier
sizes, with the assumption that market makers' quotations were always
at the minimum quotation size. FINRA stated that this review and
comparison were not a sufficient basis upon which to reasonably predict
the impact on liquidity. FINRA disagreed with OTC Markets' view that
FINRA had not studied how the revised tiers would affect overall
liquidity. FINRA noted that it had conducted multiple analyses of
relevant data. FINRA also noted that the pilot program would provide
for the ability to compare and contrast data in the most effective
manner. FINRA stated that, as part of the pilot, FINRA would review the
impact of the pilot and would provide data to the Commission so that
the Commission also could analyze the impact of the pilot. Further,
FINRA suggested that other comments by OTC Markets were not germane to
the consideration of the merits of the proposed rule change, including
the suggestion that FINRA Rule 5320, which prohibits broker-dealers
from trading ahead of customer limit orders, should be amended to allow
market makers to trade in parity with their customers.
In addition, FINRA committed to provide the Commission with the
data necessary to assess the impact of the revised tier sizes on the
OTC equity market. In Amendment No. 2, FINRA specified the categories
of data that it would provide to the Commission on a monthly basis,
starting no later than 90 days after the start of the pilot, including
price and volume information, execution data, and liquidity metrics and
the time frame within which FINRA would submit the data.\115\ FINRA
also committed to
[[Page 37465]]
provide the Commission with an assessment addressing the impact of the
pilot, the concerns raised by commenters, and the effectiveness of the
pilot in achieving the desired results.
---------------------------------------------------------------------------
\115\ In Amendment No. 2, FINRA also committed to provide the
data for five random days from each month for a one-year period
prior to the operative date of the pilot.
---------------------------------------------------------------------------
Further, in Amendment No. 2, FINRA clarified certain matters. FINRA
pointed out that, when it stated in the Original Proposal that ``only
approximately 50% of customer limit orders in the sample met the
current Rule's thresholds and would have been eligible to be
displayed,'' FINRA was referring to a sample that covered only those
securities that were priced between $0.51 and $1.00. In Amendment No.
2, FINRA described a more recent sampling based on 32 randomly selected
trading days between May and December 2011. FINRA found that the number
of customer limit orders at or above the minimum tier size increased
under the proposed tier sizes from approximately 85% of customer limit
orders at or above the minimum size that would be eligible for display
to 96% of customer limit orders.\116\ Finally, FINRA noted that the
correct implementation date period will be no sooner than 120 days, and
no later than 180 days, from the date of Commission approval of the
proposed rule change.
---------------------------------------------------------------------------
\116\ FINRA's analysis included all limit orders reported to
OATS as being received by a FINRA member, including those from other
FINRA members. FINRA excluded all proprietary orders originated by a
member from its calculations. See infra notes 133 and 134 and
accompanying text for a description of the analysis conducted by the
staff of the Commission's Division of Risk, Strategy and Financial
Innovation.
---------------------------------------------------------------------------
V. Discussion and Findings
After careful review of the proposed rule change, as modified by
Amendment Nos. 1 and 2, as well as the comment letters and the FINRA
response letters received on the proposal, the Commission finds that
the proposed rule change is consistent with the requirements of the Act
and the rules and regulations thereunder applicable to a national
securities association.
In particular, the Commission finds that the proposed rule change
is consistent with Section 15A(b)(6) of the Act,\117\ in that it is
designed, among other things, to prevent fraudulent and manipulative
acts and practices, to promote just and equitable principles of trade,
and, in general, to protect investors and the public interest. In
addition, the Commission finds that the proposed rule change is
consistent with Section 15A(b)(11), in that it includes provisions
governing the form and content of quotations relating to securities
sold otherwise than on a national securities exchange which may be
distributed or published by any member or person associated with a
member, and the persons to whom such quotations may be supplied.\118\
---------------------------------------------------------------------------
\117\ 15 U.S.C. 78o-3(b)(6).
\118\ 15 U.S.C. 78o-3(b)(11).
---------------------------------------------------------------------------
The Commission preliminarily believes that the proposed rule
change, by adjusting the minimum quotation size requirements of Rule
6433, should help facilitate the display of more customer limit orders
for OTC equity securities priced $0.20 and above than exists under the
current Rule. The Commission notes that the benefits to investors of
Rule 6460, which mandates the display of customer limit orders for OTC
equity securities when that rule's conditions are met, are reduced if
the minimum quotation requirements for OTC equity securities under Rule
6433 are set too high. The Commission preliminarily believes that
incorporating a greater number of customer limit orders in quotes could
improve the prices at which these customer orders are executed.
In addition, lowering the minimum quotation size requirements for
OTC equity securities priced $0.20 and above could foster greater
liquidity for these securities because broker-dealers that currently do
not make markets in some or all OTC equity securities could be
incentivized to become market makers in these securities. The current
minimum quotation size requirements may impede some broker-dealers from
committing resources to certain OTC equity securities because they may
consider the dollar value commitment inherent in the Rule's current
thresholds to be too high. Lower minimum quotation size thresholds for
certain OTC equity securities may prompt some broker-dealers to become
market makers in OTC equity securities because, for securities quoted
at $0.20 and above, the minimum quotation size--and thus the minimum
dollar value commitment to the security--would be reduced under the
amended Rule.
