[Federal Register: September 23, 2009 (Volume 74, Number 183)]
[Proposed Rules]
[Page 48631-48645]
[DOCID:fr23se09-27]

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Part II

Securities and Exchange Commission

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17 CFR Part 242

Elimination of Flash Order Exception From Rule 602 of Regulation NMS;
Proposed Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 242

[Release No. 34-60684; File No. S7-21-09]
RIN 3235-AK40

Elimination of Flash Order Exception From Rule 602 of Regulation
NMS

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is
concerned that the exception for flash orders from quoting requirements
under the Securities Exchange Act of 1934 (``Exchange Act''), which
originated in the context of manual trading floors for quotations that
were considered ``ephemeral,'' is no longer necessary or appropriate in
today's highly automated trading environment. Accordingly, the
Commission is proposing to amend Rule 602 of Regulation NMS under the
Exchange Act to eliminate an exception for the use of flash orders by
equity and options exchanges. In general, flash orders are communicated
to certain market participants and either executed immediately or
withdrawn immediately after communication. If the proposed amendment
were adopted, the Commission would apply Rule 301(b) of Regulation ATS
under the Exchange Act in a consistent manner with regard to the use of
flash orders by alternative trading systems. The Commission also would
apply the restrictions on locking or crossing quotations in Rule 610(d)
of Regulation NMS in a consistent manner to prohibit the practice of
displaying marketable flash orders.

DATES: Comments should be received on or before November 23, 2009.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>Please include
File No. S7-21-09 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.

All submissions should refer to File No. S7-21-09. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Theodore S. Venuti, Special Counsel,
at<PHONE_NUMBER>, Arisa Tinaves, Special Counsel, at<PHONE_NUMBER>,
Gary M. Rubin, Attorney, at<PHONE_NUMBER>, Division of Trading and
Markets, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
II. Description of Flash Orders
III. Flash Order Exception From Quoting Requirements
IV. Proposed Elimination of Flash Order Exception
V. Request for Comments
VI. Paperwork Reduction Act
VII. Consideration of Costs and Benefits
VIII. Consideration of Burden on Competition, and Promotion of
Efficiency, Competition and Capital Formation
IX. Consideration of Impact on the Economy
X. Regulatory Flexibility Act
XI. Statutory Authority
XII. Text of Proposed Rule Amendment

I. Introduction

    Rule 602 of Regulation NMS \1\ and Rule 301(b) of Regulation ATS
\2\ require exchanges and alternative trading systems (``ATSs''),
respectively, to provide their best-priced quotations to the
consolidated quotation data that is widely disseminated to the
public.\3\ The Commission is proposing to amend Rule 602 to eliminate
the exception for the use of flash orders by equity and options
exchanges. If the proposed amendment were adopted, the Commission would
apply Rule 301(b) in a consistent manner regarding the use of flash
orders by ATSs. Finally, the Commission would also apply the
restrictions on locking or crossing quotations in Rule 610(d) of
Regulation NMS \4\ in a consistent manner to prohibit the practice of
displaying flash orders with marketable prices. The practical result of
the proposal, if adopted, would be that any flash orders with non-
marketable prices would need to be included in the consolidated
quotation data and that the more frequently used practice of flashing
orders with marketable prices to certain market participants would be
prohibited. Exchanges and ATSs would be required to handle marketable
orders that they are unable to execute at the best displayed prices in
another manner, such as by routing marketable orders away to execute
against the best displayed quotations at another exchange or ATS.
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    \1\ 17 CFR 242.602.
    \2\ 17 CFR 242.301(b).
    \3\ Consolidated quotation data captures the best-priced
quotations from exchanges, ATSs, and other trading centers for
listed equities and options. This core data for a security is
consolidated and distributed to the public by a single central
processor pursuant to Commission rules.
    \4\ 17 CFR 242.610(d).
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    As discussed in section III below, Rule 602 generally requires
exchanges to make their best bids and offers in U.S.-listed securities
available in the consolidated quotation data that is widely
disseminated to the public. Paragraph (a)(1)(i)(A) of Rule 602,
however, excludes bids and offers communicated on an exchange that
either are executed immediately after communication or cancelled or
withdrawn if not executed immediately after communication. Rule 602 has
included this language since the original adoption of its predecessor
rule in 1978. The exception was intended to facilitate manual trading
in the crowd on exchange floors by excluding quotations that then were
considered ``ephemeral'' and impractical to include in the consolidated
quotation data.\5\ As securities trading became much more automated in
recent years, automated markets began to disseminate information
electronically concerning orders that either were to be executed
immediately or withdrawn if not executed immediately. These
electronically disseminated orders had a duration that was even shorter
than the ephemeral manual quotations that were contemplated in 1978.
The orders qualifying for the ``immediate execution or withdrawal''
exception from Rule 602 now are widely referred to as ``flash orders.''
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    \5\ See infra note 19.
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    The Commission is concerned that the exception for flash orders,
whether manual or automated, from Exchange

Act quoting requirements is no longer necessary or appropriate in
today's highly automated trading environment. The consolidated
quotation data is designed to provide investors with a single source of
information for the best prices in a listed security, rather than
forcing investors to obtain such information by subscribing to all of
the data feeds of the many exchanges and ATSs that trade listed
securities. The flashing of order information could lead to a two-
tiered market in which the public does not have access, through the
consolidated quotation data streams, to information about the best
available prices for U.S.-listed securities that is available to some
market participants through proprietary data feeds. In addition, flash
orders may significantly detract from incentives for market
participants to display their trading interest publicly, though flash
orders do offer potential benefits to certain types of market
participants.\6\ The Commission therefore is proposing to eliminate the
exception for flash orders from Exchange Act quoting requirements.
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    \6\ See infra notes 54-56 and accompanying text.
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II. Description of Flash Orders

