Daily Rules, Proposed Rules, and Notices of the Federal Government
On February 7, 2012, the Commission instituted proceedings to determine whether to disapprove the proposed rule changes, as modified by Amendments No. 1.
This order approves the proposed rule change, as modified by Amendments Nos. 1 and 2, and grants exemptions from the Sub-Penny Rule sought by the Exchanges in relation to the proposed rule changes.
The Exchanges are proposing to establish a Program on a pilot basis to attract retail order flow to the NYSE for NYSE-listed securities, and to NYSE Amex for NYSE Amex-listed securities as well as securities listed on The NASDAQ Stock Market LLC ("Nasdaq") and traded pursuant to unlisted trading privileges ("UTP"). The proposed Program would allow such order flow to receive potential price improvement, and would be limited to trades occurring at prices equal to or greater than $1.00 per share.
Under the proposed Program, a new class of market participants called Retail Liquidity Providers would be able to provide potential price improvement, in the form of a non-displayed order that is priced better than the Exchange's best protected bid or offer ("PBBO"),
A Retail Order would be an agency order that originated from a natural person and not a trading algorithm or any other computerized methodology. A Retail Order would be an immediate or cancel order. The Retail Member Organization submitting the order would not be able to alter the terms of such order with respect to price or side of the market. A Retail Order could be submitted in a round lot, odd lot, or partial round lot amounts.
A Retail Liquidity Provider would be required to submit Retail Price Improvement Orders for securities that are assigned to the Retail Liquidity Provider, as further discussed below. A Retail Price Improvement Order would be required to be priced better than the PBBO by at least $0.001 per share.
When a Retail Price Improvement Order is available that is priced at least $0.001 more than the PBBO for a particular security, the Exchange would disseminate an identifier, called a Retail Liquidity Identifier. The Exchanges initially proposed to disseminate the identifier through their proprietary data feeds; they then amended their
In order to become a Retail Member Organization, an Exchange member organization must conduct a retail business or handle retail orders on behalf of another broker-dealer. The member organization must submit an application with supporting documentation and an attestation to the Exchange that the order flow would qualify as Retail Orders.
The Exchange would review the application and notify the member organization of the Exchange's decision in writing. If a member organization did not receive approval to become a Retail Member Organization, then the member organization could appeal as provided below or reapply 90 days after the Exchange issued the disapproval.
The Exchange would require a Retail Member Organization to have written policies and procedures in place to assure that only bona fide retail orders are designated as such. The written policies and procedures would require that the Retail Member Organization exercise due diligence to assure that entry of a Retail Order is in compliance with the proposed rule, prior to entry of that Retail Order. In addition, the Retail Member Organization must monitor whether the Retail Order meets the requirements of the proposed rule.
If the Retail Member Organization represented the Retail Order from another broker-dealer, then the Retail Member Organization must have adequate supervisory procedures to assure that the Retail Order meets the proposed definition. Every year, the Retail Member Organization must obtain from each broker-dealer a written representation that the Retail Orders the broker-dealer sends comply with the proposed rule and must monitor the broker-dealer's order flow to meet the requirements of the proposed rule.
Under the proposal, a Retail Member Organization submitting a Retail Order could choose one of three ways for the Retail Order to interact with available contra-side interest. First, a Retail Order could interact only with available contra-side Retail Price Improvement Orders. The Exchange would label this a Type 1 Retail Order and such orders would not interact with other available contra-side interest in Exchange systems or route to other markets. Portions of a Type 1 Retail Order that are not executed would be cancelled.
Second, a Retail Order could interact first with available contra-side Retail Price Improvement Orders and any remaining portion would be executed as a non-routable Regulation NMS-compliant Immediate or Cancel Order.
Finally, a Retail Order could interact first with available contra-side Retail Price Improvement Orders and any remaining portion would be executed as a routable NYSE Immediate or Cancel Order.
The Exchange would follow price-time priority, ranking Retail Price Improvement Orders according to price and then time of entry, without regard to the size of the order. Executions would occur at the best price that completes the incoming Retail Order, unless there was not sufficient Retail Price Improvement interest to fill such order, in which case the Retail Order would be executed at the price that results in the greatest fill for that order, consistent with its terms. If there are remaining Retail Price Improvement Orders, they would be available for further incoming Retail Orders. As noted above, Retail Orders not executed would be cancelled.
To qualify, a member organization must be approved as a Designated Market Maker
A member organization must submit an application with supporting documentation to the Exchange. Thereafter, the Exchange would notify the member organization as to whether it is approved as a Retail Liquidity Provider. More than one member organization could act as a Retail Liquidity Provider for a security, and a member organization could act as a Retail Liquidity Provider for more than one security. A member organization could request the Exchange to be assigned certain securities. Once approved, the member organization must establish connectivity with relevant Exchange systems prior to trading.