If this were to occur, the increased competition from both market
makers and customer limit orders could narrow spreads and increase
liquidity in the market for OTC equity securities, to the benefit of
investors, liquidity providers and the OTC marketplace generally. The
Commission recognizes, however, that the actual broader impact of
FINRA's proposed rule change on the market for OTC equity securities
may not be known, and that the views of some commenters differ.
Accordingly, the Commission believes that it is important that FINRA
has proposed to implement the revised tier sizes as a one-year pilot
program, and to provide the Commission with data to allow Commission
staff to evaluate the actual impact of these changes on the OTC market,
as well as to perform its own assessment thereof.
Further, the proposal would reduce from nine to six the number of
price and size thresholds contained in the Rule. The Commission also
notes that the proposal is designed to expand the scope of the Rule to
cover quotations that are displayed on an inter-dealer quotation system
by ATSs and by non-market making members representing customer trading
interest. Expanding the scope of the Rule should help ensure that
minimum quotation sizes are observed consistently by all FINRA members
displaying quotations on an inter-dealer quotation system, whether
those quotations are submitted by an OTC market maker or by an ATS.
As noted above, the Commission received ten comment letters from
four separate commenters in response to the proposed rule change, as
amended.\119\ Two commenters supported the proposed rule.\120\ Two
other commenters, while generally supportive of the goal of enhancing
limit order display, questioned the need to revise the Rule's current
minimum quotation size requirements.\121\ In their various letters,
Knight and OTC Markets raised several main issues regarding both the
Original Proposal and Amendment No. 1. Specifically, these commenters
stated that the proposal: (1) Was based on a flawed and/or insufficient
data analysis and should be subject to further study; (2) would cause
lower liquidity and greater volatility for OTC equity securities; (3)
should operate as a pilot program; and (4) would not promote
efficiency, competition or capital formation.\122\ OTC Markets also
disputed whether the proposed rule change is consistent with Sections
15A(b)(6) and 15A(b)(11) of the Act.\123\
---------------------------------------------------------------------------
\119\ See supra notes 6, 11 and 13.
\120\ See Shatto Letter and Hamlet Letter, supra note 6.
\121\ Specifically, Knight stated its support for the goal of
making additional limit orders eligible under Rule 6460 for display,
whereas OTC Markets stated its support for expanding Rule 6433 to
include all quotations or orders published in inter-dealer quotation
systems. See Knight Letter I at p. 1 and OTC Markets Letter I at p.
1.
\122\ See Section 3(f) of the Act, 15 U.S.C. 78c(f).
\123\ 15 U.S.C. 78o-3(b)(6) and 15 U.S.C. 78o-3(b)(11).
---------------------------------------------------------------------------
In its review of the proposal, the Commission has carefully
considered the issues and concerns raised by these commenters and, as
discussed below, has evaluated those issues and concerns in light of
the mandate of Section
[[Page 37466]]
19(b)(2) of the Act that the Commission shall approve a proposed rule
change if it finds that such proposed rule change is consistent with
the requirements of the Act and rules and regulations thereunder
applicable to a self-regulatory organization.
A. Whether the Proposed Rule Change is Consistent With Sections
15A(b)(6) and 15A(b)(11) of the Act
FINRA is a registered national securities association that is
composed of brokers and dealers that are registered with the Commission
under Section 15(a) of the Act. Among other things, FINRA regulates its
members with respect to their activities in OTC equity securities
pursuant to authority granted to it by Congress under Section 15A of
the Act.\124\ FINRA's mandate under Section 15A(b)(6) is to assure that
its rules, among other things, are designed to ``prevent fraudulent and
manipulative acts and practices, to promote just and equitable
principles of trade, to foster cooperation and coordination with
persons engaged in regulating, clearing, settling, processing
information with respect to, and facilitating transactions in
securities, to remove impediments to and perfect the mechanism of a
free and open market and a national market system, and, in general, to
protect investors and the public interest; and are not designed to
permit unfair discrimination between customers, issuers, brokers, or
dealers * * *.'' \125\ Pursuant to Section 15A(b)(11) of the Act, FINRA
is authorized to adopt rules applicable to its members ``governing the
form and content of quotations relating to securities sold otherwise
than on a national securities exchange which may be distributed or
published by any member or person associated with a member, and the
persons to whom such quotations may be supplied.'' \126\ Such rules
must be ``designed to produce fair and informative quotations, to
prevent fictitious or misleading quotations, and to promote orderly
procedures for collecting, distributing, and publishing quotations.''
---------------------------------------------------------------------------
\124\ 15 U.S.C. 78o-3.
\125\ 15 U.S.C. 78o-3(b)(6).
\126\ 15 U.S.C. 78o-3(b)(11).
