better bids and offers away, and to layer specialist interest at prices
outside the BBO, would also be available. Specialist reserve file
capability and the yielding requirements for additional specialist
interest would become operational during this phase.
    As in Phase 1, Direct+ would continue to operate according to the
same restrictions and availability as set forth in NYSE Rules 1000-1005
today, and the Exchange anticipates that most trading would continue to
be effected in the auction market.
3. Phase 3--Automatic Routing of Orders, Elimination of Direct+
Restrictions, ``Slow'' Market Indicators, and Gap Quoting
    During Phase 3, the following changes would be implemented:
     Automatic routing of orders to automated markets posting
better bids and offers in accordance with Regulation NMS;
     Availability of NYSE IOC orders for automatic executions;
     Use of indicators to identify quotations that are not
immediately available for automatic executions;
     Implementation of gap quoting procedures;
     Elimination of size restrictions for automatic executions;
     Elimination of 30-second restriction on the entry of Auto
Ex Orders from the same person;
     Availability of automatic executions through the close;
     Elimination of Direct+ availability only to straight limit
orders;
     Elimination of Direct+ suspensions due to price (i.e., a
trade at a price that would be more than five cents from the last trade
in the stock on the Exchange);
     Elimination of Direct+ suspensions due to size (i.e., a
100-share published bid or offer);
     Conversion of marketable limit orders automatically to
Auto Ex Orders; and
     Automatic executions of designated market orders.
    Not all of these features would be made available at the same time
during this phase, but instead would be made available in all
securities over a period of time.
4. Phase 4--Floor Broker Reserve Features, Sweeps, LRPs, and New Order
Types
    Phase 4 would implement the following:

     Use of indicators to identify an execution involving an
Intermarket Sweep order;
     Floor brokers' ability to exclude interest, including
reserve, from the aggregate information available to the specialist;
     Sweep functionality for automatic executions;
     Activation of LRPs (both sweep and momentum), and the
publication via OpenBook or another Exchange data distribution channel
of the most restrictive LRP;
     Availability of new order types--AL and AM orders and
Intermarket Sweep orders;
     Specialists' ability to disseminate their layered interest
via OpenBook or another Exchange data distribution channel;
     Specialists' ability to manually enter reserve interest;
and
     Availability of IOC orders for automatic executions.
5. Phase 5--New Reporting Templates and Elimination of Suspensions of
Autoquote and Automatic Executions
    In Phase 5, NYSE proposes to implement the new Display Book system
templates and programming that would eliminate the suspension of
Autoquote and automatic executions.

G. Limited Hybrid Market Pilot

    As noted earlier, the Commission approved the testing of certain
functions the Hybrid Market on December 14, 2005, on a limited basis
and for a pilot period expiring on March 24, 2006.\227\ The Pilot
implemented testing, with respect to a limited group of securities, the
specialist interest files, the floor broker agency interest files, and
the priority, parity, and yielding rules as proposed in the Hybrid
Market.\228\
---------------------------------------------------------------------------

    \227\ See Pilot Extension, supra note 27.
    \228\ See also Pilot Amendment, supra note 27.
---------------------------------------------------------------------------

    Specifically, the Pilot allows specialists to manually layer their
proprietary trading interest outside the NYSE BBO into the Display Book
system.\229\ Specialists' proprietary interest remains in the Display
Book system until cancelled or executed. The Pilot also allows floor
brokers to electronically represent their customers' orders in the
floor broker agency interest files.\230\ Floor brokers could enter
interest in the floor broker agency interest files directly either at
the BBO or outside the BBO and could enter reserve size at the BBO so
long as 1,000 shares are displayed. In addition, the Pilot automates
the priority, parity, and yielding rules. The Pilot permits specialists
to trade on parity with orders represented by floor brokers when
specialists are increasing or decreasing their position and eliminates
floor brokers' ability to object to specialist parity. Finally, the
Pilot implemented the automation of CAP-DI orders and stop orders.\231\
---------------------------------------------------------------------------

    \229\ Prior to the Pilot, specialists could only manually place
their proprietary trading interest at the NYSE BBO.
    \230\ Prior to the Pilot, floor brokers could only enter their
customers' orders in the Display Book system through the specialist.
    \231\ In Amendment No. 8, the Exchange represented that it has
not encountered any systematic difficulties in connection with the
Pilot.
---------------------------------------------------------------------------

III. Summary of Comments and NYSE's Response

    The Commission received a total of 43 comment letters on the Hybrid
Market proposal.\232\ In addition to the amendments filed by the
Exchange that addressed many questions raised in the comment letters,
NYSE also filed the Response to Comments to address other specific
concerns raised in the comment letters.\233\
---------------------------------------------------------------------------

    \232\ See supra notes 6, 9, 12, and 13.
    \233\ See Response to Comments, supra note 14.
---------------------------------------------------------------------------

    A few commenters supported the NYSE's proposal to create a Hybrid
Market.\234\ Several commenters generally supported further automation
of the NYSE market,\235\ and some of these commenters claimed that the
Exchange had not gone far enough to create the automated mar ket that
Exchange users desire.\236\ A few commenters expressed dissatisfaction
with the proposal.\237\ Some of these commenters believed that the
Exchange failed to create a genuine hybrid market that would blend
floor-based and screen-based trading, that the proposed market did not
provide for any true inter-market competition, and that it gave
preferential treatment to specialists and/or floor brokers.\238\
---------------------------------------------------------------------------

    \234\ See IBG Letter II, Invictus Letter, and Power Letter.
    \235\ See, e.g., Ameritrade Letter, IBG Letters I and II, ICI
Letters I, II, and III, SIA Letters I, II and III, STANY Letter,
Telic Letter, and Vanguard Letter. However, one commenter suggested
that while the proposal could turn out well for liquid stocks, the
Exchange should consider separate and distinct rules for illiquid
securities. See Bear Stearns Letter.
    \236\ See, e.g., ICI Letters I and III and Telic Letter.
    \237\ See, e.g., Bloomberg Letters I and II, IBAC Letters I, II,
and III, Peake Letter I, Rutherfurd Letters I, II, III, IV, V, VI,
VII, VIII, IX, and X, Telic Letter, Torino Letter, and Weeden
Letter. See also Fidelity Letter III (urging the Commission to
consider a study indicating that NYSE's Hybrid Market would be a
substantially more costly trading environment than that of fully
electronic markets). However, see also Lipson Letter (stating that
the data does not justify Fidelity Letter III's conclusion).
    \238\ See, e.g., Bloomberg Letter I, IBAC Letters I and II,
Rutherfurd Letters I, III, and V, Telic Letter, Weeden Letter. In
particular, one of these commenters argued that specialists and
floor brokers in the proposed Hybrid Market should not be able to
charge floor brokerage commission on any orders that are executed
automatically in the Display Book system and not by the specialist
or floor broker personally. See Rutherfurd Letter I. Another
commenter was concerned that NYSE's ultimate plans would be to move
past any true ``hybrid'' and phase out the auction market entirely,
which the commenter believed would disadvantage the investing public
that relies on the face-to-face interaction on the floor to achieve
the best prices. See IBAC Letters I and II.
---------------------------------------------------------------------------

    Initially, most commenters had questions about the rules that the
Exchange had proposed. Specifically, in response to the First Notice, a
majority of commenters requested that NYSE provide more details and
specific trading examples showing how the Hybrid Market proposal would
work.\239\ Several commenters raised specific issues. For example,
several commenters on the First Notice questioned how the LRPs would
work,\240\ how specialists would participate in the Hybrid Market,\241\
how the floor broker agency interest file would interact with orders on
the Book,\242\ and how AL and AM orders would be handled.\243\ In
addition, several commenters requested more detail on automatic
execution.\244\ Specifically, commenters requested detail on how the
priority and parity rules would operate with the specialist interest
file and floor broker agency interest file,\245\ and the instances when
automatic executions would not be available.\246\
---------------------------------------------------------------------------

    \239\ See, e.g., Ameritrade Letter, Angelides Letter, Bear
Stearns Letter, Bloomberg Letter I, BSE Letter, Fidelity Letters I
and II, IBG Letter I, ICI Letter I, Instinet Letter, Peake Letter,
SIA Letter I, STANY Letter, and Telic Letter. After the Second and
Third Notices, a few commenters continued to believe that the
proposal did not fairly and accurately describe exactly what the
NYSE intended, and still had explicit questions relating to the
Hybrid Market. See also Bloomberg Letter II, IBAC Letters I and II,
and Rutherfurd Letters I, II, III, and V.
    \240\ See IBG Letter I and ICI Letter I. The Commission notes
that NYSE did not specifically define the parameters of its MLRP in
the First Notice.
    \241\ See IBG Letter I and ICI Letter I.
    \242\ See IBG Letter I and ICI Letter I.
    \243\ See IBG Letter I.
    \244\ See BSE Letter, Fidelity Letter I, and STANY Letter.
    \245\ See Fidelity Letter I, SIA Letter I, and STANY Letter.
    \246\ See BSE Letter, Instinet Letter, and STANY Letter.
---------------------------------------------------------------------------

    Several commenters also questioned how the Hybrid Market would
interact with other markets. For example, one commenter questioned
whether ITS would be capable of handling NYSE's increased interaction
with ``away markets'' and whether the Exchange had a contingency plan
to ensure that adequate linkages will be in place to accommodate the
enhancement to

Direct+.\247\ Other commenters questioned how the Hybrid Market would
operate in compliance with the ITS trade-through rule or the then-
proposed Regulation NMS.\248\
---------------------------------------------------------------------------

    \247\ See, e.g., STANY Letter. See also Ameritrade Letter
(voicing concern that Direct+ and ITS would fall short of today's
technological standards and create a slow, automated trading
environment for listed securities).
    \248\ See, e.g., Ameritrade Letter, Bloomberg Letters I and II,
BSE Letter, Fidelity Letters I and II, and SIA Letter I. See note
and accompanying text for a complete discussion of the comments on
this issue.
---------------------------------------------------------------------------

    The Exchange responded to the initial comments in its Amendment
Nos. 2 and 3, which the Commission published as the Second Notice.\249\
In addition to providing more detail on its proposal, NYSE submitted
detailed trading examples to demonstrate how its proposed Hybrid Market
would operate.\250\ Soon after the Second Notice was published, the
Commission reproposed its Regulation NMS.\251\ Commenters generally
asked the Commission to refrain from acting on NYSE's proposal until it
had made a decision on Regulation NMS to allow commenters to consider
the operation of the Hybrid Market in conjunction with Regulation
NMS.\252\ Several commenters, however, raised specific concerns about
NYSE's proposal as described in the Second Notice. For example,
commenters questioned whether it would be appropriate to allow
undisplayed floor broker interest to trade on parity with displayed
orders on the Book,\253\ whether it would be appropriate to allow
specialists to have access to non-public information about incoming
orders,\254\ and whether the sweep functionality would result in less
favorable executions of customer orders.\255\
---------------------------------------------------------------------------

    \249\ See note 8, supra.
    \250\ The Commission published these trading examples as Exhibit
A to the Second Notice.
    \251\ See Securities Exchange Act Release No. 50870 (December
16, 2004), 69 FR 77424 (December 27, 2004).
    \252\ See, e.g., ICI Letter III, Nasdaq Letter, and SIA Letters
II and III. See also Ameritrade Letter. A few commenters also urged
the Commission to examine the Hybrid Market proposal alongside
Regulation NMS. See, e.g., Angelides Letter, Fidelity Letter II,
Nasdaq Letter, and SIA Letters I, II and III.
    \253\ See Rutherfurd Letter II and Invictus Letter.
    \254\ See Rutherfurd Letter II, Invictus Letter, and ICI Letter
II.
    \255\ See Rutherfurd Letter II. See also Bloomberg Letters I and
II.
---------------------------------------------------------------------------

    After the Third Notice, certain commenters continued to question
several aspects of the proposal that they believed raised investor
fairness and logistical issues.\256\ Some of these commenters
encouraged the Exchange to modify its proposal to give priority to
investor orders and to encourage the display of limit orders.\257\
---------------------------------------------------------------------------

    \256\ See, e.g., IBAC Letters I and II (arguing that the
Commission should reject the Hybrid Market proposal because it lacks
the statutorily required information on possible impacts on
competition and because the proposal would indeed impair competition
and unfairly discriminate against floor brokers and investors), ICI
Letter III, Rutherfurd Letters IV, V, VI, VII, VIII, IX, and X, and
Vanguard Letter.
    \257\ See, e.g., ICI Letter III and Vanguard Letter.
---------------------------------------------------------------------------

