in Test Group 2, the Commission also does not believe that the Pilot is
likely to shrink margins. For these stocks the fee cap remains at
$0.0030, while exchanges are prohibited from paying rebates and
offering Linked Pricing. Consequently, the prohibition of rebates for
securities in this Test Group would conceivably allow the exchanges to
reduce fees to as low as $0.00025--if charged to both parties in a
transaction--without reducing the exchange's average net capture per
trade. While less likely given competitive dynamics, if the exchanges
wanted to increase their net capture, it is possible under the pilot
terms for total net capture in group one to be as high as $0.002 (if
both side were charged the maximum of $0.001), and in group two to be
$0.003, both of which are far in excess of the average net capture that
exchanges receive today. For these reasons, the Commission now expects
the effects of the Pilot on exchange revenue through impacting per-
trade margins to be minimal.
---------------------------------------------------------------------------

    \774\ See Proposing Release supra 1 at 13067.
    \775\ This was the case in Canada when in January 2017 the
Canadian Securities Administrators (CSA) approved the lowering of
the fee cap for non-interlisted Canadian stocks from $0.0030 to
$0.0017. In response to this regulation, the Toronto Stock Exchange
retained its $0.0004 margin per trade for continuous trading--high
priced securities ($1.00 and over) by lowering both fees and rebates
by $0.0008. Fees for taking liquidity on non-interlisted securities
reduced from $0.0023 to $0.0015 whereas rebates provided to
liquidity providers declined from $0.0019 to $0.0011. Fees and
rebates for inter-listed securities remained unchanged. See https://www.tsx.com/resource/en/1501.
---------------------------------------------------------------------------

    In addition, the Commission believes that the impact of the Pilot
on exchange revenues through changes in trading volume are difficult to
determine in advance, but recognizes that the magnitude of such changes
could be significant and some potential lost revenue could be in a
transfer to investors or among exchanges. The Commission considered
whether individual exchanges could experience a decline in trading
volume for four reasons, as multiple commenters suggested: If exchanges
lose volume to off-exchange venues, if volume declines because of
increased transaction costs, if the Pilot reduces excessive
intermediation, or if volume shifts among exchanges. The Commission
recognizes that the Pilot presents a risk that the Pilot could result
in less fee revenue for exchanges due to lower trading volumes.
However, the Commission believes that decreased trading volume, while
one possible outcome of the Pilot, is not the only reasonable outcome,
and that the ex ante effect of the Pilot on trading volume is difficult
to determine.
    First, several commenters stated that reducing or eliminating the
ability for exchanges to pay rebates may cause exchanges to become less
competitive relative to off-exchange venues like ATSs, which would not
be so constrained. The analysis in Section IV.D.2.a identifies
significant uncertainty in the potential for exchanges to be less
competitive relative to off-exchange venues such as ATSs, and
identifies conditions in which they could actually be more
competitive.\776\ Consequently, the Commission cannot determine in
advance of the Pilot whether exchanges will lose volume to off-exchange
venues.
---------------------------------------------------------------------------

    \776\ See Section IV.D.2.a. See also Section IV.C.2.b.iv
---------------------------------------------------------------------------

    Second, total trading volume, and consequently exchange revenue,
could decline if the Pilot increases transaction costs. A number of
issuers expressed the concern via comment letters that the Pilot would
lead to lower levels of trading volume because of their experience with
the Tick Size Pilot.\777\ However, not all issuers felt that the Pilot
would result in lower trading volumes. One issuer ``welcome[d] the
opportunity for [its] stock to be included in the Pilot'' and did not
``expect that a reduction or outright removal of rebates will have any
significant or harmful effects on . . . [its] stock's trading volume.''
\778\ On the other hand, if the Pilot decreases the cost of trading on
the exchanges, then the Pilot could increase trading volumes on the
exchanges. This view was expressed by one commenter who stated their
belief ``the Pilot will reduce the costs of trading on exchanges, which
may increase trading volumes on the exchanges.'' \779\ Lower costs of
trading, caused by the reduction in fees, might increase trading volume
on exchanges for at least two reasons. First, lower trading costs may
induce trades that would otherwise not have occurred by allowing
investors the ability to trade on smaller increments of information.
Lower trading costs may also induce the participation of new traders,
such as short-term traders for whom transaction costs are of greatest
concern, to transact in a given stock

who would not otherwise participate. Consequently, if the Pilot leads
to decreased trading costs, then trading volumes in those stocks may
increase--increasing exchange revenue. In Section IV.C.2.b.iv below,
the Commission discusses its belief that the effect of the Pilot on
liquidity and transaction costs is not clear and could either increase
or decrease. Given this uncertainty in the impact on liquidity, the
Commission cannot determine in advance whether the Pilot will result in
a reduction in liquidity that would reduce trading volume.
---------------------------------------------------------------------------

    \777\ See, e.g., Leaf Letter, at 1-2; Ennis Letter, at 2.
    \778\ T. Rowe Price Letter, at 4-5.
    \779\ See, e.g., TD Ameritrade Letter, at 7. Other commenters
also either expressed their belief that the Pilot would not reduce
trading volumes (see, e.g., IEX Letter II, at 8; T. Rowe Price
Letter, at 5) or expressed uncertainty about the outcome of the
Pilot on trading volume (see, e.g. Credit Suisse Commentary, at 5).
---------------------------------------------------------------------------

    Third, the Pilot may decrease trading volume, and thus exchange
revenues, if it results in a reduction in intermediation by market
makers for two reasons, but this would be a transfer to investors. The
first reason is that market makers from time to time will use
marketable orders to balance inventory. If these market makers decline
to participate due to reduced rebate incentives, then their marketable
orders will not arrive--diminishing trading volume. The second reason
decreased intermediation may lead to lower volumes is that non-market
makers might begin to execute their trades via non-marketable orders.
Non-market makers may submit marketable orders because of an inability
to achieve high fill rates with non-marketable limit orders due to
significant competition from market makers. The reduction in
intermediation may result in situations where two traders with
offsetting trades, who would have generated two separate trades with
market makers as the counterparty instead execute their trade with each
other resulting in one trade. This could occur, for example, if the
Pilot reduces queue lengths for investors as discussed in Section
IV.C.2.b.iv.(2) below. While this effect would result in a loss in
revenue to exchanges that would collect margin on a smaller number of
trades, it would be a net gain for investors because executions on a
smaller proportion of marketable orders would mean that the investors
pay less in transaction fees and would more often capture, or earn, the
spread where previously they would have paid the spread to transact.
    Fourth, even if overall trading volume does not decline or shift to
off-exchange venues during the Pilot, individual exchanges may
experience a decline in trading volume if the Pilot leads to a change
in market share among the lit exchanges. This mechanism is discussed in
Section IV.D.2.a. This section also highlights the difficulties in
determining the expected redistribution of market share among the
existing exchanges due to potentially countervailing economic effects.
To this point, one commenter noted that the loss in revenue estimated
above relied on ``exchanges' existing market share percentages'' which
``assumes that exchanges would remain equally competitive for order
flow.'' \780\ The Commission agrees that the Pilot may impact the level
and distribution of trading volume on lit exchanges but notes that such
a redistribution would be a transfer among exchanges rather than an
economic cost.
---------------------------------------------------------------------------

    \780\ NYSE Letter I, at 17.
---------------------------------------------------------------------------

    The Commission acknowledges that the reduction or elimination of
rebates may particularly affect smaller exchanges due to the liquidity
externality, especially if their primary competitive differentiation is
based upon a modified fee model. As discussed in the Proposing Release
liquidity tends to consolidate.\781\ Thus, the restrictions on rebates
resulting from the Pilot could harm smaller exchanges that may be
competing by paying large rebates rather than by producing better
prices or execution quality. In the short run, this could lead to lost
revenue for these exchanges. It could also have longer-term effects if
smaller exchanges consolidate or exit as a result of the Pilot.
However, the Commission does not believe that consolidation or exit is
likely during the pilot because only about a quarter of NMS stocks will
be included in test groups.
---------------------------------------------------------------------------

    \781\ See Proposing Release, supra note 2, at 13042.
---------------------------------------------------------------------------

    The Pilot could also impact exchanges' fee revenue after the
conclusion of the Pilot if as a result of the Pilot broker-dealers
permanently alter their order routing decisions after the Pilot is
completed. One commenter argued that this may be the case and suggested
that the Commission's claim that the Pilot's effect on broker-dealers'
routing decisions would be temporary ``[was] contradicted by the
Commission's own finding that broker-dealers would not change their
behavior unless the Transaction Fee Pilot lasts for at least one
year.'' \782\ To this point, given the competitive nature of financial
markets, the Commission does not expect that it would take most broker-
dealers up to one year to alter their behavior. Indeed, this commenter
supports this belief by stating that exchange and non-exchange trading
centers vigorously compete for trading volume, and that market
participants are sensitive to revisions in transaction-based pricing
models.\783\ Given this competition, the Commission believes market
participants will likely adjust their behavior quickly both upon the
implementation and conclusion of the Pilot, and that the Pilot duration
will incentivize broker-dealers not to ``wait out'' the Pilot who could
be otherwise inclined to do so if the duration were not sufficiently
long.\784\
---------------------------------------------------------------------------

    \782\ See NYSE Letter I, at 15-16.
    \783\ See State Street Letter, at 2.
    \784\ See Section IV.C.1.a.iii, supra.
---------------------------------------------------------------------------

    If the Pilot results in a decline in fee revenue for exchanges,
then this could lead to other costs borne by investors as a result.
Exchanges could promote additional order types and may even initiate
new types of markets as a result of the Pilot, which would only serve
to further fragment markets and add to their complexity, the costs of
which could be borne by investors.\785\ In particular, the Commission
recognizes the remote possibility that an exchange holding company
could attempt to optimize its overall performance during the Pilot by
further diversifying with other exchange models. The Commission
believes, however, that a new equity exchange registered in direct
response to the Pilot would be unlikely to become operational before
the conclusion of the Pilot. In addition, the Commission believes that
it is unlikely that exchanges will promote additional order types as a
result of the Pilot.
---------------------------------------------------------------------------

    \785\ See Section III.A. See also, e.g., Fidelity Letter, at 8.
---------------------------------------------------------------------------

    In sum, the Commission believes that the costs to the exchanges due
to narrower margins earned per trade are likely to be minimal--if any--
due to the removal of the proposed Test Group with the fee cap of
$0.0005. However, the Commission does expect that there could be a
change in trading volume or a redistribution of market share among
exchanges as market participants re-optimize their order routing
systems as a result of the Pilot. However, due to the reasons discussed
in this section, the Commission cannot determine in advance of the
Pilot whether these market share/trading volume changes will increase
or decrease exchange revenue. Consequently, the Commission acknowledges
that the Pilot may lead to lower trading volume/market share for
exchanges, which would impose a cost in terms of lost transaction fee
revenue, but is unable to quantify the expected magnitude of this
potential cost and no commenter provided an estimate of the amount of
the lost transaction fee revenue.
    While the Commission cannot determine in advance of the Pilot its
impact both in terms of direction and magnitude, the Commission has
attempted to estimate the costs should volume decline. Using data from
Table 3 in section IV.B.2.e the Commission

estimates an annualized upper bound on the profit earned from
transaction fees for each exchange. Aggregated across all exchanges
this number equals approximately $3 billion per year. However, only
about 1/4th of NMS securities will be in a test group subject to the
Pilot, so the Commission estimates the Pilot could affect the
approximately $750 million per year across all exchanges, depending on
how much volume changes. Consequently, if the Pilot were to cause a 10%
reduction in trading volume on exchanges then this change could reduce
fee revenue on the exchanges by approximately $150 million over two
years or $75 million if the Commission were to allow the Pilot to
automatically sunset at the end of the first year. However, the
Commission does not believe that the 10% reduction in trading volume is
a reasonable assumption. While the Swan Study shows that Nasdaq lost
10% of its volume using one volume measure, it lost only 200,000 shares
in another. In addition, the Swan Study finds no change in overall
volume or in off-exchange volume, just a migration from Nasdaq to other
exchanges. Therefore, the Commission does not believe that either the
10% volume reduction or, consequently, the estimate of $150 million
revenue reduction is reasonable.
ii. Broker-Dealer Systems Costs
    Although the costs of compliance with the Pilot will primarily
affect the exchanges, broker-dealers and other market participants are
also likely to incur costs as a result of the Pilot. Commenters
provided mixed information on the magnitude of these costs. While some
commenters stated that the costs to broker-dealers of the Pilot would
be substantial,\786\ other commenters stated that the costs for broker-
dealers associated with the Pilot would not be significant or expensive
because exchange fee schedules change regularly and broker-dealers are
used to adapting their order routing algorithms to new and changed fee
schedules.\787\ This section provides the Commission's estimates for
broker-dealer compliance costs associated with the Pilot.\788\
---------------------------------------------------------------------------

