Rule:Disclosure of Order Execution and Routing Practices

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-43590; File No. S7-16-00]

RIN 3235-AH95

Disclosure of Order Execution and Routing Practices

AGENCY: Securities and Exchange Commission

ACTION: rule

SUMMARY: The Securities and Exchange Commission is adopting two
rules to improve public disclosure of order execution and routing
practices. Under Rule 11Ac1-5, market centers that trade national market
system securities will be required to make available to the public monthly
electronic reports that include uniform statistical measures of execution
quality. Under Rule 11Ac1-6, broker-dealers that route customer orders in
equity and option securities will be required to make publicly available
quarterly reports that, among other things, identify the venues to which
customer orders are routed for execution. In addition, broker-dealers will
be required to disclose to customers, on request, the venues to which
their individual orders were routed. By making visible the execution
quality of the securities markets, the rules are intended to spur more
vigorous competition among market participants to provide the best
possible prices for investor orders.

EFFECTIVE DATE: January 30, 2001. For specific phase-in dates
for compliance with the rules, see section V of this release. In addition,
the national securities exchanges and the national securities association
subject to §240.11Ac1-5(b)(2) shall comply with that provision by
submitting a national market system plan to the Commission by no later
than February 15, 2001.

FOR FURTHER INFORMATION CONTACT: Susie Cho, Attorney, at (202)
942-0748, Division of Market Regulation, Securities and Exchange
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-1001.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

II. Disclosure as Minimum Step Necessary to Address
Market Fragmentation

III. Rule 11Ac1-5 – Disclosure of Order Execution
Information

A. Comments on the Disclosure Approach of the
Proposed Rule

1. Emphasis on Execution Price and Speed

2. Usefulness to Investors of Execution Quality
Information

3. Risk of Meritless Litigation

B. Scope of Rule

1. Market Center

2. Covered Order

a. Immediate-Or-Cancel Orders

b. Market Opening Orders

3. National Market System Securities

C. Required Information

1. Information Required for All Types of Orders

2. Information Required for Market and
Marketable Limit Orders

D. Procedures for Making Reports Available to the
Public

IV. Rule 11Ac1-6 – Disclosure of Order Routing
Information

A. Scope of Rule

B. Quarterly Reports

C. Customer Requests for Information

V. Effective Dates and Phase-In of Compliance Dates

VI. Paperwork Reduction Act

A. Comments on Collection of Information
Requirements

B. Total Annual Reporting and Recordkeeping Burdens

VII. Cost-Benefit Analysis

A. Costs and Benefits of Rule 11Ac1-5

1. Benefits

2. Costs

B. Costs and Benefits of Rule 11Ac1-6

1. Benefits

2. Costs

VIII. Consideration of Burden on Competition and
Promotion of Efficiency, Competition, and Capital Formation

IX. Regulatory Flexibility Analysis

A. Need for the Rules

B. Significant Issues Raised by Public Comment

C. Small Entities Subject to the Rules

1. Small Entities Affected by Rule 11Ac1-5

2. Small Entities Affected by Rule 11Ac1-6

D. Projected Reporting, Recordkeeping and other
Compliance Requirements

1. Reporting Requirements under Rule 11Ac1-5

2. Reporting Requirements under Rule 11Ac1-6

E. Agency Action to Minimize Effect on Small
Entities

1. Rule 11Ac1-5

2. Rule 11Ac1-6

X. Statutory Authority

Text of Rules

I. Introduction

The Securities and Exchange Commission (“Commission”) is adopting two rules to increase the visibility of execution quality of the U.S. securities markets for public investors.1
Market centers that execute investor orders will be required to make monthly disclosures of basic information concerning their quality of executions. Broker-dealers will be required to disclose the identity of the market centers to which they route orders on behalf of customers.

Taken together, the rules should significantly improve the opportunity for public investors to evaluate what happens to their orders after they submit them to a broker-dealer for execution.

The rules arise out of the Commission’s extended inquiry into market
fragmentation – the trading of orders in multiple locations without
interaction among those orders. In today’s markets, investor order flow in
the same security can be divided among many different “market
centers” — e.g., exchanges, over-the-counter
(“OTC”) market makers, and electronic communications networks
(“ECNs”). The primary structural component linking these market
centers in the national market system is the consolidated public quote.
Pursuant to Commission rules, the best displayed bid and offer for each
equity security are collected from all significant market centers and
disseminated to the public on a real-time basis. This centralized source
of information, however, may convey an inaccurate impression of the
significant extent to which the quality of order execution can vary across
different market centers. At some market centers, for example, as many as
50% of certain orders, particularly market orders for small sizes (less
than 500 shares), are executed at prices better than the public
quotes. Similarly, for investors seeking to use limit orders to obtain
better prices than the public quotes, there can be wide variations among
market centers in the opportunity for such orders to be executed.

At present, few market centers provide detailed public disclosure
concerning their execution quality. Rule 11Ac1-5 will assure that all
market centers publicly disclose, on a monthly basis, basic standardized
information concerning their handling and execution of orders. Such
information will include, for example, how market orders in various size
categories are executed relative to the public quotes. Also, investors for
the first time will be informed not just about quoted spreads, but also
about effective spreads – the spreads actually paid by investors
whose orders are routed to a particular market center. In addition, market
centers will disclose the extent to which they provide to investors using
limit orders executions at prices better than the public quotes.

To complement the improved public disclosure of execution quality by
market centers, the Commission also is adopting a rule to improve
disclosure of order routing by broker-dealers. Under Rule 11Ac1-6,
broker-dealers that route orders as agent on behalf of their customers
will be required to disclose, on a quarterly basis, the identity of the
market centers to which they route a significant percentage of their
orders. Broker-dealers also will be required to disclose the nature of
their relationships with such market centers, including any
internalization or payment for order flow arrangements, that could
represent a conflict of interest between the broker-dealer and its
customers. In the past, such information has been available, if at all,
only by individual customer request on a transaction-by-transaction basis.
As a result, there has been very little opportunity for the public to
evaluate the routing practices of a broker-dealer as a whole.

In a fragmented market structure with many different market centers
trading the same security, the order routing decision is critically
important, both to the individual investor whose order is routed and to
the efficiency of the market structure as a whole. The decision must be
well-informed and fully subject to competitive forces. Currently, given
the lack of comparable public information on execution quality, retail
investors may conclude that the most rational strategy is simply to opt
for a broker-dealer that offers the lowest commission and a fast
execution. As a result, there may be limited opportunities for market
participants to compete on their ability to obtain the best prices for
these investor orders. By 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.

II. Disclosure as Minimum Step Necessary to
Address Market Fragmentation

The Commission is adopting Rule 11Ac1-5 and Rule 11Ac1-6 primarily to
address the serious problems that can arise from market fragmentation. For
most stocks actively traded in the U.S. markets, there are a variety of
market centers from which to choose in determining where to route orders
for execution. Particularly for equity securities qualified for inclusion
in the Nasdaq Stock Market, Inc. (“Nasdaq”), trading is widely
dispersed among many different market centers. These include a large
number of securities dealers that act as Nasdaq market makers. In
September 2000, there were an average of 59 market makers per issue in the
top 1% of Nasdaq stocks by dollar trading volume, 29 market makers per
issue in the next 9% of stocks, and an overall average of 13 market makers
per issue. In addition, eight ECNs operate agency markets, which together
accounted for 25.8% of Nasdaq share volume in September 2000.2
For exchange-listed equities, in contrast, the primary exchanges still
retain a high percentage of order flow. In September 2000, for example,
the New York Stock Exchange, Inc. (“NYSE”) accounted for 83.3%
of share volume in NYSE equities.3

The Commission initiated its formal inquiry into market fragmentation
in December 1999 when the NYSE submitted a proposed rule change to rescind
Rule 390, its rule restricting off-board trading by NYSE members. In
February 2000, the Commission issued a release that published the NYSE’s
proposal for public comment and also requested comment on a wide range of
issues relating to market fragmentation (“Fragmentation
Release”).4 It
noted that the rescission of off-board trading rules raised at least the
potential for increased fragmentation of the market for exchange-listed
stocks. The Commission particularly highlighted its concerns that dealer
practices such as internalization and payment for order flow have
contributed to the isolation of investor limit orders and to less vigorous
quote competition.5

Among the commenters responding to the Fragmentation Release, the
investors (both institutional and retail) were unanimous in their view
that fragmentation was a problem that the Commission needed to address.
Many securities industry participants, in contrast, believed that
fragmentation merely was an inevitable adjunct of competition among market
centers, and that such competition produces many benefits for investors.
Although the comments reflected wide disagreement about a number of
potential options for Commission action that would have addressed market
fragmentation most directly, the majority of commenters supported some
form of increased disclosure by market centers and broker-dealers
concerning their execution quality and order routing practices. In July
2000, the Commission issued a release proposing Rule 11Ac1-5 and Rule
11Ac1-6 to implement this option (“Proposing Release”).6

In considering the issue of fragmentation, the overriding objective of
the Commission’s inquiry has been quite pragmatic – to assure that
investors receive the best possible prices for their orders.7
For example, do investors who seek liquidity by submitting market orders
pay the lowest possible effective spread, or liquidity premium, for their
orders? Similarly, do investors who supply liquidity by submitting limit
orders have the best possible opportunity for their orders to be executed?
The Commission believes that vigorous competition among buyers and sellers
in an individual security, particularly through an opportunity for their
orders to interact directly,8
is the only reliable means to achieve the best prices for investors. To
the extent that substantial fragmentation of order flow stands in the way
of such competition, the harm that results is not merely theoretical.
Rather, investors are forced to incur higher transaction costs, and the
efficiency of the U.S. markets is diminished.

The Commission’s concerns about fragmentation and order interaction
should not be construed as meaning that it fails to recognize the
essential importance of competition among market centers, which almost by
definition entails some fragmentation of order flow. The Commission
repeatedly has emphasized the substantial benefits to investors of such
competition, including innovative trading services, lower trading fees,
and faster executions. Accordingly, the relevant issue in addressing
fragmentation is not whether the objective of order interaction should be
pursued to the exclusion of market center competition, but how best to
secure the benefits of both market center competition and order
interaction. Although these two objectives may not 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.

Determining how best to assure an appropriate balance between market
center competition and order interaction is unquestionably a difficult
task. Nevertheless, the Commission’s year-long inquiry has led it to
conclude that increased public disclosure of execution quality and order
routing practices is a minimum step necessary to address fragmentation.
There currently is little or no publicly available information that would
enable investors to compare and evaluate execution quality among
different market centers and order routing practices among broker-dealers.
Some market centers make order execution information privately available
to independent companies, which then prepare reports on execution quality
that are sold to broker-dealers. Other market centers provide reports on
execution quality directly to broker-dealers or to their members. The
information in these reports generally has not been publicly disseminated.
Moreover, some broker-dealers have reported difficulty in obtaining useful
information on execution quality from market centers. For example,
participants in a Commission roundtable on the on-line brokerage industry
indicated that not all market centers were willing to make order execution
information available and, even when such information was made available,
not all of it was useful or in a form that allowed for cross-market
comparisons.9

Consequently, most investors have few tools with which to assess the
execution quality of different market centers and the order routing
practices of different broker-dealers. Execution quality can, however,
vary significantly across different market centers trading the same
security. If improved disclosure leads to the tightening of effective
spreads across market centers, the savings to investors could be quite
substantial. For example, the Commission staff has estimated that
investors who submit market orders for Nasdaq securities could save $110
million in annual trading costs if market centers that currently execute
such orders at effective spreads wider than the median for all Nasdaq
market centers improved their effective spreads to the median.10
The variation of execution quality across market centers also has been
shown by previous analyses of trading. In 1997, for example, the
Commission issued a Report on the Practice of Preferencing that analyzed
trading in the listed equity markets (“Preferencing Report”).
The sole objective of the Preferencing Report was to evaluate the impact
of two preferencing programs that had been formally implemented by the
Cincinnati Stock Exchange (“CSE”) and Boston Stock Exchange.11
In this limited context, the Preferencing Report found that the programs
had not had an adverse effect on the national market system as a whole
(particularly given that the programs were quite limited and represented
only a small fraction of listed order flow).12
When NYSE trading was compared directly with trading on the regional
exchanges, however, and such comparisons were made on an
“apples-to-apples” basis (i.e., categorized by trading in
the same stocks and by orders of the same size), the Preferencing Report
found significant variations in executions across market centers.13
For example, the effective spreads on the regional exchanges for small
market orders were 20% to 39% higher than those on the NYSE.14

In addition to public analyses of equity market trading, the Commission
staff is aware of similar data obtained during the examination process
indicating that execution quality can vary across market centers. In 1999,
for example, the Commission’s Office of Compliance Inspections and
Examinations (“OCIE”) conducted examinations of 21
broker-dealers for compliance with the firms’ responsibility to examine
regularly and rigorously the execution quality likely to be obtained from
different market centers. In the course of these examinations, OCIE found
that the firms had obtained private analyses of trading from independent
companies showing marked differences in execution quality among market
centers trading the same security, as well as across securities traded in
different market structures.

The Commission anticipates that the two rules adopted today could
provoke more vigorous competition on execution quality and order routing
performance. The rules will reveal if broker-dealers are routing a
significant volume of orders to market centers that execute orders at
prices substantially inferior to those available at other market centers
trading the same security. This improved visibility, in turn, could shift
order flow to those market centers that consistently generate the best
prices for investors. Finally, by facilitating comparisons among
securities traded in different market structures, the disclosures required
by the rules may bring competitive forces more directly to bear on broader
market structure issues, such as by prompting investors and issuers to
choose markets with more efficient structures.

Nevertheless, the Commission shares the concerns of many commenters
responding to both the Fragmentation Release and the Proposing Release
that improved disclosure alone might not prove sufficient to address all
of the problems that can arise from substantial market fragmentation.15
Accordingly, the Commission intends to monitor closely the effects of the
disclosure rules on trading in the coming months. The Commission also
plans to monitor the pending move to decimal trading in actively-traded
equities, which potentially could address fragmentation concerns by
enabling more vigorous competition on quoted price. After assessing the
impact of the rules and decimals, it will consider whether additional
action is necessary to address market fragmentation and further the
Exchange Act’s objectives for a national market system.

III. Rule 11Ac1-5 – Disclosure of Order
Execution Information

The Commission has decided to adopt Rule 11Ac1-5 substantially as it
was proposed, subject to certain technical modifications. The Rule will
require market centers to prepare and make available to the public monthly
reports in electronic form that categorize their order executions and
include statistical measures of execution quality. To facilitate
comparisons across market centers, the Rule adopts basic measures of
execution quality (such as effective spread, rate of price improvement and
disimprovement, fill rates, and speed of execution) and sets forth
specific instructions on how the measures are to be calculated. The
statistical information will be categorized by individual security, by
five types of order (e.g., market and inside-the-quote limit), and
four order sizes (e.g., 100-499 shares and 500-1999 shares). As a
result, users of the market center reports will have great flexibility in
determining how to summarize and analyze statistical information. Users of
the data will be able to analyze order executions for a particular
security or for any particular group of securities, as well as for any
size or type of orders across those groups of securities.

A. Comments on the Disclosure Approach of the
Proposed Rule

The Commission received 51 comment letters on the disclosure of order
execution practices reflected in the proposed rule.16
A majority of letters were supportive of the objective of improved
disclosure, although several expressed serious reservations regarding the
implementation of this objective in the proposed rule. Those who supported
the rule’s approach noted the current lack of useful, public information
with which to compare execution quality among market centers. They
believed that the information required by the rule would help address this
problem.17 The
Investment Company Institute, for example, noted that “[c]urrently,
it can be very difficult to obtain significant and meaningful data on the
execution quality of market centers. In the absence of such data, it is
difficult to compare execution quality across markets.” Interactive
Brokers believed that the rule “will be a major step forward in
improving investor awareness of the real costs they pay, both in time and
money, for trade execution.” Others noted that improved disclosure
could benefit investors by acting as a spur to competition. Knight Trading
Group believed that the proposed rules “will serve to enhance
investor protection and further competition for retail orders by enabling
investors and their fiduciaries to evaluate more effectively the market
centers to which their orders are routed.” Salomon Smith Barney noted
that “an educated investor will force firms and market centers to
compete vigorously with each other for customer order flow and improve the
quality of executions and our capital markets.” Marshall E. Blume
stated that “[t]hrough disclosure, investors will learn which markets
provide better execution, and competition, not the SEC, will determine
which markets will thrive.”18
Another commenter agreed, noting that “transparency and disclosure
are the foundation of fair competition.”19

Although fully supporting the objective of improved disclosure of order
execution practices, five commenters expressed reservations regarding the
implementation of this objective in the proposed rule. Three suggested
that the Commission should require much more detailed disclosure of
individual orders and transactions, rather than the rule’s approach of
aggregating such data into statistical categories on a stock-by-stock
basis.20 Two other
commenters expressed reservations about the usefulness of many statistical
categories included in the proposed rule, and also noted the need for
additional categories that were not included.21

The commenters that opposed the disclosure approach of the proposed
rule did so for varying reasons. Five of the commenters were opposed to
the approach primarily because they believed the Commission should address
fragmentation by mandating a unified national linkage system with
price/time priority.22
The reasons identified by other commenters opposed to the disclosure
approach can be divided into three major categories: (1) the proposed rule
would over-emphasize quantitative factors, particularly execution price
and speed, in obtaining best execution of investor orders; (2) the
information on execution quality required by the proposed rule would be
too complex and not very useful to investors; and (3) the statistical
disclosures required by the proposed rule would greatly increase the risk
of meritless private litigation. These issues are discussed below.

1. Emphasis on Execution Price and Speed

Many of the commenters opposing the disclosure approach of the proposed
rule, as well those criticizing the rule’s implementation of a disclosure
approach, believed that it would over-emphasize the quantitative factors
of execution price and speed in obtaining the best execution of investor
orders.23 The
Commission agrees with these commenters that execution price and speed are
not the sole relevant factors in obtaining best execution of investor
orders. It repeatedly has noted that other factors may be relevant, such
as (1) the size of the order, (2) the trading characteristics of the
security involved, (3) the availability of accurate information affecting
choices as to the most favorable market center for execution and the
availability of technological aids to process such information, and (4)
the cost and difficulty associated with achieving an execution in a
particular market center. Rule 11Ac1-5 does not address, much less alter,
the existing legal standards that apply to a broker-dealer’s duty of best
execution.

For example, the Commission previously has stated that a broker-dealer
must regularly and rigorously evaluate the quality of execution it obtains
for customers’ orders.24
This responsibility is not changed by Rule 11Ac1-5. Indeed, the monthly
market center reports will encompass all the orders received by a
market center from any number of different broker-dealers. In contrast, a
broker-dealer is responsible only for the execution quality of its own
customers’ orders. If a market center’s overall statistics do not reflect
the quality of execution of the orders of the broker-dealer’s customers,
the broker-dealer appropriately should consider this disparity in meeting
its duty of best execution. In sum, the rules adopted today do not define,
either explicitly or implicitly, a broker-dealer’s duty of best execution.

