average median fee and rebate information. The Commission preliminarily
believes that such updates would require fewer burden hours, as the
equities exchanges would have experience calculating necessary data and
formatting the reports as required by the proposed Rule. Accordingly,
the Commission preliminarily estimates that it would require
approximately 2 burden hours each month, or 24 burden hours on an
annualized basis, for each equities exchange to update.\203\ This
estimate contemplates the impact of publicly posting the summary using
the XML schema to be published on the Commission's website.
Accordingly, the Commission preliminarily estimates that equities
exchanges would incur, an aggregate, annual burden of 312 burden hours
to publicly post on their websites

the Exchange Transaction Fee Summaries.\204\
---------------------------------------------------------------------------

    \203\ The Commission derived the total estimated burden from the
following estimates: (Compliance Manager at 1 hour) + (Programmer
Analyst at 1 hour) = 2 burden hours per equities exchange per month.
2 burden hours per equities exchange per month x 12 months per year
= 24 burden hours per equities exchange per year.
    \204\ 2 burden hours per equities exchange x 13 equities
exchanges x 12 monthly updates = 312 burden hours per year.
---------------------------------------------------------------------------

3. Order Routing Data
    Proposed Rule 610T(d) would require each national securities
exchange that trades NMS stocks to prepare, in pipe-delimited ASCII
format, and publicly post on its website, no later than the last day of
each month, specified data containing aggregated and anonymized broker-
dealer order routing information for the prior month in accordance with
the specifications set forth in proposed Rule 610T(d). Such data would
be collected throughout the duration of the Pilot, as well as during
the six-month pre-Pilot Period and the six-month post-Pilot Period. For
the pre-Pilot Period, order routing datasets would include each NMS
stock. For the Pilot Period and post-Pilot Period, order routing
datasets would include each Pilot Security. In preparing the order
routing datasets, the equities exchanges would be required to anonymize
information relating to the identity of individual broker-dealers
before making the datasets publicly available. This anonymization would
be achieved through the use of an anonymization key developed by the
Commission, using CRDs.\205\
---------------------------------------------------------------------------

    \205\ See supra Section III.E.3.
---------------------------------------------------------------------------

    The Commission preliminarily estimates that, on average, there
would be no paperwork burden to the equities exchanges to capture the
required order routing data, as the Commission expects that the
equities exchanges would collect the required data to create the order
routing datasets through existing systems and technology already in
place for the collection and reporting of data pursuant to the CAT NMS
Plan. Furthermore, the Commission notes that the equities exchanges
currently generate similar monthly datasets pursuant to Rule 605 of
Regulation NMS.\206\ Accordingly, the Commission preliminarily believes
that the equities exchanges would be able to leverage existing systems
and technology utilized for Rule 605 reporting purposes to create the
proposed monthly order routing datasets. The Commission preliminarily
believes, however, that the equities exchanges would incur an initial
one-time burden of 80 burden hours per equities exchange to ensure that
its systems and technology are able to accommodate the proposed
requirements to aggregate, anonymize, and publicly post the order
routing information.\207\ Accordingly, the Commission preliminarily
estimates that the aggregate one-time initial burden for ensuring its
systems and technology are able to aggregate, anonymize, and post the
required order routing data in compliance with proposed Rule 610T(d)
would be 1,040 burden hours.\208\
---------------------------------------------------------------------------

    \206\ See 17 CFR 242.605.
    \207\ The Commission preliminarily estimates that an equities
exchange will assign responsibilities for review and potential
modification of its systems and technology to an Attorney, a
Compliance Manager, a Programmer Analyst and a Senior Business
Analyst. The Commission estimates the burden of reviewing and
potentially modifying its systems and technology to be as follows:
(Attorney at 20 hours) + (Compliance Manager at 20 hours) +
(Programmer Analyst at 20 hours) + (Senior Business Analyst at 20
hours) = 80 burden hours per equities exchange. See supra note 194.
    \208\ 80 burden hours per equities exchange x 13 equities
exchanges = 1,040 burden hours.
---------------------------------------------------------------------------

    Once an equities exchange has determined that it maintains the
appropriate systems and technology required for aggregation,
anonymization, and posting of the required information, the Commission
preliminarily believes that it would be necessary for each equities
exchange to undertake ongoing efforts to ensure that their systems and
technology are up to date so that the equities exchange may remain in
compliance with the proposed Rule. These efforts could include
personnel time to monitor the posting of the required data and the
maintenance of the systems necessary to post the required data. The
Commission preliminarily estimates that, on average, it would take an
equities exchange approximately 40 burden hours per year to ensure that
the systems and technology are up to date so as to facilitate
compliance with the proposed Rule.\209\ Therefore, the Commission
preliminarily estimates that the aggregate annual burden to maintain
the systems necessary to aggregate, anonymize, and post the required
order routing information to be approximately 520 burden hours per
year.\210\
---------------------------------------------------------------------------

    \209\ The Commission derived the total estimated burdens from
the following estimates, which reflect the Commission's preliminary
view that annual ongoing burdens would be approximately half the
burdens of initially ensuring it has the appropriate systems to
capture the required information in the required format: (Attorney
at 10 hours) + (Compliance Analyst at 10 hours) + (Programmer
Analyst at 10 hours) + (Business Analyst at 10 hours) = 40 burden
hours per equities exchange.
    \210\ 40 burden hours per equities exchange x 13 equities
exchanges = 520 burden hours.
---------------------------------------------------------------------------

    In addition, each equities exchange would incur an ongoing burden
associated with creating and formatting the order routing datasets to
be publicly posted each month. The equities exchanges have experience
with creating similar datasets in accordance with their obligations
under Rule 605 of Regulation NMS. The Commission preliminarily believes
that each equities exchange would incur burdens similar to those
associated with preparing Rule 605 reports.\211\ Accordingly, the
Commission preliminarily believes that each equities exchange would
incur a burden of six burden hours per month, or 72 burden hours per
year, to prepare and publicly post on its website the order routing
datasets.\212\ Therefore, the aggregate, annual burden to publicly post
on their websites order routing datasets in accordance with proposed
Rule 610T(d) would be approximately 936 burden hours.\213\
---------------------------------------------------------------------------

    \211\ See FR Doc. 2016-08552, 81 FR 22143 (April 14, 2016)
(``Request to OMB for Extension of Rule 605 of Regulation NMS'').
    \212\ Compliance Manager at 3 hours + Programmer Analyst at 3
hours = 6 burden hours per month, per equities exchange. 6 burden
hours per month x 12 months = 72 burden hours per year, per equities
exchange.
    \213\ 72 burden hours per year x 13 equities exchanges = 936
burden hours.
---------------------------------------------------------------------------

E. Collection of Information Is Mandatory

    Each collection of information discussed above would be a mandatory
collection of information.

F. Confidentiality of Responses to Collection of Information

    The Pilot Securities Exchange List, Pilot Securities Change List,
Order Routing Datasets, and the Exchange Transaction Fee Summary would
not be confidential. Rather, each would be publicly posted by the
exchanges. With respect to the Order Routing Datasets, the equities
exchanges would anonymize the data they collect under Proposed Rule
610T(d) before publicly posting it on their respective websites.

G. Retention Period for Recordkeeping Requirements

    National securities exchanges would be required to retain records
and information pursuant to Rule 17a-1 under the Exchange Act.\214\
---------------------------------------------------------------------------

    \214\ 17 CFR 240.17a-1. See also supra note 147.
---------------------------------------------------------------------------

H. Request for Comments

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to:
    67. Evaluate whether the proposed collections of information are
necessary for the proper performance of the functions of the agency,
including whether the information shall have practical utility;
    68. Evaluate the accuracy of our estimates of the burden of the
proposed collection of information;
    69. Determine whether there are ways to enhance the quality,
utility, and

clarity of the information to be collected; and
    70. Evaluate whether there are ways to minimize the burden of
collection of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology.
    Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Secretary, Securities and
Exchange Commission, 100 F Street NE, Washington, DC 20549-1090, with
reference to File Number S7-05-18. Requests for materials submitted to
OMB by the Commission with regard to this collection of information
should be in writing, with reference to File Number S7-05-18 and be
submitted to the Securities and Exchange Commission, Office of FOIA/PA
Services, 100 F Street NE, Washington, DC 20549-2736. As OMB is
required to make a decision concerning the collection of information
between 30 and 60 days after publication, a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days of
publication.

V. Economic Analysis

    As explained above, the proposed Transaction Fee Pilot is designed
to produce information on the effect of transaction-based fees on order
routing decisions by broker-dealers, as well as execution and market
quality.\215\ In recent years, a number of academics and market
participants have expressed concern that the structure of transaction-
based fee pricing may lead to potential conflicts of interest between
broker-dealers and their customers when brokers-dealers route customer
orders to trading centers offering large rebates so that the broker-
dealer can capture the rebates, even when these venues do not offer
high execution quality.\216\ However, as discussed in more detail
below, the Commission cannot determine from existing empirical evidence
the impact, if any, of transaction-based fees on order routing
decisions by broker-dealers. Specifically, determining whether a causal
relationship between exchanges' choice of transaction-based fees and
broker-dealers' routing decisions is complicated because transaction-
based fees and order routing decisions could be jointly determined and
order routing decisions could influence fees just as fees could
influence order routing decisions. Currently available data do not
permit researchers to isolate these factors and thus identify the
existence or direction of such a causal relationship, which in turn
impedes researchers' ability to determine the extent to which conflicts
may exist.\217\ Moreover, the identification of potential causal
relations between fees and order routing decisions becomes increasingly
complex as exchanges modify their fees.\218\
---------------------------------------------------------------------------

    \215\ Execution quality generally refers to how favorably
customer orders are executed. Execution quality measures are similar
to liquidity measures and tend to include transaction costs, the
speed of execution, the probability that the trade will be executed,
and the price impact of the trade. See NMS Adopting Release, supra
note 1, at 37513-15, 37537-38. Market quality encompasses execution
quality but also relates more generally to how well the markets
function. Market quality measures include liquidity, price
discovery, and volatility in prices. See, e.g., Henrik Bessembinder,
``Trade Execution Costs and Market Quality after Decimalization,''
Journal of Financial and Quantitative Analysis 38, 747-777 (2003)
available at https://doi.org/10.2307/4126742; Maureen O'Hara and Mao
Ye, ``Is Market Fragmentation Harming Market Quality?'', Journal of
Financial Economics 100, 459-474 (2011) available at https://www.sciencedirect.com/science/article/pii/S0304405X11000390.
    \216\ See, e.g., Angel, Harris and Spatt, supra note 106;
Battalio Equity Market Study, supra note 22; Harris, supra note 23.
    \217\ As proposed, the Transaction Fee Pilot would require the
exchanges to make data available to the Commission and the public.
Raw data provided by the Transaction Fee Pilot are likely to be used
by a subset of academic and regulatory researchers (hereafter
``researchers'') to develop analyses and discussion about the
effects of transaction-based fees and rebates on order routing
decisions, which could provide valuable information to the public
and to the Commission.
    \218\ Over the last five years, U.S. equities exchanges, on
average, have made 34 revisions, or approximately 6.7 revisions per
year, to their transaction-based fees and rebates. In contrast to
these changes, which are at the discretion of the exchanges and
subject to Commission review, the proposed Transaction Fee Pilot
would impose a change to access fees and rebates outside of the
exchanges' control. See Section V.B.2.b infra.
---------------------------------------------------------------------------

    Because of the existing lack of empirical evidence regarding these
potential conflicts of interest, additional information would assist
the Commission in making regulatory decisions about whether and how to
address transaction-based fees and rebates. To remedy the insufficiency
of existing empirical evidence, the Commission is proposing a
Transaction Fee Pilot, which would provide the Commission and the
public with data currently unavailable to study fees and rebates that
exchanges assess to broker-dealers and observe the effects of potential
conflicts of interest that could arise between broker-dealers and their
customers in connection with these fees. Specifically, the Commission
expects that these data are likely to shed light on the extent, if any,
to which broker-dealers route orders in ways that benefit the broker-
dealer but may not be optimal for customers. The data obtained from the
proposed Transaction Fee Pilot would inform any possible future
regulatory action that addresses these potential conflicts of interest
to the ultimate benefit of investors. In addition, the proposed
Transaction Fee Pilot data would also provide information about other
potential economic effects of reducing access fee caps or prohibiting
rebates or Linked Pricing. For example, the proposed Transaction Fee
Pilot could offer information on whether prohibiting rebates or Linked
Pricing alters broker-dealer behavior in a manner that affects market
quality. Specifically, the proposed Pilot may provide information on
how rebates affect quoted spreads, particularly for small and mid-cap
securities, as well as how changes to fees affect order flow among
trading centers.\219\
---------------------------------------------------------------------------