---------------------------------------------------------------------------
OTC Markets asserted that FINRA's proposal contravenes Section
15A(b)(6) of the Act and disregards Section 15A(b)(11) of the Act.\127\
The Commission believes that FINRA has authority under Sections
15A(b)(6) and 15A(b)(11) to establish rules governing the minimum
quotation size requirements for its members when they enter quotations
for OTC equity securities in an inter-dealer quotation system and to
revise those rules, as necessary or appropriate. The proposed rule
change, as amended, would revise the minimum quotation size
requirements for broker-dealers that quote OTC equity securities in an
inter-dealer quotation system. These minimum quotation size
requirements impact not only the size of the quotes that broker-dealers
must honor, but also the minimum size of customer limit orders that may
have a right to be displayed. In the Commission's view, FINRA's
proposed revisions are designed to protect investors by revising the
Rule's tier thresholds such that a larger percentage of customer limit
orders are reflected in quotations for OTC equity securities, thereby
potentially improving the prices at which customer limit orders will be
executed, consistent with the protection of investors and the public
interest. In addition, as noted above, lowering the minimum quotation
size requirements could incent more broker-dealers to become market
makers in OTC equity securities. Although further study will be
required during the pilot period, if more broker-dealers become market
makers in OTC equity securities, there could be a further narrowing of
spreads and an increase in liquidity in the OTC market, to the benefit
of investors, the public interest, and the perfection of a free and
open market and a national market system. In addition, the Commission
considers the proposed rule change to govern the form and content of
quotations for OTC equity securities, consistent with Section
15A(b)(11) of the Act.
---------------------------------------------------------------------------
\127\ See OTC Markets Letter IV at p. 2.
---------------------------------------------------------------------------
B. Whether FINRA's Data Analysis Was Flawed
In several comment letters, OTC Markets claimed that FINRA's
analysis that the Original Proposal would result in an increased
display of customer limit orders was flawed.\128\ OTC Markets stated
that the reduction of minimum quote size requirements ``has not been
shown by FINRA to benefit investors and has a significant risk that it
will degrade market quality.'' \129\ OTC Markets claimed that FINRA's
analysis was inaccurate and misleading because FINRA did not segment
the order data by market orders, marketable limit orders, limit orders
that would have improved the spread of the best bid/offer, limit orders
at the best bid/offer, and limit orders outside the best bid/
offer.\130\ OTC Markets also contended that FINRA failed to analyze the
number of executions against limit orders and the number of executions
involving a broker-dealer trading as principal.\131\ Both OTC Markets
and Knight urged the Commission to conduct its own analysis of FINRA's
proposal.\132\
---------------------------------------------------------------------------
\128\ See OTC Markets Letter I at p. 2; OTC Markets Letter II;
and OTC Markets Letter III at pp. 7-8.
\129\ See OTC Markets Letter I at p. 1.
\130\ See OTC Markets Letter III at p. 5.
\131\ Id.
\132\ See, e.g., OTC Markets Letter I at pp. 3-4; OTC Markets
Letter II; and Knight Letter I at p. 2. OTC Markets provided data
relating to quotes and trades in OTC equity securities that occurred
in October 2011, which the commenter provided for the benefit of
Commission staff and others to use in conjunction with a review of
FINRA's proposed rule change.
---------------------------------------------------------------------------
In response to these comments, the staff of the Commission's
Division of Risk, Strategy and Financial Innovation (``RSFI'')
undertook an empirical analysis relating to the potential effects of
the proposal, which was intended to supplement FINRA's analysis, and
performed a modification of the analysis that FINRA discussed in the
Original Proposal, using the first five trading days of November
2011.\133\ The RSFI staff found that, for customer orders with limit
prices between $0.51 and $1.00, displayable orders would increase from
47.5% to 92.6% under the revisions to the tier sizes contained in the
Original Proposal. The RSFI staff stated that this finding was
consistent with the results reported by FINRA for that particular tier
size in the Original Proposal. Applying the revised tier sizes in
Amendment No. 1, the RSFI staff discerned that the percentage of
displayable orders for the same tier threshold noted above would
increase from 47.5% to 73.8%. In addition, the RSFI staff examined
customer orders, regardless of price, and found that the percentage
displayed under the current tier structure is 92.5% and would increase
to 97.5% under Amendment No. 1. As described in detail in the RSFI
Memorandum, the RSFI staff's analysis found that the greatest increase
in transparency likely would occur for securities priced between $0.10
and $1.00.\134\ In addition, the RSFI staff
[[Page 37467]]
estimated that the proposed tier sizes included in Amendment No. 1
might reduce the transaction costs for executed limit orders that would
be newly visible by an upper bound of $7,173 per day, or 1.75% of
dollar volume for these limit order executions.
---------------------------------------------------------------------------
\133\ See Memorandum from the Division of Risk, Strategy and
Financial Innovation, dated June 1, 2012 (``RSFI Memorandum''). A
copy of the RSFI Memorandum is located in the Commission's public
file for SR-FINRA-2011-058 at http://www.sec.gov/comments/sr-finra-2011-058/finra2011058.shtml.
\134\ In Amendment No. 2, FINRA stated that it reviewed data for
32 randomly-selected days between May and December 2011 and found
that the number of customer limit orders displayed would increase
from approximately 85% under the Rule's current tiers to 96% under
the Rule's revised tiers. As noted above, the RSFI staff concluded
that the number of customer limit orders displayed would increase
from 92.5% to 97.5%. The RSFI Staff Analysis notes that the RSFI
staff considered only new customer orders; routed orders were
duplicative and therefore were removed from the sample. See RSFI
Staff Analysis, supra note 133.
