Concept Release on Equity Market Structure, 3594-3614 [2010-1045]
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Federal Register / Vol. 75, No. 13 / Thursday, January 21, 2010 / Proposed Rules
SECURITIES AND EXCHANGE
COMMISSION
17 CFR Part 242
[Release No. 34–61358; File No. S7–02–10]
RIN 3235–AK47
Concept Release on Equity Market
Structure
AGENCY: Securities and Exchange
Commission.
ACTION: Concept release; request for
comments.
SUMMARY: The Securities and Exchange
Commission (‘‘Commission’’) is
conducting a broad review of the
current equity market structure. The
review includes an evaluation of equity
market structure performance in recent
years and an assessment of whether
market structure rules have kept pace
with, among other things, changes in
trading technology and practices. To
help further its review, the Commission
is publishing this concept release to
invite public comment on a wide range
of market structure issues, including
high frequency trading, order routing,
market data linkages, and undisplayed,
or ‘‘dark,’’ liquidity. The Commission
intends to use the public’s comments to
help determine whether regulatory
initiatives to improve the current equity
market structure are needed and, if so,
the specific nature of such initiatives.
DATES: Comments should be received on
or before April 21, 2010.
ADDRESSES: Comments may be
submitted by any of the following
methods:
Electronic Comments:
• Use the Commission’s Internet
comment form (https://www.sec.gov/
rules/proposed.shtml); or
• Send an e-mail to rulecomments@sec.gov. Please include File
No. S7–02–10 on the subject line; or
• Use the Federal eRulemaking Portal
(https://www.regulations.gov). Follow the
instructions for submitting comments.
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Paper Comments:
• Send paper comments in triplicate
to Elizabeth M. Murphy, Secretary,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–1090.
All submissions should refer to File No.
S7–02–10. This file number should be
included on the subject line if e-mail is
used. To help us process and review
your comments more efficiently, please
use only one method. The Commission
will post all comments on the
Commission’s Internet Web site (https://
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www.sec.gov/rules/proposed.shtml).
Comments are also available for public
inspection and copying in the
Commission’s Public Reference Room,
100 F Street, NE., Washington, DC
20549 on official business days between
the hours of 10 a.m. and 3 p.m. All
comments received will be posted
without change; we do not edit personal
identifying information from
submissions. You should submit only
information that you wish to make
available publicly.
FOR FURTHER INFORMATION CONTACT:
Arisa Tinaves, Special Counsel, at (202)
551–5676, Gary M. Rubin, Attorney, at
(202) 551–5669, Division of Trading and
Markets, Securities and Exchange
Commission, 100 F Street, NE.,
Washington, DC 20549–7010.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. Exchange Act Requirements for a National
Market System
III. Overview of Current Market Structure
A. Trading Centers
1. Registered Exchanges
2. ECNs
3. Dark Pools
4. Broker-Dealer Internalization
B. Linkages
1. Consolidated Market Data
2. Trade-Through Protection
3. Broker Routing Services
IV. Request for Comments
A. Market Structure Performance
1. Long-Term Investors
a. Market Quality Metrics
b. Fairness of Market Structure
2. Other Measures
B. High Frequency Trading
1. Strategies
a. Passive Market Making
b. Arbitrage
c. Structural
d. Directional
2. Tools
a. Co-Location
b. Trading Center Data Feeds
3. Systemic Risks
C. Undisplayed Liquidity
1. Order Execution Quality
2. Public Price Discovery
3. Fair Access and Regulation of ATSs
D. General Request for Comments
I. Introduction
The secondary market for U.S.-listed
equities has changed dramatically in
recent years. In large part, the change
reflects the culmination of a decadeslong trend from a market structure with
primarily manual trading to a market
structure with primarily automated
trading. When Congress mandated the
establishment of a national market
system for securities in 1975, trading in
U.S.-listed equities was dominated by
exchanges with manual trading floors.
Trading equities today is no longer as
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straightforward as sending an order to
the floor of a single exchange on which
a stock is listed. As discussed in section
III below, the current market structure
can be described as dispersed and
complex: (1) Trading volume is
dispersed among many highly
automated trading centers that compete
for order flow in the same stocks; and
(2) trading centers offer a wide range of
services that are designed to attract
different types of market participants
with varying trading needs.
A primary driver and enabler of this
transformation of equity trading has
been the continual evolution of
technologies for generating, routing, and
executing orders. These technologies
have dramatically improved the speed,
capacity, and sophistication of the
trading functions that are available to
market participants. Changes in market
structure also reflect the markets’
response to regulatory actions such as
Regulation NMS, adopted in 2005,1 the
Order Handling Rules, adopted in
1996,2 as well as enforcement actions,
such as those addressing anticompetitive behavior by market makers
in NASDAQ stocks.3
The transformation of equity trading
has encompassed all types of U.S.-listed
stocks. In recent years, however, it is
perhaps most apparent in stocks listed
on the New York Stock Exchange
(‘‘NYSE’’), which constitute nearly 80%
of the capitalization of the U.S. equity
markets.4 In contrast to stocks listed on
the NASDAQ Stock Market LLC
(‘‘NASDAQ’’), which for more than a
decade have been traded in a highly
automated fashion at many different
trading centers,5 NYSE-listed stocks
were traded primarily on the floor of the
NYSE in a manual fashion until October
2006. At that time, NYSE began to offer
1 Securities Exchange Act Release No. 51808
(June 9, 2005), 70 FR 37496 (June 29, 2005)
(‘‘Regulation NMS Release’’).
2 Securities Exchange Act Release No. 37619A
(September 6, 1996), 61 FR 48290 (September 12,
1996) (‘‘Order Handling Rules Release’’).
3 See, e.g., In the Matter of National Association
of Securities Dealers, Inc., Administrative
Proceeding File No. 3–9056, Securities Exchange
Act Release No. 37538 (August 8, 1996).
4 In November 2009, for example, NYSE-listed
stocks represented approximately 78% of the
market capitalization of the Wilshire 5000 Total
Market Index. Wilshire Associates, https://
wilshire.com/Indexes/Broad/Wilshire5000/
Characteristics.html (November 17, 2009).
5 NASDAQ itself offered limited automated
execution functionality until the introduction of
SuperMontage in 2002. See Securities Exchange Act
Release No. 46429 (August 29, 2002), 67 FR 56862
(September 5, 2002) (Order with Respect to the
Implementation of NASDAQ’s SuperMontage
Facility). Prior to 2002, however, many electronic
communication networks (‘‘ECNs’’) and market
makers trading NASDAQ stocks provided
predominantly automated executions.
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protection for manual quotations that
nearly all commenters believed was
seriously outdated.7
The changes in the nature of trading
for NYSE-listed stocks have been
BILLING CODE 8011–01–C
Figure 1—NYSE executed
approximately 79.1% of the
consolidated share volume in its listed
stocks in January 2005, compared to
25.1% in October 2009.8
Figure 2—NYSE’s average speed of
execution for small, immediately
executable (marketable) orders was 10.1
6 See Securities Exchange Act Release No. 53539
(March 22, 2006), 71 FR 16353 (March 31, 2006)
(File No. SR–NYSE–2004–05) (approving proposal
to create a ‘‘Hybrid Market’’ by, among other things,
increasing the availability of automated executions);
Pierre Paulden, Keep the Change, Institutional
Investor (December 19, 2006) (‘‘Friday, October 6,
was a momentous day for the New York Stock
Exchange. That morning the Big Board broke with
214 years of tradition when it began phasing in a
new hybrid market structure that can execute trades
electronically, bypassing face-to-face auctions on its
famed floor.’’). Prior to the Hybrid Market, NYSE
offered limited automated executions.
7 Regulation NMS Release, 70 FR at 37505 n. 55
(‘‘Nearly all commenters, both those supporting and
opposing the need for an intermarket trade-through
rule, agreed that the current ITS trade-through
provisions are seriously outdated and in need of
reform. They particularly focused on the problems
created by affording equal protection against tradethroughs to both automated and manual
quotations.’’).
8 NYSE Euronext, ‘‘NYSE Euronext Announces
Trading Volumes for October 2009 (November 6,
2009) (‘‘Tape A matched market share for NYSE was
25.1% in October 2009, above the 24.5% market
share reported in October 2008’’) (available at https://
www.nyse.com/press/125741917814.html);
Securities Exchange Act Release No. 59039
(December 2, 2008), 73 FR 74770, 74782 (December
9, 2008) (File No. SR–NYSEArca–2006–21) (‘‘Given
the competitive pressures that currently
characterize the U.S. equity markets, no exchange
can afford to take its market share percentages for
granted—they can change significantly over time,
either up or down. * * * For example, the NYSE’s
reported market share of trading in NYSE-listed
stocks declined from 79.1% in January 2005 to
30.6% in June 2008.’’) (citations omitted).
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extraordinary, as indicated by the
comparisons of trading in 2005 and
2009 in Figures 1 through 5 below:
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fully automated access to its displayed
quotations.6 An important impetus for
this change was the Commission’s
adoption of Regulation NMS in 2005,
which eliminated the trade-through
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seconds in January 2005, compared to
0.7 seconds in October 2009.9
Figure 3—Consolidated average daily
share volume in NYSE-listed stocks was
2.1 billion shares in 2005, compared to
5.9 billion shares (an increase of 181%)
in January through October 2009.10
Figure 4—Consolidated average daily
trades in NYSE-listed stocks was 2.9
million trades in 2005, compared to 22.1
million trades (an increase of 662%) in
January through October 2009.11
Figure 5—Consolidated average trade
size in NYSE-listed stocks was 724
shares in 2005, compared to 268 shares
in January through October 2009.12
The foregoing statistics for NYSElisted stocks are intended solely to
illustrate the sweeping changes that are
characteristic of trading in all U.S.-listed
equities, including NASDAQ-listed
stocks and other equities such as
exchange-traded funds (‘‘ETFs’’). They
are not intended to indicate whether
these changes have led to a market
structure that is better or worse for longterm investors—an important issue on
which comment is requested in section
IV.A.1 below. Rather, the statistics for
NYSE-listed stocks provide a useful
illustration simply because the changes
occurred both more rapidly and more
recently for NYSE-listed stocks than
other types of U.S.-listed equities.
To more fully understand the effects
of these and other changes in equity
trading, the Commission is conducting a
comprehensive review of equity market
structure. It is assessing whether market
structure rules have kept pace with,
among other things, changes in trading
technology and practices. The review
already has led to several rulemaking
proposals that address particular issues
and that are intended primarily to
preserve the integrity of longstanding
market structure principles. One
proposal would eliminate the exception
for flash orders from the Securities
Exchange Act of 1934 (‘‘Exchange Act’’)
9 NYSE Euronext, Rule 605 Reports for January
2005 and October 2009 (available at https://
www.nyse.com/equities/nyseequities/
1201780422054.html) (NYSE average speed of
execution for small (100–499 shares) market orders
and marketable limit orders was 10.1 seconds in
January 2005 and 0.7 seconds in October 2009).
10 NYSE Euronext, Consolidated Volume in NYSE
Listed Issues 2000–2009 (available at https://
www.nyxdata.com/nysedata/NYSE/FactsFigures/
tabid/115/Default.aspx).
11 NYSE Euronext, Consolidated Volume in NYSE
Listed Issues 2000–2009 (available at https://
www.nyxdata.com/nysedata/NYSE/FactsFigures/
tabid/115/Default.aspx).
12 NYSE Euronext, Consolidated Volume in NYSE
Listed Issues 2000–2009 (available at https://
www.nyxdata.com/nysedata/NYSE/FactsFigures/
tabid/115/Default.aspx).
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quoting requirements.13 Another would
address certain practices associated
with non-public trading interest,
including dark pools of liquidity.14 In
addition, the Commission today is
proposing for public comment an
additional market structure initiative to
address the risk management controls of
broker-dealers with market access.15
The Commission is continuing its
review. It recognizes that market
structure issues are complex and require
a broad understanding of statutory
requirements, economic principles, and
practical trading considerations. Given
this complexity, the Commission
believes that its review would be greatly
assisted by receiving the benefit of
public comment on a broad range of
market structure issues. It particularly is
interested in hearing the views of all
types of investors and other market
participants and in receiving as much
data and analysis as possible in support
of commenters’ views.
Commenters’ views on both the
strengths and weaknesses of the current
market structure are sought. Views on
both strengths and weaknesses can help
identify new initiatives that would
enhance the strengths or improve on the
weaknesses, avoid changes that would
unintentionally cause more harm than
good, and suggest whether any current
rules are no longer necessary or are
counterproductive to the objectives of
the Exchange Act. As discussed in
section II below, Congress mandated
that the national market system should
achieve a range of objectives—efficient
execution of transactions, fair
competition among markets, price
transparency, best execution of investor
orders, and the interaction of investor
orders when consistent with efficiency
and best execution. Additionally, the
Commission’s mission includes the
protection of investors and the
facilitation of capital formation.
Appropriately achieving each of these
objectives requires a balanced market
structure that can accommodate a wide
range of participants and trading
strategies.
This release is intended to facilitate
public comment by first giving a basic
overview of the legal and factual
elements of the current equity market
structure and then presenting a wide
range of issues for comment. The
Commission cautions that it has not
13 Securities Exchange Act Release No. 60684
(September 18, 2009), 74 FR 48632 (September 23,
2009) (‘‘Flash Order Release’’).
14 Securities Exchange Act Release No. 60997
(November 13, 2009), 74 FR 61208 (November 23,
2009) (‘‘Non-Public Trading Interest Release’’).
15 Securities Exchange Act Release No. [citation
unavailable] (‘‘Market Access Release’’).
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reached any final conclusions on the
issues presented for comment. The
discussion and questions in this release
should not be interpreted as slanted in
any particular way on any particular
issue. The Commission intends to
consider carefully all comments and to
complete its review in a timely fashion.
At that point, it will determine whether
there are any problems that require a
regulatory initiative and, if so, the
nature of that initiative. Moreover, a
new regulatory requirement would first
be published in the form of a proposal
that would give the public an
opportunity to comment on the specifics
of the proposal prior to adoption.
II. Exchange Act Requirements for a
National Market System
In Section 11A of the Exchange Act,16
Congress directed the Commission to
facilitate the establishment of a national
market system in accordance with
specified findings and objectives. The
initial Congressional findings were that
the securities markets are an important
national asset that must be preserved
and strengthened, and that new data
processing and communications
techniques create the opportunity for
more efficient and effective market
operations. Congress then proceeded to
mandate a national market system
composed of multiple competing
markets that are linked through
technology. In particular, Congress
found that it is in the public interest and
appropriate for the protection of
investors and the maintenance of fair
and orderly markets to assure five
objectives:
(1) Economically efficient execution
of securities transactions;
(2) Fair competition among brokers
and dealers, among exchange markets,
and between exchange markets and
markets other than exchange markets;
(3) The availability to brokers, dealers,
and investors of information with
respect to quotations and transactions in
securities;
(4) The practicability of brokers
executing investors’ orders in the best
market; and
(5) An opportunity, consistent with
efficiency and best execution, for
investors’ orders to be executed without
the participation of a dealer.
The final Congressional finding was
that these five objectives would be
fostered by the linking of all markets for
qualified securities through
communication and data processing
facilities. Specifically, Congress found
that such linkages would foster
efficiency; enhance competition;
16 15
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increase the information available to
brokers, dealers, and investors; facilitate
the offsetting (matching) of investors’
orders; and contribute to the best
execution of investors’ orders.
Over the years, these findings and
objectives have guided the Commission
as it has sought to keep market structure
rules up-to-date with continually
changing economic conditions and
technology advances. This task has
presented certain challenges because, as
noted previously by the Commission,
the five objectives set forth in Section
11A can, at times, be difficult to
reconcile.17 In particular, the objective
of matching investor orders, or ‘‘order
interaction,’’ can be difficult to reconcile
with the objective of promoting
competition among markets. Order
interaction promotes a system that
‘‘maximizes the opportunities for the
most willing seller to meet the most
willing buyer.’’ 18 When many trading
centers compete for order flow in the
same stock, however, such competition
can lead to the fragmentation of order
flow in that stock. Fragmentation can
inhibit the interaction of investor orders
and thereby impair certain efficiencies
and the best execution of investors’
orders. Competition among trading
centers to provide specialized services
for investors also can lead to practices
that may detract from public price
transparency. On the other hand,
mandating the consolidation of order
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17 See, e.g., Securities Exchange Act Release No.
42450 (February 3, 2000), 65 FR 10577, 10580
(February 28, 2000) (‘‘Fragmentation Concept
Release’’) (‘‘[A]lthough the objectives of vigorous
competition on price and fair market center
competition may not always be entirely congruous,
they both serve to further the interests of investors
and therefore must be reconciled in the structure of
the national market system.’’).
18 H.R. Rep. 94–123, 94th Cong., 1st Sess. 50
(1975).
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flow in a single venue would create a
monopoly and thereby lose the
important benefits of competition
among markets. The benefits of such
competition include incentives for
trading centers to create new products,
provide high quality trading services
that meet the needs of investors, and
keep trading fees low.
The Commission’s task has been to
facilitate an appropriately balanced
market structure that promotes
competition among markets, while
minimizing the potentially adverse
effects of fragmentation on efficiency,
price transparency, best execution of
investor orders, and order interaction.19
An appropriately balanced market
structure also must provide for strong
investor protection and enable
businesses to raise the capital they need
to grow and to benefit the overall
economy. Given the complexity of this
task, there clearly is room for reasonable
disagreement as to whether the market
structure at any particular time is, in
fact, achieving an appropriate balance of
these multiple objectives. Accordingly,
the Commission believes it is important
to monitor these issues and,
periodically, give the public, including
the full range of investors and other
market participants, an opportunity to
19 See
S. Rep. 94–75, 94th Cong., 1st Sess. 2
(1975) (‘‘S. 249 would lay the foundation for a new
and more competitive market system, vesting in the
SEC power to eliminate all unnecessary or
inappropriate burdens on competition while at the
same time granting to that agency complete and
effective powers to pursue the goal of centralized
trading of securities in the interest of both
efficiency and investor protection.’’); Regulation
NMS Release, 70 FR at 37499 (‘‘Since Congress
mandated the establishment of an NMS in 1975, the
Commission frequently has resisted suggestions that
it adopt an approach focusing on a single form of
competition that, while perhaps easier to
administer, would forfeit the distinct, but equally
vital, benefits associated with both competition
among markets and competition among orders.’’).
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submit their views on the matter. This
concept release is intended to provide
such an opportunity.
III. Overview of Current Market
Structure
This section provides a brief overview
of the current equity market structure. It
first describes the various types of
trading centers that compete for order
flow in NMS stocks 20 and among which
liquidity is dispersed. It then describes
the primary types of linkages between or
involving these trading centers that are
designed to enable market participants
to trade effectively. This section
attempts to highlight the features of the
current equity market structure that may
be most salient in presenting issues for
public comment and is not intended to
serve as a full description of the U.S.
equity markets.
A. Trading Centers
A good place to start in describing the
current market structure is by
identifying the major types of trading
centers and giving a sense of their
current share of trading volume in NMS
stocks. Figure 6 below provides this
information with estimates of trading
volume in September 2009: 21
Figure 6
Trading Centers and Estimated % of
Share Volume in NMS Stocks
September 2009
20 Rule 600(b)(47) of Regulation NMS defines
‘‘NMS stock’’ to mean any NMS security other than
an option. Rule 600(b)(46) defines ‘‘NMS security’’
to mean any security for which trade reports are
made available pursuant to an effective transaction
reporting plan. In general, NMS stocks are those
that are listed on a national securities exchange.
21 Sources of estimated trading volume
percentages: NASDAQ; NYSE Group; BATS; Direct
Edge; data compiled from Forms ATS for 3d quarter
2009.
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Registered Exchanges
NASDAQ .......................................
NYSE ............................................
NYSE Arca ...................................
BATS ............................................
NASDAQ OMX BX .......................
Other .............................................
19.4
14.7
13.2
9.5
3.3
3.7
Total Exchange .....................
63.8
registered exchanges and ECNs.24 These
displayed trading centers execute
approximately 74.6% of share volume.
Figure 6 also identifies two types of
undisplayed trading centers—dark pools
and broker-dealers that execute trades
internally—that execute approximately
25.4% of share volume. These four
types of trading centers are described
below.
1. Registered Exchanges
ECNs
Registered exchanges collectively
execute approximately 63.8% of share
volume in NMS stocks, with no single
exchange executing more than 19.4%.
Total ECN ..............................
10.8 Registered exchanges must undertake
self-regulatory responsibility for their
Total Displayed Trading Cenmembers and file their proposed rule
ter .......................................
74.6 changes for approval with the
Commission. These proposed rule
Dark Pools
changes publicly disclose, among other
Approximately 32 22 ......................
7.9 things, the trading services and fees of
exchanges.
Broker-Dealer Internalization
The registered exchanges all have
adopted highly automated trading
23 ..........................
More than 200
17.5 systems that can offer extremely highspeed, or ‘‘low-latency,’’ order responses
Total Undisplayed Trading
Center ................................