    \219\ See Section V.C.1.a.ii infra, for further discussion of
the benefits of studying other economic effects of transaction fees
and rebates.
---------------------------------------------------------------------------

    The proposed Transaction Fee Pilot would permit the study of
whether conflicts of interest exist by (1) providing an exogenous shock
to transaction-based fees and rebates, and (2) enabling the collection
of representative results of data across a broad range of
securities.\220\ An exogenous shock is an unpredictable or unexpected
event that is outside of the economy or the system (i.e., not under the
control or influence of those being studied) but can induce endogenous
(i.e., within the system) responses. In the context of this proposed
rule, the exogenous shock would take the form of either a reduction of
the maximum permissible access fees or a prohibition on rebates or
Linked Pricing paid by all U.S. equities exchanges. This shock would
allow the Commission and others to explore how exogenous changes to
fees and rebates could lead to changes in the ways in which broker-
dealers route customer orders for a broad sample of NMS securities.
Specifically, the reduction in fees or elimination of rebates or Linked
Pricing, as required in specific test groups of the proposed Pilot, may
reduce the magnitude of a potential conflict of interest between
broker-dealers and their clients caused by transaction-based fees and
rebates. A

reduction in this potential conflict of interest would, in turn, be
reflected in measurable changes to broker-dealer order routing
decisions.
---------------------------------------------------------------------------

    \220\ See Section V.B.1 infra, for discussion of existing
studies related to these topics and their limitations. See also
Section II.B supra, for details of the Nasdaq study, which examined
a change in the access fees and rebates charged by Nasdaq for 14
stocks over a four-month period.
---------------------------------------------------------------------------

    As discussed in Section III.C, the proposed Pilot would span a two-
year period, with an automatic sunset at the end of the first year
unless, prior to that date, the Commission publishes a notice
determining that the proposed Pilot shall continue for up to another
year,\221\ and would apply to both maker-taker and taker-maker
exchanges. All NMS stocks (including ETPs) that have prices of at least
$2.00 at the time of selection would be included in the proposed Pilot
and would be segmented into three test groups and one control group.
Each test group would contain a mix of stocks and ETPs, stratified
based on variables such as market capitalization, share price, and
liquidity.\222\ Under the requirements of the proposed Pilot, the
exchanges could not charge any access fee or, where applicable, provide
rebates or Linked Pricing, in excess of the limitations indicated by
the proposed Pilot. Stocks and ETPs in Test Groups 1 and 2 would be
restricted to maximum fees of $0.0015 and $0.0005 (with no restrictions
on rebates), respectively, while Test Group 3 would eliminate the
exchanges' ability to provide rebates to liquidity providers on maker-
taker exchanges and liquidity takers on taker-maker exchanges for both
displayed and non-displayed liquidity and would prohibit Linked
Pricing. Both the Control Group and Test Group 3 would maintain the
current access fee cap of $0.0030 required by Rule 610(c) of Regulation
NMS. By construction, Test Group 3 is designed to observe the effect of
the absence of rebates or Linked Pricing on conflicts of interest and
the equilibrium fee level and how that fee level would affect order
routing decisions, execution quality, and market quality. Further,
exchanges would continue to be permitted to have varying fees within
each test group, and would be permitted to change their fees at their
discretion, subject to Commission review, during the proposed Pilot for
securities within each test group, so long as they comply with the
conditions of the applicable test group.
---------------------------------------------------------------------------

    \221\ See Section III.D infra.
    \222\ See supra note 116. The Commission would detail the
specifications of the stratification by notice.
---------------------------------------------------------------------------

    In the absence of the proposed Pilot, the Commission preliminarily
believes it is unlikely that exchanges would collectively undertake a
similar pilot and voluntarily coordinate the exogenous shock to fees
and rebates across a broad set of securities, broker-dealers, and
exchanges that would be required to appropriately analyze the effects
of changes to fees and rebates.\223\ By imposing the same modifications
to fees and rebates on all U.S. equities exchanges, the proposed Pilot
would allow the Commission and the public to obtain data that would
permit them to examine how changes to fees and rebates affect order
routing decisions of broker-dealers. Accordingly, the Commission
believes that the proposed Pilot would enable the collection of
valuable data for both the Commission and the public that would
otherwise be unavailable.
---------------------------------------------------------------------------

    \223\ See Section V.B.1.b.i infra.
---------------------------------------------------------------------------

    The Commission is mindful of the costs imposed by, and the benefits
obtained from, our rules. Whenever the Commission engages in rulemaking
and is required to consider or determine whether an action is necessary
or appropriate in the public interest, Section 3(f) of the Exchange Act
requires the Commission to consider whether the action would promote
efficiency, competition, and capital formation, in addition to the
protection of investors.\224\ Further, when making rules under the
Exchange Act, Section 23(a)(2) of the Exchange Act requires the
Commission to consider the impact such rules would have on
competition.\225\ Section 23(a)(2) of the Exchange Act also prohibits
the Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.\226\ The Commission preliminarily believes that
many of the likely impacts of this proposal on efficiency, competition,
and capital formation would be temporary in nature and would affect
markets only for the duration of the proposed Pilot. The following
analysis considers in detail the economic effects that may result from
the Transaction Fee Pilot proposed in this release.
---------------------------------------------------------------------------

    \224\ See 15 U.S.C. 77b(b) and 15 U.S.C. 78c(f).
    \225\ See 15 U.S.C. 78w(a)(2).
    \226\ Id.
---------------------------------------------------------------------------

    Where possible, the Commission has quantified the likely economic
effects of the proposed Transaction Fee Pilot; however, as explained
further below, the Commission is unable to quantify all of the economic
effects because it lacks the information necessary to provide
reasonable estimates. In some cases, quantification depends heavily on
factors outside of the control of the Commission, which make it
difficult to predict how market participants would act under the
conditions of the proposed Pilot. For example, because of the
flexibility that market participants have with respect to the choice of
trading center for execution of transactions and because those choices
can be influenced by factors outside of the scope of this pilot, such
as volume discounts, the Commission cannot quantify, ahead of the
proposed Pilot, the economic impact of any changes in order routing
decisions by broker-dealers that may result from the proposed Pilot.
Nevertheless, as described more fully below, the Commission provides
both a qualitative assessment of the potential effects and a quantified
estimate of the potential aggregate initial and aggregate ongoing
costs, where feasible. The Commission encourages commenters to provide
data and information to help quantify the costs, benefits, and the
potential impacts of the proposed rule on efficiency, competition, and
capital formation.

A. Background on Transaction-Based Fees and Potential Conflicts of
Interest

    This section provides a review of transaction-based fee models,
including a discussion of the history and mechanics of transaction-
based pricing. This section also presents an overview of the recent
concerns about potential conflicts of interest between broker-dealers
and their customers attributed to access fees and rebates assessed by
exchanges.
1. Overview of Transaction-Based Fees
    Maker-taker pricing models originated on electronic communications
networks (ECNs) in the late 1990s as ECNs attempted to attract order
flow and draw liquidity from traditional exchanges by offering rebates
to market participants that posted liquidity to their platforms.\227\
Shortly thereafter, exchanges followed suit and adopted maker-taker
pricing models as market share migrated from traditional exchanges to
ECNs. Today, nearly all U.S. equities exchanges have some form of
transaction-based pricing models.\228\
---------------------------------------------------------------------------

    \227\ In 1997, Island ECN was the first electronic trading
platform to offer rebates to attract limit orders to its platform.
    \228\ As of March 2018, EDGA and IEX do not operate as a maker-
taker or taker-maker market, although both charge flat fees. The
remaining 11 exchanges are either maker-taker (nine) or taker-maker
(two) exchanges. The baseline discusses these exchanges in more
detail.
---------------------------------------------------------------------------

    Generally, transaction-based pricing models charge fees or remit
rebates to members depending on whether their executed orders ``make''
or ``take'' liquidity from the market. An order that makes liquidity
provides share volume (or depth) on a trading center at various
execution prices, whereas an order that

takes liquidity removes the volume (or depth) resting on the trading
center provided by the make orders. Orders that make, or provide,
liquidity are non-marketable limit orders, which are limit orders that
are submitted to an exchange or other trading center that cannot be
filled immediately when they arrive because no market participant is
willing to trade at the price of the order (i.e., the limit
price).\229\ For example, if a customer places an order to sell 100
shares of a security at $9.00 per share when the prevailing market bid
price is $8.75, that customer is placing a non-marketable limit sell
order that indicates her willingness to provide 100 shares of liquidity
to the market at a price of $9.00. In contrast, orders that take, or
remove, liquidity, are marketable orders. A marketable order, in turn,
can be either a market order, which is an order to buy or sell a
security to be executed immediately at current market prices,\230\ or a
marketable limit order, which is either a limit buy order with a price
at or above the lowest offer price in the market or a limit sell order
with a price at or below the highest bid in the market. For example, if
a customer places an order to sell 100 shares of a security at $8.50
per share when the prevailing market bid price is $8.75 at a depth of
more than 100 shares, that customer is placing a marketable limit sell
order, and would take 100 shares of liquidity at a price of $8.75.
---------------------------------------------------------------------------

    \229\ A limit order is an order to buy or sell a security at a
specified price or better. As the price of the non-marketable order
gets further from the bid or offer price, the greater the likelihood
that the non-marketable order must rest until better priced orders
execute.
    \230\ As long as there are willing sellers and buyers, market
orders are filled.
---------------------------------------------------------------------------

    In maker-taker models, an exchange charges an access fee to broker-
dealers that take liquidity using marketable orders and remits a rebate
to broker-dealers that make liquidity by placing standing non-
marketable limit orders that subsequently interact with marketable
orders. In a taker-maker market, the exchange charges an access fee to
broker-dealers that provide liquidity by placing non-marketable limit
orders and pays a rebate to market participants that take liquidity
using marketable orders. In 2005, the Commission adopted Rule 610(c) of
Regulation NMS,\231\ which limited the maximum access fee that could be
charged by maker-taker exchanges to $0.0030 per share. The adoption of
the fee limit was designed to ensure the fairness and accuracy of the
displayed quotations by establishing an upper bound on the cost of
accessing such quotations,\232\ while also precluding certain trading
centers from raising their fees substantially to market participants
required to access their quotations by the Order Protection Rule,\233\
and preventing certain trading centers from taking advantage of
intermarket price protection by acting as toll booths between price
levels.\234\
---------------------------------------------------------------------------

    \231\ See NMS Adopting Release, supra note 1.
    \232\ See id. at 37543-46.
    \233\ See NMS Adopting Release, supra note 1, at 37504-38. The
Order Protection Rule is designed to ensure that investors receive a
consistent price quotation for NMS stocks across all exchanges where
a security is traded and that investors receive the best possible
execution price for marketable orders.
    \234\ See id. at 37584. See also Harris, supra note 23
(suggesting that large access fees were a response to some trading
venues paying large rebates to market participants as a means of
attracting order flow to those venues in the early days of maker-
taker exchanges).
---------------------------------------------------------------------------

2. Potential Conflicts of Interest
    Academics, market participants, regulators, and legislators
recently have expressed concern about how transaction-based fees have
affected order routing decisions by broker-dealers and the execution
quality obtained by customers.\235\ This concern has centered on the
potential for conflicts of interest between broker-dealers and their
customers that may distort best execution practices.
---------------------------------------------------------------------------

    \235\ See Staff Maker-Taker Memo, supra note 99. See also Angel,
Harris, and Spatt, supra note 106; Jeffrey Bacidore, Hernan Otero,
and Alak Vasa, ``Does Smart Routing Matter?'', Working Paper,
Investment Technology Group, Inc. (2010), available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1681449 (``Bacidore,
Otero, and Vasa''); Battalio Equity Market Study, supra note 22;
Harris, supra note 23. In addition to potential conflicts of
interest, several of these studies have also indicated that
transaction-based pricing models have led to reduced price
transparency for investors and increased market fragmentation and
complexity. These are discussed in greater detail in Section
V.C.1.b, infra.
---------------------------------------------------------------------------