    \786\ See, e.g., Larry Harris Letter, at 10-11; STANY Letter, at
2; FIA Letter, at 3; Nasdaq Letter I, at 10; Nasdaq Letter III, at
9.
    \787\ See, e.g., Vanguard Letter, at 3; Healthy Markets Letter
I, at 34.
    \788\ One commenter stated that the Commission did not consider
implementation and coding costs. See STANY Letter at 2. However, the
commenter does not elaborate on why the Proposing Release estimates
of $3,741,000 implementation costs for broker-dealers to adjust
their order routing systems at the beginning and end of the Pilot
and the $20,726,000 costs for broker-dealers to update their order
routing systems for fee changes during the Pilot failed to consider
implementation and coding. See Proposing Release, supra note 2, at
13063-13064.
---------------------------------------------------------------------------

    In response to the Pilot, market participants might have a one-time
cost at the onset and the conclusion of the Pilot to adjust their
systems to reflect the shocks and potential additional complexity of
transaction-based fees. In addition, there may be additional
modifications to routing strategies that are made in subsequent months
to adjust to changing liquidity dynamics as behavior changes associated
with the pilot settle in. Many broker-dealers have smart-order routing
systems that use algorithms to route orders based on certain criteria,
such as fill rates, time to execution, lowest fees, or highest
rebates.\789\ One commenter agreed, stating that such systems changes
``should primarily consist of modifications to the routing tables and
other associated operational activities.'' \790\ The Commission
understands that some of the associated changes and modifications may
already be coded into the smart order router (SOR) algorithms such that
changes to associated liquidity shifts may be dynamic and automated,
i.e., in need of little additional modification.
---------------------------------------------------------------------------

    \789\ See Bacidore, Jeff, Hernan Otero, and Alak Vasa, 2011,
Does smart routing matter ?, Journal of Trading 6, 32- 37.
(available at http://jot.iijournals.com/content/6/1/32), which found
that smart-order routers designed to maximize rebates delivered
worse execution quality to their clients.
    \790\ See FIF Letter at 8. See also FIA Letter at 3; Nasdaq
Letter I at 10.
---------------------------------------------------------------------------

    To estimate these costs, the Commission assumes (1) that all
broker-dealer members of exchanges will adjust their systems for the
pilot and (2) that all broker-dealer members of exchanges have
automated order routing systems.\791\ While the Pilot does not directly
require broker-dealers to adjust their systems, the Commission expects
broker-dealers who do not update their systems may incur significant
costs relative to those who do in terms of potential impacts on
execution quality and in their ability to manage fees and rebates.
Broker-dealers might choose to adjust their systems for the Pilot for
many reasons, including to recognize that the Pilot could affect
execution quality for investors and/or to better manage fees and
rebates.\792\ Therefore, the cost estimates assume that broker-dealers
will adjust to their existing systems to capture changes in fees and
rebates associated with each Test Group of securities, rather than
bearing start-up costs associated with implementing new order routing
systems.
---------------------------------------------------------------------------

    \791\ Even in the absence of smart-order routers, broker-dealers
could still adjust their execution determinations to take advantage
of the changes implemented during the Pilot and these adjustments
would incur costs. While the Commission does not estimate these
particular costs, the assumption that all broker-dealers have
automated order routing systems is reasonable and is necessary to
enable the estimation of cost estimates. The Commission believes,
however, that the costs to adjusting manual systems could be lower
than the costs to adjust automated routing systems. If any broker-
dealers still route orders manually, they likely do so because
setting up and maintaining manual systems is not economical for
them. It is likely that such firms utilize exchange routing
services.
    \792\ See sections IV.C.1.a.iii and IV.E.5.a for additional
discussion.
---------------------------------------------------------------------------

    In its estimates, the Commission recognizes that the costs
associated with adjusting the execution algorithms by broker-dealers
for the Pilot are likely to be more costly than the periodic updates
that broker-dealers may make to incorporate changes to fee schedules
implemented by exchanges or to fine tune their strategies. The
additional expected costs may occur because changes for the Pilot are
likely to require more complex programming that segments stocks into
different fee regimes (assuming exchanges implement fees customized to
each Test Group), rather than just altering codes or inputs. As of July
2017, exchanges have 18 fee categories and 21 rebate categories, on
average.\793\ If exchanges maintain the same level of complexity in
their fee schedules during the Pilot, up to a two-fold increase in the
number of fee and rebate categories could occur, which would increase
complexity for broker-dealers who incorporate fees into their order
routing decisions.\794\ Additionally, the Commission agrees with the
commenter who stated that, to the extent that broker-dealers' order
routing algorithms are programmed to the exchange, and not the
individual security, the Pilot will increase complexity by requiring an
adjustment to this methodology.\795\ The Commission estimates that the
costs to broker-dealers that are members of exchanges to make the
initial adjustment to their order routing systems at the outset of the
Pilot would be approximately $9,000 per broker-dealer, or $3,573,000 in
aggregate across the 397 broker-dealers that are currently members of
equities exchanges.\796\ The

Commission further estimates that broker-dealers would bear a similar
cost to adjust their order routing systems at the conclusion of the
Pilot.
---------------------------------------------------------------------------

    \793\ See Table 2 in Section IV.B.2.f supra.
    \794\ In addition, the Commission recognizes the potential costs
to exchanges of this complexity above in Section IV.C.2.a.
    \795\ See Larry Harris Letter, at 10-11.
    \796\ This estimate is based on the following, which reflects
the Commission's experiences with and burden estimates for broker-
dealer systems changes: [(Attorney (5 hours) x $401) + (Compliance
Manager (10 hours) x $298) + (Programmer Analyst (10 hours) x $232)
+ (Senior Business Analyst (5 hours) x $265)] [ap] $9,000 per
broker-dealer that is a member of at least one exchange. As of
December 31, 2016, 397 unique broker-dealers were members of
exchanges (Form X-17a-5). The aggregate costs of updating order
routing systems to reflect the Transaction Fee Pilot requirements
would cost $9,000 x 397 [ap] $3,573,000. Note that smaller broker
dealers will often use the smart order router of larger broker
dealers or those offered by exchanges, and will therefore benefit
indirectly from the work done by the providers of their smart order
routing services.
---------------------------------------------------------------------------

    Additionally, the Commission expects that broker-dealers would
update their order routing systems with changes to fees or rebates
submitted by exchanges through Form 19b-4 fee filings to the Commission
during the Pilot. As discussed in the baseline, exchanges, on average,
make changes to fees or rebates approximately seven times per year;
therefore, broker-dealers are likely to have experience in updating the
order routing systems to reflect these routine changes to fees and
rebates.\797\ As in the estimates of the costs of the initial and final
adjustments, broker-dealers are likely to face higher costs per update
as a result of the Pilot because of the added complexity of having to
update multiple modules within their order routing systems. The
Commission's estimates of these updates assume that exchanges update
their fees schedules as often during the pilot as at present.
Therefore, the costs to broker-dealers associated with the Pilot are
the additional costs associated with the complexity of the updates and
not the total cost of the updates.\798\ In other words, broker-dealers
would have updated their systems (or routing tables) anyway in the
absence of the Pilot to reflect the same number of exchange fee and
rebate changes. The Commission estimates described below reflect the
additional cost of the Pilot (``additional costs''), which is how much
more an update might cost during the Pilot compared to a scenario
without the Pilot.
---------------------------------------------------------------------------

    \797\ Several commenters made similar statements. See, e.g.,
Vanguard Letter, at 3; Healthy Markets Letter I, at 34.
    \798\ The Commission cannot estimate and commenters provided no
insight into the degree to which the number of fee and rebate
revisions by exchanges will increase or decrease during the Pilot.
---------------------------------------------------------------------------

    The Commission believes that the per-update additional costs
associated with these changes are likely to be a small fraction of the
costs associated with the initial costs of adjusting the routing
systems to reflect the required fee and rebate revisions at the outset
of the Pilot. The Commission estimates that the additional costs to
broker-dealers that are members of exchanges to make periodic
adjustments to their order routing systems to reflect changes in fees
and rebates would be $265 per adjustment, or approximately $105,000 in
aggregate across the 397 broker-dealers that are members of U.S.
equities exchanges.\799\ As shown above, the Commission expects that
exchanges, if submitting changes to fees and rebates at the same rate
as they have in the last five years, would submit 182 total revisions
to fees and rebates over the two-year pilot duration. Therefore, the
aggregate costs of updating order routing systems would be $48,000 per
broker-dealer, or $19,056,000 in total across all broker-dealers.\800\
If the Pilot were to automatically sunset at the end of the first year,
the aggregate costs of updating order routing systems would be $24,000
per broker-dealer, or $9,528,000 in total across all broker-dealers.
---------------------------------------------------------------------------

    \799\ This estimate is based on the following, which reflects
the Commission's experiences with and burden estimates for broker-
dealer systems changes: [(Compliance Manager (0.5 hours) x $298) +
(Programmer Analyst (0.5 hours) x $232)] = $265 per broker-dealer
that is a member of at least one exchange. The aggregate costs
updating order routing systems to reflect the periodic fee and
rebate revisions would cost $265 x 397 [ap] $105,000.
    \800\ If 182 total fee and rebate changes were to occur over the
duration of the Pilot (13 equities exchanges x 7 revisions per year
x 2 years = 182), each broker-dealer would bear costs of updating
its order routing systems of $265 x 182 [ap] $48,000, or $19,056,000
($48,000 x 397) in aggregate across all broker-dealers over the
first year of the Pilot. The Commission estimates that costs would
be $9,528,000 ($265 x 13 exchanges x 7 updates x 397 broker-dealers)
if the Commission determined that Pilot automatically sunset at the
end of the first year.
---------------------------------------------------------------------------

    In sum the Commission believes that the all in costs to broker-
dealers of updating their order routing systems as a result of the
Pilot will average approximately $66,000 per broker-dealer to update
their systems over the entire Pilot Period. If the Pilot automatically
sunsets at the end of the first year, the costs associated with these
updates will be approximately $42,000 per broker-dealer.\801\ The
Commission notes that these estimates may be overstated. Not all
broker-dealers are members of all exchanges, which would reduce the
total number of changes to the order-routing systems that they would
implement. Additionally, the exchanges could resort to more simplified
fee schedules relative to the current baseline, which would reduce
broker-dealers' costs of updating their systems for the Pilot.
---------------------------------------------------------------------------

    \801\ These costs reflect the estimated cost of $9,000 at the
outset of the Pilot to update the order routing system to reflect
the changes to the fee structure for securities in the test groups,
$48,000 to reflect the incremental costs of the estimated 182
revisions to fee schedules during the Pilot ($265 per revisions x 7
revisions per year x 2 years x 13 exchanges), and $9,000 at the
conclusion of the Pilot to unwind changes to the order routing
systems, for a total of $66,000 per broker-dealer. If the Pilot were
to automatically sunset at the end of one year, then these costs
would be approximately $42,000 ($265 x 7 revisions x 13
exchanges+2*$9,000) per broker-dealer.
---------------------------------------------------------------------------

iii. Temporary Increase in Brokerage Commissions
    Beyond the implementation and compliance costs for exchanges and
broker-dealers associated with the Pilot, the changes to the exchange
transaction-based fee and rebate structure could lead to temporary
increases in brokerage commissions charged to their customers. Several
studies show, and several commenters concurred, that brokerage
commissions today are at historically low levels.\802\ Brokerage
clients may have a preference for low commissions with services
provided by broker-dealers, and in turn, may allow broker-dealers to
capture rebates (and bear the costs of access fees), either through
explicit contracts or implicit agreements.\803\ As a result, the Pilot
could lead to higher overall commissions as rebates obtained by broker-
dealers fall,\804\ thereby temporarily reducing the overall welfare of
retail brokerage clients as a result of increased commissions.\805\
---------------------------------------------------------------------------

    \802\ See, e.g., Angel, Harris, & Spatt, supra note 530.
    \803\ See Regulation NMS Subcommittee Recommendation for an
Access Fee Pilot (June 10, 2016), available at https://www.sec.gov/spotlight/emsac/emsac-regulation-nms-recommendation61016.pdf (``June
Recommendation''). See also Shawn O'Donoghue, 2015, ``The Effect of
Maker-Taker Fees on Investor Order Choice and Execution Quality in
U.S. Stock Markets'', Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2607302.
    \804\ Several commenters made similar statements. See, e.g.,
NYSE Letter I, at 13; ASA Letter, at 2.
    \805\ The Commission acknowledges differing effects on brokerage
commissions could occur as a result of the Pilot depending on
whether the client is a retail customer versus an institutional
customer. For instance, some brokerage accounts charge per-
transaction commissions to retail clients. Institutional
commissions, on the other hand, are highly negotiated and may be
based on something other than a per trade or per share basis, such
as a flat fee for use of a broker's order routing algorithm;
however, data on the structure or magnitude of institutional
commissions is not publicly available.
---------------------------------------------------------------------------