---------------------------------------------------------------------------
The Commission believes that the RSFI Staff Analysis supports
FINRA's rationale for the proposed rule change, as amended, in that
there would be a material increase in the number of customer limit
orders to be displayed under the revisions to Rule 6433. OTC Markets
claimed that FINRA's analysis failed to account for the fact that
FINRA's Rule 6460 requires a market maker that receives customer limit
orders to aggregate those orders for purposes of the limit order
display rule.\135\ In response, FINRA stated that many of the 10,000
OTC equity securities quoted on inter-dealer quotation systems trade
infrequently and at widely varying volume levels each day.\136\ FINRA
noted that, based on its review of quotation and trade data for OTC
equity securities over a two week period, less than three percent of
OTC equity securities with a priced quotation trade 100 or more times
per day.\137\
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\135\ See OTC Markets Letter I at pp. 2-3. See also Regulatory
Notice 10-42 (September 2010) (``firms must aggregate same-priced
customer limit orders in OTC Equity Securities * * *.'') (citing
Securities Exchange Act Release No. 37619A (September 6, 1996), 61
FR 48290 (September 12, 1996) (adopting Rule 11Ac1-4 under the Act,
which requires the display of customer limit orders priced better
than a specialist's or OTC market maker's quote. Rule 11Ac1-4 was
subsequently redesignated as Rule 604 under Regulation NMS) (``Order
Handling Rules Release'')).
\136\ See FINRA Response I at p. 3.
\137\ Id.
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C. Whether the Proposal Would Result in an Impact on Liquidity and
Volatility
Knight argued that FINRA had not adequately demonstrated that the
proposed revisions to the minimum quotation size requirements for OTC
equity securities would benefit investors and instead countered that
the proposal would degrade the quality of the market for these
securities.\138\ Knight also stated that the proposal could impact
market liquidity and increase costs to market makers, which could
result in market makers' departure from the OTC market.\139\ Both
Knight and OTC Markets urged the Commission to undertake an economic
analysis of the anticipated effects of the proposal as part of its
consideration of the proposed rule change and suggested that, if the
Commission decided to move forward with the proposal, it should
consider approving the proposed changes to the Rule's tier structure on
a pilot basis.
---------------------------------------------------------------------------
\138\ See Knight Letter I at p. 1.
\139\ See Knight Letter I at p. 2.
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The Commission recognizes that FINRA's proposal involves a
balancing of potentially competing forces. Following the May 2011
implementation of Rule 6460, which requires the display of certain
customer limit orders in OTC equity securities, FINRA reviewed OATS
data and concluded that, for OTC equity securities priced between $0.51
and $0.9999 per share, a significant percentage of customer limit
orders were not eligible for display under the Rule.\140\ As the
Commission noted when it approved FINRA's proposed rule change to adopt
Rule 6460, ``FINRA's limit order display proposal marks a positive step
in efforts to improve the transparency of OTC Equity Securities and the
handling of customer limit orders in this market sector.'' \141\
FINRA's proposal to amend Rule 6433 in a manner that would result in a
greater number of customer limit orders being displayed could further
increase transparency, and promote competition and narrow spreads, in
the OTC market. The Commission notes that OTC equity securities
historically have been subject to Commission action in part because
they lack transparency.\142\
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\140\ See Notice at p.65308 and Amendment No. 2 at p. 7.
\141\ See NMS-Principled Rules Approval Order, supra note 4.
\142\ See generally Securities Exchange Act Release No. 64612
(June 7, 2011) (suspension of trading in common stock of 17
companies trading in OTC markets); Securities Exchange Act Release
No. 66980 (May 14, 2012) (suspension of trading in common stock of
379 companies quoted on OTC Link). See also Catton v. Defense
Technology Systems, Inc., 457 F. Supp. 2d 374 (S.D.N.Y. 2006);
S.E.C. v. Simmons, 2008 WL 7935266 (M.D.Fla. Apr 25, 2008); SEC v.
Irwin Boock, Stanton B.J. DeFreitas, Nicolette D. Loisel, Roger L.
Shoss, and Jason C. Wong, Birte Boock, and 1621566 Ontario, Inc.,
2011 WL 3792819 (S.D.N.Y. August 25, 2011), reconsideration denied,
2011 WL 5417106 (S.D.N.Y. November 9, 2011).
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On the other hand, Knight and OTC Markets expressed concern that
FINRA's proposal would lead to a diminution of liquidity and efficiency
for OTC equity securities and potentially exacerbate volatility in this
market segment.\143\ Both commenters believed that market makers would
reduce their quoted sizes to conform to the proposed lower tier
sizes.\144\ While OTC Markets did not dispute that FINRA's proposal
would increase the number of displayed customer limit orders, it
believed that a ``decrease in displayed proprietary liquidity will
overwhelmingly offset the benefit of the increased number of customer
limit orders displayed.'' \145\
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\143\ See OTC Markets Letter 1 at p. 3; OTC Markets Letter III
at pp. 4-6; OTC Markets Letter IV at pp. 2-3; OTC Markets Letter V
at p. 2; and Knight Letter I at pp. 1-2.
\144\ See OTC Markets Letter 1 at p. 3; OTC Markets Letter III
at p. 6; and Knight Letter I at pp. 1-2.
\145\ See OTC Markets Letter III at p. 7.