    Broker-dealers are required to use reasonable diligence to execute
customer orders according to best execution standards, which require
broker-dealers ``to execute customers' trades at the most favorable
terms reasonably available under the circumstances . . .'' \236\ When
seeking best execution for their orders, broker-dealers often consider
opportunities to obtain prices better than those currently quoted. In
order to comply with best execution standards, broker-dealers evaluate
their aggregate customer orders and periodically assess which competing
trading center offers the most favorable terms of execution.\237\ The
quoted prices that are used by broker-dealers to meet their best
execution standards do not reflect any access fees assessed or rebates
offered by the exchanges.\238\
---------------------------------------------------------------------------

    \236\ See NMS Adopting Release, supra note 1, at 37537-38. See
also supra note 215.
    \237\ See NMS Adopting Release, supra note 1, at 37537-38.
    \238\ See, e.g., Angel, Harris, and Spatt, supra note 106.
---------------------------------------------------------------------------

    Even while complying with best execution requirements, broker-
dealers may route non-marketable limit orders to trading centers that
offer the best quoted prices but that also offer high rebates for those
orders, which the broker-dealers may then retain, rather than pass
through to customers.\239\ The availability of high rebates, however,
may influence how broker-dealers route customer orders to the detriment
of customers, even if orders are still routed to an exchange posting
the best quoted prices.\240\ One study, for example, shows lower
execution quality, in terms of reduced probability of execution or
increased time to execution, for non-marketable limit orders on
exchanges that pay high rebates.\241\ Thus, broker-dealers may route
orders to exchanges that have the best quoted prices but are suboptimal
for customers in other ways

because orders are either less likely or take longer to execute.
---------------------------------------------------------------------------

    \239\ The potential conflicts of interest are more likely when
broker-dealers retain the rebates, because such broker-dealers have
greater incentive to maximize those rebates potentially at the
expense of customer execution quality. The Battalio Equity Market
Study, for example, found that a sample of retail broker-dealers
appear to route orders to venues that offer large rebates, thereby
maximizing order flow payments. However, as noted in the Battalio
Equity Market Study, routing orders to venues with large rebates did
not result in superior execution quality for non-marketable limit
orders. See Battalio Equity Market Study, supra note 22. See also
David Cimon, ``Broker Routing Decisions in Limit Order Markets,''
Working paper, Bank of Canada, (2017) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2789804. Cimon provides
a theoretical model of conflicts of interest in broker-dealer
markets, where broker-dealers route marketable orders to venues with
low access fees to reduce the access fees paid by the broker-dealer,
increasing the volume of uninformed orders and lowering the risk of
adverse selection for non-marketable limit orders posted to that
venue.
    \240\ The duty of best execution requires broker-dealers to
execute customer trades at the most favorable terms reasonably
available under the circumstances. See NMS Adopting Release, supra
note 1, at 37537-38. The duty of best execution is not inconsistent
with the automated routing of orders; however, broker-dealers must
periodically assess the quality of competing markets to ensure that
order flow is directed to markets providing the most beneficial
terms for their customer orders.
    \241\ See, Battalio Equity Market Study, supra note 22, which
finds some evidence that execution quality is related to the
transaction-based fees. For instance, in their analysis of a single
order-routing system, for a sample of matched limit orders placed on
high fee and low fee venues, high fee venues have a fill rate of
approximately 73%, while low fee venues have a fill rate of
approximately 99% (Table V). Further, in a multiple regression
analysis (Table VI), the study shows that the probability of filling
an order is decreasing as the take fee increases, while the time to
execution increases. The limitations of the Battalio Equity Market
Study are discussed below in Section V.B.1.b, infra.
---------------------------------------------------------------------------

    Maker-taker exchanges with high rebates tend to have high access
fees, which increase the cost to broker-dealers to execute marketable
orders. These high access fees may lead broker-dealers to route
marketable orders to exchanges with lower access fees, even though
there may be a significant number of standing non-marketable limit
orders on exchanges with higher access fees.\242\ As the broker-dealers
route marketable orders to exchanges with lower access fees, execution
quality for the non-marketable limit orders is likely to deteriorate
because the non-marketable limit orders are likely to have lower
probability of execution and longer times to execution for orders that
do execute. High rebates may also limit the ability of an exchange to
generate a liquidity externality because these high rebates could draw
order flow to exchanges with low execution quality, despite the
availability of higher execution quality on other trading centers.\243\
This behavior may fragment order flow. In contrast, if exchanges did
not provide high rebates, broker-dealers may be more likely to route
orders to exchanges that quote the best price and have the best overall
execution quality,\244\ permitting order flow to consolidate on those
venues.
---------------------------------------------------------------------------

    \242\ See, Angel, Harris, and Spatt, supra note 106.
    \243\ A liquidity externality occurs when a given trading center
becomes the preferred trading destination for both marketable and
non-marketable orders.
    \244\ See Battalio Equity Market Study, supra note 22, at 2232
(``[O]ur results suggest that . . . routing decisions based
primarily on rebates/fees are inconsistent with best execution. For
limit order traders, there are significant opportunity costs [with
respect to execution quality] with routing all nonmarketable limit
orders to a single venue offering the highest liquidity rebates.'').
---------------------------------------------------------------------------

    In general, customer orders routed to exchanges that remit high
rebates are also more likely to face adverse selection when
executed.\245\ Adverse selection occurs when one party to a transaction
has less information about the value of an asset than the other party
to the transaction, resulting in the possibility that the less informed
party only transacts when it is disadvantageous to do so. In the
context of order execution, adverse selection is likely to occur
because some fraction of market participants is likely to possess more
precise information about the value of a security.\246\ Order flow from
these ``informed traders'' is generally routed to exchanges. In order
for the exchanges to draw sufficient liquidity to satisfy the orders
placed by informed traders, they may offer high rebates to broker-
dealers to attract non-marketable limit orders, which are likely to be
placed by uninformed traders, to satisfy the demands of informed
traders' order flow.\247\ Under such circumstances, these non-
marketable limit orders face an adverse selection problem because they
execute against marketable orders that likely were placed by informed
traders.\248\ As adverse selection increases at high rebate/high fee
exchanges, informed traders will always execute orders to the detriment
of uninformed traders (retail customers), i.e., the orders will more
likely be executed at disadvantageous prices for the uniformed traders
relative to customer orders routed to low rebate/low fee exchanges,
where the likelihood of facing an informed trader is less.\249\ In
these situations, the broker-dealers thus face a potential conflict of
interest when they receive high rebates from the exchanges seeking to
attract liquidity while their customers bear costs of the
disadvantageous prices resulting from the adverse selection.
---------------------------------------------------------------------------

    \245\ See, Angel, Harris, and Spatt, supra note 106. See also
Peter Hoffman, ``Adverse Selection, Market Access and Inter-market
Competition,'' Journal of Banking & Finance 65, 108-119 (2016),
available at https://www.sciencedirect.com/science/article/pii/S0378426615002976; Sviatoslav Rosov, ``HFT, Price Improvement,
Adverse Selection: An Expensive Way to Get Tighter Spreads?'', CFA
Institute (2014) available at https://blogs.cfainstitute.org/marketintegrity/2014/12/18/hft-price-improvement-adverse-selection-an-expensive-way-to-get-tighter-spreads/ (``Rosov'').
    \246\ Some market participants may know more about the value of
a security because some investors, such as some professional
traders, could just be better at processing public information. See,
e.g., Michael Brennan and Avanidhar Subrahmanyam, ``Market
Microstructure and Asset Pricing: On the Compensation for
Illiquidity in Stock Returns,'' Journal of Financial Economics 41,
441-464 (1996), available at http://www.sciencedirect.com/science/article/pii/0304405X9500870K; David Easley and Maureen O'Hara,
``Information and the Cost of Capital,'' Journal of Finance 59,
1553-1583 (2004), available at http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.2004.00672.x/pdf.
    \247\ Exchanges do not have sufficient liquidity from retail
marketable orders because they are generally internalized or routed
to wholesalers to avoid access fees. Several studies indicate that
internalizers are unlikely to accept marketable orders from market
participants that are likely to be informed. See Angel, Harris, and
Spatt, supra note 216; Rosov, supra note 245.
    \248\ See, e.g., Dolgopolov, supra note 21. For example, if an
investor had a non-marketable limit buy order at $10, when the
current market price was $10.25, that standing limit order to buy at
$10 is likely to only get executed when prices are declining.
    \249\ See Katya Malinova and Andreas Park, ``Subsidizing
Liquidity; the Impact of Make/Take Fees on Market Quality,'' Journal
of Finance 70, 509-536 (2015), available at http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.2004.00672.x/pdf
(examining the introduction of maker rebates on the Toronto Stock
Exchange); Yiping Lin, Peter Swan, and Frederick H. deB. Harris,
``Maker-Taker Fees, Liquidity Competition, and High Frequency
Trading,'' Working Paper, University of New South Wales (2017)
(examining the Nasdaq pilot, described above in Section II.B). In
analyses of markets where exchanges conducted pilots altering the
access fees and rebates paid on subsets of stocks, results indicate
that markets with lower access fees (and rebates) had reduced
adverse selection costs. Venues with lower access fees could draw
increased order flow from both informed and uninformed traders. If
the proportion of informed traders is unlikely to change due to fees
and rebates changes, as overall order flow increases due to lower
access fees, then the likeihood of transacting with an informed
trader declines, thereby reducing the adverse selection costs to
traders.
---------------------------------------------------------------------------

    Given the competitive nature of the broker-dealer industry,\250\
the Commission considered whether competition could alleviate potential
conflicts of interest between investors and broker-dealers, as
investors choose between broker-dealers that offer to place orders on
their behalf. To the extent that investors are able to identify broker-
dealers that do not act on potential conflicts of interest, investors
could discourage broker-dealers from acting on such conflicts of
interest. The Commission preliminarily believes, however, that
competition between broker-dealers may not resolve this issue because
of a combination of three reasons: Asymmetric information, switching
costs and a lack of collective action.
---------------------------------------------------------------------------

    \250\ See Section V.B.2.a infra.
---------------------------------------------------------------------------

    First, asymmetric information between broker-dealers and their
customers limits the ability of customers to identify broker-dealers
that do not act on potential conflicts of interest. For example,
customers do not generally have access to information about broker-
dealers' individual sources of revenue.\251\ As discussed below in more
detail, although disclosures required pursuant to Rule 606 provide
information about material conflicts of interest related to payment for
order flow, these disclosures do not provide information on the effect
of transaction-based fees on order routing decisions. Moreover, while
under Rule 606, a customer may request information about the venues to
which her orders were routed in the prior six months, a customer cannot
necessarily use this information to compare how these orders would have
been treated by other broker-dealers. Further, these

disclosures do not provide customers with information about the payment
and collection of transaction-based fees and rebates by broker-dealers.
---------------------------------------------------------------------------

    \251\ While consolidated revenues may be available from Form 10-
K filings for broker-dealers that are public reporting companies,
broker-dealers do not report revenues attributable to specific
sources, such as rebates from a particular exchange or payments for
order flow from a particular venue. For instance, revenues derived
from commissions and fees are often just reported in aggregate as
``Commissions and Fees.'' Therefore, even though aggregate revenues
for some broker-dealers are publicly available, customers do not
have access to the information on individual sources of revenue that
could reveal potential conflicts of interest.
---------------------------------------------------------------------------

    Second, even if investors had sufficient information to conclude
they would be better served by a different broker-dealer, investors may
face costs in switching broker-dealers.\252\ If these switching costs
are high relative to the costs that investors anticipate may arise from
potential conflicts of interest, investors may not switch broker-
dealers even if it appears that their broker-dealer may have acted on
conflicts of interest.
---------------------------------------------------------------------------

    \252\ These switching costs may be monetary, but may also have a
time and effort component.
---------------------------------------------------------------------------