    For instance, the elimination of rebates and Linked Pricing in Test
Group 2 could result in a transfer from broker-dealers to exchanges.
Assuming, as discussed above, the margin between fees and rebates is
approximately $0.0002 per share,\806\ with transaction fees of $0.0030
per share and rebates of $0.0028 per share, Test Group 2 could result
in a transfer of $0.0028 from broker-dealers to the exchanges with

respect to their passively posted non-marketable orders, particularly
because exchanges would be prohibited from offering Linked Pricing
mechanisms that could act as substitutes for cash rebates.\807\ The
estimates of the potential increased revenue to exchanges are as
follows.
---------------------------------------------------------------------------

    \806\ There are approximately 8,000 NMS securities and just
under 800 will be included in Test Group 2.
    \807\ Although the Commission believes that competition among
exchanges would drive transaction fees down for Test Group 2 as a
result of the elimination of rebates, exchanges could charge
transaction fees as high as the current cap of $0.0030.
---------------------------------------------------------------------------

    Assuming that the share volume in Test Group 2 would be
approximately 12.5% of the total share volume across all
securities,\808\ using data from Table 2 in the baseline, Test Group 2
would have share volume of approximately 11.5 billion each month.\809\
If the margin between fee revenue and rebate cost is $0.0002, as
discussed above, then under the assumption that exchanges reduce fees
to $0.0002 in Test Group 2, the Commission anticipates no change in
revenue for exchanges, and no transfer from broker-dealers. If,
instead, exchanges charged the maximum fees of $0.0030 while they are
prohibited from paying rebates or Linked Pricing in Test Group 2, the
Commission estimates a monthly aggregate increase in revenues across
all exchanges of $32,200,000.\810\ If the volume on each exchange does
not change, then the estimated annual average increase in revenues
across all exchanges would be $386.4 million [$32,200,000 x 12 =
$386.4M]. This transfer of rebates from the broker-dealers to exchanges
could potentially increase exchange revenue by approximately
64.1%.\811\ Moreover, these costs could likely fall to investors in the
form of higher commissions or fees charged to cover the decrease in
broker-dealer revenue due to losses in rebates for securities in Test
Group 2.\812\
---------------------------------------------------------------------------

    \808\ As designed, the Pilot would allocate an equal number of
securities to the two test groups and the control group (e.g., the
test groups combined would have approximately 25% of the NMS
securities and the control group would have 75%). Each test group
will have one-half of the combined test group allocation, thereby,
in total leaving each test group with 12.5% of NMS securities
included in the pilot. Assuming that the allocation of share volume
would be similar due to the stratification of the sample discussed
above, each test group would have approximately 12.5% of total share
volume each month.
    \809\ Table 2 in the baseline shows aggregate exchange share
volume for July 2017 was 91.7 billion shares, of which 12.5% would
be 11.5 billion shares. Further, the Commission estimates that these
volume figures would be similar across all months, assuming no
seasonality in share volume.
    \810\ If Test Group 2 has monthly share volume of 11.5 billion
shares, and the margin would increase by $0.0028 ($0.0030--$0.0002),
the revenue increase per month is estimated to be 11.5 billion x
$0.0028 [ap] $32,200,000.
    \811\ As discussed in section IV.B.2.d, the net of rebate
revenue for NYSE (NYSE, NYSE Arca, NYSE American, and NYSE
National), Nasdaq (Nasdaq, BX, and PSX), and Cboe (Cboe BZX, Cboe
BYX, Cboe EDGA, and Cboe EGDX), was $602 million during 2017 ($196M
+ $253M + $153M). If the estimated margin increased by $386.4
million, then the percentage increase in this margin would be $386.4
million/$602 million [ap] 64.1%.
    \812\ Consistent with this idea one commenter suggested that,
any benefits or costs accruing to broker-dealers as a result of
changes in fees and rebates are likely to be passed onto their
customers. See Decimus Letter, at 2.
---------------------------------------------------------------------------

    The Commission further acknowledges that if brokerage commissions
were to increase as a result of the Pilot, broker-dealers could
continue to charge higher commissions even after the conclusion of the
Pilot. However, due to competition among broker-dealers, including the
proliferation of low-cost online broker-dealers, the Commission
believes that broker-dealers would be unlikely to significantly
increase brokerage commissions as a result of the Pilot.\813\
---------------------------------------------------------------------------

    \813\ See supra Section IV.B.2. and IV.D.2. (discussing the
competitive environment for broker-dealer services). But cf. Decimus
Letter, at 2-4; NYSE Letter I, at 13; ASA Letter, at 2 (noting the
possibility that commissions would increase).
---------------------------------------------------------------------------

    Lastly, the Commission acknowledges that brokerage commissions may
decrease during the Pilot if the Pilot results in lower execution costs
for some test groups, then those lower costs may be passed on to
investors in the form of lower commissions. For example, if a broker-
dealer pays the transaction fee more often than they earn the rebate,
the reduction of fee caps would reduce the cost of transacting for this
broker-dealer, which the broker-dealer may pass onto investors in the
form of lower commissions.\814\
---------------------------------------------------------------------------

    \814\ See Decimus Letter, at 2-4.
---------------------------------------------------------------------------

iv. Temporary Reduction in Liquidity
    The effect of the Pilot on liquidity is uncertain as there are
reasons why the Pilot may increase as well as decrease liquidity.
Several commenters expressed concern that the Pilot would reduce
liquidity. These commenter statements largely focus on the impact of
the reduction or elimination of rebates. In considering the comments,
and as analyzed in the following sections, the Commission considered
the impact of the direct effect of rebates on quoted spreads, the
impact of a loss of liquidity provision on quoted spreads and depth,
the impact of changes in adverse selection on transaction costs, and
the impact of potential conflicts of interest on execution quality. In
addition, the Commission analyzed estimates of the costs of a potential
reduction in liquidity provided by commenters.
    The Pilot could result in a positive, negative, or neutral change
in liquidity for the stocks in test groups. Adding to this uncertainty,
some commenters felt that to the extent that there are liquidity
effects, such effects would be minimal.\815\ Also, the impacts of the
Pilot on liquidity may not be uniform across all securities and several
commenters believed that widening of spreads would be limited to a
small number of securities. Some commenters stated that the widening of
spreads is unlikely to affect the most and least liquid securities, or
will not adversely affect liquidity at all.\816\ Further, as some
commenters explained, less liquid stocks tend to have wider spreads,
and therefore, the impact of rebates as an incentive to provide
liquidity may become less relevant for these securities.\817\
---------------------------------------------------------------------------

    \815\ See, e.g., Angel Letter II, at 3.
    \816\ See, e.g., Citigroup Letter, at 3; Credit Suisse Letter,
at 1; Decimus Letter, at 4; MFS Letter, at 1.
    \817\ See, e.g., IEX Letter II, at 5; Credit Suisse Commentary,
at 3.
---------------------------------------------------------------------------

(1) Direct Impact of Fees and Rebates on Quoted Spreads
    The Commission believes the impact of the Pilot on liquidity and
transaction costs through a direct adjustment of the quoted prices is
uncertain. One study argues that transaction-based rebates may
artificially narrow the quoted spread on make-take exchanges by the
amount of the rebate.\818\ This effect would particularly impact retail
investors whose orders are largely internalized at the best quoted
prices. However, whether rebates can effectively narrow quoted spreads
in a given stock depends on whether that stock's natural quoted spread
(without artificial narrowing) is constrained by the tick size. For
example, if a stock has a natural quoted spread of less than one penny,
which is the minimum tick size, then rebates cannot possibly
artificially narrow the quoted spread. Many of the most active stocks
have average quoted spreads very close to a penny and the Commission
believes that the natural spread in some of these stocks could be at or
less than a penny. Consequently, the Commission believes that rebates
might not artificially narrow spreads in at least some of the most
active stocks and, therefore, that the Pilot might not result in wider
quoted spreads in all stocks.\819\
---------------------------------------------------------------------------

    \818\ See Angel, Harris, & Spatt, supra note 530.
    \819\ See also TD Ameritrade Letter, at 3 (concurring with the
view that the Pilot is less likely to affect highly liquid
securities).
---------------------------------------------------------------------------

(2) Potential Reduction in Liquidity Provision
    The Commission recognizes that the Pilot could reduce the
incentives to

provide liquidity, but believes that the impact of this reduced
incentive on quoted spreads and transaction costs could be positive or
negative and could vary across securities. In particular, the
Commission believes that despite a potential reduction in liquidity
provision, some investors could actually experience lower or higher
transaction costs in some securities for several reasons. Generally,
this section provides reasons to expect an increase in transaction
costs as well as reasons to expect a decrease in transaction costs.
Likely, several of these effects will offset to create a new
equilibrium, but the Commission cannot predict whether investors will
face higher or lower transaction costs in this new equilibrium.
    First, some commenters stated that the removal of rebates could
cause some liquidity providers to stop providing liquidity, which would
result in a temporary increase in transaction costs during the Pilot as
the remaining liquidity providers would face less competition for their
services and therefore could charge wider spreads to liquidity
demanders.\820\ One Commenter suggested that this effect could be seen
by comparing spreads on non-rebate exchanges like Cboe EDGA with the
rebate paying exchange Cboe EDGX. The Commenter noted that average
spreads on Cboe EDGX tend to be lower than those on Cboe EDGA.\821\
However, the Commission does not believe that this data point provides
robust evidence that spreads will widen across all securities because
EDGA and EDGX tend to trade securities with different characteristics,
consistent with another commenter who stated that ``EDGA only traffics
in the most liquid names'' consequently comparing average spreads on
EDGA and EDGX is not appropriate. Additionally this analysis does not
establish a causal link between rebates and quote quality.\822\
---------------------------------------------------------------------------

    \820\ See also Pragma Letter, at 2; Magma Letter, at 2; STA
Letter, at 3; STANY Letter, at 2; Morgan Stanley Letter, at 3-4;
Energizer Letter, at 1.
    \821\ See NYSE Letter II, at 2, 9. See also, Nasdaq Letter III,
at 4-6 (presenting similar data suggesting that quote quality on
make-take exchanges is better than on inverted exchanges).
    \822\ See section IV.C.1.a.ii.(3) for a discussion on causality,
See also Mulson Letter II, at 1.
---------------------------------------------------------------------------

    The Commission notes that a reduction in liquidity provision might
not result in wider quoted spreads and greater transaction costs,
particularly in more active securities. In particular, as suggested by
some commenters, if rebates result in excessive intermediation,\823\ or
if ``natural'' buyers and sellers set quoted prices,\824\ a reduction
in rebates need not widen quoted spreads and increase transaction costs
and could actually reduce transaction costs to the benefit of
investors. Excessive intermediation makes it more difficult for non-
market makers to get passive orders to the front of the queue and could
induce them to cross the spread to trade aggressively a greater
fraction of the time. If a reduction in rebates can result in less
excessive intermediation, then a reduction in liquidity provision by
market makers might not adversely impact transaction costs but could
instead decrease queue lengths faced by non-market maker liquidity
providers such as institutional investors. This could allow investors
trading test group stocks to potentially experience better execution
quality because they could be able to obtain better queue priority on
their passive orders. Better queue priority would both diminish adverse
selection costs for passive orders and also decrease the fraction of
time investors are required to pay the spread and potential take fee to
execute a trade.\825\ The Commission does not have the data necessary
to empirically analyze whether rebates indeed result in excessive
intermediation, but expects the Pilot to facilitate such analysis.
---------------------------------------------------------------------------

    \823\ See NYSE Letter II, at 4 (noting that ``some institutions
believe maker-taker pricing unnecessarily subsidizes quoting in
sufficiently liquid securities, resulting in `excessive
intermediation' that crowds out long-term investor participation in
the market.''). See also T. Rowe Price Letter, at 2.
    \824\ See, e.g., Mulson Letter.
    \825\ See Pragma Letter, at 2; IEX Letter I, at 6; IEX Letter
III, at 4-6. But cf. NYSE Letter II, at 11.
---------------------------------------------------------------------------

    The Commission recognizes the risk, noted by some commenters, that
the Pilot could increase the cost of transacting if the reduction of
rebates leads to a reduction in quoted depth.\826\ If the reduction in
rebates in test group securities results in liquidity providers such as
market makers posting less displayed liquidity, quoted depth could
decline even if quoted spreads does not decline. This lower depth could
result in increased costs of transacting larger quantities. These
effects could be more pronounced in small stocks if, as some commenters
suggest, rebates are important to induce market makers to provide
liquidity in small stocks either directly or through cross
subsidization of liquidity.\827\
---------------------------------------------------------------------------