    A number of commenters emphasized the significance of NYSE's
proposal.\258\ In fact, one commenter stated that NYSE's proposal was
``among the most significant SRO rule changes that the Commission has
had to evaluate for quite some time.'' \259\ Although the same
commenter favored a quick approval and implementation of the
proposal,\260\ other commenters cautioned the Commission to proceed
slowly in considering the NYSE's rule change, to give the industry and
investors an opportunity to gain a full understanding of the proposal's
effect.\261\ Some commenters believed that Direct+ should be subject to
a pilot program or have a phase-in period so that there would be an
opportunity to review the impact of the proposed changes before they
become a permanent fixture of the equities markets.\262\
---------------------------------------------------------------------------

    \258\ See Fidelity Letter I, IBG Letter I, and Weeden Letter.
    \259\ See IBG Letter I.
    \260\ See IBG Letter II.
    \261\ See, e.g., Angelides Letter, Bear Stearns Letter, SIA
Letter I, and Weeden Letter. A few commenters believed that the
Commission should hold a public hearing on the proposal. See, e.g.,
Angelides Letter, Fidelity Letter I, IBAC Letter II, and STANY
Letter.
    \262\ See, e.g., Bear Stearns Letter, Invictus Letter, SIA
Letter III, and STANY Letter.
---------------------------------------------------------------------------

    In its response, the Exchange stated that the proposed enhancements
to Direct+ were responsive to customer requests for greater electronic
access to the liquidity on the Exchange. The Exchange believed that
this, along with the new opportunities for price improvement via AL and
AM orders, would make for a better market, would encourage the display
of liquidity, and would allow customers to access this liquidity in the
manner that best suits their needs. In response to commenters' concerns
over the implementation of the Hybrid Market, the Exchange proposed, in
the Third Notice, to launch the Hybrid Market proposal in phases. The
Exchange believes this phased implementation should help ensure the
proper functioning of market participants' Hybrid Market-related
systems, promote the integration of Hybrid Market facilities into the
marketplace, and allow market participants adequate time to become
familiar with the features of the Hybrid Market.\263\
---------------------------------------------------------------------------

    \263\ In addition, as noted above, the Exchange implemented a
limited pilot to begin testing some of its Hybrid Market systems and
to give its floor members an opportunity to utilize its
functionality in live trading. See discussion of the Pilot in
Section II(G), supra.
---------------------------------------------------------------------------

A. Liquidity Available for Automatic Executions

    Several commenters argued that off-floor participants should be
able to place liquidity on the Display Book system without the use of a
floor member.\264\ Two commenters argued that the NYSE's proposal
failed to provide any material inducement to non-NYSE liquidity
providers to participate in the Hybrid Market.\265\ One of these
commenters stated that the proposal would ``perpetuate asymmetric
information between specialists, floor brokers and customers that only
serves to discourage competing liquidity providers * * *'' from
providing better prices and more liquidity.\266\
---------------------------------------------------------------------------

    \264\ See Rutherfurd Letters I and V, ICI Letter III, and
Vanguard Letter. But see ICI Letter II (noting that it did not
object to the Exchange providing floor brokers with the ability to
represent their customers as they do today).
    \265\ See Telic Letter and Weeden Letter.
    \266\ See Telic Letter.
---------------------------------------------------------------------------

1. Specialist Interest File and Specialist Reserve
    As discussed earlier, specialists would have the ability to
manually and systematically place in the Display Book their dealer
interest at prices at or outside the Exchange BBO.\267\ In addition, a
specialist would be able to maintain undisplayed reserve interest on
behalf of its dealer account at the Exchange BBO, provided that the
specialist displayed at least 2,000 shares at that price on the same
side of the market.\268\ Specialist interest at the Exchange BBO would
be disseminated; specialist reserve would not be disseminated. In
addition, specialist interest away from the Exchange BBO could be
disseminated, at the option of the specialist, via the NYSE's OpenBook
data feed.
---------------------------------------------------------------------------

    \267\ See proposed NYSE Rule 104(b)(i) and 104(c)(viii).
    \268\ See proposed NYSE Rule 104(d)(i).
---------------------------------------------------------------------------

    Many comments questioned the appropriateness of creating an
undisplayed interest file for those market participants that have a
time and place advantage relative to the rest of the marketplace.\269\
One commenter advised that the Exchange either continually monitor the
specialist's dealer position in real time to preclude unlawful trading
activity or require the specialist interest file to yield to all orders
in all instances.\270\
---------------------------------------------------------------------------

    \269\ See, e.g., Bloomberg Letters I and II, Rutherfurd Letters
I, III and V, and SIA Letter I.
    \270\ See Rutherfurd Letter I.

---------------------------------------------------------------------------

    The Exchange responded that it believes that the specialist
interest file would allow specialists to provide value by committing
capital and layering the Display Book system outside the BBO. According
to NYSE, such interest would benefit the marketplace by increasing
liquidity at prices outside the BBO, bridging temporary gaps in supply
and demand, dampening volatility, and potentially improving clean-up
prices. Additionally, the Exchange noted that specialists would have
the option to display all of their specialist interest file away from
the BBO in the aggregate price/volume information disseminated via NYSE
OpenBook.
(a) Specialists' Parity
    The Exchange also has proposed to amend its Rule 108 to provide
that the specialist interest file would be entitled to trade on parity
with interest in the floor broker agency interest files regardless of
whether the specialist is increasing or decreasing its position.
Specialist interest would, however, continue to yield to orders on the
Book. Three commenters opposed these proposed changes to NYSE Rule
108.\271\ Two believed that placing specialist proprietary trading on
parity with investors' orders would misalign the interests of
participants on the Exchange and likely contribute to the
ineffectiveness of the Hybrid Market.\272\ The other commenter
considered this change to be a contravention of the specialists'
negative obligation to trade only when reasonably necessary to maintain
a fair and orderly market.\273\ According to this commenter, specialist
parity acquisitions would amount to unnecessary dealer intervention
because there would be no market ``necessity'' for the specialist to
effect proprietary trades in these situations, where public orders
could otherwise fully satisfy contra-side interest.\274\
---------------------------------------------------------------------------

    \271\ See IBAC Letters I and II, ICI Letter III, and Rutherfurd
Letters III, IV, V, VI, VII, VIII, IX, and X. Two of these
commenters also challenged NYSE's interpretation of NYSE Rule 108
that provides that specialists can trade on parity with orders in
the Crowd when establishing or increasing their position, provided
that the floor broker or its customer does not object. See, e.g.,
IBAC Letter I and Rutherfurd Letters III, IV, V, VI, VII, VIII, IX,
and X.
    \272\ See IBAC Letters I (also contending that it would increase
volatility in the market) and II and ICI Letter III.
    \273\ See Rutherfurd Letters III, IV, V, VI, VII, VIII, IX, and
X. According to the commenter, since Section 11A of the Act promotes
the objective of public order interaction without dealer
intervention, specialist parity acquisitions would constitute an
example of unnecessary dealer intervention and could not be
reconciled with Section 11A. See Rutherfurd Letter III. See also
IBAC Letter I.
    \274\ See Rutherfurd Letters III, IV, V, VI, VII, VIII, IX, and
X.
---------------------------------------------------------------------------

    In response, the Exchange noted that, under current practice, floor
brokers in the Crowd may permit the specialist to be on parity with
their orders. The Exchange stated its belief that parity provides an
incentive for specialists to participate in the price discovery process
at the point of sale, and has the beneficial effects of dampening
volatility and lowering execution costs for investors. In response to
the concern that a specialist trading on parity when establishing or
increasing its position could be inconsistent with the negative
obligation, the Exchange clarified that the general negative obligation
incorporated into NYSE Rule 104.10 would continue to apply to all
specialist trading on the NYSE.\275\
---------------------------------------------------------------------------

    \275\ See also note infra and accompanying text.
---------------------------------------------------------------------------

2. Floor Broker Agency Interest Files and Reserve
    NYSE proposes to permit floor brokers to participate in the Hybrid
Market by allowing them to systematically provide liquidity at varying
prices at or outside the BBO with respect to orders the broker is
representing, but only while standing in the Crowd.\276\ While a floor
broker's agency interest, except reserve, would be displayed as part of
the quotation when it is at the BBO, floor broker agency interest
outside of the BBO would not be displayed. NYSE proposes to allow floor
broker agency interest to trade on parity with the specialist interest
file,\277\ and in many cases, with orders on the Book.
---------------------------------------------------------------------------

    \276\ However, as noted earlier, a floor broker would be
permitted to leave the Crowd without canceling its agency interest
files to recharge its handheld device. See proposed NYSE Rule
70.20(f).
    \277\ The specialist interest file would only trade on parity
with the floor broker agency interest file when there are no orders
on the Book executable at a particular price.
---------------------------------------------------------------------------

    The Commission received one comment letter criticizing the
requirement that floor brokers be physically present in the Crowd to
place interest in its floor broker agency interest file.\278\ Most of
the other comments regarding floor broker agency interest file focused
on the Exchange's proposal to not require the display of such interest
that is outside of the BBO while providing this interest with the
ability to trade on parity with displayed interest.\279\ Specifically,
several commenters questioned the fairness of allowing non-displayed
floor broker agency interest to trade on parity with disclosed orders
on the Book.\280\ Some commenters argued that this practice would be
inconsistent with the Exchange's goal of providing incentives to place
limit orders on the Exchange, and predicted that investors would be
reluctant to place limit orders on the Book knowing that they might not
be fully rewarded for displaying those orders.\281\
---------------------------------------------------------------------------

    \278\ See Invictus Letter. This commenter believed that the
proposed requirement that a floor broker agency interest file be
cancelled when the floor broker leaves the Crowd and the proposed
definition of a Crowd would be at odds with the direction of
technology, greater speed, productivity, and liquidity. Because
floor brokers are equipped with hand held computers and can act in a
virtual capacity at any post where they have customer interest
files, this commenter believed that limiting them to a distance of
five contiguous panels at the same post would be arbitrary and
unnecessarily restrictive and would put customers who use
independent floor brokers at a disadvantage. In response to this
criticism, the Exchange explained that, like the current floor today
where a floor broker has to be in the Crowd to participate in the
auction, the floor broker agency interest file was designed to allow
the floor broker to continue participation in the auction, but in an
automatic execution environment. In addition, the Exchange believes
that the range of five contiguous panels in the proposed definition
of a Crowd represents the appropriate range of proximity to enable
brokers to also participate in the auction market. Furthermore, the
Exchange pointed out that, if a floor broker must leave the Crowd
and therefore cancel its agency interest file, the broker could
ensure that its customers' orders are still represented in that
Crowd by sending such orders to the specialist, sending the orders
to Direct+ via its handheld devices for automatic execution, or
transferring the orders to another member for representation in the
Crowd. In Amendment No. 8, NYSE proposes to limit this restriction
by allowing a floor broker to leave the Crowd to recharge a handheld
device without canceling its agency interest file.
    \279\ See, e.g., Bloomberg Letters I and II, ICI Letters I, II,
and III, Rutherfurd Letters I, II, III, and V, SIA Letter I, STANY
Letter, and Vanguard Letter.
    \280\ See, e.g., Bloomberg Letters I and II, ICI Letters I, II,
and III, Rutherfurd Letters I, II, III, and V, SIA Letter I, STANY
Letter, and Vanguard Letter.
    While supporting the NYSE's proposal to have the floor broker's
undisplayed reserve interest at the BBO yield to displayed interest
at that price, one commenter questioned why the Exchange did not
extend this concept to its execution priorities at other levels of
the book. See ICI Letter II.
    \281\ See, e.g., ICI Letters II and III, Rutherfurd Letters II
and V, STANY Letter, and Vanguard Letter.
---------------------------------------------------------------------------

    Commenters also expressed the opinion that the proposal appeared to
be designed to preserve the time and place advantages that floor
members currently enjoy over public investors.\282\ For example, one
commenter believed that, by authorizing this parity structure, the
Exchange would be affording the floor broker agency interest file with
three major execution advantages over orders on the Book: (1) Floor
broker agency interest entered later in time could deny an execution to
public limit orders

entered earlier in time; \283\ (2) floor broker agency interest would
often be entitled to superior parity splits with the Book, since the
proposed parity structure would treat the Book as only one bidder
(irrespective of the number of orders on the Book, the aggregate number
of shares, and their times of entry); \284\ and (3) floor brokers would
enjoy an informational and order entry advantage that will allow them
to ``see'' the orders on the Book and make trading decisions by
entering floor broker agency interest.\285\
---------------------------------------------------------------------------