    The presence of switching costs also may exacerbate a collective
action problem among investors.\253\ While investors could provide
incentives to broker-dealers to eliminate potential conflicts of
interest by threatening to move accounts away from broker-dealers known
to act on conflicts of interest, switching costs may undermine the
credibility of such a threat. This is because, although each customer
individually bears a cost to switch accounts, the benefits of a
successful threat, while conditional on a sufficient number of
customers agreeing to switch, are available to all customers whether
they would switch or not. If the switching costs are high relative to
the proportion of customer defections necessary to threaten a broker-
dealer, customers are unlikely to generate enough of a threat to alter
broker-dealers' behavior.
---------------------------------------------------------------------------

    \253\ Collective action occurs when a number of individuals or
entities work together to achieve a common objective, such as
investors acting to reduce the potential conflicts of interest in
order routing decisions by broker-dealers.
---------------------------------------------------------------------------

B. Baseline

    We compare the economic effects of the proposed rule, including
benefits, costs, and effects on efficiency, competition, and capital
formation, to a baseline that consists of the existing regulatory
framework and market structure. As explained above, by temporarily
altering the fee and rebate structure for certain NMS stocks (including
ETPs), the proposed Pilot is designed to produce information on order
routing behavior that would not otherwise be available. The baseline
discusses the existing set of information, as well as the exchanges'
current practices with respect to fees and rebates and the regulations
governing those fees and rebates.
1. Current Information Baseline
    While the studies cited above discuss the potential issues for
investors associated with transaction-based fee models,\254\ limited
empirical evidence exists to date about the extent that potential
conflicts of interest arise from maker-taker and taker-maker pricing
models and how transaction-based fees affect the integrity and
structure of the U.S. equity markets. Below, we discuss the existing
information currently available to the Commission or the public that
concerns the relationship between transaction-based fees and order
routing decisions and describe the limitations of this information for
use in policy discussions regarding transaction-based fees and
potential conflicts of interest.
---------------------------------------------------------------------------

    \254\ See supra note 216.
---------------------------------------------------------------------------

a. Existing Information
    The existing empirical studies available regarding the relation
between transaction-based fees, order routing decisions, and execution
quality consists of two studies: One academic study and a study
conducted by Nasdaq.\255\ According to the Battalio Equity Market
Study, broker-dealers appear to trade execution quality of customer
orders, as measured by the likelihood of and time to execution (and not
price), for the rebates obtained by providing liquidity to maker-taker
venues.\256\ By routing orders to exchanges that pay high rebates,
broker-dealers may engage in rebate capture at the expense of client
execution.\257\ Using data obtained from mandatory Rule 606 disclosures
over a two-month window,\258\ the Battalio Equity Market Study also
identified that four of the ten broker-dealers included in the analysis
route limit orders exclusively to market makers or to exchanges that
offered the largest liquidity rebates (and charging the highest access
fees).\259\ A number of tests in the Battalio Equity Market Study also
show that low-fee venues provide better execution quality for limit
orders, as measured by the likelihood of an order fill, the speed of
execution, and higher average realized spreads, relative to high-fee
venues, suggesting that order routing decisions to high rebate venues
are likely to be suboptimal from a customer's perspective, and may be
indicative of potential conflicts of interest.
---------------------------------------------------------------------------

    \255\ Although a number of studies theoretically suggest that
the transaction-based pricing structure coupled with discretion by
broker-dealers over order routing decisions could lead to potential
conflicts of interest with their customers, only the Battalio Equity
Market Study provides empirical evidence on the effect of fees and
rebates on order routing. Battalio Equity Market Study, supra note
22. As discussed more thoroughly below in Section V.B.1.b, the
Battalio Equity Market Study, while enlightening, has a number of
limitations that inhibit the ability to draw causal inferences from
it about potential conflicts of interest. See, e.g., Angel, Harris,
and Spatt, supra notes 106 and 216; Dolgopolov, supra note 21;
Harris, supra note 23.
    \256\ The Battalio Equity Market Study's abstract of the paper
states: ``We identify retail brokers that seemingly route orders to
maximize order flow payments by selling market orders and sending
limit order to venues paying large liquidity rebates. . . . [W]e
document a negative relation between limit order execution quality
and rebate/fee level. This finding suggests that order routing
designed to maximize liquidity rebates does not maximize limit order
execution quality. . . .'' See Battalio Equity Market Study, supra
note 22, at 2193.
    \257\ See Battalio Equity Market Study, supra note 22. See also
Section V.A.2 supra, for an overview of the potential conflicts of
interest that emerge.
    \258\ Rule 606 requires broker-dealers to provide quarterly
reports that provide an overview of their routing practices. See
Securities Exchange Act Release No. 51808 (November 27, 2000), 65 FR
75414, (December 1, 2000) (``Disclosure or Order Execution and
Routing Practices''). Rule 606 disclosures require broker-dealers to
disclose material aspects of their relationships with certain
trading venues, including a description of payment for order flow.
The reports, however, do not require broker-dealers to disclose the
amounts of payment for order flow, or the rebates received or access
fees paid.
    \259\ See Battalio Equity Market Study, supra note 22. The
Battalio Equity Market Study, however, does not specify whether the
limit orders are marketable or non-marketable limit orders, as Rule
606 disclosures do not segment these orders.
---------------------------------------------------------------------------

    Separately, and as discussed in Section II.B,\260\ Nasdaq
independently conducted a study, whereby it lowered access fees and
rebates for a sample of 14 stocks over a period of four months in 2015,
providing an exogenous shock to the transaction-based pricing model on
the exchange. The Nasdaq experiment lowered both the access fees
charged and the liquidity rebates paid on the securities included in
their study.\261\ Nasdaq's analysis indicated that Nasdaq's reduction
in access fees and liquidity rebates reduced Nasdaq's market share and
Nasdaq's incidence of providing the NBBO, suggesting that Nasdaq
experienced a decline in some measures of market quality as a result of
the changes to access fees and rebates.\262\ Further, Nasdaq found that

there was a shift in the composition of the top five liquidity
providers for the securities that occurred as a result of the
experiment.\263\
---------------------------------------------------------------------------

    \260\ See supra notes 31 and 32 and corresponding text.
    \261\ The Nasdaq study lowered access fees to $0.0005 and
rebates to $0.0004 simultaneously for a set of 14 securities, half
of which identified Nasdaq as the primary listing exchange, the
other half which identified the NYSE as the primary listing
exchange. The Nasdaq released two reports (see supra note 31)
examining the changes to a number of metrics related to market
quality.
    \262\ Although the 14 stocks experienced a decline in market
share on Nasdaq and their incidence of time at the NBBO, there was
no statistically significant change in the level of liquidity
taking, variance ratio, realized spread, return autocorrelation,
effective spread, relative effective spread, quoted spread, relative
quoted spread, displayed dollar depth at the NBBO, or time between
either quote updates or price changes in the NBBO. See Nasdaq May
Report, supra note 31.
    \263\ The top five liquidity providers prior to the start of the
pilot significantly reduced their liquidity provision from 44.5% of
the liquidity provided pre-pilot to 28.7% in the pilot period.
However, the top five liquidity providers from the pilot period had
a significant increase in their liquidity provision from 29.7% pre-
pilot to 41.5% in the pilot period. See Nasdaq May Report, supra
note 31.
---------------------------------------------------------------------------

    Two studies have examined exogenous shifts between maker-taker and
payment for order flow pricing models on U.S. options exchanges.\264\
These studies found that the movement from a payment for order flow
model to a maker-taker model led to a decrease in execution costs for
option classes affected by the shift, improved quoted spreads, and
altered broker-dealer order routing behavior to account for the
fees.\265\ However, the change to a payment for order flow model from a
maker-taker model yielded better execution quality, but a reduction in
the number of orders and order volume.\266\
---------------------------------------------------------------------------

    \264\ See Amber Anand, Jian Hua, and Tim McCormick, ``Make-Take
Structure and Market Quality: Evidence from the U.S. Options
Markets,'' Management Science 62, 3217-3290 (2016), available at:
https://pubsonline.informs.org/doi/abs/10.1287/mnsc.2015.2274
(``Anand, Hua, and McCormick''); Robert Battalio, Todd Griffith, and
Robert Van Ness, ``Make-Take Fees versus Order Flow Inducements:
Evidence from the NASDAQ OMX PHLX Exchange,'' Working Paper,
University of Notre Dame (2017), available at: http://www1.villanova.edu/content/dam/villanova/VSB/assets/marc/marc2017/SSRN-id2870000.pdf (``Battalio, Griffith, and Van Ness''). Anand,
Hua, and McCormick explores the transition from a payment for order
flow model to a maker-taker model on NYSE ARCA, while Battalio,
Griffith, and Van Ness examines the shift on NASDAQ OMX PHLX
(``PHLX'') from a maker-taker model to a payment for order flow
model.
    \265\ See Anand, Hua, and McCormick, supra note 264.
    \266\ See Battalio, Griffith, and Van Ness, supra note 264.
---------------------------------------------------------------------------

    A number of existing data sources could be used independently or in
combination to relate transaction-based fees to order routing and
execution quality. For instance, in the Battalio Equity Market Study
and the Nasdaq Study discussed above, researchers employed some
combination of Rule 606 data, proprietary broker-dealer data, the Trade
and Quote (TAQ) database,\267\ and proprietary exchange data. In
addition, while not employed in previous studies, CAT data, Rule 605
data, and exchanges' Form 19b-4 fee filings and fee schedules available
from each exchange's website, could provide insights into the relation
between transaction-based fees, order routing, and execution quality.
---------------------------------------------------------------------------

    \267\ The Battalio Equity Market Study, supra note 22, relies on
Rule 606 disclosures to identify order routing for a small sample of
broker-dealers, proprietary broker-dealer data from a single smart-
order routing system to capture limit order execution quality for
this broker-dealer's orders, and the TAQ data to measure execution
quality as a function of each venue's taker fee or rebate.
---------------------------------------------------------------------------

    Rule 606 requires broker-dealers to make publicly available
quarterly reports that provide an overview of their routing practices
for non-directed retail orders in NMS securities. As a further
requirement of Rule 606, broker-dealers must disclose the identities of
the ten venues to which the largest number of orders were routed for
execution. Rule 606 disclosures additionally require broker-dealers to
disclose material aspects of their relationships with trading venues to
which they route orders, including a description of payment for order
flow and any profit sharing relationships, which, like rebates, could
lead to potential conflicts of interest for broker-dealers when routing
orders.\268\ Researchers and other analysts interested in order routing
data can download these forms quarterly directly from broker-dealer
websites.
---------------------------------------------------------------------------

    \268\ Conflicts of interest for broker-dealers potentially could
arise from a number of sources, including affiliations with trading
venues, receipt of payment for order flow, receipt of payment from
profit-sharing relationships, and rebates. Rule 606, however,
requires only descriptions of any arrangements for payment for order
flow, but does not require broker-dealers to provide information on
the net amount of payment for order flow, payment received from
profit-sharing relationships, or disclosure of access fees paid or
rebates received. See Disclosure of Order Execution and Routing
Practice, supra note 258, at 75425-28.
---------------------------------------------------------------------------

    Proprietary data from broker-dealers or exchanges could also
provide information about order routing and execution quality. Broker-
dealer data include information on the orders received and routed by
that broker-dealer, including where the broker-dealer routed orders,
whether the orders execute, and the price, size, and time of execution.
Exchange data include information on the order received by an exchange,
including which members routed orders to the exchange, whether the
orders execute, and the price, size, and time of execution. As these
data include commercially sensitive information, they are not broadly
available.
    Once the CAT Phase 1 becomes operational,\269\ the Commission and
SROs will have information on all exchange routing and exchange
executions for all NMS securities. In CAT Phase 1, exchanges would
record and report order events on every order they receive for NMS
securities. Order events include order receipt, order routes, order
modifications, order cancelations, and order executions.
---------------------------------------------------------------------------

    \269\ See supra note 172.
---------------------------------------------------------------------------

    Rule 605 data provides information about execution quality by
market center, including exchanges, ATSs, and broker-dealers that
execute orders, by requiring standardized reports of statistical
information regarding order execution, and was designed to improve the
public disclosure of order execution practices by exchanges.\270\ These
data are available monthly from market center websites or data vendors,
and provide information on execution quality statistics such as
transaction costs, execution speed, and fill rates reported separately
for marketable and non-marketable orders.
---------------------------------------------------------------------------

    \270\ See Disclosure of Order Execution and Routing Practice,
supra note 258, at 75417-25.
---------------------------------------------------------------------------