The Commission strongly believes, however, that most investors care a
great deal about the quality of prices at which their orders are executed,
and that an opportunity for more vigorous competition among market
participants to provide the best quality of execution will enhance the
efficiency of the national market system. Rule 11Ac1-5 is needed, not
because price is the only important factor in routing orders, but because
there currently is little or no public information that would allow
investors to assess a broker-dealer’s handling of its customer orders. For
example, the Rule will allow investors to monitor the extent to which, in
choosing execution venues, there are, in fact, systematic trade-offs that
must be made between price and other factors, and the amount of those
trade-offs. For example, if the best prices are consistently produced by
one of the leading market centers with cutting-edge, highly-reliable
trading systems, there would be little, if any, trade-off between price
and systems reliability. Similarly, the rules will help customer weigh the
trade-off between a market center that provided immediate executions at
the quote, and a market center that executed orders on average in under 30
seconds, but that consistently generated prices resulting in average
effective spreads that were a significant amount per share better than
those paid by investors at other market centers. Currently, however,
investors have little or no information that would allow them to evaluate
how their broker-dealer has responded to such trade-offs. Rule 11Ac1-5 is
intended to remedy this glaring absence of public information.

The Rule’s disclosure of the average spreads at which investor orders
are executed should not be construed as meaning that only price
“improvement” – defined as the execution of an order at a price
better than the public quote at the time the market center received the
order – is important. Price improvement is likely to be important to many
small investors because small orders are the most likely, at least at some
market centers, to receive significantly better prices than the public
quotes. The Rule does not, however, focus solely on orders that receive
price improvement. It requires the same types and degree of disclosure for
orders that are executed at the quotes and at prices outside the quotes.
Moreover, many commenters mistakenly believed that Rule 11Ac1-5 focused on
price “improvement” to the exclusion of other important aspects
of execution that relate to price, particularly the amount of liquidity
available at different market centers. However, liquidity and price are
integrally related. Liquidity reflects the extent to which larger size
orders can be executed at prices that are equal to or not far away from
the quotes when the order is submitted. To measure the amount of liquidity
available at different market centers, Rule 11Ac1-5 requires separate
disclosures concerning the extent to which orders are executed at prices
better than the quotes, equal to the quotes, and outside the quotes. Each
of these disclosures will be categorized by the following order sizes –
100-499, 500-1999, 2000-4999, and 5000 or more shares. Thus, these
categories of information enable the comparison of the performance of
market centers in executing larger orders at prices equal to the public
quotes. Moreover, one particular measure included in the Rule – the
average effective spread – will capture the net effect of all
executions in an order size. For example, a market center’s average
effective spread for market orders of 2000-4999 shares in a security will
reflect the share-weighted average of the executions it provided for all
of those orders. Thus, if a market center gave only a few orders price
improvement, but executed most orders at prices outside the quotes, its
average effective spread would be higher than the average effective spread
reported by a market center that executed a high percentage of orders at
prices equal to the public quotes.

The Commission also wishes to emphasize that Rule 11Ac1-5 is intended
to establish a baseline level of disclosure that all market centers must
meet in order to facilitate cross-market comparisons of execution quality.
It does not preclude market centers from disclosing whatever additional
information concerning their order execution practices that they believe
would more fully convey the quality of their services.

2. Usefulness to Investors of Execution
Quality Information

Commenters opposed to the proposed rule also questioned the usefulness
to investors of the information on execution quality that would be
included in the market center reports. In particular, they believed that
the information was too complex for investors to understand, that the
reports would overwhelm investors with statistical data, and that, as a
result, investors would be vulnerable to being misled by those willing to
“spin” the data to serve their own self interest.25

As an initial matter, the Commission disagrees with the notion that
investors are incapable of understanding the fundamental principles of
execution quality reflected in Rule 11Ac1-5.26
Investors’ current lack of familiarity with the statistical
measures, rather than their inherent complexity, may contribute to an
impression that the measures are complex. To date, very few market centers
have made any public disclosures concerning their execution quality, such
as their effective spread and rate of price improvement for different
types of orders. The quoted spread, in contrast, has been widely
disseminated pursuant to Commission rules and that is what investors have
come to know. Given the enormous appetite of investors in recent years for
better information about the markets (fueled largely by improved
technology and lower communication costs), the Commission anticipates that
many investors will come to appreciate the important distinction between
quoted prices and the prices they actually receive. Nearly every
statistical measure included in Rule 11Ac1-5, each of which is based on
execution price and speed of execution, is straightforward in principle.

Commenters correctly observed, however, that a large volume of
statistical data will be disclosed in the monthly execution quality
reports. As discussed in the Proposing Release, the large volume of
statistics reflects a deliberate decision by the Commission to avoid the
dangers of overly-general statistics. Assigning a single “execution
quality” score to market centers, for example, would hide major
differences in execution quality, potentially creating far more problems
that it solved. Instead, Rule 11Ac1-5, taking advantage of improved and
more efficient information technology, requires electronic disclosure of
basic order execution information that is categorized on a stock-by-stock
basis. After this basic information is disclosed by all market centers in
a uniform manner, market participants and other interested parties will be
able to determine the most appropriate classes of stocks and orders to use
in comparing execution quality across market centers.

Given the large volume of data that will be included in the reports,
most individual investors likely would not obtain and digest the reports
themselves.27 The
Commission anticipates that independent analysts, consultants,
broker-dealers, the financial press, and market centers will analyze the
information and produce summaries that respond to the needs of investors.
Some commenters expressed discomfort with the varied and unstructured
analysis that might arise once execution quality statistics become
available to the public. However, many market participants will have an
interest in clearly communicating to investors the salient information in
ways that investors can understand. In time, investors should be able to
assess the credibility of these analyses and use them in evaluating
execution performance. Indeed, one of the most serious problems investors
currently face with respect to choosing a broker is assessing the quality
of order routing and execution services provided by various
broker-dealers. After the rules adopted today become effective,
competitive forces can be brought to bear on broker-dealers both
with respect to the explicit trading costs associated with brokerage
commissions and the implicit trading costs associated with execution
quality. The Commission believes that investors ultimately will be the
beneficiaries of this expanded competition.28

3. Risk of Meritless Litigation

Several commenters expressed concern that the required disclosures of
order execution and routing practices would greatly increase the risk of
private securities litigation alleging that broker-dealers failed to meet
their duty of best execution.29
The Commission expresses no opinion on some of the broader criticisms of
private litigation made by these commenters. It is concerned, however,
about comments that the required disclosures, particularly the detailed
statistical information required by Rule 11Ac1-5, could be subject to
misinterpretation that might pose a risk of meritless litigation.
The Commission wishes to make clear its views as to the limits of these
data in evaluating a broker-dealer’s compliance with its legal duty of
best execution. Both Rule 11Ac1-5 and Rule 11Ac1-6 are designed to require
disclosure pursuant to Section 11A of the Exchange Act. They are not
antifraud rules, nor do they create new duties under the antifraud
provisions of the federal securities laws. The rules themselves create
neither express nor implied private rights of action. Furthermore, Rule
11Ac1-5 and Rule 11Ac1-6 do not address and therefore do not change the
existing legal standards that govern a broker-dealer’s duty of best
execution. The market center reports will provide statistical disclosures
regarding certain of the factors relevant to a broker-dealer’s order
routing decision, but these factors alone are not determinative of whether
the broker-dealer achieved best execution.

Rule 11Ac1-5 and Rule 11Ac1-6 are designed to generate uniform, general
purpose statistics that will prompt more vigorous competition on execution
quality. The information that will be generated as a result of these rules
will not, by itself, be sufficient to support conclusions regarding a
broker-dealer’s compliance with its legal responsibility to obtain the
best execution of customer orders. Any such conclusions would require a
more in-depth analysis of the broker-dealer’s order routing practices than
will be available from the disclosures required by the rules.

For example, as discussed in section III.A.1 above, the execution
quality statistics included in Rule 11Ac1-5 do not encompass every factor
that may be relevant in determining whether a broker-dealer has obtained
best execution. In addition, the statistics in a market center’s reports
typically will reflect orders received from a number of different routing
broker-dealers. Legal conclusions about any one broker-dealer’s routing
practices require an assessment of additional information concerning how
that broker-dealer’s customer orders were executed. Moreover, under Rule
11Ac1-6, a broker-dealer’s quarterly report will provide a general
overview of its order routing practices. The information on where orders
were routed during the quarter will be broken out only by the listing
status of the security – NYSE, Nasdaq, Amex/other, and options. Within
these categories, a broker-dealer may have varied its routing of different
types of orders, or orders in different securities, so as to obtain
results that would not be evident from the general statistics presented in
the market center reports.

In sum, while the order execution and routing disclosures will
represent a significant step forward in the quality of information that is
currently publicly available, they alone will not provide a reliable basis
to assess a broker-dealer’s compliance with its duty of best execution.
Therefore, the resulting statistics, by themselves, do not demonstrate
whether or not broker-dealers have complied with their legal duties to
their customers,30
and to conclude otherwise would be contrary to the Commission’s prior
statements, discussed below, about the duty of best execution.
Furthermore, the Commission believes that the possibility of multiple,
inconsistent standards in interpreting this information in relation to
various state law claims could tend to frustrate the statutory objective
of establishing and monitoring the development of a national market system31
and would undermine the Commission’s effort to assure the practicability
of brokers achieving best execution.32

The Commission previously has expressed three conclusions inconsistent
with an overly-simplistic determination that a broker-dealer breached the
duty of best execution. First, a broker-dealer is required to seek to
obtain the most favorable terms reasonably available under the
circumstances for a transaction (which may not in every case necessarily
be the best price that might be available).33
Second, the duty of best execution does not necessarily require
broker-dealers with a large volume of orders to determine individually
where to route each order. Third, a broker-dealer does not violate its
best execution obligation solely because it receives payment for order
flow or trades as principal with customer orders.34

To emphasize these points, we have added a “Preliminary Note”
to Rule 11Ac1-5. It provides as follows:

§240.11Ac1-5 requires market centers to make available standardized,
monthly reports of statistical information concerning their order
executions. This information is presented in accordance with uniform
standards that are based on broad assumptions about order execution and
routing practices. The information will provide a starting point to
promote visibility and competition on the part of market centers and
broker-dealers, particularly on the factors of execution price and speed.
The disclosures required by this Section do not encompass all of the
factors that may be important to investors in evaluating the order routing
services of a broker-dealer. In addition, any particular market center’s
statistics will encompass varying types of orders routed by different
broker-dealers on behalf of customers with a wide range of objectives.
Accordingly, the statistical information required by this Section alone
does not create a reliable basis to address whether any particular
broker-dealer failed to obtain the most favorable terms reasonably
available under the circumstances for customer orders.

The Commission believes that this clear statement will substantially
address the danger of meritless litigation that might impose significant
indirect costs on broker-dealers.

B. Scope of Rule

Paragraph (b)(1) of Rule 11Ac1-5 provides that every market center
shall make available for each calendar month an electronic report on the
covered orders in national market system securities that it received for
execution from any person. Thus, the Rule is limited in scope to market
centers, covered orders, and national market system securities.

1. Market Center

Paragraph (a)(14) of the Rule defines the term “market
center” as any exchange market maker, OTC market maker, alternative
trading system, national securities exchange,35
or national securities association. This definition is intended to cover
entities that hold themselves out as willing to accept and execute orders
in national market system securities. In addition, the language in
paragraph (b)(1) that a market center must report on orders that it
“received for execution from any person” is intended to assign
the disclosure obligation to the entity that is expected to control
whether and when an order will be executed.36

The Commission anticipates that the reporting entity for the vast
majority of orders will be an exchange specialist, OTC market maker, or
ATS. Although specialists and market makers frequently operate under the
auspices of an SRO (and such an SRO likely will greatly assist its members
in meeting the disclosure requirements of the Rule),37
the responsibility for executing orders generally is handled by the
individual firms, and execution quality may vary significantly among them.
This is particularly true where an exchange has multiple market makers in
a security. It therefore is appropriate for the monthly reports to reflect
these potential differences. In some cases, however, orders may be
executed through a facility operated by an SRO without a member
significantly controlling the order executions. Examples may include (1)
the Small Order Execution System (“SOES”) operated by Nasdaq,
and (2) floor brokers who receive orders on the floor of an exchange and
obtain an execution of the orders with little participation by a
specialist. The definition of market center includes exchanges and
associations to cover these situations.38

2. Covered Order

The definition of “covered order” in paragraph (a)(8) of Rule
11Ac1-5 contains several conditions and exclusions that are intended to
limit its scope to those orders that provide a basis for meaningful and
comparable statistical measures of execution quality. First, the Rule
applies only to market orders or limit orders that are received by a
market center during regular trading hours and, if executed, executed
during such time. The term “regular trading hours” is defined in
paragraph (a)(19) of the Rule to mean between 9:30 a.m. and 4:00 p.m.
Eastern Time, or such other time as is set forth in the procedures
established pursuant to paragraph (b)(2) of the Rule. There are
substantial differences in the nature of the market between regular
trading hours and after-hours, and orders executed at these times should
not be blended together in the same statistics.39
In addition, covered orders must be received during the time that a
consolidated BBO is being disseminated.40
This restriction is necessary because nearly all of the statistical
measures included in the Rule depend on the availability of a consolidated
BBO at the time of order receipt. The term “consolidated best bid and
offer” is defined in paragraph (a)(7) as the highest firm bid and the
lowest firm offer for a security that is calculated and disseminated on a
current and continuous basis pursuant to an effective national market
system plan. The two plans that currently provide for the calculation and
dissemination of a consolidated best bid and offer for national market
system securities are the Consolidated Quotation Plan for listed equities
and the Nasdaq/National Market System Plan for Nasdaq equities.41

The definition of covered order excludes any orders for which the
customer requested special handling for execution and that, if not
excluded, could skew general statistical measures of execution quality.
Types of orders specifically excluded from the Rule include, but are not
limited to, orders to be executed at a market opening or closing price,
stop orders, orders such as short sales that must be executed on a
particular tick or bid, orders submitted on a “not held” basis,
orders for other than regular settlement, and orders to be executed at
prices unrelated to the market price at the time of execution. All of
these exclusions are retained from the proposed rule. In addition, the
Rule as adopted now specifically excludes all-or-none orders on the basis
that they often may be more difficult to execute than orders without a
substantial minimum quantity requirement.42

Two types of orders warrant further discussion. The first type —
immediate-or-cancel orders — is included in the Rule. The second – orders
to be executed at a market opening price – is excluded for operational
reasons, notwithstanding the significant issues of quality of disclosure
for investors submitting these orders, particularly in Nasdaq securities.

a. Immediate-Or-Cancel Orders

The Commission has determined that “immediate-or-cancel”
orders should be included in Rule 11Ac1-5. Immediate-or-cancel orders are
immediately subject to execution under normal conditions. These orders are
functionally nearly the same as orders that are submitted and cancelled
almost immediately thereafter, which are included in the Rule. If not
executed, they simply will be included in the statistic for a market
center’s cancelled orders under subparagraph (b)(1)(i)(C) of the Rule.
Moreover, ECNs trading Nasdaq securities receive a substantial number of
immediate-or-cancel orders, particularly those that are marketable limit
orders. Thus, including these orders may be important to accurately assess
the quality of these ECNs, and statistics that reflect the execution
quality of these orders in ECNs may be of significant interest to
investors.

b. Market Opening Orders

The Proposing Release requested comment on the appropriateness of
excluding orders that are to be executed at a market opening price.
Several commenters believed that such orders should be included in the
Rule. Edward D. Jones & Co., for example, observed that approximately
10-20% of its order flow typically was executed at the opening and that it
would be useful, particularly for Nasdaq securities, to segregate opening
orders into a separate statistic. The Investment Company Institute stated
that “the quality of execution of market opening orders in the Nasdaq
market has been an issue of significant concern to market
participants” and that “information on the quality of execution
at the opening would assist market participants in determining how to
trade securities at the opening of the market.”

The Commission fully shares the concerns of commenters over the need
for improved information on the quality of execution of opening orders in
Nasdaq securities. In this respect, the market for Nasdaq securities
differs significantly from the market for exchange-listed securities,
where the primary exchange generates and disseminates a single opening
price. Moreover, it is the Commission’s understanding that it is industry
practice in the listed markets to provide investors with this single
opening price for opening orders that are executed away from the primary
exchange. In the market for Nasdaq securities, in contrast, it appears to
be the common practice of many market centers to execute opening orders to
buy at the quoted offer and opening orders to sell at the quoted bid,
thereby charging a liquidity premium for a large volume of orders that
effectively cross each other at a single point in time.

The Commission is aware that several important market centers trading
Nasdaq securities have begun to offer services that give investors an
opportunity to avoid paying a liquidity premium on opening orders. Such
services can include, for example, “mid-point pricing,” pursuant
to which both buy and sell orders are executed at the midpoint of the
opening quoted bid and offer.43

The Commission is concerned that many investors may not be fully aware
of the significant distinction between Nasdaq and listed securities with
respect to the execution of opening orders. The Commission also is
concerned that many investors may not be aware of the differing services
offered by market centers for execution of opening orders in Nasdaq
securities, and their impact on execution quality. Without question,
including a separate category for opening orders in the Rule 11Ac1-5
statistics would highlight the differences in quality of execution of
opening orders across market centers. Nevertheless, the Commission is
reluctant to expand the quantity of the Rule’s continuing and marketwide
disclosure requirements to address an issue that is limited to a specific
segment of the equities markets. Including additional statistics for
opening orders in market center reports alone would increase the size of
the reports by 20%. All market centers, both those trading listed and
Nasdaq securities, would be required to include the opening order
information, even though it would be nearly the same for all market
centers offering a single price execution of these orders. In addition,
Nasdaq is actively considering new opening procedures that could reduce
disparities in execution quality.

Instead of substantially expanding the quantity of statistics required
by the Rule to address this issue, the Commission believes that the
markets and broker-dealers handling customer orders should be given a
further opportunity to improve execution quality at the opening in Nasdaq
securities. Market centers generally inform broker-dealers in advance how
they will execute opening orders. Broker-dealers are subject to a best
execution duty in executing customer orders at the opening, and should
take into account the alternative methods in determining how to obtain
best execution for their customer orders. Broker-dealers are encouraged to
communicate clearly to customers the choices available for execution of
opening orders, as well as the broker-dealer’s policy for obtaining best
execution of such orders. If necessary in the future, the Commission will
consider requiring statistical disclosure of order execution quality at
the opening.

3. National Market System Securities

Rule 11Ac1-5 applies only to securities that are designated as national
market system securities under Exchange Act Rule 11Aa2-1. Currently, this
designation applies to exchange-listed equities and equities included in
the National Market tier of Nasdaq.44
It does not apply to Nasdaq SmallCap securities, Over-the-Counter Bulletin
Board securities, and exchange-listed options. SmallCap stocks tend to be
inactively traded and, as a group, generate less than 5% of the dollar
volume on Nasdaq while making up nearly 25% of Nasdaq companies.45
Given the relatively light dollar amount of trading in these and Bulletin
Board securities, the Commission believes at this time that the value of
statistical measures of trading may not justify the costs to produce the
information. After gaining experience with the Rule’s operation, it will
consider whether the scope of the Rule should be expanded.