25.4 and executions. Published average
response times at some exchanges, for
example, have been reduced to less than
Figure 6 identifies two types of
1 millisecond.25 Many exchanges offer
trading centers that display quotations
in the consolidated quotation data that
24 Consolidated quotation data is described in
is widely distributed to the public—
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2 Direct Edge ................................
3 Others ........................................
9.8
1.0
22 Data compiled from Forms ATS submitted to
Commission for 3d quarter 2009.
23 More than 200 broker-dealers (excluding ATSs)
have identified themselves to FINRA as market
centers that must provide monthly reports on order
execution quality under Rule 605 of Regulation
NMS (list available at https://apps.finra.org/
datadirectory/1/marketmaker.aspx).
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section III.B.1. below.
25 See, e.g., BATS Exchange, Inc., https://
batstrading.com/resources/features/
bats_exchange_Latency.pdf (June 2009) (average
latency (time to accept, process, and acknowledge
or fill order) of 320 microseconds; NASDAQ,
https://www.nasdaqtrader.com/trader.aspx?id=inet
(December 12, 2009) (average latency (time to
accept, process, and acknowledge or fill order) of
294 microseconds).
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individual data feeds that deliver
information concerning their orders and
trades directly to customers. To further
reduce latency in transmitting market
data and order messages, many
exchanges also offer co-location services
that enable exchange customers to place
their servers in close proximity to the
exchange’s matching engine. Exchange
data feeds and co-location services are
discussed further in section IV.B.2.
below.
Registered exchanges typically offer a
wide range of order types for trading on
their automated systems. Some of their
order types are displayable in full if
they are not executed immediately.
Others are undisplayed, in full or in
part. For example, a reserve order type
will display part of the size of an order
at a particular price, while holding the
balance of the order in reserve and
refreshing the displayed size as needed.
In general, displayed orders are given
execution priority at any given price
over fully undisplayed orders and the
undisplayed size of reserve orders.26
In addition, many exchanges have
adopted a ‘‘maker-taker’’ pricing model
in an effort to attract liquidity providers.
Under this model, non-marketable,
26 See, e.g., BATS Exchange, Inc., Rule 11.12
(equally priced trading interest executed in time
priority in the following order: (1) Displayed size
of limit orders; (2) non-displayed limit orders; (3)
pegged orders; (4) mid-point peg orders; (5) reserve
size of orders; and (6) discretionary portion of
discretionary orders); NASDAQ Rule 4757(a)(1)
(book processing algorithm executes trading interest
in the following order: (1) Displayed orders; (2)
non-displayed orders and the reserve portion of
quotes and reserve orders (in price/time priority
among such interest); and (3) the discretionary
portion of discretionary orders.
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resting orders that offer (make) liquidity
at a particular price receive a liquidity
rebate if they are executed, while
incoming orders that execute against
(take) the liquidity of resting orders are
charged an access fee. Rule 610(c) of
Regulation NMS caps the amount of the
access fee for executions against the best
displayed prices of an exchange at 0.3
cents per share. Exchanges typically
charge a somewhat higher access fee
than the amount of their liquidity
rebates, and retain the difference as
compensation. Sometimes, however,
exchanges have offered ‘‘inverted’’
pricing and pay a liquidity rebate that
exceeds the access fee.
Highly automated exchange systems
and liquidity rebates have helped
establish a business model for a new
type of professional liquidity provider
that is distinct from the more traditional
exchange specialist and over-thecounter (‘‘OTC’’) market maker. In
particular, proprietary trading firms and
the proprietary trading desks of multiservice broker-dealers now take
advantage of low-latency systems and
liquidity rebates by submitting large
numbers of non-marketable orders
(often cancelling a very high percentage
of them), which provide liquidity to the
market electronically. As discussed in
section IV.B. below, these proprietary
traders often are labeled high-frequency
traders, though the term does not have
a settled definition and may encompass
a variety of strategies in addition to
passive market making.
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2. ECNs
The five ECNs that actively trade
NMS stocks collectively execute
approximately 10.8% of share volume.
Almost all ECN volume is executed by
two ECNs operated by Direct Edge,
which has submitted applications for
registration of its two trading platforms
as exchanges.27 ECNs are regulated as
alternative trading systems (‘‘ATSs’’).
Regulation of ATSs is discussed in the
next section below in connection with
dark pools, which also are ATSs. The
key characteristic of an ECN is that it
provides its best-priced orders for
inclusion in the consolidated quotation
data, whether voluntarily or as required
by Rule 301(b)(3) of Regulation ATS. In
general, ECNs offer trading services
(such as displayed and undisplayed
order types, maker-taker pricing, and
data feeds) that are analogous to those
of registered exchanges.
27 Securities Exchange Act Release No. 60651
(September 11, 2009), 74 FR 47827 (September 17,
2009) (Notice of filing of applications for
registration as national securities exchanges by
EDGX Exchange, Inc. and EDGA Exchange, Inc.).
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3. Dark Pools
Dark pools are ATSs that, in contrast
to ECNs, do not provide their bestpriced orders for inclusion in the
consolidated quotation data. In general,
dark pools offer trading services to
institutional investors and others that
seek to execute large trading interest in
a manner that will minimize the
movement of prices against the trading
interest and thereby reduce trading
costs.28 There are approximately 32
dark pools that actively trade NMS
stocks, and they executed
approximately 7.9% of share volume in
NMS stocks in the third quarter of
2009.29 ATSs, both dark pools and
ECNs, fall within the statutory
definition of an exchange, but are
exempted if they comply with
Regulation ATS. Regulation ATS
requires ATSs to be registered as brokerdealers with the Commission, which
entails becoming a member of the
Financial Industry Regulatory Authority
(‘‘FINRA’’) and fully complying with the
broker-dealer regulatory regime. Unlike
a registered exchange, an ATS is not
required to file proposed rule changes
with the Commission or otherwise
publicly disclose its trading services
and fees. ATSs also do not have any
self-regulatory responsibilities, such as
market surveillance. The regulatory
differences between registered
exchanges and ATSs are addressed
further in section IV.C.3. below.
Dark pools can vary quite widely in
the services they offer their customers.
For example, some dark pools, such as
block crossing networks, offer
specialized size discovery mechanisms
that attempt to bring large buyers and
sellers in the same NMS stock together
anonymously and to facilitate a trade
between them. The average trade size of
these block crossing networks can be as
high as 50,000 shares.30 Most dark
pools, though they may handle large
orders, primarily execute trades with
small sizes that are more comparable to
the average size of trades in the public
markets, which was less than 300 shares
28 See Non-Public Trading Interest Release, 74 FR
at 61208–61209.
29 Data compiled from Forms ATS submitted to
Commission for 3d quarter 2009. Some OTC market
makers offer dark liquidity primarily in a principal
capacity and do not operate as ATSs. For purposes
of this release, these trading centers are not defined
as dark pools because they are not ATSs. These
trading centers may, however, offer electronic dark
liquidity services that are analogous to those offered
by dark pools.
30 See, e.g., https://www.liquidnet.com/about/
liquidStats.html (average U.S. execution size in July
2009 was 49,638 shares for manually negotiated
trades via Liquidnet’s negotiation product); https://
www.pipelinetrading.com/AboutPipeline/
CompanyInfo.aspx (average trade size of 50,000
shares in Pipeline).
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3599
in July 2009.31 These dark pools that
primarily match smaller orders (though
the matched orders may be ‘‘child’’
orders of much larger ‘‘parent’’ orders)
execute more than 90% of dark pool
trading volume.32 The majority of this
volume is executed by dark pools that
are sponsored by multi-service brokerdealers. These broker-dealers also offer
order routing services, trade as principal
in the sponsored ATS, or both.
4. Broker-Dealer Internalization
The other type of undisplayed trading
center is a non-ATS broker-dealer that
internally executes trades, whether as
agent or principal. Notably, many
broker-dealers may submit orders to
exchanges or ECNs, which then are
included in the consolidated quotation
data. The internalized executions of
broker-dealers, however, primarily
reflect liquidity that is not included in
the consolidated quotation data. Brokerdealer internalization accordingly
should be classified as undisplayed
liquidity. There are a large number of
broker-dealers that execute trades
internally in NMS stocks—more than
200 publish execution quality statistics
under Rule 605 of Regulation NMS.33
Broker-dealer internalization accounts
for approximately 17.5% of share
volume in NMS stocks.
Broker-dealers that internalize
executions generally fall into two
categories—OTC market makers and
block positioners. An OTC market
maker is defined in Rule 600(b)(52) of
Regulation NMS as ‘‘any dealer that
holds itself out as being willing to buy
and sell to its customers, or others, in
the United States, an NMS stock for its
own account on a regular or continuous
basis otherwise than on a national
securities exchange in amounts of less
than block size.’’ ‘‘Block size’’ is defined
in Rule 600(b)(9) as an order of at least
10,000 shares or for a quantity of stock
having a market value of at least
$200,000. A block positioner generally
means any broker-dealer in the business
of executing, as principal or agent, block
size trades for its customers. To
facilitate trades, block positioners often
commit their own capital to trade as
principal with at least some part of the
customer’s block order.
Broker-dealers that act as OTC market
makers and block positioners conduct
31 See, e.g., https://www.nasdaqtrader.com/trader/
aspx?id=marketshare (average size of NASDAQ
matched trades in July 2009 was 228 shares);
https://nyxdata.com/nysedata/asp/factbook (NYSE
Group average trade size in all stocks traded in July
2009 was 267 shares).
32 Data compiled from Forms ATS submitted to
Commission for 3d quarter 2009.
33 See supra note 23.
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their business primarily by directly
negotiating with customers or with
other broker-dealers representing
customer orders. OTC market makers,
for example, appear to handle a very
large percentage of marketable
(immediately executable) order flow of
individual investors that is routed by
retail brokerage firms. A review of the
order routing disclosures required by
Rule 606 of Regulation NMS of eight
broker-dealers with significant retail
customer accounts reveals that nearly
100% of their customer market orders
are routed to OTC market makers.34 The
review also indicates that most of these
retail brokers either receive payment for
order flow in connection with the
routing of orders or are affiliated with
an OTC market maker that executes the
orders. The Rule 606 Reports disclose
that the amount of payment for order
flow generally is 0.1 cent per share or
less.35
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B. Linkages
Given the dispersal of liquidity across
a large number of trading centers of
different types, an important question is
whether trading centers are sufficiently
linked together in a unified national
market system. Thus far in this release,
the term ‘‘dispersed’’ has been used to
describe the current market structure
rather than ‘‘fragmented.’’ The term
‘‘fragmentation’’ connotes a negative
judgment that the linkages among
competing trading centers are
insufficient to achieve the Exchange Act
objectives of efficiency, price
transparency, best execution, and order
interaction. Whether fragmentation is in
fact a problem in the current market
structure is a critically important issue
on which comment is requested in
section IV below in a variety of contexts.
This section will give an overview of the
primary types of linkages that operate in
the current market structure—
consolidated market data, trade-through
protection, and broker routing services.
1. Consolidated Market Data
When Congress mandated a national
market system in 1975, it emphasized
that the systems for collecting and
distributing consolidated market data
would ‘‘form the heart of the national
market system.’’ 36 As described further
below, consolidated market data
includes both: (1) Pre-trade
transparency—real-time information on
the best-priced quotations at which
34 Review of Rule 606 Reports for 2d quarter 2009
of eight broker-dealers with substantial number of
retail customer accounts.
35 Id.
36 H.R. Rep. No. 94–229, 94th Cong., 1st Sess. 93
(1975).
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trades may be executed in the future
(‘‘consolidated quotation data’’); and (2)
post-trade transparency—real-time
reports of trades as they are executed
(‘‘consolidated trade data’’). As a result,
the public has ready access to a
comprehensive, accurate, and reliable
source of information for the prices and
volume of any NMS stock at any time
during the trading day. This information
serves an essential linkage function by
helping assure that the public is aware
of the best displayed prices for a stock,
no matter where they may arise in the
national market system. It also enables
investors to monitor the prices at which
their orders are executed and assess
whether their orders received best
execution.
Consolidated market data is collected
and distributed pursuant to a variety of
Exchange Act rules and joint-industry
plans. With respect to pre-trade
transparency, Rule 602 of Regulation
NMS requires exchange members and
certain OTC market makers that exceed
a 1% trading volume threshold to
provide their best-priced quotations to
their respective exchanges or FINRA,
and these self-regulatory organizations
(‘‘SROs’’), in turn, are required to make
this information available to vendors.
Rule 604 of Regulation NMS requires
exchange specialists and OTC market
makers to display certain customer limit
orders in their best-priced quotations
provided under Rule 602. In addition,
Rule 301(b)(3) of Regulation ATS
requires an ATS that displays orders to
more than one person in the ATS and
exceeds a 5% trading volume threshold
to provide its best-priced orders for
inclusion in the quotation data made
available under Rule 602.37
Importantly, the Commission’s rules
do not require the display of a customer
limit order if the customer does not
wish the order to be displayed.38
Customers have the freedom to display
or not display depending on their
trading objectives. On the other hand,
the selective display of orders generally
is prohibited in order to prevent the
creation of significant private markets
and two-tiered access to pricing
37 The Commission has proposed lowering the
trading volume threshold for order display
obligations from 5% to 0.25%. Non-Public Trading
Interest Release, 74 FR at 61213.
38 Rule 604 of Regulation NMS, for example,
explicitly recognizes the ability of customers to
control whether their limit orders are displayed to
the public. Rule 604(b)(2) provides an exception
from the limit order display requirement for orders
that are placed by customers who expressly request
that the order not be displayed. Rule 604(b)(4)
provides an exception for all block size orders
unless the customer requests that the order be
displayed.
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information.39 Accordingly, the display
of orders to some market participants
generally will require that the order be
included in the consolidated quotation
data that is widely available to the
public.
With respect to post-trade
transparency, Rule 601 of Regulation
NMS requires the equity exchanges and
FINRA to file a transaction reporting
plan regarding transactions in listed
equity securities. The members of these
SROs are required to comply with the
relevant SRO rules for trade reporting.
FINRA’s trade reporting requirements
apply to all ATSs that trade NMS stocks,
both ECNs and dark pools, as well as to
broker-dealers that internalize. FINRA
currently requires members to report
their trades as soon as practicable, but
no later than 90 seconds.40 FINRA has
proposed to reduce the reporting time
period to 30 seconds, noting that more
than 99.9% of transactions are reported
to FINRA in 30 seconds or less.41
Finally, Rule 603(b) of Regulation
NMS requires the equity exchanges and
FINRA to act jointly pursuant to one or
more effective national market system
plans to disseminate consolidated
information, including an NBBO, on
quotations for and transactions in NMS
stocks. It also requires that consolidated
information for each NMS stock be
disseminated through a single plan
processor.
To comply with these requirements,
the equity exchanges and FINRA
participate in three joint-industry plans
(‘‘Plans’’).42 Pursuant to the Plans, three
39 See, e.g., Rule 301(b)(3) of Regulation ATS;
Rule 602(a)(1) of Regulation NMS; Order Handling
Rules Release, 61 FR at 48307 (‘‘Although offering
benefits to some market participants, widespread
participation in these hidden markets has reduced
the completeness and value of publicly available
quotations contrary to the purposes of the NMS.’’).
40 Securities Exchange Act Release No. 60960
(November 6, 2009), 74 FR 59272, 59273 (November
17, 2009) (File No. SR–FINRA–2009–061) (in its
description of the proposed rule change, FINRA
stated that ‘‘[a]lthough members would have 30
seconds to report, FINRA reiterates that—as is the
case today—members must report trades as soon as
practical and cannot withhold trade reports, e.g., by
programming their systems to delay reporting until
the last permissible second’’).
41 Id. (from February 23, 2009 through February
27, 2009, 99.90% of trades submitted to a FINRA
Facility for public reporting were reported in 30
seconds or less).
42 The three joint-industry plans are: (1) The CTA
Plan, which is operated by the Consolidated Tape
Association and disseminates transaction
information for securities with their primary listing
on exchanges other than NASDAQ; (2) the CQ Plan,
which disseminates consolidated quotation
information for securities with their primary listing
on exchanges other than NASDAQ; and (3) the
NASDAQ UTP Plan, which disseminates
consolidated transaction and quotation information
for securities with their primary listing on
NASDAQ. The CTA Plan and CQ Plan are available
at https://www.nyxdata.com/nysedata/
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separate networks distribute
consolidated market data for NMS
stocks: (1) Network A for securities with
their primary listing on the NYSE; (2)
Network B for securities with their
primary listing on exchanges other than
the NYSE or NASDAQ; and (3) Network
C for securities with their primary
listing on NASDAQ. The three Networks
establish fees for the data, which must
be filed for Commission approval. The
three Networks collect the applicable
fees and, after deduction of Network
expenses (which do not include the
costs incurred by SROs to generate
market data and provide such data to
the Networks), allocate the remaining
revenues to the SROs. The revenues,
expenses, and allocations for each of the
three Networks are set forth in Table 1
below:43
TABLE 1—2008 FINANCIAL INFORMATION FOR NETWORKS A, B, AND C
Network A
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Revenues .................................................................................
Expenses .................................................................................
Net Income ..............................................................................
Allocations:
NASDAQ ...........................................................................
NYSE Arca .......................................................................
NYSE ................................................................................
FINRA ...............................................................................
NSX ..................................................................................
ISE ....................................................................................
NYSE Amex ......................................................................
BATS ................................................................................
CBOE ................................................................................
CHX ..................................................................................
Phlx ...................................................................................
BSE ...................................................................................
Network B
Network C
Total
$209,218,000
6,078,000
203,140,000
$119,876,000
3,066,000
116,810,000
$134,861,000
5,729,000
129,132,000
$463,955,000
14,873,000
449,082,000
47,845,000
37,080,000
68,391,000
24,325,000
7,100,000
15,260,000
1,000
2,356,000
80,000
565,000
134,000
3,000
34,885,000
38,235,000
0
16,458,000
11,575,000
1,477,000
9,760,000
2,770,000
1,046,000
574,000
30,000
..............................
60,614,000
26,307,000
0
20,772,000
17,123,000
1,883,000
14,000
1,538,000
433,000
298,000
146,000
4,000
143,343,000
101,622,000
68,391,000
61,555,000
35,798,000
18,620,000
9,775,000
6,664,000
1,559,000
1,437,000
310,000
7,000
In addition to providing quotation
and trade information to the three
Networks for distribution in
consolidated data, many exchanges and
ECNs offer individual data feeds
directly to customers that include
information that is provided in
consolidated data. The individual data
feeds of exchanges and ECNs also can
include a variety of other types of
information, such as ‘‘depth-of-book’’
quotations at prices inferior to their
best-priced quotations. Rule 603(a) of
Regulation NMS requires all exchanges,
ATSs, and other broker-dealers that
offer individual data feeds to make the
data available on terms that are fair and
reasonable and not unreasonably
discriminatory. Exchanges, ATSs, and
other broker-dealers are prohibited from
providing their data directly to
customers any sooner than they provide
their data to the plan processors for the
Networks.44 The fact that trading center
data feeds do not need to go through the
extra step of consolidation at a plan
processor, however, means that such
data feeds can reach end-users faster
than the consolidated data feeds. The
average latencies of the consolidation
function at plan processors (from the
time the processor receives information
from the SROs to the time it distributes
consolidated information to the public)
are as follows: (1) Network A and
Network B—less than 5 milliseconds for
quotation data and less than 10
milliseconds for trade data; and (2)
Network C—5.892 milliseconds for
quotation data and 6.680 milliseconds
for trade data.45 The individual trading
center data feeds are discussed below in
section IV.B.2.b.
Another important type of linkage in
the current market structure is the
protection against trade-throughs
provided by Rule 611 of Regulation
NMS. A trade-through is the execution
of a trade at a price inferior to a
protected quotation for an NMS stock. A
protected quotation must be displayed
by an automated trading center, must be
disseminated in the consolidated
quotation data, and must be an
automated quotation that is the best bid
or best offer of an exchange or FINRA.
Importantly, Rule 611 applies to all
trading centers, not just those that
display protected quotations. Trading
center is defined broadly in Rule
600(b)(78) to include, among others, all
exchanges, all ATSs (including ECNs
and dark pools), all OTC market makers,
and any other broker-dealer that
executes orders internally, whether as
agent or principal.
Rule 611(a)(1) requires all trading
centers to establish, maintain, and
enforce written policies and procedures
that are reasonably designed to prevent
trade-throughs of protected quotations,
subject to the exceptions set forth in
Rule 611(b). Protection against tradethroughs is an important linkage among
trading centers because it provides a
baseline assurance that: (1) Marketable
orders will receive at least the best
displayed price, regardless of the
particular trading center that executes
the order or where the best price is
displayed in the national market system;
and (2) quotations that are displayed at
one trading center will not be bypassed
by trades with inferior prices at any
trading center in the national market
system.
Rule 611 also helps promote linkages
among trading centers by encouraging
them, when they do not have available
trading interest at the best price, to route
marketable orders to a trading center
that is displaying the best price.