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Although the Commission recognizes these commenters' concerns
regarding the potential negative impact of FINRA's proposal on the OTC
market,\146\ the Commission notes that they offered limited data
supporting their claims.\147\ In addition, as discussed above, as well
as increasing the number of customer limit orders eligible for display
and the potential for better executions, arguments can be made that
FINRA's proposal will benefit the OTC market by facilitating market
making activity, reducing spreads and increasing liquidity. While
market makers may tend to reduce their quoted size to the minimum
required by FINRA's rules,\148\ the reduction in capital commitment per
security could allow them to make markets in a wider range of OTC
equity securities. This could enhance market maker competition and--
along with competition from customer limit orders--result in a
reduction in spreads in the OTC market. While the displayed size at the
tighter inside price may
[[Page 37468]]
decline, the overall impact on liquidity--looking at the cumulative
depth available--may be neutral or positive. If this were the case, the
impact of FINRA's proposal on volatility could be neutral or positive
as well.
---------------------------------------------------------------------------
\146\ OTC Markets stated that FINRA, in its amended proposal,
made a minimal effort to protect proprietary liquidity and to
research the amended proposal's ``probable negative effect on
proprietary liquidity.'' See OTC Markets Letter V at p. 6.
\147\ OTC Markets' commented that it analyzed the impact of the
proposal with respect to share volume, dollar volume and number of
trades, based on trade data for October 27, 2011. See OTC Markets
Letter III at pp. 5-7. According to OTC Markets, its analysis
suggested that the proposed rule would not significantly increase
liquidity but would impose a direct cost on investors, particularly
investors placing marketable orders. The Commission notes that OTC
Markets' analysis was based on the tier sizes set forth in the
Original Proposal. See Section V.D. below for a reference to OTC
Markets' analysis of the impact of the revisions to the Rule
proposed in Amendment No. 1. The Commission believes that FINRA's
proposed minimum quotation size requirements and the operation of
those new quote size requirements as a pilot program, as set forth
in Amendment No. 1, are designed to address the concerns of this
commenter and could mitigate potential adverse impacts the proposal
could have on dealers and investors.
\148\ The Commission also notes that the proposed rule change
does not mandate that market makers in OTC equity securities conform
to the new tier sizes. In fact, market makers would continue to have
the ability to quote at sizes greater than the new minimum tier
sizes. As the Commission previously found, when OTC market makers
were required to display only 100 shares regardless of the price of
the shares, the trading practices of active market makers were to
display higher liquidity than the minimum. See Securities Exchange
Act Release No. 32570 (July 1, 1993), 58 FR 36725 (July 8, 1993)
(Order Approving Proposed Rule Change by the National Association of
Securities Dealers, Inc. Relating to Quotation Size Requirements for
Market Makers in OTC Equity Securities).
---------------------------------------------------------------------------
Because of the uncertainty of the actual impact of FINRA's proposal
on market maker behavior, however, the Commission believes that it is
necessary to conduct a meaningful review of data collected during the
pilot period to credibly assess this aspect of the proposed rule
change.\149\ The Commission notes that, in Amendment No. 2, FINRA
committed to provide the Commission with specified data to assist the
Commission in its assessment of the impact of the pilot on the OTC
market.\150\ Further, FINRA committed to provide, at least 60 days
before the conclusion of the pilot, its own assessment of the impact of
the pilot, addressing the concerns raised by commenters regarding the
efficacy of the pilot in achieving its intended effects. Moreover,
FINRA committed to revisit the pilot program during its pendency should
an analysis of the data show degradation in liquidity and other factors
indicating that the revisions to the Rule are having an adverse effect
on OTC equity securities. Finally, the Commission notes that FINRA's
adjustment of the minimum quotation sizes in Amendment No. 1 was
designed to address some of the concerns expressed by commenters with
respect to the impact of the Original Proposal on the quality of the
OTC market.\151\
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\149\ With respect to the comment from Knight that the proposed
rule change would have an adverse impact on both dealers and
investors, the Commission preliminarily believes that the revised
proposal, as described in Amendment No. 1, would facilitate the
display of additional customer orders while still requiring a
reasonable commitment of liquidity from market makers. See Knight
Letter I at pp. 1-2.
\150\ In Amendment No. 2, FINRA committed to provide the
following data to the Commission, on a monthly basis, to allow its
staff to evaluate the impact of the pilot: the price of the first
trade of each trading day executed at or after 9:30:00 a.m., based
on execution time; the price of the last trade of each trading day
executed at or before 4:00:00 p.m., based on execution time; daily
share volume; daily dollar volume; number of limit orders from
customers and in total; percentage of day the size of the BBO (i.e.,
best bid and offer on FINRA's OTCBB facility and OTC Link) equals
minimum quote size; number of market makers actively quoting; number
of executions from a limit order and number of limit orders at the
BBO or better by tier size from a customer and in total; time-
weighted quoted spread; effective spread; time-weighted quoted depth
(number of shares) at the inside; and time-weighted quoted depth
(dollar value of shares) at the inside.
\151\ OTC Markets suggested that FINRA bolster liquidity in the
OTC equity market by allowing a broker-dealer that displays
liquidity in an OTC equity security and subsequently receives a
customer limit order in that security at a price equal to the firm's
proprietary quote to ''trade in parity'' with its customer. See OTC
Markets Letter V at p. 6. The Commission notes that this suggestion
would require FINRA to file a proposed rule change to amend FINRA
Rule 5320. FINRA Rule 5320 generally prohibits a member from trading
for its own account in an equity security, including OTC equity
securities, at a price that is equal to or better than an unexecuted
customer limit order in that security, unless the member immediately
thereafter executes the customer limit order at the price at which
it traded for its own account or better. Because an amendment to
Rule 5320 is not a matter currently before the Commission, the
Commission is not taking any action on such a proposal at this time.