The Proposing Release requested comment on whether Rule 11Ac1-5 should
apply to orders for listed options. Interactive Brokers LLC strongly
believed that the Rule should apply to options trading.46
The Chicago Board Options Exchange (“CBOE”), in contrast, did
not think that the Rule’s disclosure approach was appropriate for options
trading, although it did express support for the objective of improved
disclosure in general.47
The Commission continues to believe that there is a need for improved
disclosure of execution quality in the options markets, particularly now
that there is widespread trading of options on multiple exchanges and
expanding payment for options order flow. Nevertheless, potentially
difficult issues would have to be addressed before options could be
included within Rule 11Ac1-5. For example, a consolidated BBO is not, at
this time, calculated and disseminated for options trading. A consolidated
BBO is an essential element for nearly every statistical measure in the
Rule, such as calculating price improvement and classifying types of limit
orders (e.g., inside-the-quote and at-the-quote limit orders).
Although each exchange potentially could calculate its own consolidated
BBO, the calculations might vary at times and fail to provide a uniform
basis for comparable statistics. In addition, categorization of orders on
a security-by-security basis would be much less practical for the options
markets, where there may be hundreds of series of options for one
underlying security. The Commission’s Office of Economic Analysis and OCIE
currently are preparing a report on payment for order flow in the options
markets. The report necessarily will address the quality of execution of
options orders. After the report is completed, the Commission will
consider whether additional action is needed to improve the quality of
disclosure of execution quality in the options markets.

C. Required Information

Paragraph (b)(1) of Rule 11Ac1-5 requires market center reports to be
categorized by individual security, order type, and order size. These
categories are defined in paragraphs (a)(4) through (a)(6) of the Rule.
The five types of orders are market, marketable limit, inside-the-quote
limit, at-the-quote limit, and near-the-quote limit. The four buckets of
order size are 100-499, 500-1999, 2000-4999, and 5000 or more shares. With
this degree of categorization, a market center will, for example, produce
statistical information for the subcategory of market orders for 100-499
shares in an individual stock.

Several commenters criticized the categories specified in the proposed
rule.48 The
Commission has decided to retain the categories at this time, although
experience with the Rule may indicate ways in which they could be improved
in the future. The categories are intended to strike a balance between (1)
sufficient aggregation of orders to produce statistics that are
meaningful, and (2) sufficient differentiation of orders to facilitate
fair comparisons of execution quality across market centers. If a market
center believes that the categories do not fully reflect its order flow
and execution practices, it is encouraged to make any additional
information publicly available that it believes would be helpful to
investors.

1. Information Required for All Types of
Orders

For each subcategory of security/order type/order size, paragraph
(b)(1)(i) specifies eleven columns of information that must be provided.
The first five columns provide general information on the orders received
by a market center in a subcategory and the disposition of those orders.
The first column is “the number of covered orders.” The second,
however, is “the cumulative number of shares of covered orders”;
and thereafter all statistics required by the Rule are expressed either in
number of shares or in share-weighted amounts. The Rule uses share-based
statistics primarily to deal with those situations in which a single order
receives less than a full execution or more than one partial execution.

The Rule requires disclosure of the number of shares cancelled prior to
execution,49 and
the number of shares executed at both the receiving market center and at
any other venue (after being routed elsewhere by the receiving market
center). Thereafter, all statistical measures of order execution for a
market center will encompass both orders that were executed at the
receiving market center and orders that were executed elsewhere. In
calculating its statistics, a market center will use the time it received
the order and the consolidated BBO at the time it received the order, not
the time and consolidated BBO when the venue to which an order was
forwarded received the order. The Commission believes that a market center
should be held accountable for all orders that it receives for execution
and should not be given an opportunity to exclude difficult orders from
its statistical measures of execution quality by routing them to other
venues. In addition, from the perspective of the customer who submitted
the order, the fact that a market center chooses to route the order
elsewhere does not reduce the customer’s interest in a fast execution that
reflects the consolidated BBO as close to the time of order submission as
possible. Consequently, in evaluating the quality of order routing and
execution services, it is important for customers to know how a market
center handles all orders that it receives, not just those it chooses to
execute.

The term “time of order receipt” is defined in paragraph
(a)(21) of the Rule as the time (to the second) that an order was received
by a market center for execution. The definition is intended to identify
the time that an order reaches the control of the market center that is
expected, at least initially, to execute the order. In many cases, a
broker-dealer may receive an order from a customer in a security for which
the broker-dealer also is an OTC market maker or an exchange specialist.
In such cases, the market center will be considered to have received an
order for execution only when the order is transmitted to the department
of the firm responsible for making a market in the security.

A commenter noted the danger that a market center might attempt to
manipulate the time of receipt for its order flow. It stated, for example,
that “a market maker executing captive market orders pursuant to an
internalization or payment for order flow arrangement who has agreed to
`step up and match’ the NBBO can create for itself a free option by
monitoring market movements before and/or after receipt of any order and
assigning as an execution price for that order whatever `NBBO’ is most
favorable to the market maker during the brief option period.”50
The Commission agrees that it is critically important for market centers
to assign a time of receipt (including seconds) to orders in a prompt,
consistent, and non-manipulatory manner. The Commission’s inspections of
market centers will include a review for compliance with this standard,
and failure to meet the standard would be a serious violation of the Rule.

The next five columns required by paragraph (b)(1)(i) of the Rule ask
for the number of shares that were executed within specified periods of
time after order receipt (such as “from 0 to 9 seconds” and
“from 10 to 29 seconds”). Although required for all types of
orders, the Commission anticipates that this information will be most
useful for evaluating the execution of non-marketable limit orders. These
statistics are intended to provide useful comparisons to the overall fill
rates for non-marketable limit orders.51
Particularly for inside-the-quote and at-the-quote limit orders, the
submitter of the order reasonably may expect that the order should be
executed relatively quickly, and information on the likelihood that such
an order will be executed with 10 seconds, 30 seconds, and so on, at
different market centers may be helpful in guiding the order routing
decision.

The column of information required for all types of orders is the
average realized spread. The term “average realized spread” is
defined in paragraph (a)(3) of the Rule and is calculated by comparing the
execution price of an order with the midpoint of the consolidated BBO as
it stands five minutes after the time of order execution.52
The smaller the average realized spread, the more market prices have moved
adversely to the market center’s liquidity providers after the order was
executed, which shrinks the spread “realized” by the liquidity
providers. In other words, a low average realized spread indicates that
the market center was providing liquidity even though prices were moving
against it for reasons such as news or market volatility.

Many commenters questioned the usefulness of this statistic and
recommended that it be eliminated.53
The Commission believes, however, that the average realized spread is an
essential measure for evaluating a market center’s order execution
practices and so we have retained the measure in the Rule. Most
importantly, marketwide disclosure of realized spreads will help address a
potentially serious incentive problem that could arise during
“stressed” markets (i.e., when prices are moving
quickly). A market center of “last resort” – one that executes a
greater proportion of orders when the market is stressed — generally will
post wider effective spreads during those periods, even though the
realized spread may remain quite low or negative (because prices are
moving rapidly against those providing liquidity during the stressed
period). Thus, marketwide disclosure of realized spreads can help identify
those market centers willing to supply liquidity during difficult times.
If average realized spread were not included in the Rule, it might create
an incentive for market centers to avoid trading in times of stress,
leading to a drop in liquidity at the very time when it is most needed.

In addition, for market orders (as well as marketable limit orders),
average realized spread can measure the extent to which
“informed” and “uninformed” orders are routed to
different market centers. Informed orders are those submitted by persons
with better information than is generally available in the market. They
therefore represent a substantial risk to liquidity providers that take
the other side of these informed trades. In contrast, orders submitted by
persons without an information advantage (often small orders) present less
risk to liquidity providers and in theory should receive the most
favorable effective spreads available in the market. Market centers may
attempt to identify and secure a substantial flow of uninformed orders,
while avoiding, and perhaps even rejecting, informed orders. The average
realized spread statistic for market and marketable limit orders can
highlight the extent to which market centers receive uninformed orders (as
indicated by higher realized spreads than other market centers), thereby
potentially helping to spur more vigorous competition to provide the best
prices to these orders to the benefit of many retail investors. Other
market centers, for example, may seek to obtain such profitable order flow
by offering to execute the orders at narrower effective spreads (which
also would result in narrower realized spreads for these orders).

Finally, average realized spread can generate useful information for
non-marketable limit orders. The most significant risk of using such
orders is that they will not be executed and will miss the market. The
likelihood of execution can vary depending on the extent to which traders
that are able to see all the orders (such as specialists, floor traders,
and OTC market makers) are able to step in front of displayed limit orders
by improving on the limit price as market orders arrive on the other side
of the market. This can lead to another type of trading cost for limit
orders that is commonly referred to as “adverse selection” – the
greater likelihood that limit orders will be executed when the market is
moving significantly against them. The frequency with which local traders
step in front of limit orders can heighten the cost of adverse selection
for limit order investors. This “last mover” advantage for local
trading interest can be substantial, and the average realized spread can
indicate the extent to which it affects the execution costs of limit
orders.54

For market centers that comply with Rule 11Ac1-5 by comparing their
order data with a record of the consolidated quote stream (the method
commonly used today to prepare analyses of execution quality), calculating
the statistic is not significantly more burdensome than calculating the
Rule’s other statistics. As with effective spread (discussed below),
execution prices are compared with a record of the consolidated quote
stream. Effective spread is calculated using the quotes at the time of
order receipt; realized spread is calculated using the quotes five minutes
after the time of order execution.

2. Information Required for Market and
Marketable Limit Orders

Subparagraph (b)(1)(ii) of Rule 11Ac1-5 specifies an additional nine
columns of information for subcategories of market orders and marketable
limit orders. These columns are intended to help evaluate how well these
orders are executed by comparing their execution prices with the
consolidated BBO at the time of order receipt. The time of order receipt
is used rather than the time of order execution primarily based on an
understanding that customers, at least for purposes of evaluating
execution quality, generally expect orders to be executed at prices that
reflect, as closely as possible, the displayed quotes at the time they
submit their orders. The earliest time at which a market center can be
held responsible for executing an order is the time of receipt.

The first of these columns is the average “effective” spread
(in contrast to the average “realized” spread that was discussed
above). Average effective spread is defined in paragraph (a)(2) of the
Rule and is calculated by comparing the execution price of an order with
the midpoint of the consolidated BBO at the time of order receipt. The
larger the effective spread, the higher the transaction costs for market
and marketable limit orders in that security. The average effective spread
is a comprehensive statistic that summarizes the extent to which market
and marketable limit orders are given price improvement, executed at the
quotes, and executed outside the quotes. As such, it is a useful single
measure of the overall liquidity premium paid by those submitting market
and marketable limit orders to a market center.

The eight columns of information required for market and
marketable limit orders essentially break out the major determinants of
execution quality that are summarized in the average effective spread.
They also are intended to provide a substantial basis to weigh any
potential trade-offs between execution speed and execution price. Orders
are classified based on whether they were “executed with price
improvement,” “executed at the quote,” or “executed
outside the quote,” as defined in paragraphs (a)(10) through (a)(12).
For shares executed with price improvement and shares executed outside the
quote, market centers will disclose the number of shares, the average
amount per share of price improvement or price disimprovement, and the
average speed of execution. For shares executed at the quote, market
centers will disclose the number of shares and the average speed of
execution. Not only will these statistics help broker-dealers and
investors evaluate where to find the fastest executions at the best
prices, they also will indicate the extent to which market centers are
able to execute larger orders at prices equal to or better than the
quotes. They thereby indicate the volume of liquidity available at
different market centers.

Many commenters suggested including an additional statistic for
“size improvement” or “liquidity enhancement” in the
Rule. These measures generally are calculated by comparing the size of
order executions at the quotes with the size associated with the
consolidated BBO at the time of order receipt. The Commission did not add
this type of measure to the Rule, primarily because of its desire to
minimize as much as possible the complexity and quantity of statistics to
be disclosed. As discussed in section III.A.1 above, Rule 11Ac1-5 already
includes several measures that will reflect the extent to which a market
center is able to execute larger orders at prices equal to the public
quotes, such as the average effective spread and number of shares executed
at the quotes for larger sizes of orders. Moreover, the size associated
with the consolidated BBO may not provide a useful basis on which to
compare execution quality among market centers. For example, consolidated
size varies substantially between Nasdaq and listed securities. For listed
securities, the quoted size nearly always reflects the quotes of the
primary exchanges and generally is much larger than the size associated
with the public quotes for Nasdaq securities.

The Proposing Release requested comment on the usefulness of all the
basic measures of execution quality included in the proposed rule, as well
as on any alternative measures that commenters might suggest. For
non-marketable limit orders, the Proposing Release specifically mentioned
(1) the length of time that an order remained on a market center’s order
book while the limit price was at the consolidated BBO or better, and (2)
the number of trades or share volume printed on the consolidated tape at
prices equal to or less favorable than the limit order price. Several
commenters expressed support for including these alternatives in the Rule.55
In addition, commenters suggested many other statistical measures of
execution quality that could be included.56
At this time, however, the Commission has decided not to expand the volume
of statistics required by the Rule. Many of the suggested alternatives
would have substantially increased the complexity of the Rule. For
simplicity reasons, the Commission therefore has retained the basic
measures that were included in the proposal. Market centers are
encouraged, however, to make publicly available any additional measures of
execution quality that they believe will be helpful to broker-dealers and
investors, particularly if they are concerned that the Rule’s basic
measures do not adequately capture the complexity of their order flow and
executions.

D. Procedures for Making Reports Available to
the Public

In light of the large volume of data the monthly order execution
reports necessarily will include, they must be made available by market
centers in electronic form rather than in writing. Consequently, paragraph
(b)(2) of Rule 11Ac1-5 directs the SROs to act jointly in establishing
procedures for market centers to follow in making their monthly reports
available to the public in a readily accessible, uniform, and usable
electronic format.57
Given that the reports will be made available each month by a large number
of market centers, the Commission’s primary concern is that interested
parties have the ability to access the reports easily and efficiently.
Thus, for example, it will be helpful for all the reports to be prepared
in a compatible electronic format, and for users to have ready access to
the locations where reports can be obtained. The volume of data included
in the monthly reports, while large in written form, will not be large
when compared with many electronic files commonly made available to the
public over the Internet.

Rule 11Ac1-5 will be effective 60 days after publication of this
release in the Federal Register. Market centers must comply with
the Rule according to the phase-in schedule set forth in section V below.
The SROs are directed to prepare and submit a joint national market system
plan to the Commission for approval under Exchange Act Rule 11Aa3-2 by no
later than February 15, 2001. At that point, public comment will be
invited on the proposed plan prior to Commission approval. Many of the
more detailed issues relating both to the format of the reports and to the
means of access to the reports can perhaps more appropriately be addressed
in the context of approval of a joint plan.

In the event that a joint-SRO plan has not been approved by the
Commission prior to the compliance date of the Rule, paragraph (b)(2) also
provides that market centers shall prepare their reports in a consistent,
usable, and machine-readable electronic format, and make such reports
available for downloading from an Internet web site that is free and
readily accessible to the public. This backstop requirement will assure
that valuable information on order execution quality will be made
available to the public without undue delay. If necessary, the Commission
will take additional action to specify in more detail a uniform format and
means of dissemination for the monthly market center reports.

Paragraph (b)(3) of Rule 11Ac1-5 requires market centers to make their
reports available within one month after the end of the month addressed in
the report. Market centers must make their reports available without
charge. If a market center believes that its particular circumstances
warrant an exemption from the provisions of the Rule, it may request an
unconditional or conditional exemption pursuant to paragraph (c) of the
Rule, which has been added to the proposed rule. Such an exemption will be
granted if the Commission finds that it necessary or appropriate in the
public interest, and is consistent with the protection of investors.

IV. Rule 11Ac1-6 – Disclosure of Order Routing
Information

The Commission is adopting Rule 11Ac1-6 with significant changes from
the proposed rule. Primarily in response to concerns of commenters, it has
substantially cut back the amount of information that broker-dealers will
be required to disclose concerning their order routing practices. The
majority of commenters supported disclosures that would enable investors
to better understand where orders are routed for execution and the
relationships between broker-dealers and trading venues.58
Several, however, expressed concern about the length and usefulness of
some of the disclosure requirements included in the proposed rule.59
In addition, a number of other commenters generally questioned the value
of the required disclosures.60
As discussed in section II above, the Commission believes that quarterly
reports identifying the venues to which broker-dealers routed their
customer orders and discussing potential conflicts of interest will be
useful to investors. To maintain the brevity and reduce the compliance
burdens of the reports, it has decided to delete several provisions from
the proposed rule that would have required potentially long and complex
explanations of order routing choices of broker-dealers.

Under Rule 11Ac1-6 as adopted, a broker-dealer that routes orders on
behalf of customers will be required to prepare quarterly reports that
disclose the identity of the venues to which it routed orders for
execution. The reports also will disclose the nature of the
broker-dealer’s relationship with those venues, including the existence of
any internalization or payment for order flow arrangements. Finally,
broker-dealers will be required to disclose, on customer request, where
they routed a customer’s individual orders for execution.

In a significant change from the rule as proposed, a broker-dealer will
not be required to prepare a narrative section for the reports that
discusses and analyzes its order routing practices. The Commission agrees
with commenters that such a requirement could result in reports that were
overly long and complex. In addition, a broker-dealer will not be required
to identify every venue to which it routed any orders. Instead, only the
most significant venues – the top ten and any others that received 5% or
more of the broker-dealer’s orders – must be disclosed. The primary
purpose of the Rule as adopted is simply to assure public disclosure of
the significant venues to which a broker-dealer routes its customer’s
orders and to facilitate an evaluation of potential conflicts of interest
between the broker-dealer and its customers. When combined with the
information to be made available by market centers under Rule 11Ac1-5, the
quarterly reports should provide a much clearer picture of a
broker-dealer’s order routing practices than has previously been available
to the public.

A. Scope of Rule

The scope of Rule 11Ac1-6 is broader than the scope of proposed Rule
11Ac1-5. First, Rule 11Ac1-6 covers a wider range of securities. The
definition of “covered security” in paragraph (a)(1) includes
not only national market system securities (i.e., exchange-listed
equities and Nasdaq National Market equities), but also Nasdaq SmallCap
equities and listed options.61
Second, the Rule applies to all broker-dealers that route orders on behalf
of their customers. The term “customer order” is defined as any
order to buy or sell a covered security that is not for the account of a
broker-dealer. It excludes, however, any order for a quantity of a
security having a market value of at least $50,000 for a covered security
that is an option contract and a market value of at least $200,000 for any
other covered security. Large orders are excluded in recognition of the
fact that a general overview of order routing practices is more useful for
smaller orders that tend to be homogenous.62

Finally, Rule 11Ac1-6 applies to all types of orders (e.g.,
pre-opening orders and short sale orders), but broker-dealers must give an
overview of their routing practices only for “non-directed
orders.” Paragraph (a)(5) defines a non-directed order as any
customer order other than a directed order. Paragraph (a)(3) defines a
directed order as a customer order that the customer specifically
instructs the broker-dealer to route to a particular venue for execution.
Consequently, all customer orders are non-directed orders in the absence
of specific customer instructions on where they are to be routed.