The Exchange would notify a member organization in writing if the Exchange does not approve the member organization's application to be a Retail Liquidity Provider. Such member organization could request an appeal as provided below. The member organization could also reapply 90 days after the Exchange issues the disapproval notice.
Once approved as a Retail Liquidity Provider, a member organization could withdraw by providing notice to the Exchange. The withdrawal would become effective when the Exchange reassigns the securities to another Retail Liquidity Provider, but no later than 30 days after the Exchange receives the withdrawal notice. In the event that the Exchange takes longer than 30 days to reassign the securities, the withdrawing Retail Liquidity Provider would have no further obligations under the proposed rule.
The proposed rule changes would impose several requirements on Retail Liquidity Providers. First, a Retail Liquidity Provider could enter a Retail
To calculate the 5% quoting requirement, the Exchange would determine the average percentage of time a Retail Liquidity Provider maintains a Retail Price Improvement Order in each assigned security during the regular trading day on a daily and monthly basis. The Exchange would use the following definitions. The "Daily Bid Percentage" would be calculated by determining the percentage of time a Retail Liquidity Provider maintains a Retail Price Improvement Order priced higher than the best protected bid during each trading day for a calendar month. The "Daily Offer Percentage" would be calculated by determining the percentage of time a Retail Liquidity Provider maintains a Retail Price Improvement Order priced lower than the best protected offer during each trading day for a calendar month. The "Monthly Average Bid Percentage" would be calculated for each security by summing the security's "Daily Bid Percentages" for each trading day in a calendar month, then dividing the resulting sum by the total number of trading days in such month. The "Monthly Average Offer Percentage" would be calculated for each security by summing the security's "Daily Offer Percentages" for each trading day in a calendar month, then dividing the resulting sum by the total number of trading days in such month.
The proposed rule changes specify that only Retail Price Improvement Orders entered through the trading day would be used when calculating the 5% quoting requirements. Further, a Retail Liquidity Provider would have an initial two-month grace period from the 5% quoting requirement, so that the Exchange would impose the 5% quoting requirements on the first day of the third consecutive calendar month after the member organization began operation as a Retail Liquidity Provider.
The proposed rule changes provide for penalties when a Retail Liquidity Provider or a Retail Member Organization fails to meet the requirements of the rule.
If a Retail Liquidity Provider fails to meet the 5% quoting requirements in any assigned security for three consecutive months, the Exchange, in its sole discretion, may: (1) Revoke the assignment of any or all of the affected securities; (2) revoke the assignment of unaffected securities; or (3) disqualify the member organization to serve as a Retail Liquidity Provider. If the Exchange moves to disqualify a Retail Liquidity Provider's status, then the Exchange would notify, in writing, the Retail Liquidity Provider one calendar month prior to the determination. Likewise, the Exchange would notify the Retail Liquidity Provider in writing if the Exchange ultimately determined to disqualify the status of that Retail Liquidity Provider. As noted earlier, a Retail Liquidity Provider that is disqualified may appeal as provided below or reapply.
With respect to Retail Member Organizations, the Exchange could disqualify a Retail Member Organization if the Retail Orders submitted by the Retail Member Organization did not comply with the requirements of the proposed rule. The Exchange would have sole discretion to make such a determination. The Exchange would provide written notice to the Retail Member Organization when disqualification determinations are made. Similar to a disqualified Retail Liquidity Provider, a disqualified Retail Member Organization could appeal as provided below or reapply.
Under the proposals, the Exchange would establish a Retail Liquidity Program Panel to review disapproval or disqualification decisions. An affected member organization would have five business days after notice to request review. If a member organization is disqualified as a Retail Liquidity Provider and has appealed, the Exchange would stay the reassignment of securities pending completion of the appeal process.
The Panel would consist of the Exchange's Chief Regulatory Officer or his or her designee, and two officers of the Exchange as designated by the co-head of U.S. Listings and Cash Execution. The Panel would review the appeal and issue a decision within the time frame prescribed by the Exchange. The Panel's decision would constitute final action by the Exchange, and the Panel could modify or overturn any Exchange action taken under the proposed rule.
As noted above, the Commission received a total of 32 comment letters concerning the NYSE proposal and 7 comment letters concerning the NYSE Amex proposal, including letters submitted after the Commission published the Order Instituting Proceedings and Notice of Amendments No. 2. Several commenters expressed support for some or all elements of the Exchanges' proposed Program.