    Beyond Rule 605 data, researchers could also use the TAQ database
as a means of measuring order execution quality. The TAQ database is
publicly available (for a fee) from the NYSE and provides access to all
trades and quotes for NMS securities, from which researchers and other
analysts can estimate trade-based measures of execution quality.
    Finally, researchers and other analysts can manually create
datasets of exchange fees and rebates from the information that
exchanges provide on their websites and release in their Notice of
Filing of Proposed Rule Changes, which would capture information
contained in exchanges' Form 19b-4 fee filings. The Form 19b-4 fee
filings record changes to the existing exchange fee schedules with the
Commission. At any point that an exchange chooses to make a change to
any aspect of its access fees and rebates, the exchange must provide
notice to the Commission that it is filing a proposed rule change to
amend its existing fee and rebate schedule. Exchanges may file their
revisions to fees and rebates for immediate effectiveness upon
submitting the Form 19b-4 fee filings with the Commission.
b. Limitations of Existing Information
    Existing studies and available data sources are limited in ways
that are likely to reduce the strength of conclusions that relate to
the impact of transaction-based fees and rebates on order routing
decisions and the existence or magnitude of potential conflicts of
interest between broker-dealers and their customers. The limitations of
existing studies fall primarily into two categories: (1) The results of
the studies may not be representative, and (2) the results of the

studies cannot make a causal connection needed to inform on potential
conflicts of interest. This section discusses those limitations as well
as separately discussing the limitations associated with existing
sources of data mentioned above.
i. Representative Results
    The results of both the Battalio Equity Market Study and the Nasdaq
study may not be representative of the potential impacts of broad
changes in access fees or rebates. Drawing market-wide inferences from
the limited samples in these studies could be problematic because the
results are predicated on information obtained from a single broker-
dealer or trading venue. First, the Battalio Equity Market Study uses
order level data from a single broker-dealer to determine the relation
between maker-taker fees and limit order execution quality. Analysis
based on observation of a single broker-dealer may not provide
representative results because the relation between transaction-based
fees and potential conflicts of interest may not be generalizable to
other broker-dealers. For example, over 400 broker-dealers maintain
membership with at least one U.S. equities exchange.\271\ If the single
broker-dealer examined in the Battalio Equity Market Study has
significantly different order routing behavior than the average broker-
dealer that routes orders to exchanges, the information obtained from
examining the relation between transaction-based fees and order routing
decisions of that broker-dealer would not be representative of the
entire market and therefore would provide an incomplete representation
of potential conflicts of interest.
---------------------------------------------------------------------------

    \271\ Estimates based on data from Form 1 of the X-17A-5
filings. As of December 31, 2016, 3,972 broker-dealers that filed
form X-17A-5. See Section V.B.2.a infra.
---------------------------------------------------------------------------

    The Battalio Equity Market Study also relies on a sample of Rule
606 order routing decisions obtained directly from the reporting
entities' websites from a limited sample of ten well-known national
retail brokers from a single quarterly reporting cycle (October and
November 2012). As discussed above, over 400 broker-dealers are members
of at least one national securities exchange. The ten retail brokers
analyzed in the Battalio Equity Market Study make up approximately 2.1%
of the broker-dealers with exchange memberships, and less than 0.3% of
broker-dealers overall. Although these are well-known retail brokers,
due to the lack of representativeness of the sample (e.g., the majority
of the broker-dealers represented in the Battalio Equity Market Study
are online broker-dealers), these broker-dealers may be more (or less)
likely than the average broker-dealer to route customer orders in ways
that benefit themselves at the expense of their customers. The findings
in the Battalio Equity Market Study, therefore, may not be
representative of a broader sample of broker-dealers. Moreover, the
Commission is unable to determine if the Battalio Equity Market Study's
analyses of the Rule 606 disclosure data has statistical power because
the authors did not provide any statistical analyses beyond the
percentage of market or limit orders routed to a particular exchange.
    Similarly, the results of the Nasdaq study may not be
representative of the broader market, as the Nasdaq study affected only
a very small sample of common stocks and focused on order routing to a
single exchange. As discussed in Section II.B, Nasdaq selected 14
stocks to be part of the analysis, which represent only 0.3% of all NMS
stocks. The sample is unlikely to be representative of the universe of
NMS securities for two reasons: (1) The sample included a small number
of stocks (and no ETPs),\272\ and (2) less than one-third of these
stocks were small or mid-capitalization at the time of the analysis,
although most had market capitalizations close to $3 billion
immediately prior to the study.\273\ Further, the analysis only focused
on the effects of changes to transaction-based fees for a single
exchange: Nasdaq. As the other equities exchanges did not have similar
changes to transaction-based fees and rebates, any inferences drawn
from the Nasdaq study may not be valid under different circumstances in
which all equities exchanges were subject to consistent revisions to
transaction-based fees.
---------------------------------------------------------------------------

    \272\ Only common stocks were included in the Nasdaq study,
while the proposed Pilot will include NMS stocks, which includes
common stocks as well as ETPs.
    \273\ Market capitalizations are computed from CRSP shares
outstanding and stock price, as of December 31, 2014.
---------------------------------------------------------------------------

    In the spirit of the Nasdaq study, exchanges could coordinate
voluntarily to simultaneously implement a pilot similar to the Nasdaq
pilot on all exchanges over a broader sample of stocks, to produce more
representative results. The Commission preliminarily believes, however,
that exchanges would not be likely to coordinate changes to access fees
and rebates for the purpose of studying potential conflicts of interest
between broker-dealers and their customers because of competitive
incentives, such as inducements to draw order flow away from
competitors.\274\
---------------------------------------------------------------------------

    \274\ With respect to the Nasdaq study, the purpose of revising
access fees and rebates was to determine how these changes affected
market share and Nasdaq's fraction of time at the NBBO.
---------------------------------------------------------------------------

    Researchers could conduct studies with data sources currently
available that provide more representative results than those provided
in existing studies. However, the Commission preliminarily believes
that data limitations discussed in greater detail below could make such
studies difficult. Moreover, the results of such studies would unlikely
be able to establish a causal connection between transaction-based fees
and order routing decisions by broker-dealers needed to inform policy
decisions on potential conflicts of interest. The importance of causal
inference is discussed in the next section.
ii. Causality
    In addition to limitations in how representative results may be,
existing studies are also of limited use for policy decisions because
they cannot test for causal relationships between transaction fees and
order routing decisions. Because transaction-based fees and order
routing decisions could be jointly determined, researchers cannot
readily disentangle the direction of causality, and therefore cannot
determine the extent that potential conflicts exist. The identification
of causal relations between fees and order routing decisions becomes
increasingly complex because exchanges have some discretion to modify
their fees.\275\ In practice, researchers attempt to identify and
measure causal relations in two ways: (1) Exogenous shocks, which have
been discussed above, and (2) econometric techniques, such as an
instrumental variables approach.\276\
---------------------------------------------------------------------------

    \275\ Over the last five years, the exchanges, on average, have
made 34 revisions, or approximately 6.7 revisions per year, to their
transaction-based fees and rebates. See Section V.B.2.b infra.
    \276\ The method of instrumental variables is used to estimate
causal relationships when controlled experiments or exogenous shocks
are not feasible. An ``instrument'' changes the explanatory variable
but has no independent effect on the dependent variable, allowing a
researcher to uncover the causal effect of the explanatory variables
on the dependent variable of interest.
---------------------------------------------------------------------------

    Although the Nasdaq study implements an exogenous shock, which
could have permitted causal inference regarding the relationships
between transaction fees, order routing, and market quality, that study
did not analyze the impact of potential conflicts of interest on order
routing decisions. Further, even if the Nasdaq study had analyzed a
causal relationship between transaction-based fee and rebates and
potential conflicts of interest, the

limited representativeness of the Nasdaq sample, would limit the
generality of the study.
    With respect to the transition between forms of pricing models that
occurred on the option exchanges, discussed above, the key limitation
is the comparison of maker-taker pricing models with payment for order
flow pricing models. Studies that explore these regime shifts between
maker-taker to payment for order flow models are not comparing
situations in which one regime could theoretically have lower conflicts
of interest than the other.\277\ Each of these types of models is
likely to create potential conflicts of interest that could affect how
broker-dealers route their customer orders,\278\ although evidence does
not suggest that one form of pricing model is more or less prone to
conflicts than another. Moreover, the change from one form of pricing
model to another could introduce new conflicts of interest that did not
previously exist. Therefore, the Commission preliminarily believes that
exchange-driven transitions between maker-taker and payment for order
flow pricing models are not likely to provide information about
potential conflicts of interest driven by the maker-taker and taker-
maker models or to inform the Commission about future regulatory
decisions regarding transaction-based fees.
---------------------------------------------------------------------------

    \277\ See supra note 264.
    \278\ See Robert Battalio, Andriy Shkilko, and Robert Van Ness,
``To Pay or Be Paid? The Impact of Taker Fees and Order Flow
Inducements on Trading Costs in U.S. Options Markets,'' Journal of
Financial and Quantitative Analysis 51, 1637-1662 (2016), available
at: https://www.cambridge.org/core/services/aop-cambridge-core/content/view/0782CE3E9679C29BB910A66192D27201/S0022109016000582a.pdf/div-class-title-to-pay-or-be-paid-the-impact-of-taker-fees-and-order-flow-inducements-on-trading-costs-in-u-s-options-markets-div.pdf.
---------------------------------------------------------------------------

    The Battalio Equity Market Study attempts to test for causal
relationships between liquidity rebates and order routing decisions of
broker-dealers using an instrumental variables approach. However, in
the absence of an exogenous shock to access fee caps or rebates outside
the control of exchanges, the authors are unable to definitively
determine the causes of broker-dealers' order routing decisions through
the use of econometric techniques. Consequently, the authors are unable
to disentangle whether fees and rebates drive broker-dealer order
routing decisions or order routing decisions determine fees and rebates
chosen by exchanges.
    Although exchanges revise their fee schedules frequently, the
Commission preliminarily does not believe that studying order routing
and execution quality around these fee changes alone can establish
causality because fee changes are at the discretion of exchanges and
could be caused by changes to order routing behavior. In the absence of
an event outside of the control of the exchanges (e.g., an exogenous
shock to either fees or rebates), identifying the direction of
causality between changes in fees and order routing behavior is nearly
impossible. Thus, any discretionary actions by exchanges to revise
their fee schedules independently of other exchanges is unlikely to
yield information that would be valuable to the Commission for
informing any future policy decisions about potential conflicts of
interest between broker-dealers and their customers.
iii. Existing Data Sources
    As noted above, several data sources provide information on order
routing and execution quality. While researchers theoretically could
use these data sources to produce representative results regarding the
relation between transaction-based fees, order routing, and execution
quality, the Commission preliminarily believes that data limitations,
would make these studies difficult to produce.
    As discussed previously, Rule 606 disclosures provide information
on order routing. Rule 606 disclosures are currently the only data
publicly available to researchers and others on order routing by
broker-dealers; however, limitations in the Rule 606 data reduce the
ability of researchers to use the data to produce representative
results. The data are cumbersome to collect on a broad scale, as
researchers would generally need to access each broker-dealer's web
page to manually download the data. The Rule 606 data are also only
available at a quarterly frequency, and broker dealers are not required
to maintain historical data, which hampers the ability to efficiently
produce research on multiple quarters of data, and could lead to short
sample periods that may provide relatively limited power for
statistical tests.\279\ Notably, there currently is no central
repository of these data, so any collection of this information by
researchers would be a lengthy and labor-intensive process. For
example, a researcher that has not already downloaded a time series of
Rule 606 reports would need to download one quarter at a time, waiting
three months for each quarter's data to create a time series;
assembling a single year's worth of data would require nine to twelve
months. Such delays could significantly increase the opportunity costs
of undertaking such studies and decrease the likelihood of new research
on the relation between transaction-based fees and order routing
decisions. Moreover, these limitations also could prevent other
researchers and other analysts from verifying or replicating analyses
if researchers did not concurrently collect the Rule 606 reports across
the same periods of observation.
---------------------------------------------------------------------------

    \279\ See supra note 118.
---------------------------------------------------------------------------