    \826\ See Pragma Letter, at 2; Nasdaq Letter I, at 6.
    \827\ See Nasdaq Letter I, at 8-9; Nasdaq Letter III, at 9.
However another commenter suggested that the impact of the Pilot on
small stocks would be mitigated by the fact that small stocks tend
to have wider spreads, and thus rebates form a smaller fraction of
total market making incentives. See Decimus Letter, at 4-5
---------------------------------------------------------------------------

    The Commission also recognizes the potential for a reduction in
liquidity and an increase in transaction costs for ETPs and
particularly less active ETPs. Multiple commenters expressed concern
that the Pilot might particularly reduce liquidity in ETPs.\828\ These
commenters noted that, unlike in stocks, the Pilot might affect
liquidity for ETPs in one of two ways: It may affect liquidity in
shares of the ETP, or it may affect liquidity in the underlying assets
of the ETP. The Pilot may reduce liquidity in the shares of the ETP if
the reduction of or elimination of rebates induces market makers to
stop or reduce providing liquidity for shares of an ETP. Moreover,
another commenter expressed concern that the Pilot is inconsistent with
exchanges programs for ETP market makers, whereby incentives are made
available to market makers to act as liquidity providers for small,
less liquid ETPs and therefore the negative impact of the Pilot could
be the most pronounced among illiquid ETPs.\829\ Additionally, the
Pilot may affect the liquidity of ETPs if it impacts the liquidity of
the underlying securities. If the Pilot affects liquidity in shares of
an ETP or impacts the liquidity of the ETP's underlying securities, it
will also affect the costs to authorized participants of eliminating
ETP mispricing by participating in the create-redeem process.\830\
---------------------------------------------------------------------------

    \828\ See, e.g., ICI Letter I, at 4; BlackRock Letter, at 1-2;
FIA Letter, at 4; SIFMA Letter, at 4; Issuer Network Letter I, at 3;
Schwab Letter, at 3; Fidelity Letter, at 9; Invesco Letter, at 2;
State Street Letter, at 3; Clearpool Letter, at 8; STA Letter, at 4;
STANY Letter, at 4; Healthy Markets Letter II, at 8; Healthy Markets
Letter I, at 11; Nasdaq Letter I, at 8; NYSE Letter I, at 7; Cboe
Letter I, at 17; Credit Suisse Commentary, at 6; Morgan Stanley
Letter, at 3-4.
    \829\ See Virtu Letter, at 7.
    \830\ See infra Section IV.D.1.
---------------------------------------------------------------------------

    Additionally, the Commission recognizes that the Pilot might result
in other unforeseen changes to market dynamics,\831\ including improved
or diminished execution quality by certain trading centers which could
shift the level of market participation. Also, the Pilot may affect the
ability of exchanges and ATSs to draw liquidity provision through
innovative methods other than rebates. The effects of these changes may
have a positive, neutral, or negative effect on liquidity.
Consequently, the Commission believes that there is significant
uncertainty surrounding the effects of the Pilot on liquidity.
---------------------------------------------------------------------------

    \831\ See IEX Letter II, at 7.
---------------------------------------------------------------------------

(3) Conflicts of Interest
    As noted above, the Commission is not certain of the extent to
which some broker-dealers route investor orders to avoid fees or to
capture rebates in such

a way that reduces execution quality. To the extent they do, the Pilot
could improve execution quality. This would occur if, as many
commenters and studies have argued, the offering of rebates produces a
conflict of interest that induces orders to be routed to exchanges with
sub-optimal execution quality.\832\ Consequently, the removal or
reduction of rebates may cause orders to be routed to exchanges with
better execution quality and the execution quality in the stocks in the
Test Groups could improve. As noted above, commenters disagreed on
whether broker-dealers act on such conflicts of interest and the
Commission lacks sufficient information to determine the magnitude of
any such conflicts. The Commission notes that the objective of the
Pilot is, in part, to study such conflicts of interest.
---------------------------------------------------------------------------

    \832\ See Section III.A.
---------------------------------------------------------------------------

(4) Cost Estimates
    Multiple commenters provided quantitative cost estimates associated
with expected changes in liquidity. The commenters' estimates all rely
on the assumption that a reduction in rebates will increase quoted
spreads and transaction costs but took different approaches, resulting
in a wide range of estimates from $24 million to $4 billion per year.
Overall, while the Commission appreciates the cost estimates, the
Commission reiterates that the Pilot could either increase or decrease
investor transaction costs for the reasons explained above. However,
for the reasons discussed below, the Commission believes that each of
the commenters overestimated the potential costs to investors. Below,
the Commission first describes each estimate, adjusts the estimate for
the change in the structure of the Pilot and then discusses how the
assumptions might affect the estimation.
    The first commenter estimated costs of $24 million per year. Across
all three proposed test groups, this commenter calculated an
anticipated reduction in the average rebate of $0.002267 per share, and
that approximately 50% of all liquidity providers will be affected by
the rebate reduction by ``updating their quotes to less aggressive
prices,'' leading to an increased cost to cross the spread of $0.001134
per share.\833\ Assuming only stocks with an average quoted spread in
excess of $0.02 will be adversely affected by the rebate reduction,
this commenter estimated that the costs to its customers of a wider
quoted spread would be $24 million annually.\834\
---------------------------------------------------------------------------

    \833\ See TD Ameritrade Letter, at 3.
    \834\ See id.
---------------------------------------------------------------------------

    To account for the changes to the Pilot since the proposal,
Commission staff estimate that this commenter's approach would estimate
a cost of $12.7 million per year. To arrive at this estimate, the
Commission adjusted the average rebate reduction to 0.0024 to account
for the change to the test groups and adjusted the average implied
volume to account for the inclusion of less than half the number of
stocks in test groups.
    Despite these adjustments, the Commission notes that the estimate
is likely imprecise. In particular, this estimate relies on an
assumption that the spreads will widen by 50% of the reduction in
rebates but does not provide support for this assumption. The commenter
does not explain why they expect this relation between rebates and
liquidity or provide an explanation for why they feel that 50% is the
appropriate adjustment to use. Further, this adjustment does not allow
for some liquidity demanders to supply liquidity more often if queue
lengths decline with rebates. Such a switch would reduce the impact on
transaction costs. The commenter also does not explain whether the
share volume used to estimate the costs was all share volume in
securities with average quoted spreads of less than two cents or just
that portion likely to be in a test group. If the commenter included
all volume, the estimates would be closer to $6.34 million.
    A second commenter estimated that if effective spreads widened by
10% for the 100 top securities, ``the Pilot could conservatively cost
investors over $400 million more in annual execution costs.'' \835\ The
commenter does not provide an analysis, either quantitative or
qualitative, to support their belief that a 10% increase is appropriate
to use or explain their methodology. The commenter provided little
information about its assumptions or underlying data that would allow
the Commission to examine the robustness of the estimate or to adjust
the estimate for the changes in the Pilot since the proposal. As such
the best way for the Commission to adjust the estimate for the changes
in the Pilot is to divide it by two, $200 million, because the changes
reduced the number of securities in the Pilot by slightly more than
half. However, because of uncertainties about methodology and
assumptions, the Commission cannot adjust with any certainty the $400
million estimate and does not believe that a $200 million estimate is
reliable. The Commission recognizes that the changes to the Pilot could
also change the commenter's estimate of how much spreads widen.
---------------------------------------------------------------------------

    \835\ Cboe Letter I, at 3.
---------------------------------------------------------------------------

    A third commenter provided an analysis that suggested that, due to
wider spreads, the increased costs to investors would be at least $1
billion per year and potentially $4 billion.\836\ Like the first
commenter, this $1 billion estimate assumes an adjustment to
transaction costs based on the reduction in the rebate, except that
this commenter doubled the rebate to adjust transaction costs. To
compute their estimate, the commenter estimates the weighted reduction
in rebates across all stocks, taking into account the fact that most
stocks will see no change in rebates. The commenter then uses the
expected weighted average reduction in rebates to compute their
estimate for the Pilot's impact on average spreads across all stocks.
The commenter then multiplies the expected impact on spreads by total
trading volume to arrive at a total of approximately $1 billion in
estimated costs per year.\837\ Using the commenter's method, the
adopted rule would have an average rebate reduction of approximately
$0.0004, which would widen spreads by $0.0009, or approximately half
the prior increase, for a new cost estimate of $600 million per year.
---------------------------------------------------------------------------

    \836\ See NYSE Letter I, at 13 and NYSE Letter IV, at 4. The
commenter estimated the $1 billion increase in expected costs by
computing a new consolidated spread, equal to the current
consolidated spread + (rebated reduction x 2), where the rebate
reduction is the blended average fee change of $0.00082, and
multiplied this rebate reduction by 2 as market makers on both sides
of the quote will adjust to reflect the rebate reduction. The
commenter indicated that this estimation results in a 1.1% increase
in average spreads to 28.1 bps. Id. at Addendum 4-5. For principal
trades, the anticipated increase in costs as calculated by this
commenter is the cost to cross the wider spread netted against lower
access fees, while for agency trades, the costs equal the cost to
cross the new wider spread. The commenter showed, ``on net, an
estimated cost of $1.08bn to the industry, of which $721MM would be
incurred by agency flow.'' Id. at Addendum 5. See also STANY Letter,
at 2.
    \837\ The Commenter adjusts their estimate to account for agency
verses principle flow using the following formulas. Agency cost =
Change in Spread*1/2 * Market Notional Value * Agency Share;
Principal Cost = [Change in Spread*1/2 * Market Notional Value *
Principal Share]--[Fee Reduction * Market Volume * Principal Share *
Maker/Taker Venue Share].
---------------------------------------------------------------------------

    Other commenters responded to this commenter's $1 billion estimate
in various ways. One commenter criticized the use of quoted spreads to
estimate costs.\838\ Likewise, several commenters

suggested that the commenter's estimates of potential harm are
overstated by as much as 90%.\839\
---------------------------------------------------------------------------

    \838\ See IEX Letter II, at 6. ``Given that institutional
investor orders are typically far larger than [the quoted spread],
and retail investor orders are generally executed off-exchange,''
the quoted spread is ``particularly relevant'' in ``cases where a
market participant is attempting to buy or sell, on an exchange,
fewer shares than the total amount displayed at the [NBBO][.]'' Id.
NYSE responded to this comment by noting that nearly all trading on
exchange is for amounts smaller than the quoted depth, so the quoted
spread is relevant. See NYSE Letter II, at 10.
    \839\ See, e.g., IEX Letter II, at 4; Healthy Markets Letter II,
at 2 (arguing that the NYSE cost estimate to investors of $1 billion
has been ``sufficiently debunked as purely fictional''); Decimus
Letter, at 4 (arguing that the NYSE approach ignores potential
indirect benefits to market participants of lower access fees (and
possibly lower brokerage commissions), and that the Pilot would
provide the information necessary to obtain meaningful analysis of
changes to fees and rebates on order routing decisions and execution
quality).
---------------------------------------------------------------------------

    The Commission views the commenter's $1 billion estimate as likely
overstating the realistic costs associated with the Pilot should it
result in increased spreads. One reason the estimate may be overstated
is that, as some commenters have noted, and as discussed in section
IV.C.2.b.iv.(1), the Pilot might have a diminished impact on penny
constrained securities. In a supplemental analysis using TAQ data from
the last quarter of 2017 and the first two quarters of 2018, the
Commission estimates that between 50-70% of share trading volume occurs
in stocks that are penny constrained.\840\ Consequently, to the extent
that rebates play a diminished or no role in determining the spread of
penny constrained stocks the commenter's estimates will significantly
overstate the impact of increased spreads on transaction costs. Also,
the commenter's estimate assumes that spreads will widen by twice the
reduction in rebates, an assumption that some commenters question and
that the Commission views as a likely upper limit to the impact of the
Pilot on quoted spreads.\841\ This assumption does not take into
account that non-market makers may begin to provide liquidity more
often during the Pilot in securities with lower or no rebates due to a
potential decrease in intermediation by market makers, which may
mitigate the impact of less intermediation by market makers as a result
of lower rebates.\842\ Consequently, the Commission acknowledges that
to the extent that the Pilot impacts spreads in a certain small number
of test group stocks, this could engender costs to investors. However,
as described above, the Commission believes that the estimate of $1
billion per year is likely a significant overstatement of the actual
costs that would be incurred in such a scenario.\843\
---------------------------------------------------------------------------