However, a number of commenters raised concerns about the proposed rule changes. The main areas of concern were: (1) The time and manner of the Commission's action on the proposed rule changes, given the potential impact on overall market structure; (2) the proposals' impact on the Sub-Penny Rule; (3) whether the proposals impede fair access; and (4) whether the proposals implicate rules and standards relating to best execution and order protection.
Several commenters requested that the Commission delay taking action on the proposals until the Commission has had additional time to examine the proposals' potential impact on market structure.
The Exchanges responded that the proposed Program is designed to attract retail order flow to the Exchanges by competing with the current practices of broker-dealers that internalize much of the market's retail order flow. Additionally, the Exchanges responded that the fees and credits they would implement as part of the Program would be similar to those used by investors in the over-the-counter ("OTC") market with retail order flow providers.
A number of commenters raised concerns about the proposed Program's use of sub-penny orders, and its implications with respect to the Sub-Penny Rule.
Other commenters articulated similar concerns about protecting public limit orders and public price discovery,
In response, the Exchanges stated that currently, OTC market makers internalize retail order flow at negotiated sub-penny prices and not at their publicly displayed quotes. The Exchanges agree that the market structure impact of sub-penny executions may warrant further Commission consideration. However, the Exchanges also believe that the Program does not raise any new issues with respect to sub-penny executions; rather it simply seeks to compete for retail order flow within the current market landscape, while offering potentially greater price improvement to retail investors and transparency to the marketplace.
The Exchanges also rejected commenters' concerns about non-displayed liquidity stepping ahead of displayed limit orders for insignificant amounts. According to the Exchanges, the Commission's guidance with respect to the Sub-Penny Rule concerns market professionals using displayed sub-penny orders to gain execution priority over customer limit orders. The Exchanges distinguished the proposed Program by noting that the Retail Liquidity Identifier would not be priced and Retail Price Improvement Orders would not be displayed. Accordingly, the Exchanges stated that the Program would limit its sub-penny activity to sub-penny executions. Similarly, in response to comments about the consequences of moving the "tick size" to $0.001, the Exchanges stated that the "tick size" would not in fact be altered because the sub-penny components of the Program would not be displayed.
Finally, in response to the concern that the proposals might lead to more sub-penny trading, the Exchanges stated that they do not anticipate such a result because they believe instead that the proposals would likely reallocate existing retail order flow from internalizing broker-dealers to the Exchanges. Moreover, the Exchanges stated that, if the proposals led to additional sub-penny executions for retail order flow, it would benefit retail investors by creating additional price competition, and, therefore, greater opportunity for price improvement, for such retail order flow.
Commenters also highlighted several elements of the Program that potentially implicate the Commission's rules governing fair access. First, several commenters raised questions about whether the proposals would, in essence, create a private market. Some commenters wrote that the proposed segmentation of retail order flow could amount to unfair discrimination,
Some commenters also took issue with the proposals to the extent that the
The Exchanges responded that the proposals do not create a fair access issue because, in their view, the Retail Liquidity Identifier does not meet the definition of "quotation" under Regulation NMS. In essence, the Exchanges believe that the Retail Liquidity Identifier cannot be considered a "bid" or "offer" because the identifier would not contain a price. According to the Exchanges, there would be no fairness issue in signifying the presence of liquidity by distributing the Retail Liquidity Identifier through a proprietary data feed, especially because participation in the proposed program would be discretionary. However, in response to concerns about the dissemination of the Retail Liquidity Identifier, the Exchanges represented in their third consolidated response letter that the Retail Liquidity Identifier would be available through the consolidated public market data stream immediately upon implementation of the Program, if approved.
Another issue raised by the commenters relates to the clarity and transparency of certain defined terms in the proposals. Specifically, some commenters expressed concern that, under the proposals, the Exchanges would have too much discretion to certify or approve Retail Member Organizations and Retail Liquidity Providers, creating the potential for discriminatory treatment.
The Exchanges responded that they would continually monitor and evaluate all aspects of the Retail Member Organization certification process during the pilot period. The Exchanges disagreed that the definition of "Retail Order" and the Retail Member Organization certification process are unclear or not subject to enforcement. According to the Exchanges, the authentication and certification procedures, together with the requirement that Retail Member Organizations have written policies and procedures to assure that they only submit qualifying retail orders, would result in reliable identification and segmentation of retail order flow. The Exchanges also did not believe there were ambiguities in defining a Retail Order to exclude orders originating from a trading algorithm or computerized methodology; however, the Exchanges committed to providing interpretive guidance to any firms that have questions about the definition. Finally, the Exchanges stated that the Program would be subject to regulatory review by FINRA pursuant to a regulatory services agreement with the Exchanges.