    \282\ See, e.g., Bloomberg Letters I and II, ICI Letters I, II,
and III, Rutherfurd Letters I, II, and III, and SIA Letter I.
    \283\ See Rutherfurd Letters III and V. This commenter believed
that the proposal would allow floor brokers to enter interest in
reaction to their knowledge of public orders on the Book, and
thereby supersede the clearly established price/time priority of
such public limit orders. The commenter believed this to be
fundamentally unfair to public investors and unknown in other major
securities markets. See Rutherfurd Letter V.
    \284\ This commenter believed that the Exchange's examples do
not reveal the fact that the Book would be deemed to be only one
``bidder'' regardless of how many individual orders are on the Book
at the same price, while every broker who enters an agency interest
file would be considered a separate ``bidder.'' See Rutherfurd
Letter V. This commenter believed that, if the floor broker agency
interest file is permitted to compete directly with the price/time
priority of the Book, it should be treated as only one bidder. See
Rutherfurd Letter I.
    \285\ See Rutherfurd Letters I, III, and V (also claiming that
Amendment No. 6 failed to address the floor brokers' informational
advantage in placing orders and their advantage in being able to
supersede the price/time priority of orders on the Book and in being
treated as a separate ``bidders,'' whereas limit orders on the Book
would be treated as one ``bidder''). The commenter also argued that
the principal beneficiary of the clean up methodology would be
undisplayed floor broker agency interest files, which could be
entered on the Display Book with knowledge of, and in relation to,
the limit orders on the Book to take advantage of possible sweep
executions.
---------------------------------------------------------------------------

    Accordingly, commenters insisted that for a floor broker agency
interest file to be on parity with other orders at its price, a broker
should be required to display orders placed in their agency interest
file in the same manner as at the BBO.\286\ If the Exchange believes
that floor brokers' agency interest should be undisplayed, commenters
argued that those orders should not be provided parity with fully-
displayed orders on the Book.\287\
---------------------------------------------------------------------------

    \286\ See, e.g., ICI Letters I, II and III, Rutherfurd Letters I
and II, SIA Letter I, and Vanguard Letter.
    \287\ See, e.g., ICI Letters I, II and III (recommending that
the Exchange provide execution priority on the same level as fully
displayed investors' orders only to the portion of those orders
represented by the floor brokers that are displayed). See also SIA
Letter I.
---------------------------------------------------------------------------

    One commenter suggested that the Exchange give qualified customers
the option either to give their agency interest to a floor broker or
enter it directly in the Display Book system themselves.\288\
Similarly, with respect to a floor broker's ability to place
undisplayed reserve interest at the BBO, two commenters suggested that
the Exchange provide investors with a similar reserve feature where
investors would have the direct ability to conceal a portion of their
orders at the BBO, and not be required to do so solely through the use
of a floor broker.\289\ One of these commenters argued that this aspect
of the proposal would not support economically efficient executions or
the ability of investors to interact directly, and thus would be
inconsistent with the principles of section 11A under the Act.\290\
---------------------------------------------------------------------------

    \288\ See Rutherfurd Letters I and III.
    \289\ See, e.g., ICI Letters I and III and Vanguard Letter.
    \290\ See Vanguard Letter.
---------------------------------------------------------------------------

    In general support of the floor broker agency interest file, the
Exchange stated that this feature would allow customers both to take
advantage of floor broker knowledge and trading expertise, as well as
the efficiencies of automatic executions. The Exchange believes that
floor brokers would be able to use the interest file to effectively
represent interest that their customers do not wish to display, and,
simultaneously, permit this interest to be accessed by incoming orders
and participate in automatic executions and sweeps.
    Furthermore, in addressing comments that undisplayed floor broker
agency interest should not trade on parity with displayed orders on the
Book, the Exchange proposed in Amendment No. 6 to revise the standing
of orders on the Book and floor broker agency interest during a sweep.
Specifically, the Exchange proposes to revise NYSE Rule 70 to provide
that during a sweep, the amount of floor broker agency interest that
would have been displayed had there been a new quote at the clean-up
price would trade on parity with displayed interest, e.g. orders on the
Book, at that price. The amount of any floor broker agency interest
that would have been placed in the broker's reserve would yield to
displayed interest. The Exchange believes that this amendment is
consistent with the concept that displayed interest at each price point
would execute before non-displayed interest at the same price point and
the corollary principle that non-displayed interest at a better price
would trade ahead of displayed interest at a worse price, while taking
into account the fact that during a sweep there is no opportunity for
floor broker agency interest at the clean-up price to be displayed
before an execution that occurs at that price.\291\
---------------------------------------------------------------------------

    \291\ However, see Rutherfurd Letter V. This commenter argued
that the NYSE's revision in Amendment No. 6 to the standing of floor
broker agency interest during a sweep would be ineffective (i.e., no
one would be aware of the floor broker agency interest file except
for the floor broker since the interest would not actually be
displayed prior to a sweep transaction). Accordingly, the commenter
believed that the amendment would not attract liquidity or solve the
problems of unfairness to the Book, since investors with orders on
the Book would still have no information about interest in the floor
broker agency interest files.
---------------------------------------------------------------------------

    With respect to suggestions that the floor broker agency interest
file would provide floor brokers with some form of advantage over
public customers, the Exchange emphasized that floor brokers would only
have access to information pertaining to their own agency interest, and
no access to other broker's files. Similarly, the Exchange proposed
that neither specialists on the floor nor the Specialist Algorithms
would have access to any information about specific orders in floor
broker agency interest files.\292\ Under the proposal, specialists
would only be able to view the total aggregated broker agency interest
at each price, except for any interest a broker has elected to not
disclose to the specialist.
---------------------------------------------------------------------------

    \292\ Only the specialist on the floor would have access to
limited information pertaining to interest in the files. The
specialist would not know the number of customer orders behind such
volume, who the orders are for, which brokers represent the orders,
or the limit prices for such orders. See Response to Comments, supra
note 14.
---------------------------------------------------------------------------

    Furthermore, in response to comments questioning the reserve
feature of the floor broker agency interest file and whether it would
grant too much advantage to floor brokers,\293\ the Exchange argued
that the existence of reserve interest would not be unique to the
Exchange, and that electronic order books in other markets have a
reserve functionality at all price levels, not just the BBO.\294\ In
the Hybrid Market, the Exchange believes that the reserve functionality
would allow floor brokers to use their skills to determine the best way
to represent their customers' interests, whether that be through the
display of some or all of the customer order. Furthermore, the Exchange
believes that the reserve feature would benefit the marketplace as a
whole by providing liquidity and dampening price volatility. Since
reserve interest would yield to

displayed interest at the Exchange BBO, but would participate in
automatic executions at that price provided there is sufficient contra-
side liquidity, the Exchange believes that reserve interest would
benefit incoming orders by providing more liquidity at the BBO, yet
without disadvantaging displayed interest at the BBO. The Exchange
believes that it would be unable to attract and aggregate liquidity as
effectively if a reserve feature was not offered, as it is in other
competing market centers. In response to comments that investors should
have a similar feature to directly enter interest in reserve, the
Exchange represents that the reserve feature would be available to all
investors through floor brokers. Customers seeking to participate in
the reserve interest file would be able to do so by sending their
orders to floor brokers with appropriate instructions as to how they
want their orders handled. The Exchange believes that creating a
reserve feature exclusively for on-floor participants would provide an
incentive for participating in price discovery at the point of sale,
and would allow differentiation from typical electronic communication
network (ECN) functionality.
---------------------------------------------------------------------------

    \293\ See, e.g., Bloomberg Letters I and II, ICI Letter III,
Rutherfurd Letter I, SIA Letter I, and Vanguard Letter.
    \294\ However, see Rutherfurd Letter V. This commenter argues
that markets with reserve features are, for the most part, non-
primary, non-price discovery markets whose lack of transparency does
not materially impact the overall price discovery process. However,
the commenter believes that the critical distinction between other
markets that have reserve features and the NYSE's proposed Hybrid
Market is that there is not a similar concept of ``parity'' in those
markets (e.g., a trader cannot enter a reserve order in those
markets that will supersede the price/time priority of a previously
entered order).
---------------------------------------------------------------------------

B. Automatic Executions

1. Sweeping the Display Book System
    With respect to sweeps, two commenters noted that incoming
investors' orders that sweep the Display Book system would be executed
at a clean-up price, which could be inferior to other prices placed in
the Display Book system.\295\ Specifically, one commenter believed that
the proposed sweep methodology would result in executions less
favorable to investors than that of the current floor auction, which
allows floor brokers with a large order to trade at intervening price
levels instead of only a clean-up price.\296\ The other commenter
questioned whether the Exchange's proposal would be consistent with
best execution requirements of brokers.\297\
---------------------------------------------------------------------------

    \295\ See, e.g., Bloomberg Letters I and II and Rutherfurd
Letters I, III, and V (declaring that the sweep clean up price
methodology would be a benefit only to those trade initiators who
seek such a price; otherwise, there is significant economic
dislocation for them with respect to the traditional pricing of
large orders that cannot be filled at published bid or offer
prices).
    \296\ See Rutherfurd Letter I.
    \297\ See Bloomberg Letters I and II.
---------------------------------------------------------------------------

    Two commenters also suggested that the proposed sweep function
should be considered in relation to the pilot program in Regulation
SHO, e.g. the effect a sell short sweep order would have under the
pilot where consecutive bids were hit.\298\ In Amendment No. 8, the
Exchange proposes in NYSE Rule 1000(d)(iii)(E) to clarify that during a
sweep, sell short orders, other than those involving Regulation SHO
pilot securities, would have to comply with the conditions outlined in
the SEC's Short Sale Rule, Rule 10a-1, and NYSE Rule 440B.
---------------------------------------------------------------------------

    \298\ See Rothenberg Letter and SIA Letter I.
---------------------------------------------------------------------------

2. Automated Routing to Other Markets
    Initially, a number of commenters generally believed that the
proposal would allow limit orders to be swept on NYSE at prices that
are inferior to prices immediately available at other markets.\299\ In
addition, some commenters initially believed that the proposal did not
clearly indicate how a specialist would be able to match the NBBO on an
away market, and noted that there did not appear to be a minimum size
requirement for specialists to match away markets. Specifically, some
commenters thought that the NYSE specialist could program its systems
to automatically put up a pre-emptive 100 share bid or offer to match
the NBBO at any given time on any other market, and thus would not be
obligated to send trades to another market.\300\
---------------------------------------------------------------------------

    \299\ See, e.g., Ameritrade Letter, Bloomberg Letters I and II,
Fidelity Letters I and II, and SIA Letter I.
    \300\ See, e.g., Bloomberg Letters I and II, Fidelity Letter I,
SIA Letter I.
---------------------------------------------------------------------------

    In addressing these comments, the Exchange emphasized in its Second
Notice and Response to Comments that the proposed Hybrid Market would
operate in full conformity with all SEC rules, including Regulation
NMS. In response to specific comments that the specialist in the Hybrid
Market proposal could trade through better prices on another market
center below the NBBO, the Exchange stressed in the Second Notice that
the operation of sweeps, including the automatic electronic routing of
orders to the market centers displaying better priced bids and offers,
would be consistent with the fundamental tenet of the ITS trade-through
rule and Regulation NMS--that the best bids and offers published by
other market centers are entitled to protection. The Exchange
represented that best bids (offers) published by away markets that are
better than a clean-up price would be satisfied in their entirety. The
Exchange further represented that, as today, best bids and offers in
these markets (i.e., ``top of the book'') would be entitled to price
protection in the Hybrid Market.\301\ The Exchange disagreed with
comments suggesting that it should also provide price protection at
intervening price levels, and argues that while intermarket price-time
priority has been extensively debated, it has not been viewed to be in
the best interest of the national market system.
---------------------------------------------------------------------------

    \301\ As discussed earlier, except for IOC and Intermarket Sweep
orders, NYSE proposes to automatically route portions of an Auto Ex
Order that would satisfy a protected quote of an away market, unless
the specialist matches the better published price.
---------------------------------------------------------------------------

    Furthermore, the Exchange pointed out that a specialist already has
the option of matching a better published bid or offer rather than
shipping an order to that bid or offer. The Exchange believes that the
proposed rules would simply make this process more efficient by
permitting the specialist to electronically match or ship. During the
sweep, a commitment to trade that satisfies the full amount of any
better bid or offer that is published as the best bid or offer by
another market center would be auto-routed to such market (if a
prohibited trade-through would otherwise occur), which the Exchange
argues is consistent with the ITS trade-through rule and Regulation
NMS.