Although Rule 611 does not directly
require such routing services (a trading
center can, for example, cancel and
return an order when it does not have
the best price), competitive factors have
default.aspx?tabid=227. The NASDAQ UTP Plan is
available at https://www.utpplan.com.
43 The Network financial information for 2008 is
preliminary and unaudited.
44 Regulation NMS Release, 70 FR at 37567
(‘‘Adopted Rule 603(a) will not require a market
center to synchronize the delivery of its data to end-
users with delivery of data by a Network processor
to end-users. Rather independently distributed data
could not be made available on a more timely basis
than core data is made available to a Network
processor. Stated another way, adopted Rule 603(a)
prohibits an SRO or broker-dealer from transmitting
data to a vendor or user any sooner than it transmits
the data to a Network processor.’’). The plan
processor for the CTA Plan and CQ Plan is the
Securities Industry Automation Corporation
(‘‘SIAC’’). The plan processor for the NASDAQ UTP
Plan is NASDAQ.
45 Sources: SIAC for Network A and Network B;
NASDAQ for Network C.
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led many trading centers to offer routing
services to their customers. Prior to Rule
611, exchanges routed orders through an
inflexible, partially manual system
called the Intermarket Trading System
(‘‘ITS’’).46 With Regulation NMS,
however, the Commission adopted a
‘‘private linkages’’ approach that relies
exclusively on brokers to provide
routing services, both among exchanges
and between customers and exchanges.
These broker routing services are
discussed next.
3. Broker Routing Services
In a dispersed and complex market
structure with many different trading
centers offering a wide spectrum of
services, brokers play a significant role
in linking trading centers together into
a unified national market system.
Brokers compete to offer the
sophisticated technology tools that are
needed to monitor liquidity at many
different venues and to implement order
routing strategies. To perform this
function, brokers may monitor the
execution of orders at both displayed
and undisplayed trading centers to
assess the availability of undisplayed
trading interest. Brokers may, for
example, construct real-time ‘‘heat
maps’’ in an effort to discern and access
both displayed and undisplayed
liquidity at trading centers throughout
the national market system.
Using their knowledge of available
liquidity, many brokers offer smart
order routing technology to access such
liquidity. Many brokers also offer
sophisticated algorithms that will take
the large orders of institutional investors
and others, divide a large ‘‘parent’’ order
into many smaller ‘‘child’’ orders, and
route the child orders over time to
different trading centers in accordance
with the particular trading strategy
chosen by the customer. Such
algorithms may be ‘‘aggressive,’’ for
example, and seek to take liquidity
quickly at many different trading
centers, or they may be ‘‘passive,’’ and
submit resting orders at one or more
trading centers and await executions at
favorable prices.
To the extent they help customers
cope with the dispersal of liquidity
among a large number of trading centers
of different types and achieve the best
execution of their customers’ orders, the
routing services of brokers can
contribute to the broader policy goal of
promoting efficient markets.
Under the private linkages approach
adopted by Regulation NMS, market
46 See Regulation NMS Release, 70 FR at 37538–
37539 (‘‘Although ITS promotes access among
participants that is uniform and free, it also is often
slow and limited.’’).
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participants obtain access to the various
trading centers through broker-dealers
that are members or subscribers of the
particular trading center.47 Rule 610(a)
of Regulation NMS, for example,
prohibits an SRO trading facility from
imposing unfairly discriminatory terms
that would prevent or inhibit any
person from obtaining efficient access
through an SRO member to the
displayed quotations of the SRO trading
facility. Rule 610(c) limits the fees that
a trading center can charge for access to
its displayed quotations at the best
prices. Rule 611(d) requires SROs to
establish, maintain, and enforce rules
that restrict their members from
displaying quotations that lock or cross
previously displayed quotations.
Section 6(a)(2) of the Exchange Act
requires registered exchanges to allow
any qualified and registered brokerdealer to become a member of the
exchange—a key element in assuring
fair access to exchange services. In
contrast, the access requirements that
apply to ATSs are much more limited.
Regulation ATS includes two distinct
types of access requirements: (1) order
display and execution access in Rule
301(b)(3); and (2) fair access to ATS
services in general in Rule 301(b)(5). An
ATS must meet order display and
execution access requirements if it
displays orders to more than one person
in the ATS and exceeds a 5% trading
volume threshold.48 An ATS must meet
the general fair access requirement if it
exceeds a 5% trading volume threshold.
If an ATS neither displays orders to
more than one person in the ATS nor
exceeds a 5% trading volume threshold,
Regulation ATS does not impose access
requirements on the ATS.
An essential type of access that
should not be overlooked is the fair
access to clearance and settlement
systems required by Section 17A of the
Exchange Act. If brokers cannot
efficiently clear and settle transactions
at the full range of trading centers, they
will not be able to perform their linkage
function properly.
The linkage function of brokers also is
supported by a broker’s legal duty of
best execution. This duty requires a
broker to obtain the most favorable
terms reasonably available when
47 See Regulation NMS Release, 70 FR at 37540
(‘‘[M]any different private firms have entered the
business of linking with a wide range of trading
centers and then offering their customers access to
those trading centers through the private firms’
linkages. Competitive forces determine the types
and costs of these private linkages.’’).
48 The Commission has proposed reducing the
threshold for order display and execution access to
0.25%. Non-Public Trading Interest Release, 74 FR
at 61213. It has not proposed to change the
threshold for fair access in general.
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executing a customer order.49 Of course,
this legal duty is not the only pressure
on brokers to obtain best execution. The
existence of strong competitive pressure
to attract and retain customers
encourages brokers to provide high
quality routing services to their
customers. In this regard, Rules 605 and
606 of Regulation NMS are designed to
support competition by enhancing the
transparency of order execution and
routing practices. Rule 605 requires
market centers to publish monthly
reports of statistics on their order
execution quality. Rule 606 requires
brokers to publish quarterly reports on
their routing practices, including the
venues to which they route orders for
execution. As the Commission
emphasized when it adopted the rules
in 2000, ‘‘[b]y increasing the visibility of
order execution and routing practices,
the rules adopted today are intended to
empower market forces with the means
to achieve a more competitive and
efficient national market system for
public investors.’’ 50 In section IV.A.1.b.
below, comment is requested on
whether Rules 605 and 606 should be
updated for the current market
structure.
IV. Request for Comments
This section will focus on three
categories of issues that the Commission
particularly wishes to present for
comment—the performance of the
current market structure, high frequency
trading, and undisplayed liquidity. The
Commission emphasizes, however, that
it is interested in receiving comments
on all aspects of the equity market
structure that the public believes are
important. The discussion in this
release should not be construed as in
any way limiting the scope of comments
that will be considered.
This concept release focuses on the
structure of the equity markets and does
not discuss the markets for other types
of instruments that are related to
equities, such as options and OTC
derivatives. The limited scope of this
release is designed to focus on a discrete
set of issues that have gained increased
prominence in the equity markets.
Comment is requested, however, on the
extent to which the issues identified in
this release are intertwined with other
markets. For example, market
participants may look to alternative
instruments if they believe the equity
markets are not optimal for their trading
49 See, e.g., Regulation NMS Release, 70 FR at
37537–37538 (discussion of duty of best execution).
50 Securities Exchange Act Release No. 43590
(November 17, 2000), 65 FR 75414, 75415
(December 1, 2000) (Disclosure of Order Execution
and Routing Practices).
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objectives. Should the Commission
consider the extent to which
instruments substitute for one another
in evaluating equity market structure?
In addition, comment is requested on
the impact of globalization on market
structure. How does global competition
for trading activity impact the U.S.
market structure? Should global
competition affect the approach to
regulation in the U.S.? Will trading
activity and capital tend to move either
to the U.S. or overseas in response to
different regulation in the U.S.? How
should the Commission consider these
globalization issues in its review of
market structure?
A. Market Structure Performance
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The secondary markets for NMS
stocks are essential to the economic
success of the country and to the
financial well-being of individual
Americans. High quality trading markets
promote capital raising and capital
allocation by establishing prices for
securities and by enabling investors to
enter and exit their positions in
securities when they wish to do so.51
The Commission wishes to request
comment broadly on how well or poorly
the current market structure is
performing its vital economic functions.
In recent months, the Commission has
heard a variety of concerns about
particular aspects of the current market
structure, as well as the view that recent
improvements to the equity markets
have benefitted both individual and
institutional investors. The concerns
about market structure often have
related to high frequency trading and
various types of undisplayed liquidity.
Prior to discussing these particular areas
of concern in this release, the
Commission believes it is important to
assess more broadly the performance of
the market structure, particularly for
long-term investors and for businesses
seeking to raise capital. Assessing
overall market structure performance
should help provide context for
particular concerns, as well as the
51 See, e.g., S. Report 94–75 at 3 (‘‘The rapid
attainment of a national market system as envisaged
by this bill is important, therefore, not simply to
provide greater investor protection and bolster
sagging investor confidence but also to assure that
the country maintains a strong, effective and
efficient capital raising and capital allocating
system in the years ahead. The basic goals of the
Exchange Act remain salutary and unchallenged: to
provide fair and honest mechanisms for the pricing
of securities, to assure that dealing in securities is
fair and without undue preferences or advantages
among investors, to ensure that securities can be
purchased and sold at economically efficient
transaction costs, and to provide, to the maximum
degree practicable, markets that are open and
orderly.’’).
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nature of any regulatory response that
may be appropriate to address concerns.
1. Long-Term Investors
In assessing the performance of the
current equity market structure and
whether it is meeting the relevant
Exchange Act objectives, the
Commission is particularly focused on
the interests of long-term investors.
These are the market participants who
provide capital investment and are
willing to accept the risk of ownership
in listed companies for an extended
period of time. Unlike long-term
investors, professional traders generally
seek to establish and liquidate positions
in a shorter time frame. Professional
traders with these short time frames
often have different interests than
investors concerned about the long-term
prospects of a company.52 For example,
short-term professional traders may like
short-term volatility to the extent it
offers more trading opportunities, while
long-term investors do not. The net
effect of trading strategies pursued by
various short-term professional traders,
however, may not increase volatility
and may work to dampen volatility.
Nevertheless, the interests of investors
and professional traders may at times be
aligned. Indeed, the collective effect of
professional traders competing to profit
from short-term trading strategies can
work to the advantage of long-term
investors. For example, as just noted,
short-term trading strategies may work
to dampen short-term volatility.
Professional traders with an informed
view of prices can promote efficient
pricing. Professional traders competing
to provide liquidity may narrow spreads
and give investors the benefit of better
prices when they simply want to trade
immediately at the best available price.
Given the difference in time horizons,
however, the trading needs of long-term
investors and short-term professional
traders often may diverge. Professional
trading is a highly competitive endeavor
in which success or failure may depend
on employing the fastest systems and
the most sophisticated trading strategies
that require major expenditures to
develop and operate. Such systems and
strategies may not be particularly useful,
in contrast, for investors seeking to
establish a long-term position rather
52 See Regulation NMS Release, 70 FR at 37500
(‘‘The Commission recognizes that it is important to
avoid false dichotomies between the interests of
short-term traders and long-term investors, and that
many difficult line-drawing exercises can arise in
precisely defining the difference between the two
terms. For present purposes, however, these issues
can be handled by simply noting that it makes little
sense to refer to someone as ‘investing’ in a
company for a few seconds, minutes, or hours.’’)
(citation omitted).
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than profit from fleeting price
movements. Where the interests of longterm investors and short-term
professional traders diverge, the
Commission repeatedly has emphasized
that its duty is to uphold the interests
of long-term investors.53
Comment is requested on the
practicality of distinguishing the
interests of long-term investors from
those of short-term professional traders
when assessing market structure issues.
In what circumstances should an
investor be considered a ‘‘long-term
investor’’? If a time component is
needed to define this class of investor,
how should the Commission determine
the length of expected ownership that
renders an investor ‘‘long-term’’? Under
what circumstances would a distinction
between a long-term investor and a
short-term professional trader become
unclear, and how prevalent are these
circumstances? To the extent that
improved market liquidity and depth
promote the interests of long-term
investors by leading to reduced
transaction costs, what steps should the
Commission consider taking to promote
market liquidity and depth?
Long-term investors include
individuals that invest directly in
equities and institutions that invest on
behalf of many individuals. The
Commission is interested in hearing
how all types of individual investors
and all sizes of institutional investors—
small, medium, and large—are faring in
the current market structure. For
example, has the current market
structure become so dispersed and
complex that only the largest
institutions can afford to deploy their
own highly sophisticated trading tools?
If so, are smaller institutions able to
trade effectively? Some broker-dealers
offer sophisticated trading tools, such as
smart routing and algorithmic trading.
How accessible are these trading tools to
smaller institutions? Are the costs of
paying for these tools so high that they
are effectively inaccessible? Moreover,
to the extent that a competitive
advantage flows from these trading
53 See, e.g., Flash Order Release, 74 FR at 48635–
48636; Regulation NMS Release, 70 FR at 37499–
37501; Fragmentation Concept Release, 65 FR at
10581 n. 26; see also S. Rep. No. 73–1455, 73rd
Cong., 2d Sess. 5 (1934) (‘‘Transactions in securities
on organized exchanges and over-the-counter are
affected with the national public interest. * * * In
former years transactions in securities were carried
on by a relatively small portion of the American
people. During the last decade, however, due
largely to the development of means of
communication * * * the entire Nation has become
acutely sensitive to the activities on the securities
exchanges. While only a fraction of the multitude
who now own securities can be regarded as actively
trading on the exchanges, the operations of these
few profoundly affect the holdings of all.’’).
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tools, does that competitive advantage
help to promote and enable
competition, beneficial innovation, and,
ultimately, enhanced market quality? Is
there a risk that certain competitive
advantages may reduce competition or
lead to detrimental innovations? To
what extent is it important for market
participants to be allowed to gain
competitive advantages, such as by
using more sophisticated trading tools?
In addition, the Commission
recognizes that there is wide variation
in types of equity securities and that
there may be important differences in
market performance among the different
types. With respect to corporate
equities, for example, the Commission is
interested in how market structure
impacts stocks of varying levels of
market capitalization (for example, top
tier, large, middle, and small). A vital
function of the equity markets is to
support the capital raising function,
including capital raising by small
companies. The Commission recognizes
that small company stocks may trade
differently than large company stocks
and requests comment specifically on
how the market structure performs for
smaller companies and whether it
supports the capital raising function for
them.
a. Market Quality Metrics
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Given these broad concerns for all
types of long-term investors and the full
range of equities, what are useful
metrics for assessing the performance of
the current market structure? In the
past, the Commission and its staff have
considered a wide variety of metrics,
most of which have applied to smaller
orders (such as 10,000 shares or less).54
These metrics have included measures
of spreads—the difference between the
prices that buyers pay and sellers
receive when they are seeking to trade
immediately at the best prices. Spread
measures include quoted spreads,
effective spreads (which reflects
whether investors receive prices that are
54 See, e.g., Memorandum to File from Office of
Economic Analysis dated December 15, 2004
regarding comparative analysis of execution quality
on NYSE and NASDAQ based on a matched sample
of stocks (‘‘Comparative Analysis of Execution
Quality’’) (available at https://www.sec.gov/spotlight/
regnms.htm); Memorandum to File from Office of
Economic Analysis dated December 15, 2004
regarding Analysis of Volatility for Stocks
Switching from Nasdaq to NYSE (available at https://
www.sec.gov/spotlight/regnms.htm); Office of
Economic Analysis, Report on Comparison of Order
Executions Across Equity Market Structures
(January 8, 2001) (‘‘Report on Comparison of Order
Executions’’) (available at https://www.sec.gov/news/
studies/ordrxmkt.htm); Commission, Report on the
Practice of Preferencing (April 15, 1997) (available
at https://www.sec.gov/news/studies/studiesarchive/
1997archive.shtml).
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better than, equal to, or worse than
quoted spreads), and realized spreads
(which reflects how investors are
affected by subsequent price movements
in a stock). Another often used metric
has been speed of execution.55
Short-Term Volatility. Spreads and
speed of execution may not, however,
give a full picture of execution quality,
even for the small orders of individual
investors that generally will be fully
executed in one transaction (unlike the
large orders of institutional investors
that may require many smaller
executions). For example, short-term
price volatility may harm individual
investors if they are persistently unable
to react to changing prices as fast as
high frequency traders. As the
Commission previously has noted, longterm investors may not be in a position
to assess and take advantage of shortterm price movements.56 Excessive
short-term volatility may indicate that
long-term investors, even when they
initially pay a narrow spread, are being
harmed by short-term price movements
that could be many times the amount of
the spread.
The Commission has used a variety of
measures of short-term volatility,
including variance ratios (for example, 5
minute return variance to 60 minute
return variance, 1 day return variance to
1 week return variance, and 1 day return
variance to 4 week return variance).57
Variance ratios are useful because they
focus on short-term volatility that may
55 When assessing market structure during the
development of Regulation NMS, for example,
Commission staff used Rule 605 data to measure
quoted spreads, effective spreads, realized spreads,
price impact, net price improvement, execution
speed, and fill rates. All of the cost values were
calculated both in terms of absolute value (cents)
and in terms of proportional costs as a percentage
of stock prices. Comparative Analysis of Execution
Quality at 8–9.
56 Fragmentation Concept Release, 65 FR at 10581
n. 26 (‘‘In theory, short-term price swings that hurt
investors on one side of the market can benefit
investors on the other side of the market. In
practice, professional traders, who have the time
and resources to monitor market dynamics closely,
are far more likely than investors to be on the
profitable side of short-term price swings (for
example, by buying early in a short-term price rise
and selling early before the price decline).’’).
57 Variance ratios are calculated by comparing
return variances for a short time period with return
variances for a longer time period. One of the
advantages of this measure of volatility is that
‘‘there is a built-in control for the underlying
uncertainty as to the ‘true’ value of the stock. For
example, the high variance of returns on technology
stocks is to be expected given the high uncertainty
as to their future cash flows. The point is that this
uncertainty will manifest itself in both the daily
and weekly return variances. When [Commission
staff] divide the weekly return by the daily return,
the natural uncertainty associated with the stock
‘washes out’ and [Commission staff] are left with a
measure associated with transaction costs or some
other form of inefficiency.’’ Report on Comparison
of Order Executions, supra note 54, at 18.
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be directly related to market structure
quality, as opposed to long-term
volatility that may be much more
affected by fundamental economic
forces that are independent of market
structure quality. Another possible
metric for assessing whether investors
are harmed by short-term volatility is
realized spread, which indicates
whether prices moved for or against the
submitter of the order after the order
was executed. Rule 605, for example,
measures realized spreads based on
quotations 5 minutes after the time of
order execution.
Finally, the Commission has
evaluated various measures of the depth
that is immediately available to fill
orders. These metrics include fill rates
for limit orders, quoted size at the inside
prices, the effect of reserve size and
undisplayed size at the inside prices or
better, and quoted depth at prices away
from the inside.
Metrics for Smaller Orders. Comment
is requested on whether these metrics
that focus on the execution of smaller
orders continue to be useful. Which
metrics are most useful in today’s
market structure? Are there other useful
metrics not listed above? Are there other
relevant metrics that reflect how
individual investors are likely to trade?
For example, a significant number of
individual investor orders are submitted
after regular trading hours when such
investors have an opportunity to
evaluate their portfolios. These orders
typically are executed at opening prices.
What are the best metrics for assessing
whether individual investor orders are
executed fairly and efficiently at the
opening? Are there other particular
times or contexts in which retail
investors often trade and, if so, what are
the best metrics for determining
whether they are treated fairly and
efficiently in those contexts as well?
Measuring Institutional Investor
Transaction Costs. Most of the
Commission’s past analyses of market
performance have focused on the
execution of smaller orders (for
example, less than 10,000 shares), rather
than attempting to measure the overall
transaction costs of institutional
investors to execute large orders (for
example, greater than 100,000 shares).
Measuring the transaction costs of
institutional investors that need to trade
in large size can be extremely
complex.58 These large orders often are
58 See generally Investment Company Act Release
No. 26313 (December 18, 2003), 68 FR 74820, 74821
(December 24, 2003) (Request for Comments on
Measures to Improve Disclosure of Mutual Fund
Transaction Costs) (‘‘The Commission is aware of
the need for transparency of mutual fund fees and
expenses and committed to improving disclosure of
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broken up into smaller child orders and
executed in a series of transactions.
Metrics that apply to small order
executions may miss how well or poorly
the large order traded overall. Direct
measures of large order transaction costs
typically require access to institutional
order data that is not publicly available.
In this regard, a few trading analytics
firms with access to institutional order
data publish periodic analyses of
institutional investor transaction
costs.59 These analyses allow such costs
to be tracked over time to determine
whether they are improving or
worsening. Comment is requested on
these published analyses generally and
whether they accurately reflect the
transaction costs experienced by
institutional investors. Are there other
studies or analyses of institutional
trading costs that the Commission
should consider? Comment is requested
in general on other means for assessing
the transaction costs of institutional
investors in the current market
structure. For example, are any of the
measures of short-term volatility
discussed above useful for assessing the
transactions costs of larger orders and,
if so, how?