    In addition, the quarterly frequency of the Rule 606 reports by
broker-dealers is different from the frequency of changes in fee
schedules by exchanges (e.g., as presented in Table 2, over a recent
five-year measurement period, the average exchange updated its fees
schedule approximately 6.7 times per year).\280\ Further, while the
Rule 606 data provides order routing at the broker-dealer level, such
information is not granular enough to thoroughly study potential
conflicts of interest.
---------------------------------------------------------------------------

    \280\ Not every fee schedule revision pertains to access fees or
rebates. To focus only on these revisions, each Form 19b-4 fee
filing was evaluated to determine that revisions to fees or rebates
were pertinent to this baseline.
---------------------------------------------------------------------------

    The value of Rule 606 disclosures for identifying possible
conflicts of interest resulting from transaction-based fees would be
limited for a number of additional reasons, even if the Commission were
to require a historical time series of these disclosures for all
broker-dealers.
    First, each broker-dealer discloses data for only its top ten order
routing venues. Second, because broker-dealers disclose data at a
quarterly frequency, a five-year sample of Rule 606 data for a single
broker-dealer, would include only 20 observations, limiting statistical
power. Third, although Rule 606 reports also provide some disclosure
about potential broker-dealer conflicts of interest, they do not
include any disclosure of access fees assessed or rebates offered by
exchanges to the broker-dealers. Fourth, Rule 606 data do not
distinguish between marketable and non-marketable limit orders.
Finally, Rule 606 currently covers only retail orders. If institutional
orders also are subject to potential conflicts of interest, studying
Rule 606 data alone would not inform on such conflicts of interest.
    To produce representative results using proprietary broker-dealer
or exchange data would require obtaining these data from a sufficient
number of diverse broker-dealers and exchanges. However, proprietary
data from broker-dealers or exchanges are generally not available to
the public. While some researchers have obtained such data

from a single broker-dealer or exchange, and some broker-dealers and
exchanges employ their own researchers, the Commission preliminarily
believes that it would be difficult for researchers to obtain such data
from a sufficient number of broker-dealers or exchanges in order to
produce representative results.
    Regardless of whether researchers would obtain data from Rule 606
disclosures or directly from exchanges, much of the data currently
available is either unstructured or in a non-standardized format. For
instance, many broker-dealers provide PDF files of Rule 606
disclosures, while exchanges use bespoke terminology to classify their
fees and rebates, which likely limits the value of these data for
researchers examining the effect of fees and rebates on order routing
decisions. This lack of standardization across platforms could make it
difficult for researchers to aggregate data and construct
representative samples for comparison and analyses.
    While Rule 605 and TAQ data are available to researchers and may
provide information about execution quality, they too have a number of
limitations. For example, Rule 605 data provides execution quality
information for both marketable and non-marketable orders; however, the
methodologies for estimating measures of the speed of execution of non-
marketable orders are outdated.\281\ For instance, Rule 605 measures
realized spreads based on quotations five minutes after the time of
order execution and recent research suggests using quotations that more
closely follow a trade, because any temporary price impact of a trade
goes away within seconds, not minutes, of the trade.\282\ Like Rule 606
data, Rule 605 data also covers smaller retail-sized orders only, and
the data are only available at the monthly frequency. Instead,
researchers and the Commission could rely on TAQ data, a publicly
available dataset provided by the NYSE to subscribers, in order to
capture some measures of execution quality. However, the TAQ data has
limited information on limit order execution quality that would be
valuable to the Commission and others.
---------------------------------------------------------------------------

    \281\ See Concept Release, supra note 3.
    \282\ See, e.g., Jennifer Conrad and Sunil Wahal, ``The Term
Structure of Liquidity Provision,'' Working Paper, University of
North Carolina--Chapel Hill (2017), available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2837111.
---------------------------------------------------------------------------

    To incorporate transaction-based fee information into analyses,
researchers would need to manually collect and compile the information
from exchanges' websites and their Form 19b-4 fee filings, which notify
the Commission of changes to those fee schedules. Although the current
fee schedules are posted on exchange websites, in order to identify
changes to those fees, researchers would need to search the
Commission's website for such Form 19b-4 fee filings to identify when
exchanges change their fees and to gather information about those fees,
as exchanges do not file their fees on a routine basis, but rather only
when making changes. Such information would be cumbersome to compile.
Additionally, because of the complexity of exchange fee structures and
the lack of standardization of these structures across exchanges,
identifying comparable fees across exchanges is unwieldy. For example,
identifying the base or top-tier fees across exchanges could be
difficult for researchers. As shown in Table 2 below, the average
exchange has 24 different access fee categories and 21 different rebate
categories. Further, exchanges do not disclose per share average or
median fees charged and rebates earned on any report or filing, so such
information is unavailable to the public. To add to the impediments to
fee data aggregation and comparison, Form 19b-4 fee filings are
available only as PDF files downloadable from the Commission's website,
thereby increasing the costs of aggregation across exchanges over time
by researchers.
    Even if limitations to data availability and aggregation were
overcome and researchers could construct a representative sample of fee
and routing data, researchers would still face obstacles in
understanding the relationship between transaction-based fees and
rebates and routing decisions. Without an exogenous shock to fees and
rebates to infer the causal relation between these transaction-based
fees and order routing decisions, researchers would not be able to
analyze whether the order routing decisions observed are driven by fees
and rebates or vice versa.\283\
---------------------------------------------------------------------------

    \283\ See Section V.B.1.b.ii supra.
---------------------------------------------------------------------------

2. Current Market Environment
    This section provides an overview of the market for trading
services, and of the exchanges and ATSs that could be affected as a
result of revisions to the transaction-based fee structure required by
the proposed Pilot. Where information is currently available to the
Commission, a description of the current practices of exchanges along
dimensions that are relevant to the proposed Pilot (e.g., summary
information on their current fee schedule or the frequency of fee
revisions) are included.
a. Market for Trading Services
    The market for trading services, which is served by exchanges,
ATSs, and other liquidity providers (internalizers and others),\284\
relies on competition to supply investors with execution services at
efficient prices. These trading venues, which compete to match traders
with counterparties, provide a platform for price negotiation and
dissemination of trading information. The market for trading services
in NMS securities consists of 13 national equity market exchanges and
34 ATSs. Other off-exchange venues include internalizers and
wholesalers, which execute a substantial volume of retail order flow.
The remainder of this section discusses the current competitive
landscape for exchanges and ATSs relevant to our economic analysis of
the proposed Pilot.
---------------------------------------------------------------------------

    \284\ See supra note 247.
---------------------------------------------------------------------------

    Since the adoption of Regulation NMS in 2005, the market for
trading services has become more fragmented and competitive. As of July
18, 2017, 13 national equity market exchanges operate in the U.S., as
shown in Table 1. Of these exchanges, nine are maker-taker exchanges
and two are taker-maker pricing exchanges; the EDGA and IEX operate as
flat-fee exchanges.\285\ Since Regulation NMS was adopted in 2005, the
market for trading services has become significantly more competitive
as measured by the decline in market share of individual exchanges,
discussed in more detail below. The number of U.S. equities exchanges
has increased by over 60%, as the number of exchanges increased from
eight exchanges in 2005 to 13 exchanges operating today, as shown in
Table 1.\286\

Several studies have suggested that transaction-based fee pricing
partially drove the increase in the number of U.S. equities exchanges
since 2005.\287\
---------------------------------------------------------------------------

    \285\ IEX charges a flat fee of $0.0009 for trades against non-
displayed liquidity on both sides of the market, and charges $0.0003
for trade execution against displayed liquidity. See https://iextrading.com/trading/fees. As of March 2018, EDGA is no longer
operating as a taker-maker market, but is also operating as a flat-
fee venue. See http://markets.cboe.com/us/equities/.
    \286\ Although 13 U.S. equities exchanges currently operate as
of March 2018, the majority of these exchanges are part of exchange
families. For instance, NYSE, NYSE Arca, NYSE American, and NYSE
National, are all part of the NYSE Group, which is wholly owned by
the Intercontinental Exchange (ICE), while Nasdaq, Phlx, and BX, are
owned by Nasdaq. BATS, BATS-Y, EDGA, and EDGX, which all operated as
ATSs in 2005, are all subsidiaries of Cboe Global Market, Inc.
Although many exchanges belong to exchange groups, the Commission
preliminarily believes that each of these exchanges operates
independently of the other exchanges owned by the same parent
company. IEX became a registered exchange in 2016. Further, NSX
(NYSE National) existed as an exchange in 2005, but halted
operations in 2016. It was acquired by NYSE/ICE in January 2017,
which indicated at the time of the acquisition that it will operate
the exchange as NYSE National. See ``NYSE Finalizes Acquisition of
National Stock Exchange,'' Press Release, Intercontinental Exchange
(January 31, 2017), available at: http://ir.theice.com/press/press-releases/all-categories/2017/01-31-2017-232800326. Researchers can
adequately control for exchanges that are subsidiaries of the same
parent when conducting analyses of the effect of changes in
transaction-based fees on order routes.
    \287\ See, e.g., Angel, Harris, and Spatt, supra notes 106 and
216; Harris, supra note 23.
---------------------------------------------------------------------------

    Execution services are a lucrative business, which encourages new
trading centers to enter the market in the hopes of capturing rents
associated with order execution.\288\ As discussed above, liquidity
externalities, where the more liquid venues attract more interest and
therefore more liquidity, could result in a single venue (or very
limited number of venues) being the preferred trading location for any
given stock because all traders could optimally route orders to the
venue with the highest liquidity for a given stock.\289\ If rebates
offered by exchanges are large enough, they provide incentives for
market participants to route orders to those venues, in order to
capture the rebates. Rebates offered by exchanges, therefore, may
``break'' the liquidity externality.
---------------------------------------------------------------------------

    \288\ See id.
    \289\ Liquidity externalities are discussed in more detail in
Section V.A.2, supra.
    \290\ Shares are computed based on share volume. Market shares
for the exchanges reported do not add up to 100%, since
approximately 37% of share volume trades off-exchange on over-the-
counter venues.
    \291\ As of March 2018, EDGA is no longer operating as a taker-
maker exchange and is now operating as a flat-fee venue; however, it
was operating as one as of July 2017 when the data for this table
was obtained.
    \292\ In 2005, BX existed as the Boston Stock Exchange.
    \293\ As of July 2017, NYSE American is no longer a purely
maker-taker market as only certain types of market participants
(electronic Designated Market Makers) are eligible for rebates. See
NYSE American Equities Price List, available at: https://www.nyse.com/publicdocs/nyse/markets/nyse-american/NYSE_America_Equities_Price_List.pdf.
    \294\ NYSE acquired NSX in January 2017, and the exchange is now
known as NYSE National. Although not currently operational, the
Commission has assumed for the purposes of this analysis that it
will be operational during the Pilot.