    \840\ To determine if a stock is penny constrained, the
Commission applied the simple filter: If the stock's trade weighted
quoted spread was less than 1.1 cents, then the stock was considered
penny constrained. This threshold yielded approximately 50% of
trading volume occurring in stocks that are penny constrained. If
the threshold is lifted to 2 cents (implying that at least some of
the time the stock was penny constrained), then the fraction of
trading volume in penny constrained stocks rises to 70%. Note that
the sample period for the supplemental analysis is during the Tick
Size Pilot. As such, these figures could underestimate the
percentage of volume in penny constrained securities.
    \841\ See Section IV.2.b.iv.(1).
    \842\ One assumption made by NYSE is that ``a reduction in the
average passive rebate. . .will result in both the bid and offer
being backed off, on average, by the exact same amount as the rebate
reduction.'' However, as another commenter argued this ``assumes
that only rebate driven liquidity providers set the quote'' when
``in reality the quote is almost always set by natural investors,
who have a view of fair price, that is informed by both fundamental
and quantitative research as well as the likely impact of their own
short term trading intentions. See Mulson Letter, at 1. As discussed
earlier in this section, the many potential effects of rebates on
quoted spreads create significant uncertainty. See also Decimus
Letter, at 4; Mulson Letter, at 1; IEX Letter II, at 4. NYSE
responded to these comments by noting that even if their volume
estimates are overstated by 20%, the cost is still significant and
suggesting that investors would not provide liquidity because doing
so would increase leakage costs. See NYSE Letter II, at 10-11.
    \843\ See Mulson Letter I, at 1 and IEX Letter II, at 4.
---------------------------------------------------------------------------

    The commenter's $4 billion estimate is based on the comparison
between the spreads on a maker-taker exchange compared to the spreads
on a taker-maker exchange described above in Section IV.C.2.b.iv(2),
which the Commission views as even more imprecise than the $1 billion
estimate for the reasons laid out above. Beyond the concerns expressed
in Section IV.C.2.b.iv(2), the Commission notes that the difference
between the spreads of a maker-taker exchange and a taker-maker
exchange would result from the difference between the fee paid to post
an order and the rebate to post. As such, the implied impact of no
rebates would be no more than \1/2\ the spread difference. Thus, thus
using the full spread difference overstates costs by a factor of 2.
Further, to get the $4 billion estimate, the commenter applied the
spread differential to all NMS securities. Because Test Group 2 will be
only about 12.5% of securities, applying the spread differential to all
NMS securities overstates the cost by a factor of 8. In sum, using the
commenter's approach, but correcting for these issues, would yield a
cost 16 times smaller than the commenter's, or $125 million.
v. Impact on Issuers
    Several commenters expressed concerns that adverse effects to
liquidity could induce long-term costs, such as higher costs of capital
for issuers subject to certain Test Groups where the incentives to
provide liquidity are reduced, likely affecting small and mid-
capitalization issuers most severely.\844\ One commenter believed that
issuers would have higher costs of capital as a result of wider
spreads, making any attempts to raise capital more expensive,
particularly for issuers in certain Test Groups of the Pilot.\845\
Additionally, a number of commenters also expressed concern that wider
spreads due to a reduction in rebates could also adversely affect
issuers that engage in share repurchase programs.\846\
---------------------------------------------------------------------------

    \844\ See NYSE Letter I, at 3, 13-14; ASA Letter, at 3; e.g.,
Level Brands Letter, at 1; Johnson Letter, at 1; P&G Letter, at 1;
Sensient Letter, at 1; Apache Letter, at 2; Ethan Allen Letter, at
1-2.
    \845\ See NYSE Letter I, at 3 and section IV.D.3 for further
discussion of NYSE's cost of capital estimates.
    \846\ See, e.g., Apache Letter, at 2; ACCO Letter, at 1;
NorthWestern Letter, at 2; Weingarten Letter, at 1.
---------------------------------------------------------------------------

    The Commission addresses these comments in the capital formation
analysis in Section IV.D.3 and concludes that the Pilot is not expected
to have a large impact on issuer cost of capital. While the Commission
acknowledges the risk that the Pilot may impact liquidity for some
securities, as explained above, the Commission believes that the impact
of such an effect on the cost of capital for such securities would
likely be minimal.\847\
---------------------------------------------------------------------------

    \847\ See section IV.D.3
---------------------------------------------------------------------------

    With the exception of the impact on cost of capital, one commenter
stated that the Pilot will require burdensome expenditures by public
companies at the start and conclusion of the Pilot.\848\ The Commission
recognizes that some national securities exchanges and broker-dealers
are public companies that could incur the costs described in Sections
IV.C.2.a and IV.C.2.b.ii at the start and conclusion of the Pilot.
However, the commenter did not provide details on what expenditures
other public companies will incur as a result of the Pilot. The
Commission does not know what such expenditures would be or what they
would entail; nevertheless, we do not believe that there will be any
such expenditures.
---------------------------------------------------------------------------

    \848\ See Nasdaq Letter I at 10.
---------------------------------------------------------------------------

vi. Costs to Broker-Dealers of Reverse Engineering Identities in the
Order Routing Data
    Some commenters expressed concern that proposed public
dissemination of order routing information would enable competitors to
gain proprietary information regarding trading strategies.\849\ The
commenters suggested

that, for example, market participants could learn the identities of
individual broker-dealers by sending a specific broker-dealer an order
for a relatively thinly-traded security and then study the order
routing reports to identify which broker-dealers transacted that
security on a given day. The concern is that if market participants can
identify the primary venues that certain broker-dealers tend to rout
to, then they may be able to use this information along with live
market data to identify specific trading algorithms of individual
broker-dealers. This could increase transaction costs for broker-
dealers if the market participants are able to use this data to
identify when a certain algorithm is being used to execute a trade in
live time and then to opportunistically trade around the algorithm to
profit from any price impact created by the trades.
---------------------------------------------------------------------------

    \849\ See, e.g., FIA Letter, at 3; Virtu Letter, at 7-8; SIFMA
Letter, at 6; FIF Letter, at 2; Citadel Letter, at 4; Citi Letter,
at 6; TD Ameritrade Letter, at 5; STANY Letter, at 5; IEX Letter I,
at 10; Credit Suisse Commentary, at 6; Morgan Stanley Letter, at 4.
---------------------------------------------------------------------------

    As described above, the Commission has modified its proposal in
response to these comments. Consequently, the Commission is not
adopting the requirement that exchanges publicly post the order routing
datasets and instead the Commission will receive the order routing
data. This change significantly reduces the risks identified by the
commenters about reverse engineering, and the Commission is sensitive
to the need to protect the data from unauthorized disclosure.

D. Impact on Efficiency, Competition, and Capital Formation

    The Commission has considered the effects of the Pilot on
efficiency, competition, and capital formation.\850\ As discussed in
further detail below, the Commission believes that many of the direct
effects of this rule on efficiency, competition, and capital formation
would likely be temporary in nature and affect markets only for the
duration of the Pilot. The Commission believes that the information
obtained as a result of the Pilot could improve regulatory efficiency,
because analyses of this data are likely to provide a more
representative view of the effect of transaction-based fees on order
routing decisions than would be available to the Commission in the
absence of the Pilot. Further, the Pilot may have a number of temporary
effects on price efficiency, the competitive dynamics between
exchanges, exchanges and off-exchange trading venues, broker-dealers,
and issuers, including ETPs. Although the Pilot may temporarily affect
liquidity,\851\ the Commission does not believe that this will result
in the Pilot having a significant effect on capital formation. One
commenter believed that the Commission did not sufficiently address the
impacts of the Pilot on efficiency, competition, and capital formation
in the proposing release.\852\ Several other commenters stated that the
Commission inadequately provided justification for the assertions in
the proposing release that the effects on efficiency, competition, and
capital formation would be temporary in nature and ``would affect
markets only for the duration of the [proposed] Pilot.'' \853\ The
Commission addresses below commenters' concerns about issues stemming
from efficiency, competition, and capital formation.
---------------------------------------------------------------------------

    \850\ Exchange Act Section 3(f) requires the Commission when
engaging in rulemaking to consider or determine whether an action is
necessary or appropriate in the public interest, and to consider, in
addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation. See 15
U.S.C. 78c(f).
    \851\ See supra Section IV.C.2.b.iv.
    \852\ See Nasdaq Letter I, at 3, 8. This commenter expressed
concern that the Proposal did not considered the effects on issuers
and ETPs. See id., at 8. This commenter also stated that ``the
Proposal is a blunt tool lacking nuance that will negatively affect
efficiency, competition, and capital formation--none of which have
been adequately addressed by the Commission.'' See id.
    \853\ See NYSE Letter I, at 15-16. See also, e.g., Level Brands
Letter, at 1; Johnson Letter, at 1; Knight-Swift Letter, at 1.
---------------------------------------------------------------------------

1. Efficiency
    This section discusses the potential impact the Pilot could have on
efficiency. The Commission believes that information learned from the
Pilot could potentially improve future regulatory efficiency.
Additionally, the Commission believes that the Pilot could have a
number of temporary impacts on efficiency, including: The efficiency of
capital allocation, price efficiency and price discovery, and the
efficiency of fees and rebates.
    As discussed in detail above,\854\ the Commission believes that
there is significant uncertainty regarding the effect, if any, that the
Pilot will have on liquidity and trading volume on exchanges.
Therefore, the Commission is unable to determine ex ante the overall
effects the Pilot will have on the efficiency of capital allocation,
price efficiency, or the efficiency of fees and rebates.\855\ However,
the Commission believes that the Pilot will provide useful data that
will better inform future policy recommendations of the effects of fees
and rebates on price efficiency.\856\
---------------------------------------------------------------------------

    \854\ See supra Sections IV.C.2.b.i and IV.C.2.b.iv.
    \855\ One commenter stated that it did not ``expect that a
reduction or outright removal of rebates will have any significant
or harmful effects on the quality of prices displayed in the public
lit market, interfere with genuine liquidity and price formation, or
negatively impact [its] stock's trading volume, spread or displayed
size.'' See T. Rowe Price Letter, at 5.
    \856\ See supra Section IV.C.1.a.ii.
---------------------------------------------------------------------------

    The Pilot will provide the Commission with an opportunity to
empirically examine the effects of an exogenous shock to transaction
fees and rebates on order routing behavior, execution quality and
market quality. Insofar as the data produced by the Pilot permits the
Commission and the public to evaluate and comment upon the potential
impacts of alternative policy options, the rule may promote regulatory
efficiency.\857\ In the absence of the Pilot, the Commission would have
to rely on currently available data to inform future policy decisions
related to transaction-based fees and rebates and data limitations may
impair the efficiency of policy decisions based on this
information.\858\
---------------------------------------------------------------------------

    \857\ See supra Section IV.C.1.a.i for a discussion of the
potential benefits from studying the Pilot data and supra Section
IV.C.1.a.iii for a discussion of the potential limitations of
studying the Pilot data.
    \858\ See supra Section IV.B.1.b.
---------------------------------------------------------------------------

    The temporary efficiency impacts the Commission expects during the
Pilot depend on how the Pilot fee and rebate restrictions for the two
Test Groups balance the interests of different groups of market
participants. For example, if during the Pilot, the lower fee cap and
no-rebate restriction induced by the Pilot cause broker-dealers to be
more likely to route customer orders to trading centers with better
pricing, higher speed of execution, or higher probability of execution,
rather than to trading centers with the largest rebates,\859\ the Pilot
may temporarily improve the efficiency of capital allocation by
lowering execution costs.\860\ Alternatively, the efficiency of capital
allocation could be reduced if, as a response to the loss in revenue
from rebates, broker-dealers increase commissions or fees charged to
customers.\861\ Higher commissions or fees could reduce customers'
willingness to trade or could lead to a lower injection of capital into
the markets by investors because a larger fraction of each investable
dollar would go to compensate broker-dealers for the lost revenue.
However, because rebates are generally accompanied by higher
transaction fees, the overall costs to broker-dealers to route orders
to exchanges could decline for some Test Groups, which could lead to a
decrease in commissions or fees and temporarily

increase the efficiency of capital allocation.
---------------------------------------------------------------------------

    \859\ See supra Section IV.C.1.b.
    \860\ See supra Section IV.C.2.b.iv.
    \861\ See supra Section IV.C.2.b.iii.
---------------------------------------------------------------------------

    For the duration of the Pilot, lower transaction fees could improve
the liquidity of stocks and ETPs in some Test Groups by reducing the
costs to execute marketable orders.\862\ As marketable orders become
less costly, these orders are likely to be routed to exchanges with
lower transaction fees, improving execution quality and possibly
creating a liquidity externality,\863\ whereby lower transaction fee
venues will become the preferred trading center for marketable and non-
marketable orders.\864\ An increase in liquidity could improve
informational efficiency by allowing securities prices to adjust more
quickly to changes in fundamentals.
---------------------------------------------------------------------------