Trend of Market Quality Metrics. With
respect to all of the metrics that are
useful for assessing market structure
performance for long-term investors, the
Commission is interested in whether
commenters believe they show
improvement or worsening in recent
years. For example, do the relevant
the costs that are borne by mutual fund investors;
but it is mindful of the complexities associated with
identifying, measuring, and accounting for
transaction costs.’’).
59 See, e.g., U.S. Government Accountability
Office, ‘‘Securities Markets: Decimal Pricing Has
Contributed to Lower Trading Costs and a More
Challenging Trading Environment,’’ at 96 (May
2005) (‘‘We obtained data from three leading firms
that collect and analyze information about
institutional investors’ trading costs. These trade
analytics firms * * * obtain trade data directly
from institutional investors and brokerage firms and
calculate trading costs, including market impact
costs (the extent to which the security changes in
price after the investor begins trading), typically for
the purpose of helping investors and traders limit
costs of trading. These firms also aggregate client
data so as to approximate total average trading costs
for all institutional investors. Generally, the client
base represented in aggregate cost data can be used
to make generalizations about the institutional
investor industry.’’); see also Pam Abramowitz,
Technology Drives Trading Costs, Institutional
Investor (November 4, 2009) (13th annual survey of
transaction costs conducted for Institutional
Investor Magazine by Elkins/McSherry); Elkins
McSherry LLC, ‘‘Trading Cost Averages and
Volatility Continued to Decline in 3Q09’’
(November 2009) (available at https://
www.elkinsmcsherry.com/em/pdfs/Newsletters/
Nov_2009_newsletter.pdf); Investment Technology
Group, Inc., ‘‘ITG Global Trading Cost Review: 2009
Q2’’ (September 15, 2009) (available at https://
www.itg.com/news_events/papers/
ITGGlobalTradingCostReview_2009Q2.pdf).
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metrics indicate that market quality has
improved or worsened over the last ten
years and the last five years? Have
markets improved or worsened more
recently, since January 2009? Which of
the recent developments in market
structure do you consider to have the
greatest effect on market quality? The
Commission wishes to hear about any
current regulations that may be
harming, rather than improving, market
quality. Specifically, how could any
current regulations be modified to fit
more properly with the current market?
Recognizing that there is no such
thing as a perfect market structure that
entirely eliminates transaction costs, the
Commission believes that an
understanding of trends is important
because they provide a useful,
pragmatic touchstone for assessing the
goals with respect to market structure
performance.60
Effect of Broad Economic Forces. The
Commission notes that many metrics of
market performance may be affected by
broad economic forces, such as the
global financial crisis during the
Autumn of 2008, that operate
independently of market structure.
Periods of high volatility may be
associated with high intermediation
costs. This may reflect both
compensation for risk assumed by
liquidity providers and the higher
demand for immediacy by long-term
investors. How should the effect of these
economic forces be adjusted for in
assessing the performance of market
structure over the last ten years, five
years, and the last year? For example,
the CBOE Volatility Index (‘‘VIX’’)
reached record levels during 2008.61
The VIX is sometimes referred to as the
‘‘fear index’’ because it measures
expected volatility of the S&P 500 Index
over the next 30 calendar days.62 To
what extent are metrics of market
structure performance correlated with
the VIX or other analogous measures of
60 A very recent study, for example, examined
trading activity trends through the end of 2008.
Chordia, Tarun, Richard Roll, & Avanidar
Subrahmanyam, Why Has Trading Volume
Increased? (January 6, 2010). It focused on
comparisons of pre- and post-decimal trading in
NYSE-listed stocks (subperiods from 1993–2000
and 2001–2008). Among the study’s findings are
that average effective spreads decreased
significantly (from 10.2 cents to 2.2 cents for small
trades (<$10,000) and from 10.7 cents to 2.7 cents
for large trades (>$10,000)), while average depth
available at the inside bid and offer declined
significantly (from 11,130 shares to 2797 shares).
61 See infra note 81 and accompanying text.
62 See Chicago Board Options Exchange, ‘‘The
CBOE Volatility Index—VIX,’’ at 1, 4 (‘‘VIX
measures 30-day expected volatility of the S&P 500
Index. The components of VIX are near- and nextterm put and call options, usually in the first and
second SPX contract months.’’) (available at
https://www.cboe.com/micro/vix/vixwhite.pdf).
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volatility? Is the level of the VIX largely
independent of market structure quality
or are the level of the VIX and market
structure quality interdependent? Given
that the VIX measures expected
volatility over the next 30 days, how
important is the VIX to long-term
investors?
b. Fairness of Market Structure
The Commission requests comment
on whether the current market structure
is fair for long-term investors. For
example, the speed of trading has
increased to the point that the fastest
traders now measure their latencies in
microseconds. Is it necessary or
economically feasible for long-term
investors to expend resources on the
very fastest and most highly
sophisticated systems or otherwise
obtain access to these systems? If not,
does the fact that professional traders
likely always will be able to trade faster
than long-term investors render the
equity markets unfair for these
investors? Or do the different trading
needs and objectives of long-term
investors mean that the disparities in
speed in today’s market structure are
not significant to the interests of such
investors? In addition, what standards
should the Commission apply in
assessing the fairness of the equity
markets? For example, is it unfair for
market participants to obtain a
competitive advantage by investing in
technology and human resources that
enable them to trade more effectively
and profitably than others?
Rules 605 and 606 and Other Tools to
Protect Investor Interests. In assessing
the fairness of the current market
structure, the Commission is interested
in whether long-term investors and their
brokers have the tools they need to
protect their own interests in a
dispersed and complex market
structure. Do, for example, brokerdealers provide routing tools to their
agency customers that are as powerful
and effective as the routing tools they
may use for their proprietary trading? If
not, is this difference in access to
technology unfair to long-term
investors? Or is a broker-dealer’s ability
to develop and use more powerful and
effective trading tools a competitive
advantage that spurs competition and
beneficial innovation?
In addition, comment is requested on
Rules 605 and 606, which were adopted
in 2000. Do these rules need to be
updated and, if so, in what respects? Do
Rule 605 and Rule 606 reports continue
to provide useful information for
investors and their brokers in assessing
the quality of order execution and
routing practices? The Commission
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notes that Rule 606 statistics reveal that
brokers with significant retail customer
accounts send the great majority of nondirected marketable orders to OTC
market makers that internalize
executions, often pursuant to payment
for order flow arrangements.63 Do
individual investors understand and
pay attention to Rule 605 and 606
statistics? If not, what market
participants, if any, make decisions
based on this data? Are those decisions
beneficial to individual investors?
Rule 605 currently requires that the
speed of execution for immediately
executable orders (market orders and
marketable limit orders) be disclosed to
the tenth of a second. Do investors and
brokers need more finely tuned
statistics, such as hundredths or
thousandths of a second? For nonmarketable limit orders with prices that
render them not immediately executable
at the best displayed prices, the shortest
time category is 0–9 seconds. Would a
shorter time period be useful for
investors that use non-marketable limit
orders? In addition, Rule 605 does not
include any statistics measuring the
execution quality of orders submitted
for execution at opening or closing
prices. Would such statistics be helpful
to investors? Rule 605 also does not
include any statistics measuring
commission costs of orders, access fees,
or liquidity rebates. Would such
statistics be helpful to investors?
Rule 605 does not require disclosure
of the amount of time that canceled nonmarketable orders are displayed in the
order book of trading center before
cancellation. Considering the high
cancellation percentage of nonmarketable orders, should Rule 605
require the disclosure of the average
time that canceled orders were
displayed in the order book?
Conversely, should Rule 605 exclude or
otherwise distinguish canceled orders
with a very limited duration (such as
less than one second)?
Moreover, Rules 605 and 606 were
drafted primarily with the interests of
individual investors in mind and are
focused on the execution of smaller
orders. Orders with large sizes, for
example, are excluded from both
rules.64 Should the rules be updated to
63 See
supra note 34 and accompanying text.
64 Orders with a size of 10,000 shares or greater
are exempt from Rule 605 reporting. See generally
Staff Legal Bulletin 12R: Frequently Asked
Questions About Rule 11Ac1–5 (Revised), now
Regulation NMS Rule 605, Question 26: Exemption
of Block Orders (available at https://www.sec.gov/
divisions/marketreg/disclosure.htm). Rule 606
requires broker-dealers to report on their routing of
‘‘non-directed orders,’’ which is defined in Rule
600(b)(48) as limited to customer orders. ‘‘Customer
order’’ is defined in Rule 600(b)(18) of Regulation
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address the interests of institutional
investors in efficiently executing large
orders (whether in one large trade or
many smaller trades)? If so, what
metrics would be useful for institutional
investors?
Intermarket sweep orders (‘‘ISOs’’) are
mostly used by institutional traders.65
Rule 605 disclosures do not report
regular orders and ISOs separately.66
Would a distinction between ISO and
non-ISO marketable orders benefit
individual and/or institutional
investors? Should any other order types
be treated differently in Rule 605
reports?
More broadly, are there any
approaches to improving the
transparency of the order routing and
order execution practices for
institutional investors that the
Commission should consider? For
example, do institutional investors
currently have sufficient information
about the smart order routing services
and order algorithms offered by their
brokers? Would a regulatory initiative to
improve disclosure of these broker
services be useful and, if so, what type
of initiative should the Commission
pursue?
2. Other Measures
The Commission requests comment
on any other measures of market
structure performance that the public
believes the Commission should
consider. For example, are there useful
metrics for assessing the quality of price
discovery in equity markets, such as
how efficiently prices respond to new
information? In addition, what is the
best approach for assessing whether the
NMS to exclude an order in NMS stocks with a
market value of at least $200,000. See generally
Staff Legal Bulletin 13A: Frequently Asked
Questions About Rule 11Ac1–6, now Regulation
NMS Rule 606, Question 6: Definition of Customer
Orders—Large Order Exclusion (available at https://
www.sec.gov/divisions/marketreg/disclosure.htm).
65 Intermarket sweep orders are exceptions
provided in Rule 611(b)(5) and (6) that enable an
order router to sweep one or more price levels
simultaneously at multiple trading centers without
violating trade-through restrictions. As defined in
Rule 600(b)(30) of Regulation NMS, intermarket
sweep orders must be routed to execute against the
full displayed size of any protected quotation that
otherwise would be traded through by the orders.
In addition, a single ISO can be routed to the best
displayed price at the time of routing to help assure
an execution even if quotations change after the
order is routed. See Responses to Frequently Asked
Questions Concerning Rule 611 and Rule 610 of
Regulation NMS, Question 4.04 (April 4, 2008
Update) (available at https://www.sec.gov/divisions/
marketreg/nmsfaq610-11.htm).
66 An ISO is excluded from a Rule 605 report as
requiring special handling if it has a limit price that
is inferior to the NBBO at the time of order receipt.
All other ISOs should be included in a Rule 605
report, absent another applicable exclusion. Id. at
Question 7.06.
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secondary markets are appropriately
supporting the capital-raising function
for companies of all sizes?
B. High Frequency Trading
One of the most significant market
structure developments in recent years
is high frequency trading (‘‘HFT’’). The
term is relatively new and is not yet
clearly defined. It typically is used to
refer to professional traders acting in a
proprietary capacity that engage in
strategies that generate a large number
of trades on a daily basis. These traders
could be organized in a variety of ways,
including as a proprietary trading firm
(which may or may not be a registered
broker-dealer and member of FINRA), as
the proprietary trading desk of a multiservice broker-dealer, or as a hedge fund
(all of which are referred to hereinafter
collectively as a ‘‘proprietary firm’’).
Other characteristics often attributed to
proprietary firms engaged in HFT are:
(1) The use of extraordinarily highspeed and sophisticated computer
programs for generating, routing, and
executing orders; (2) use of co-location
services and individual data feeds
offered by exchanges and others to
minimize network and other types of
latencies; (3) very short time-frames for
establishing and liquidating positions;
(4) the submission of numerous orders
that are cancelled shortly after
submission; and (5) ending the trading
day in as close to a flat position as
possible (that is, not carrying
significant, unhedged positions overnight). Estimates of HFT volume in the
equity markets vary widely, though they
typically are 50% of total volume or
higher.67 By any measure, HFT is a
dominant component of the current
market structure and is likely to affect
nearly all aspects of its performance.
The Commission today is proposing
an initiative to address a discrete HFT
concern that the Commission already
has identified. It would address the use
of various types of arrangements to
obtain the fastest possible market
access.68 This concept release is
intended to request comment on the full
range of concerns with respect to HFT,
67 See, e.g., Jonathan Spicer and Herbert Lash,
Who’s Afraid of High-Frequency Trading?,
Reuters.com, December 2, 2009 (available at
https://www.reuters.com/article/
idUSN173583920091202) (‘‘High-frequency trading
now accounts for 60 percent of total U.S. equity
volume, and is spreading overseas and into other
markets.’’); Scott Patterson and Geoffrey Rogow,
What’s Behind High-Frequency Trading, Wall Street
Journal, August 1, 2009 (‘‘High frequency trading
now accounts for more than half of all stock-trading
volume in the U.S.’’);
68 Market Access Release, supra note 15.
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in contrast to the discrete concerns the
Commission already has identified.
The lack of a clear definition of HFT,
however, complicates the Commission’s
broader review of market structure
issues. The lack of clarity may, for
example, contribute to the widely
varying estimates of HFT volume in
today’s equity markets. Although the
term itself clearly implies a large
volume of trades, some concerns that
have been raised about particular
strategies used by proprietary firms may
not necessarily involve a large number
of trades. Indeed, any particular
proprietary firm may simultaneously be
employing many different strategies,
some of which generate a large number
of trades and some that do not.
Conceivably, some of these strategies
may benefit market quality and longterm investors and others could be
harmful.
In sum, the types of firms engaged in
professional trading and the types of
strategies they employ can vary
considerably. Rather than attempt any
single, precise definition of HFT, this
release will focus on particular
strategies and tools that may be used by
proprietary firms and inquire whether
these strategies and tools raise concerns
that the Commission should address.
1. Strategies
Comment generally is requested on
the strategies employed by proprietary
firms in the current market structure.
What are the most frequently used
strategies? What are the key features of
each strategy? What technology tools
and other market structure components
(such as exchange fee structures) are
necessary to implement each strategy?
Have any of these strategies been a
competitive response to particular
market structure components or to
particular problems or challenges in the
current market structure? Does
implementation of a specific strategy
benefit or harm market structure
performance and the interests of longterm investors? Is it possible to reliably
identify harmful strategies through, for
example, such metrics as adding or
taking liquidity, or trading with
(momentum) or against (contrarian)
prevailing price movements? Are there
regulatory tools that would address
harmful strategies while at the same
time have a minimal impact on
beneficial strategies?
Do commenters believe that the
overall use of harmful strategies by
proprietary firms is sufficiently
widespread that the Commission should
consider a regulatory initiative to
address the problem? What type of
regulatory initiative would be most
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effective? For example, should there be
a minimum requirement on the duration
of orders (such as one second) before
they can be cancelled, whether across
the board, in particular contexts, or
when used by particular types of
traders? If so, what would be an
appropriate time period? Should the use
of ‘‘pinging’’ orders by all or some
traders to assess undisplayed liquidity
be prohibited or restricted in all or some
contexts? 69
The use of certain strategies by some
proprietary firms has, in many trading
centers, largely replaced the role of
specialists and market makers with
affirmative and negative obligations.70
Has market quality improved or suffered
from this development? How important
are affirmative and negative obligations
to market quality in today’s market
structure? Are they more important for
any particular equity type or during
certain periods, such as times of stress?
Should some or all proprietary firms be
subject to affirmative or negative trading
obligations that are designed to promote
market quality and prevent harmful
conduct? Is there any evidence that
proprietary firms increase or reduce the
amount of liquidity they provide to the
market during times of stress?
As noted above, the Commission
wishes to request comment broadly on
all strategies used by proprietary firms.
To help present issues for comment, but
without limiting the broad request, this
release next will briefly discuss four
broad types of trading strategies that
often are associated with proprietary
firms—passive market making,
arbitrage, structural, and directional.
The discussion of directional strategies
will focus on two directional strategies
that may pose particular problems for
long-term investors—order anticipation
and momentum ignition. The
69 A ‘‘pinging’’ order is an immediate-or-cancel
order that can be used to search for and access all
types of undisplayed liquidity, including dark pools
and undisplayed order types at exchanges and
ECNs. The trading center that receives an
immediate-or-cancel order will execute the order
immediately if it has available liquidity at or better
than the limit price of the order and otherwise will
immediately respond to the order with a
cancellation. As noted in section IV.B.1.d. below,
there is an important distinction between using
tools such as pinging orders as part of a normal
search for liquidity with which to trade and using
such tools to detect and trade in front of large
trading interest as part of an ‘‘order anticipation’’
trading strategy.
70 Affirmative and negative obligations generally
are intended to promote market quality. Affirmative
obligations might include a requirement to
consistently display high quality, two-sided
quotations that help dampen price moves, while
negative obligations might include a restriction on
‘‘reaching across the market’’ to execute against
displayed quotations and thereby cause price
moves.
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Commission notes that many of the
trading strategies discussed below are
not new. What is new is the technology
that allows proprietary firms to better
identify and execute trading strategies.
a. Passive Market Making
Passive market making primarily
involves the submission of nonmarketable resting orders (bids and
offers) that provide liquidity to the
marketplace at specified prices. While
the proprietary firm engaging in passive
market making may sometimes take
liquidity if necessary to liquidate a
position rapidly, the primary sources of
profits are from earning the spread by
buying at the bid and selling at the offer
and capturing any liquidity rebates
offered by trading centers to liquiditysupplying orders. If the proprietary firm
is layering the book with multiple bids
and offers at different prices and sizes,
this strategy can generate an enormous
volume of orders and high cancellation
rates of 90% of more. The orders also
may have an extremely short duration
before they are cancelled if not
executed, often of a second or less.
Although proprietary firms that
employ passive market making
strategies are a new type of market
participant, the liquidity providing
function they perform is not new.
Professional traders with a permanent
presence in the marketplace, standing
ready to buy and sell on an ongoing
basis, are a perennial type of participant
in financial markets. Proprietary firms
largely have replaced more traditional
types of liquidity providers in the equity
markets, such as exchange specialists on
manual trading floors and OTC market
makers that trade directly with
customers. In contrast, proprietary firms
generally are not given special time and
place privileges in exchange trading
(nor are they subject to the affirmative
and negative trading obligations that
have accompanied such privileges). In
addition, proprietary firms typically do
not trade directly with customer order
flow, but rather trade by submitting
orders to external trading venues such
as exchanges and ATSs.71
Proprietary firms participate in the
marketplace in some ways that are
similar to both exchange specialists and
OTC market makers. Indeed, a single
firm or its affiliates may operate
simultaneously in all three capacities.
For example, proprietary traders are like
71 It is possible for a single firm to provide
liquidity in a variety of different forms. Some firms,
for example, may blur the distinction between
proprietary firms and OTC market makers by both
trading actively in external trading centers and
operating trading centers themselves that offer
customers direct electronic access to their liquidity.
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exchange specialists in the sense that
they transact most of their volume in
public markets where their orders will
trade with all comers. Unlike the
traditional floor specialists, however,
they do not have time and place
advantages, except insofar as their
sophistication and size enables them to
employ the fastest, most powerful
systems for generating, routing, and
cancelling orders and thereby most take
advantage of the current highly
automated market structure (including
such tools as individual trading center
data feeds and co-location discussed
below in section IV.B.2.). Proprietary
traders are analogous to OTC market
makers in that they have considerable
flexibility in trading without significant
negative or affirmative obligations for
overall market quality. But unlike an
OTC market maker, a proprietary firm
typically does not trade directly with
customers. The proprietary firm
therefore may not have ongoing
relationships with customers that can
pressure the proprietary trader to
provide liquidity in tough trading
conditions or less actively traded stocks.
Quality of Liquidity. The Commission
requests comment on the passive market
making strategies of proprietary firms.
To what extent do proprietary firms
engage in the types of strategies
described above? Do they provide
valuable liquidity to the market for toptier, large, medium, and small
capitalization stocks? Has market
quality improved or worsened as
traditional types of liquidity providers
have been replaced by proprietary
firms? Does the very brief duration of
many of their orders significantly
detract from the quality of liquidity in
the current market structure? For
example, are their orders accurately
characterized as phantom liquidity that
disappears when most needed by longterm investors and other market
participants? Or, is the collective result
of many different proprietary firms
engaging in passive market making a
relatively stable quoted market in which
there are many quotation updates
(primarily updates to size of the NBBO),
but relatively few changes in the price
of the NBBO? What types of data are
most useful in assessing the quality of
liquidity provided by proprietary firms?
Liquidity Rebates. One important
aspect of passive market making is the
liquidity rebates offered by many
exchanges and ECNs when resting
orders that add liquidity are accessed by
those seeking to trade immediately by
taking liquidity. The Commission
requests comment on the volume of
high frequency trading geared toward
earning liquidity rebates and on the
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benefits or drawbacks of such trading.