---------------------------------------------------------------------------
Knight stated that the Commission should ``properly evaluate the
costs and benefits'' associated with FINRA's proposal and other SRO
proposed rule changes.\152\ Similarly, OTC Markets requested that the
Commission conduct a ``thorough economic analysis'' of the effects of
FINRA's proposal on the OTC market.\153\ As noted above, RSFI staff
conducted an empirical analysis relating to the potential effects of
FINRA's proposal on the display of customer limit orders and the
transaction costs for executed customer limit orders.\154\ In addition,
FINRA has committed to provide the Commission with data necessary to
evaluate the impact of the pilot on the OTC market, as well as with its
own assessment thereof. The Commission notes that interested persons
are welcome to submit additional comments and empirical evidence during
the pilot period with respect to, among other things, the operation of
the revised minimum quotation size requirements, their effectiveness in
achieving their intended goals, and the costs associated therewith. The
Commission will take such comments, as well as empirical evidence,
submitted by interested persons during the pilot period into account in
considering whether to approve, in accordance with Section 19(b) of the
Act, any FINRA proposed rule change that would make the pilot permanent
or would make any other changes to the pilot.
---------------------------------------------------------------------------
\152\ See Knight Letter II at p. 2.
\153\ See OTC Markets Letter V at p. 7.
\154\ See supra notes 133 and 134 and accompanying text.
---------------------------------------------------------------------------
D. Pilot Program
In letters commenting on the Original Proposal, Knight and OTC
Markets suggested that FINRA implement its revised minimum quotation
requirements as a pilot program.\155\ OTC Markets, for example, would
``support any action by the Commission to promote a pilot program to
better determine the effects of a change in tier sizes in the OTC
Market.'' \156\
---------------------------------------------------------------------------
\155\ See Knight Letter I at p. 2 and OTC Markets Letter IV at
p. 3.
\156\ See OTC Markets Letter IV at p. 3.
---------------------------------------------------------------------------
In response to these and other suggestions of commenters, FINRA
submitted Amendment No. 1 to revise the price and size tiers in
comparison to the Original Proposal and committed to operate the
revised Rule as a one-year pilot program. In responding to the
Commission's notice of Amendment No. 1,\157\ Knight offered its support
for a pilot program so that the impact of the revised Rule could be
evaluated.\158\ Knight, however, expressed the view that a three- to
four-month pilot program would suffice for FINRA to gather the
necessary data for its analysis. Knight remarked that the potential
impact of the newly-enacted JOBS Act must be considered in connection
with the proposed revisions to Rule 6433. Knight pointed to the
provision of the JOBS Act that requires the Commission to study the
impact of decimalization, including its impact on small and mid-sized
issuers' securities. Knight urged that the Commission's study of
minimum tick size requirements and FINRA's proposed minimum tier size
requirements for OTC equity securities be evaluated together.
---------------------------------------------------------------------------
\157\ See supra note 12 (Notice of Amendment No. 1).
\158\ See Knight Letter II at p. 2.
---------------------------------------------------------------------------
OTC Markets also submitted a comment letter in response to the
Commission's notice of Amendment No. 1.\159\ OTC Markets criticized the
revised proposal in Amendment No. 1 because, in OTC Markets' view,
FINRA did not include a substantial analysis to support its latest
proposed tier thresholds. OTC Markets stated that it conducted an
internal study that indicated that, under the proposal set forth in
Amendment No. 1, approximately 51% of the securities with priced quotes
on its OTC Link platform would experience considerable reductions in
liquidity. OTC Markets remarked that the Commission's impending tick
size study could incorporate an analysis of the effects of the amended
proposed rule change.
---------------------------------------------------------------------------
\159\ See OTC Markets Letter V.
---------------------------------------------------------------------------
The Commission notes that initially both Knight and OTC Markets
suggested that FINRA adopt the proposal on a pilot basis. Knight
continues to favor a pilot program, albeit for a period of time shorter
than the one year proposed by FINRA. OTC Markets, however, states that
FINRA and the Commission first should seek academics and economists to
conduct a study of the proposal and then consider a three-month pilot
[[Page 37469]]
program. As discussed above, the Commission preliminarily believes that
FINRA's proposed rule change should help facilitate the display of more
customer limit orders, and thereby increase transparency, promote
competition, and potentially narrow spreads and provide better
executions in the OTC market. In addition, by reducing the required
capital commitment of market makers per security, arguments can be made
that FINRA's proposal may enhance market making competition and further
reduce spreads. The Commission recognizes, however, that Knight and OTC
Markets have deep concerns about the impact of FINRA's proposal on the
quality of the OTC market. Although both FINRA and Commission staff
analyses have confirmed that FINRA's proposal should increase the
number of customer limit orders eligible for display, the Commission
believes that the uncertainty regarding the impact of FINRA's proposal
on market maker behavior warrants its implementation on a pilot basis.
During the pilot period, FINRA will submit the data and analysis
described in Amendment No. 2, which will afford the Commission an
opportunity to assess the proposal's impact on, among other things, the
liquidity of OTC equity securities. Although Knight and OTC Markets
were of the view that a one-year pilot period is too long, the
Commission believes that a one-year pilot is reasonable to allow the
Commission to meaningfully and reliably evaluate its impact of FINRA's
proposal on the market for OTC equity securities. In addition, the
Commission notes that, in Amendment No. 2, FINRA committed to monitor
the impact of the pilot and, if it concludes that the revised tier
sizes have a significant negative impact on the OTC market, including
on liquidity, to consider rescinding the pilot prior to its expiration.