B. Quarterly Reports

Paragraph (b)(1) of the Rule 11Ac1-6 requires broker-dealers to make
publicly available for each calendar quarter a report on its routing of
non-directed orders in covered securities. The term “make publicly
available” is defined to require broker-dealers to do three steps —
post on a free Internet web site, furnish a written copy on request, and
notify customers at least annually that a written copy will be furnished
on request. The Commission expects that the broker-dealer quarterly
reports on order routing will be of direct interest to investors, and so
is requiring that broker-dealers make them readily available via the
Internet. In addition, a primarily Internet method of dissemination will
ease the burden of compliance on broker-dealers by reducing paperwork and
costs. The reports must be provided on request for customers that may lack
Internet access.

Paragraph (b)(2) requires that a quarterly report be made publicly
available within one month after the end of the quarter addressed in the
report. A longer two-month period was included in the proposed rule to
allow broker-dealers an opportunity to evaluate the monthly market center
reports under Rule 11Ac1-5 prior to preparing their narrative discussion
and analysis of order routing practices. Because this narrative disclosure
has been eliminated from the Rule as adopted, the lag-period between
end-of-quarter and report dissemination has been shortened to one month to
provide more timely disclosures to the public.

Rule 11Ac1-6 as adopted requires that a quarterly report be divided
into four separate sections for four different types of covered securities
— one for equity securities listed on the NYSE, one for equity securities
qualified for inclusion in Nasdaq, one for equity securities listed on the
Amex or any other national securities exchange, and one for options. These
sections reflect potentially significant differences in routing practices
for the four types of securities and should enhance the usefulness of the
quarterly reports to investors. For each of these four sections,
paragraphs (b)(1)(i) and (ii) of the Rule require broker-dealers to give a
quantitative description of the aggregate nature of their order
flow. In this respect, Rule 11Ac1-6 is unlike Rule 11Ac1-5, which requires
market centers to categorize their orders on a security-by-security basis.
As noted above, the quarterly reports on order routing are intended to
provide a general overview of a broker-dealer’s practices that is
accessible and useful to individual investors. Broker-dealers are free,
however, to disclose any additional information concerning their order
routing practices that they believe will be helpful to customers.

A broker-dealer’s quantitative description of order routing must
include the percentage of total customer orders for a particular section
that were non-directed orders, and the percentages of total non-directed
orders for a section that were market orders, limit orders, and other
orders. This general description of a broker-dealer’s order flow should
facilitate customer understanding of its routing practices. For example, a
customer may use the reports to evaluate whether the broker-dealer
specializes in the type of orders that the customer typically uses. The
quantitative description also will include the identity of the ten venues
to which the largest number of non-directed orders for the section were
routed for execution, as well as any venue to which five percent or more
of non-directed orders were routed.63
In contrast, the proposed rule would have required disclosure of all
venues to which non-directed orders were routed. A commenter noted that
large broker-dealers may route a relatively small number of orders to many
different venues.64
Disclosure therefore has been limited to the most significant venues.65

For each of the venues identified in each section of the report, the
broker-dealer must disclose the percentage of total non-directed orders
for the section routed to the venue, and the percentages of total
non-directed market orders, non-directed limit orders, and non-directed
other orders for the section that were routed to the venue. The
percentages, rather than numbers, of orders are used to facilitate
customer understanding of the probability that particular types of orders
will be routed to different venues without the need for calculations, as
well as to protect potentially sensitive order flow information.

Under paragraph (b)(1)(iii), a broker-dealer also will be required to
discuss the material aspects of its relationship with each venue
identified in each section of the report, including a description of any
payment for order flow arrangement or profit-sharing relationship as it
relates to the type of securities for that section. The term “payment
for order flow” is defined very broadly in Exchange Act Rule
10b-10(d)(9) to include any payment or benefit that results in
compensation to the broker-dealer for routing orders to a particular
venue. This definition encompasses a wide range of practices in addition
to monetary payments, such as “research, clearing, custody, products
or services,” “reciprocal agreements for the provision of order
flow,” and “discounts, rebates, or any other reductions of or
credits against any fee to, or expense or other financial obligation of,
the broker or dealer routing a customer order that exceeds that fee,
expense or financial obligation.” The term “profit-sharing
relationship” is defined in paragraph (a)(7) of Rule 11Ac1-5 to mean
any ownership or other type of affiliation under which the broker-dealer,
directly or indirectly, shares in any profits that may be derived from the
execution of non-directed orders. It therefore specifically covers
internalization of customer orders by a broker-dealer that executes
customer orders as principal.

The purpose of requiring disclosure concerning the relationships
between a broker-dealer and the venues to which it routes orders is to
alert customers to potential conflicts of interest that may influence the
broker-dealer’s order-routing practices. Currently, Rule 10b-10(a)(2)(i)(C)
requires a broker-dealer, when acting as agent for the customer, to
disclose on the confirmation of a transaction whether payment for order
flow was received and that the source and nature of the compensation for
the transaction will be furnished on written request. In addition,
Exchange Act Rule 11Ac1-3(a) requires broker-dealers to disclose in new
and annual account statements its policies on the receipt of payment for
order flow and its policies for routing orders that are subject to payment
for order flow. The Commission believes that disclosure of potential
conflicts of interest in conjunction with a quantitative
description of where all non-directed orders are routed may provide
customers with a clearer understanding of a broker-dealer’s order routing
practices than is provided under current rules. The Commission intends to
consider in the near future whether to modify or rescind, as necessary,
the disclosure requirements currently in effect concerning payment for
order flow, in light of the new quarterly disclosure requirements.

Rule 11Ac1-6 does not require that broker-dealers provide a
quantitative estimate of the aggregate dollar amount of payment for
order flow received during a quarter from each order execution venue.
First, there are potentially a multitude of varying arrangements for
payment for order flow. Estimating the amounts produced by such
arrangements could be difficult, subjective, and costly. Second, the
Commission is concerned that disclosure of the aggregate dollar amounts of
payment for order flow, without requiring comparable disclosure of the
dollar amount of trading profits that redound to the benefit of
broker-dealers pursuant to profit-sharing relationships, potentially could
paint an inaccurate picture of the relative financial incentives generated
by the two types of relationships.

Although the Rule 11Ac1-6 does not require an estimate of the aggregate
dollar amount of payment for order flow, a broker’s description of a
payment for order flow arrangement must include disclosure of the material
aspects of the arrangement. These would include a description of the terms
of the arrangement, such as any amounts per share or per order that the
broker receives. Similarly, in describing a profit-sharing relationship, a
broker would be expected to disclose the extent to which it could share in
profits derived from the execution of non-directed orders. An example
would be the extent of the ownership relation between the broker and
execution venue.

Finally, as noted above, the Rule as adopted does not include a
requirement that broker-dealers provide a narrative discussion and
analysis of their order routing practices. Broker-dealers remain free, of
course, to communicate such information concerning their order routing
practices that they believe would be helpful to customers.

C. Customer Requests for Information

A broker-dealer’s quarterly reports should provide a useful picture of
its order routing practices as a whole, but will not inform individual
customers where their own orders were routed. Currently, there is no
market-wide requirement that brokers disclose where they route individual
orders on behalf of customers. Although NYSE Rule 409(f) requires NYSE
members, when confirming transactions, to disclose “the name of the
securities market on which the transaction was made,” transactions
executed at venues other than exchanges typically are classified as
“OTC.” Thus, the identity of the particular OTC market maker or
ATS that executed an order is not required to be disclosed. Moreover, the
NYSE’s rule does not cover non-members or securities that are not listed
on the NYSE.

To assure that customers have ready access to routing information
concerning their own orders, paragraph (c) of Rule 11Ac1-6 requires
broker-dealers, on request of a customer, to disclose to the customer the
identity of the venue to which the customer’s orders were routed for
execution in the six months prior to the request, whether the orders were
directed orders or non-directed orders, and the time of the transactions,
if any, that resulted from such orders.66
To alert customers to the availability of individual order routing
information, paragraph (c)(2) of the Rule requires broker-dealers to
notify their customers at least annually of their option to request such
information.

With Rule 11Ac1-6, those customers interested in monitoring the
broker-dealer’s routing their orders will be entitled to learn important
information about how their orders were handled. When combined with
information that such customers may already maintain, such as the time
they submitted an order to their broker-dealer, the consolidated BBO at
the time they submitted the order, and the price at which an order was
executed, the information to be provided on request potentially could give
customers a considerable capacity to monitor and evaluate their
broker-dealer’s order routing decisions and the quality of executions
obtained at different venues. Broker-dealers would not, however, be
required to bear the expense of providing individualized order routing
information to those who had not asked to receive it.

V. Effective Dates and Phase-In of Compliance
Dates

Rule 11Ac1-5 is effective on [insert date 60 days after publication in
the Federal Register]. The first phase-in of securities subject to
the Rule will begin on Monday, April 2, 2001. As of this date, the Rule
will apply to the 1000 NYSE securities, 1000 Nasdaq securities, and 200
Amex securities with the highest average daily share volume for the
quarter ending December 31, 2000. On this first phase-in date, market
centers must begin collecting the necessary data to prepare their monthly
reports. In addition, they must make their first report, for April 2001,
available by the end of May 2001. The second phase-in date will be July 2,
2001. From this date forward, the Rule will apply to the next 1000 NYSE
securities, the next 1000 Nasdaq securities, and the next 200 Amex
securities with the highest average daily share volume for the quarter
ending March 31, 2001. The third and phase-in of Rule 11Ac1-5 will
begin on October 1, 2001. From this date forward, the Rule will apply to
all national market system securities. As discussed in section VI.B below,
the Commission believes that all market centers currently collect the
basic order data that is necessary to generate the Rule’s statistical
measures. In addition, many market centers already prepare, or retain
independent companies to prepare, similar statistical reports for private
use. It is likely, therefore, that market centers will be able to make
arrangements for production of reports under Rule 11Ac1-5 in advance of
the compliance dates. If a market center believes that it will be unable
to meet the compliance dates for good cause, it may request a temporary
exemption from the Commission pursuant to paragraph (c) of the Rule.
Finally, the Commission directs the national securities exchanges and the
national securities association subject to Rule 11Ac1-5(b)(2) to comply
with that provision by submitting a national market system plan to the
Commission by no later than February 15, 2001.

Rule 11Ac1-6 also is effective on [insert date 60 days after
publication in the Federal Register]. Broker-dealers must comply
with the Rule for all covered securities on July 2, 2001. Accordingly, a
broker-dealer’s first report, for the quarter beginning in July and ending
in September, must be made publicly available by the end of October 2001.
In addition, broker-dealers would be required to respond to customer
requests for information on orders that were routed on July 2, 2001, and
after.

VI. Paperwork Reduction Act

As explained in the Proposing Release, certain provisions of Rule
11Ac1-5 and Rule 11Ac1-6 contain “collection of information”
requirements within the meaning of the Paperwork Reduction Act of 1995
(“PRA”).67
Accordingly, the Commission submitted the collection of information
requirements contained in the rules to the Office of Management and Budget
(“OMB”) for review. They were approved by OMB, which assigned
the following control numbers: Rule 11Ac1-5, control number 3235-0542, and
Rule 11Ac1-6, control number 3235-0541, with an expiration date for each
of November 30, 2003. The collections of information are in accordance
with Section 3507 of the PRA.68
With regard to Rule 11Ac1-5, the Commission staff has adjusted its PRA
burden estimate in response to comments to include the potential for
upfront preparations to comply with the data collection requirements of
the Rule. With regard to Rule 11Ac1-6, the Commission staff has adjusted
its PRA burden estimate to reflect a change from the rule as proposed that
reduces the amount of information that broker-dealers will be required to
disclose concerning their order routing practices. Accordingly, the
Commission has submitted PRA change worksheets to OMB to reflect the
adjusted estimates of the burden of compliance.

The collections of information relate to rules that will help further
the national market system objectives set forth in Exchange Act Section
11A(a)(1)(C). These objectives include the economically efficient
execution of orders, fair competition among broker-dealers and among
markets, the availability to broker-dealers and investors of information
with respect to transactions in securities, and the practicability of
brokers executing investors’ orders in the best market. The collection of
information obligations imposed by Rule 11Ac1-5 and Rule 11Ac1-6 are
mandatory. The monthly order execution reports prepared and disseminated
in electronic form by market centers pursuant to proposed Rule 11Ac1-5
will be available to the public and will not be kept confidential.
Likewise, the quarterly order routing reports prepared and disseminated by
broker-dealers pursuant to Rule 11Ac1-6 will be available to the public
and will not be kept confidential. The individual responses by
broker-dealers to customer requests for order routing information required
by Rule 11Ac1-6 will be made available the customer and not to the general
public. The Commission, SROs, and other securities regulatory authorities
would gain possession of the responses only upon request. Any responses
received by the Commission, SROs, and other securities regulatory
authorities will be kept confidential to the extent permitted by the
Freedom of Information Act.69
An agency may not conduct or sponsor, and a person is not required to
comply with, a collection of information unless it displays a currently
valid OMB control number.

A. Comments on Collection of Information
Requirements

The Commission requested public comment on the collection of
information requirements contained in the Proposing Release. Commenters
that addressed recordkeeping and reporting burdens generally focused their
attention on the statistical disclosures required by Rule 11Ac1-5. Knight
Trading Group, Inc. believed that Rule 11Ac1-5 would be “feasible and
implementable without undue burden on market centers because they already
must produce much of the required information” pursuant to existing
regulatory requirements. Knight also noted that third party vendors could
generate the required reports for market centers and that “such an
approach would offer an alternative for market centers that do not wish to
incur the costs associated with developing and administering any systems
needed to collect and disseminate the required information.”70
The Investment Company Institute stated that “given technological
advances in the dissemination of information and the wide use of the
Internet by retail investors, we believe that the reports can be made
available to the public in a reasonably efficient manner at a low
cost.”71 In
addition, the Transaction Auditing Group, Inc., a third party service
provider for the analysis and reporting of execution quality, noted that
“as long as dissemination is permitted via the Internet, the
collection, analysis and publication of large volumes of information would
be feasible.72

Several other commenters, in contrast, suggested generally that
complying with the recordkeeping and reporting requirements of Rule
11Ac1-5 would be burdensome for many market centers.73
A comment letter submitted on behalf of five broker-dealer firms, for
example, stated that, although the firms had “not done a rigorous
cost analysis with respect to the proposals, the Firms expect that the
cost of compliance would be considerable, in terms of programming and
monitoring tasks.”74
The CHX stated that the “data capture, preparation and reporting
burden involved in complying with proposed Rule 11Ac1-5 would be
significant, even for the CHX, and, in all likelihood, excessive for many
other market centers.”75
The Phlx estimated that “the cost of creating the reporting system,
as well as creating the interfaces with our members to meet their
requirements under the Rule, would be at least $500,000 and require
between six months and one year to fully implement.”76

The Commission does not agree with these high estimates concerning the
recordkeeping and reporting burden of Rule 11Ac1-5. As a basis for
compliance, market centers themselves need maintain only the most basic
order information, such as the type and size of order, the time of order
receipt, the time of order execution, and execution price.77
The Commission believes that all market centers retain this basic order
data.78 This data
must then be compared with a record of the consolidated quote stream to
generate the statistics required by Rule 11Ac1-5. Although some market
centers may choose to program their own systems to perform this task,
third party vendors already provide this service for many market centers.
Based on Commission staff discussions with industry sources, it appears
that individual market centers could obtain this service for approximately
$2500 per month, and smaller market centers may be able to obtain this
same service at an even lower cost. Accordingly, the Commission believes
that the total costs to prepare the monthly order execution reports do not
appear to be large for any market center.79

While the Commission received no comments that specifically addressed
the PRA discussion of Rule 11Ac1-6, it did receive several comments that
touched on PRA related issues. Most commenters supported improved
disclosure of order routing practices by broker-dealers. Some, however,
were concerned about the potentially long length and limited usefulness of
some of the disclosure requirements included in the rule as proposed.80
To maintain the brevity and reduce the compliance burdens of the quarterly
reports, the Commission has deleted several provisions from the proposed
rule that would have required potentially long and complex disclosures. In
particular, it has eliminated paragraph (b)(iv) of the proposed rule,
which would have required a discussion of the significant objectives that
the broker or dealer considered in determining where to route non-directed
orders, the extent to which order executions achieved those objectives, a
comparison of the quality of executions actually obtained with those
produced by other venues for comparable orders during the relevant time
period, and whether the broker or dealer has made or intends to make any
material change in its order routing practices in the succeeding quarter.
In addition, paragraph (b)(ii) has been altered so that a broker-dealer
will not be required to identify every venue to which it routed any
orders. Instead, only the top ten venues and any others that received 5%
of more of the broker-dealer’s orders must be disclosed.

One commenter addressed the burden of complying with paragraph (c) of
Rule 11Ac1-6, which requires broker-dealers to provide, upon customer
request, information regarding the customer’s orders routed for execution
in the six months prior to the request. The commenter asserted that
“it is apparent that this would be a time-consuming, burdensome and
expensive requirement to fulfill.”81
The Commission strongly believes that those brokerage customers who
express an interest in obtaining information about the routing of their
own orders should have ready access to such information. Indeed, another
commenter doubted that, as a matter of agency law, “any firm would
presently fail to honor such a customer request.” 82
Particularly considering that the level of disclosure contained in the
quarterly broker-dealer reports has been reduced, a requirement that
broker-dealers respond to customer requests for order information will
help assure that customers can obtain the data they need to evaluate the
quality of their broker-dealer’s services. Broker-dealers must retain
customer order information to comply with existing regulatory
requirements. The Commission does not believe that responding to customer
requests for such information will constitute an unduly burdensome
requirement for broker-dealers.

B. Total Annual Reporting and Recordkeeping
Burdens

The collection of information obligations of Rule 11Ac1-5 will apply to
all market centers that receive covered orders in national market system
securities. Market centers are defined as exchange market makers, OTC
market makers, alternative trading systems, national securities exchanges,
and national securities associations. The Commission estimates that
approximately 140 exchange market makers, 450 OTC market makers, 29
alternative trading systems, seven national securities exchanges, and one
national securities association will be subject to the collection of
information obligations of Rule 11Ac1-5. Each of these respondents will be
required to respond to the collection of information on a monthly basis.

Rule 11Ac1-5 will require market centers to make available to the
public monthly order execution reports in electronic form. To prepare the
reports, market centers first will need to collect basic data on orders
and executions (e.g., type and size of order, time of order receipt
and execution). Second, this data will need to be processed to calculate
the statistics required by the Rule and present those statistics in an
electronic report.