C. Availability of Direct+ and Liquidity Replenishment Points

    Two commenters supported NYSE's proposal to remove order size and
time entry restrictions in Direct+.\302\ Commenters, however, requested
more detail on when automatic executions would not be available.\303\
Specifically, many commenters requested after the First Notice that the
Exchange supply additional details and examples regarding the operation
of LRPs, including the determination and dissemination of the LRP to
the public, the frequency of triggering a LRP, and the specific
parameters of a MLRP.\304\ Some commenters questioned whether LRPs
would be too restrictive or even necessary to dampen volatility, and
expressed concern over the length of time LRPs could stop automatic
execution in the Hybrid Market.\305\ Commenters suggested that the
Exchange reexamine the rules governing halts and resumption of trading
to ensure that the LRP parameters are realistic.\306\ After the Third
Notice, one

commenter asserted that market volatility should not be artificially
limited through the mechanism of LRPs, but that investors should be
free to place, and interact with, orders at all price points without
unnecessary market center intervention.\307\ Another commenter
expressed concern about the priority of order execution coming out of
an LRP.\308\ This commenter wondered if an order that caused the price
of a security to reach an LRP would be denied priority coming out of
the LRP.
---------------------------------------------------------------------------

    \302\ See Rutherfurd Letter III and STANY Letter.
    \303\ See, e.g., BSE Letter, Instinet Letter, SIA Letter I, and
STANY Letter.
    \304\ See, e.g., Ameritrade Letter, Bear Stearns Letter, BSE
Letter, IBG Letter I, ICI Letters I and II, SIA Letter I, and STANY
Letter.
    \305\ See, e.g., Ameritrade Letter, Bear Stearns Letter, ICI
Letters I and II, and SIA Letter I. See also SIA Letter III and
Vanguard Letter. One of these commenters thought that the parameters
of the MLRP could be too restrictive for very liquid stocks. See ICI
Letter II.
    \306\ See, e.g., Ameritrade Letter, ICI Letters I, and Vanguard
Letter.
    \307\ See Vanguard Letter.
    \308\ See SIA Letter III.
---------------------------------------------------------------------------

    The Exchange described LRPs as pre-determined price points at which
electronic trading would briefly convert to auction market trading.
With respect to MLRPs, the Exchange believed that excessive volatility
could occur in situations other than electronic sweeps and thus
proposed a LRP based on price movement over a period of time. The
Exchange also described in the Second and Third Notices the specific
parameters of MLRPs, and clarified that automatic executions could
occur within the MLRP range.
    In addressing commenters' concerns over the use of LRPs in the
Hybrid Market, the Exchange stated that it believes that LRPs would
promote reasonable price continuity and foster market quality. When a
LRP converts the market exclusively to an auction market on a temporary
basis, the Exchange believes this would provide an opportunity to
moderate volatility by permitting new orders, as well as Crowd and
specialist interest, to add liquidity. Furthermore, the Exchange
represented that the LRP parameters were selected by the Exchange after
careful evaluation and discussions with market participants, and have
been designed to limit automatic executions infrequently. According to
the Exchange, when reached, LRPs would allow buyers and sellers to
react to fast-changing market conditions and provide an opportunity for
orders to interact with Crowd interest not encompassed in the broker
agency interest file and with specialist interest, enabling the auction
market to supplement liquidity and lower volatility. In addition, to
respond to commenters' requests for more details on LRPs, the Exchange
provided additional discussion and examples in the Second Notice, and
also set out the timeframes within which automatic executions and
Autoquote would resume after a LRP is reached.
    Similar to the concerns expressed over LRPs, many commenters also
generally questioned the particular methods and frequency of
suspensions of automatic executions in the Hybrid Market.\309\ For
instance, a few commenters requested that the Exchange provide more
information on how often the Exchange could preclude investors from
obtaining an automated sweep of the Display Book and the timeframes
within which the security would remain in an auction capacity or
``slow'' mode.\310\ Like the comments relating to LRPs, commenters
suggested that the proposed rules regarding halts and resumption of
trading be examined to ensure that they are structured in a manner to
permit the least amount of disruption as possible.\311\ One commenter
questioned whether NYSE would be considered reopening its market for
purposes of Regulation NMS each time a LRP is reached or a specialist
has gapped the quote.\312\
---------------------------------------------------------------------------

    \309\ See, e.g., Ameritrade Letter, Bloomberg Letters I and II,
BSE Letter, Fidelity Letter I, ICI Letter I, Instinet Letter, SIA
Letter I, and STANY Letter.
    \310\ See, e.g., Fidelity Letter I, and SIA Letter I.
    \311\ See, e.g., ICI Letter III and Vanguard Letter.
    More specifically, several commenters also expressed concern
over the suspension of automatic execution when the specialist has
gapped the quote. See BSE Letter, ICI Letter I, Nasdaq Letter, and
SIA Letter III. In justifying the specialist's use of gapped quotes,
the Exchange explained in the Second Notice that gap quotes would be
used by specialists in response to trading scenarios in which price
dislocation is expected, such as a sudden influx of orders on one
side of the market, one or more large-size orders with no off-
setting interest, or when a member proposes to effect a one-sided
block size transaction or a cross at a significant premium or
discount to the prevailing market. In an attempt to mitigate
volatility, specialists would use gap quotes to signal the potential
price movement so as to attract contra-side liquidity. The Exchange
also clarified in the Second Notice that, when the quotation is
gapped, automatic executions and Autoquote would be suspended,
although incoming orders and cancellations would update the Book
electronically. Furthermore, the Exchange explained that better
priced orders would be taken into account in the transaction
resulting from the gapped quotation and that Floor Officials would
oversee the gap quote process, including its duration.
    \312\ See Nasdaq Letter. The Commission notes that turning off
automatic executions, for example, for a gap quoting situation, the
triggering of a LRP, or the reporting of a block size transaction,
would not in and of itself halt trading and thus trigger a reopening
pursuant to Rule 611(b)(3) of Regulation NMS. See Securities
Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496 (June 29,
2005).
---------------------------------------------------------------------------

    In response to these comments, the Exchange represented that
Autoquote and automatic executions would be suspended infrequently and
only in certain limited circumstances, such as when trading on the
Exchange reaches a LRP, when the quote is gapped in accordance with
Exchange procedures, when trading in a security has been halted, when
the quote is not firm, or when a block size transaction involving
orders in the Display Book system is manually reported.\313\ The
Exchange believes that suspension of Autoquote and automatic executions
to report block trades is necessary to protect customer orders on the
Book and facilitate orderly executions in limited ``breakout''
situations and during the reporting of a block size transaction.
---------------------------------------------------------------------------

    \313\ Autoquote and automatic executions would resume when the
manual reporting is concluded.
---------------------------------------------------------------------------

    The Exchange will disseminate a systematic indication, consistent
with Regulation NMS, when automatic executions against its published
quotation are unavailable. In addition, in situations when automatic
executions are suspended due to a gapped quote or LRP, NYSE will notify
members by way of an indicator that the NYSE quotation is not firm.
    The Exchange represented that once the Hybrid Market is
implemented, all other instances of manual reporting \314\ would not
suspend Autoquote and automatic executions, and the quote would
automatically update to reflect the entry of better bids and offers and
cancellations. Finally, in the Second Notice, the Exchange represented,
based on its original proposal which proposed to suspend automatic
executions and Autoquote more frequently, that it expected Autoquote
and automatic executions to be available at least 99.7% of the
time.\315\
---------------------------------------------------------------------------

    \314\ For example, trades occurring within the Crowd or between
the Crowd and the specialist, as either agent or dealer, are
reported manually.
    \315\ One commenter argued that automatic executions should be
available 100% of the time because it is during times when news is
disseminated or when there is an imbalance or when there is a fast
market that its customers need certainty of execution. See
Ameritrade Letter. See also ICI Letter I.
---------------------------------------------------------------------------

D. Role of the Specialist in the Hybrid Market

1. Specialist Algorithm
    The Exchange proposes to allow specialists to participate
automatically in the Hybrid Market by capturing many specialist
functions and replicating certain specialist privileges in an
electronic environment. As discussed earlier, specialists would be
permitted to establish Specialist Algorithms to send specific quoting
and trading messages via the API to the Display Book system.
    After the First Notice, the Commission received a number of
comments questioning the operation of the Specialist Algorithm in the
Hybrid Market, including its ability to generate quoting and trading
messages on behalf of the specialist's dealer account and the sequence
of priority and parity rules with respect to the specialist interest
file and incoming orders.\316\ Although one

commenter appeared to support the amendments to NYSE Rule 104 that
describe the Specialist Algorithm,\317\ several of the comments raised
issues of fairness and transparency in the operation of the Specialist
Algorithm.\318\ Specifically, commenters opposed allowing the
Specialist Algorithm to ``read'' certain information before other
market participants and to interact with incoming orders and quotes on
the Display Book system based on that information.\319\ Two commenters
questioned whether the operation of the Specialist Algorithm was
consistent with the specialist's negative and affirmative
obligations.\320\ One of these commenters opposed providing only the
specialists with the ability to trade algorithmically with incoming
orders and believed it would greatly increase the specialists' speed
advantage and tilt the playing field toward the specialists and away
from the investing public.\321\ These two commenters also viewed as
ineffective the Exchange's proposal to delay the processing of
algorithmic messages (based on the average transit time from the CMS)
to give specialists and other market participants a similar opportunity
to trade with the Exchange's published quotation.\322\
---------------------------------------------------------------------------

    \316\ See, e.g., Bloomberg Letter I, BSE Letter, IBG Letter I,
ICI Letter I, Peake Letter I, SIA Letter I, STANY Letter, and Telic
Letter. See also Rutherfurd Letter III (advising after the Third
Notice in response to NYSE's proposed change to its Rule 92 that the
Exchange should program its system so that the specialist's dealer
orders can never be executed ahead of a public limit order that is
executable at the same price of the proposed specialist trade).
    \317\ See Invictus Letter (stating that proposed NYSE Rule 104
appears constructive as a potential risk management tool and may
speed the process of providing liquidity by specialists). However,
this commenter expressed a concern over the potential of piercing
the information barrier, whereby the data, within the computers
running the algorithms and the staff monitoring the books across all
the specialists within a firm, could be communicated outside the
Exchange and be seen by upstairs traders or other business units
affiliated with the specialists. This commenter believed that there
should be an affirmative statement from the Exchange concerning this
prohibition. In Amendment No. 8, NYSE clarified that its current
information barrier rules would prevent a specialist firm from
sharing information with its affiliated business units.
Specifically, the Exchange represented that pursuant to NYSE Rule
104(i), Specialist Algorithms would have to be designed to comply
with all Exchange rules, policies, and procedures, including NYSE
Rule 98, which requires the existence of information barriers
between the specialist operations and other business operations in
situations where the specialist is part of an integrated firm.
    \318\ See, e.g., IBAC Letters I and II, ICI Letters I, II, and
III, Rutherfurd Letters I, III, V, and IX, SIA Letters I and III,
and Vanguard Letter.
    \319\ See, e.g., IBAC Letter I, ICI Letters I, II (recommending
that the Hybrid Market proposal be amended to make this information
available to investors as well), and III, Rutherfurd Letters I, III,
and V, SIA Letters I and III, and Vanguard Letter.
    \320\ See IBAC Letter I and Rutherfurd Letters I, III, and V.
    \321\ See IBAC Letters I (questioning the effectiveness of
NYSE's solution that floor brokers will be able to mitigate the
impact of specialist algorithmic trading by entering bids and offers
into the floor broker agency interest file) and II.
    \322\ See IBAC Letter I and Rutherfurd Letter V.
---------------------------------------------------------------------------

    In support of the API and the Specialist Algorithm, the Exchange
asserted that specialists provide significant value to the market: They
commit capital to narrow quotes, add liquidity, and stabilize
prices.\323\ The Exchange maintained that its proposed rules provide
specialists with the ability to transmit to the Display Book system
algorithmic messages to quote or trade on behalf of their dealer
accounts so that they are able to fulfill their market making
obligations once electronic trading increases. According to the
Exchange, this algorithmically-based trading and quoting would be
permissible only in certain, limited ways that preclude the opportunity
for abuse. By allowing specialists to do electronically that which they
are able to do manually today, the Exchange believes that specialists
would be able to continue to provide value and liquidity in the Hybrid
Market.
---------------------------------------------------------------------------