    As noted in section IV.B.1 below, the phrases ``executed
immediately'' or ``withdrawn if not executed immediately'' in Rule
602(a)(1)(i)(A) can cover a variety of different trading mechanisms on
both a manual trading floor and an automated trading system. In
general, however, the particular type of electronic flash order that
equity and options markets now use the most has the following basic
features:
    First, the use of a flash order type is voluntary. Markets that
offer flash order types also offer order types that provide order
routers with the ability to access liquidity at the market without
using a flash order type.\7\
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    \7\ The basic type of order that accesses a market's liquidity
without the possibility of a flash is the ``immediate-or-cancel''
(``IOC'') order. An IOC order only seeks to take any liquidity that
is currently available at a market when the order arrives with no
possibility of further action by the market with the order. In
contrast, a flash order is transmitted to other market participants
in an effort to attract additional liquidity to the market. See,
e.g., Rule 600(b)(3) of Regulation NMS (for a quotation to qualify
as an ``automated quotation'' that can be protected against trade-
throughs, the trading center displaying the quotation must provide
an immediate-or-cancel functionality); Chicago Board Stock Exchange
(``CBSX'') Rule 52.6(a) (immediate-or-cancel orders will not be
flashed).
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    Second, flash orders almost always are ``marketable'' \8\--they are
buy orders that are immediately executable at the price of the national
best offer and sell orders that are immediately executable at the price
of the national best bid.\9\ For example, if the national best bid and
national best offer (``NBBO'') in a listed security are $20.10 and
$20.15, respectively, marketable buy orders are executable at $20.15
and marketable sell orders are executable at $20.10. Marketable orders
can be said to ``take'' liquidity. The submitter wants to trade
immediately and is willing to pay the ``spread'' between the NBBO (in
the example, the five cent difference between $20.10 and $20.15) for
the opportunity to trade immediately. In contrast, non-marketable
orders--for example, those orders that establish the national best bid
and offer--are ``resting'' orders that seek to trade at better prices
than those that are immediately available and to earn the NBBO spread
rather than pay it. These resting orders provide quotation information
for investors and add liquidity and depth to the market. Non-marketable
orders run the risk, however, of missing an execution if they are
unable to interact with contra side marketable order flow. That is why
the Commission long has been concerned with promoting the opportunity
for publicly displayed orders to interact with contra side marketable
order flow.\10\
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    \8\ See, e.g., Letter dated June 3, 2009 from William O'Brien,
Chief Executive Officer, Direct Edge ECN LLC (``Direct Edge'') to
Elizabeth M. Murphy, Secretary, Commission (``Direct Edge Letter'')
at 1 (Direct Edge's Enhanced Liquidity Provider program provides
optional display period for marketable orders); International
Securities Exchange (``ISE'') Rule 803, Supplementary Material .02
(prior to sending a Linkage Order to another exchange, a Public
Customer Order shall be exposed at the national best bid for a sell
order or national best offer price for a buy order).
    \9\ The term ``national best bid and national best offer'' is
defined in Rule 600(b)(42) of Regulation NMS as the highest priced
bid and the lowest priced offer disseminated in the consolidated
quotation data. The characteristics of marketable and non-marketable
orders are discussed at length in the Commission's Concept Release
on Market Fragmentation. Securities Exchange Act Release No. 42450
(February 23, 2000) 65 FR 10577 (February 28, 2000) (SR-NYSE-99-48)
(``Concept Release on Market Fragmentation'').
    \10\ See, e.g., Securities Exchange Act Release No. 51808 (June
9, 2005) 70 FR 37496, 37502 (June 29, 2005) (``NMS Release'')
(``[T]he Commission believes that a rule establishing price
protection on an order-by-order basis for all NMS stocks is needed
to protect the interests of investors, promote the display of limit
orders, and thereby improve the efficiency of the NMS as a
whole.''); Concept Release on Market Fragmentation, supra note 9, at
10577 (``The Commission is concerned, however, that customer limit
orders and dealer quotes may be isolated from full interaction with
other buying and selling interest in today's markets. * * * To the
extent that the price-setting customer's limit order remains
unexecuted and subsequent buying interest is filled at the
customer's price, the customer's order has been isolated, and the
incentive of customers to improve prices potentially
compromised.''); Securities Exchange Act Release No. 37619A
(September 6, 1996), 61 FR 48290, 48297 (September 12, 1996)
(``Order Handling Rules Release'') (``In 1975, Congress envisioned
an NMS in which public limit orders in qualified securities would
have a central role. Congress anticipated that the NMS would make
all specialists and market makers aware of public customer limit
orders held anywhere in the system, and provide enhanced protection
and priority for limit orders in stocks qualified for trading in the
national market system.''); see also S. Report No. 90-75, 94th
Cong., 1st Sess. 18 (1975) (``The Committee is satisfied that S. 249
grants the Commission complete and effective authority to implement
a system for the satisfaction of public limit orders.'').
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    Third, on arrival at a market and prior to being flashed, flash
orders first will interact immediately with any available contra side
trading interest at the exchange that receives the order.\11\ For
example, a marketable flash order to buy can execute immediately
against a displayed order at the receiving exchange that is priced at
the national best offer. As a result, the public is able to interact
with such orders at that market--prior to the order being flashed--by
submitting a non-marketable resting order that is priced at the
national best bid for buy orders and the national best offer for sell
orders.
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    \11\ See, e.g., CBSX Rule 52.6(a) (under CBSX flash order rule,
the CBSX system will automatically attempt to match market orders
against orders at the best price in the CBSX book unless filling the
order would result in an execution of a trade-through of another
exchange's protected quotation); Boston Options Exchange Rules, ch.
5, sec. 16(b)(iii)(2) (under BOX flash order rule, if there is a
quote on BOX that is equal to the NBBO, then the order will be
executed against the relevant quote).
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    Fourth, if a market does not have available trading interest at the
national best offer when a marketable flash order to buy arrives, or at
the national best bid when a marketable flash order to sell arrives,
the market will flash the order to its market participants at the
national best offer for flash orders to buy and the national best bid
for flash orders to sell.\12\ The markets disseminate the order
information as part of their data feeds. Some distribute the data only
to members, and some provide the data to anyone who wants to receive
it.\13\
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    \12\ See, e.g., CBSX Rule 52.6(a) (orders ``flashed to CBSX
Traders at the NBBO price for a period of time not to exceed 500
milliseconds as determined by CBSX''); ISE Rule 803, Supplementary
Material .02 (before a Linkage Order is sent to another exchange,
``a Public Customer Order shall be exposed at the current NBBO price
to all Exchange Members for a time period established by the
Exchange not to exceed one (1) second'').
    \13\ See, e.g., Direct Edge Letter, supra note 8, at 4 (Direct
Edge provides its data feed with flash order information at no
charge to any recipient who wishes to receive the data).
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    Fifth, market participants that receive the flashed order
information have a very brief period in which to respond with their own
order to execute against the flashed order at a price that matches the
NBBO price (that is, the national best offer for flash orders to buy
and the national best bid for flash orders to sell).