The Commission believes that market centers covered by the Rule retain
all of the underlying raw data necessary to generate these reports in
electronic format. Consequently, it does not appear that the Rule will
require substantial additional data collection burdens. Commenters noted,
however, that market centers may incur startup costs to prepare their
systems to generate the specific data required by the Rule.83
The Commission staff estimates that, on average, market centers could
spend 90 hours to complete these preparations. Assuming internal staff
costs of $53 per hour, the estimated 627 market centers could expend a
total of approximately $3 million in startup costs, or a total of
approximately $600,000 per year annualized over an expected useful life of
five years. In addition, the Commission staff estimates that, on an
ongoing basis, the Rule will cause respondents to spend an average of 6
hours per month in additional time to collect the data necessary to
generate the reports, or 72 hours per year.84
With an estimated 627 market centers subject to the Rule, the total data
collection burden to comply with the monthly reporting requirement is
estimated to be $600,000 per year for startup costs and 45,144 hours per
year on an ongoing basis.

Once the necessary data is collected, market centers can either program
their systems to generate the statistics and reports, or transfer the data
to a service provider (such as an independent company in the business of
preparing such reports or an SRO) that will generate the statistics and
reports. Although the largest market centers and SROs may choose to
generate the reports themselves, the Commission anticipates that the great
majority of market centers will rely on service providers to prepare the
reports for them. It is significantly more efficient to consolidate the
processing and reporting function in a limited number of entities than for
each market center to prepare its own reports. Once an entity has incurred
the upfront costs of programming its systems to process data and generate
a report for a single market center, there is very little additional cost
to performing the same function for many additional market centers. Based
on discussions with industry sources, the Commission staff estimates that
an individual market center could retain a service provider to prepare a
monthly report for approximately $2500 per month. This per-respondent
estimate is based on the rate that a market center could expect to obtain
if it negotiated on an individual basis. Based on discussions with
industry sources, we believe it is likely that a group of market centers,
particularly the smaller members of a particular SRO, could obtain a much
lower per-respondent rate on a collective basis. Thus, particularly for
the smaller members of an SRO, the monthly cost to retain a service
provider could be substantially less than $2500. Based on the $2500
estimate, however, the monthly cost to the 627 market centers to retain
service providers to prepare reports would be $1,567,500, or an annual
cost of approximately $18.8 million.

Rule 11Ac1-6 will require broker-dealers to prepare and disseminate
quarterly order routing reports. Much of the information needed to
generate these reports already should be collected by broker-dealers in
connection with their periodic evaluations of their order routing
practices. To comply with the Rule, however, broker-dealers will incur
additional burdens in preparing the reports and disseminating them on a
free Internet web site (and responding to requests for written copies of
the reports).

The collection of information obligations of Rule 11Ac1-6 will apply to
all broker-dealers that route non-directed customer orders in covered
securities. The Commission estimates that there are currently
approximately 3800 broker-dealers that could be subject to the collection
of information obligations of the Rule.85
Each of these respondents (if engaged in the business of routing
non-directed orders on behalf of customers) will be required to respond to
the collection of information on a quarterly basis with respect to the
Rule’s reporting obligations, and on an ongoing basis with respect to the
Rule’s requirement to respond to customer requests for order routing
information.

There are extreme differences in the nature of the securities business
conducted by the approximately 3800 broker-dealers that could be subject
to the Rule. They range from the very largest firms with nationwide
operations, which are relatively few in number, to thousands of much
smaller introducing firms. To handle their customer accounts, these small
firms rely primarily on clearing brokers. There currently are
approximately 330 clearing brokers. The Commission previously has noted
that “from a functional perspective, introducing and clearing brokers
act as a unit in handling a customer’s account. In most respects,
introducing brokers are dependent on clearing firms to clear and to
execute customer trades, to handle customer funds and securities, and to
handle many back-office functions, including issuing confirmations of
customer trades and customer account statements.”86
The Commission anticipates that clearing brokers primarily will bear the
burden of complying with the reporting and recordkeeping requirements of
the Rule on behalf of many small introducing firms. In addition, however,
there are approximately 610 introducing brokers that receive funds or
securities from their customers.87
Because at least some of these firms also may have greater involvement in
determining where customer orders are routed for execution, they have been
included, along with clearing brokers, in estimating the total burden of
the Rule.

As discussed above, the reporting requirements of Rule 11Ac1-6 have
been cut back from the proposed rule. The Commission staff estimates that
each firm significantly involved in order routing practices will incur an
average burden of 20 hours to prepare and disseminate a quarterly report
required by Rule 11Ac1-6, or a burden of 80 hours per year. With an
estimated 940 broker-dealers significantly involved in order routing
practices, the total burden per year to comply with the quarterly
reporting requirement in Rule 11Ac1-6 is estimated to be 75,200 hours.

Rule 11Ac1-6 also would require broker-dealers to respond to individual
customer requests for information on orders handled by the broker-dealer
for that customer. Clearing brokers generally would bear the burden of
responding to these requests. The Commission staff estimates that each
clearing broker will incur an average burden of 0.2 hours to prepare,
deliver, and retain a response to a customer required by Rule 11Ac1-6. The
annual burden could vary significantly among clearing brokers based on the
number of customers and number of inquiries by each customer. The
Commission staff estimates that an average clearing broker will incur an
annual burden of 400 hours (2000 responses x 0.2 hours/response) to
prepare, disseminate and retain responses to customers required by the
Rule. With an estimated 330 clearing brokers subject to the Rule, the
total burden per year to comply with the customer response requirement in
Rule 11Ac1-6 is estimated to be 132,000 hours.

VII. Cost-Benefit Analysis

The Commission is adopting two rules to improve public disclosure of
broker-dealer and market center practices in the routing and execution of
customer orders. The rules are intended to increase access to information
about how investors’ securities transactions are executed, thereby
enhancing an investor’s ability to make choices on the basis of execution
criteria important to the particular investor. The required disclosures
also should aid broker-dealers in satisfying their duty of best execution.
The disclosures and enhanced investor knowledge should promote vigorous
and beneficial competition among broker-dealers to seek out, and among
market centers to provide, superior execution of customer orders.

A. Costs and Benefits of Rule 11Ac1-5

Under Rule 11Ac1-5, each market center (defined as any national
securities exchange, national securities association, exchange market
maker, OTC market maker, or alternative trading system) will be required
to make monthly disclosure of certain statistical measures of execution
quality on a security-by-security basis.88
The Commission anticipates that the Rule will generate the benefits and
costs described below.

1. Benefits

There currently is little or no publicly available information that
would allow investors and broker-dealers to compare and evaluate execution
quality among different market centers. Some market centers make order
execution information privately available to independent companies, which
then prepare reports on execution quality that are sold to broker-dealers.
Other market centers provide reports on execution quality directly to
broker-dealers or to their members. The information in these reports
generally has not been publicly disseminated. Moreover, some
broker-dealers have reported difficulty in obtaining useful information on
execution quality from market centers. For example, participants in a
Commission roundtable on the on-line brokerage industry indicated that not
all market centers were willing to make order execution information
available and, even when such information was made available, not all of
it was useful or in a form that allowed for cross-market comparisons.

By improving public disclosure of execution quality, the Commission
anticipates that the Rule will help broker-dealers fulfill their duty of
best execution. That duty requires a broker-dealer to seek the most
favorable terms reasonably available under the circumstances for a
customer’s order. Routing orders to a market center that merely guarantees
an execution at the best published quote does not necessarily satisfy that
duty; best execution is a facts and circumstances determination. A
broker-dealer must consider several factors affecting the quality of
execution, including, for example, the opportunity for price improvement,
the likelihood of execution (which is particularly important for customer
limit orders), the speed of execution, and the trading characteristics of
the security, together with other non-price factors such as reliability
and service. While broker-dealers currently may be able to obtain order
execution information from some market centers, that information may be of
limited use and may not allow broker-dealers to compare execution quality
among the different market centers. Although these statistics are by no
means determinative of best execution, the Commission expects that the
monthly reporting of the uniform statistical measures required by the Rule
will provide broker-dealers with a clearer sense of execution quality
among market centers, and will be helpful to broker-dealers in seeking to
fulfill their duty of best execution.

The Commission also believes that the reporting required by Rule
11Ac1-5 will facilitate investors’ ability to evaluate the quality of
order executions provided by different market centers and to have
meaningful input into how their broker-dealer executes their orders.
Differences in execution quality across market centers can be very
important to investors. For example, a difference in execution price of
1/16th for a 1000 share order can equal a savings of $62.50 for
an investor. Currently, investors possess few tools to compare order
executions on different markets, and they typically leave routing
decisions to their broker-dealer. Different investors, however, may have
different concerns and priorities related to execution of their orders,
such as an opportunity for price improvement and the speed of execution.
The Rule will require disclosure of information that will enhance
investors’ evaluation of these matters.

The Commission believes that Rule 11Ac1-5 will have the additional
benefit of stimulating competition between market centers to improve the
quality of their executions. Market centers compete to attract order flow.
An important way in which market centers seek to attract order flow is by
providing – and developing a reputation for providing – superior
executions. The Rule will give broker-dealers and investors meaningful
information, which they have not previously had, bearing on execution
quality. Access to that information will allow broker-dealers and
investors to direct orders to market centers on the basis of their order
execution performance. Improved disclosure should result in some increase
in the number of shares executed with price improvement and a reduction in
the number of shares executed with price “disimprovement.” Price
disimprovement can occur, for example, because of quote exhaustion – the
cumulative volume of orders is greater than quoted size and the market
center does not provide liquidity enhancement. The Commission anticipates
that public disclosure will benefit investors by putting competitive
pressure on market centers to reduce inefficiencies, to increase
opportunities for price improvement, to decrease instances of price
disimprovement, and to improve the quality of execution in all other
respects. Market centers that are able to provide better service should be
rewarded with more order flow. Ultimately, the Commission anticipates that
these improvements in execution also will benefit investors by leading to
reduced trading costs, increased trading quality, and possibly increased
trading volume.

For example, if investors that now pay more than the median effective
spread were able to obtain executions at the median effective spread, the
required disclosures could save investors in Nasdaq stocks $110 million in
annual trading costs,.89
Moreover, the savings to investors would be even greater if effective
spreads improved to the level of the 25th percentile of Nasdaq
market centers.90
There also could be a similar type of benefit for investors in the listed
markets, although possibly to a lesser extent given the smaller number of
market centers. Finally, over time the disclosures rules may provide the
impetus for new market structures that provide further reductions in
trading costs.

In commenting on the costs and benefits of Rule 11Ac1-5, the Mercatus
Center asserted that the potential savings in transaction costs for
investors must also be counted as a cost to market intermediaries, noting
that “this sum is simply a transfer of wealth from brokers and market
centers to investors” and that “when calculating the net
benefits or costs of a rule, such wealth transfers cancel each other
out.”91 In
contrast, we believe that the savings to investors described above may be
associated with an additional net benefit that would be realized at the
market centers. The ultimate result depends on what causes the differences
in execution quality that we currently observe across market centers. If
these differences are all due to differences in efficiency, then the
potential savings to investors discussed above would necessarily be the
result of transfers of order flow to the more efficient market centers.
This consolidation would likely result in further efficiencies due to
economies of scale.

On the other hand, the differences in transaction costs across market
centers may reflect differing abilities by market centers to thwart
competitive pressures and earn quasi-monopoly rents in the absence of
adequate disclosure. If this were the case, then any investor savings
might simply be the result of squeezing out some of these excess profits,
with no attendant change in order routing practices. As the Mercatus
Center points out, under this scenario the savings to investors represent
a wealth transfer from the owners of the market centers. Of course, there
are several other benefits to investors, discussed below, that flow from
reduced transactions costs, even if one assumes that there are no net
efficiency improvements available.

The savings calculation presented above implicitly assumes no change in
the amount or type of transactions made by investors. Apart from direct
savings to investors, a reduction in transaction costs will allow
investors to manage their portfolios to better match their needs and
desires, through a combination of rebalancing more frequently and
incorporating a different mix of securities.92
For example, some investors currently may avoid holding certain
less-liquid securities because of transaction costs. After the Rule is
implemented, they may want to include these securities in their portfolio
if the Rule leads to a significant reduction in transaction costs.

Another potential benefit of reduced transactions costs is a reduction
in the cost of capital applied to new investments. Amihud and Mendelson
(1986)93 provide
both theoretical and empirical evidence that lower relative spreads are
associated with lower required returns. Further, their empirical
conclusions are supported by Brennan and Subrahmanyam (1996).94
The intuition behind these studies is simple: in considering how much they
are willing to pay for securities up front, investors consider how much of
the future value will be lost to transaction costs.95

2. Costs

For purposes of the Paperwork Reduction Act, the Commission staff has
estimated that compliance with Rule 11Ac1-5 by the estimated 627 market
centers could require 56, 430 hours for initial preparations and, on an
ongoing basis, impose 45,144 in burden hours for data collection and $18.8
million in other costs ($2500 per month for preparation of reports by
service vendors). The staff estimates that 100% of the burden hours could
be expended by market centers’ internal staff. Assuming internal staff
costs of $53 per hour, the estimated 627 market centers could expend a
total of approximately $600,000 per year in startup costs (a total of $3
million annualized over an expected useful life of five years) and a total
of approximately $2.4 million per year in ongoing data collection costs.
The estimated aggregate annual cost for compliance with the Rule could be
approximately $21.8 million ($18.8 million + $2.4 million + $0.6 million).

Several commenters asserted that the costs of disclosing the execution
quality information required by Rule 11Ac1-5 would be substantial. Many of
these same commenters asserted that the benefits of the rules would be
minimal and that the costs associated with the rules would outweigh the
benefits.96

As discussed above in connection with the PRA, the Commission disagrees
with these commenters’ estimates regarding the direct costs of compliance
with Rule 11Ac1-5. As a basis for compliance, market centers themselves
need maintain only the most basic order information, such as the type and
size of order, the time of order receipt, the time of order execution, and
execution price. The Commission believes that all market centers retain
this basic order data.97
Such data then must be compared with a record of the consolidated quote
stream to generate the statistics required by the Rule. Although some
market centers may choose to program their own systems to perform this
task, independent companies already provide this service for many market
centers. These independent companies have expended the up-front costs of
automating the processes and maintaining a record of the consolidated
quote stream. Market centers need only transmit their basic order
information to the service provider, which then is able to generate the
necessary reports from the information. Based on discussions with industry
sources, it appears that individual market centers could obtain this
service for approximately $2500 per month, and it is possible that smaller
market centers could obtain this same service at an even lower cost.
Accordingly, the total costs to prepare the monthly order execution
reports do not appear to be large for any market center. The Commission
believes the significant potential benefits from disclosure justify these
costs.

B. Costs and Benefits of Rule 11Ac1-6

Under Rule 11Ac1-6, broker-dealers that route orders in equity and
options securities on behalf of customers will be required to prepare
quarterly reports that give an overview of their order routing practices.
The Rule also will require broker-dealers to disclose to customers, on
request, where that customer’s individual orders were routed for
execution.

1. Benefits

The Commission anticipates that improved disclosure of order routing
practices will result in better-informed investors, will provide
broker-dealers with more incentives to obtain superior executions for
their customer orders, and will thereby increase competition between
market centers to provide superior executions. Currently, the decision
about where to route a customer order is frequently made by the
broker-dealer, and broker-dealers may make that decision, at least in
part, on the basis of factors that are unknown to their customers. The
Rule’s disclosure requirements will provide investors with a clearer
picture of the overall routing practices of different broker-dealers. The
Commission contemplates that this will lead to greater investor
involvement in order routing decisions and, ultimately, will result in
improved execution practices. Because of the disclosure requirements,
broker-dealers may be more inclined (or investors may direct their
broker-dealers) to route orders to market centers providing superior
executions. Broker-dealers who fail to do so may lose customers to other
broker-dealers who will do so. In addition, the improved visibility could
shift order flow to those market centers that consistently generate the
best prices for investors. This increased investor knowledge and
involvement could ultimately have the effect of increasing competition
between market centers to provide superior execution.

The order routing disclosures of Rule 11Ac1-6, when combined with the
execution quality disclosure made by market centers, will allow investors
to monitor the extent to which, in choosing execution venues, there are,
in fact, systematic trade-offs that must be made between price and other
factors, and the amount of those trade-offs. For example, if the best
prices are consistently produced by one of the leading market centers with
cutting-edge, highly-reliable trading systems, there would be little, if
any, trade-off between price and systems reliability. Similarly, the rules
will help customers weigh the trade-off between a market center that
provided immediate executions at the quote, and a market center that
executed orders on average in under 30 seconds, but that consistently
generated prices resulting in average effective spreads that were a
significant amount per share better than those paid by investors at other
market centers. Currently, however, investors have little or no
information that would allow them to evaluate how their broker-dealer has
responded to such trade-offs. Rule 11Ac1-6, along with Rule 11Ac1-5, is
intended to remedy this glaring absence of public information. After the
rules become effective, competitive forces can be brought to bear on
broker-dealers both with respect to the explicit trading costs
associated with brokerage commissions and the implicit trading costs
associated with execution quality. The Commission believes that investors
ultimately will be the beneficiaries of this expanded competition.

2. Costs

For purposes of the Paperwork Reduction Act, the Commission staff has
estimated that the Rule 11Ac1-6 could, on an annual basis, impose 75,200
burden hours on broker-dealers to comply with the quarterly reporting
requirement of the Rule. The staff estimates that 100% of those burden
hours will be expended by broker-dealers’ internal staff. Assuming
internal staff costs that average $85 per hour,98
the aggregate annual cost of compliance with the quarterly reporting
requirement could be approximately $6.4 million. In addition, compliance
with the Rule will require staff time to respond to requests by customers
for disclosure of the market centers to which their orders have been
routed. For purposes of the Paperwork Reduction Act, the Commission staff
has estimated that compliance with such requests could, on an annual
basis, impose 132,000 burden hours. Assuming average internal staff costs
of $53 per hour, the annual cost of compliance with the customer response
requirement could be approximately $7 million.

As noted in section III.A.3 above, several commenters have raised
concerns over the potential risk of meritless class-action suits faced by
brokers as a result of increased disclosure. From society’s perspective,
the time and effort spent both asserting and defending any meritless
action is a net cost. The Commission believes, however, that the potential
for meritless litigation has been minimized by its inclusion of a
Preliminary Note to Rule 11Ac1-5. The Note, with the attendant discussion
in this release, states, among other things, that the statistical
disclosures do not encompass all of the factors that may be important to
investors in evaluating the order routing services of a broker-dealer and
that the disclosures alone do not create a reliable basis to address
whether any particular broker-dealer failed to meet its legal duty of best
execution. This clear statement should substantially address the risk that
the required disclosures will be misinterpreted and misused in private
litigation. In light of the addition of the Preliminary Note and the best
execution considerations addressed above, the Commission believes that the
benefits of better visibility of execution quality justify any residual
risk of meritless litigation arising after the additional information is
publicly available.