    \323\ The Exchange represented that currently specialists
provide approximately 9% of total volume, approximately 80% of which
is stabilizing in nature. See Response to Comments, supra note 14.
---------------------------------------------------------------------------

    In addressing comments that the specialist's ability to access
certain information and then algorithmically trade and quote based on
that information would give the specialist an unfair informational
advantage over other market participants, the Exchange said that
specialists would need to engage in algorithmic trading to effectively
participate in the Hybrid Market and continue to fulfill their market
making obligations in an efficient and effective manner. The Exchange
contends that, without this ability, specialists in an automated
environment would be unable to ensure that there is appropriate price
continuity and depth, in which price movements are accompanied by
appropriate volume, and that unreasonable price variations between
trades are avoided. The Exchange stressed that the Specialist Algorithm
would not be privy to any more or different information than
specialists currently have today.\324\ In the Hybrid Market, the
Specialist Algorithm would be required to function according to new
NYSE rules and take predetermined actions before an order arrives at
the Display Book system. To do this effectively, the Specialist
Algorithm would need to take into account the size and price of an
incoming order to determine the appropriate algorithmic action.\325\
According to the Exchange, specialists' algorithmic trading would be
strictly controlled and limited to relatively few circumstances as
detailed in NYSE Rule 104. The Exchange represents that the
requirements detailed in NYSE Rule 104(b)-(h) for algorithmic trading
would be enforced systematically, and, in some ways, would be more
restrictive than current auction market rules.\326\
---------------------------------------------------------------------------

    \324\ In response to commenters that argued that specialists
would have an informational advantage over other market participants
due to their ability to see floor broker agency interest files, the
Exchange clarified that specialists would only be able to view the
total aggregated floor broker agency interest at each price, except
for any interest a broker has elected not to have disclosed to the
specialist. The Exchange argued that specialists need to know the
amount of buy and sell interest at each price to fulfill their
obligation to maintain a fair and orderly market and to determine
appropriate prices in manual trading situations, such as after a
quote is gapped or when a LRP has been reached. The Exchange
maintains that specialists would thus not be given an advantage over
other market participants, as commenters may believe (See ICI Letter
II). Moreover, the Exchange emphasized that a broker can elect to
exclude its agency interest from the aggregate disclosed to the
specialist without jeopardizing such interest from participating in
automatic executions.
    \325\ For example, to fulfill their obligations, specialists
today have knowledge of incoming orders, as well as CAP and stop
orders. See Response to Comments, supra note 14.
    \326\ See also note infra and accompanying text.
---------------------------------------------------------------------------

    For example, to ensure that an algorithmically-generated message to
trade with the Exchange published quotation (i.e., to hit a bid or take
an offer) does not have an advantage--since the specialist's system
would be aware of an incoming order that would change the BBO before
such new bid or offer is publicly disseminated--the processing of the
specialist's algorithmically-generated message would be delayed so as
to give all market participants a comparable opportunity to trade with
such bid or offer. This would be accomplished by delaying processing of
the algorithmically-generated message for a period based upon the
average transit time from the system to the Display Book system.
According to the Exchange, the delay parameter would be adjusted
periodically to account for changes to the average transit time
resulting from capacity and other upgrades to Exchange systems.
    In addition, per proposed NYSE Rule 104(b)(ii), neither the
specialist on the floor nor the messages generated by the Algorithms
would have the ability to affect the order in which algorithmically-
generated messages and incoming orders are processed by the Display
Book system. In correcting one commenter's impression that orders would
have to go through the

specialist's trading system before they are sent to the book for
processing,\327\ the Exchange clarified that an incoming order would
not be delayed in its arrival at, or processing by, the Display Book. A
copy of the order would go to the specialist's system, and the actual
order would continue on its path to the Display Book for processing.
---------------------------------------------------------------------------

    \327\ See, e.g., SIA Letter III.
---------------------------------------------------------------------------

    With regard to commenters' recommendation that the Exchange
aggressively monitor the Specialist Algorithm to preclude unlawful
trading activity, the Exchange pointed out that algorithmically-
generated messages would provide improved audit trail data for NYSE
Regulation, since detailed information regarding such messages and the
systems within which they operate would be captured systematically. In
addition, the rules would require specialists to produce information
and documentation regarding their systems that should assist NYSE's
oversight of specialists' algorithmic trading.\328\ To ensure that the
specialists' ability to trade algorithmically is consistent with the
expectations of market participants, the Exchange also plans to
establish a committee composed of representatives of the various
Exchange constituencies that would review the functioning of the Hybrid
Market based upon experience and data, including specialist trading
data.\329\
---------------------------------------------------------------------------

    \328\ For example, proposed Exchange Rule 104(f)(ii) requires
that specialists notify the Exchange in writing within such time as
the Exchange shall designate, whenever an algorithm is not operating
and the time, cause, and duration of such non-operation.
    \329\ One commenter viewed this aspect of the proposal as a
``positive step.'' See SIA Letter III.
---------------------------------------------------------------------------

2. Specialists' Ability To Systematically Price Improve Incoming Orders
    Commenters objected to the specialists' ability, on behalf of their
dealer accounts, to provide price improvement electronically to all or
part of a marketable incoming order.\330\ These commenters believed
that the specialists' ability to ``see'' information before others and
price improve is fundamentally unfair to other market participants and
a disincentive to displaying limit orders.\331\ One of these commenters
claimed that the algorithmic price improvement functionality would
provide the specialist with a unique proprietary trading opportunity
and would be inconsistent with the specialist's negative
obligation.\332\ This commenter also believed the requirement that the
specialist be represented in the quote for a minimum of 1000 shares to
price improve would be ineffective, and suggested that the Exchange
restrict the specialist to providing algorithmic price improvement only
when the incoming order would otherwise trade against the specialist's
bid or offer.\333\ In addition, two commenters urged the Exchange to
provide floor brokers with the functionality to provide price
improvement electronically in the current proposal, rather than in a
later filing, to promptly level the playing field between specialists
and investors.\334\
---------------------------------------------------------------------------

    \330\ See, e.g., IBAC Letters I and II, ICI Letter III,
Rutherfurd Letters I, III, and V, and Vanguard Letter.
    \331\ See, e.g., IBAC Letter I, ICI Letters II and III (claiming
that their members are much more likely not to post orders on the
Exchange due to the ability of specialist to electronically interact
with orders through this mechanism), Rutherfurd Letters I, III, and
V (asserting that the specialist algorithmic price improvement to
incoming Auto Ex Orders that would otherwise be automatically
executed against the contra-side bid or offer has no net public
benefit and discourages the placement of public limit orders on
Book), and Vanguard Letter (arguing that if the specialist is
willing to provide liquidity at a price that is better than the BBO,
then the specialist should be required to display that liquidity).
    \332\ See Rutherfurd Letter V (stating that NYSE's approach
transforms the specialist from the trader of last resort to the only
one who can trade in the first place).
    \333\ See Rutherfurd Letter V.
    \334\ See IBAC Letters I and II (urging the Commission to not
approve the Hybrid Market proposal until this functionality is
provided to floor brokers) and ICI Letter III.
---------------------------------------------------------------------------

    The Exchange represented that throughout the process of formulating
rules governing specialist-provided price improvement, the Exchange has
sought to balance the benefit this would provide to incoming customer
orders with the interests of customers who have displayed orders at
prices inferior (albeit by as little as one cent) to that at which the
specialist would be willing to trade, or who would like a similar
opportunity to trade with incoming orders. Although comments have
criticized the algorithmic price improvement of one cent as ``penny-
jumping,'' \335\ the Exchange believes that the ability of the
specialist to provide price improvement of one cent when the quotation
spread is two cents provides a meaningful benefit to the incoming
order, and is consistent with Federal securities laws and Exchange
rules, which permit any market participant to bid, offer, or trade one
cent (i.e., the minimum variation) better than an existing bid or
offer.
---------------------------------------------------------------------------

    \335\ See, e.g., Rutherfurd Letter III.
---------------------------------------------------------------------------

    In response to comments that other market participants should also
have the ability to systematically price improve or trade with incoming
orders, the Exchange indicated that it is in the process of developing
the means by which floor brokers would have the ability to do this
through a discretionary price capability. In addition, the Exchange
proposes to automatically convert CAP-DI orders that are able to trade
along with the specialist at the improved price, so that these orders
can participate in that execution. The Exchange believes that the
opportunity for price improvement is an important factor in market
quality and a hallmark of the Exchange, and thus seeks to preserve this
important feature in the Hybrid Market.

E. Auction Limit and Auction Market Orders

    Under NYSE's proposal, AL and AM orders would automate the
opportunity for investors to seek potential price improvement of a
penny or better. The Exchange describes AL and AM orders as market and
marketable limit orders that would be exposed to the auction and
electronic market and would have the possibility of price improvement.
These orders would automatically execute if: (1) The order is not
executed within 15 seconds; or (2) a quoting or trading action triggers
automatic execution before the 15-second period times out.
    After the First Notice, a few commenters had specific questions
regarding how AL and AM orders would be processed and handled.\336\
These commenters requested clarification and examples relating to the
execution of these orders and how they would interact with existing
order types, the time priority of these orders when an incoming order
triggers their execution, and which participants could trade with these
orders. After the Second and Third Notices, another commenter, who
supported the current NYSE methodology of price improvement resulting
from order competition in the auction market, asserted that the
proposed 15-second exposure procedure for price improvement of AL and
AM orders would likely result in less price improvement, a risk of
price disimprovement, and a greater prospect of orders not even being
executed.\337\
---------------------------------------------------------------------------

    \336\ See BSE Letter, IBG Letter I, SIA Letter I, and STANY
Letter.
    \337\ See Rutherfurd Letters I, III (stating that, given the
prospect of inferior pricing, NYSE's proposal effectively gives the
specialist an illegal ``not held'' order, and renders it virtually
impossible for broker-dealers with ``best execution''
responsibilities to seek price improvement on the Exchange), and V
(stating that AL and AM orders can be executed at worse prices
because later arriving orders could exhaust contra-side liquidity, a
result unknown in today's physical auction).
---------------------------------------------------------------------------

    In addressing the need for more details, NYSE provided an extensive

discussion in the Second Notice on AL and AM orders, including how they
would be electronically executed when they arrive at the Display Book
if the Exchange quotation is at the minimum variation, or routed away
to another market center if that market center is publishing the
national best bid (offer) and it causes a minimum variation with the
Exchange's best offer (bid). The Exchange also clarified that if AL and
AM orders are not automatically executed or routed away upon entry,
they would be quoted at a price to attract liquidity (a penny better
than the Exchange best bid or offer, as applicable) while retaining
their limit price. Furthermore, the Exchange clarified in the Second
Notice the three events that would cause automatic execution of an AL
or AM order before 15 seconds has elapsed,\338\ and also provided
detailed examples of how AL and AM orders would function in the Hybrid
Market.
---------------------------------------------------------------------------

    \338\ The three events are: (i) The arrival of a subsequent
order at a better price on the same side of the market as an AL or
AM order; (ii) the execution of an order on the same side of the
market as an AL or AM order that exhausts some or all of the
displayed contra-side volume available in the Exchange quotation;
and (iii) the cancellation of some or all of the displayed contra-
side volume, or the improvement of the displayed contra-side price,
creating a minimum variation market or allowing execution of the AL
or AM order with price improvement. See proposed NYSE Rule 123F.
---------------------------------------------------------------------------

IV. Discussion

    After careful review, the Commission finds that the proposed rule
change, as amended, is consistent with the requirements of the Act and
the rules and regulations thereunder applicable to a national
securities exchange and, in particular, with the requirements of
section 6(b) of the Act.\339\ Specifically, the Commission finds that
approval of the proposed rule change, as amended, is consistent with
section 6(b)(5) of the Act \340\ in that the proposal is designed to
promote just and equitable principles of trade, to remove impediments
to and perfect the mechanism of a free and open market and a national
market system, and, in general, to protect investors and the public
interest. The Commission also finds that the proposed rule change is
consistent with section 6(b)(8) of the Act,\341\ which prohibits an
exchange's rules from imposing a burden on competition that is not
necessary or appropriate in furtherance of the Act. The Commission
believes that the proposed rule change, as amended, is also consistent
with section 11A(a)(1)(C) of the Act,\342\ in which Congress found that
it is in the public interest and appropriate for the protection of
investors and the maintenance of fair and orderly markets to assure:
(1) Economically efficient execution of securities transactions; (2)
fair competition among brokers and dealers and among exchange markets,
and between exchange markets, and markets other than exchange markets;
(3) the availability to brokers, dealers, and investors of information
with respect to quotations and transactions in securities; (4) the
practicability of brokers executing investors' orders in the best
market; and (5) an opportunity for investors' orders to be executed
without the participation of a dealer.
---------------------------------------------------------------------------