The time periods vary in length, but generally are one second or
less.\14\ As a result, although all those who take a market's data feed
will receive the flashed order information, only market participants
with pre-programmed systems capable of responding very rapidly will
have a realistic opportunity, as a practical matter, to respond to a
flashed order. In other words, only those who have invested in
sophisticated trading systems are able to effectively access flash
orders.
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    \14\ See, e.g., BOX Rules, ch. 5, sec. 16(b)(iii)(2(a) (one
second); CBSX Rule 52.6(a) (no more than 500 milliseconds); ISE Rule
803, Supplementary Material .02 (not to exceed one second).
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    Sixth, if there is an order responding to the flashed order, the
flash order will execute against the response. If there is no response
to the flashed order, markets generally will route orders away to
execute against the best-priced quotations on other markets.\15\
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    \15\ See, e.g., CBSX Rule 52.6(a) (``CBSX System shall route
[intermarket sweep orders] on behalf of the market order to all
Protected Quotations priced better than the CBSX disseminated
price''); ISE Rule 803, Supplementary Material .02(d) (if an order
cannot be executed in full after exposure, ``the Primary Market
Maker will proceed to send a Linkage Order on the customer's behalf
for the balance of the order'' if it is marketable against the then-
current NBBO).
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III. Flash Order Exception From Quoting Requirements

    Rule 602 generally requires exchanges to make available to vendors,
including the central processors for the consolidated quotation data
that is widely disseminated to the public, the best bids and best
offers for listed securities that are communicated on an exchange by
any responsible broker or dealer.\16\ The consolidated quotation data
streams are the primary vehicles for public price transparency in the
U.S. equity and options markets. The central processors for these data
streams collect the best bids and best offers from the exchanges and
Financial Industry Regulatory Authority (``FINRA'') \17\ and distribute
them in consolidated data streams that are widely available to the
public. The consolidated data streams are designed to assure that the
public has affordable, accurate, and reliable real-time information on
the best prices available for listed securities.\18\
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    \16\ The term ``responsible broker or dealer'' is defined in
Rule 600(b)(65) of Regulation NMS.
    \17\ FINRA collects quotation data from over-the-counter market
participants, including ATSs.
    \18\ The consolidated quotation data streams and their policy
objectives are fully described in the Commission's Concept Release
on Regulation of Market Information Fees and Revenues. Securities
Exchange Act Release No. 42208 (December 9, 1999) 64 FR 70613
(December 17, 1999).
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    Paragraph (a)(1)(i)(A) of Rule 602, however, excepts ``any bid or
offer executed immediately after communication and any bid or offer
communicated by a responsible broker or dealer other than an exchange
market maker which is cancelled or withdrawn if not executed
immediately after communication.'' This language was included in the
predecessor to Rule 602 when it originally was adopted in 1978 and was
intended to accommodate the ``ephemeral'' quotations of non-specialist
participants in exchange crowds.\19\ As a result, bids and offers that
either are immediately executed or, if not executed, immediately
cancelled or withdrawn are not required to be included in the
consolidated quotation data.
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    \19\ See Securities Exchange Act Release No. 14415 (January 26,
1978), 43 FR 4342 (February 1, 1978) (``This determination is
consistent with the Commission's intent in providing this exception
for `ephemeral' quotations in the 1977 Proposal; that is, that the
Rule as adopted reflects the fact that certain non-specialist
participants in exchange `crowds' have bids and offers which, while
narrowing the exchange quotation for an instant in time, never in
fact become part of the quoted market on the exchange because they
are withdrawn immediately if not accepted.''). Rule 602 originally
was designated as Rule 11Ac1-1 under the Exchange Act. It was
redesignated as Rule 602 as part of the adoption of Regulation NMS
in 2005, but its substance was unchanged.
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    By its terms, Rule 602(a)(1)(i)(A) applies only to exchanges. The
relevant parts of Rule 602 in the over-the-counter context apply to
national securities associations and OTC market makers. As a result,
ATSs generally are not directly subject to Rule 602 requirements. Rule
301(b)(3)(ii) of Regulation ATS, however, requires certain ATSs to
include their best priced orders displayed to more than one person in
the consolidated quotation data made available to the public pursuant
to Rule 602.\20\ Consistent with the language in Rule 602 excepting
exchanges from including flash orders in the consolidated quotation
data, the Commission has not applied Rule 301 to require ATSs to
include flash orders in the consolidated quotation data.
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    \20\ In general, ATSs that meet a 5% volume threshold in NMS
stocks are required to include their best-priced displayed orders in
the consolidated quotation data. See infra note 64.
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    Similarly, the Commission has not applied the Rule 610(d)
restrictions on displaying quotations that ``lock'' or ``cross''
another market's displayed quotation, to flash orders with marketable
prices.\21\ For many years, the restrictions on locking and crossing
quotations for exchange-listed equities were imposed in the Intermarket
Trading System (``ITS'') Plan.\22\ In 2005, the Commission adopted Rule
610(d) of Regulation NMS to address locking and crossing quotations for
NMS stocks. Among other things, Rule 610(d) requires the self-
regulatory organizations (``SROs'') to adopt rules that prohibit their
members from engaging in a pattern or practice of displaying quotations
that lock or cross protected quotations in NMS stocks.\23\
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    \21\ A ``locking'' quotation has a price that equals the price
of the previously displayed contra side NBBO. For example, if the
national best offer to sell were $20, a subsequent bid to buy with a
price of $20 would be a locking quotation. A ``crossing'' quotation
has a price that is higher or lower than the price of the previously
displayed contra side NBBO. For example, if the national best offer
to sell were $20, a subsequent bid to buy with any price higher than
$20 would be a crossing quotation. Conversely, if the national best
bid to buy were $19, a subsequent offer to sell with any price lower
than $19 would be a crossing quotation.
    \22\ All equities exchanges and the NASD were participants in
the ITS Plan. The ITS Plan is described in the NMS Release, supra
note 10, at 37501.
    \23\ Restrictions on locking and crossing quotations for
exchange-listed options currently are imposed in the Options Linkage
Plan. The Options Linkage Plan is a Commission-approved national
market system plan. Securities Exchange Act Release No. 60405 (July
30, 2009), 74 FR 39362 (August 6, 2009) (Order Approving the
National Market System Plan Relating to Options Order Protection and
Locked/Crossed Markets Submitted by the Chicago Board Options
Exchange, Incorporated, International Securities Exchange, LLC, The
NASDAQ Stock Market LLC, NASDAQ OMX BX, Inc., NASDAQ OMX PHLX, Inc.,
NYSE Amex LLC, and NYSE Arca, Inc.) (``Options Linkage Plan'').
Similar to Rule 610(d), Section 6 of the Options Linkage Plan
requires the options exchanges to adopt rules that prohibit their
members from engaging in a pattern or practice of displaying locking
or crossing quotations.
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    In January 2004, the Commission approved an exchange rule filing
for orders in listed options that were flashed electronically to market
participants for a three-second period, rather than manually on the
floor of an exchange.\24\ The Commission generally has sought to
interpret its rules in such a way that they promote fair competition
between manual and automated markets.\25\ The Commission noted that the
electronic flash process was designed to protect against trading
through better displayed prices at other