Commenters also raised issues related to access fees. One commenter suggested that the appropriate amount of access fees would need to be revisited if the "tick size" is reduced from $0.01 to $0.001 because the maximum allowable fee of $0.003 per share would significantly increase in relation to the minimum pricing increment.
The Exchanges responded that approval of the proposals does not require reexamination of any access fee issue. The Exchanges noted that there would be no visible prices disseminated as part of the program and expressed the view that the proposals did not contemplate "quotes" subject to the Commission's fair access rules. Given that the proposals did not contemplate "quotes," the Exchanges also contended that a broker's obligations under Regulation NMS would not require it to route a retail order to the Exchanges to interact with a Retail Price Improvement Order. Finally, the Exchanges believe that the proposals comport with the principles behind the Commission's access rules because they intend to welcome broad participation in the Program.
Several commenters took the position that the Program would complicate broker-dealers' best execution duties. According to one commenter, the Exchanges' dissemination of the Retail Liquidity Identifier would raise a number of issues, including whether broker-dealers would be required to route to the Exchanges when they see a Retail Liquidity Identifier; whether, if other exchanges were to adopt similar proposals and disseminate flags similar to the Retail Liquidity Identifier, a broker-dealer would be required to sweep all liquidity inside the spread before executing at the NBBO; whether the Exchanges would be required to route Retail Orders they receive to other market centers if those away markets offered the possibility of further price improvement; and whether broker-dealers would be required to subscribe to the Exchanges' proprietary feeds to be able to receive the Retail Liquidity Identifier.
Another commenter questioned whether, if other exchanges were to adopt competing programs and disseminate flags similar to the Retail
The Exchanges responded that they believe the proposals do not raise any best execution challenges that are not already confronted by broker-dealers in the current market environment. The Exchanges stated that best execution is a facts and circumstances determination and requires many factors to be considered.
One commenter also raised related concerns about the proposals' potential impact on broker-dealer obligations under FINRA Rule 5320, also known as the "Manning" rule.
In response to this comment, the Exchanges stated that the Manning obligations of a Retail Liquidity Provider would be no different from the obligations on an OTC market maker that internalizes orders. The Exchanges stated that OTC market makers commonly rely on the "no-knowledge" exception contained in Supplementary Material .02 of FINRA Rule 5320 to separate their proprietary trading from their handling of customer orders. The Exchanges expressed their view that this exception should be equally applicable to Retail Liquidity Providers participating in the Program.
After careful review of the proposals, the comment letters received, and the Exchanges' responses, the Commission finds that the proposed rule changes are consistent with the requirements of the Act and the rules and regulations thereunder that are applicable to a national securities exchange. In particular, the Commission finds that the proposed rule changes, subject to their terms as pilots, are consistent with Section 6(b)(5) of the Act,
The Commission finds that the Program, as it is proposed on a pilot basis, is consistent with the Act because it is reasonably designed to benefit retail investors by providing price improvement to retail order flow. The Commission also believes that the Program could promote competition for retail order flow among execution venues, and that this could benefit retail investors by creating additional price improvement opportunities for their order flow. Currently, most marketable retail order flow is executed in the OTC markets, pursuant to bilateral agreements, without ever reaching a public exchange. The Commission recently noted that "a very large percentage of marketable (immediately executable) order flow of individual investors" is executed, or "internalized," by broker-dealers in the OTC markets.
The Program proposes to create additional price improvement opportunities for retail investors by segmenting retail order flow on the Exchanges and requiring liquidity providers that want to interact with such retail order flow to do so at a price at least $0.001 per share better than the Protected Best Bid or Offer. As noted above, some commenters questioned the fairness of treating retail order flow differently from other order flow on an exchange by offering price improvement opportunities only to retail orders. Commenters also raised several concerns relating to the way the Program proposes to define and identify retail order flow.
In this case, the Commission finds that while the Program would treat retail order flow differently from order flow submitted by other market participants, such segmentation would not be inconsistent with Section 6(b)(5) of the Act, which requires that the rules of an exchange are not designed to permit unfair discrimination.
As noted above, certain commenters questioned the fairness of preventing institutional investors from submitting Retail Orders, and thus receiving price improvement on their orders.
The Commission does not share the concern expressed by several commenters that the Program will cause a major shift in market structure. Instead, the Commission believes the Program should closely replicate the trading dynamics that exist in the OTC markets and will simply present another competitive venue for retail order flow execution. While some commenters stated that the Program would potentially increase sub-penny trading, the Commission believes that the Program will likely reallocate existing retail order flow from the OTC markets to the Exchanges, and is not likely to alter the incentives for market participants to post limit orders in a material way, given that liquidity providers already interact with most retail order flow in non-displayed markets.