    \862\ See supra Section IV.C.1.b.
    \863\ As discussed in detail above, improvements in execution
quality could present as better prices for execution, higher
probability of execution, and faster time to execution. See supra
Section IV.C.2.b.iv.
    \864\  See infra Section IV.D.2.b.
---------------------------------------------------------------------------

    As a result of the Pilot, price efficiency might also improve;
quoted spreads also may more closely reflect the net cost of trading
and could temporarily increase price transparency for securities in
certain test groups.\865\ Currently, most broker-dealers do not relay
information about amounts of fees paid or rebates received on trades to
their customers, thereby limiting the transparency of the total costs
incurred to execute a trade. The Pilot would not mandate disclosure by
the exchanges or the broker-dealers of order-level transaction-based
fees and, therefore, will not resolve the limitations to transparency
of the total fees paid and rebates received by broker-dealers for
particular orders. As fees decline or rebates are removed in some Test
Groups, however, the deviation in the net cost of trading from the
quoted spread could shrink, thereby at least partially improving price
transparency for the duration of the Pilot, and temporarily improving
pricing efficiency and price discovery.\866\ Therefore, as an
additional benefit of the Pilot, the Pilot will allow an examination of
the temporary effect of revisions to transaction fees and rebates on
quoted spreads, to better inform future policy recommendations of the
effects of exchange transaction-based fees and rebates on price
efficiency.\867\
---------------------------------------------------------------------------

    \865\ See supra Section IV.C.1.b.
    \866\ Some commenters argued that transaction fees and rebates
harm price transparency because the prices displayed by exchanges do
not include fee or rebate information and therefore do not fully
reflect net trade prices. See ICI Letter I, at 2; Goldman Sachs
Letter, at 3; Invesco Letter, at 2; State Street Letter, at 2;
Wellington Letter, at 1; Oppenheimer Letter, at 2; Capital Group
Letter, at 3; Citi Letter, at 2. A number of academic studies also
made this argument. See, e.g., Angel, Harris, & Spatt, supra note
530, and Harris, id.
    \867\ See supra Section IV.C.1.a.ii.
---------------------------------------------------------------------------

    On the other hand, if the reduction in rebates and Linked Pricing
harms liquidity,\868\ or causes more informed order flow to be routed
to off-exchange trading venues,\869\ then the Pilot may temporarily
impair price efficiency and the price discovery process.\870\ A
reduction in rebates could cause informed traders to route more of
their non-marketable orders to off-exchange trading venues, which could
reduce price discovery, because these orders would no longer be
included in displayed quotes or limit order book depth. If liquidity
temporarily worsens, then it may lead to a temporary widening of the
NBBO, which could lead to a decline in the overall informational
efficiency of prices. If liquidity worsens, it could also cause
informed traders to route more of their marketable orders off-exchange,
which could harm price discovery by reducing the ability of market
participants to discern the direction of their order flow. However, if
spreads widen or queues shorten, it could attract informed non-
marketable orders onto exchanges, which could improve price discovery,
because exchange quotes would be more informative. Because the
Commission cannot ex ante predict the effects of the Pilot on liquidity
and competition between exchanges and off-exchange trading venues for
order flow,\871\ the Commission is unable to determine the overall
effects of the Pilot on price efficiency and the price discovery
process.
---------------------------------------------------------------------------

    \868\ See supra Section IV.C.2.b.iv.
    \869\ See infra Section IV.D.2.a.
    \870\ Some commenters argued that rebates improved price
discovery by promoting displayed liquidity on exchanges and
narrowing the NBBO. See, e.g., State Street Letter, at 2; Virtu
Letter, at 3; Magma Letter, at 3; Schwab Letter, at 1; Fidelity
Letter, at 3; Cboe Letter I, at 15-16. One commenter argues that the
removal of rebates could harm price discovery by causing more market
participants to route their orders to off-exchange venues, instead
of lit exchanges, where they would be included in the price
discovery process. See Nasdaq Letter I, at 2, 4.
    \871\ See supra Section IV.C.2.b.iv and infra Section IV.D.2.a.
---------------------------------------------------------------------------

    Changes in liquidity could also impact the price efficiency of
ETPs. A change in liquidly for either the ETP itself or the underlying
securities could impact the create-redeem process for ETPs. This
process is an important element in ETP price efficiency and helps to
keep the price of the ETP in line with the value of its underlying
securities. If there is a mispricing, authorized participants can trade
on the mispricing by either purchasing the underlying shares to create
a share of the ETP, or by redeeming a share of the ETP and selling the
assets underlying the ETP. These actions affect the existing supply of
ETP shares and help to eliminate mispricing. Consequently, if the Pilot
impacts liquidity in either the underlying assets, or the ETP itself,
it will impact the cost to authorized participants of eliminating
mispricing by participating in the create-redeem process. Since the
Commission does not ex ante know how the Pilot will impact
liquidity,\872\ it cannot quantify the effects of the Pilot on ETP
price efficiency. If the Pilot results in improved liquidity for the
stocks in the various Test Groups, or for the ETP itself, then its
impact on the create-redeem process may be positive and ETP price
efficiency may increase as its value may more closely track the value
of their underlying assets through a lower cost create-redeem process.
The opposite is true if the Pilot negatively affects liquidity in
either the ETPs or the underlying securities.
---------------------------------------------------------------------------

    \872\ See supra Section IV.C.2.b.iv.
---------------------------------------------------------------------------

    Finally, the Commission acknowledges that the fee caps and
prohibition on rebates or Linked Pricing imposed on the Test Groups
during the Pilot further constrain the exchanges' abilities to
strategically choose fee and rebate schedules and for some NMS stocks
may restrict the fees and rebates further beyond the current levels,
which could be less efficient from the exchanges' perspective. The rule
could temporarily result in more or less efficient fee and rebate
schedules because the exchanges might not be able to optimize their
pricing structure for some Test Groups of securities.\873\ While the
Commission does not currently have information to determine the current
level of efficiency of fees and rebates, the information that the
Commission and the public receive from the Pilot could enable the
analysis of market impacts stemming from changes to fees, potentially
permitting the Commission to assess alternative requirements for
transaction-based fees and rebates that may be more efficient.
---------------------------------------------------------------------------

    \873\ See supra Section IV.C.2.b.i.
---------------------------------------------------------------------------

    Several commenters asserted that fee and rebate restrictions
proposed by the Commission would be government imposed price-controls
that would increase inefficiencies and harm consumers.\874\ One of
these commenters elaborated that ``Government-imposed price controls
are well understood to have a negative impact on competition and
innovation'' and that ``they are only

indicated where they overcome severe market imperfection such as
monopoly ownership of a critical resource.'' \875\ As discussed in
detail above,\876\ the Commission believes that the current fee and
rebate system may have resulted in a number of market failures,
including rebates incentivizing brokers to route orders to trading
venues that pay the highest rebates, instead of the venues that offer
better execution. However, the Commission currently lacks the data to
estimate the extent of any existing market failures.\877\ While the
Commission acknowledges that the Pilot's restrictions on rebates and
fees could potentially harm efficiency, if these market failures
currently do exist, then the fee and rebate restrictions in Test Group
stocks could temporarily improve efficiency for the duration of the
Pilot. Additionally, the information the Commission learns from the
Pilot could be used by the Commission in future rulemakings to inform
future policy decisions.\878\
---------------------------------------------------------------------------

    \874\ See Nasdaq Letter I, at 2, 5; Cboe Letter I, at 7.
    \875\ See Nasdaq Letter I, at 11-12.
    \876\ See supra Section IV.A.
    \877\ See supra Section IV.B.1. and Section IV.C.1.a.iii.
    \878\ See supra Section IV.C.1.a.
---------------------------------------------------------------------------

2. Competition
    This section discusses the potential effects of the Pilot on
competition. The Commission believes that the Pilot could have a
temporary effect on the competitive dynamics between exchanges,
exchanges and off-exchange trading venues, broker-dealers, and issuers,
particularly ETPs. Additionally, as discussed in detail below,\879\ the
Pilot could potentially have competitive effects for smaller exchanges
that last beyond the Pilot. This could occur if the Pilot attenuates
the potentially distortive impact of transaction-based fees and rebates
and causes broker-dealers to route orders to trading centers they
perceive as more liquid. This could have a lasting effect on the order
flow and revenue of smaller exchanges if it produces a liquidity
externality that persists beyond the Pilot.\880\ However, the
Commission believes that this is unlikely to occur, because the Pilot
would be for a limited duration and the effects are unlikely to be
significant enough to cause this result.\881\
---------------------------------------------------------------------------

    \879\ See infra Section IV.D.2.b (Competition Between
Exchanges).
    \880\ See Proposing Release, supra note 2, at 13042, for a
discussion of a liquidity externality.
    \881\ See infra Section IV.D.2.b (Competition Between
Exchanges).
---------------------------------------------------------------------------

    Because the Commission is unable to determine ex ante the Pilot's
effects on liquidity,\882\ the Commission is unable to quantify many of
the effects of the Pilot on competition. In the sections below the
Commission offers a qualitative discussion of the effects of the Pilot
on competitive.
---------------------------------------------------------------------------

    \882\ See supra Section IV.C.2.b.iv.
---------------------------------------------------------------------------

a. Competition Between Exchanges and Off-Exchange Trading Venues
    This section discusses the potential effects of the Pilot on
competition between exchanges and off-exchange trading venues,
including ATSs, which, as discussed in the baseline,\883\ execute
approximately 14% of trading volume. Although the Pilot could
temporarily affect the competition for order flow between exchanges and
off-exchange trading venues, the Commission believes that the overall
effects of the Pilot on this competition are unclear, because, as
discussed in detail below, there are reasons why the Pilot may
temporarily increase as well as decrease the order flow routed to off-
exchange trading venues.
---------------------------------------------------------------------------

    \883\ See supra Section IV.B.2.a.
---------------------------------------------------------------------------

    A number of commenters argued that restricting exchange rebates and
fees for stocks in the test Groups without placing similar restrictions
on off-exchange venues could place exchanges at a competitive
disadvantage.\884\ Although the Commission acknowledges that the Pilot
may potentially place exchanges at a competitive disadvantage relative
to off-exchange trading venues, the Commission believes that the
overall effects of the Pilot on this competition would depend on how
on-exchange liquidity is affected by the Pilot as well as the
renegotiation costs that off-exchange trading venues would incur in
order to take advantage of the restrictions on exchange fees and
rebates. For example, as discussed in detail above,\885\ ATSs sometimes
negotiate bespoke agreements with individual subscribers for a bundle
of services. If the costs of renegotiating these agreements are high,
then off-exchange trading venues may not be able to adjust their
pricing models to take advantage of the exchange pricing restrictions,
in which case competition between exchanges and off-exchange venues
could be unaffected.\886\ Additionally, as discussed below, if off-
exchange renegotiation costs are high, some of the restrictions on
transaction fees could give certain exchanges a competitive advantage
relative to off-exchange venues in attracting certain types of order
flow. However, if off-exchange renegotiation costs are small or the
Pilot fee and rebate restrictions place certain exchanges at a
disadvantage relative to the current pricing policies of some off-
exchange trading venues, then the Pilot could affect competition
between exchanges and off-exchange trading venues.
---------------------------------------------------------------------------

    \884\ Commenters expressed concern that the Pilot would inhibit
exchanges' ability to compete with off-exchange trading centers, in
part due to a reduced ability to innovate on changes to fees and
rebates. See, e.g., Cboe Letter I, at 7, 16-17; Nasdaq Letter I, at
6; NYSE Letter I, at 1-2, 4-5; Magma Letter, at 2; FIA Letter, at 3-
4; ASA Letter, at 3; P&G Letter, at 1; ACCO Letter, at 1; Johnson
Letter, at 1.
    \885\ See supra note 47 and accompanying text.
    \886\ It might be difficult for an ATS to renegotiate these
agreements with all of their clients in order to take advantage of
the exchange price restrictions on a subset of securities (i.e.,
stocks in the Test Groups).
---------------------------------------------------------------------------

    Although the Commission acknowledges that the distribution of
trading volume could change between exchanges and off-exchange trading
venues, the Commission believes these changes are difficult to
determine in advance and cannot predict ex ante whether these changes
would increase or decrease exchange market share.\887\ As discussed
above,\888\ the Commission lacks data on the current pricing schedules
offered by off-exchange venues as well as information on how this
affects the routing decisions of broker-dealers. The Commission also
lacks information on how difficult it is for off-exchange trading
venues to adjust their pricing schedules. Additionally, as discussed
above,\889\ the Pilot's effects on liquidity could be either positive
or negative and vary across securities. Therefore, the Commission is
unable to quantify or determine the overall effects that the Pilot will
have on competition between exchanges and off-exchange trading venues.
However, if competitive rebalancing among trading centers occurs as a
result of the Pilot, it could provide information to the Commission
about order routing decisions and execution quality to inform future
policy actions.
---------------------------------------------------------------------------