Finally, both Knight and OTC Markets urged that the Commission
assess the impact of the proposed rule change in connection with the
tick size study mandated by the JOBS Act.\160\ Pursuant to the JOBS
Act, the Commission is required, among other things, to study the
impact that decimalization has had on the number of initial public
offerings, as well as on liquidity for small and middle capitalization
company securities. The Commission notes that FINRA's proposal
addresses the minimum quotation size requirements for OTC equity
securities, and not the pricing increments at which these securities
trade. The Commission recognizes that both minimum quotation size
requirements and minimum pricing increments can impact liquidity,
spreads and other core aspects of the OTC market in similar ways. The
Commission believes, however, that it is appropriate to approve FINRA's
proposal on a pilot basis to assess its impact on the market for OTC
equity securities.
---------------------------------------------------------------------------
\160\ See supra note 108.
---------------------------------------------------------------------------
E. Efficiency, Competition, and Capital Formation
Knight and OTC Markets stated that FINRA failed to consider the
proposed rule change in light of Section 3(f) of the Act.\161\ Section
3(f) requires that whenever, pursuant to the Act, the Commission is
engaged in rulemaking, or in the review of an SRO rule, and is required
to consider or determine whether an action is necessary or appropriate
in the public interest, the Commission shall also consider, in addition
to the protection of investors, whether the action will promote
efficiency, competition, and capital formation.
---------------------------------------------------------------------------
\161\ 15 U.S.C. 78c(f). See also OTC Markets Letter III at p. 2;
Knight Letter II at p. 1 (incorporating views of OTC Markets Letter
III); OTC Markets Letter IV at p. 2; OTC Markets Letter V at p. 5.
---------------------------------------------------------------------------
As discussed above, the Commission preliminarily believes that the
proposed rule change could promote efficiency \162\ by increasing the
transparency of customer limit orders \163\ and potentially narrowing
spreads and providing better executions.\164\ Currently, better-priced
customer limit orders need not be displayed if the size of those orders
is below the minimum quotation size for the pertinent OTC equity
security.\165\ Thus, customers who place such limit orders in a size
smaller than the applicable minimum quotation size would not be
entitled to have their orders displayed.
---------------------------------------------------------------------------
\162\ Knight expressed concern that the proposal ``could have
far-reaching effects on the liquidity and efficiency of the OTC
market * * *.'' See Knight Letter I at p. 2. OTC Markets expressed
concern regarding the ``potential negative effects on displayed
liquidity and costs related to the execution of marketable orders.''
See OTC Markets Letter IV at p. 2.
\163\ See NMS-Principled Rules Approval Order, supra note 4 at
37494 (``The Commission believes that extending limit order display
requirements to OTC Equity Securities is reasonably designed to
increase transparency in the market for OTC Equity Securities.'')
\164\ See id. (``As it has previously stated, the Commission
believes that limit orders are a valuable component of price
discovery, and that uniformly requiring display of such orders will
encourage tighter, deeper, and more efficient markets.''); see also
Order Handling Rules Release, supra note 135 at 48294 (``The display
of limit orders can be expected to narrow the bid-ask spread when
this buying and selling interest is priced better than publicly
disclosed prices.'').
\165\ Customer limit orders priced at the market maker's quote
also need not be displayed depending on whether the size of the
customer limit order is de minimus and whether the market maker's
quote is at the best bid or offer. See FINRA Rule 6460.
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The Commission preliminarily believes that, by increasing the
display of customer limit orders, spreads in OTC equity securities
could be narrowed, allowing market participants to trade at better
prices.\166\ In addition, although further consideration will be given
to the actual impact of the proposed rule change on efficiency during
the pilot period, FINRA's proposal--by reducing the required per
security capital commitment by market makers\167\--could incent market
makers to make markets in a wider range of OTC equity securities,
potentially reducing spreads and increasing liquidity.
---------------------------------------------------------------------------
\166\ See NMS-Principled Rules Approval Order, supra note 4 at
37494. See also generally Michael J. Barclay, et al., Effects of
Market Reform on the Trading Costs and Depths of Nasdaq Stocks,
Journal of Finance (May 6, 2003); Foucault, et al., Working Paper:
Limit Order Book as a Market for Liquidity (May 30, 2001) (available
at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=269908).
\167\ See NMS-Principled Rules Approval Order (``The Commission
notes that FINRA's limit order display proposal acknowledges the
role that market makers traditionally have played in providing price
discovery and liquidity to the OTC Equity Securities market.'').
---------------------------------------------------------------------------
The Commission further preliminarily believes that the proposed
rule could enhance competition by increasing the number of customer
limit orders that are displayed to the market, thereby increasing quote
competition and the likelihood of price improvement for OTC equity
securities.\168\ The Commission acknowledges that the narrowing of
spreads that result from the increased display of customer limit orders
could result in decreased profits for market makers, thus making them
less willing to provide liquidity to the marketplace.\169\ However, as
discussed above, the decrease in the minimum quotation size
requirements also could
[[Page 37470]]
result in increased quoting by market makers because of the reduced
capital commitment required per security, and thus increase competition
among market makers. As with the proposal's effects on efficiency, the
Commission will give further consideration to the actual impact of the
proposed rule change on competition during the pilot period.