                            Table 1--U.S. National Equities Exchanges as of July 2017
----------------------------------------------------------------------------------------------------------------
                                                                                Exchange in   Market Share
                    Exchange                               Market fee type              2005?        \290\ (%)
----------------------------------------------------------------------------------------------------------------
Cboe BZX--https://markets.cboe.com.............  Maker-Taker.......................  ...........            5.95
Cboe BYX--https://markets.cboe.com.............  Taker-Maker.......................  ...........            4.80
Cboe EDGA \291\--https://markets.cboe.com......  Taker-Maker.......................  ...........            1.64
Cboe EDGX--https://markets.cboe.com............  Maker-Taker.......................  ...........            6.38
BX \292\--www.nasdaqtrader.com.................  Taker-Maker.......................     [check]             3.02
Phlx (PSX)--www.nasdaqtrader.com...............  Maker-Taker.......................     [check]             0.76
Nasdaq--www.nasdaqtrader.com...................  Maker-Taker.......................     [check]            14.51
NYSE Arca--https://www.nyse.com/markets........  Maker-Taker.......................     [check]             9.03
NYSE American \293\--https://www.nyse.com/       Maker-Taker.......................     [check]             0.34
 markets.
NYSE--https://www.nyse.com/markets.............  Maker-Taker.......................     [check]            13.90
NYSE National \294\--https://www.nyse.com/       Maker-Taker.......................     [check]   ..............
 markets.
CHX--www.chx.com...............................  Maker-Taker.......................     [check]             0.42
IEX--www.iextrading.com........................  ..................................  ...........            2.14
----------------------------------------------------------------------------------------------------------------

    Table 1 also highlights that market share of trading volume among
exchanges is not very concentrated. Although NYSE and Nasdaq have the
largest overall total volume market shares of approximately 14% each
among the exchanges, as of July 2017, these two exchanges collectively
account for less than 30% of the total market share of trading volume
for NMS securities, indicating that the market for trading services has
become decentralized, and has become more so over time. For instance,
between 2004 and 2013, the market share of NYSE-listed stocks on the
NYSE declined from approximately 80% to 20%, while market share on
other exchanges and off-exchange trading centers has increased.\295\
This decentralization provides market participants with a choice among
venues when they route orders, and may also encourage exchanges to
attract order flow. For instance, transaction-based fees represent one
means by which national securities exchanges may compete for order
flow, and exchanges may adopt business models that focus on attracting
order flow by offering large rebates or charging competitive fees.
Exchanges may compete for order flow on other dimensions as well, by
offering better execution quality and innovations in order types and
other trading mechanisms.
---------------------------------------------------------------------------

    \295\ See Angel, Harris, and Spatt, supra note 216, Figures 2.17
and 2.18. Although less evident than for NYSE-listed securities, the
effect is similar for the Nasdaq market.
---------------------------------------------------------------------------

    In addition to competing with other U.S. equities exchanges,
exchanges also compete for order flow from off-exchange trading
centers, including ATSs, internalizers, and others. Broker-dealers may
opt to route order flow off-exchange, as they may be able to avoid
access fees paid to exchanges for doing so. Off-exchange trading makes
up a substantial fraction of total volume, as approximately 37% of all
transaction reports are routed using the NYSE and Nasdaq Trade
Reporting Facilities as of July 2017.\296\ Of that off-exchange NMS
share volume, approximately 13% was attributable to ATSs, of which 34
traded NMS securities as of July 2017.\297\ The remaining 24% of off-
exchange share volume is routed to other off-exchange trading centers,
such as internalizers.\298\ In aggregate, broker-dealers and other
market participants have a large and varied set of options as to where
they route orders, whether to exchanges or to

off-exchange trading centers. Moreover, empirical evidence suggests
that traditional exchanges, such as NYSE and Nasdaq, are losing market
share to off-exchange trading centers and newer exchanges,\299\ which
may provide different incentives to broker-dealers in order to attract
this order flow, including access fees and rebates. We discuss the
current environment for transaction-based fees in the next section.
---------------------------------------------------------------------------

    \296\ Data on off-exchange market share are available from the
BATS Global Market web page, available at http://markets.cboe.com/us/equities/market_share/
    \297\ The estimates of ATSs that trade NMS stocks and ATS trade
volume share was developed using weekly summaries of trade volume
collected from ATSs pursuant to FINRA Rule 4552. See also Securities
Exchange Act Release No. 76474 (November 18, 2015), 80 FR 80998,
81109 (December 28, 2015) (Regulation of NMS Stock Alternative
Trading Systems). The estimates in this release were calculated in
the same manner as in the cited release. See also ``OTC (ATS & Non-
ATS) Transparency,'' FINRA, available at: http://www.finra.org/Industry/Compliance/MarketTransparency/ATS/.
    \298\ Total market share is collected from the BATS Global
Market web page, available at: http://markets.cboe.com/us/equities/market_share/. ATS weekly market share is collected from FINRA,
available at: https://otctransparency.finra.org.
    \299\ See Angel, Harris, and Spatt, supra note 216.
---------------------------------------------------------------------------

    The proposed Pilot is also likely to affect competition among
broker-dealers that route institutional and retail orders. These
broker-dealers compete in a segment of the market for broker-dealer
services. The market for broker-dealer services is highly competitive,
with most business concentrated among a small set of large broker-
dealers and thousands of small broker-dealers competing in niche or
regional segments of the market.\300\ Large broker-dealers typically
enjoy economies of scale over small broker-dealers and compete with
each other to service the smaller broker-dealers, who are both their
competitors and their customers.\301\ As of December 31, 2016,
approximately 4,000 broker-dealers filed Form X-17a-5. These firms
varied in size, with median assets of approximately $725,000, average
assets of nearly $1 billion, and total assets across all broker-dealers
of approximately $3.9 trillion. The twenty largest broker-dealers held
approximately 75% of the assets of broker-dealers overall, with total
assets of $2.93 trillion, indicating the high degree of concentration
in the industry. Of the 3,972 broker-dealers that filed Form X-17a-5,
430 are members of U.S. equities exchanges. Broker-dealers that are
members of equities exchanges had, on average, higher total assets than
other broker-dealers, with median assets of $21 million, average assets
of $8.6 billion, and total assets across all broker-dealers that are
members of exchanges of $3.6 trillion.
---------------------------------------------------------------------------

    \300\ See Securities Exchange Act Release No. 63241 (November 3,
2010), 75 FR 69791, 69822 (November 15, 2010) (``Risk Management
Controls for Brokers or Dealers with Market Access'').
    \301\ See id.
---------------------------------------------------------------------------

b. Transaction-Based Fees and Rebates
    Exchanges are required to disclose their current fee schedules,
which include transaction-based fees and rebates, connectivity fees,
membership fees, among others.\302\ When exchanges update their fees,
they are required to file Form 19b-4 with the Commission, which if
filed pursuant to Section 19(b)(3)(A) makes fee changes effective upon
filing.\303\ Although these fee schedules and Form 19b-4 fee filings
contain information about fees beyond transaction-based fees and
rebates, in this baseline, the discussion is limited to only
transaction-based fees and rebates and any changes thereto.
---------------------------------------------------------------------------

    \302\ See 17 CFR 240.19b-4(m)(1), which requires each SRO to
post and maintain a current and complete version of its rules,
including those related to transaction-based fees and rebates, on
its website.
    \303\ As discussed in Section V.B.1.b.iii supra, fee
information, such as that included in exchange fee schedules or Form
19b-4 fee filings, does not have standardization or formatting
requirements.
---------------------------------------------------------------------------

    Table 2 reports the range of minimum and maximum access fees and
rebates, as well as the number of categories for each (in parentheses
below the fee ranges), by exchange, for the most recently available fee
schedule.\304\ On average, U.S. exchanges have 24 access fee categories
and 21 rebate categories associated with these fee schedules. For the
maker-taker exchanges, access fees are capped at $0.0030, but are as
little as zero in some fee categories for some exchanges; taker-maker
exchanges, because they are not restricted in the amount they can
charge to non-marketable limit orders, have fees that range as high as
$0.0033. Seven exchanges have some categories of rebates that exceed
the maximum access fees charged by exchanges.
---------------------------------------------------------------------------

    \304\ The access fee and rebate ranges in Table 2 are collected
from recent fee schedules (as of July 18, 2017) available from each
individual exchange's website (listed in Table 1). Table 2 provides
the date from which these fee schedules were reported. The ranges in
fees are the minimum and maximum fees and rebates reported by each
exchange.
---------------------------------------------------------------------------

    Table 2 also provides the number of fee revisions for the exchanges
as reported in their Form 19b-4 fee filings to the Commission in the
last five years (July 16, 2012-July 18, 2017). Exchanges, on average,
have changed their fee schedules 34 times in the last five years,\305\
indicating that the average exchange revises its transaction-based fee
schedules about seven times per year (approximately every 7.4 weeks).
---------------------------------------------------------------------------

    \305\ The median number of revisions to fee and rebate schedules
by exchanges is 38 over the five-year period.

                        Table 2--Summary of Transaction-Based Fee Schedules for U.S. National Equities Exchanges as of July 2017
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                           Number of     Date of last
               Exchange                  revisions  (5   fee schedule        Access fees  (# of categories)             Rebates  (# of categories)
                                            years)         available
--------------------------------------------------------------------------------------------------------------------------------------------------------
Cboe BZX..............................              40       7/15/2017  $0.0000-$0.0030 (31)...................  $0.0010-$0.0032 (16)
Cboe BYX..............................              45       7/15/2017  $0.0000-$0.0033 (36)...................  $0.0010-$0.0025 (12)
Cboe EDGA.............................              47       7/15/2017  $0.0000-$0.0032 (48)...................  $0.0011-$0.0027 (10)
Cboe EDGX.............................              64       7/15/2017  $0.0000-$0.0030 (37)...................  $0.0011-$0.0034 (19)
BX....................................              31       7/13/2017  $0.0005-$0.0030 (10)...................  $0.0000-$0.0025 (8)
Phlx (PSX)............................              26       7/15/2017  $0.0026-$0.0030 (5)....................  $0.0023-$0.0031 (7)
Nasdaq................................              59       7/20/2017  $0.0030 (2)............................  $0.0000-$0.0034 (36)
NYSE Arca.............................              51        7/3/2017  $0.0006-$0.0030 (68)...................  $0.0002-$0.0033 (61)
NYSE American.........................               9       7/24/2017  $0.0003-$0.0030 (34)...................  $0.0000-$0.0045 (41)
NYSE..................................              38        7/1/2017  $0.0003-$0.0030 (14)...................  $0.0000-$0.0045 (40)
NYSE National \306\...................              19       9/20/2016  $0.0003-$0.0030 (2)....................  $0.0000 (1)
CHX...................................               8        5/3/2017  $0.0030 (1)............................  $0.0020 (1)
IEX...................................               1       8/19/2016  $0.0009................................  -$0.0009
--------------------------------------------------------------------------------------------------------------------------------------------------------

    For several of the exchange families, information about revenues
and costs attributed to transaction-based fees and rebates is available
in aggregate from Form 10-K filings. Using the statements of income
from Form 10-K filings for 2016 capturing the net (of rebates)
transactions-based revenues, the Nasdaq exchanges (Nasdaq, BX, and PSX)

earned $564 million.\307\ Based on the same measure the NYSE-affiliated
exchanges (NYSE, NYSE Arca, NYSE American, and NYSE National) earned
$223 million in transaction-based fees net of rebates,\308\ while the
BATS Global Markets (now, Cboe BZX, Cboe BYX, Cboe EDGA, and Cboe
EGDX), for the nine months ended September 30, 2016, earned $177
million in transaction-based fees net of rebates.\309\ Neither CHX nor
IEX or their affiliates are publicly traded, meaning that these
exchanges do not file an annual Form 10-K with the Commission. As a
result, public information regarding the revenues or profits associated
with transaction-based fees does not exist for these exchanges.
---------------------------------------------------------------------------

    \306\ NYSE acquired NSX in January 2017, and the exchange is now
known as NYSE National. As of March 2018, the exchange currently has
not submitted new fee schedules nor has it reported any trading
volume in recent months.
    \307\ See the Nasdaq 2016 Form 10-K filings, available at:
https://www.sec.gov/Archives/edgar/data/1120193/000112019317000003/ndaq1231201610-k.htm. Net transaction-based revenues for equity
securities were approximately 25% of total operating margin.
    \308\ See the Intercontinental Exchange 2016 Form 10-K filings,
available at: http://otp.investis.com/clients/us/intercontinental_exchange_group2/SEC/sec-show.aspx?Type=html&FilingId=11827791&Cik=0001571949. For the
Intercontinental Exchange, net transaction-based revenues were
approximately 10% of operating income for 2016.
    \309\ See the Bats Global Markets Form 10-Q filings (September
30, 2016), available at: http://www.snl.com/Cache/36600023.pdf. Cboe
announced its intent to acquire BATS Global Markets in September
2016, and the acquisition became effective on March 1, 2017. For the
nine-month ending September 30, 2016, the net transaction-based
revenues were 62% of BATS operating profits over the same time
period.
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    Information on the net transactions-based revenues for each
individual exchange, as opposed to the amounts reported for exchange
groups in Form 10-K filings, is not currently publicly available,
making it difficult to analyze the fees and rebates for an individual
exchange. To estimate the net transactions-based revenues for each
individual exchange, Table 3 reports the maximum and median net
transaction-based fees based on each exchange's most recently reported
fee schedule and the share volume of each exchange for June 16, 2017
through July 18, 2017.\310\ As evidenced by the significant differences
between the sum of net of rebate revenues for entities reporting to the
same exchange group obtained from Table 3 and the total net of rebate
revenues for each exchange family reported on the Form 10-K or 10-Q
filings, this approach does not yield reliable results, highlighting
the limitations on the data currently available to researchers.
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    \310\ The share volume is obtained from the Cboe website,
available at http://markets.cboe.com/us/equities/market_share/. To
compute the maximum profit attainable, staff took the difference
between the highest possible access fee and the lowest possible
rebate and multiplied it by the monthly share volume. For a midpoint
profit, the median of the access fees less the median of the rebates
is computed and multiplied it by share volume. In order to make the
results comparable to those reported above from Form 10-K filings,
the monthly profits are annualized by multiplying each monthly
profit amount by 12.