markets, and that the process would allow exchange participants to
provide efficient and competitive executions for flashed orders.\26\
Subsequently, other options exchanges adopted similar rules.\27\
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    \24\ The first exchange to use the flash order exception for
electronically communicated orders was the Boston Options Exchange
(``BOX'') facility of the Boston Stock Exchange (``BSE'').
Securities Exchange Act Release No. 49068 (January 13, 2004), 69 FR
2775 (January 20, 2004) (SR-BSE-2002-15). BOX flashed orders as part
of a process called an ``NBBO filter.''
    \25\ See id. at 2776-2777 (``Overall, the Commission believes
that approving the BSE's proposal to establish trading rules for the
BOX facility should confer important benefits to the public and
provide U.S. market participants with a new market in which to trade
standardized options. As a fully electronic options market with
relatively lower barriers to access, BOX's entry into the options
marketplace may potentially reduce the costs of trading to investors
and market professionals, enhance innovation, and increase
competition between and among the options exchanges, resulting in
better prices and executions for investors.'') (citations omitted).
    \26\ Id. at 2783.
    \27\ See, e.g., Securities Exchange Act Release Nos. 51544
(April 14, 2005) 70 FR 20613 (April 20, 2005) (SR-Phlx-2005-03);
53167 (January 23, 2006) 71 FR 5094 (January 31, 2006) (SR-CBOE-
2005-89); 57812 (May 12, 2008) 73 FR 28846 (May 19, 2008) (SR-ISE-
2008-28).
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    In September 2006, the Commission approved an exchange rule filing
for the use of flash orders on the equity trading platform of the
Chicago Board Options Exchange (``CBOE'').\28\ The Commission received
no comments on the CBOE proposal. In May 2009, two more exchanges--
Nasdaq and BATS--filed proposed rule changes to begin offering flash
orders for equity trading.\29\ The proposed rule changes of Nasdaq and
BATS cited the Commission's previous approval of the CBSX filing and
were filed as immediately effective pursuant to Exchange Act Rule 19b-
4(f)(6).\30\ In this regard, the Nasdaq and BATS filings fell within
the interpretive guidance issued by the Commission last year that was
designed to streamline the handling of SRO proposed rule changes,
particularly for exchange trading rules.\31\
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    \28\ Securities Exchange Act Release No. 54422 (September 11,
2006) 71 FR 54537 (September 15, 2006) (SR-CBOE-2004-21).
    \29\ Securities Exchange Act Release Nos. 60040 (June 3, 2009)
74 FR 27577 (June 10, 2009) (SR-BATS-2009-014); 59875 (May 6, 2009)
74 FR 22794 (May 14, 2009) (SR-NASDAQ-2009-043); 60039 (June 3,
2009) 74 FR 27635 (June 9, 2009 (SR-NASDAQ-2009-050); and 60037
(June 3, 2009) 74 FR 27367 (June 9, 2009) (SR-NASDAQ-2009-048).
    \30\ Rule 19b-4(f)(6) permits a proposed rule change to become
immediately effective so long as each policy issue raised by the
proposed trading rule: (1) has been considered previously by the
Commission when the Commission approved another exchange's trading
rule; and (2) the rule change resolves such policy issue in a manner
consistent with such prior approval. Securities Exchange Act Release
No. 58092 (July 3, 2008) 73 FR 40144, 40147 (July 11, 2008).
    \31\ See id. at 40147 (``[T]he Commission recognizes that
national securities exchanges registered under section 6(a) of the
Exchange Act face increased competitive pressures from entities that
trade the same or similar financial instruments--such as foreign
exchanges, futures exchanges, ECNs, and ATSs. These competitors can
change their trading rules or trade new products without filing them
with the Commission.'').
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    Commenters opposed to the Nasdaq and BATS filings raised serious
concerns about the effect of flash orders on investors and on the
integrity of the markets.\32\ NYSE Euronext noted that in today's
trading environment, ``where trading and reaction time are discussed in
micro seconds, an order that is held for even 500 milliseconds cannot
be deemed an ``immediate'' execution.'' \33\ GETCO was concerned that
flash orders reduce the incentive to display aggressively priced
liquidity, noting that ``[m]arket participants interested in finding
the best priced orders to execute against would be encouraged to join
the disparate system of `step-up' order display systems on the various
exchanges so that they could execute against better priced `step-up'
orders without displaying limit orders on the public markets.'' \34\
Similarly, Morgan Stanley stated that ``[w]e believe that the [proposed
rule changes] will provide a material disincentive to publicly display
limit orders on exchanges, thereby impairing price discovery.'' \35\
Further, SIFMA sought a fuller public discussion of issues raised by
the proposed rule changes, including ``the creation of essentially a
two tiered market (with some able to pay for a non-public direct data
feed to trade with better-priced quotes versus those quotes that are
accessible to the general public), thus raising fair access issues and
issues re: investor confidence, transparency and our market structure
in general.'' \36\
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    \32\ Letter dated May 28, 2009 from Janet M. Kissane, Senior
Vice President--Legal & Corporate Secretary, Office of the General
Counsel, NYSE Euronext to Elizabeth M. Murphy, Secretary, Commission
(``NYSE Euronext Letter''); Letter dated June 4, 2009 from Stephen
Schuler and Daniel Tierney, Managing Members, Global Electronic
Trading Company to Elizabeth M. Murphy, Secretary, Commission
(``GETCO Letter''); Letter dated June 4, 2009 from Ann Vlcek,
Managing Director and Associate General Counsel, Securities Industry
and Financial Markets Association to Elizabeth M. Murphy, Secretary,
Commission (``SIFMA Letter''); and Letter dated June 17, 2009 from
William P. Neuberger and Andrew F. Silverman, Managing Directors,
Global Co-Heads of Morgan Stanley Electronic Trading to Elizabeth M.
Murphy, Secretary, Commission (``Morgan Stanley Letter'').
    \33\ NYSE Euronext Letter at 3; see also GETCO Letter at 3;
Morgan Stanley Letter at 5-6.
    \34\ GETCO Letter at 4; see also NYSE Euronext Letter at 6
(``reducing publicly available liquidity in this way may impact bid-
offer spreads and the execution costs to customers'').
    \35\ Morgan Stanley Letter at 4.
    \36\ SIFMA Letter at 2.
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    In contrast, Direct Edge--an alternative trading system--submitted
a comment letter supporting the proposed rule changes.\37\ The letter
noted that Direct Edge offers a pre-routing display product to its
participants--the Enhanced Liquidity Provider (``ELP'') program--
pursuant to which marketable orders are displayed to any of its
participants who wish to receive the information in a data feed for
which there is no charge.\38\ It stated that ``[l]iquidity-aggregation
products like Direct Edge's ELP program seek to bring together
traditional and non-traditional liquidity in a consolidated, easy-to-
access manner designed to maximize the potential for execution, reduce
implicit and explicit transaction costs, and otherwise improve
execution quality for our customers.'' \39\ Another commenter, Woodbine
Associates, was concerned that flash orders could have an ``undesirable
impact'' if offered by market centers with a majority of order flow,
but recommended that the Commission ``allow flash orders, monitor their
use, and study the effect on the market.''\40\
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    \37\ See Direct Edge Letter, supra note 8.
    \38\ Direct Edge Letter at 4.
    \39\ Direct Edge Letter at 2.
    \40\ Letter dated June 30, 2009 from Woodbine Associates
(``Woodbine Letter'') at 1, 2.
---------------------------------------------------------------------------