    \339\ 15 U.S.C. 78f(b). In approving this proposal, the
Commission has considered the proposed rules' impact on efficiency,
competition, and capital formation. 15 U.S.C. 78c(f).
    \340\ 15 U.S.C. 78f(b)(5).
    \341\ 15 U.S.C. 78f(b)(8).
    \342\ 15 U.S.C. 78k-1(a)(1)(C).
---------------------------------------------------------------------------

    The adoption of Hybrid Market proposal may fundamentally change the
Exchange's current market structure from a floor-based auction market
with an emphasis on human contact, to a predominantly electronic market
with limited human intervention. Today, the vast majority of orders
sent to NYSE for execution are handled manually by NYSE floor members--
specialists and floor brokers. Specialists represent orders that are
electronically submitted to the Exchange via DOT or left with them for
representation by floor brokers. Floor brokers receive their own
customers' orders at their booths on the floor that are delivered
electronically or by telephone. These floor members represent each
order individually in the market, ascertaining the current market by
seeking contra-side liquidity.
    Trading on NYSE may be considerably different once the Hybrid
Market proposal is implemented. Orders that currently are represented
individually are more likely to be executed automatically without human
intervention.\343\ While NYSE has proposed to move to a more automated
model, it also seeks to retain substantive roles for its floor members.
Specialists will be permitted to perform many of their obligations to
maintain a fair and orderly market electronically, while floor brokers
will be able to represent their customer orders electronically. To
create the Hybrid Market, the Exchange has proposed significant changes
to its rules and systems to alter the way specialists, floor brokers,
and customers would participate and interact.
---------------------------------------------------------------------------

    \343\ Several commenters generally supported NYSE's move to a
more automated trading model. See, e.g., Ameritrade Letter, IBG
Letters I and II, ICI Letters I, II, and III, SIA Letters I, II, and
III, STANY Letter, Telic Letter, and Vanguard Letter.
---------------------------------------------------------------------------

    As discussed more fully below, the Commission finds that the Hybrid
Market proposal, by allowing greater electronic access to liquidity on
NYSE, should help perfect the mechanism of a free and open market. The
Hybrid Market proposal should provide investors with a more efficient
mechanism to have their orders executed on the Exchange. The Commission
also finds that the Hybrid Market should facilitate securities
transactions by providing investors with faster access to the trading
interest reflected in NYSE's published quotation, as well as interest
away from the Exchange BBO.\344\ Finally, the Commission finds that the
Hybrid Market could enhance the opportunity for a customer's order to
be executed without dealer participation, consistent with the goals of
the Act.
---------------------------------------------------------------------------

    \344\ The Commission notes that, while it believes the proposed
rule change, as amended, is consistent with the requirements of the
Act, the Commission makes no determination whether the Hybrid Market
would satisfy the ``automated trading center'' definition in Rule
600(b)(4) of Regulation NMS. See Securities Exchange Act Release No.
51808 (June 9, 2005), 70 FR 37496 (June 29, 2005).
---------------------------------------------------------------------------

A. Increased Access to Display Book System

    Under the proposal, a wide range of additional order types could be
entered into Direct+ for automatic execution. For example, all
marketable limit orders, designated market orders, designated IOC
orders (including ITS Commitments), and Intermarket Sweep orders, would
be able to receive automatic execution against interest placed in the
Display Book system. In addition, for the first time, Auto Ex Orders
would have the ability, within certain limits, to sweep interest
outside the Exchange BBO. The proposal also would eliminate the size
and the 30-second order entry restrictions that currently limit
automated access to the Exchange's quote via Direct+. The Commission
finds that the availability of automatic executions for a much wider
range of order types, the ability of Auto Ex Orders to sweep the NYSE
depth-of-book, and the elimination of the size and timing restrictions
for Auto Ex Orders, are consistent with the requirements of the Act.
Specifically, the Commission believes that providing more instantaneous
access to liquidity on the Display Book system should facilitate the
efficient execution of orders on the Exchange and potentially could
enhance the ability of executions to occur without the participation of
a dealer.
    In addition to broadening the scope of automatic executions, NYSE
has proposed to limit the instances when Direct+ would not be
available.

Currently, under NYSE rules, Direct+ is unavailable under many
circumstances. Some of these reflect the needs of NYSE's current market
structure, which is largely a manual auction on the floor. For example,
specialists have broad discretion to disable Direct+ by publishing 100
share quotes and manually reporting floor transactions.\345\ When
Direct+ is disabled, Auto Ex Orders are directed to the specialist for
manual handling in the auction. In addition, NYSE Rule 1000 permits
Direct+ to be turned off if a block size transaction away from the NYSE
BBO is in the process of being completed on the floor.\346\ In such
instances, the specialist publishes a quote that is five cents away
from the last reported sale, and this has the effect of disabling
Direct+.\347\ Further, NYSE Rule 1000 permits Direct+ to be turned off
if the NYSE quote is not firm, the execution price would be more than
five cents away from the last reported transaction price, a better
price exists in another ITS market, or trading has been halted.\348\
---------------------------------------------------------------------------

    \345\ See NYSE Rule 1000(iv).
    \346\ See NYSE Rule 1000(v).
    \347\ In a separate proposal, the Exchange is proposing to
require specialists to publish a 100 x 100 share market quote that
reflects the last reported transaction in connection with a block
size transaction. See supra note 134.
    \348\ See NYSE Rule 1000.
---------------------------------------------------------------------------

    Under the proposal, Direct+ would be unavailable only when: (1) The
NYSE quote is not firm; (2) trading has been halted; (3) the specialist
has gapped the quotation in accordance with Exchange procedures; (4)
trading has reached a LRP; (5) a block size transaction involving
orders in the Display Book system is being manually reported; or (6) an
Auto Ex Order is entered for a high-priced security. The Commission
believes that these proposed changes should ensure that automatic
executions are more readily available on NYSE than they are today.
    Further, the Commission believes the proposal should provide
specialists with less discretion to disengage Direct+ than they have
today. This reduced specialist discretion both should help ensure that
automated executions are more widely available on NYSE and help
alleviate concerns that specialists might manipulate the automated/non-
automated status of NYSE for their own benefit. Specifically,
specialists would only be permitted in two instances to actively
disengage Direct+: (1) By gapping the NYSE quotation and (2) by
manually reporting block size transactions that involve orders on the
Display Book system. NYSE believes that the specialist, when faced with
a substantial order imbalance, may need the ability to attempt to
attract additional liquidity in a controlled environment without
automatic executions. NYSE has sought to ensure that specialists do not
frequently enter gapped quotations for the purpose of disabling Direct+
by requiring that when a specialist gaps the quote, it must follow
certain procedures and consult with floor officials.\349\ Specialists
will also be permitted to disengage Direct+ when manually reporting a
block size transaction that involves orders on the Display Book system.
The Commission believes that this limited ability to disengage Direct+
could be necessary due to the practical difficulties of integrating
orders on the Book into large transactions on the floor.
---------------------------------------------------------------------------

    \349\ See NYSE Information Memo 04-27. The Commission notes that
NYSE must update this information memo to reflect that automatic
executions on both sides of the market will be suspended once the
quote is gapped.
---------------------------------------------------------------------------

    The Commission also believes that the other limited instances when
Direct+ will not be available are reasonable. High-priced securities
would be ineligible to participate in automatic executions because they
are thinly traded and, according to the Exchange, customers would
obtain better representation if transactions in these securities are
handled in the manual auction market. Finally, when trading is halted
or when the NYSE quotation is not firm, no execution, automatic or
manual, would be available.
    The Commission notes that when Direct+ is disengaged, whether due
to an LRP or any of the other events that cause the NYSE market to
revert to a manual market, the NYSE quote would not be an ``automated
quotation,'' and thus not entitled to protection under Rule 611 of
Regulation NMS.\350\ When this occurs, NYSE also would be required to
immediately identify its quotation as a manual quotation if it is to be
considered an ``automated trading center'' for purposes of Regulation
NMS.\351\ In addition, when the NYSE quotation is not available for
automatic execution because of a LRP or gapped quotation, NYSE would
identify such quotes as non-firm. The Commission believes that these
requirements may provide an incentive to NYSE to keep the frequency and
length of the unavailability of automatic executions to a minimum.
---------------------------------------------------------------------------

    \350\ 17 CFR 242.611.
    \351\ See 17 CFR 242.600(b)(4)(iii).
---------------------------------------------------------------------------

1. Liquidity Replenishment Points
    Under the proposal, when trading on the Exchange reaches a LRP,
automatic executions would be unavailable and the Hybrid Market would
temporarily revert to an auction market. NYSE has proposed two types of
LRPs: (1) The sweep LRP and (2) MLRP. As discussed in Section II(A)(5)
above, the sweep LRP price would be set at the nearest five-cent
increment outside the NYSE BBO, rounded to the next nickel. The MLRP
price would be calculated by adding the greater of $.25 or 1% of the
security's price to its lowest price within a rolling 30-second period
and subtracting that amount from the security's highest price within
the same time period. In the event that there is no transaction in a
security within the 30-second period, the MLRP would be based on the
last transaction on the Exchange.
    Initially, commenters questioned the specifics of LRPs, including
whether they were too restrictive and whether they were necessary.\352\
After NYSE proposed the parameters for MLRP, one commenter questioned
whether the parameters would cause frequent suspension of Autoquote and
automatic execution.\353\ Another commenter believed that market
volatility should not be artificially limited and that LRPs are too
restrictive for active securities.\354\
---------------------------------------------------------------------------

    \352\ See, e.g., Ameritrade Letter, Bear Stearns Letter, BSE
Letter, IBG Letter I, ICI Letters I and II, SIA Letter I, and STANY
Letter.
    \353\ See ICI Letter II.
    \354\ See Vanguard Letter.
---------------------------------------------------------------------------

    According to NYSE, the LRPs are intended to moderate volatility,
which may increase when the Hybrid Market is implemented and a larger
portion of NYSE trades are executed electronically. NYSE believes that
reverting to a manual market in times of volatility will enhance the
quality of executions in its market.
    As noted above, the Commission believes that the increased
availability of automated executions should facilitate the efficient
execution of orders on the Exchange and enhance the opportunity for
executions to occur without the participation of a dealer. NYSE
believes, however, that precluding automatic executions under certain
circumstances--such as where market volatility has triggered an LRP--
will provide its customers with better executions by fully utilizing
the expertise of its floor members. In the Commission's view, this type
of hybrid market model is consistent with the requirements of the Act,
and, as such, is within the realm of judgments generally left to the
discretion of individual markets. Creating a new market model also has
the potential to foster intermarket competition. Accordingly, the
Commission finds that NYSE's use of LRPs in the context of its Hybrid

Market is consistent with the requirements of the Act.