    \887\ One commenter agreed and stated the Pilot could cause a
shift in the balance of activity between exchanges and off-exchange
trading centers, but that the direction of such a shift cannot be
presupposed. See Decimus Letter, at 5. This commenter also noted
that transaction-based fees are one of the drivers behind the
current shift by market participants to off-exchange trading
centers. Id. at 5-6.
    \888\ See supra Section IV.B.1.b.vii.
    \889\ See supra Section IV.C.2.b.iv.
---------------------------------------------------------------------------

    Commenter statements regarding the effects of the Pilot on
competition between exchanges and off-exchange trading venues indicated
that the Pilot could have different effects on the competition for
marketable and non-marketable order flow. In considering the comments,
and as analyzed in the following sections, the Commission considered
the differential impact

changes in exchange fees and rebates could have on the competition
between exchanges and off-exchange trading venues for marketable and
non-marketable order flow. As the discussion above indicates, and as
commenters point out, it is not clear how the Pilot will affect the
competition for both marketable and non-marketable order flow.\890\
Additionally, since the impacts of the Pilot on liquidity may not be
uniform across all securities,\891\ the effects of the Pilot on
competition for marketable and non-marketable order flow may not be
uniform across all securities. Therefore, as discussed above, the
Commission is unable to quantitatively estimate how the Pilot could
affect competition between exchanges and off-exchange trading venues to
attract different types of order flow. In the sections below the
Commission offers a qualitative discussion regarding how various
effects of the Pilot could affect this competition.
---------------------------------------------------------------------------

    \890\ See Decimus Letter, at 5-6.
    \891\ See supra Section IV.C.2.b.iv.
---------------------------------------------------------------------------

i. Marketable Order Flow
    The Pilot could increase or decrease the share of marketable order
flow routed to off-exchange trading venues. This is reflected in the
divergent views of commenters, who argue over the effects that reduced
access fees and rebates could have on the share of marketable order
flow routed to off-exchange trading venues. In considering these
comments, the Commission considered a number of ways the Pilot could
potentially impact competition for marketable order flow, including:
The impact of changes in liquidity, the direct impact of changes in
access fees and rebates, the impact of changes in off-exchange fill
rates, and the impact of the Order Protection Rule.
    Changes in liquidity caused by the Pilot could affect how much
marketable order flow is directed to off-exchange trading venues.
However, because the overall effects of the Pilot on liquidity could be
positive or negative and vary across securities,\892\ the overall
effects of changes in liquidity on the direction of marketable order
flow are also unclear. Therefore, the Commission is unable to predict
the overall effect that changes in liquidity caused by the Pilot will
have on the competition for marketable order flow between exchanges and
off-exchange trading venues.
---------------------------------------------------------------------------

    \892\ See supra Section IV.C.2.b.iv.
---------------------------------------------------------------------------

    A number of commenters argued that if the Pilot temporarily
decreases liquidity in the test Groups due to the elimination or
reduction of rebates,\893\ more order flow will likely be directed to
off-exchange trading venues.\894\ As the Commission previously
discussed,\895\ the competition between on and off exchange venues for
order flow is characterized as providing a tradeoff between immediacy
and execution quality. Off exchange venues tend to get better trade
execution on average than lit exchanges, largely because they trade
between the prevailing NBBO, but at the cost of not being able to
guarantee that a transaction will occur. Thus, the impact of the Pilot
on the competition between exchanges and off exchange venues for
marketable order flow will depend on how the Pilot impacts execution
quality and the cost of immediacy on exchanges compared to the
potential for price improvement and the chance of filling an order at
an off-exchange venue.
---------------------------------------------------------------------------

    \893\ See id.
    \894\ See, e.g., Magma Letter, at 2; Home Depot Letter, at 1.
    \895\ See Securities Exchange Act Release No. 76474 (Nov. 18,
2015), 80 FR 80998 (Dec. 28, 2015), 81116-81117. See also Securities
Exchange Act Release Nos. 83663 (July 18, 2018), 83 FR 38768 (August
7, 2018), 38891-38892.
---------------------------------------------------------------------------

    If a reduction in rebates causes quoted spreads to widen,\896\ it
could increase the attractiveness of off-exchange price improvement and
would likely cause more institutional or proprietary marketable order
flow to be directed to off-exchange ATSs. Additionally, if spreads
widen, broker-dealers would likely be incentivized to internalize more
marketable institutional order flow. If spreads do not widen, a
decrease in quoted depth could also result in more marketable orders
being routed off-exchange. If quoted depth decreases,\897\ and if
market participants believe that off-exchange venues offer improved
execution, it could cause more large marketable orders to get routed to
ATSs or be internalized, in order to avoid the increased costs of
walking up the book. Alternatively, if liquidity improves, it could
reduce the cost of immediacy and the benefits of off-exchange price
improvement, which could result in more marketable order flow being
routed to exchanges.
---------------------------------------------------------------------------

    \896\ See supra Section IV.C.2.b.iv.2.
    \897\ See id.
---------------------------------------------------------------------------

    Changes in exchange access fees and rebates for stocks in the test
groups could also directly affect whether some types of marketable
order flow are routed to exchanges or off-exchange trading venues.
However, as discussed in detail above,\898\ the Commission currently
faces limitations in determining the effects that exchange transaction
fees and rebates have on order routing decisions. The Commission is
unable to quantify how changes in exchange transaction fees and rebates
for stocks in the test groups will affect the routing decisions for
marketable order flow between exchanges and off-exchange trading
venues. Therefore, the Commission is unable to determine in advance
what effect changes in exchange transaction fees and rebates caused by
the Pilot will have on the competition for marketable order flow. One
of the goals of the Pilot is to provide the Commission with data so
that it can better evaluate these effects.
---------------------------------------------------------------------------

    \898\ See supra Section IV.B.1.a and Section IV.B.1.b.
---------------------------------------------------------------------------

    If renegotiation costs are too high for off-exchange trading venues
to adjust their pricing schedules, lower transaction fees on maker-
taker exchanges could cause some marketable order flow that would be
routed to ATSs and other off-exchange trading centers to instead be
routed to these exchanges. For example, if the equilibrium transaction
fee in Test Group 2 is below $0.0030 in the absence of rebates,
exchanges may be able to draw order flow away from off-exchange trading
centers.
    Several commenters agreed that lower access fees could induce some
market participants to bring order flow back to exchanges.\899\ One of
these commenters stated that ``the potential that substantially lower
take fees in test group securities will counter any potential loss of
rebate-driven volume.'' \900\ One commenter disagreed and noted that
lowering fees would not attract marketable order flow to
exchanges.\901\ This commenter noted

that if high access fees drove market participants to route orders to
off-exchange trading centers, then lower cost venues, such as NYSE
American or EDGA would have larger market share.\902\ Another commenter
disagreed and argued that ``the cost of accessing lit markets in the
form of access fees on securities exchanges has been one of the key
drivers behind the continuing proliferation of non-exchange trading
venues.'' \903\ Given the disagreement among commenters, the Commission
believes it is possible that lower transaction fees could potentially
result in more marketable order flow being routed to exchanges.
However, as discussed above, the Commission faces limitations in
quantifying the effects that lower exchange transaction fees will have
on marketable order flow and is unable to determine how likely this is
to occur. One of the goals of the Pilot is to provide the Commission
with data so that it can better evaluate these effects.
---------------------------------------------------------------------------

    \899\ See, e.g., IEX Letter II, at 7, 8-9; TD Ameritrade Letter,
at 7; Citi Letter, at 4; Decimus Letter, at 5-6.
    \900\ See IEX Letter II, at 8.
    \901\ See NYSE Letter II, at 12; NYSE Letter I, at 16. This
commenter argued that market participants choose to send orders to
off-exchange venues for reasons other than avoiding fees, such that
simply lowering fees would not attract marketable order flow to
exchanges. See NYSE Letter I, at 16. Another commenter noted that
the Commission's assertion that any potential degradation of the
effective bid-ask spread due to lower or reduced rebates could be
mitigated by lower access fees was ``not supported by empirical data
or substantive analysis.'' See Nasdaq Letter I, at 8-9. In response
to these comments, the Commission notes that its belief is support
by some theoretical studies that show that it is the net fees, i.e.,
the rebates plus fees, that affect trading costs. See e.g. Colliard,
J.E. & Foucault, T. (2012). ``Trading fees and efficiency in limit
order markets.'' Review of Financial Studies, Vol. 25 (11), 3389-
3421 (available at: https://academic.oup.com/rfs/article/25/11/3389/1566107). Some empirical studies produce similar results. See, e.g.
Malinova, K. & Park, A. (2015). ``Subsidizing Liquidity: The Impact
of Make/Take Fees on Market Quality.'' Journal of Finance, Vol
70(5), 509-36 (available at: https://onlinelibrary.wiley.com/doi/10.1111/jofi.12230). According to this literature, the effects of a
reduction in rebates could potentially be offset by lower
transaction fees. The Commission also notes that some commenters
acknowledged this could be a potential effect of lower access fees.
See supra note 23. However, other academic literature shows that in
the presence of a fixed tick size, changes in fees and rebates can
still affect trading volume, even in the absence of a change in the
total fee. See e.g. Foucault, T., Kadan, O., & Kandel, E. (2013).
``Liquidity Cycles and Make/Take Fees in Electronic Markets.''
Journal of Finance, Vol. 68(1), 299-341 (available at: https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.2012.01801.x).
According to this literature, a reduction in transaction fees may
not fully offset the effects of an equal reduction in rebates. Given
the mixed results from the academic literature and the disagreement
among commenters, the Commission believes it is possible that lower
transaction fees could potentially reduce some of the effects of an
increase in effective bid-ask spreads caused by a reduction rebates,
although the magnitude of this reduction is uncertain. The
Commission believes that the Pilot would generate data and analysis
that would help the Commission better understand the cumulative
effects of changes in transactions fees and rebates on spreads and
trading costs. See supra Section IV.C.1.a.i.
    \902\ See NYSE Letter II, at 12.
    \903\ See Decimus Letter, at 5-6.
---------------------------------------------------------------------------

    To the extent that conflicts of interest affect order routing,\904\
lower rebates on taker-maker venues could potentially increase the off-
exchange share of trading volume by causing broker-dealers to increase
the internalization of smaller marketable orders, even if on-exchange
liquidity or execution quality does not change.
---------------------------------------------------------------------------

    \904\ See supra Section IV.A.1 (Market Failure at the Broker-
Dealer Level).
---------------------------------------------------------------------------

    Changes in the fill rates of orders at off-exchange trading venues
could also affect how much marketable order flow is directed to off-
exchange trading venues. However, there are reasons the Pilot could
increase or decrease the fill rates of orders at off-exchange trading
venues. Therefore, the effect these changes will have on the
competition for marketable order flow is uncertain.
    As discussed below,\905\ there are reasons the Pilot could cause an
increase or decrease in the non-marketable order flow routed to off-
exchange trading venues. If there is an increase in the non-marketable
order flow routed to off-exchange trading venues, then the fill rates
of marketable orders routed to off-exchange trading venues would
increase, which could cause more marketable order flow to be directed
to off-exchange trading venues. Alternatively, a decrease in the non-
marketable order flow routed to off-exchange trading venues would cause
a decrease in the fill rate for marketable orders, which would cause
less marketable order flow to be directed to off-exchange trading
venues.
---------------------------------------------------------------------------

    \905\ See infra Section IV.D.2.a.ii (Nonmarketable Order Flow).
---------------------------------------------------------------------------

    One factor that could reduce the chance of marketable orders being
routed away from exchanges is that exchanges have a protected quote.
One commenter believed that any off-exchange shifts are likely to be
limited because these trading centers do not have a protected quote,
and any shifts that would occur would still need to be consistent with
best execution and not just redistribution to account for market
participants' cost considerations.\906\ However, given that 34% of all
transaction volume occurs off-exchange at trading venues without a
protected quote, it is unclear how much effect a protected quote will
have on this competition.\907\
---------------------------------------------------------------------------

    \906\ See Healthy Markets Letter, at 10. Another commenter also
emphasized that exchanges have the advantage of a protected quote
and that they have an advantage in receiving orders that require
immediate execution. See IEX Letter II, at 8.
    \907\ See supra Section IV.B.2.a.
---------------------------------------------------------------------------

    The Commission does not expect the Pilot will have a significant
effect on the competition for retail marketable orders. Normally, these
orders are internalized by off-exchange wholesale broker-dealers who
pay retail broker-dealers for the order flow.\908\ Since the Pilot does
not restrict these rebates, the Commission does not expect the Pilot to
affect the routing of marketable retail order flow.
---------------------------------------------------------------------------