    For listed equities and listed options in July 2009, the Commission
estimates that the total volume of flash orders that received an
execution during the flash process was approximately 3.1% and 1.9%,
respectively, of total trading volume.\41\ BATS, Nasdaq, and Nasdaq OMX
BX decided to discontinue offering a flash order type as of September
1, 2009.\42\ Accordingly, the total volume of executed flash orders may
have declined as of that date.
---------------------------------------------------------------------------

    \41\ The Commission's estimate of flash order trading volume in
July 2009 reflects discussions with the markets that offered flash
orders during that time--CBSX, Direct Edge, BATS, Nasdaq, and Nasdaq
OMX BX for equity trading, and BOX, CBOE, and ISE for options
trading. These volume estimates reflect executions by market
participants in response to flashed order information.
    \42\ See Securities Exchange Act Release Nos. 60569 (August 26,
2009), 74 FR 45268 (September 1, 2009) (SR-BATS-2009-028); 60570
(August 26, 2009), 74 FR 45504 (September 2, 2009) (SR-NASDAQ-2009-
079); 60571 (August 26, 2009), 74 FR 45502 (September 2, 2009) (SR-
BX-2009-051). The Commission notes that, if the proposal is adopted,
exchanges with flash order rules would need to file proposed rule
changes to eliminate flash orders from their rule books.
---------------------------------------------------------------------------

IV. Proposed Elimination of Flash Order Exception

A. Concerns About Flash Orders

    The Commission is proposing to eliminate the flash order exception
from Exchange Act quoting requirements. The Commission is concerned
that the use of flash orders by exchanges and other markets,
particularly if it were to expand in trading volume, could detract from
the fairness and efficiency of the national market system.\43\ In its
analysis of flash order types, the Commission will consider the
interests of long-term investors and the extent to which they are
helped or harmed by these orders, rather than on the interests of
professional short-term traders that may have invested in sophisticated
trading systems capable of responding to flash orders. The interests of
long-term investors and professional short-term traders in fair and
efficient markets

often will coincide. Indeed, vigorous competition among professional
short-term traders can itself lead to very important benefits for long-
term investors, including narrower spreads and greater depth. If,
however, the interests of long-term investors and professional short-
term traders conflict, the Commission previously has emphasized that
``its clear responsibility is to uphold the interests of long-term
investors.'' \44\ The Commission preliminarily believes that, in
today's highly automated trading environment, the exception for flash
orders from Exchange Act quoting requirements may no longer serve the
interests of long-term investors and could detract from the efficiency
of the national market system.
---------------------------------------------------------------------------

    \43\ See also supra note 32.
    \44\ NMS Release, supra note 10, at 37500 (noting that ``it
makes little sense to refer to someone as `investing' in a company
for a few seconds, minutes, or hours''). The Commission further
noted that giving priority to the interests of long-term investors
is consistent with both the legislative history of the Exchange Act
and the strong policy goal to reduce the cost of capital for U.S.-
listed companies. Id. at 37499-37500.
---------------------------------------------------------------------------

    Today, the overwhelming majority of trading volume in listed
equities and listed options is routed and executed through highly
automated systems. Among other things, these sophisticated systems have
dramatically reduced the time period for collecting and disseminating
quotations.\45\ In contrast to the primarily manual trading when the
Commission originally adopted the exception for flash orders in 1978,
flash orders no longer are clearly distinguishable from quotations that
are disseminated in the consolidated quotation data. As a result, the
rationale for requiring markets to include their best-priced quotations
in the consolidated quotation data and for prohibiting the practice of
displaying quotations with prices that lock previously displayed
quotations would appear to apply equally to flash orders in today's
trading environment.
---------------------------------------------------------------------------