Table 3--Estimates of Annualized Per-Exchange Net Transaction-Based Fee Revenues From Transaction-Based Fees and
                                          Monthly Exchange Share Volume
                                        [for June 16, 2017-July 18, 2017]
                                                  [in millions]
----------------------------------------------------------------------------------------------------------------
                                                    Annualized       Per share      Annualized       Per share
            Exchanges              Share  volume     midpoint         profit          maximum         profit
                                       \311\        difference       (median)       difference       (maximum)
----------------------------------------------------------------------------------------------------------------
Cboe BZX........................           8,677         ($62.5)       ($0.0006)          $208.2         $0.0020
Cboe BYX........................           7,003           (8.4)        (0.0001)           193.3          0.0023
Cboe EDGA.......................           2,388           (8.6)        (0.0003)            60.2          0.0021
Cboe EDGX.......................           9,310          (83.8)        (0.0008)           212.3          0.0019
BX..............................           4,411            24.5          0.0005           158.8          0.0030
Phlx (PSX)......................           1,115             1.3          0.0001             9.4          0.0007
Nasdaq..........................          21,171           330.3          0.0013           762.2          0.0030
NYSE Arca.......................          13,175             7.9          0.0001           442.7          0.0028
NYSE American...................             494           (3.6)        (0.0006)            17.8          0.0030
NYSE............................          20,277           (146)        (0.0006)             730          0.0030
NYSE National...................  ..............  ..............  ..............  ..............  ..............
CHX.............................             609             7.3          0.0010             7.3          0.0010
IEX.............................           3,117             N/A         $0.0000             N/A          0.0000
----------------------------------------------------------------------------------------------------------------

C. Analysis of Benefits and Costs of Proposed Transaction Fee Pilot
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    \311\ Monthly share volume obtained from Cboe for June 16, 2017
through July 18, 2017, available at http://markets.cboe.com/us/equities/market_share/.
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1. Benefits of Proposed Transaction Fee Pilot
    The Commission expects that the benefits of the proposed
Transaction Fee Pilot would fall into two categories: More informed
policy decisions, including more information about potential conflicts
of interest between broker-dealers and their customers (primary
benefits) and more information on other issues important to the
Commission (ancillary benefits), as well as other benefits that may
accrue to market participants for the duration of the proposed Pilot.
In this section we discuss each of the categories of benefits as well
as potential limitations to those benefits.
a. Benefits of More Informed Policy Decisions
i. Benefits of Studying Potential Conflicts of Interest
    The Commission preliminarily believes that the proposed Transaction
Fee Pilot would lead to a more thorough understanding of issues related
to potential conflicts of interest arising from transaction-based
pricing models, which would ultimately inform the Commission's policy
decisions. This increased understanding would derive from design
elements of the proposed Transaction Fee Pilot that address the
limitations of currently available information described in the
baseline: Lack of representative results, inability to identify
causality, and insufficient publicly available data. The data obtained
will improve the quality of research and analysis by the Commission and
others, which will provide additional data about the effect of
transaction-based fees on order routing decisions of broker-dealers in
ways that reflect potential conflicts of interest with their clients.
The Commission believes that these additional data, which would be
unavailable in the absence of the proposed Pilot, would help the

Commission make more informed and effective future policy decisions to
the ultimate benefit of investors.
    To obtain the additional data to understand the relationship
between fees and rebates and order routing decisions, the proposed
Transaction Fee Pilot would simultaneously create several different fee
environments, each of which restricts transaction-based fees
differently, and would make available data that allows researchers to
compare order routing, execution quality, and market quality in these
fee environments to the current fee environment. The study of these
comparisons would inform the Commission and the public about any
possible conflicts of interest that arise as a result of transaction-
based fees. The Commission preliminarily believes that the different
fee environments created by the proposed Pilot, even though implemented
temporarily and over representative subsamples NMS securities, would
produce effects on order routing decisions by broker-dealers that are
identical or similar to those that would arise under a similar
permanent change to our regulatory environment. Therefore, the
Commission preliminarily believes that the information obtained from
the Pilot will help inform our consideration of any future proposals.
    As noted, three distinct features of the proposed Pilot's design
would facilitate analyses of the relationship, if any, between fees and
potential conflicts of interest. Specifically, the proposed Pilot is
designed to provide (1) representative results; (2) sufficient
information to determine causality; and (3) more direct access to data
that is currently unavailable or requires lengthy and labor-intensive
effort to compile and process. The following sections discuss in detail
each of these aspects of the proposed Pilot and how they could improve
upon the information currently available.

A. Representative Results

    In the context of the proposed Transaction Fee Pilot,
representativeness of results means that the impact of the proposed
Pilot's terms on a Test Group during the Pilot Period is likely to be
consistent with the impact of the results on the Test Group if the
Pilot's terms were permanent (as opposed to temporary).
Representativeness is desirable for researchers and policy makers
because it ensures that inferences drawn from the results of analysis
of Pilot data are likely to be similar to those that would emerge if
the terms were permanent. As discussed in the baseline, current
analyses are limited in their ability to broadly inform policy choices
by some combination of the following: Order routing data from a single
broker-dealer, a small sample of securities, a single exchange, or a
short sample period. By contrast, the Commission preliminarily believes
that the proposed Pilot, as designed, would produce more representative
results. Specifically, as discussed in detail below, the proposed Pilot
would cover a large stratified sample of nearly all NMS stocks
(including ETPs), both maker-taker and taker-maker exchanges, and
access fee caps as well as a prohibition on rebates or Linked Pricing,
and would have a two-year duration with an automatic sunset at the end
of the first year unless the Commission determines, at its discretion,
that the proposed Pilot shall continue for up to another year.\312\ The
proposed Pilot also would capture and make available to the public for
research and analysis, a comprehensive database of the order routing
decisions of all broker-dealers that route orders to U.S. equities
exchanges. As detailed in the baseline, it would be infeasible for
researchers to compile current data sources across all broker-dealers.
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    \312\ As designed, the proposed Pilot will only exclude NMS
securities that have prices below $2.00 per share as of the date of
pilot selection. As detailed above, the data would also be produced
for a six-month pre-Pilot Period and a six-month post-Pilot Period.
---------------------------------------------------------------------------

    The Commission preliminarily believes that the proposed Pilot would
produce representative results, presenting a significant improvement on
existing studies, because the proposed Pilot applies to a large
stratified sample of NMS stocks (including ETPs) with prices of at
least $2.00 per share at the date of the Pilot Securities selection,
and with no restrictions on market capitalization. In particular, the
Commission recognizes that any possible conflicts of interest related
to transaction-based fees could vary across securities such that the
results of a pilot focused only on large capitalization stocks may not
provide information relevant to small capitalization stocks or
ETPs.\313\ Including nearly all NMS securities allows the results to
inform policy choices across any subset of these securities. The
stratification of the stocks selected for each test group is designed
to ensure that each test group and the control group have a similar
composition, facilitating a comparison across groups, which further
supports the representativeness of results. If, for instance, the test
groups and control group had a different composition, researchers might
not be able to distinguish whether differences across test groups and
the control group stem from different fee environments or different
sample composition, rendering the results less representative. In
addition, the Commission preliminarily believes that the sample sizes
in the test groups are sufficient to provide the statistical power
necessary to identify differences across the samples.
---------------------------------------------------------------------------

    \313\ See, e.g., Battalio Equity Market Study, supra note 22.
---------------------------------------------------------------------------

    Representativeness of results of the Pilot would also be promoted
by the choice of the Pilot Security selection date. The proposed rule
would allow the Commission to select the Pilot Securities at any point
in time up to Pilot start date. As noted in Section III.E.1, the
Commission anticipates that it would assign and designate by notice
each Pilot Security to one Test Group or the Control Group
approximately one month prior to the start of the Pilot. By assigning
securities close to the start of the Pilot, each Test Group and the
Control Group are likely to be more comparable during the Pilot.
Because stratification criteria (e.g., market capitalization and
liquidity) vary naturally over time, the closer the assignments occurs
to the proposed Pilot effective date, the more comparable the Test
Groups would be during the proposed Pilot. Selection of securities
close to the start of the proposed Pilot would also be more likely to
include the intended universe of securities, by capturing securities
that enter the market between the possible adoption of the rule and the
start of the proposed Pilot, while avoiding securities that exit during
this period. Further, to the extent that market participants would
change their behavior in anticipation of the proposed Pilot, setting
the selection period close to the proposed Pilot effective date could
reduce the effect of such behavior on pre-Pilot data.
    The results of the proposed Pilot would be further representative
because the proposed Pilot applies to all U.S. equities exchanges
regardless of fee structure. Broker-dealers potentially face
transaction-fee related conflicts of interest regardless of whether
those fees are on maker-taker exchanges or taker-maker exchanges.
Further, a pilot that addresses only a single fee structure would not
produce results relevant for policy choices that also would apply to
another fee structure.
    Applying the proposed Pilot to all exchanges also improves upon the
existing analysis of the limited fee experiment conducted by Nasdaq,
which only covered a single exchange, as explained in Section V.B.1.
While the results from that study are suggestive

that broker-dealers routed customer orders to other exchanges that did
not change their transaction-based fees, reasons other than potential
conflicts of interest could have impacted the changes in order routing
decisions. The Commission believes that the proposed Pilot would
achieve representativeness by requiring transaction-fee changes for all
U.S. equities exchanges, which would allow researchers to identify how
these revisions affect order routing decisions across exchanges.
Further, the proposed Pilot would require that changes to fees or
rebates would be applied at the security level, which means that for
any given security, the limitation on access fees or rebates would be
ubiquitous across all exchanges.
    In addition, the proposed Pilot achieves representativeness by
imposing access fee caps and a prohibition on rebates or Linked
Pricing. The existing literature suggests that the potential conflicts
of interest arising from access fees could induce behavior that would
be different from the behavior induced from conflicts arising from
rebates or Linked Pricing. Therefore, the inclusion of caps on both
access fees and rebates or Linked Pricing allows for a more
comprehensive analysis of any possible conflicts of interest than could
be achieved by focusing solely on access fees or rebates. For example,
Test Group 2 limits access fees to $0.0005, which could feasibly limit
rebates paid on displayed liquidity, while Test Group 3 strictly
prohibits rebates or Linked Pricing across the entire depth of book for
displayed and non-displayed liquidity. On the surface, it appears that
Test Groups 2 and 3 both could eliminate rebates paid to broker-
dealers; however, these categories are not equal in their ability to
reduce rebates.\314\
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    \314\ The Commission preliminarily believes that applying the
top of book and depth of book restriction to Test Group 3, but not
in Test Group 2, is not an area of significant difference between
the two test groups. Section III.C.3, supra, provides discussion for
why Test Groups 1 and 2 do not have requirements to access fees for
non-displayed or depth-of-book liquidity.
---------------------------------------------------------------------------

    Test Group 3 would completely prohibit rebates or Linked Pricing,
which could provide information on how exchanges compete for order flow
when rebates are not an option for exchanges, and could provide insight
into the equilibrium level of access fees in the absence of rebates or
Linked Pricing.\315\ Prohibiting exchanges from offering rebates or
Linked Pricing in Test Group 3 is necessary to maintain the economic
integrity of Test Group 3 and to provide information about Test Group 3
consistent with its objective to test the impact of eliminating rebates
on the natural equilibrium level of fees, within the current regulatory
structure, and the potential conflicts of interest that rebates may
cause.\316\ Although Rule 610(c) of Regulation NMS caps the maximum
access fee for exchanges at $0.0030, in the absence of rebates or
Linked Pricing, competition among exchanges could drive the average
access fee to an amount substantially below $0.0030.\317\ In other
words, Test Group 3 would allow competition among exchanges, in the
absence of rebates or Linked Pricing, to determine the level of access