Are liquidity rebates unfair to long-term
investors because they necessarily will
be paid primarily to proprietary firms
engaging in passive market making
strategies? Or do they generally benefit
long-term investors by promoting
narrower spreads and more immediately
accessible liquidity? Do liquidity rebates
reward proprietary firms for any
particular types of trading that do not
benefit long-term investors or market
quality? For example, are there risk-free
trading strategies driven solely by the
ability to recoup a rebate that offer little
or no utility to the marketplace? Are
these strategies most likely when a
trading center offers inverted pricing
and pays a liquidity rebate that is higher
than its access fee for taking liquidity?
Does the distribution of consolidated
market data revenues pursuant to the
Plans lead to the current trading center
pricing schedules? If so, would there be
any benefits to restructuring the Plans
and, if so, how?
b. Arbitrage
An arbitrage strategy seeks to capture
pricing inefficiencies between related
products or markets. For example, the
strategy may seek to identify
discrepancies between the price of an
ETF and the underlying basket of stocks
and buy (sell) the ETF and
simultaneously sell (buy) the underlying
basket to capture the price difference.
Many of the trades necessary to execute
an arbitrage strategy are likely to involve
taking liquidity, in contrast to the
passive market making strategy that
primarily involves providing liquidity.
In this respect, it is quite possible for a
proprietary firm using an arbitrage
strategy to trade with a proprietary firm
using a passive market making strategy,
and for both firms to end up profiting
from the trade. Arbitrage strategies also
generally will involve positions that are
substantially hedged across different
products or markets, though the hedged
positions may last for several days or
more.
The Commission requests comment
on arbitrage strategies and whether they
benefit or harm the interests of longterm investors and market quality in
general. To what extent do proprietary
firms engage in the types of strategies
described above? For example, what is
the volume of trading attributable to
arbitrage involving ETFs (both in the
ETF itself and in any underlying
securities) and has the increasing
popularity of ETFs in recent years
significantly affected volume and
trading patterns in the equity markets?
If so, has the impact of ETF trading been
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positive or negative for long-term
investors and overall market quality?
In addition, to what extent are
arbitrage strategies focused on capturing
pricing differences among the many
different trading centers in NMS stocks?
For example, do these arbitrage
strategies significantly depend on
latencies among trading center data
feeds and the consolidated market data
feeds? Are these strategies beneficial for
long-term investors and market
structure quality? If not, how should
such strategies be addressed?
c. Structural
Some proprietary firm strategies may
exploit structural vulnerabilities in the
market or in certain market participants.
For example, by obtaining the fastest
delivery of market data through colocation arrangements and individual
trading center data feeds (discussed
below in section IV.B.2.), proprietary
firms theoretically could profit by
identifying market participants who are
offering executions at stale prices. In
addition, some market participants offer
guarantee match features to guarantee
the NBBO up to a certain limit. A
proprietary firm could enter a small
limit order in one part of the market to
set up a new NBBO, after which the
same proprietary firm triggers
guaranteed match trades in the opposite
direction.72 Are proprietary firms able
to profitably exploit these structural
vulnerabilities? To what extent do
proprietary firms engage in the types of
strategies described above? What is the
effect of this trading on market quality?
d. Directional
Neither passive market making nor
arbitrage strategies generally involve a
proprietary firm taking a significant,
unhedged position based on an
anticipation of an intra-day price
movement of a particular direction.
There may, however, be a wide variety
of short-term strategies that anticipate
such a movement in prices. Some
‘‘directional’’ strategies may be as
straightforward as concluding that a
stock price temporarily has moved away
from its ‘‘fundamental value’’ and
establishing a position in anticipation
that the price will return to such value.
These speculative strategies often may
contribute to the quality of price
discovery in a stock.73
72 The Commission has found that similar
conduct is manipulative, in violation of Section
10(b) of the Exchange Act and Rule 10b–5
thereunder. See Terrance Yoshikawa, Securities
Exchange Act Release No. 53731 (April 26, 2006)
(Commission opinion affirming NASD disciplinary
action).
73 See, e.g., Sanford Grossman & Joseph Stiglitz,
On the Impossibility of Informationally Efficient
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The Commission requests comment
on two types of directional strategies
that may present serious problems in
today’s market structure—order
anticipation and momentum ignition.
Order Anticipation Strategies. One
example of an order anticipation
strategy is when a proprietary firm seeks
to ascertain the existence of one or more
large buyers (sellers) in the market and
to buy (sell) ahead of the large orders
with the goal of capturing a price
movement in the direction of the large
trading interest (a price rise for buyers
and a price decline for sellers).74 After
a profitable price movement, the
proprietary firm then may attempt to
sell to (buy from) the large buyer (seller)
or be the counterparty to the large
buyer’s (seller’s) trading. In addition,
the proprietary firm may view the
trading interest of the large buyer
(seller) as a free option to trade against
if the price moves contrary to the
proprietary firm’s position.
Of course, any proprietary firm or
other person that violates a duty to a
large buyer or seller or misappropriates
their order information and then uses
the information for its own trading to
the detriment of the large buyer and
seller has engaged in misconduct that
already is prohibited, such as forms of
front running. Regulatory authorities
currently examine for, investigate, and
prosecute this type of misconduct and
will continue to do so. The Commission
requests comment on any regulatory
change that would limit the potential for
proprietary firms to profit from
misconduct with respect to the trading
activities of large buyers and sellers.
The type of order anticipation strategy
referred to in this release involves any
means to ascertain the existence of a
large buyer (seller) that does not involve
violation of a duty, misappropriation of
information, or other misconduct.
Examples include the employment of
sophisticated pattern recognition
software to ascertain from publicly
available information the existence of a
Markets, American Economic Review (June 1980)
(‘‘We propose here a model in which there is an
equilibrium degree of disequilibrium: prices reflect
the information of informed individuals
(arbitrageurs) but only partially, so that those who
expend resources do receive compensation. How
informed the price system is depends on the
number of individuals who are informed, but the
number of individuals who are informed is itself an
endogenous variable in the model.’’).
74 See Larry Harris, Trading and Exchanges:
Market Microstructure for Practitioners (2003) at
222, 245 (‘‘Harris Treatise’’) (‘‘Order anticipators are
speculators who try to profit by trading before
others trade. They make money when they correctly
anticipate how other traders will affect prices or
when they can extract option values from the orders
that other traders offer to the market.’’) (emphasis
in original).
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large buyer (seller), or the sophisticated
use of orders to ‘‘ping’’ different market
centers in an attempt to locate and trade
in front of large buyers and sellers.
It is important to recognize the
distinction between order anticipation
and a normal search for liquidity to
implement a trading strategy. When a
proprietary firm employs an order
anticipation strategy and detects a large
buyer (seller), it will first attempt to buy
(sell), and the proprietary firm largely
will be indifferent to whether the party
is a buyer or a seller. In contrast, longterm investors searching for liquidity to
trade against will be seeking specifically
either to establish a position or to
liquidate a position. If buying, the longterm investor will attempt to find large
selling interest and buy from it or, if
selling, will attempt to find large buying
interest and sell to it. Both the long-term
investor and the large buyer (seller)
benefit from the liquidity seeking
strategy, in contrast to the order
anticipation strategy where the large
buyer (seller) is harmed when the
proprietary firm initially trades in front
of the large buyer (seller).
Order anticipation is a not a new
strategy. Indeed, a 2003 treatise on
market structure described order
anticipation as follows: ‘‘Order
anticipators are parasitic traders. They
profit only when they can prey on other
traders. They do not make prices more
informative, and they do not make
markets more liquid. * * * Large
traders are especially vulnerable to
order anticipators.’’75 An important
issue for purposes of this release is
whether the current market structure
and the availability of sophisticated,
high-speed trading tools enable
proprietary firms to engage in order
anticipation strategies on a greater scale
than in the past. Alternatively, is it
possible that the widespread use of
high-speed trading tools by a variety of
proprietary firms and institutions limits
the ability of market participants to
engage in profitable order anticipation
strategies? Does your answer depend on
whether top tier, large, medium, or
small market capitalization stocks are
considered?
The Commission requests comment
on all aspects of order anticipation
strategies. Do commenters believe that
order anticipation significantly detracts
from market quality and harms
institutional investors (for example,
does it represent a substantial transfer of
wealth from the individuals represented
by institutional investors to proprietary
firms)? Do commenters believe that
order anticipation has become more or
75 Harris
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less prevalent in recent years? If more
prevalent, is the use of proprietary firm
strategies an important factor in this
development? If commenters believe
order anticipation has become more
prevalent, are there ways to distinguish
order anticipation from other beneficial
trading strategies? Are there regulatory
tools that would effectively address
concerns about order anticipation,
without unintentionally interfering with
other strategies that may be beneficial
for long-term investors and market
quality?
Momentum Ignition Strategies.
Another type of directional strategy that
may raise concerns in the current
market structure is momentum ignition.
With this strategy, the proprietary firm
may initiate a series of orders and trades
(along with perhaps spreading false
rumors in the marketplace) in an
attempt to ignite a rapid price move
either up or down. For example, the
trader may intend that the rapid
submission and cancellation of many
orders, along with the execution of some
trades, will ‘‘spoof’’ the algorithms of
other traders into action and cause them
to buy (sell) more aggressively. Or the
trader may intend to trigger standing
stop loss orders that would help cause
a price decline. By establishing a
position early, the proprietary firm will
attempt to profit by subsequently
liquidating the position if successful in
igniting a price movement. This type of
strategy may be most harmful in less
actively traded stocks, which may
receive little analyst or other public
attention and be vulnerable to price
movements sparked by a relatively
small amount of volume.
Of course, any market participant that
manipulates the market has engaged in
misconduct that already is prohibited.
The Commission and other regulatory
authorities already employ their
examination and enforcement resources
to detect violations and bring
appropriate proceedings against the
perpetrators. This concept release is
focused on the issue of whether
additional regulatory tools are needed to
address illegal practices, as well as any
other practices associated with
momentum ignition strategies. For
example, while spreading false rumors
to cause price moves is illegal, such
rumors can be hard to find (if not spread
in writing), and it can be difficult to
ascertain the identity of those who
spread rumors to cause price moves.
The Commission requests comment
on whether momentum ignition
strategies are a significant problem in
the current market structure. To what
extent do proprietary firms engage in
the types of strategies described above?
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Does, for example, the speed of trading
and ability to generate a large amount of
orders across multiple trading centers
render this type of strategy more of a
problem today? If momentum ignition
strategies have caused harm, are there
objective indicia that would reliably
identify problematic strategies? Are
there regulatory tools (beyond the
currently applicable anti-fraud and antimanipulation provisions) that would
effectively reduce or eliminate the use
of momentum ignition strategies while
at the same time have a minimal impact
on other strategies that are beneficial to
long-term investors and market quality?
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2. Tools
This section will focus on two
important tools that often are used by
proprietary firms to implement their
short-term trading strategies—colocation and trading center data feeds.
a. Co-Location
Many proprietary firm strategies are
highly dependent upon speed—speed of
market data delivery from trading center
servers to servers of the proprietary
firm; speed of decision processing of
trading engines of the proprietary firm;
speed of access to trading center servers
by servers of the proprietary firm; and
speed of order execution and response
by trading centers. Speed matters both
in the absolute sense of achieving very
small latencies and in the relative sense
of being faster than competitors, even if
only by a microsecond. Co-location is
one means to save micro-seconds of
latency.
Co-location is a service offered by
trading centers that operate their own
data centers and by third parties that
host the matching engines of trading
centers. The trading center or third
party rents rack space to market
participants that enables them to place
their servers in close physical proximity
to a trading center’s matching engine.
Co-location helps minimize network
and other types of latencies between the
matching engine of trading centers and
the servers of market participants.
The Commission believes that the colocation services offered by registered
exchanges are subject to the Exchange
Act. Exchanges that intend to offer colocation services must file proposed rule
changes and receive approval of such
rule changes in advance of offering the
services to customers.76 The terms of co76 Section 3(a)(27) of the Exchange Act defines
‘‘rules of an exchange’’ as, among other things, a
stated policy, practice, or interpretation of the
exchange that the Commission has by rule
determined to be rules of the exchange. Rule 19b4(b) under the Exchange Act defines ‘‘stated policy,
practice, or interpretation’’ to mean, in part, [a]ny
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location services must not be unfairly
discriminatory, and the fees must be
equitably allocated and reasonable.77
Fairness of Co-Location Services.
Beyond these basic statutory
requirements, the Commission broadly
requests comment on co-location and
whether it benefits or harms long-term
investors and market quality. For
example, does co-location provide
proprietary firms an unfair advantage
because they generally will have greater
resources and sophistication to take
advantage of co-location services than
other market participants, including
long-term investors? If so, specify how
this disparity harms long-term investors.
Conversely, does co-location offer
benefits to long-term investors? For
example, do co-location services enable
liquidity providers to operate more
efficiently and thereby increase the
quality of liquidity they provide to the
markets? Please quantify any harm or
benefits, if possible. Is it fair for some
market participants to pay to obtain
better access to the markets than is
available to those not in a position to
pay for or otherwise obtain co-location
services? Aside from physical
proximity, are there other aspects of
services offered by exchanges to colocation participants that may lead to
unfair access concerns?
In addition, are brokers generally able
to obtain and use co-location services on
behalf of their customers? If so, are longterm investors harmed by not being able
to use co-location directly? Are colocation fees so high that they
effectively create a barrier for smaller
firms? Do commenters believe that colocation services fundamentally differ
from other respects in which market
participants can obtain latency
advantages, particularly if co-location
services are not in short supply and are
available to anyone on terms that are
fair and reasonable and not
unreasonably discriminatory?
If commenters believe that co-location
services create unfair access to trading,
should the Commission prohibit or
restrict exchanges, and other trading
centers, such as ATSs, from offering colocation services? If exchanges and
other trading centers were no longer
permitted to provide the services, would
third parties, who may be outside the
Commission’s regulatory authority, be
encouraged to obtain space close to an
exchange’s data center and rent such
space to market participants?
material aspect of the operation of the facilities of
the self-regulatory organization.’’ The Commission
views co-location services as being a material aspect
of the operation of the facilities of an exchange.
77 Section 6(b)(4) and (5) of the Exchange Act.
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Alternatively, could exchanges and
other trading centers batch process all
orders each second and, if so, what
would be the effect of such a policy on
market quality?
The Commission also requests
comment on exchanges and other
trading centers that place their trading
engines in data facilities operated by
third parties. Such parties are not
regulated entities subject to the access
and other requirements of the Exchange
Act and Commission rules. Could this
disparity create competitive
disadvantages among trading centers?
Should the third party data centers be
considered facilities of the exchange or
trading center? Alternatively, should the
Commission require trading centers to
obtain contractual commitments from
third parties to provide any co-location
services on terms consistent with the
Exchange Act and Commission rules?
With respect to those market
participants that purchase co-location
services, should exchanges and other
trading centers be subject to specific
requirements to help assure that all
participants are treated in a manner that
is not unfairly discriminatory? Latency
can arise from a variety of sources, such
as cable length and capacity, processing
capabilities, and queuing. Is it possible
for trading centers to guarantee equal
latency across all market participants
that use comparable co-location
services? Should the Commission
require latency transparency—the
disclosure of information that would
enable market participants to make
informed decisions about their speed of
access to an exchange or other trading
center? Such disclosures could include,
for example, periodic public reports on
the latencies of the fastest market
participants (on an anonymous basis), as
well as private reports directly to
individual market participants of their
specific latencies. If latency disclosure
should be required, what information
should be disclosed and in what
manner?
Affirmative or Negative Trading
Obligations. Finally, the Commission
requests comment on whether all or
some market participants (such as
proprietary firms) that obtain colocation services should be subject to
any affirmative or negative obligations
with respect to their trading behavior.
Such obligations historically were
applied to exchange specialists that
enjoyed a unique time and place
advantage on the floor of an exchange.
Are co-location services analogous to
the specialist advantages? Or does the
wider availability of co-location services
to many market participants distinguish
co-located market participants from
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exchange specialists? If all or some colocation participants should be subject
to trading obligations, what should be
the nature of such obligations? For
example, should some or all co-location
participants be prohibited from
aggressively taking liquidity and moving
prices always or only under specified
circumstances? If only under specified
circumstances, what should those
include or exclude? Should some or all
co-location participants ever be required
to provide liquidity on an ongoing basis
or in certain contexts?
b. Trading Center Data Feeds
Another important tool widely used
by proprietary firms is the individual
data feeds offered by many exchanges
and ECNs. As discussed in section
III.B.1. above, the consolidated data
feeds include the best-priced quotations
of all exchanges and certain ATSs and
all reported trades. The individual data
feeds of exchanges and ECNs generally
will include their own best-priced
quotations and trades, as well as other
information, such as inferior-priced
orders included in their depth-of-book.
When it adopted Regulation NMS in
2005, the Commission did not require
exchanges, ATSs, and other brokerdealers to delay their individual data
feeds to synchronize with the
distribution of consolidated data, but
prohibited them from independently
transmitting their own data any sooner
than they transmitted the data to the
plan processors.78
Given the extra step required for SROs
to transmit market data to plan
processors, and for plan processors to
consolidate the information and
distribute it the public, the information
in the individual data feeds of
exchanges and ECNs generally reaches
market participants faster than the same
information in the consolidated data
feeds. The extent of the latency
depends, among other things, on the
speed of the systems used by the plan
processors to transmit and process
consolidated data and on the distances
between the trading centers, the plan
processors, and the recipients. As noted
above,79 the Commission understands
that the average latency of plan
processors for the consolidated data
feeds generally is less than 10
milliseconds. This latency captures the
difference in time between receipt of
data by the plan processors from the
SROs and distribution of the data by the
plan processors to the public.
Latency of Consolidated Data. The
Commission requests comment on all
78 Regulation
79 See
NMS Release, 70 FR at 37567.
supra note 45 and accompanying text.
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aspects of the latency between
consolidated data feeds and individual
trading center data feeds. What have
market participants experienced in
terms of the degree of latency between
trading center and consolidated data? Is
the latency as small as possible given
the necessity of the consolidation
function, or could plan processor
systems be improved to significantly
reduce the latency from current levels,
while still retaining the high level of
reliability required of plan processors?
More broadly, is the existence of any
latency, or the disparity in information
transmitted, fair to investors or other
market participants that rely on the
consolidated market data feeds and do
not use individual trading center data
feeds? If so, should the unfairness be
addressed by a requirement that trading
center data be delayed for a sufficient
period of time to assure that
consolidated data reaches users first?
Would such a mandated delay
adequately address unfairness? Would a
mandatory delay seriously detract from
the efficiency of trading and harm longterm investors and market quality?
Should the Commission require that
additional information be included in
the consolidated market data feeds?
Odd-Lot Transactions. Finally, the
consolidated trade data currently does
not include reports of odd lot orders or
odd lot transactions (transactions with
sizes of less than 1 round lot, which
generally is 100 shares). It appears that
a substantial volume of trading
(approximately 4%) may be attributable
to odd lot transactions. Why is the
volume of odd lots so high? Should the
Commission be concerned about this
level of activity not appearing in the
consolidated trade data? Has there been
an increase in the volume of odd lots
recently? If so, why? Do market
participants have incentives to
strategically trade in odd lots to
circumvent the trade disclosure or other
regulatory requirements? Would these
trades be important for price discovery
if they were included in the
consolidated trade data? Should these
transactions be required to be reported
in the consolidated trade data? Why?
3. Systemic Risks
Stepping back from the particular
strategies and tools used by proprietary
traders, comment is requested more
broadly on whether HFT poses
significant risks to the integrity of the
current equity market structure. For
example, do the high speed and
enormous message traffic of automated
trading systems threaten the integrity of
trading center operations? Also, many
proprietary firms potentially could
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3611
engage in similar or connected trading
strategies that, if such strategies
generated significant losses at the same
time, could cause many proprietary
firms to become financially distressed
and lead to large fluctuations in market
prices. To the extent that proprietary
firms obtain financing for their trading
activity from broker-dealers or other
types of financial institutions, the
significant losses of many proprietary
firms at the same time also could lead
to more widespread financial distress.80
Comment also is requested on
whether proprietary traders help
promote market integrity by providing
an important source of liquidity in
difficult trading conditions. The
Commission notes that, from an
operational standpoint, the equity
markets performed well during the
world-wide financial crisis in the
Autumn of 2008 when volume and
volatility spiked to record highs.81
Unlike some financial crises in the past,
the equity markets continued to operate
smoothly and participants generally
were able to trade at currently displayed
prices (though most investors likely
suffered significant losses from the
general decline of market prices). Does
80 A broker-dealer conducting a general securities
business that is required to register with the
Commission under Section 15(b) of the Exchange
Act must comply with the Commission’s net capital
rule, Exchange Act Rule 15c3–1. Under Rule 15c3–
1, broker-dealers are required to maintain, at all
times, a minimum amount of net capital. This
means that firms must be able to demonstrate that
they have sufficient net capital for intra-day
positions. In addition, if a broker-dealer is engaged
in proprietary trading on margin, it may be subject
to certain provisions of Regulation T, 12 CFR 220.1,
et seq., as well as SRO margin rules applicable to
broker-dealers. See, e.g., NYSE Rule 431(e)(5)
(specialists’ and market makers’ accounts), (e)(6)(A)
(broker/dealer accounts), (e)(6)(B) (Joint Back Office
Arrangements) and NASD Rule 2520(e)(5), (e)(6)(A)
and (e)(6)(B). Moreover, high frequency traders who
are not broker-dealers must comply with the SRO
day trading rules if they meet the definition of
‘‘pattern day trader.’’ NYSE Rule 431(f)(8)(B) and
NASD Rule 2520(f)(8)(B).