    \45\ See NYSE Euronext Letter at 4.
---------------------------------------------------------------------------

    The Commission also is concerned that flash orders may create a
two-tiered market in which the public does not have access, through the
consolidated quotation data streams, to information about the best
available prices for listed securities. A flash order generally is
displayed at a marketable price that will be better than the best
displayed price for the security in the consolidated quotation data.
For example, a flash order to buy would be displayed at a higher price
than the national best bid, and a flash order to sell would be
displayed at a lower price than the national best offer. Yet the public
does not receive this flashed order information in the consolidated
quotation data. Instead, only those market participants that receive a
market's individual data feed have access to the improved price
information. The consolidated quotation data streams are intended to
provide a single source of information on the best prices for a listed
security across all markets, rather than force the public to obtain
data from many different exchanges and other markets to learn the best
prices.\46\ This objective would not be met if exchanges and ATSs
disseminate pricing information that, due to the technological
evolution of the markets, is functionally quite similar to quotations,
yet is not required to be included in the consolidated quotation data.
---------------------------------------------------------------------------

    \46\ See Rule 603(b) of Regulation NMS (providing for the
dissemination of all consolidated information for an individual NMS
stock through a single plan processor).
---------------------------------------------------------------------------

    In addition, the Commission is concerned about the extent to which
flash orders may discourage the public display of trading interest and
harm quote competition among markets. The Commission long has
emphasized the need to encourage displayed liquidity in the form of
publicly displayed limit orders.\47\ Such orders establish the current
``market'' for a stock and thereby provide a critical reference point
for investors. Flash orders, however, generally are executed by a
market at prices that match the best displayed prices for a stock at
another market. In this respect, flash orders potentially deprive those
who publicly display their interest at the best price from receiving a
speedy execution at that price. The opportunity to obtain the fastest
possible execution at a price is the primary incentive for the display
of trading interest.\48\ Particularly if flash orders were offered by
all major markets for a security and greatly expanded in trading
volume, they could significantly undermine the incentives to display
limit orders and to quote competitively, and thereby detract from the
efficiency of the national market system.
---------------------------------------------------------------------------

    \47\ See, e.g., NMS Release, supra note 10, at 37527 (``The
Commission believes, however, that the long-term strength of the NMS
as a whole is best promoted by fostering greater depth and
liquidity, and it follows from this that the Commission should
examine the extent to which it can encourage the limit orders that
provide this depth and liquidity to the market at the best
prices.''); Order Handling Rules Release, supra note 10, at 48293
(``[T]he display of customer limit orders advances the national
market system goal of the public availability of quotation
information, as well as fair competition, market efficiency, best
execution, and disintermediation.'').
    \48\ See NMS Release, supra note 10, at 37505.
---------------------------------------------------------------------------

    For example, the flash process provides a vehicle for certain
market participants to match displayed prices on an order-by-order
basis by responding to flashes. It therefore gives these participants a
``last-mover'' advantage over displayed orders in other markets. Rather
than displaying their orders or quotations in advance of incoming
marketable order flow to attract an execution, these market
participants can wait to receive the flashed order and program their
systems to pick and choose when to execute. The availability of this
``flash'' alternative to quoting as a means to supply liquidity may
reduce their incentives to display liquidity.
    Moreover, the flash process diverts a certain amount of order flow
that otherwise might be routed directly to execute against displayed
quotations in other markets. The Commission recognizes that orders in
listed equities may be routed to venues that do not display their
trading interest in the consolidated quotation data.\49\ Certain
benefits, including adding liquidity, may result from routing orders to
undisplayed venues. Given the importance of displayed quotations for
market efficiency,\50\ however, the Commission is particularly
concerned about additional marketable order flow--orders that are
immediately executable at the national best bid or offer--that may be
diverted from the public quoting markets and that could further reduce
the incentives for the public display of quotations.
---------------------------------------------------------------------------

    \49\ For example, some of these undisplayed venues are called
``dark pools,'' which are reported to execute approximately 8% of
total trading volume in listed equities. See, e.g., Nina Mehta,
Inching Toward Dark Pool Reporting Standards, Traders Magazine
Online News, June 26, 2009, http://tradersmagazine.com/news/dark-
pool-reporting-103943-1.html. In addition, some exchanges, when they
do not have available trading interest to execute marketable orders
at the best displayed prices, give participants a choice of routing
their orders in response to ``indications of interest'' from
undisplayed venues that are not included in the consolidated
quotation data. See, e.g., NYSE Arca, ``Client Notice: NYSE Arca to
Provide Indication of Interest (IOI) Routing'' (March 12, 2008)
(routing service for ``non-displayed liquidity pools'').
    \50\ See supra note 10.
---------------------------------------------------------------------------

    The Commission also is concerned that the flashing of orders at
marketable prices may undermine the purposes of Rule 610(d) of
Regulation NMS, which is designed to protect displayed quotations from
being locked by equal-priced contra side quotations.\51\ Marketable
prices are, by definition, prices that at least equal the best contra
side quotation for a stock. For example,

a marketable flash order to buy will be displayed at the price of the
national best offer and a marketable flash order to sell will be
displayed at the price of the national best bid. In adopting Rule
610(d), the Commission emphasized that ``giving priority to the first-
displayed quotation will encourage the posting of quotations and
contribute to fair and orderly markets.'' \52\ The Commission
preliminarily believes that flash orders may be inconsistent with this
policy. The flashing of orders is no longer distinguishable in today's
highly automating trading from the dissemination of automated
quotations. If marketable flash orders were included in the
consolidated quotation data, for example, such orders clearly would be
locking quotations in violation of Rule 610(d). The practical result of
the Commission's proposal, therefore, would be that flash orders could
no longer be displayed to anyone at prices that equal the best priced
contra side quotation in a stock. A market that was unable to execute
incoming marketable orders at the best prices would need to handle them
in another fashion. Depending on the order router's wishes, a market
could route the order away to access the best displayed prices on other
exchanges, reprice and display the order at a permissible price, or
cancel the order back to the order router. It also is possible,
however, that the order may be routed to a dark venue.\53\
---------------------------------------------------------------------------