B. Autoquote

    NYSE has proposed to disengage its Autoquote system in three
specified instances. Specifically, Autoquote would not be available
when the specialist gaps the quote, when the specialist is manually
reporting a block size transaction that includes orders in the Display
Book system, or when an LRP has been reached. The Commission believes
that it is consistent with the requirements of the Act to disengage
Autoquote for limited periods to accommodate these specific activities
in the auction market. For example, in the circumstances when the quote
is gapped or an LRP is reached, the Commission believes that Autoquote
may be disengaged to permit the specialist to more effectively fulfill
its obligation to maintain a fair and orderly market by controlling the
NYSE quote during limited periods of significant market activity.
Accordingly, the Commission finds that the proposed provisions relating
to Autoquote are consistent with requirements of the Act.\355\
---------------------------------------------------------------------------

    \355\ The Commission notes that the display of customer limit
orders is governed by the Limit Order Display Rule, 17 CFR 242.604,
and that even if Autoquote is disengaged, specialists may be
required to display such orders in compliance with this rule. The
Exchange represented that it would notify specialists after an LRP
has disengaged Autoquote to alert specialists of their obligations
under the Limit Order Display Rule.
---------------------------------------------------------------------------

C. Liquidity Available for Automatic Execution

    As discussed in Section II(A) above, NYSE proposes to allow its
floor members to post liquidity in the Display Book system
electronically, so that it is available for automatic executions.
Specifically, NYSE proposes to create two new files within the Display
Book system--the specialist interest file and the floor broker agency
interest file. Specialists and floor brokers would be allowed to place
liquidity within these new files in the Display Book system at the
Exchange BBO or outside the Exchange BBO. The liquidity within these
interest files would not be disseminated, unless it is priced at the
Exchange BBO.\356\
---------------------------------------------------------------------------

    \356\ Specialists could elect to disseminate their interest via
NYSE OpenBook. The specialist would be able to view aggregate floor
broker interest at each price level, unless the floor broker elects
to exclude its interest from the specialist's view.
---------------------------------------------------------------------------

    In addition, specialists and floor brokers could enter reserve size
at the Exchange BBO. This interest would not be disseminated and would
trade after all displayed interest at the BBO has been filled.
Specialists would be required to display at least 2,000 shares at the
BBO to enter reserve size, and floor brokers would be required to
display 1,000 shares. The Display Book system will automatically
replenish specialist interest files and floor broker agency interest
files to the minimum displayed amounts, unless there is insufficient
reserve size to display the minimums. In such cases, the entire amount
of reserve will be added to the displayed size.
    The proposed specialist interest file and proposed floor broker
agency interest file generated several comments. Generally, commenters
raised several broad issues related to the ability of specialists to
see interest in the floor broker agency interest files, the lack of
display of both reserve interest and floor broker agency interest away
from the BBO, and NYSE's requirement that floor brokers remain in the
``Crowd'' when utilizing the floor broker interest file.\357\
Specifically, a number of commenters questioned the lack of
transparency of the floor broker agency interest file, given that floor
broker interest would not be publicly disseminated unless it were at
the NYSE BBO.\358\ These commenters argued that the floor broker agency
interest file, if not displayed, should not be entitled to trade on
parity with displayed orders on the Book.\359\
---------------------------------------------------------------------------

    \357\ As discussed further below, the specialist interest file
and the floor broker agency interest file generated comments
regarding the priority and parity rules that would be implemented
for these files.
    \358\ See, e.g., Bloomberg Letters I and II, ICI Letters I, II,
and III, Rutherfurd Letters I, II, III, and V, SIA Letter I, and
STANY Letter. See also Vanguard Letter.
    \359\ For a complete description of the parity issues, see infra
Section IV(D).
---------------------------------------------------------------------------

    The Commission finds that NYSE's proposal to allow floor brokers
and specialists to electronically participate in the Hybrid Market is
consistent with the requirements of the Act. This capability could
increase the liquidity available for automatic executions on NYSE.
Moreover, including the interest of these floor members and their
customers in the Hybrid Market electronically could improve the prices
at which Auto Ex Orders that sweep the Display Book system may execute.
In addition, the proposal should allow customers of floor brokers to
more effectively participate in an electronic trading environment.
    The Commission also finds that making floor broker agency interest
information available to specialists is consistent with the
requirements of the Act. In the Hybrid Market, specialists would
continue to have the obligation to conduct the auction on the floor.
Thus, to ensure that all interest is represented in an auction, the
Commission believes that a specialist would need full information about
the liquidity available and the prices at which such liquidity is
available. The availability of this information also may assist
specialists in maintaining a fair and orderly market under NYSE Rule
104 and Rule 11b-1 under the Act. Further, floor brokers that do not
want specialists to have information about their interest have the
discretion to exclude their interest from the aggregate information
available to specialists if they believe that doing so is in the best
interest of their customers. The Commission also notes that Specialist
Algorithms would not be able to view or make quoting or trading
decisions based on interest in the floor broker agency file that is not
publicly available.\360\
---------------------------------------------------------------------------

    \360\ See proposed NYSE Rule 104(c)(ii).
---------------------------------------------------------------------------

    The Commission further finds that the floor broker reserve function
is consistent with the requirements of the Act as it could provide
floor brokers with greater flexibility in handling and working large
customer orders. In particular, the reserve function could prove useful
to institutions that wish to minimize the market impact of their large
orders. Furthermore, allowing floor brokers to place interest in
reserve could increase participation on NYSE, which might enhance the
depth and liquidity of NYSE's market. The Commission also believes that
it is consistent with the requirements of the Act to allow specialists
to place reserve interest in the Display Book system as it too could
increase the liquidity available for execution at the Exchange BBO.
    Two commenters suggested that NYSE allow investors to place
reserve, or undisplayed, interest in the Display Book system.\361\ One
of these commenters argued that depriving investors of this ability
would be inconsistent with the principles set forth in section 11A of
the Act.\362\ The Commission believes that the decision to limit the
availability of reserve orders to specialists and floor brokers, under
the conditions proposed by NYSE, is within the realm of judgments
generally left to the discretion of an individual market and is
consistent with the requirements of the Act. In addition, this aspect
of the Hybrid Market is similar to how the NYSE market operates today,
as investors today must use a floor member to represent their
undisplayed interest on the Exchange.
---------------------------------------------------------------------------

    \361\ See ICI Letters I and II and Vanguard Letter.
    \362\ See Vanguard Letter.

---------------------------------------------------------------------------

    The Commission notes that two features of NYSE's proposal to allow
undisplayed reserve interest should help ensure that market
participants continue to have an incentive to display quotes or orders
on NYSE: (1) Specialists and floor brokers must display a minimum
number of shares at the BBO to have undisplayed reserve interest; and
(2) displayed interest will have priority over all undisplayed reserve
interest. The Commission believes that, taken together, these
requirements could promote additional depth at the Exchange BBO, while
preserving incentives for investors to display limit orders.
Accordingly, the Commission finds that NYSE's proposal to allow floor
brokers and specialists to have undisplayed reserve in the Display Book
system is consistent with the requirements of the Act.
    NYSE also proposes to require floor brokers to be in the ``Crowd''
when the floor broker maintains interest in the floor broker agency
interest file. NYSE defines a ``Crowd'' as any five contiguous panels
at any one trading post. It would be a violation of Exchange Rules for
a floor broker to leave the Crowd without canceling its interest in the
file,\363\ but if this occurs, the floor broker nevertheless would be
held to any resulting executions. One commenter believed that limiting
the Crowd to five contiguous panels is arbitrary and unnecessarily
restrictive.\364\
---------------------------------------------------------------------------

    \363\ The floor brokers would be permitted to leave the Crowd to
recharge its handheld device. See proposed NYSE Rule 70.20(f).
    \364\ See Invictus Letter.
---------------------------------------------------------------------------

    The Commission believes that the requirement that a floor broker be
present while representing orders in the Display Book system is within
the realm of judgments generally left to the discretion of an
individual market and is consistent with the requirements of the Act.
NYSE has proposed to create a Hybrid Market that combines a manual
auction market on the floor with an electronic market. The Commission
notes that NYSE currently requires floor brokers to be present in the
Crowd to represent their customer orders in the auction market.\365\
NYSE stated that it believes five contiguous panels is the appropriate
range of proximity to enable floor brokers to electronically
participate in the Hybrid Market and, at the same time, physically
participate in the auction component of the Hybrid Market. Under these
circumstances, the Commission believes that it is reasonable for NYSE
to require floor brokers to be available to actively represent their
customers, even when their customers' interest is in the Display Book
system, by requiring floor brokers to be present in the Crowd.
---------------------------------------------------------------------------

    \365\ See, e.g., NYSE Rule 117.10.
---------------------------------------------------------------------------

D. Automatic Executions

    Under the proposal, Auto Ex Orders would execute against interest
in the Display Book system, including the Book, floor broker agency
interest files, and specialist interest files. Auto Ex Orders would
first execute against interest at the Exchange BBO. Once interest at
the Exchange BBO is exhausted, an Auto Ex Order would trade with
interest outside the Exchange BBO, automatically sweeping the Display
Book system, until it is: (1) Executed; (2) its limit price, if any, is
reached; or (3) a LRP is reached, whichever occurs first. During a
sweep, the residual would trade at the clean-up price.
    The Commission notes that the ability to sweep the NYSE Display
Book system is a significant expansion of the availability of automatic
executions on the Exchange. Currently, Auto Ex Orders that are for a
size greater than the Exchange BBO trade automatically with the BBO,
and then the residual is routed to the specialist for manual handling.
The Commission believes that the ability to automatically execute
against the depth of interest on the NYSE Display Book system should
enhance the speed of executions and facilitate more efficient
transactions on the Exchange.
    Several commenters raised concerns about the rules NYSE proposed
governing how automatic executions would occur against interest in the
Display Book system. In particular, commenters raised concerns about
how the rules of priority, parity, and precedence would apply with
regard to interest in the Display Book system.\366\
---------------------------------------------------------------------------

    \366\ See, e.g., Bloomberg Letters I and II, IBAC Letters I and
II, IBG Letter I, ICI Letters I, II, and III, Rutherfurd Letters I,
II, III, IV, V, VI, VII, VIII, IX, and X, SIA Letter I, STANY
Letter, and Vanguard Letter.
---------------------------------------------------------------------------

    Currently, executions on the Exchange are governed by NYSE Rules
72, 104, and 108. When more than one market participant is bidding or
offering the best price, these rules detail which participant(s) have
the right to fill the order--either entirely, or a certain percentage
of it--before anyone else. As a general rule, the first person to quote
the price at which the security is ultimately traded is entitled to
``priority''--the right to fill the order before anyone else.\367\
``Parity,'' on the other hand, means that none of the market
participants competing to fill the order has rights over any other
based on quoting the best price first.\368\ Generally, in a situation
of this kind, participation in the order must be divided pro rata among
the crowd participants who simultaneously bid to fill the order at the
best price. To create incentives for market participants to provide
liquidity, current Exchange rules may permit certain participants to
trade ahead of others who are on parity if they are quoting in size.
(This is known as ``precedence based on size.'')\369\
---------------------------------------------------------------------------

    \367\ See NYSE Rule 72(a).
    \368\ See NYSE Rule 72(e).
    \369\ See NYSE Rule 72(c) and (d).
---------------------------------------------------------------------------

    Specialists are subject to additional restrictions on their ability
to trade for their own accounts, given their special position in the
marketplace. Specifically, specialists, as agents for orders on the
Book, are required to yield to orders on the Book.\370\ Today,
specialists also are limited, pursuant to NYSE Rules 104 and 108, when
trading for their own accounts along with orders represented by floor
brokers. NYSE Rules 72 and 104 provide that when a specialist is
decreasing or liquidating its position, the specialist is entitled to
parity unless requested by a floor broker, on behalf of its customer,
to yield. NYSE Rule 108 provides that a specialist is not entitled to
parity when increasing or establishing its position, but, according to
NYSE, it has interpreted this rule as permitting the specialist to
trade on parity when increasing its position, so long as the floor
broker consents.\371\
---------------------------------------------------------------------------

    \370\ See NYSE Rule 92.
    \371\ See supra note 101.
---------------------------------------------------------------------------

    NYSE proposes certain changes to its rules of priority, parity, and
precedence. For example, NYSE proposes that the interest in the floor
broker agency interest file and specialist interest file trade on
parity once all interest in the Book has been satisfied, with neither
entitled to priority. To accomplish this, NYSE would prohibit a floor
broker from placing any interest in its agency interest file that would
restrict the ability of the specialist to trade on parity. In other
words, specialists would be entitled to trade on parity with orders
represented by floor brokers in the floor broker agency interest file,
and floor brokers would not be able to object to such specialist
trading.\372\ The Exchange also proposes to eliminate the regulatory
distinction, in this context, between situations where the specialist
is increasing or decreasing its position.
---------------------------------------------------------------------------

    \372\ If the floor broker does not want the specialist to trade
on parity with its customer, it could place its customer's order on
the Book.
---------------------------------------------------------------------------