81 See, e.g., NYSE Euronext, Consolidated Volume
in NYSE Listed Issues 2000–2009 (available at
https://www.nyxdata.com/nysedata/NYSE/
FactsFigures/tabid/115/Default.aspx) (consolidated
average daily volume in NYSE-listed stocks reached
a then-record high of 7.1 billion shares in October
2008, compared to an average of 3.4 billion shares
for the year 2007); Pam Abramowitz, Technology
Drives Trading Costs, Institutional Investor
(November 4, 2009) (‘‘[V]olatility has fallen
substantially over the past six to nine months as
equity markets have rallied. * * * [The] VIX,
which hit an all-time high of 89.53 in October 2008,
averaged 25.49 in the third quarter of 2009, close
to its precrisis historical average of 20.3’’); Tom
Lauricella, Volatility Requires New Strategies, Wall
Street Journal (October 20, 2008) (‘‘The stock
market’s collapse and unprecedented daily price
swings are forcing investors of all stripes to rethink
their strategies, all the while looking for any hints
that the financial markets will stabilize. * * * So
far this month, there have been 10 days where the
Dow Jones Industrial Average ricocheted in a range
of more than 5% * * *’’).
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the 2008 experience indicate that
systemic risk is appropriately
minimized in the current market
structure? If not, what further steps
should the Commission take to address
systemic risk? Should, for example, all
proprietary firms be required to register
as broker-dealers and become members
of FINRA to help assure that their
operations are subject to full regulatory
oversight? Moreover, does the current
regulatory regime adequately address
the particular concerns raised by
proprietary firms and their trading
strategies and tools?
C. Undisplayed Liquidity
As noted in section III.A. above,
undisplayed liquidity is trading interest
that is available for execution at a
trading center, but is not included in the
consolidated quotation data that is
widely disseminated to the public.
Undisplayed liquidity also is commonly
known as ‘‘dark’’ liquidity. The
Commission recently published
proposals to address certain practices
with respect to undisplayed liquidity.
These include the use of actionable
indications of interest, or ‘‘IOIs,’’ to
attract order flow, the lowering of the
trading volume threshold that would
trigger ATS order display obligations,
and the real-time disclosure of the
identity of ATSs on the public reports
of their executed trades.82 This release
is intended to request comment on a
wide range of issues with respect to
undisplayed liquidity in all of its forms.
Undisplayed liquidity in general is
not a new phenomenon. Market
participants that need to trade in large
size, such as institutional investors,
always have faced a difficult trading
dilemma. On the one hand, if they
prematurely reveal the full extent of
their large trading interest to the market,
then market prices are likely to run
away from them (a price rise for those
seeking to buy and a price decline for
those seeking to sell), which would
greatly increase their transaction costs
and reduce their overall investment
returns. On the other hand, if an
institutional investor that wants to trade
in large size does nothing, then it will
not trade at all. Finding effective and
innovative ways to trade in large size
with minimized transaction costs is a
perennial challenge for institutional
investors, the brokers that represent
their orders in the marketplace, and the
trading centers that seek to execute their
orders.
A primary source of dark liquidity for
many years was found on the manual
82 See Non-Public Trading Interest Release, 74 FR
at 61209–61210.
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trading floors of exchanges. The floor
brokers ‘‘worked’’ the large orders of
their customers by executing such
orders in a number of smaller
transactions without revealing to
potential counterparties the total size of
the order. One consequence of the
decline in market share of the NYSE
floor in recent years is that this
historically large undisplayed liquidity
pool in NYSE-listed stocks appears to
have largely migrated to other types of
venues. As discussed in section III.A.3.
above, a recent form of undisplayed
liquidity is the dark pool—an ATS that
does not display quotations in the
consolidated quotation data. Other
sources of undisplayed liquidity are
broker-dealers that internalize orders 83
and undisplayed order types of
exchanges and ECNs.
Although they offer liquidity that is
not included in the consolidated
quotation data, dark pools and OTC
market makers generally trade with
reference to the best displayed
quotations and execute orders at prices
that are equal to or better than the
NBBO. Indeed, all dark pools and OTC
market makers are covered by the tradethrough restrictions of Rule 611 and,
subject to limited exceptions, cannot
execute transactions at prices that are
inferior to the best displayed prices.
The Commission requests comment
on all forms of undisplayed liquidity in
the current market structure. It
particularly wants to present three
issues for comment—the effect of
undisplayed liquidity on order
execution quality, the effect of
undisplayed liquidity on public price
discovery, and fair access to sources of
undisplayed liquidity.
1. Order Execution Quality
It appears that a significant percentage
of the orders of individual investors are
executed at OTC market makers, and
that a significant percentage of the
orders of institutional investors are
executed in dark pools. Comment is
requested on the order execution quality
provided to these long-term investors.
Given the strong Exchange Act policy
preference in favor of price transparency
and displayed markets, do dark pools
and OTC market makers offer
substantial advantages in order
execution quality to long-term
investors? If so, do these advantages
83 As noted in section III.A.2. above, many brokerdealers may submit orders to exchanges or ECNs,
which then are included in the consolidated
quotation data. The internalized executions of
broker-dealers, however, primarily reflect liquidity
that is not included in the consolidated quotation
data and are appropriately classified as undisplayed
liquidity.
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justify the diversion of a large
percentage of investor order flow away
from the displayed markets that play a
more prominent role in providing
public price discovery? If investors were
limited in their ability to use
undisplayed liquidity, how would
trading behavior change, if at all? What
types of activity might evolve to replace
undisplayed liquidity if its use were
constrained?
Individual Investors. Liquidity
providers generally consider the orders
of individual investors very attractive to
trade with because such investors are
presumed on average to not be as
informed about short-term price
movements as are professional traders.
Do individual investor orders receive
high quality executions when routed to
OTC market makers? For example, does
competition among OTC market makers
to attract order flow lead to significantly
better prices for individual investor
orders than they could obtain in the
public markets? Do OTC market makers
charge access fees comparable to those
charged by public markets? Does the
existence of payment for order flow
arrangements between routing brokers
and OTC market makers (and
internalization arrangements when the
routing broker and OTC market maker
are affiliated) detract from the quality of
executions for investor orders? If more
individual investor orders were routed
to public markets, would it promote
quote competition in the public
markets, lead to narrower spreads, and
ultimately improve order execution
quality for individual investors beyond
current levels? Finally, are a significant
number of individual investor orders
executed in dark pools and, if so, what
is the execution quality for these orders?
Institutional Investors. An important
objective of many dark pools is to offer
institutional investors an efficient venue
in which to trade in large size (often by
splitting a large parent order into many
child orders) with minimized market
impact. To what extent do dark pools
meet this objective of improving
execution quality for the large orders of
institutional investors? Does execution
quality vary across different types of
dark pools and, if so, which types? If so,
does this difference depend on the
characteristics of particular securities
(such as market capitalization and
security price)?
As noted above in section IV.C., many
dark pools execute orders with reference
to the displayed prices in public
markets. Does this reference pricing
create opportunities for institutional
investors to be treated unfairly by
improper behavior (such as placing a
small order to change the NBBO for a
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very short period and quickly
submitting orders to dark pools for
execution at prices affected by the new
NBBO)? 84 If so, to what extent does
gaming occur? Do all types of dark pools
employ anti-gaming tools? How
effective are such tools?
Finally, are institutional investors
able to trade more efficiently using
undisplayed liquidity at dark pools and
broker-dealers than they are using the
undisplayed liquidity at exchanges and
ECNs? What are the advantages and
disadvantages of each form of
undisplayed liquidity? If the use of
undisplayed liquidity at dark pools and
broker-dealers were curtailed in any
way, could institutional investors adjust
by using undisplayed liquidity on
exchanges and ECNs without incurring
higher transaction costs?
2. Public Price Discovery
Comment is requested on whether the
trading volume of undisplayed liquidity
has reached a sufficiently significant
level that it has detracted from the
quality of public price discovery and
execution quality. For example, has the
level of undisplayed liquidity led to
increased spreads, reduced depth, or
increased short-term volatility in the
displayed trading centers? If so, has
such harm to public price discovery led
to a general worsening of execution
quality for investors in undisplayed
markets that execute trades with
reference to prices in the displayed
markets?
It appears that a significant percentage
of the orders of long-term investors are
executed either in dark pools or at OTC
market makers, while a large percentage
of the trading volume in displayed
trading centers is attributable to
proprietary firms executing short-term
trading strategies. Has there in fact been
an increase in the proportion of longterm investor orders executed in
undisplayed trading centers? If so, what
is the reason for this tendency and is the
practice beneficial or harmful to longterm investors and to market quality?
With respect to undisplayed order types
on exchanges and ECNs, do commenters
believe that these order types raise
similar concerns about public price
discovery as undisplayed liquidity at
dark pools and broker-dealers?
If commenters do not believe the
current level of undisplayed liquidity
has detracted from the quality of public
price discovery, is there any level at
which they believe the Commission
should be concerned? In this regard, it
appears that the overall percentage of
84 The Commission has found that similar
conduct is manipulative. See supra note 72.
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trading volume between undisplayed
trading centers and displayed trading
centers has remained fairly steady for
many years between 70% and 80%.85
Does this overall percentage accurately
reflect the effect of undisplayed
liquidity on public price discovery or
does it mask potentially important
changes in the routing of underlying
types of order flow? For example, the
NYSE captures a smaller percentage of
trading in NYSE-listed stocks, while the
overall volume in NYSE stocks has
increased dramatically.86 Should this
change in market share be interpreted to
mean that a greater percentage of longterm individual investor and long-term
institutional investor order flow in
NYSE-listed stocks has shifted to dark
pools and OTC market makers, while
the public markets are executing an
expanding volume of trading that is
primarily attributable to HFT strategies?
If so, does this underlying shift in order
flow affect the quality of public price
discovery in NYSE-listed stocks and
what are the reasons for this
development? Do similar order flow
patterns affect the quality of public
price discovery in stocks listed on other
exchanges as well?
Trade-At Rule. If commenters believe
that the quality of public price
discovery has been harmed by
undisplayed liquidity, are there
regulatory tools that the Commission
should consider to address the problem?
Should the Commission consider a
‘‘trade-at’’ rule that would prohibit any
trading center from executing a trade at
the price of the NBBO unless the trading
center was displaying that price at the
time it received the incoming contraside order? Under this type of rule, for
example, a trading center that was not
displaying the NBBO at the time it
received an incoming marketable order
could either: (1) Execute the order with
significant price improvement (such as
the minimum allowable quoting
increment (generally one cent)); or (2)
route ISOs to full displayed size of
NBBO quotations and then execute the
balance of the order at the NBBO price.
The Commission requests comment
on all aspects of a trade-at rule. Would
it help promote pre-trade public price
discovery by preventing the diversion of
a significant volume of highly valuable
marketable order flow away from the
displayed trading centers and to
undisplayed trading centers? If so, to
what extent would the increased routing
of this marketable order flow to
displayed trading centers create
significantly greater incentives for
market participants to display
quotations in greater size or with more
aggressive prices?
Given the order-routing and trading
system technologies currently in place
to prevent trade-throughs, would it be
feasible for market participants to
comply with a trade-at rule at
reasonable cost? Should a trade-at rule
apply to all types of trading centers (e.g.,
exchanges, ECNs, OTC market makers,
and dark pools) or only to some of
them? If so, which ones and why? In
addition, if the Commission were to
consider such a rule, how should it treat
the issue of displayed markets that
charge access fees? Should it, for
example, condition the ‘‘trade-at’’
protection of a displayed quotation on
there being no access fee or an access
fee that is much smaller than the current
0.3 cent per share cap in Rule 610(c) of
Regulation NMS?
Depth-of-Book Protection. Rule 611
currently provides trade-through
protection only to quotations that reflect
the best, ‘‘top-of-book,’’ prices of a
trading center.87 Should Rule 611 be
expanded to provide trade-through
protection to the displayed ‘‘depth-ofbook’’ quotations of a trading center?
Would depth-of-book protection
significantly promote the greater display
of trading interest? Is depth-of-book
protection feasible under current trading
conditions and could the securities
industry implement depth-of-book
protection at reasonable cost?
Low-Priced Stocks. There may be
greater incentives for broker-dealer
internalization in low-priced stocks
than in higher priced stocks. In lowpriced stocks, the minimum one cent
per share pricing increment of Rule 612
of Regulation NMS is much larger on a
percentage basis than it is in higherpriced stocks. For example, a one cent
spread in a $20 stock is 5 basis points,
while a one cent spread in a $2 stock is
50 basis points—10 times as wide on a
percentage basis. Does the larger
percentage spread in low-price stocks
lead to greater internalization by OTC
market makers or more trading volume
in dark pools? If so, why? Should the
Commission consider reducing the
minimum pricing increment in Rule 612
for lower priced stocks?
85 See supra note 21 and accompanying text
(estimated 25.4% of share volume in NMS stocks
executed in undisplayed trading centers in
September 2009).
86 See supra notes 8 and 10 and accompanying
text.
87 See Regulation NMS Release, 70 FR at 37529–
37530 (discussion of decision not to adopt a
‘‘Voluntary Depth Alternative’’ that would have
provided trade-through protection to depth-of-book
quotations that a market voluntarily included in the
consolidated quotation data).
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A significant difference between the
undisplayed liquidity offered by
exchanges and the undisplayed
liquidity offered by dark pools and
broker-dealers is the extent of access
they allow to such liquidity. As noted
in section III.B.3. above, registered
exchanges are required to offer broad
access to broker-dealers. As ATSs that
are exempt from exchange registration,
dark pools are not required to provide
fair access unless they reach a 5%
trading volume threshold in a stock,
which none currently do.88 Brokerdealers that internalize also are not
subject to fair access requirements. As a
result, access to the undisplayed
liquidity of dark pools and brokerdealers is determined primarily by
private negotiation.
The Commission requests comment
on whether trading centers offering
undisplayed liquidity are subject to
appropriate regulatory requirements for
the type of business they conduct. For
example, should the trading volume
threshold in Regulation ATS that
triggers the fair access requirement be
lowered from its current 5%? If so, what
is the appropriate threshold?
If an ATS exceeds the trading volume
threshold, Regulation ATS requires that
the ATS have access standards that do
not unreasonably prohibit or limit any
person in respect to access services, and
prohibits the ATS from applying such
standards in an unfair or discriminatory
manner. Do commenters believe that all
types of dark pools can comply with
this fair access requirement, yet still
achieve the objective of enabling
institutional investors to trade in large
size with minimized price impact? Can
dark pool restrictions designed to
prevent predatory trading behavior 89 be
drafted in an objective fashion that
would comply with the Regulation ATS
fair access requirement?
The majority of dark pool volume is
executed in ATSs that are sponsored by
multi-service broker-dealers.90 Can a
broker-dealer sponsored dark pool apply
objective fair access standards
reasonably to prevent predatory trading,
but without using such standards as a
pretext to discriminate based on the
competitive self interest of the
sponsoring broker?
Finally, do investors have sufficient
information about dark pools to make
informed decisions about whether in
fact they should seek access to dark
pools? Should dark pools be required to
provide improved transparency on their
trading services and the nature of their
participants? If so, what disclosure
should be required and in what manner
should ATSs provide such disclosures?
88 The Commission understands that ECNs,
unlike most dark pools, generally offer wide access
to their services, including undisplayed liquidity,
even if not subject to the fair access requirement of
Rule 301(b)(5) of Regulation ATS.
89 See, e.g., section IV.B.1.d. supra (discussion of
order anticipation strategies that seek to ascertain
the existence of large buyers and sellers).
90 Data compiled from Forms ATS submitted to
Commission for 3d quarter 2009.
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More broadly, are there any other
aspects of ATS regulation that should be
enhanced for dark pools or for all ATSs,
including ECNs? For example, do ATSs
contribute appropriately to the costs of
consolidated market surveillance?
Currently, FINRA is the SRO for ATSs,
and ATSs must pay the applicable
FINRA regulatory fees. Do these FINRA
fees adequately reflect the significant
volume currently executed by ATSs?
Should ATSs be required to contribute
more directly to the cost of market
surveillance? Finally, are there any
ways in which Regulation ATS should
be modified or supplemented to
appropriately reflect the significant role
of ATSs in the current market structure?
D. General Request for Comments
The Commission requests and
encourages all interested persons to
submit their views on any aspect of the
current equity market structure. While
this release was intended to present
particular issues for comment, it was
not intended in any way to limit the
scope of comments or issues to be
considered. In addition, the views of
commenters are of greater assistance
when they are accompanied by
supporting data and analysis.
Dated: January 14, 2010.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010–1045 Filed 1–20–10; 8:45 am]
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E:\FR\FM\21JAP2.SGM
21JAP2
]]>Agencies
[Federal Register Volume 75, Number 13 (Thursday, January 21, 2010)]
[Proposed Rules]
[Pages 3594-3614]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-1045]
[[Page 3593]]
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Part III
Securities and Exchange Commission
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17 CFR Part 242
Concept Release on Equity Market Structure; Proposed Rule
Federal Register / Vol. 75 , No. 13 / Thursday, January 21, 2010 /
Proposed Rules
[[Page 3594]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-61358; File No. S7-02-10]
RIN 3235-AK47
Concept Release on Equity Market Structure
AGENCY: Securities and Exchange Commission.
ACTION: Concept release; request for comments.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
conducting a broad review of the current equity market structure. The
review includes an evaluation of equity market structure performance in
recent years and an assessment of whether market structure rules have
kept pace with, among other things, changes in trading technology and
practices. To help further its review, the Commission is publishing
this concept release to invite public comment on a wide range of market
structure issues, including high frequency trading, order routing,
market data linkages, and undisplayed, or ``dark,'' liquidity. The
Commission intends to use the public's comments to help determine
whether regulatory initiatives to improve the current equity market
structure are needed and, if so, the specific nature of such
initiatives.
DATES: Comments should be received on or before April 21, 2010.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments:
Use the Commission's Internet comment form (https://www.sec.gov/rules/proposed.shtml); or
Send an e-mail to rule-comments@sec.gov. Please include
File No. S7-02-10 on the subject line; or
Use the Federal eRulemaking Portal (https://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments:
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File No. S7-02-10. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (https://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: Arisa Tinaves, Special Counsel, at
(202) 551-5676, Gary M. Rubin, Attorney, at (202) 551-5669, Division of
Trading and Markets, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-7010.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. Exchange Act Requirements for a National Market System
III. Overview of Current Market Structure
A. Trading Centers
1. Registered Exchanges
2. ECNs
3. Dark Pools
4. Broker-Dealer Internalization
B. Linkages
1. Consolidated Market Data
2. Trade-Through Protection
3. Broker Routing Services
IV. Request for Comments
A. Market Structure Performance
1. Long-Term Investors
a. Market Quality Metrics
b. Fairness of Market Structure
2. Other Measures
B. High Frequency Trading
1. Strategies
a. Passive Market Making
b. Arbitrage
c. Structural
d. Directional
2. Tools
a. Co-Location
b. Trading Center Data Feeds
3. Systemic Risks
C. Undisplayed Liquidity
1. Order Execution Quality
2. Public Price Discovery
3. Fair Access and Regulation of ATSs
D. General Request for Comments
I. Introduction
The secondary market for U.S.-listed equities has changed
dramatically in recent years. In large part, the change reflects the
culmination of a decades-long trend from a market structure with
primarily manual trading to a market structure with primarily automated
trading. When Congress mandated the establishment of a national market
system for securities in 1975, trading in U.S.-listed equities was
dominated by exchanges with manual trading floors. Trading equities
today is no longer as straightforward as sending an order to the floor
of a single exchange on which a stock is listed. As discussed in
section III below, the current market structure can be described as
dispersed and complex: (1) Trading volume is dispersed among many
highly automated trading centers that compete for order flow in the
same stocks; and (2) trading centers offer a wide range of services
that are designed to attract different types of market participants
with varying trading needs.
A primary driver and enabler of this transformation of equity
trading has been the continual evolution of technologies for
generating, routing, and executing orders. These technologies have
dramatically improved the speed, capacity, and sophistication of the
trading functions that are available to market participants. Changes in
market structure also reflect the markets' response to regulatory
actions such as Regulation NMS, adopted in 2005,\1\ the Order Handling
Rules, adopted in 1996,\2\ as well as enforcement actions, such as
those addressing anti-competitive behavior by market makers in NASDAQ
stocks.\3\
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\1\ Securities Exchange Act Release No. 51808 (June 9, 2005), 70
FR 37496 (June 29, 2005) (``Regulation NMS Release'').
\2\ Securities Exchange Act Release No. 37619A (September 6,
1996), 61 FR 48290 (September 12, 1996) (``Order Handling Rules
Release'').