    \51\ As noted in note 23 supra, the Options Linkage Plan
includes a prohibition on a pattern or practice of displaying
locking or crossing quotations in listed options that is analogous
to Rule 610(d).
    \52\ NMS Release, supra note 10, at 37547.
    \53\ As noted in section V below, the Commission's staff is
reviewing other forms of dark trading interest that are not included
in the consolidated public quotation data, and the Commission
expects to consider initiatives in this area in the near future.
---------------------------------------------------------------------------

    The proposed elimination of the exception for flash orders from
Exchange Act quoting requirements also likely would affect the
competition among exchanges and ATSs for trading volume. Much of a
market's revenue is generated, directly or indirectly, through the
execution of trades. Accordingly, markets have strong incentives to
maximize their executed volume, both by attracting the largest possible
volume of order flow and by executing as much of that order flow as
possible. Flash orders give markets an additional opportunity to
execute marketable orders even if they do not have available contra
trading interest at the best displayed prices when the flash order
arrives. In this respect, flash orders can be viewed as one competitive
strategy to maximize a market's trading volume and revenues, which
would be curtailed by adoption of the proposal.
    The Commission preliminarily believes, however, that any limitation
on a market's competitive choices would be justified by other effects
of the proposal that would promote competition, protect investors, and
enhance efficiency. As an initial matter, it is important to recognize
that, both currently and if the proposal were adopted, all exchanges
and ATSs would operate under the same rules for flash orders.
Currently, the availability of the flash order type benefits markets
that do not have available contra side trading interest at the best
displayed prices when an order arrives by giving them a second chance
to execute the order. In this respect, the current rule tends to
benefit those markets that have the least available trading interest at
the best prices, including displayed limit orders. If adopted, the
proposal would give markets even greater incentives to attract trading
interest at the best displayed prices, including displayed limit
orders, in advance of the arrival of marketable orders, as well as
better opportunities to attract marketable order flow by displaying the
best prices. It thereby would promote competition for the displayed
liquidity that is vital to the fairness and efficiency of the listed
securities markets. In addition, the proposal would help protect the
interests of investors who are willing to display their trading
interest publicly.
    Finally, the flashing of orders to many market participants creates
a risk that recipients of the information could act in ways that
disadvantage the flashed order. With today's sophisticated order
handling and execution systems, those market participants with the
fastest systems are able to react to information in a shorter time
frame than the length of the flash order exposures. As a result, such a
participant would be capable of receiving a flashed order and reacting
to it before the flashed order, if it did not receive a fill in the
flash process, could be executed elsewhere. For example, a recipient of
a flash order that was quoting on another exchange would be capable of
adjusting its quotes to avoid being hit by the flash order if it
subsequently were routed to that exchange. Alternatively, a recipient
would be capable of rapidly transmitting orders that would take out
trading interest at other exchanges before an unfilled flash order
could be routed to those exchanges. In both cases, a flashed order that
did not receive an execution in the flash process would also be less
likely to receive a quality execution elsewhere.
    Of course, flash orders are voluntary on the part of order routers.
They involve a willing decision on the part of order routers to
disseminate the order information to a group that generally will
include highly sophisticated professional traders. Those who choose to
use the flash order type (which often will be a broker that owes a duty
of best execution to its customer for the routing decision) probably
already consider the extent to which flashed orders may contain
significant information content that could lead the recipients of flash
order information to act contrary to the interests of the orders.
Stated another way, those who are highly concerned about information
leakage generally would be unlikely to flash their order information to
a large number of professional traders. As a result, there is an
inverse relationship between the extent to which flash orders are used
beneficially by order submitters and the extent to which the recipients
of flash orders could gain an information advantage. If used
beneficially by order submitters, the information leakage and
information advantage would be minimized for the user of the flash
order. If not used beneficially, however, the flash order type appears
to raise particular risks for customers whose order information is
flashed.
    The Commission recognizes that flash orders offer potential
benefits to certain types of market participants. For those seeking
liquidity, the flash mechanism may attract additional liquidity from
market participants who are not willing to display their trading
interest publicly. Flash orders thereby may provide an opportunity for
a better execution than if they were routed elsewhere.\54\ There is no
guarantee, for example, that an order routed to execute against a
displayed quotation will, in fact, obtain an execution. The displayed
quotation may already be executed against or cancelled before the
routed order arrives. Of course, the delay in routing during a flash
period may further decrease the likelihood of an execution in the
displayed market for the flash order because prices at the displayed
market may move away from the flash order during the flash process.
Those who route flash orders, however, may use them selectively in
those contexts where they believe an order is less likely to receive a
full execution if routed elsewhere.
---------------------------------------------------------------------------

    \54\ See Direct Edge Letter at 2.
---------------------------------------------------------------------------

    In addition, many markets that display quotations charge fees
(often known as ``take'' fees) for accessing those quotations. Flash
orders may be executed through the flash process for lower fees than
the fees charged by many markets for accessing displayed quotations.
Indeed, some markets have offered rebates on orders that are executed
during a flash, so that the order, rather than paying a fee, will earn

a rebate.\55\ The combined difference between receiving a rebate for an
executed flash order versus paying a fee for accessing a displayed
quotation may be a significant incentive for traders to submit flash
orders.\56\
---------------------------------------------------------------------------

    \55\ NASDAQ OMX, Flash Functionality, http://
www.nasdaqtrader.com/content/ProductsServices/Trading/Flash_
factsheet.pdf and BATS Global Markets, BATS Exchange Releases BOLT,
http://www.batstrading.com/resources/press_releases/BATS_
Exchange_Announces_BOLT_FINAL.pdf. As noted supra note 42, Nasdaq
and BATS have announced that they will no longer offer a flash order
functionality as of September 1, 2009.
    \56\ When it adopted Rule 610(d), the Commission specifically
considered and disapproved the practice of deliberately locking a
displayed quotation to obtain a liquidity rebate. NMS Release, supra
note 10, at 37547 (restriction on locking quotations was intended to
address a market participant that ``chooses to lock rather than
execute the already-displayed quotation to receive a liquidity
rebate'').
---------------------------------------------------------------------------