VIII. Consideration of Burden on Competition
and Promotion of Efficiency, Competition, and Capital Formation

Section 23(a)(2) of the Exchange Act requires the Commission, when
making rules under the Exchange Act, to consider the impact of such rules
on competition.99
In addition, Section 3(f) of the Exchange Act requires the Commission,
when engaging in rulemaking that requires it to consider or determine
whether an action is necessary or appropriate in the public interest, to
consider whether the action will promote efficiency, competition, and
capital formation.100

The Commission has considered Rule 11Ac1-5 and Rule 11Ac1-6 in light of
these standards and believes that the rules will not impose a burden on
competition not necessary or appropriate in furtherance of the purposes of
the Exchange Act. To the contrary, by enhancing the disclosure of order
execution and order routing practices, the Rules should promote fair and
vigorous competition. Investors currently have little information to
evaluate the order routing practices of their broker-dealers. As a result,
there currently may be limited opportunities for fair competition among
broker-dealers based on the quality of their order routing services. By
requiring broker-dealers to disclose information on their order routing
practices, the Rules may stimulate competition among broker-dealers based
on the quality of their order routing services. Similarly, by requiring
market centers to disclose order execution information in a manner that
permits comparative analysis, the rules may stimulate competition among
market centers based on the quality of their order execution services. In
addition, because the rules would apply equally to market centers, with
respect to order execution disclosure, and broker-dealers, with respect to
order routing disclosure, the rules would not result in disparate
treatment of these entities that could hinder competition.

The Commission also believes that the rules will allow investors and
broker-dealers to make better-informed choices in finding the best market
for orders to be executed. Accordingly, the rules may promote market
efficiency. In addition, the availability of information on order
execution and order routing quality may bolster investor confidence,
thereby promoting capital formation.

IX. Regulatory Flexibility Analysis

This Regulatory Flexibility Analysis (“FRFA”) has been
prepared in accordance with the Regulatory Flexibility Act.101
It relates to Rule 11Ac1-5 and Rule 11Ac1-6 under the Exchange Act. The
rules will require market centers to make disclosures of order execution
information and broker-dealers to make disclosures of order routing
information.

A. Need for the Rules

The Commission believes that there is a need for improved disclosure of
order execution information by market centers. Investors today can obtain
consolidated quote information that represents the best bid and offer from
among different market centers. This information, however, may not
accurately reflect the quality of order executions that may be obtained
from the different market centers. Many market centers offer significant
opportunities for execution of orders at prices better that the
consolidated quote. Conversely, some market centers execute orders at
prices less favorable than the consolidated quote at the time of order
receipt. The amount of price improvement or disimprovement may result in
significant savings or costs to investors. Although some market centers
make order execution information available to private companies or to
their members, this information generally has not been publicly
disseminated. Moreover, the lack of uniformity in the way this information
is prepared has made it difficult for users of the information to compare
execution quality across market centers.

The Commission also believes that there is a corresponding need for
disclosure of order routing information by broker-dealers. If investors do
not know where their broker-dealers route orders for execution, the order
execution information provided by market centers will be of little benefit
to investors. The lack of availability of order routing information also
may make it difficult for investors to monitor their broker-dealer’s
order-routing decisions.

Rule 11Ac1-5 is designed to address the need for improved disclosure of
order execution information by market centers. In particular, the Rule is
intended to provide investors and broker-dealers with uniform information
on execution quality that can be used to compare execution quality across
market centers. This information should assist investors and
broker-dealers in finding the best market for orders to be executed,
thereby promoting competition among market centers and broker-dealers on
the basis execution quality and leading to more efficient transactions in
securities.

Rule 11Ac1-6 is designed to address the complementary need for
broker-dealers to disclose to customers where their orders are routed for
execution. The primary objective of the rule is to afford customers a
greater opportunity to monitor their broker-dealer’s order routing
practices. Supplied with information on where their orders are routed, as
well as information about the quality of execution from the market centers
to which their orders are routed, investors will be able to make better
informed decisions with respect to their orders. The information also may
assist investors in selecting a broker-dealer.

B. Significant Issues Raised by Public Comment

No commenter specifically addressed the Initial Regulatory Flexibility
Analysis that was included in the Proposing Release. Some commenters
stated, however, that they believed compliance with the proposed rules,
particularly Rule 11Ac1-5, could be significantly more burdensome for
smaller firms than for large ones.102
As discussed below, the Commission does not agree that compliance with the
rules will be unduly burdensome for those entities that are considered
small entities for purposes of the Regulatory Flexibility Act.

C. Small Entities Subject to the Rules

Both Rule 11Ac1-5 and Rule 11Ac1-6 will affect entities that are
considered small entities for purposes of the Regulatory Flexibility Act.

1. Small Entities Affected by Rule 11Ac1-5

Rule 11Ac1-5 will impose disclosure requirements on every market center
that receives covered orders in national market system securities. Market
centers are defined as exchange market makers, OTC market makers,
alternative trading systems, national securities exchanges, and national
securities associations.

Exchange market makers, OTC market makers, and alternative trading
systems that are not registered as exchanges are required to register as
broker-dealers. Accordingly, these entities would be considered small
entities if they fall within the standard for small entities that applies
to broker-dealers. Under Exchange Act Rule 0-10(b), a broker-dealer is
considered a small entity for purposes of Regulatory Flexibility Act if
(1) it had total capital of less than $500,000 on the date in the prior
fiscal year as of which its audited financial statements were prepared,
of, if not required to prepare such statements, it had total capital of
less than $500,000 on the last business day of the preceding fiscal year,
and (2) it is not affiliated with any person (other than a natural person)
that is not a small entity.103
Based on this standard, the Commission estimates that two exchange market
makers, one OTC market maker, and no alternative trading systems that will
be subject to Rule 11Ac1-5 are small entities.104

None of the national securities exchanges or the national securities
association subject to the Rule is a small entity. Paragraph (e) of the
Exchange Act Rule 0-10105
provides that the term “small business,” when referring to an
exchange, means any exchange that has been exempted from the reporting
requirements of 17 CFR 240.11Aa3-1. Under this standard, none of the
national securities exchanges affected by the Rule is a small entity.
Similarly, the national securities association subject to the Rule is not
a small entity as defined by 13 CFR 121.201.

2. Small Entities Affected by Rule 11Ac1-6

Rule 11Ac1-6 will impose disclosure requirements on every broker-dealer
that routes non-directed customer orders in covered securities. Under the
standard for determining whether a broker-dealer is a small entity in
Exchange Act Rule 0-10(b), the Commission estimates that approximately 41
broker-dealers subject to Rule 11Ac1-6 are small entities.106

D. Projected Reporting, Recordkeeping and other
Compliance Requirements

1. Reporting Requirements under Rule 11Ac1-5

Rule 11Ac1-5 will impose new reporting requirements on market centers,
including those considered small entities. Under the Rule, market centers
will be required to prepare and make available to the public monthly
reports that categorize and summarize their order executions. For purposes
of the Paperwork Reduction Act, the Commission staff estimates that
individual market centers will spend 90 hours in initial preparations and,
on an annual basis, spend 72 burden hours and incur $30,000 ($2500 per
month) in monetary costs to comply with the monthly reporting requirement.
Assuming internal compliance staff costs of $53 per hour, the total cost
per small entity for burden hours will be $4770 for initial preparations
and $3816 on an annual basis. The Commission estimates the total cost, on
an ongoing basis, required to prepare and disseminate the monthly reports
by the estimated three small entities subject to the Rule will be $108,360
per year (3 x ($30,000+$3816)). As discussed further above, small entities
likely could obtain a much reduced rate through the auspices of an SRO or
other organization.

2. Reporting Requirements under Rule 11Ac1-6

Rule 11Ac1-6 will impose new reporting requirements on broker-dealers,
including those considered small entities. Under the Rule, broker-dealers
will be required to prepare and make available to the public quarterly
reports that give an overview of their routing of non-directed orders in
covered securities. In addition, broker-dealers, on request of a customer,
will be required to disclose the identity of the venues to which the
customer’s orders were routed in the six months prior to the request,
whether the orders were directed or non-directed orders, and the time of
the transactions resulting from such orders.

As discussed in section VI.B above, it is unlikely that many small
entities will have significant involvement in order routing practices,
primarily because they are affiliated with a clearing broker. With respect
to the 41 small entities that are subject to the Rule and are not
affiliated with a clearing broker, the Commission does not anticipate that
they engage in significant order routing on behalf of customers. If any of
the 41 small entities were required to comply with the Rule, the
Commission staff estimates that they would expend, on average, 32 hours to
prepare quarterly reports and 2 hours to respond to eight customer
requests.107
Assuming internal compliance costs that average $85 per hour, the
aggregate cost for each small entity to comply with the Rule is estimated
to be $2890.

E. Agency Action to Minimize Effect on Small
Entities

The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish the stated objectives,
while minimizing any significant adverse impact on small entities. In
connection with Rule 11Ac1-5 and Rule 11Ac1-6, the Commission considered
the following alternatives: (1) the establishment of differing compliance
or reporting requirements or timetables that take into account the
resources available to small entities; (2) the clarification,
consolidation, or simplification of compliance and reporting requirements
under the rules for small entities; (3) the use of performance rather than
design standards; and (4) an exemption from coverage of the rules, or any
part thereof, for small entities.

1. Rule 11Ac1-5

Rule 11Ac1-5 is designed to provide uniform order execution information
from the different market centers to allow investors and broker-dealers to
compare execution quality across markets. Accordingly, the Commission
believes that establishing differing reporting requirements for small
entities would be inconsistent with the objectives of the Rule. Similarly,
the Commission believes that the clarification, consolidation, or
simplification of reporting requirements for small entities would be
inconsistent with the objective of providing uniform order execution
information from the different market centers.

Regarding the use of performance standards rather than design
standards, Rule 11Ac1-5 specifies the statistical measures that must
appear in the monthly order execution reports. The Commission considered
whether the Rule should require market centers only to make available
electronic files with raw data on an order-by-order basis. Under this
alternative, market centers would provide the necessary fields of
information, and analysts could calculate the statistical measures of
execution quality that they consider appropriate. The Commission has not
adopted this alternative because it would be inconsistent with the
objective of assuring a uniform basis for comparing execution quality
across market centers. The Rule does not establish a particular technology
for disseminating the required reports to the public, other than requiring
that market centers make their data available for downloading from a free
website in a consistent, usable, and machine-readable electronic format.

As to whether Rule 11Ac1-5 should exempt small entities from its
coverage, the Commission considered several alternatives that could
minimize the impact of the Rule on small entities. Specifically, the
Commission considered an exemption for market centers that execute
relatively few orders in total. Also, the Commission considered an
exemption to eliminate the disclosure requirement for individual
securities in which a market center executes relatively few orders.
Finally, as discussed above, the Commission considered whether it would be
feasible to allow small market centers to provide raw data rather than the
statistical measures required by the proposed rule. No commenters
expressed support for these types of exemptions or exceptions for small
entities. Given the need for a uniform basis to compare execution quality
across market centers, the Commission has determined not to adopt
exemptions or exclusions specifically for small entities.

2. Rule 11Ac1-6

Rule 11Ac1-6 is designed to provide investors with information on the
order routing practices of their broker-dealers. The Rule requires
broker-dealers to prepare quarterly order routing reports and respond to
requests from individual investors for information on how their orders
were routed. As to the establishment of different reporting requirements
or timetables and the clarification, consolidation, or simplification of
reporting requirements for small entities, the Commission does not believe
that the proposal could be formulated differently for small entities and
still achieve its stated objectives.

The Commission requested comment on whether to exclude from the Rule
broker-dealers that route a relatively small number of customer orders. No
commenter expressed support for such an exclusion. Moreover, an exemption
from the Rule for small entities would be inconsistent with the objectives
of the Rule. Its primary objective is to afford customers a greater
opportunity to monitor their broker-dealer’s order routing practices. All
broker-dealers currently have an obligation to periodically review their
order routing practices to meet their duty of best execution to their
customers. The Commission does not believe that the disclosures required
by Rule 11Ac1-6 will be unduly burdensome for small entities, particularly
now that the requirement of a narrative discussion and analysis of order
routing objectives and results has been eliminated from the rule as it was
proposed.

X. Statutory Authority

Pursuant to the Exchange Act and particularly Sections 3(b), 5, 6, 11A,
15, 17, 19, 23(a), and 36 thereof, 15 U.S.C. 78c, 78e, 78f, 78k-1, 78o,
78q, 78s, 78w(a), and 78mm, the Commission proposes to adopt Sections
240.11Ac1-5 and 240.11Ac1-6 of Chapter II of Title 17 of the Code of
Federal Regulations
in the manner set forth below.

List of Subjects in 17 CFR Part 240

Broker-dealers, Reporting and recordkeeping requirements, Securities.

Text of Rules

For the reasons set forth in the preamble, the Commission is amending
Chapter II of Title 17 of the Code of Federal Regulations as
follows:

PART 240 – GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE

ACT OF 1934

1. The authority citation for Part 240 continues to read in part as
follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 77ggg,
77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 78k-1, 78l,
78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 78mm, 79q,
79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless
otherwise noted.

*****

2. Sections 240.11Ac1-5 and 240.11Ac1-6 are added before the
undesignated center heading “Securities Exempted from
Registration” to read as follows:

§ 240.11Ac1-5 Disclosure of order execution information.

Preliminary Note

§240.11Ac1-5 requires market centers to make available standardized,
monthly reports of statistical information concerning their order
executions. This information is presented in accordance with uniform
standards that are based on broad assumptions about order execution and
routing practices. The information will provide a starting point to
promote visibility and competition on the part of market centers and
broker-dealers, particularly on the factors of execution price and speed.
The disclosures required by this Section do not encompass all of the
factors that may be important to investors in evaluating the order routing
services of a broker-dealer. In addition, any particular market center’s
statistics will encompass varying types of orders routed by different
broker-dealers on behalf of customers with a wide range of objectives.
Accordingly, the statistical information required by this Section alone
does not create a reliable basis to address whether any particular
broker-dealer failed to obtain the most favorable terms reasonably
available under the circumstances for customer orders.

(a) Definitions. For the purposes of this section:

(1) The term alternative trading system shall have the meaning
provided in §242.300(c) of this chapter.

(2) The term average effective spread shall mean the
share-weighted average of effective spreads for order executions
calculated, for buy orders, as double the amount of difference between the
execution price and the midpoint of the consolidated best bid and offer at
the time of order receipt and, for sell orders, as double the amount of
difference between the midpoint of the consolidated best bid and offer at
the time of order receipt and the execution price.

(3) The term average realized spread shall mean the
share-weighted average of realized spreads for order executions
calculated, for buy orders, as double the amount of difference between the
execution price and the midpoint of the consolidated best bid and offer
five minutes after the time of order execution and, for sell orders, as
double the amount of difference between the midpoint of the consolidated
best bid and offer five minutes after the time of order execution and the
execution price; provided, however, that the midpoint of the final
consolidated best bid and offer disseminated for regular trading hours
shall be used to calculate a realized spread if it is disseminated less
than five minutes after the time of order execution.

(4) The term categorized by order size shall mean dividing
orders into separate categories for sizes from 100 to 499 shares, from 500
to 1999 shares, from 2000 to 4999 shares, and 5000 or greater shares.

(5) The term categorized by order type shall mean dividing
orders into separate categories for market orders, marketable limit
orders, inside-the-quote limit orders, at-the-quote limit orders, and
near-the-quote limit orders.

(6) The term categorized by security shall mean dividing orders
into separate categories for each national market system security that is
included in a report.

(7) The term consolidated best bid and offer shall mean the
highest firm bid and the lowest firm offer for a security that is
calculated and disseminated on a current and continuous basis pursuant to
an effective national market system plan.

(8) The term covered order shall mean any market order or any
limit order (including immediate-or-cancel orders) received by a market
center during regular trading hours at a time when a consolidated best bid
and offer is being disseminated, and, if executed, is executed during
regular trading hours, but shall exclude any order for which the customer
requests special handling for execution, including, but not limited to,
orders to be executed at a market opening price or a market closing price,
orders submitted with stop prices, orders to be executed only at their
full size, orders to be executed on a particular type of tick or bid,
orders submitted on a “not held” basis, orders for other than
regular settlement, and orders to be executed at prices unrelated to the
market price of the security at the time of execution.

(9) The term exchange market maker shall mean any member of a
national securities exchange that is registered as a specialist or market
maker pursuant to the rules of such exchange.

(10) The term executed at the quote shall mean, for buy orders,
execution at a price equal to the consolidated best offer at the time of
order receipt and, for sell orders, execution at a price equal to the
consolidated best bid at the time of order receipt.

(11) The term executed outside the quote shall mean, for buy
orders, execution at a price higher than the consolidated best offer at
the time of order receipt and, for sell orders, execution at a price lower
than the consolidated best bid at the time of order receipt.

(12) The term executed with price improvement shall mean, for
buy orders, execution at a price lower than the consolidated best offer at
the time of order receipt and, for sell orders, execution at a price
higher than the consolidated best bid at the time of order receipt.

(13) The terms inside-the-quote limit order, at-the-quote
limit order
, and near-the-quote limit order shall mean
non-marketable buy orders with limit prices that are, respectively, higher
than, equal to, and lower by $0.10 or less than the consolidated best bid
at the time of order receipt, and non-marketable sell orders with limit
prices that are, respectively, lower than, equal to, and higher by $0.10
or less than the consolidated best offer at the time of order receipt.

(14) The term market center shall mean any exchange market
maker, OTC market maker, alternative trading system, national securities
exchange, or national securities association.

(15) The term marketable limit order shall mean any buy order
with a limit price equal to or greater than the consolidated best offer at
the time of order receipt, and any sell order with a limit price equal to
or less than the consolidated best bid at the time of order receipt.

(16) The term effective national market system plan shall have
the meaning provided in §240.11Aa3-2(a)(2).

(17) The term national market system security shall have the
meaning provided in §240.11Aa2-1.

(18) The term OTC market maker shall mean any dealer that holds
itself out as being willing to buy from and sell to its customers, or
others, in the United States, a national market system security for its
own account on a regular or continuous basis otherwise than on a national
securities exchange in amounts of less than block size.

(19) The term regular trading hours shall mean the time between
9:30 a.m. and 4:00 p.m. Eastern Time, or such other time as is set forth
in the procedures established pursuant to paragraph (c)(2) of this
section.

(20) The term time of order execution shall mean the time (to
the second) that an order was executed at any venue.

(21) The term time of order receipt shall mean the time (to the
second) that an order was received by a market center for execution.

(b) Monthly electronic reports by market centers.