When the Commission is engaged in rulemaking or the review of a rule filed by a self-regulatory organization, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.
The Commission also believes that the Program is sufficiently tailored to provide the benefits of potential price improvement only to bona fide retail order flow originating from natural persons.
In addition, the Commission finds that the Program's proposed dissemination of a Retail Liquidity Identifier would increase the amount of pricing information available to the marketplace and is consistent with the Act. The identifier would be disseminated through the consolidated public market data stream
Lastly, some commenters questioned whether the exchange rule filing process was an appropriate means to introduce the Program, given the Program's impact on broader market structure, and the limited timeframe in which the Commission would be able to consider the Program and comments thereto. Given that the Program involves modifying the Exchanges' trading rules to create new order types and categories of members, however, the Commission believes that the Program was appropriately proposed through the rule filing process pursuant to Section 19(b)(1) of the Act. In addition, the Commission does not believe that the Program is likely to significantly impact market structure because the Program is designed to replicate the trading dynamics that exist in the OTC markets and will simply present another competitive venue for retail order flow execution.
Furthermore, the Commission notes that it is approving the Program on a pilot basis. Approving the Program on a pilot basis will allow the Exchanges and market participants to gain valuable practical experience with the Program during the pilot period. This experience should allow the Exchanges and the Commission to determine whether modifications to the Program are necessary or appropriate prior to any Commission decision to approve the Program on a permanent basis. The Exchanges also have agreed to provide the Commission with a significant amount of data that should assist the Commission in its evaluation of the Program. Specifically, the Exchanges have represented that they "will produce data throughout the pilot, which will include statistics about participation, the frequency and level of price improvement provided by the Program, and any effects on the broader market structure." The Commission expects that the Exchanges will monitor the scope and operation of the Program and study the data produced during that time with respect to such issues, and will propose any modifications to the Program that may be necessary or appropriate.
The Commission also welcomes additional comments, and empirical evidence, on the Program during the pilot period to further assist the Commission in its evaluation of the Program.
Pursuant to its authority under Rule 612(c) of Regulation NMS,
When the Commission adopted the Sub-Penny Rule in 2005, it identified a
* If investors' limit orders lose execution priority for a nominal amount, investors may over time decline to use them, thus depriving the markets of liquidity.
* When market participants can gain execution priority for a nominal amount, important customer protection rules such as exchange priority rules and the Manning Rule could be undermined.
* Flickering quotations that can result from widespread sub-penny pricing could make it more difficult for broker-dealers to satisfy their best execution obligations and other regulatory responsibilities.
* Widespread sub-penny quoting could decrease market depth and lead to higher transaction costs.
* Decreasing depth at the inside could cause institutions to rely more on execution alternatives away from the exchanges, potentially increasing fragmentation in the securities markets.
At the same time, the Commission "acknowledge[d] the possibility that the balance of costs and benefits could shift in a limited number of cases or as the markets continue to evolve."
The Commission believes that the Exchanges' proposal raises such a case. As described above, under the current market structure, few marketable retail orders in equity securities are routed to exchanges. The vast majority of marketable retail orders are internalized by OTC market makers, who typically pay retail brokers for their order flow. Retail investors can benefit from such arrangements to the extent that OTC market makers offer them price improvement over the NBBO. Price improvement is typically offered in sub-penny amounts.
The limited exemptions granted today should promote competition between exchanges and OTC market makers in a manner that is reasonably designed to minimize the problems that the Commission identified when adopting the Sub-Penny Rule. Under the Program, sub-penny prices will not be disseminated through the consolidated quotation data stream, which should avoid quote flickering and its reduced depth at the inside quotation. Furthermore, while the Commission remains concerned about providing enough incentives for market participants to display limit orders, the Commission does not believe that granting this exemption (and approving the accompanying proposed rule changes) will reduce such incentives. Market participants that display limit orders currently are not able to interact with marketable retail order flow because it is almost entirely routed to internalizing OTC market makers that offer sub-penny executions. Consequently, enabling the Exchanges to compete for this retail order flow through the Program should not materially detract from the current incentives to display limit orders, while potentially resulting in greater order interaction and price improvement for marketable retail orders. To the extent that the Program may raise Manning and best execution issues for broker-dealers, these issues are already presented by the existing practices of OTC market makers.
The exemptions being granted today are limited to a one-year pilot. The Exchanges have stated that "sub-penny trading and pricing could potentially result in undesirable market behavior," and therefore they will "monitor the Program in an effort to identify and address any such behavior."