---------------------------------------------------------------------------
\168\ See id. See also Order Handling Rules Release, supra note
135 at 48294 (``The uniform display of limit orders also will lead
to increased quote-based competition. Market makers will not only be
competing amongst themselves, but also against customer limit orders
represented in the quote.''). See also generally Michael J. Barclay,
et al., Effects of Market Reform on the Trading Costs and Depths of
Nasdaq Stocks, Journal of Finance (May 6, 2003); Jeffrey Smith, The
Effects of Order Handling Rules and 16ths on Nasdaq: a Cross-
sectional Analysis, NASD Working Paper 98-02 (October 29, 1998).
\169\ See Amendment No. 2, supra note 14 at p. 8. See also
Knight Letter I at p. 2 (``we do have concerns that any increase in
costs to market making liquidity providers may further result in
additional departures of market makers * * * .''); OTC Markets
Letter III at p. 6 (``Smaller tier sizes also have the effect of
reducing passive liquidity providers that create additional
liquidity by competing at the inside price for investor executions,
as the liquidity is based on a multiple of the inside size.'').
---------------------------------------------------------------------------
The Commission also has considered whether the proposed rule change
would promote capital formation.\170\ The Commission notes that
increased display of customer limit orders could result in narrower
spreads which, in turn, could attract more investors to the
marketplace. Increased investor activity could result in more efficient
pricing and increased liquidity. Efficient pricing and increased
liquidity could make the OTC marketplace a more attractive venue for
capital formation, benefiting small issuers.\171\ However, if the
revised tier sizes result in less activity by market makers, overall
liquidity in the marketplace could decline. Such a decline could result
in increased volatility and less efficient pricing for OTC equity
securities. As a result, the OTC marketplace could become a less
attractive venue for capital formation and thus negatively impact
smaller issuers. The Commission preliminarily believes the overall
impact of the proposal on the OTC marketplace will not be significantly
negative or positive, but will monitor the impact of the revised tier
sizes in connection with the pilot program.
---------------------------------------------------------------------------
\170\ See OTC Markets Letter III at p. 4 (``tier sizes should be
designed to create the optimum balance to maximize marketplace
efficiency and capital formation'').
\171\ See Amendment No. 1, supra note 12 at p. 6, in which FINRA
stated that ``the improved display of customer limit orders
resulting from the revised minimum quotation sizes will enhance the
quality of published quotations for OTC Equity Securities and
enhance competition and pricing efficiency in the market for OTC
Equity Securities, which also should have a positive impact on
capital formation.''
---------------------------------------------------------------------------
VI. Accelerated Approval
The Commission finds goods cause, pursuant to Section 19(b)(2) of
the Exchange Act,\172\ for approving the proposed rule change, as
modified by Amendment Nos. 1 and 2 thereto, prior to the 30th day after
publication of notice of the filing of Amendment No. 2 in the Federal
Register. The proposed rule change, as amended, was informed by FINRA's
consideration and incorporation of many suggestions made in comments to
the Original Proposal, the Order Instituting Proceedings and Amendment
No. 1. Amendment No. 2 reflects FINRA's efforts to adjust its proposal
to better address commenters' concerns and allow the impact of its
proposal to be studied on a pilot basis. The proposed rule change, as
amended, will allow the Commission to further consider, during the
pilot period, issues raised by commenters with respect to certain
aspects of the proposal, and to benefit from actual experience with the
revised tier sizes that are being approved today on a pilot basis. Such
further consideration will allow the Commission to consider whether
modifications to the proposal are warranted prior to any decision to
approve it on a permanent basis.
---------------------------------------------------------------------------
\172\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------
Accordingly, the Commission finds that good cause exists to approve
the proposal, as modified by Amendment Nos. 1 and 2, on an accelerated
basis.
VII. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing, including whether Amendment No. 2
to the proposed rule change is consistent with the Act. Comments may be
submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
Send an email to [email protected]. Please include
File Number SR-FINRA-2011-058 on the subject line.
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 Number SR-FINRA-2011-058. This
file number should be included on the subject line if email is used.
To help the Commission 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/sro.shtml). Copies of the submission, all subsequent amendments,
all written statements with respect to the proposed rule change that
are filed with the Commission, and all written communications relating
to the proposed rule change between the Commission and any person,
other than those that may be withheld from the public in accordance
with the provisions of 5 U.S.C. 552, will be available for Web site
viewing and printing in the Commission's Public Reference Room on
official business days between the hours of 10:00 a.m. and 3:00 p.m.
Copies of such filing also will be available for inspection and copying
at the principal office of FINRA. All comments received will be posted
without change; the Commission does not edit personal identifying
information from submissions. You should submit only information that
you wish to make available publicly. All submissions should refer to
File Number SR-FINRA-2011-058, and should be submitted on or before
July 12, 2012.
VIII. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\173\ that the proposed rule change (SR-FINRA-2011-058), as
modified by Amendment Nos. 1 and 2, be, and hereby is, approved on an
accelerated basis as a one-year pilot.
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\173\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\174\
---------------------------------------------------------------------------
\174\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2012-15126 Filed 6-20-12; 8:45 am]
BILLING CODE 8011-01-P