\3\ See, e.g., In the Matter of National Association of
Securities Dealers, Inc., Administrative Proceeding File No. 3-9056,
Securities Exchange Act Release No. 37538 (August 8, 1996).
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The transformation of equity trading has encompassed all types of
U.S.-listed stocks. In recent years, however, it is perhaps most
apparent in stocks listed on the New York Stock Exchange (``NYSE''),
which constitute nearly 80% of the capitalization of the U.S. equity
markets.\4\ In contrast to stocks listed on the NASDAQ Stock Market LLC
(``NASDAQ''), which for more than a decade have been traded in a highly
automated fashion at many different trading centers,\5\ NYSE-listed
stocks were traded primarily on the floor of the NYSE in a manual
fashion until October 2006. At that time, NYSE began to offer
[[Page 3595]]
fully automated access to its displayed quotations.\6\ An important
impetus for this change was the Commission's adoption of Regulation NMS
in 2005, which eliminated the trade-through protection for manual
quotations that nearly all commenters believed was seriously
outdated.\7\
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\4\ In November 2009, for example, NYSE-listed stocks
represented approximately 78% of the market capitalization of the
Wilshire 5000 Total Market Index. Wilshire Associates, https://wilshire.com/Indexes/Broad/Wilshire5000/Characteristics.html
(November 17, 2009).
\5\ NASDAQ itself offered limited automated execution
functionality until the introduction of SuperMontage in 2002. See
Securities Exchange Act Release No. 46429 (August 29, 2002), 67 FR
56862 (September 5, 2002) (Order with Respect to the Implementation
of NASDAQ's SuperMontage Facility). Prior to 2002, however, many
electronic communication networks (``ECNs'') and market makers
trading NASDAQ stocks provided predominantly automated executions.
\6\ See Securities Exchange Act Release No. 53539 (March 22,
2006), 71 FR 16353 (March 31, 2006) (File No. SR-NYSE-2004-05)
(approving proposal to create a ``Hybrid Market'' by, among other
things, increasing the availability of automated executions); Pierre
Paulden, Keep the Change, Institutional Investor (December 19, 2006)
(``Friday, October 6, was a momentous day for the New York Stock
Exchange. That morning the Big Board broke with 214 years of
tradition when it began phasing in a new hybrid market structure
that can execute trades electronically, bypassing face-to-face
auctions on its famed floor.''). Prior to the Hybrid Market, NYSE
offered limited automated executions.
\7\ Regulation NMS Release, 70 FR at 37505 n. 55 (``Nearly all
commenters, both those supporting and opposing the need for an
intermarket trade-through rule, agreed that the current ITS trade-
through provisions are seriously outdated and in need of reform.
They particularly focused on the problems created by affording equal
protection against trade-throughs to both automated and manual
quotations.'').
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The changes in the nature of trading for NYSE-listed stocks have
been extraordinary, as indicated by the comparisons of trading in 2005
and 2009 in Figures 1 through 5 below:
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BILLING CODE 8011-01-C
Figure 1--NYSE executed approximately 79.1% of the consolidated
share volume in its listed stocks in January 2005, compared to 25.1% in
October 2009.\8\
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\8\ NYSE Euronext, ``NYSE Euronext Announces Trading Volumes for
October 2009 (November 6, 2009) (``Tape A matched market share for
NYSE was 25.1% in October 2009, above the 24.5% market share
reported in October 2008'') (available at https://www.nyse.com/press/125741917814.html); Securities Exchange Act Release No. 59039
(December 2, 2008), 73 FR 74770, 74782 (December 9, 2008) (File No.
SR-NYSEArca-2006-21) (``Given the competitive pressures that
currently characterize the U.S. equity markets, no exchange can
afford to take its market share percentages for granted--they can
change significantly over time, either up or down. * * * For
example, the NYSE's reported market share of trading in NYSE-listed
stocks declined from 79.1% in January 2005 to 30.6% in June 2008.'')
(citations omitted).
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Figure 2--NYSE's average speed of execution for small, immediately
executable (marketable) orders was 10.1
[[Page 3596]]
seconds in January 2005, compared to 0.7 seconds in October 2009.\9\
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\9\ NYSE Euronext, Rule 605 Reports for January 2005 and October
2009 (available at https://www.nyse.com/equities/nyseequities/1201780422054.html) (NYSE average speed of execution for small (100-
499 shares) market orders and marketable limit orders was 10.1
seconds in January 2005 and 0.7 seconds in October 2009).
---------------------------------------------------------------------------
Figure 3--Consolidated average daily share volume in NYSE-listed
stocks was 2.1 billion shares in 2005, compared to 5.9 billion shares
(an increase of 181%) in January through October 2009.\10\
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\10\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues
2000-2009 (available at https://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).
---------------------------------------------------------------------------
Figure 4--Consolidated average daily trades in NYSE-listed stocks
was 2.9 million trades in 2005, compared to 22.1 million trades (an
increase of 662%) in January through October 2009.\11\
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\11\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues
2000-2009 (available at https://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).
---------------------------------------------------------------------------
Figure 5--Consolidated average trade size in NYSE-listed stocks was
724 shares in 2005, compared to 268 shares in January through October
2009.\12\
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\12\ NYSE Euronext, Consolidated Volume in NYSE Listed Issues
2000-2009 (available at https://www.nyxdata.com/nysedata/NYSE/FactsFigures/tabid/115/Default.aspx).
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The foregoing statistics for NYSE-listed stocks are intended solely
to illustrate the sweeping changes that are characteristic of trading
in all U.S.-listed equities, including NASDAQ-listed stocks and other
equities such as exchange-traded funds (``ETFs''). They are not
intended to indicate whether these changes have led to a market
structure that is better or worse for long-term investors--an important
issue on which comment is requested in section IV.A.1 below. Rather,
the statistics for NYSE-listed stocks provide a useful illustration
simply because the changes occurred both more rapidly and more recently
for NYSE-listed stocks than other types of U.S.-listed equities.
To more fully understand the effects of these and other changes in
equity trading, the Commission is conducting a comprehensive review of
equity market structure. It is assessing whether market structure rules
have kept pace with, among other things, changes in trading technology
and practices. The review already has led to several rulemaking
proposals that address particular issues and that are intended
primarily to preserve the integrity of longstanding market structure
principles. One proposal would eliminate the exception for flash orders
from the Securities Exchange Act of 1934 (``Exchange Act'') quoting
requirements.\13\ Another would address certain practices associated
with non-public trading interest, including dark pools of
liquidity.\14\ In addition, the Commission today is proposing for
public comment an additional market structure initiative to address the
risk management controls of broker-dealers with market access.\15\
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\13\ Securities Exchange Act Release No. 60684 (September 18,
2009), 74 FR 48632 (September 23, 2009) (``Flash Order Release'').
\14\ Securities Exchange Act Release No. 60997 (November 13,
2009), 74 FR 61208 (November 23, 2009) (``Non-Public Trading
Interest Release'').
\15\ Securities Exchange Act Release No. [citation unavailable]
(``Market Access Release'').
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The Commission is continuing its review. It recognizes that market
structure issues are complex and require a broad understanding of
statutory requirements, economic principles, and practical trading
considerations. Given this complexity, the Commission believes that its
review would be greatly assisted by receiving the benefit of public
comment on a broad range of market structure issues. It particularly is
interested in hearing the views of all types of investors and other
market participants and in receiving as much data and analysis as
possible in support of commenters' views.
Commenters' views on both the strengths and weaknesses of the
current market structure are sought. Views on both strengths and
weaknesses can help identify new initiatives that would enhance the
strengths or improve on the weaknesses, avoid changes that would
unintentionally cause more harm than good, and suggest whether any
current rules are no longer necessary or are counterproductive to the
objectives of the Exchange Act. As discussed in section II below,
Congress mandated that the national market system should achieve a
range of objectives--efficient execution of transactions, fair
competition among markets, price transparency, best execution of
investor orders, and the interaction of investor orders when consistent
with efficiency and best execution. Additionally, the Commission's
mission includes the protection of investors and the facilitation of
capital formation. Appropriately achieving each of these objectives
requires a balanced market structure that can accommodate a wide range
of participants and trading strategies.
This release is intended to facilitate public comment by first
giving a basic overview of the legal and factual elements of the
current equity market structure and then presenting a wide range of
issues for comment. The Commission cautions that it has not reached any
final conclusions on the issues presented for comment. The discussion
and questions in this release should not be interpreted as slanted in
any particular way on any particular issue. The Commission intends to
consider carefully all comments and to complete its review in a timely
fashion. At that point, it will determine whether there are any
problems that require a regulatory initiative and, if so, the nature of
that initiative. Moreover, a new regulatory requirement would first be
published in the form of a proposal that would give the public an
opportunity to comment on the specifics of the proposal prior to
adoption.
II. Exchange Act Requirements for a National Market System
In Section 11A of the Exchange Act,\16\ Congress directed the
Commission to facilitate the establishment of a national market system
in accordance with specified findings and objectives. The initial
Congressional findings were that the securities markets are an
important national asset that must be preserved and strengthened, and
that new data processing and communications techniques create the
opportunity for more efficient and effective market operations.
Congress then proceeded to mandate a national market system composed of
multiple competing markets that are linked through technology. In
particular, Congress found that it is in the public interest and
appropriate for the protection of investors and the maintenance of fair
and orderly markets to assure five objectives:
---------------------------------------------------------------------------
\16\ 15 U.S.C. 78k-1.
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(1) Economically efficient execution of securities transactions;
(2) Fair competition among brokers and dealers, among exchange
markets, and between exchange markets and markets other than exchange
markets;
(3) The availability to brokers, dealers, and investors of
information with respect to quotations and transactions in securities;
(4) The practicability of brokers executing investors' orders in
the best market; and
(5) An opportunity, consistent with efficiency and best execution,
for investors' orders to be executed without the participation of a
dealer.
The final Congressional finding was that these five objectives
would be fostered by the linking of all markets for qualified
securities through communication and data processing facilities.
Specifically, Congress found that such linkages would foster
efficiency; enhance competition;
[[Page 3597]]
increase the information available to brokers, dealers, and investors;
facilitate the offsetting (matching) of investors' orders; and
contribute to the best execution of investors' orders.
Over the years, these findings and objectives have guided the
Commission as it has sought to keep market structure rules up-to-date
with continually changing economic conditions and technology advances.
This task has presented certain challenges because, as noted previously
by the Commission, the five objectives set forth in Section 11A can, at
times, be difficult to reconcile.\17\ In particular, the objective of
matching investor orders, or ``order interaction,'' can be difficult to
reconcile with the objective of promoting competition among markets.
Order interaction promotes a system that ``maximizes the opportunities
for the most willing seller to meet the most willing buyer.'' \18\ When
many trading centers compete for order flow in the same stock, however,
such competition can lead to the fragmentation of order flow in that
stock. Fragmentation can inhibit the interaction of investor orders and
thereby impair certain efficiencies and the best execution of
investors' orders. Competition among trading centers to provide
specialized services for investors also can lead to practices that may
detract from public price transparency. On the other hand, mandating
the consolidation of order flow in a single venue would create a
monopoly and thereby lose the important benefits of competition among
markets. The benefits of such competition include incentives for
trading centers to create new products, provide high quality trading
services that meet the needs of investors, and keep trading fees low.
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\17\ See, e.g., Securities Exchange Act Release No. 42450
(February 3, 2000), 65 FR 10577, 10580 (February 28, 2000)
(``Fragmentation Concept Release'') (``[A]lthough the objectives of
vigorous competition on price and fair market center competition may
not always be entirely congruous, they both serve to further the
interests of investors and therefore must be reconciled in the
structure of the national market system.'').
\18\ H.R. Rep. 94-123, 94th Cong., 1st Sess. 50 (1975).
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The Commission's task has been to facilitate an appropriately
balanced market structure that promotes competition among markets,
while minimizing the potentially adverse effects of fragmentation on
efficiency, price transparency, best execution of investor orders, and
order interaction.\19\ An appropriately balanced market structure also
must provide for strong investor protection and enable businesses to
raise the capital they need to grow and to benefit the overall economy.
Given the complexity of this task, there clearly is room for reasonable
disagreement as to whether the market structure at any particular time
is, in fact, achieving an appropriate balance of these multiple
objectives. Accordingly, the Commission believes it is important to
monitor these issues and, periodically, give the public, including the
full range of investors and other market participants, an opportunity
to submit their views on the matter. This concept release is intended
to provide such an opportunity.
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\19\ See S. Rep. 94-75, 94th Cong., 1st Sess. 2 (1975) (``S. 249
would lay the foundation for a new and more competitive market
system, vesting in the SEC power to eliminate all unnecessary or
inappropriate burdens on competition while at the same time granting
to that agency complete and effective powers to pursue the goal of
centralized trading of securities in the interest of both efficiency
and investor protection.''); Regulation NMS Release, 70 FR at 37499
(``Since Congress mandated the establishment of an NMS in 1975, the
Commission frequently has resisted suggestions that it adopt an
approach focusing on a single form of competition that, while
perhaps easier to administer, would forfeit the distinct, but
equally vital, benefits associated with both competition among
markets and competition among orders.'').
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III. Overview of Current Market Structure
This section provides a brief overview of the current equity market
structure. It first describes the various types of trading centers that
compete for order flow in NMS stocks \20\ and among which liquidity is
dispersed. It then describes the primary types of linkages between or
involving these trading centers that are designed to enable market
participants to trade effectively. This section attempts to highlight
the features of the current equity market structure that may be most
salient in presenting issues for public comment and is not intended to
serve as a full description of the U.S. equity markets.
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\20\ Rule 600(b)(47) of Regulation NMS defines ``NMS stock'' to
mean any NMS security other than an option. Rule 600(b)(46) defines
``NMS security'' to mean any security for which trade reports are
made available pursuant to an effective transaction reporting plan.
In general, NMS stocks are those that are listed on a national
securities exchange.
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A. Trading Centers
A good place to start in describing the current market structure is
by identifying the major types of trading centers and giving a sense of
their current share of trading volume in NMS stocks. Figure 6 below
provides this information with estimates of trading volume in September
2009: \21\
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\21\ Sources of estimated trading volume percentages: NASDAQ;
NYSE Group; BATS; Direct Edge; data compiled from Forms ATS for 3d
quarter 2009.
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Figure 6
Trading Centers and Estimated % of Share Volume in NMS Stocks September
2009
[[Page 3598]]
[GRAPHIC] [TIFF OMITTED] TP21JA10.002
------------------------------------------------------------------------
Percent
------------------------------------------------------------------------
Registered Exchanges
------------------------------------------------------------------------
NASDAQ....................................................... 19.4
NYSE......................................................... 14.7
NYSE Arca.................................................... 13.2
BATS......................................................... 9.5
NASDAQ OMX BX................................................ 3.3
Other........................................................ 3.7
----------
Total Exchange........................................... 63.8
------------------------------------------------------------------------
ECNs
------------------------------------------------------------------------
2 Direct Edge................................................ 9.8
3 Others..................................................... 1.0
----------
Total ECN................................................ 10.8
----------
Total Displayed Trading Center........................... 74.6
------------------------------------------------------------------------
Dark Pools
------------------------------------------------------------------------
Approximately 32 \22\........................................ 7.9
------------------------------------------------------------------------
Broker-Dealer Internalization
------------------------------------------------------------------------
More than 200 \23\........................................... 17.5
----------
Total Undisplayed Trading Center......................... 25.4
------------------------------------------------------------------------
Figure 6 identifies two types of trading centers that display
quotations in the consolidated quotation data that is widely
distributed to the public--registered exchanges and ECNs.\24\ These
displayed trading centers execute approximately 74.6% of share volume.
Figure 6 also identifies two types of undisplayed trading centers--dark
pools and broker-dealers that execute trades internally--that execute
approximately 25.4% of share volume. These four types of trading
centers are described below.
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\22\ Data compiled from Forms ATS submitted to Commission for 3d
quarter 2009.
\23\ More than 200 broker-dealers (excluding ATSs) have
identified themselves to FINRA as market centers that must provide
monthly reports on order execution quality under Rule 605 of
Regulation NMS (list available at https://apps.finra.org/datadirectory/1/marketmaker.aspx).
\24\ Consolidated quotation data is described in section
III.B.1. below.
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1. Registered Exchanges
Registered exchanges collectively execute approximately 63.8% of
share volume in NMS stocks, with no single exchange executing more than
19.4%. Registered exchanges must undertake self-regulatory
responsibility for their members and file their proposed rule changes
for approval with the Commission. These proposed rule changes publicly
disclose, among other things, the trading services and fees of
exchanges.
The registered exchanges all have adopted highly automated trading
systems that can offer extremely high-speed, or ``low-latency,'' order
responses and executions. Published average response times at some
exchanges, for example, have been reduced to less than 1
millisecond.\25\ Many exchanges offer individual data feeds that
deliver information concerning their orders and trades directly to
customers. To further reduce latency in transmitting market data and
order messages, many exchanges also offer co-location services that
enable exchange customers to place their servers in close proximity to
the exchange's matching engine. Exchange data feeds and co-location
services are discussed further in section IV.B.2. below.
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\25\ See, e.g., BATS Exchange, Inc., https://batstrading.com/resources/features/bats_exchange_Latency.pdf (June 2009) (average
latency (time to accept, process, and acknowledge or fill order) of
320 microseconds; NASDAQ, https://www.nasdaqtrader.com/trader.aspx?id=inet (December 12, 2009) (average latency (time to
accept, process, and acknowledge or fill order) of 294
microseconds).
---------------------------------------------------------------------------
Registered exchanges typically offer a wide range of order types
for trading on their automated systems. Some of their order types are
displayable in full if they are not executed immediately. Others are
undisplayed, in full or in part. For example, a reserve order type will
display part of the size of an order at a particular price, while
holding the balance of the order in reserve and refreshing the
displayed size as needed. In general, displayed orders are given
execution priority at any given price over fully undisplayed orders and
the undisplayed size of reserve orders.\26\
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\26\ See, e.g., BATS Exchange, Inc., Rule 11.12 (equally priced
trading interest executed in time priority in the following order:
(1) Displayed size of limit orders; (2) non-displayed limit orders;
(3) pegged orders; (4) mid-point peg orders; (5) reserve size of
orders; and (6) discretionary portion of discretionary orders);
NASDAQ Rule 4757(a)(1) (book processing algorithm executes trading
interest in the following order: (1) Displayed orders; (2) non-
displayed orders and the reserve portion of quotes and reserve
orders (in price/time priority among such interest); and (3) the
discretionary portion of discretionary orders.
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In addition, many exchanges have adopted a ``maker-taker'' pricing
model in an effort to attract liquidity providers. Under this model,
non-marketable,
[[Page 3599]]
resting orders that offer (make) liquidity at a particular price
receive a liquidity rebate if they are executed, while incoming orders
that execute against (take) the liquidity of resting orders are charged
an access fee. Rule 610(c) of Regulation NMS caps the amount of the
access fee for executions against the best displayed prices of an
exchange at 0.3 cents per share. Exchanges typically charge a somewhat
higher access fee than the amount of their liquidity rebates, and
retain the difference as compensation. Sometimes, however, exchanges
have offered ``inverted'' pricing and pay a liquidity rebate that
exceeds the access fee.
Highly automated exchange systems and liquidity rebates have helped
establish a business model for a new type of professional liquidity
provider that is distinct from the more traditional exchange specialist
and over-the-counter (``OTC'') market maker. In particular, proprietary
trading firms and the proprietary trading desks of multi-service
broker-dealers now take advantage of low-latency systems and liquidity
rebates by submitting large numbers of non-marketable orders (often
cancelling a very high percentage of them), which provide liquidity to
the market electronically. As discussed in section IV.B. below, these
proprietary traders often are labeled high-frequency traders, though
the term does not have a settled definition and may encompass a variety
of strategies in addition to passive market making.
2. ECNs
The five ECNs that actively trade NMS stocks collectively execute
approximately 10.8% of share volume. Almost all ECN volume is executed
by two ECNs operated by Direct Edge, which has submitted applications
for registration of its two trading platforms as exchanges.\27\ ECNs
are regulated as alternative trading systems (``ATSs''). Regulation of
ATSs is discussed in the next section below in connection with dark
pools, which also are ATSs. The key characteristic of an ECN is that it
provides its best-priced orders for inclusion in the consolidated
quotation data, whether voluntarily or as required by Rule 301(b)(3) of
Regulation ATS. In general, ECNs offer trading services (such as
displayed and undisplayed order types, maker-taker pricing, and data
feeds) that are analogous to those of registered exchanges.
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\27\ Securities Exchange Act Release No. 60651 (September 11,
2009), 74 FR 47827 (September 17, 2009) (Notice of filing of
applications for registration as national securities exchanges by
EDGX Exchange, Inc. and EDGA Exchange, Inc.).