(1) Every market center shall make available for each calendar month,
in accordance with the procedures established pursuant to paragraph (b)(2)
of this section, a report on the covered orders in national market system
securities that it received for execution from any person. Such report
shall be in electronic form; shall be categorized by security, order type,
and order size; and shall include the following columns of information:

(i) For market orders, marketable limit orders, inside-the-quote limit
orders, at-the-quote limit orders, and near-the-quote limit orders:

(A) The number of covered orders;

(B) The cumulative number of shares of covered orders;

(C) The cumulative number of shares of covered orders cancelled prior
to execution;

(D) The cumulative number of shares of covered orders executed at the
receiving market center;

(E) The cumulative number of shares of covered orders executed at any
other venue;

(F) The cumulative number of shares of covered orders executed from 0
to 9 seconds after the time of order receipt;

(G) The cumulative number of shares of covered orders executed from 10
to 29 seconds after the time of order receipt;

(H) The cumulative number of shares of covered orders executed from 30
seconds to 59 seconds after the time of order receipt;

(I) The cumulative number of shares of covered orders executed from 60
seconds to 299 seconds after the time of order receipt;

(J) The cumulative number of shares of covered orders executed from 5
minutes to 30 minutes after the time of order receipt; and

(K) The average realized spread for executions of covered orders; and

(ii) For market orders and marketable limit orders:

(A) The average effective spread for executions of covered orders;

(B) The cumulative number of shares of covered orders executed with
price improvement;

(C) For shares executed with price improvement, the share-weighted
average amount per share that prices were improved;

(D) For shares executed with price improvement, the share-weighted
average period from the time of order receipt to the time of order
execution;

(E) The cumulative number of shares of covered orders executed at the
quote;

(F) For shares executed at the quote, the share-weighted average period
from the time of order receipt to the time of order execution;

(G) The cumulative number of shares of covered orders executed outside
the quote;

(H) For shares executed outside the quote, the share-weighted average
amount per share that prices were outside the quote; and

(I) For shares executed outside the quote, the share-weighted average
period from the time of order receipt to the time of order execution.

(2) Every national securities exchange on which national market system
securities are traded and national securities association shall act
jointly in establishing procedures for market centers to follow in making
available to the public the reports required by paragraph (b)(1) of this
section in a uniform, readily accessible, and usable electronic form. In
the event there is no effective national market system plan establishing
such procedures, market centers shall prepare their reports in a
consistent, usable, and machine-readable electronic format, and make such
reports available for downloading from an Internet web site that is free
and readily accessible to the public.

(3) A market center shall make available the report required by
paragraph (b)(1) of this section within one month after the end of the
month addressed in the report.

(c) Exemptions. The Commission may, by order upon application,
conditionally or unconditionally exempt any person, security, or
transaction, or any class or classes of persons, securities, or
transactions, from any provision or provisions of this section, if the
Commission determines that such exemption is necessary or appropriate in
the public interest, and is consistent with the protection of investors.

§240.11Ac1-6 Disclosure of order routing information.

(a) Definitions. For the purposes of this section:

(1) The term covered security shall mean:

(i) Any national market system security and any other security for
which a transaction report, last sale data or quotation information is
disseminated through an automated quotation system as defined in Section
3(a)(51)(A)(ii) of the Act (15 U.S.C. 78c(a)(51)(A)(ii)); and

(ii) Any option contract traded on a national securities exchange for
which last sale reports and quotation information are made available
pursuant to an effective national market system plan.

(2) The term customer order shall mean an order to buy or sell a
covered security that is not for the account of a broker or dealer, but
shall not include any order for a quantity of a security having a market
value of at least $50,000 for a covered security that is an option
contract and a market value of at least $200,000 for any other covered
security.

(3) The term directed order shall mean a customer order that the
customer specifically instructed the broker or dealer to route to a
particular venue for execution.

(4) The term make publicly available shall mean posting on an
Internet web site that is free and readily accessible to the public,
furnishing a written copy to customers on request without charge, and
notifying customers at least annually in writing that a written copy will
be furnished on request.

(5) The term non-directed order shall mean any customer order
other than a directed order.

(6) The term effective national market system plan shall have
the meaning provided in §240.11Aa3-2(a)(2).

(7) The term national market system security shall have the
meaning provided in §240.11Aa2-1.

(8) The term payment for order flow shall have the meaning
provided in §240.10b-10(d)(9).

(9) The term profit-sharing relationship shall mean any
ownership or other type of affiliation under which the broker or dealer,
directly or indirectly, may share in any profits that may be derived from
the execution of non-directed orders.

(10) The term time of the transaction shall have the meaning
provided in §240.10b-10(d)(3).

(b) Quarterly report on order routing.

(1) Every broker or dealer shall make publicly available for each
calendar quarter a report on its routing of non-directed orders in covered
securities during that quarter. For covered securities other than option
contracts, such report shall be divided into three separate sections for
securities that are listed on the New York Stock Exchange, Inc.,
securities that are qualified for inclusion in the Nasdaq Stock Market,
Inc., and securities that are listed on the American Stock Exchange LLC or
any other national securities exchange. Such report also shall include a
separate section for covered securities that are option contracts. Each of
the four sections in a report shall include the following information:

(i) The percentage of total customer orders for the section that were
non-directed orders, and the percentages of total non-directed orders for
the section that were market orders, limit orders, and other orders;

(ii) The identity of the ten venues to which the largest number of
total non-directed orders for the section were routed for execution and of
any venue to which five percent or more of non-directed orders were routed
for execution, the percentage of total non-directed orders for the section
routed to the venue, and the percentages of total non-directed market
orders, total non-directed limit orders, and total non-directed other
orders for the section that were routed to the venue; and

(iii) A discussion of the material aspects of the broker’s or dealer’s
relationship with each venue identified pursuant to paragraph (b)(1)(ii)
of this section, including a description of any arrangement for payment
for order flow and any profit-sharing relationship.

(2) A broker or dealer shall make the report required by paragraph
(b)(1) of this section publicly available within one month after the end
of the quarter addressed in the report.

(c) Customer requests for information on order routing.

(1) Every broker or dealer shall, on request of a customer, disclose to
its customer the identity of the venue to which the customer’s orders were
routed for execution in the six months prior to the request, whether the
orders were directed orders or non-directed orders, and the time of the
transactions, if any, that resulted from such orders.

(2) A broker or dealer shall notify customers in writing at least
annually of the availability on request of the information specified in
paragraph (c)(1) of this section.

(d) Exemptions. The Commission may, by order upon application,
conditionally or unconditionally exempt any person, security, or
transaction, or any class or classes of persons, securities, or
transactions, from any provision or provisions of this section, if the
Commission determines that such exemption is necessary or appropriate in
the public interest, and is consistent with the protection of investors.

By the Commission.

Jonathan G. Katz

Secretary

Dated: November 17, 2000

Footnotes

1 The two rules, 17
CFR 240.11Ac1-5 and 17 CFR 240.1Ac1-6, were proposed for public comment in
Securities Exchange Act Release No. 43084 (July 28, 2000), 65 FR 48406
(“Proposing Release”). Section 11A of the Securities Exchange
Act of 1934, 15 U.S.C. 78k-1, grants the Commission authority to
promulgate rules necessary or appropriate to assure the fairness and
usefulness of information on securities transactions and to assure that
broker-dealers transmit orders in a manner consistent with the
establishment and operation of a national market system. The principal
national market system objectives set forth in Section 11A(a)(1) include
the efficient execution of securities transactions, fair competition among
market participants, the public availability of information on securities
transactions, and the best execution of investor orders. The rules adopted
today should significantly further these objectives.

2 Source: NASD
Economic Research Dept., www.nasdaq.marketdata.com (visited Oct.
31, 2000). It is doubtful that the emergence of agency market centers
operated by ECNs has significantly worsened fragmentation in the market
for Nasdaq securities. Since the creation of the Nasdaq market in the
1970’s, order flow in such securities always has been fragmented among a
significant number of market makers.

3 Source: NYSE. In
addition, the American Stock Exchange LLC (“Amex”) accounted for
69.9% of share volume in Amex equities during September 2000. Source:
Amex.

4 Securities
Exchange Act Release No. 42450 (Feb. 28, 2000), 65 FR 10577. The
Commission subsequently approved the rescission of Rule 390, in part
because the rule had tended to restrict the competitive opportunities in
listed securities of ECNs that operate agency markets. Securities Exchange
Act Release No. 42758 (May 5, 2000), 65 FR 30175. It emphasized, however,
that its desire to clear away any regulatory barriers to competition
should not be interpreted as an indication of whether the ECNs would or
should attractive a significant amount of listed market share. That will
be determined by competition. The Commission also emphasized that its
criticism of Rule 390 should not be interpreted as criticism of the
quality of the NYSE’s market, noting that studies repeatedly had
demonstrated its high quality of execution and important public price
discovery function. Id. at note 28 and accompanying text.

5 These dealer
practices are discussed in section IV.A.2 of the Fragmentation Release.

6 Securities
Exchange Act Release No. 43084 (July 28, 2000), 65 FR 48406.

7 Section IV.A.1
of the Fragmentation Release discusses the various ways in which investors
seek to obtain the best prices, including the use of market orders by
investors seeking liquidity and the use of limit orders by investors
supplying liquidity. In addition, it discusses the alternatives used by
large investors to interact with smaller orders (often by offering better
prices for such orders) without being forced to display their full trading
interest, which might move the market significantly against them.

8 An opportunity
for investor orders to be executed without the participation of a dealer
is, subject to efficiency and best execution objectives, one of the five
principal objectives for a national market system. Exchange Act Section
11A(a)(1)(C)(v), 15 U.S.C. 78k-1(a)(1)(C)(v).

9 See
Report by Commissioner Laura S. Unger, On-Line Brokerage: Keeping Apace
of Cyberspace
40-41 (Nov. 1999) (available at http://www.sec.gov).
One of the recommendations in Commissioner Unger’s Report was that the
Commission should consider requiring market centers to make publicly
available certain uniform information on execution quality and requiring
broker-dealers to provide their customers with plain English information
about the execution quality available at different market centers, order
handling practices, and the broker-dealer’s receipt of inducements for
order flow. Id. at 45. In addition, one of the largest
broker-dealers noted in its comment letter on the Fragmentation Release
that even it had been frustrated in its own attempts to obtain useful
order execution data from certain markets. Letter from Lon Gorman, Vice
Chairman and President, Capital Markets & Trading Group, Charles
Schwab & Co., to Jonathan G. Katz, Secretary, SEC, dated July 5, 2000,
at 7.

10 This estimate
is described in the cost-benefit discussion in section VII.A.1 below.

11 The practice
of preferencing, under which orders are directed to a particular exchange
specialist that is entitled to take priority in execution over same-priced
orders entered prior in time, is quite similar to internalization by OTC
market makers.

12 The
Preferencing Report specifically noted (p. 172) that preferencing programs
would require reconsideration if “a significant increase in the
amount of preferencing activity as a percentage of overall national market
system activity” resulted in the decline of execution quality on the
national market system.

13 Commenters on
the Proposing Release correctly noted that the Preferencing Report found
higher fill rates for non-marketable limit orders on the regional
exchanges than on the NYSE. Letter from Jeffrey T. Brown, Vice President
Regulation and General Counsel, Cincinnati Stock Exchange, to Jonathan G.
Katz, Secretary, SEC, dated Sept. 25, 2000, at 9 (“CSE Letter”);
Letter from Richard Brueckner, Chief Operating Officer, Pershing Division
of Donaldson, Lufkin & Jenrette Securities Corporation, to Jonathan
Katz, Secretary, SEC, dated Sept. 29, 2000, at 3 (“Pershing
Letter”). The fill rates are reported in Tables V-17 and V-18 of the
Preferencing Study. Only a small number of non-marketable limit orders,
however, were routed to the regional exchanges, even when evaluated as a
percentage of total order flow (and therefore adjusting for the much
smaller share volume of the regional exchanges). See Preferencing
Report, Table V-2 (regional exchanges’ non-marketable limit orders
represented 11.5% to 17.3% of their total order executions compared to
45.7% of NYSE executions). Indeed, the Preferencing Study found that four
of the five largest broker-dealer participants in the CSE preferencing
program (all that were examined) generally did not use the CSE’s limit
order book, but preferred either to place limit orders on their
proprietary limit order books or to route the limit orders to the primary
market. Preferencing Report at 114.

14 Preferencing
Report, Table V-7. In addition, Table V-11 indicates that, when compared
for same stocks and order sizes, the NYSE average price improvement rate
for small market orders was 45% to 180% higher than that of the regional
exchanges. Analogous results were reflected in other tables (V-12, V-14,
V-15, V-16) that were adjusted for trading in the same stocks and order
sizes. Most of the tables in the Preferencing Report, however, compared
NYSE trading for one week in all of its stocks with regional exchange
trading for four weeks in a smaller number of NYSE stocks. They therefore
did not attempt to capture distinctions between trading in comparable
stocks during the same time period, as will be facilitated by the monthly
market center reports to be made available under Rule 11Ac1-5.

15 See, e.g.,
Letter from Craig S. Tyle, General Counsel, Investment Company Institute,
to Jonathan G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 1 (“ICI
Letter”); Letter from Robin Roger, Managing Director and Counsel,
Morgan Stanley Dean Witter & Co., to Jonathan G. Katz, Secretary, SEC,
dated Sept. 25, 2000, at 1 (“Morgan Stanley Letter”); Letter
from Mary A. Burnes, Principal, OTC Trading, Edward D. Jones & Co., to
Jonathan G. Katz, Secretary, SEC, dated Sept. 19, 2000, at 1 (“Edward
Jones Letter”); Letter from Robert C. Gasser, Managing Director, J.P.
Morgan Securities Inc., to Jonathan Katz, Secretary, SEC, dated Oct. 5,
2000, at 2 (“J.P. Morgan Letter”).

16 The comment
letters and a comprehensive summary of comments have been placed in Public
File No. S7-16-00, which is available for inspection in the Commission’s
Public Reference Room.

17 See, e.g.,
ICI Letter, note 15 above, at 2; Letter from James E. Buck, Senior Vice
President & Secretary, NYSE, to Jonathan G. Katz, Secretary, SEC,
dated Oct. 17, 2000, at 1 (“NYSE Letter”); Letter from Thomas
Peterffy, Chairman, and David M. Battan, Vice President and General
Counsel, Interactive Brokers LLC, to Jonathan G. Katz, Secretary, SEC,
dated Sept. 22, 2000, at 2 (“Interactive Brokers Letter”);
Letter from Michael T. Dorsey, Senior Vice President and General Counsel,
Knight Trading Group, Inc., to Jonathan G. Katz, Secretary, SEC, dated
Oct. 25, 2000, at 2 (“Knight Trading Letter”); Letter from
William R. Harts, Managing Director, Salomon Smith Barney Inc., to
Jonathan G. Katz, Secretary, SEC, dated Nov. 3, 2000, at 1 (“Salomon
Smith Barney Letter”); Letter from Andrew A. Davis, Chairman and CEO,
The Rock Island Company, and William R. Surman, Senior Vice President –
Equity, Rock Island Securities, Inc., to Jonathan G. Katz, Secretary, SEC,
dated Sept. 8, 2000, at 2 (“Rock Island Letter”); Letter from
Alan R. Shapiro, President, and Howard Kohos, Executive Vice President,
Transaction Auditing Group, Inc., to Jonathan G. Katz, Secretary, SEC,
dated Sept. 22, 2000, at 8 (“TAG Letter”).

18 Letter from
Marshall E. Blume, Howard Butcher III Professor of Financial Management,
The Wharton School, University of Pennsylvania, to Jonathan G. Katz,
Secretary, SEC, dated Sept. 7, 2000, at 1 (“Blume Letter”).

19 Letter from
Meng-yuan Wang, Executive Director of EMM, UBS Warburg, to Jonathan G.
Katz, Secretary, SEC, dated Sept. 25, 2000, at 1.

20 CSE Letter,
note 13 above, at 9; Blume Letter, note 18 above, at 1; Letter from
Cameron Smith, General Counsel, Island ECN, to Jonathan Katz, Secretary,
SEC, dated Sept. 27, 2000, at 9 (“Island Letter”). The Proposing
Release requested comment on disclosure of “raw data” as an
alternative. The Commission is not adopting the alternative. If a market
center believes, however, that the basic statistical measures included in
the Rule do not adequately reflect the complexity of its order flow and
execution quality, it also could make its raw data publicly available as a
means to promote greater understanding of its performance.

21 Letter from
Mark B. Sutton, Chairman, Market Structure Committee, Securities Industry
Association, to Jonathan G. Katz, Secretary, SEC, dated Sept. 26, 2000, at
1 (“SIA Market Structure Committee Letter”; Letter from Lon
Gorman, Vice Chairman, Charles Schwab & Co., to Jonathan G. Katz,
Secretary, SEC, dated Sept. 28, 2000, at 1-2 (“Schwab Letter”).

22 See, e.g.,
Morgan Stanley Letter, note 15 above, at 1; Letter from Junius W. Peake,
Monfort Distinguished Professor of Finance, Kenneth W. Monfort College of
Business, to Jonathan G. Katz, Secretary, SEC, dated Sept. 6, 2000, at 3
(“Peake Letter”).

23 See, e.g.,
Pershing Letter, note 13 above, at 1 (“The Commission seems to be
trying to create a quantitative definition of best execution.”); SIA
Market Structure Committee Letter, note 21 above, at 3 (the proposed rules
“elevate price and speed over other, less easily quantifiable,
measures that may be important to certain investors in assessing execution
quality”); Schwab Letter, note 21 above, at 9 (“by focusing on
price and speed, the Commission is explicitly endorsing these elements and
implicitly indicating that all others are not relevant in the
determination of best execution”).

24 See, e.g.,
Securities Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290
(“Order Handling Rules Release”), at section III.C.2.

25 See, e.g.,
Morgan Stanley Letter, note 15 above, at 12-13; Pershing Letter, note 13
above, at 2; Letter from Robert H. Forney, President and Chief Executive
Officer, Chicago Stock Exchange, to Jonathan G. Katz, Secretary, SEC,
dated Oct. 5, 2000, at 9 (“CHX Letter”); Letter from Lanny A.
Schwartz, Executive Vice President and General Counsel, Philadelphia Stock
Exchange, Inc., to Jonathan G. Katz, Secretary, SEC, dated Sept. 22, 2000,
at 1 (“Phlx Letter”).

26 For example,
the quoted spread and the effective spread are analogous to the
manufacturer’s suggested retail price (“MSRP”) for a product and
the varying prices actually charged at different stores. The first
reflects the price that might be charged; the second reflects the price
actually charged, which could be better or worse than the first, and often
is. The Commission similarly believes that investors, with proper
explanation, can grasp the concept underlying average realized spread.
This statistic is calculated by comparing the execution price of an order
with the public quotes as they stand five minutes after the time of
execution. As discussed further in section III.C.1 below, it measures the
extent to which a market center receives order flow that is difficult to
handle – either because it arrives during times when the markets are
stressed or it comes from informed traders. It highlights those market
centers that are willing to accept such difficult order flow, a
praiseworthy quality that the Commission does not want the Rule’s
disclosure requirements to discourage.

27 If
interested, however, investors with access to the Internet and capable of
using widely-available office application software could readily download
and analyze a market center’s monthly execution quality report. Private
vendors also may offer services that enable individual investors to access
and review market center reports.