    \908\ See Battalio Equity Market Study, supra note 530.
---------------------------------------------------------------------------

ii. Nonmarketable Order Flow
    The Pilot could increase or decrease the share of non-marketable
order flow routed to off-exchange trading venues. This is reflected in
the divergent views of commenters, who argue over the effects that
reduced rebates could have on the share of non-marketable order flow
routed to off-exchange trading venues. In considering these comments,
and as discussed below, the Commission considered factors that could
affect the decision to supply liquidity on exchanges or at off-exchange
trading venues. Furthermore, in considering comments, the Commission
also considered a number of ways the Pilot could potentially impact
competition for non-marketable order flow, including: The impact of
changes in rebates, the impact of changes in liquidity, and the impact
of changes in off-exchange fill rates.
    The decision to submit a non-marketable order on-exchange or route
it to an off-exchange trading venue is a trade-off between the profits
earned from providing liquidity on-exchange compared to the expected
execution price and probability of having the order filled off-
exchange. Higher exchange rebates, wider spreads, higher on-exchange
fill rates (shorter on-exchange queue lengths), and lower off-exchange
fill rates would all increase the chance of a trader deciding to
provide liquidity on-exchange compared to routing an order to an off-
exchange venue.\909\ The impact of the Pilot on the competition between
exchanges and off-exchange venues for non-marketable order flow will
depend on how the Pilot affects these dimensions.
---------------------------------------------------------------------------

    \909\ See supra Section IV.B.2.b.
---------------------------------------------------------------------------

    The Commission believes that the overall effect on the competition
between exchanges and off-exchange venues for non-marketable order flow
from a reduction in rebates for stocks in the test groups is unclear,
because a reduction in rebates could result in either an increase or
decrease in liquidity.\910\ In theory, a reduction in exchange rebates
without any changes in liquidity or fill rates would likely cause more
non-marketable order flow to be routed to off-exchange trading venues.
However, the Commission believes that this event is unlikely, because a
reduction in exchange rebates and transaction fees could also affect
liquidity. Since a reduction in exchange rebates and transaction fees
could cause liquidity to increase or decrease,\911\ it could also cause
the share of non-marketable order flow routed to off-exchange trading
venues to increase or decrease.
---------------------------------------------------------------------------

    \910\ See supra Section IV.C.2.b.iv.
    \911\ See id.
---------------------------------------------------------------------------

    Several commenters voiced concerns that reduced rebates could cause
liquidity to migrate from exchanges to

non-exchange trading centers, because exchanges will be restricted from
providing rebates as incentives for liquidity provision, whereas non-
exchange trading centers could freely offer rebates and other
incentives to draw orders away from exchanges.\912\ In contrast,
several commenters disagreed and noted that ATSs generally do not pay
rebates and tend to charge lower fees than the large exchanges,\913\
and that such a pricing model would make it challenging for ATSs to
start providing rebates sufficiently large enough to draw volume from
exchanges. If rebates incentivize liquidity provision by providing
extra revenue to liquidity providers, a reduction in rebates for stocks
in the Test Groups could incentivize them to divert some of their non-
marketable liquidity providing orders from maker-taker exchanges to
off-exchange trading venues.\914\ However, this decision could also be
affected by how the rebate reductions impacted other dimensions of
liquidity, so the overall effect is difficult to determine.
---------------------------------------------------------------------------

    \912\ See, e.g., Cboe Letter I, at 7-8; Themis Trading Letter I,
at 1; MFS Investment Letter, at 2; Wellington Management Letter, at
1; FIA Letter, at 3-4; ASA Letter, at 3; Era Letter, at 2; Knight-
Swift Letter, at 2. One of the commenters suggested the Commission
should evaluate how disparate treatment of liquidity provision
between exchanges and non-exchange trading centers could affect
market participants' incentives to compete for displayed liquidity.
See Mastercard Letter, at 2. Another of the commenters also noted
that the competitive balance between exchanges and off-exchange
trading centers is uneven due to differences in regulatory
oversight, including filings of fee changes; the ability to assess
different fees to different customers; and the ability to offer sub-
penny price improvements. See Cboe Letter I, at 8.
    \913\ See IEX Letter II, at 8. One commenter disagreed and noted
that although ``few ATSs currently use maker-taker fee structures,
but they have done so in the past and would be incentivized to do so
in the future'' and that ``restricting fee structures on exchanges
only would encourage those off-exchange venues to expand their use
of order-routing incentives to gain a competitive advantage.'' See
NYSE Letter I, at 4-5
    \914\ It could also result in market makers reducing their
overall submission of non-marketable orders to supply liquidity, if
it is the case that rebates encourage market makers to engage in
excessive intermediation. This in turn could result in a reduction
in trading volume. See supra note 823 and accompanying text.
---------------------------------------------------------------------------

    As discussed above, changes in liquidity could also affect the
decision regarding where to route non-marketable limit orders. Since
the effects of the Pilot on liquidity could be either positive or
negative, The Commission is uncertain how these changes will affect the
competition for non-marketable order flow between exchanges and off-
exchange trading venues. If on-exchange liquidity worsens and bid-ask
spreads widen or quoted depth decreases,\915\ then institutional
traders could direct more of their non-marketable orders to supply
liquidity on maker-taker exchanges, either because realized spreads
increased or because the queue position and fill rates of their on-
exchange nonmarketable orders increased.\916\ Alternatively, if
liquidity improves and either bid-ask spreads tighten or quoted depth
increases,\917\ institutional traders could direct more their non-
marketable orders to off-exchanges venues, because the profits earned
from providing liquidity decreased.
---------------------------------------------------------------------------

    \915\ See supra Section IV.C.2.b.iv.
    \916\ It could incentivize institutional or proprietary traders
to substitute their marketable orders with nonmarketable limit
orders on maker-taker exchanges.
    \917\ See supra Section IV.C.2.b.iv.
---------------------------------------------------------------------------

    Change in the rate that orders are filled off-exchange could also
cause changes in the routing of non-marketable orders between exchanges
and off-exchange trading venues. However, as discussed below, the
effect of the Pilot on the fill rate of off-exchange non-marketable
orders is unclear. Therefore it is difficult to determine the Pilot's
effect on the routing of non-marketable orders. Changes in the rates at
which non-marketable orders are filled off-exchange depend on how the
routing of marketable order flow to off-exchange trading venues
changes. If a reduction in fees causes more marketable orders to be
routed to exchanges \918\ it could reduce the fill rate of off-exchange
orders, which could cause institutions or proprietary traders to
substitute some of their off-exchange orders with non-marketable orders
to supply liquidity on maker-taker exchanges. Alternatively, if the
Pilot causes more marketable orders to be routed to off-exchange
trading venues,\919\ it could increase off-exchange fill rates, which
could cause more orders that would have supplied liquidity on exchange
to be routed to off-exchange venues. However, as discussed above, the
Commission is unclear whether the share of marketable order flow routed
to off-exchange trading venues will increase or decrease.
---------------------------------------------------------------------------

    \918\ See supra Section IV.D.2.a.i.
    \919\ See id.
---------------------------------------------------------------------------

    The Commission does not expect the Pilot will have a significant
effect on the competition between exchanges and off-exchange trading
venues for retail non-marketable orders. Often, these orders are routed
by retail broker-dealers to maker-taker exchanges or to wholesale
broker-dealers who pay retail broker-dealers for the order flow. The
Commission believes that, despite the reduction in rebates, these
orders will still be routed to exchanges or to wholesale broker-dealers
who pay them for their order flow.\920\
---------------------------------------------------------------------------

    \920\ As discussed in detail below, the Commission believes
retail non-marketable orders for securities in Test Group 1 will
still be routed to maker-taker exchanges. The restrictions on
rebates in Test Group 2 may cause some of these orders to be routed
to taker-maker venues, if they result in better execution quality.
See infra Section IV.D.2.b.
---------------------------------------------------------------------------

b. Competition Between Exchanges
    This section discusses the potential effects of the Pilot on
competition between exchanges that use transaction-based fee and rebate
pricing models. Although the Pilot could temporarily affect the
competition for order flow between exchanges, the Commission believes
that many of the effects of the Pilot on this competition, including
the expected redistribution of market share among the existing
exchanges, are unclear and difficult to determine in advance. This is
reflected in the divergent views of commenters, who disagree about the
effects that reduced rebates and transaction fees could have on
competition between different types of exchanges.
    Exchanges that pay fees and remit rebates frequently revise their
fee schedules in order to remain competitive and to attract order flow.
The impact of the rule on competition depends on the extent to which
the fee cap and prohibition on rebates or Linked Pricing restrict
exchanges' transaction-based fee strategies. As discussed in detail
above,\921\ the Commission believes that the Pilot, while changing
either transaction fees or rebates on certain subsets of securities,
could leave the margins that exchanges obtain from transaction-based
pricing models unchanged. On the one hand, this could preserve the
current state of competition among exchanges in the market for those
securities. For instance, it may be possible for exchanges to modify
fee structures in a way that leaves margins unchanged and does not
impact competition between exchanges.\922\
---------------------------------------------------------------------------

    \921\ See supra Section IV.C.2.b.i.
    \922\ One commenter agreed with this view and suggested that
even though the fee cap for the Proposed Test Group 1 was half of
the current level, ``there was still significant enough
differentiation available in the fee structure that trading may not
appear materially different than the control group.'' See Credit
Suisse Commentary, at 3. However, another commenter argued that the
fee cap in Proposed Test Group 1 would reduce the exchange's ability
to compete on fees by 50%. See Cboe Letter I, at 16.
---------------------------------------------------------------------------

    On the other hand, the restrictions on fees and rebates could also
alter the competitive dynamics between different exchanges. For
example, the restrictions on fees and rebates could make

exchanges more similar in Test Group stocks.\923\ This could alter
competition between exchanges by causing market participants to focus
less on differences in fees and rebates and more on other metrics, such
as execution quality when deciding to which exchanges to route order
flow.
---------------------------------------------------------------------------

    \923\ See supra Section IV.C.2.b.i.
---------------------------------------------------------------------------

    As discussed in detail above,\924\ the Commission cannot ex ante
predict whether the Pilot will increase or decrease trading volume on
certain exchanges. Consequently, the Commission acknowledges
significant uncertainty with respect to the effect of the Pilot on
exchange competition.
---------------------------------------------------------------------------

    \924\ See id.
---------------------------------------------------------------------------

    One commenter suggested that ``inverted venues would likely
increase market share as maker rebates disappear and the fee
differential between venues declines for market makers, lowering the
relative cost for queue priority.'' \925\ The Commission acknowledges
that it is possible that a reduction in rebates in Test Group stocks
could make maker-taker exchanges less competitive for non-marketable
orders and cause liquidity provision to migrate to inverted venues.
However, if a reduction in rebates reduces excessive
intermediation,\926\ causes market makers to shift their liquidity
provision off-exchange,\927\ or worsens liquidity,\928\ then
institutional or proprietary traders' non-marketable orders could get
better queue position and have higher fill rates on maker-taker venues,
which could attract non-marketable order flow from taker-maker venues,
where maker participants pay fees for better queue positions and fill
rates.
---------------------------------------------------------------------------

    \925\ See Credit Suisse Commentary, at 4.
    \926\ See supra note 823 and accompanying text.
    \927\ See supra Section IV.D.2.a.
    \928\ See supra Section IV.C.2.b.iv.
---------------------------------------------------------------------------

    If the Pilot causes changes in liquidity between exchanges in Test
Group stocks,\929\ it could affect the decision where to route
marketable order flow. If an exchange experiences an improvement/
decline in liquidity it may also experience an increase/decline in
marketable order flow, especially since lower differences in fees/
rebates between exchanges could reduce broker-dealer conflicts of
interest and make them rely more on execution quality when deciding
where to route marketable orders.\930\ Additionally, it is also
possible that lower transaction fees on maker-taker venues could make
these venues more competitive and better able to attract marketable
order flow in Test Group stocks from inverted venues.
---------------------------------------------------------------------------

    \929\ See id.
    \930\ See supra Section IV.C.1.b.
---------------------------------------------------------------------------

    The Pilot could also alter competition between exchanges by causing
exchanges to choose to compete less intensively for order flow in one
Test Group, and instead focus on stocks and ETPs in the other Test
Group. Some of the shortfall in the competition for order flow for this
subset of securities could be filled by off-exchange trading
centers.\931\ Alternatively, exchanges may revise pricing strategies
for stocks in other groups, choosing to implicitly subsidize rebates
for stocks in Test Group 1 using fees from Control Group stocks.\932\
This may increase competition for order flow in one Test Group while
reducing it in the other. In the presence of tighter restrictions on
transaction-based fees during the Pilot Period, exchanges could also
compete in other ways to attract trading volume (e.g., discounts on
connectivity fees or increased volume discounts), although the
Commission believes that for Test Group 1 the ability to offer