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3. Dark Pools
Dark pools are ATSs that, in contrast to ECNs, do not provide their
best-priced orders for inclusion in the consolidated quotation data. In
general, dark pools offer trading services to institutional investors
and others that seek to execute large trading interest in a manner that
will minimize the movement of prices against the trading interest and
thereby reduce trading costs.\28\ There are approximately 32 dark pools
that actively trade NMS stocks, and they executed approximately 7.9% of
share volume in NMS stocks in the third quarter of 2009.\29\ ATSs, both
dark pools and ECNs, fall within the statutory definition of an
exchange, but are exempted if they comply with Regulation ATS.
Regulation ATS requires ATSs to be registered as broker-dealers with
the Commission, which entails becoming a member of the Financial
Industry Regulatory Authority (``FINRA'') and fully complying with the
broker-dealer regulatory regime. Unlike a registered exchange, an ATS
is not required to file proposed rule changes with the Commission or
otherwise publicly disclose its trading services and fees. ATSs also do
not have any self-regulatory responsibilities, such as market
surveillance. The regulatory differences between registered exchanges
and ATSs are addressed further in section IV.C.3. below.
---------------------------------------------------------------------------
\28\ See Non-Public Trading Interest Release, 74 FR at 61208-
61209.
\29\ Data compiled from Forms ATS submitted to Commission for 3d
quarter 2009. Some OTC market makers offer dark liquidity primarily
in a principal capacity and do not operate as ATSs. For purposes of
this release, these trading centers are not defined as dark pools
because they are not ATSs. These trading centers may, however, offer
electronic dark liquidity services that are analogous to those
offered by dark pools.
---------------------------------------------------------------------------
Dark pools can vary quite widely in the services they offer their
customers. For example, some dark pools, such as block crossing
networks, offer specialized size discovery mechanisms that attempt to
bring large buyers and sellers in the same NMS stock together
anonymously and to facilitate a trade between them. The average trade
size of these block crossing networks can be as high as 50,000
shares.\30\ Most dark pools, though they may handle large orders,
primarily execute trades with small sizes that are more comparable to
the average size of trades in the public markets, which was less than
300 shares in July 2009.\31\ These dark pools that primarily match
smaller orders (though the matched orders may be ``child'' orders of
much larger ``parent'' orders) execute more than 90% of dark pool
trading volume.\32\ The majority of this volume is executed by dark
pools that are sponsored by multi-service broker-dealers. These broker-
dealers also offer order routing services, trade as principal in the
sponsored ATS, or both.
---------------------------------------------------------------------------
\30\ See, e.g., https://www.liquidnet.com/about/liquidStats.html
(average U.S. execution size in July 2009 was 49,638 shares for
manually negotiated trades via Liquidnet's negotiation product);
https://www.pipelinetrading.com/AboutPipeline/CompanyInfo.aspx
(average trade size of 50,000 shares in Pipeline).
\31\ See, e.g., https://www.nasdaqtrader.com/trader/aspx?id=marketshare (average size of NASDAQ matched trades in July
2009 was 228 shares); https://nyxdata.com/nysedata/asp/factbook (NYSE
Group average trade size in all stocks traded in July 2009 was 267
shares).
\32\ Data compiled from Forms ATS submitted to Commission for 3d
quarter 2009.
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4. Broker-Dealer Internalization
The other type of undisplayed trading center is a non-ATS broker-
dealer that internally executes trades, whether as agent or principal.
Notably, many broker-dealers may submit orders to exchanges or ECNs,
which then are included in the consolidated quotation data. The
internalized executions of broker-dealers, however, primarily reflect
liquidity that is not included in the consolidated quotation data.
Broker-dealer internalization accordingly should be classified as
undisplayed liquidity. There are a large number of broker-dealers that
execute trades internally in NMS stocks--more than 200 publish
execution quality statistics under Rule 605 of Regulation NMS.\33\
Broker-dealer internalization accounts for approximately 17.5% of share
volume in NMS stocks.
---------------------------------------------------------------------------
\33\ See supra note 23.
---------------------------------------------------------------------------
Broker-dealers that internalize executions generally fall into two
categories--OTC market makers and block positioners. An OTC market
maker is defined in Rule 600(b)(52) of Regulation NMS as ``any dealer
that holds itself out as being willing to buy and sell to its
customers, or others, in the United States, an NMS stock for its own
account on a regular or continuous basis otherwise than on a national
securities exchange in amounts of less than block size.'' ``Block
size'' is defined in Rule 600(b)(9) as an order of at least 10,000
shares or for a quantity of stock having a market value of at least
$200,000. A block positioner generally means any broker-dealer in the
business of executing, as principal or agent, block size trades for its
customers. To facilitate trades, block positioners often commit their
own capital to trade as principal with at least some part of the
customer's block order.
Broker-dealers that act as OTC market makers and block positioners
conduct
[[Page 3600]]
their business primarily by directly negotiating with customers or with
other broker-dealers representing customer orders. OTC market makers,
for example, appear to handle a very large percentage of marketable
(immediately executable) order flow of individual investors that is
routed by retail brokerage firms. A review of the order routing
disclosures required by Rule 606 of Regulation NMS of eight broker-
dealers with significant retail customer accounts reveals that nearly
100% of their customer market orders are routed to OTC market
makers.\34\ The review also indicates that most of these retail brokers
either receive payment for order flow in connection with the routing of
orders or are affiliated with an OTC market maker that executes the
orders. The Rule 606 Reports disclose that the amount of payment for
order flow generally is 0.1 cent per share or less.\35\
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\34\ Review of Rule 606 Reports for 2d quarter 2009 of eight
broker-dealers with substantial number of retail customer accounts.
\35\ Id.
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B. Linkages
Given the dispersal of liquidity across a large number of trading
centers of different types, an important question is whether trading
centers are sufficiently linked together in a unified national market
system. Thus far in this release, the term ``dispersed'' has been used
to describe the current market structure rather than ``fragmented.''
The term ``fragmentation'' connotes a negative judgment that the
linkages among competing trading centers are insufficient to achieve
the Exchange Act objectives of efficiency, price transparency, best
execution, and order interaction. Whether fragmentation is in fact a
problem in the current market structure is a critically important issue
on which comment is requested in section IV below in a variety of
contexts. This section will give an overview of the primary types of
linkages that operate in the current market structure--consolidated
market data, trade-through protection, and broker routing services.
1. Consolidated Market Data
When Congress mandated a national market system in 1975, it
emphasized that the systems for collecting and distributing
consolidated market data would ``form the heart of the national market
system.'' \36\ As described further below, consolidated market data
includes both: (1) Pre-trade transparency--real-time information on the
best-priced quotations at which trades may be executed in the future
(``consolidated quotation data''); and (2) post-trade transparency--
real-time reports of trades as they are executed (``consolidated trade
data''). As a result, the public has ready access to a comprehensive,
accurate, and reliable source of information for the prices and volume
of any NMS stock at any time during the trading day. This information
serves an essential linkage function by helping assure that the public
is aware of the best displayed prices for a stock, no matter where they
may arise in the national market system. It also enables investors to
monitor the prices at which their orders are executed and assess
whether their orders received best execution.
---------------------------------------------------------------------------
\36\ H.R. Rep. No. 94-229, 94th Cong., 1st Sess. 93 (1975).
---------------------------------------------------------------------------
Consolidated market data is collected and distributed pursuant to a
variety of Exchange Act rules and joint-industry plans. With respect to
pre-trade transparency, Rule 602 of Regulation NMS requires exchange
members and certain OTC market makers that exceed a 1% trading volume
threshold to provide their best-priced quotations to their respective
exchanges or FINRA, and these self-regulatory organizations (``SROs''),
in turn, are required to make this information available to vendors.
Rule 604 of Regulation NMS requires exchange specialists and OTC market
makers to display certain customer limit orders in their best-priced
quotations provided under Rule 602. In addition, Rule 301(b)(3) of
Regulation ATS requires an ATS that displays orders to more than one
person in the ATS and exceeds a 5% trading volume threshold to provide
its best-priced orders for inclusion in the quotation data made
available under Rule 602.\37\
---------------------------------------------------------------------------
\37\ The Commission has proposed lowering the trading volume
threshold for order display obligations from 5% to 0.25%. Non-Public
Trading Interest Release, 74 FR at 61213.
---------------------------------------------------------------------------
Importantly, the Commission's rules do not require the display of a
customer limit order if the customer does not wish the order to be
displayed.\38\ Customers have the freedom to display or not display
depending on their trading objectives. On the other hand, the selective
display of orders generally is prohibited in order to prevent the
creation of significant private markets and two-tiered access to
pricing information.\39\ Accordingly, the display of orders to some
market participants generally will require that the order be included
in the consolidated quotation data that is widely available to the
public.
---------------------------------------------------------------------------
\38\ Rule 604 of Regulation NMS, for example, explicitly
recognizes the ability of customers to control whether their limit
orders are displayed to the public. Rule 604(b)(2) provides an
exception from the limit order display requirement for orders that
are placed by customers who expressly request that the order not be
displayed. Rule 604(b)(4) provides an exception for all block size
orders unless the customer requests that the order be displayed.
\39\ See, e.g., Rule 301(b)(3) of Regulation ATS; Rule 602(a)(1)
of Regulation NMS; Order Handling Rules Release, 61 FR at 48307
(``Although offering benefits to some market participants,
widespread participation in these hidden markets has reduced the
completeness and value of publicly available quotations contrary to
the purposes of the NMS.'').
---------------------------------------------------------------------------
With respect to post-trade transparency, Rule 601 of Regulation NMS
requires the equity exchanges and FINRA to file a transaction reporting
plan regarding transactions in listed equity securities. The members of
these SROs are required to comply with the relevant SRO rules for trade
reporting. FINRA's trade reporting requirements apply to all ATSs that
trade NMS stocks, both ECNs and dark pools, as well as to broker-
dealers that internalize. FINRA currently requires members to report
their trades as soon as practicable, but no later than 90 seconds.\40\
FINRA has proposed to reduce the reporting time period to 30 seconds,
noting that more than 99.9% of transactions are reported to FINRA in 30
seconds or less.\41\
---------------------------------------------------------------------------
\40\ Securities Exchange Act Release No. 60960 (November 6,
2009), 74 FR 59272, 59273 (November 17, 2009) (File No. SR-FINRA-
2009-061) (in its description of the proposed rule change, FINRA
stated that ``[a]lthough members would have 30 seconds to report,
FINRA reiterates that--as is the case today--members must report
trades as soon as practical and cannot withhold trade reports, e.g.,
by programming their systems to delay reporting until the last
permissible second'').
\41\ Id. (from February 23, 2009 through February 27, 2009,
99.90% of trades submitted to a FINRA Facility for public reporting
were reported in 30 seconds or less).
---------------------------------------------------------------------------
Finally, Rule 603(b) of Regulation NMS requires the equity
exchanges and FINRA to act jointly pursuant to one or more effective
national market system plans to disseminate consolidated information,
including an NBBO, on quotations for and transactions in NMS stocks. It
also requires that consolidated information for each NMS stock be
disseminated through a single plan processor.
To comply with these requirements, the equity exchanges and FINRA
participate in three joint-industry plans (``Plans'').\42\ Pursuant to
the Plans, three
[[Page 3601]]
separate networks distribute consolidated market data for NMS stocks:
(1) Network A for securities with their primary listing on the NYSE;
(2) Network B for securities with their primary listing on exchanges
other than the NYSE or NASDAQ; and (3) Network C for securities with
their primary listing on NASDAQ. The three Networks establish fees for
the data, which must be filed for Commission approval. The three
Networks collect the applicable fees and, after deduction of Network
expenses (which do not include the costs incurred by SROs to generate
market data and provide such data to the Networks), allocate the
remaining revenues to the SROs. The revenues, expenses, and allocations
for each of the three Networks are set forth in Table 1 below:\43\
---------------------------------------------------------------------------
\42\ The three joint-industry plans are: (1) The CTA Plan, which
is operated by the Consolidated Tape Association and disseminates
transaction information for securities with their primary listing on
exchanges other than NASDAQ; (2) the CQ Plan, which disseminates
consolidated quotation information for securities with their primary
listing on exchanges other than NASDAQ; and (3) the NASDAQ UTP Plan,
which disseminates consolidated transaction and quotation
information for securities with their primary listing on NASDAQ. The
CTA Plan and CQ Plan are available at https://www.nyxdata.com/nysedata/default.aspx?tabid=227. The NASDAQ UTP Plan is available at
https://www.utpplan.com.
\43\ The Network financial information for 2008 is preliminary
and unaudited.
Table 1--2008 Financial Information for Networks A, B, and C
----------------------------------------------------------------------------------------------------------------
Network A Network B Network C Total
----------------------------------------------------------------------------------------------------------------
Revenues............................ $209,218,000 $119,876,000 $134,861,000 $463,955,000
Expenses............................ 6,078,000 3,066,000 5,729,000 14,873,000
Net Income.......................... 203,140,000 116,810,000 129,132,000 449,082,000
Allocations:
NASDAQ.......................... 47,845,000 34,885,000 60,614,000 143,343,000
NYSE Arca....................... 37,080,000 38,235,000 26,307,000 101,622,000
NYSE............................ 68,391,000 0 0 68,391,000
FINRA........................... 24,325,000 16,458,000 20,772,000 61,555,000
NSX............................. 7,100,000 11,575,000 17,123,000 35,798,000
ISE............................. 15,260,000 1,477,000 1,883,000 18,620,000
NYSE Amex....................... 1,000 9,760,000 14,000 9,775,000
BATS............................ 2,356,000 2,770,000 1,538,000 6,664,000
CBOE............................ 80,000 1,046,000 433,000 1,559,000
CHX............................. 565,000 574,000 298,000 1,437,000
Phlx............................ 134,000 30,000 146,000 310,000
BSE............................. 3,000 ................. 4,000 7,000
----------------------------------------------------------------------------------------------------------------
In addition to providing quotation and trade information to the
three Networks for distribution in consolidated data, many exchanges
and ECNs offer individual data feeds directly to customers that include
information that is provided in consolidated data. The individual data
feeds of exchanges and ECNs also can include a variety of other types
of information, such as ``depth-of-book'' quotations at prices inferior
to their best-priced quotations. Rule 603(a) of Regulation NMS requires
all exchanges, ATSs, and other broker-dealers that offer individual
data feeds to make the data available on terms that are fair and
reasonable and not unreasonably discriminatory. Exchanges, ATSs, and
other broker-dealers are prohibited from providing their data directly
to customers any sooner than they provide their data to the plan
processors for the Networks.\44\ The fact that trading center data
feeds do not need to go through the extra step of consolidation at a
plan processor, however, means that such data feeds can reach end-users
faster than the consolidated data feeds. The average latencies of the
consolidation function at plan processors (from the time the processor
receives information from the SROs to the time it distributes
consolidated information to the public) are as follows: (1) Network A
and Network B--less than 5 milliseconds for quotation data and less
than 10 milliseconds for trade data; and (2) Network C--5.892
milliseconds for quotation data and 6.680 milliseconds for trade
data.\45\ The individual trading center data feeds are discussed below
in section IV.B.2.b.
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\44\ Regulation NMS Release, 70 FR at 37567 (``Adopted Rule
603(a) will not require a market center to synchronize the delivery
of its data to end-users with delivery of data by a Network
processor to end-users. Rather independently distributed data could
not be made available on a more timely basis than core data is made
available to a Network processor. Stated another way, adopted Rule
603(a) prohibits an SRO or broker-dealer from transmitting data to a
vendor or user any sooner than it transmits the data to a Network
processor.''). The plan processor for the CTA Plan and CQ Plan is
the Securities Industry Automation Corporation (``SIAC''). The plan
processor for the NASDAQ UTP Plan is NASDAQ.
\45\ Sources: SIAC for Network A and Network B; NASDAQ for
Network C.
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2. Trade-Through Protection
Another important type of linkage in the current market structure
is the protection against trade-throughs provided by Rule 611 of
Regulation NMS. A trade-through is the execution of a trade at a price
inferior to a protected quotation for an NMS stock. A protected
quotation must be displayed by an automated trading center, must be
disseminated in the consolidated quotation data, and must be an
automated quotation that is the best bid or best offer of an exchange
or FINRA. Importantly, Rule 611 applies to all trading centers, not
just those that display protected quotations. Trading center is defined
broadly in Rule 600(b)(78) to include, among others, all exchanges, all
ATSs (including ECNs and dark pools), all OTC market makers, and any
other broker-dealer that executes orders internally, whether as agent
or principal.
Rule 611(a)(1) requires all trading centers to establish, maintain,
and enforce written policies and procedures that are reasonably
designed to prevent trade-throughs of protected quotations, subject to
the exceptions set forth in Rule 611(b). Protection against trade-
throughs is an important linkage among trading centers because it
provides a baseline assurance that: (1) Marketable orders will receive
at least the best displayed price, regardless of the particular trading
center that executes the order or where the best price is displayed in
the national market system; and (2) quotations that are displayed at
one trading center will not be bypassed by trades with inferior prices
at any trading center in the national market system.
Rule 611 also helps promote linkages among trading centers by
encouraging them, when they do not have available trading interest at
the best price, to route marketable orders to a trading center that is
displaying the best price. Although Rule 611 does not directly require
such routing services (a trading center can, for example, cancel and
return an order when it does not have the best price), competitive
factors have
[[Page 3602]]
led many trading centers to offer routing services to their customers.
Prior to Rule 611, exchanges routed orders through an inflexible,
partially manual system called the Intermarket Trading System
(``ITS'').\46\ With Regulation NMS, however, the Commission adopted a
``private linkages'' approach that relies exclusively on brokers to
provide routing services, both among exchanges and between customers
and exchanges. These broker routing services are discussed next.
---------------------------------------------------------------------------
\46\ See Regulation NMS Release, 70 FR at 37538-37539
(``Although ITS promotes access among participants that is uniform
and free, it also is often slow and limited.'').
---------------------------------------------------------------------------
3. Broker Routing Services
In a dispersed and complex market structure with many different
trading centers offering a wide spectrum of services, brokers play a
significant role in linking trading centers together into a unified
national market system. Brokers compete to offer the sophisticated
technology tools that are needed to monitor liquidity at many different
venues and to implement order routing strategies. To perform this
function, brokers may monitor the execution of orders at both displayed
and undisplayed trading centers to assess the availability of
undisplayed trading interest. Brokers may, for example, construct real-
time ``heat maps'' in an effort to discern and access both displayed
and undisplayed liquidity at trading centers throughout the national
market system.
Using their knowledge of available liquidity, many brokers offer
smart order routing technology to access such liquidity. Many brokers
also offer sophisticated algorithms that will take the large orders of
institutional investors and others, divide a large ``parent'' order
into many smaller ``child'' orders, and route the child orders over
time to different trading centers in accordance with the particular
trading strategy chosen by the customer. Such algorithms may be
``aggressive,'' for example, and seek to take liquidity quickly at many
different trading centers, or they may be ``passive,'' and submit
resting orders at one or more trading centers and await executions at
favorable prices.
To the extent they help customers cope with the dispersal of
liquidity among a large number of trading centers of different types
and achieve the best execution of their customers' orders, the routing
services of brokers can contribute to the broader policy goal of
promoting efficient markets.
Under the private linkages approach adopted by Regulation NMS,
market participants obtain access to the various trading centers
through broker-dealers that are members or subscribers of the
particular trading center.\47\ Rule 610(a) of Regulation NMS, for
example, prohibits an SRO trading facility from imposing unfairly
discriminatory terms that would prevent or inhibit any person from
obtaining efficient access through an SRO member to the displayed
quotations of the SRO trading facility. Rule 610(c) limits the fees
that a trading center can charge for access to its displayed quotations
at the best prices. Rule 611(d) requires SROs to establish, maintain,
and enforce rules that restrict their members from displaying
quotations that lock or cross previously displayed quotations.
---------------------------------------------------------------------------
\47\ See Regulation NMS Release, 70 FR at 37540 (``[M]any
different private firms have entered the business of linking with a
wide range of trading centers and then offering their customers
access to those trading centers through the private firms' linkages.
Competitive forces determine the types and costs of these private
linkages.'').
---------------------------------------------------------------------------
Section 6(a)(2) of the Exchange Act requires registered exchanges
to allow any qualified and registered broker-dealer to become a member
of the exchange--a key element in assuring fair access to exchange
services. In contrast, the access requirements that apply to ATSs are
much more limited. Regulation ATS includes two distinct types of access
requirements: (1) order display and execution access in Rule 301(b)(3);
and (2) fair access to ATS services in general in Rule 301(b)(5). An
ATS must meet order display and execution access requirements if it
displays orders to more than one person in the ATS and exceeds a 5%
trading volume threshold.\48\ An ATS must meet the general fair access
requirement if it exceeds a 5% trading volume threshold. If an ATS
neither displays orders to more than one person in the ATS nor exceeds
a 5% trading volume threshold, Regulation ATS does not impose access
requirements on the ATS.
---------------------------------------------------------------------------
\48\ The Commission has proposed reducing the threshold for
order display and execution access to 0.25%. Non-Public Trading
Interest Release, 74 FR at 61213. It has not proposed to change the
threshold for fair access in general.
---------------------------------------------------------------------------
An essential type of access that should not be overlooked is the
fair access to clearance and settlement systems required by Section 17A
of the Exchange Act. If brokers cannot efficiently clear and settl