28 A commenter
suggested that, without an independent verification requirement, some
market centers might produce reports that were materially misleading.
Morgan Stanley Letter, note 15 above, at 17. The Commission does not
believe that an independent verification requirement is necessary at this
time. Market centers subject to Rule 11Ac1-5 will be regulated entities
that have met the integrity and competence standards of the Exchange Act.
In addition, all market centers will be subject to inspection by the
Commission. If registered as a broker-dealer, they also will be subject to
inspection by their respective self-regulatory organizations (“SROs”).
The Exchange Act grants the Commission and SROs ample enforcement powers
to deal with any market center that makes materially misleading
disclosures concerning its execution quality.

29 SIA Market
Structure Committee Letter, note 21 above, at 5; Letter from Bruce E.
Coolidge of Wilmer, Cutler & Pickering, to Jonathan G. Katz,
Secretary, SEC, dated Oct. 10, 2000; Letter from Roger D. Blanc of Wilkie
Farr & Gallagher, to Jonathan G. Katz, Secretary, SEC, dated Oct. 5,
2000, at 10 (“Wilkie Farr & Gallagher Letter”); Schwab
Letter, note 21 above, at 13-17; Morgan Stanley Letter, note 15 above, at
17; Letter from the Regulatory Studies Program of the Mercatus Center at
George Mason University, to Jonathan G. Katz, Secretary, SEC, dated Sept.
22, 2000, at 14 (“Mercatus Center Letter”). But see
Knight Trading Letter, note 17 above, at 12-14.

30 For this
reason, broker-dealers will be able to explain in their disclosures to
customers the full range of factors that influenced their order routing
decisions.

31 Exchange Act
Section 11A(a)(2). See also Guice v. Charles Schwab & Co.,
674 N.E.2d 282 (N.Y. 1996), cert. denied, 520 U.S. 1118 (1997).

32 Exchange Act
Section 11A(a)(1)(C)(iv).

33 Similarly,
the Commission has noted that “in evaluating its procedures for
handling limit orders, the broker-dealer must take into account any material
differences in execution quality.” Order Handling Rules Release, note
24 above, at section III.C.2 (emphasis added).

34 See id.
at section III.C.2.

35 A national
securities exchange is an exchange registered under Section 6 of the
Exchange Act. An exchange exempted from registration pursuant to Section 5
of the Exchange Act therefore is not included within the Rule’s definition
of market center.

36 When a market
center receives an order for execution, the order must be included in its
statistical disclosures of execution quality even if the order is routed
to another venue for execution. See section III.C.1 below.

37 Indeed, the
Commission anticipates that many SROs may, on behalf of their members,
assume substantially all responsibility for complying with the Rule. Such
an assumption of responsibility would be an acceptable way for an SRO and
its members to meet the Rule’s requirements.

38 The
Commission’s staff will be available to provide interpretive guidance to
market centers on how orders should be reported under the Rule.

39 See
Division of Market Regulation, SEC, Report on Electronic Communications
Networks and After-Hours Trading (June 2000), at 29 (for the 15 largest
capitalization stocks in the Nasdaq 100 index, average quoted spread,
average effective spread, and trade price volatility increased
significantly after the close of regular trading hours).

40 The Proposing
Release requested comment on orders received when the consolidated BBO is
locked or crossed. One commenter suggested that such orders be excluded,
as well as orders received during “fast” markets. TAG Letter,
note 17 above, at 4. The adopted Rule continues to encompass such orders.
Its statistical measures can all be calculated during periods when markets
are locked, crossed, and fast. Moreover, one of the important
characteristics of a market center is its ability to handle orders well
during difficult market conditions.

41 The full
title of the Nasdaq Plan is “Joint Self-Regulatory Plan Governing the
Collection, Consolidation, and Dissemination of Quotation and Transaction
Information for Exchange-Listed Nasdaq/National Market System Securities
and for Nasdaq/National Market System Securities Traded on an Unlisted
Trading Privilege Basis.”

42 One commenter
requested clarification concerning orders that are not sent to a market
center for prompt execution, as are traditional market orders, or that are
not priced orders. Letter from P. Mats Goebels, Senior Vice President
& General Counsel, ITG, Inc., to Jonathan G. Katz, Secretary, SEC,
dated Sept. 29, 2000, at 5. Such orders would not fall within the
definition of “covered order” in subparagraph (a)(8), which
applies only to market orders and limit orders.

43 The market
centers that offer these improved prices for opening orders may, however,
exclude them from their payment for order flow schedules, thereby
potentially reducing the payments to broker-dealers that obtain these
better prices for their customers.

44 Rule 11Aa2-1
incorporates the definition of “reported security” that is used
in Exchange Act Rule 11Aa3-1 — any security for which transaction reports
are made available pursuant to a reporting plan approved under Rule
11Aa3-1. Only exchange-listed equities and Nasdaq National Market equities
currently fall within this definition.

45 See
NASD Economic Research Dept., http://www.marketdata.nasdaq.com
(visited June 27, 2000).

46 Interactive
Brokers Letter, note 17 above, at 4.

47 Letter from
Thomas A. Bond, Chicago Board Options Exchange, to Jonathan G. Katz,
Secretary, SEC, dated Oct. 9, 2000, at 3 (“CBOE Letter”).

48 Phlx Letter,
note 25 above, at 4; CSE Letter, note 13 above, at 6-7; Schwab Letter,
note 21 above, at 10-11.

49 A commenter
suggested that the Rule should exclude cancelled orders in calculations of
execution quality measures. Letter from Richard G. Ketchum, National
Association of Securities Dealers, Inc., to Jonathan G. Katz, Secretary,
SEC, dated Oct. 17, 2000, at 3. In fact, the Rule does not specify whether
cancelled orders should or should not be included in calculating measures
such as price improvement rates for market orders and fill rates for limit
orders. Instead, market centers will disclose the number of cancelled
shares, and analysts are free to use or exclude cancelled orders in
performing their calculations as they think most appropriate.

50 Interactive
Brokers Letter, note 17 above, at 3-4.

51 The overall
fill rates for such orders can be calculated by comparing the number of
shares executed with the total number of shares received. Such overall
fill rates for non-marketable limit orders can be difficult to interpret
because of the problem of cancelled orders. An aggressive user of
non-marketable limit orders frequently will submit orders with limit
prices at or inside the current consolidated BBO. If market prices move
away from the order, the order submitter may cancel and resubmit the order
at a new limit price that reflects the changing consolidated BBO.
Consequently, the same person potentially may cancel and resubmit an order
several times to maintain the aggressiveness of the limit price. These
cancellations can make it difficult to evaluate overall fill rates and
cancellation rates.

52 The proposed
rule incorporated a 30-minute time period for calculating average realized
spread. Several commenters suggested that, given the volatility of stock
prices, five minutes would be a more appropriate time period and would
generate more useful information. ICI Letter, note 15 above, at 4; Rock
Island Letter, note 17 above, at 2. The Commission agrees and has
incorporated a five-minute time period in the Rule as adopted.

53 See, e.g.,
NYSE Letter, note 17 above, at 9-10; NASD Letter, note 49 above, at 4-5;
SIA Market Structure Committee Letter, note 21 above, at 4.

54 For example,
if local traders at a particular market center display a great deal of
expertise in deciding when to step ahead of displayed limit orders, the
average realized spread for those limit orders would be comparatively high
(they would almost always be executed only when the market was moving
significantly against them).

55 See, e.g.,
TAG Letter, note 17 above, at 5; Edward Jones Letter, note 15 above, at 3.

56 See, e.g.,
NASD Letter, note 49 above, at 5; Schwab Letter, note 21 above, at 9-10.

57 Section
11A(a)(3)(B) of the Exchange Act authorizes the Commission, by rule or
order, to require SROs to act jointly with respect to matters as to which
they share authority in planning, developing, operating, or regulating the
national market system.

58 See, e.g.,
Letter from Edward J. Nicoll, Chairman and CEO, Datek Online Holdings
Corp., to Jonathan G. Katz, Secretary, SEC, dated Sept. 25, 2000, at 1
(“Datek Letter”); Letter from James H. Lee, President Momentum
Securities, LLC, to Jonathan G. Katz, Secretary, SEC, dated Oct. 11, 2000,
at 5; ICI Letter, note 15 above, at 5.

59 NASD Letter,
note 49 above, at 4; CHX Letter, note 25 above, at 11; Edward Jones
Letter, note 15 above, at 4.

60 Morgan
Stanley Letter, note 15 above, at 15; Schwab Letter, note 21 above, at
3-4; Wilkie Farr & Gallagher Letter, note 29 above, at 3.

61 To include
Nasdaq SmallCap equities, paragraph (a)(1)(i) of Rule 11Ac1-6 incorporates
the language of current Rule 11Ac1-1(a)(1) – “any other security for
which a transaction report, last sale data or quotation information is
disseminated through an automated quotation system as described in Section
3(a)(51)(A)(ii) of the Act.” This language covers SmallCap equities,
but excludes equities quoted on the OTC Bulletin Board operated by the
NASD. To include option securities, paragraph (a)(1)(ii) of the Rule
includes “any option contract traded on a national securities
exchange for which last sale reports and quotation information are made
available pursuant to a national market system plan.” This language
includes any option securities for which market information is
disseminated on a real-time basis pursuant to the national market system
plan administered by the Options Price Reporting Authority (“OPRA”).

62 In
addition, a new paragraph (d) has been included in the Rule explicitly
providing that the Commission may exempt any person, security, or
transaction, or any class or classes of persons, securities, or
transactions, from any provision or provisions of Rule 11Ac1-6. Such an
exemption will be granted if the Commission determines that it is
necessary or appropriate in the public interest, and is consistent with
the protection of investors.

63 The term
“venue” is intended to be interpreted broadly to cover
“market centers” within the meaning of Rule 11Ac1-5(a)(14), as
well as any other person or entity to which a broker routes non-directed
orders for execution. Consequently, the term excludes an entity
that is used merely as a vehicle to route an order to a venue selected by
the broker-dealer. Interpretive issues may arise in determining the
applicability of the Rule when a person or entity trades under the
auspices of an exchange. To assure meaningful disclosure of significant
execution venues, all orders routed to a particular exchange for execution
should be aggregated when calculating a broker-dealer’s top ten market
centers and those with 5% of orders. If a particular market maker or
dealer at the exchange receives orders pursuant to any arrangement that
gives it a preference to trade with the order as principal, such
arrangement must be specifically included in the discussion of the
relationship between broker-dealer and venue that is required by Rule
11Ac1-6(b)(1)(iii).

64 Schwab
Letter, note 21 above, at 5.

65 Interpretive
issues could arise in the case of an order that is routed to multiple
venues by the broker-dealer (if an execution venue alone makes the
decision to forward an order to a second venue, the second venue generally
would not be included in a broker-dealer’s report). If an order is
executed after being routed by the broker-dealer to multiple venues, the
venue that executed the order should be considered the venue to which the
order was routed for purposes of the Rule. If an order is not
executed after being routed to multiple venues (e.g., it was
cancelled or expired), the first venue should be considered the venue to
which the order was routed for purposes of the Rule. The Commission’s
staff will be available to provide further interpretive guidance on
compliance with the Rule.

66 Currently,
Rule 10b-10(a)(1) requires a broker-dealer to include the time of
transaction on the confirmation of a transaction or a statement that the
time of transaction will be furnished on written request. To assure
consistency, paragraph (a)(9) of Rule 11Ac1-6 adopts the definition of the
term “time of the transaction” set forth in Rule 10b-10(d)(3) –
“the time of execution, to the extent feasible, of the customer’s
order.” Broker-dealers must maintain customer order information to
comply with Rule 10b-10 and other existing regulatory requirements. The
Commission therefore disagrees with a commenter’s assertion that the
“on request” disclosures of Rule 11Ac1-6 would be costly and
redundant. Schwab Letter, note 21 above, at 6. Another commenter doubted,
as a matter of agency law, that “any firm would presently fail to
honor such a customer request.” Datek Letter, note 58 above, at 5.

67 44 U.S.C.
3501 et seq.

68 44 U.S.C.
3507.

69 5 U.S.C.
552 et seq.

70 Knight
Trading Letter, note 17 above, at 6, 9.

71 ICI Letter,
note 15 above, at 5.

72 TAG Letter,
note 17 above, at 2.

73 See,
e.g., Charles Schwab Letter, note 21 above, at 12; CHX Letter, note
25 above, at 6; Morgan Stanley Letter, note 15 above, at 18; Letter from
Deborah A. Lamb, Chair, Advocacy Advisory Committee, and Maria J.A. Clark,
Associate, Association for Investment Management and Research, to Jonathan
G. Katz, Secretary, SEC, dated Sept. 22, 2000, at 3-4.

74 Wilkie Farr
& Gallagher Letter, note 29 above, at 4.

75 CHX Letter,
note 25 above, at 6.

76 Phlx
Letter, note 25 above, at 3.

77 In its
comment letter, BRUT ECN disputed the Proposing Release’s estimate of six
hours per month to collect the data necessary to generate the monthly
reports. It stated that its compliance would require “upwards of 100
hours initially to ensure for the efficient generation of required data,
although said process would streamline future compliance efforts.”
Letter from William O’Brien, Senior Vice President & General Counsel,
The BRUT ECN, L.L.C., to Jonathan G. Katz, Secretary, SEC, dated Oct. 5,
2000, at 1 n. 3 (“BRUT Letter”). To reflect the potential for
upfront preparations to comply with data collection requirements, the
estimated burden of compliance in section VI.B below has been updated.

78 For
example, NASD rules require members trading Nasdaq securities to submit
electronic data on individual order executions to the NASD pursuant to its
Order Audit Trail System (“OATS”) requirements. NASD Rules
6950-6957. This data includes the basic order information that would be
necessary to calculate the statistical measures of execution quality
required by Rule 11Ac1-5. One commenter stated that it believed “the
NASD’s OATS project, which entailed the development of data collection and
warehousing on a similar scale, is a useful comparison of the development
costs” of Rule 11Ac1-5. Schwab Letter, note 21 above, at 12. Market
centers that already comply with the OATS data requirements, however, will
have the Nasdaq order information necessary to comply with the data
collection requirements of Rule 11Ac1-5.

79 The CHX
stated that the Proposing Release’s “estimate of six hours per month
for each market center to generate the required reports seems to us
unrealistically low.” CHX Letter, note 25 above, at 6. The Proposing
Release, however, separately addressed the issues of (1) data collection
and (2) generation of the monthly reports from such data. The estimate of
six hours per month applied solely to the burden of data collection.
After the data is collected by market centers, it can be transferred to
third party vendors with programs in place to generate the necessary
reports. The Proposing Release estimated that vendors could provide this
service for approximately $2500 per month.

80 See,
e.g., Morgan Stanley Letter, note 15 above, at 15; NASD Letter,
note 49 above, at 4; CBOE Letter, note 47 above, at 4-5.

81 Schwab
Letter, note 21 above, at 6. In addition, another commenter believed that
the proposed retention period of six months was “onerous and
unnecessary” and that a 90-day time period would be sufficient.
Edward Jones Letter, note 15 above, at 5. The Commission has retained the
six-month period to assure that individual customers, after having an
opportunity to review the quarterly reports giving a general overview of
their broker-dealers’ order routing practices, can obtain information
concerning their own orders for the full period covered by the quarterly
report.

82 Datek
Letter, note 58 above, at 5.

83 See
BRUT Letter, note 77 above, at 1.

84 These
figures could vary substantially among market centers. In addition, some
SROs may provide this data collection service for their members because
such centralized data collection is more efficient than data collection by
individual members.

85 This
estimate is based on FYE 1999 FOCUS Reports received by the Commission.
While there are currently approximately 7500 broker-dealers registered
with the Commission, only approximately 3800 broker-dealers potentially
route non-directed orders in covered securities.

86 Securities
Exchange Act Release No. 40122 (June 30, 1998), 63 FR 35508, n. 65.

87 This
estimate is based on FYE 1999 FOCUS Reports received by the Commission.

88 As set out
more specifically in section III.C above, the required disclosures will
reflect statistical measures of such things as number of orders, number of
shares, number of cancelled orders, size of spreads, frequency and size of
price improvement, frequency of executions at the quote, frequency of
executions outside the quote, and speed of execution (both with and
without price improvement).

89 These
savings are based on a sample of market orders for 10 high-volume Nasdaq
securities from June 2000, and represent the projected benefits summed
over all Nasdaq stocks for one year. The annual savings exclude changes in
effective spread for marketable limit orders and for any trade greater
than 4999 shares.

90 Under this
assumption, annual savings to Nasdaq investors would be approximately $175
million. These savings are calculated in the manner described in the
preceding note.

91 Mercatus
Center Letter, note 29 above, at 16.

92 The
Mercatus Center’s comment letter addresses the potential benefits
associated with more frequent rebalancing, but ignores the potential
changes in securities that investors choose.

93 Yakov
Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread,
17 J. Financial Economics 223 (1986).

94 Michael J.
Brennan & Avanidhar Subrahmanyam, Market Microstructure and Asset
Pricing: On the Compensation for Illiquidity in Stock Returns
, 41 J.
Financial Economics 441 (1996).

95 Both
studies examine cross-sectional differences in required returns associated
with cross-sectional differences in transaction costs so their empirical
estimates may not be indicative of the size of the reduction in
market-wide required returns that would accompany a market-wide reduction
in transaction costs.

96 Mercatus
Center Letter, note 29 above, at 18; Phlx Letter, note 25 above, at 3;
Morgan Stanley Letter, note 15 above, at 18; Wilkie Farr & Gallagher
Letter, note 29 above, at 4.

97 For
example, NASD rules require members trading Nasdaq securities to submit
electronic data on individual order executions to the NASD pursuant to its
Order Audit Trail System requirements. NASD Rules 6950-6957. This data
includes the basic order information that would be necessary to calculate
the statistical measures of execution quality required by Rule 11Ac1-5.

98 A higher
average rate of internal staff costs is used for the preparation of
quarterly reports based on the assumption that they would be prepared, at
least in part, by higher level staff than that involved with responding to
customer requests.

99 15 U.S.C.
78w(a).

100 15 U.S.C.
78c(f).

101 5 U.S.C.
601 et seq.

102 Morgan
Stanley Letter, note 15 above, at 18; Wilkie Farr & Gallagher Letter,
note 29 above, at 4.

103 Exchange
Act Rule 0-10(b), 17 CFR 240.0-10(c).

104 These
estimates are based on the FYE 1999 FOCUS Reports received by the
Commission from exchange market makers, OTC market makers, and ATSs that
would be subject to Rule 11Ac1-5.

105 17 CFR
240.0-10(e).

106 This
estimate is based on the FYE 1999 FOCUS Reports received by the Commission
from broker-dealers subject to Rule 11Ac1-6.

107 These
estimates are smaller than those used generally to estimate the burden
costs for purposes of the Paperwork Reduction Act. Assuming any of the 41
small entities actually route non-directed orders on behalf of customers,
it is likely that the number of orders would be very small. The burden of
preparing quarterly reports and responding to customer requests would
therefore be substantially less than the overall industry average.

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