    In addition, NYSE proposes to permit the floor broker agency
interest file to trade on parity with orders in the Book

to the extent that neither is entitled to priority. At the BBO, floor
broker agency interest that is displayed would trade on parity with
interest in the Book. During sweeps, floor broker agency interest that
is designated as eligible for display if the price moves to the BBO
would be permitted to trade on parity with the Book. Floor broker
agency interest that would not be displayed even if at the BBO (i.e.,
reserve interest) would not be entitled to trade on parity with the
Book during a sweep at the clean-up price.
    These proposed changes generated several comments. For example,
three commenters believed that NYSE should not allow specialists to
trade on parity with the floor broker agency interest file when
specialists are increasing or establishing their position.\373\ One
commenter argued that allowing specialists to trade on parity with the
floor broker agency interest file would be inconsistent with the
specialists' negative obligation, as well as section 11A of the Act,
which encourages order interaction without the participation of a
dealer.\374\ Other commenters raised concerns about the ability of
undisplayed floor broker interest outside the BBO to trade on parity
during sweeps with displayed orders on the Book.\375\ For example, some
commenters argued that permitting floor brokers to conceal their
interest from other market participants, while allowing this
undisplayed interest to trade on parity with displayed interest, would
provide a disincentive for investors to place limit orders on the Book,
since investors would not be rewarded for taking the risk to display
their orders.\376\
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    \373\ See IBAC Letters I and II, ICI Letter III and Rutherfurd
Letters III, IV, V, VI, VII, VIII, IX, and X.
    \374\ See Rutherfurd Letters III, IV, V, VI, VII, VIII, IX, and
X. See also IBAC Letter I.
    \375\ See, e.g., Bloomberg Letters I and II, ICI Letters I, II,
and III, Rutherfurd Letters I, II, III, and V, SIA Letter I, STANY
Letter, and Vanguard Letter.
    \376\ See, e.g., ICI Letters II and III, Rutherfurd Letters II
and V, STANY Letter, and Vanguard Letter.
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    The Commission's standard for reviewing trading rules filed by
exchanges is based on whether the rules are consistent with the
requirements of the Act, such as provisions that require that market
participants be treated fairly and provisions that limit the role of
specialists.\377\ The Commission also reviews trading rules to see if
the rules discriminate in favor of some members over others, or in
favor of members over public customers.\378\ Trading rules also must
promote fair and orderly markets, as well as the specified goals of the
national market system.\379\
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    \377\ See, e.g., 15 U.S.C. 78f(b)(5) and 15 U.S.C. 78k.
    \378\ 15 U.S.C. 78f(b)(5).
    \379\ 15 U.S.C. 78f(b)(5) and 15 U.S.C. 78k-1.
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    The Commission finds that NYSE's proposal to permit specialists to
trade on parity with the floor broker agency interest after interest on
the Book has been exhausted is consistent with the requirements of the
Act. The Commission notes that specialists will continue to be
restricted in their ability to trade pursuant to section 11(b) and Rule
11b-1 of the Act,\380\ and NYSE Rule 104. The Commission expects and
the Exchange represented that it expects the Specialist Algorithms to
be programmed and operated in a manner to ensure that specialist
proprietary trading is conducted consistent with section 11(b) of the
Act,\381\ Rule 11b-1, and NYSE Rule 104.
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    \380\ 17 CFR 240.11b-1(a)(2). In light of these changes, the
Commission expects the Exchange to update its surveillance
procedures and the specialist firms to update their compliance
programs to ensure that specialist trading is conducted in a manner
that is consistent with the requirements of the Act and NYSE rules.
    \381\ 15 U.S.C. 78k(b).
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    In accordance with SEC Rule 11b-1, NYSE Rule 104 restricts the
specialist's ability to trade for its own account. SEC Rule 11b-1
provides that exchanges may permit members to register as specialists
so long as their rules include, among other things, ``provisions
restricting [the specialist's] dealings so far as practicable to those
reasonably necessary to permit [it] to maintain a fair and orderly
market * * *'' NYSE Rule 104 specifically prohibits a specialist from
dealing in its own account ``unless such dealings are reasonably
necessary to permit such specialist to maintain a fair and orderly
market * * *'' Currently, the specialist makes the determination as to
whether its proprietary transactions are reasonably necessary based on
the anticipated needs of the market and the conditions of the market at
the time the transaction is effected. As proposed, the specialist may
not have access to all of the information that it has today regarding
the condition of the market at the time of sale. Specifically, the
specialist may not, and the Specialist Algorithm will not, have access
to information regarding floor broker reserve at the BBO or floor
broker agency interest outside of the BBO. Accordingly, the Commission
must consider the application of the restrictions in SEC Rule 11b-1 and
NYSE Rule 104 to the specialist's proprietary trading in the Hybrid
Market.
    In the Hybrid Market, specialists will remain obligated to
determine whether their proprietary trades are reasonably necessary to
maintain a fair and orderly market. The specialist will be expected to
actively monitor, both personally and through the Specialist Algorithm,
whether the interest placed in the specialist interest file remains
appropriate in light of current market conditions and the specialist's
obligations under NYSE Rule 104, and to make appropriate adjustments.
Nonetheless, the Commission recognizes that the role of the specialist
in the more automated Hybrid Market will be somewhat different from its
traditional role on the Exchange floor. Specifically, the specialist
will participate in automatic executions that occur against proprietary
interest previously placed in the specialist interest file. The
Commission also recognizes that, in the Hybrid Market, the specialist
will not individually handle each trade that occurs on the Exchange,
and may not necessarily know of--personally or algorithmically--other
trading interest available in the market prior to an execution for its
proprietary account. The specialist may not, and the Specialist
Algorithm will not, know whether there is floor broker reserve interest
available at the BBO, or floor broker agency interest available outside
the BBO. Accordingly, the specialist must make decisions whether to add
orders to the specialist interest file without knowing the full extent
of other trading interest available in the market, and consequently may
trade on parity with other available floor broker interest.
    As noted above, the Exchange believes that providing specialists
parity with floor broker agency interest will incent specialists to
participate in the price discovery process at the point of sale and
thus dampen volatility and lower execution costs for investors. The
Exchange also believes that withholding information about floor broker
reserve interest at the BBO, and floor broker agency interest outside
the BBO, from the Specialist Algorithm--and in some cases from the
specialist himself--will allow floor brokers to more effectively
represent their customer orders, and thus further incent liquidity and
dampen price volatility in the Hybrid Market.
    Although the Commission recognizes that these features may inhibit
somewhat the ability of specialists to assess the condition of the
market to comply with their ongoing negative obligations under SEC Rule
11b-1 and NYSE Rule 104, the potential benefits these features may
bring to the quality of the Hybrid Market justify the risks of

unnecessary specialist trading. The specialist must design its
Specialist Algorithm to support a fair and orderly market, which
includes varying its position in light of the anticipated needs of the
market. The specialist also must adjust the operation of the Specialist
Algorithm to the extent it becomes aware of changes in the market that
would render its operation inconsistent with its obligation. However,
the Commission recognizes that the specialist may, and the Specialist
Algorithm will, have less than full information about the floor broker
interest. So long as the specialist has programmed the Specialist
Algorithm, taking into account and including as inputs all relevant
factors available to the Specialist Algorithm, in a manner designed to
support a fair and orderly market, and the specialist has made
adjustments to the operation of the Specialist Algorithm based on its
knowledge of market information, the Commission believes the specialist
could trade on parity with floor broker interest consistent with its
obligations under SEC Rule 11b-1 and NYSE Rule 104 in the Hybrid
Market.\382\
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    \382\ NYSE has represented that prior to the rollout of the
third phase of the Hybrid Market, it will develop guidance to
clarify how it expects specialists to comply with the NYSE Rule 104
in the Hybrid Market. Telephone call between Catherine R. Kinney,
President and Co-Chief Operating Officer, NYSE Group, Inc., and
Richard G. Ketchum, Chief Regulatory Officer, NYSE Regulation, Inc.,
and Kelly M. Riley, Assistant Director, Division, SEC, on March 22,
2006. See also Amendment No. 8. The Commission believes that
specific guidance is necessary to help assure that specialists can
effectively program the algorithms to trade in compliance with the
negative obligation.
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    In addition, the Commission finds that NYSE's proposal to permit
interest in the floor broker agency interest files to trade on parity
with orders in the Book, subject to certain limitations, is consistent
with the requirements of the Act. NYSE appears to have sought to
balance the incentives for placing interest in the Book against the
ability of floor brokers to effectively represent their customers. The
proposal limits the ability of interests in the floor broker agency
interest files outside the BBO to trade on parity with orders in the
Book by requiring floor brokers to designate the amount of interest
that would be displayed if the price becomes the Exchange BBO, and
permitting only that amount to trade on parity. The Commission believes
that providing floor brokers with this additional incentive to place
liquidity in the Display Book system could allow them to more
effectively represent their customer orders, without materially
reducing the incentives to display liquidity on the Book.
    The Commission believes that exchanges have a degree of
flexibility, in their judgment, to determine the methods of non-
discretionary order interaction on their markets so long as the
requirements of the Act are met. Accordingly, the Commission believes
that NYSE's proposed changes to its rules of priority, parity and
precedence are consistent with the requirements of the Act.

E. Role of Specialist in the Hybrid Market

    To preserve a meaningful role for the specialist, NYSE has proposed
to permit specialists to participate electronically in the Hybrid
Market and replicate certain existing specialist privileges in an
electronic manner. For example, NYSE has proposed to provide
specialists with access to certain information about incoming orders
before they are processed by the Display Book system.\383\ This
information would be transmitted to the specialist via the API. Based
on this and other information, specialists would use the Specialist
Algorithms to generate quoting or trading messages, which would be
transmitted to the Display Book system via the API. The Specialist
Algorithm would be able to make limited quoting and trading decisions
in response to incoming orders, such as to provide price improvement,
improve the Exchange BBO, or supply size to fill the incoming order at
the Exchange BBO.
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    \383\ See supra note 167.
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    The proposal to create Specialist Algorithms generated several
comments. Five commenters believed that it would be unfair for the
Specialist Algorithms to view information prior to other market
participants and for the specialist to act on that information.\384\
These commenters believed that other market participants should be
given the same opportunity.\385\ For instance, one commenter viewed as
one-sided NYSE's proposal to provide specialists with the ability to
algorithmically trade with incoming orders while providing no similar
tool for floor brokers, and believed this would thwart, rather than
foster, fair competition.\386\ Another commenter was concerned that the
information barriers within a specialist firm could be breached,
resulting in the dissemination of non-public information outside the
Exchange, including upstairs traders or other business units affiliated
with the specialist firm.\387\ This commenter believed that the
Exchange should affirmatively state a prohibition against such sharing
of information.
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    \384\ See IBAC Letter I, ICI Letters I, II, and III, Rutherfurd
Letters I, III, and V, SIA Letters I and III, and Vanguard Letter.
See also IBAC Letter II.
    \385\ See id.
    \386\ See IBAC Letters I and II. See also ICI Letter III.
    \387\ See Invictus Letter.
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    Specialists will continue to be required to perform their
obligations to maintain a fair and orderly market.\388\ For example,
pursuant to NYSE Rule 104, specialists will continue to be required to
trade for their own account when there is a lack of price continuity,
depth, or a disparity between supply and demand. In addition,
specialists will continue to oversee the auction market and play an
active role when large transactions are routed to the NYSE floor for
execution. To enable specialists to effectively perform these
functions, NYSE has proposed to replicate some of the existing
specialist privileges--including an informational advantage--in an
electronic manner. As discussed below, the Commission finds that NYSE
has sufficiently limited the specialists' informational advantage so
that, in light of the specialists' ongoing duties and obligations to
the market, the proposal is consistent with the requirements of the
Act.
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    \388\ See also Section IV(D), supra, for a discussion on the
application of SEC Rule 11b-1 and NYSE Rule 104 in the Hybrid
Market.
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1. Price Improvement
    Under the proposal, the specialist could program its algorithm to
offer price improvement to incoming orders under certain circumstances.
The amount of price improvement would vary, depending on the spread.
For example, price improvement must be at least three cents when the
spread is more than five cents, at least two cents when the spread is
three cents to five cents, and one cent when the spread is two cents.
To offer electronic price improvement, the specialist must be
represented in the bid or offer in a meaningful amount, which NYSE
would define as a minimum of 1,000 shares for the most 100 active
stocks on the Exchange and 500 shares for all other stocks on the
Exchange.\389\
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    \389\ The Exchange would determine the 100 most active stocks
based on the average daily volume and would provide notice to its
members on a quarterly basis, or more frequently as the Exchange
from time to time shall determine. See proposed NYSE Rule
104(e)(ii).
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    Commenters objected to the ability of a specialist to provide price
improvement electronically to all or part

of a marketable incoming order.\390\ One commenter believed that the
specialist's ability to provide algorithmic price improvement would not