    Finally, some market participants that choose to receive and
respond to flash orders may represent large institutional investors
that are reluctant to display quotations publicly to avoid revealing
their full trading interest to the market, but are willing to step up
on an order-by-order basis and provide liquidity to flash orders. Such
investors may have the sophisticated systems themselves to respond to
flash orders or may rely on the systems of their brokers. Executions
against flash orders could help lower the transaction costs of these
institutional investors.
    The Commission expects that any negative effect of the elimination
of the exception for flash orders from Exchange Act quoting
requirements would be mitigated by the ability of market participants
to adapt their trading strategies to the new rules. In addition, higher
incentives to display liquidity and alternative forms of competition
for order flow could mitigate any negative effect of the proposal.
    To summarize, the Commission recognizes that flash orders may have
some benefits, but preliminarily believes that, in the context of
today's highly automated trading environment, those benefits do not
justify the negative aspects of flash orders. In reaching this
preliminary view, the Commission also has considered the potential
damage to public confidence in the securities markets caused by
practices that may give professional short-term traders an unfair
advantage over long-term investors. Professional short-term traders
inevitably have advantages in the active trading of securities--that
is, buying and selling securities repeatedly throughout the trading
day. Active trading is a highly competitive endeavor, and many
professional short-term traders devote substantial resources to develop
the systems and expertise to trade successfully. Ultimately, this
competition among professional short-term traders can greatly benefit
long-term investors if it leads to better execution quality (such as
narrower spreads and greater liquidity) when investors enter the market
to establish or liquidate their positions in a security.
    Practices that may give professional short-term traders undue
advantages without creating sufficient corollary benefits to long-term
investors, or that can undermine the goals of Commission rules, for
example promoting displayed liquidity, may cause damage to public
confidence in the fairness of the markets, and this must be considered
by the Commission in fulfilling its regulatory responsibility under the
Exchange Act. Indeed, the Congressional concern to maintain and promote
public confidence in the fairness of the securities markets has been a
hallmark of the federal securities laws for the last 75 years.\57\
---------------------------------------------------------------------------

    \57\ See, e.g., Section 2(a) of the Exchange Act (securities
transactions are affected with a national public interest which
makes it necessary to ``insure the maintenance of fair and honest
markets in such transactions'').
---------------------------------------------------------------------------

    The Commission also has considered the potential costs and benefits
of flash orders at the level of individual transactions. When an order
is flashed and receives an execution, three different market
participants are most directly affected: (1) The submitter of the flash
order that received an execution; (2) the receiver of the flashed
information that supplied dark liquidity to the order; (3) and the
market participant that was willing to supply liquidity through a
publicly displayed quotation establishing the best price for a
security, yet did not receive an execution at that price. Although the
first two parties received the benefits of a desired trade, potentially
with lower fees than they otherwise might have paid, the third party
that established the best displayed price did not receive an execution
and thereby suffered a cost. Moreover, displayed liquidity is a public
good that benefits investors and traders generally.\58\ When the market
participants that generate this public good are harmed by a missed
trading opportunity, it creates an externality that can detract from
the efficiency of the securities markets.\59\ Though the costs of
failing to reward the public display of liquidity are difficult to
quantify, the Commission's practical experience over the years with
initiatives to promote the public display of liquidity have
demonstrated their value for investors.\60\
---------------------------------------------------------------------------

    \58\ NMS Release, supra note 10, at 37516.
    \59\ Id.
    \60\ See, e.g., Concept Release on Market Fragmentation, supra
note 9, at 10584 n. 53 (citing academic studies finding that the
required display of customer limit orders, by providing greater
price transparency and enhancing public price discovery, led to
substantial reductions in transaction costs for both retail and
institutional investors).
---------------------------------------------------------------------------

    Given all of these factors, the Commission preliminarily believes
that the benefits of flash orders for some market participants do not
justify their costs to other market participants, the national market
system, and the public interest. It therefore is proposing to eliminate
the exception for flash orders from Exchange Act quoting requirements.

B. Description of Proposal

1. Proposed Amendment of Rule 602
    Under the proposal, paragraph (a)(1)(i)(A) of Rule 602 would be
eliminated in its entirety. The Commission recognizes that a number of
exchanges currently offer a variety of trading services other than
flash orders that conceivably could be affected by the elimination of
the paragraph. These may include price improvement auctions and various
types of facilitation and exposure mechanisms for large orders.\61\ The
Commission preliminarily believes that the status of these trading
mechanisms under Rule 602 would not be altered by the proposed
amendment. For example, the Commission preliminarily believes that
orders exposed as part of a competitive auction that provides an
opportunity to obtain better prices than displayed quotations generally
would not constitute bids and offers that must be provided to the
consolidated quotation stream, nor would the responses to those orders
if they were actionable only with respect to the exposed order. Comment
is requested on the potential impact of the proposal on exchange
trading services other than flash orders.
---------------------------------------------------------------------------

    \61\ See, e.g., BOX Rules, ch. V, sec. 18 (Price Improvement
Mechanism); CBOE Rule 6.13A (Simple Auction Liaison); and ISE Rule
716(d) (Facilitation Mechanism).
---------------------------------------------------------------------------

    As noted in section III above, the language in Rule 602(a)(1)(i)(A)
originally was adopted to accommodate ephemeral quotations on manual
trading floors. Historically, exchange members located on trading
floors have conducted on the spot discussions of price which could not
practically be reflected in the published quotation and were generally
understood to fall within the exemption of Rule 602(a)(1)(i)(A).
Although trading floors have changed dramatically in recent years, some
of the

historical practices may still be necessary for the effective
functioning of a trading floor. For example, when floor brokers
represent large discretionary orders they must be able to discuss terms
of a prospective trade. If it were necessary to make such terms public,
it would interfere with, and might make impossible, the effective
representation of such large orders on a trading floor. Similarly,
floor brokers can ``request a market'' in a security either
hypothetically (or conditionally) or with a view to executing a
particular order in hand. In either case, the response of the ``trading
crowd'' can be different than the published quotation. It may be
impractical to require such responses to be published. Even if
publication were technically feasible, it could significantly impair
floor brokers' ability to represent large orders effectively. There may
be other examples as well of floor practices that are necessary for
floors to function effectively, but that could be viewed as conflicting
with Rule 602 as proposed to be amended.
    The Commission preliminarily believes that the concerns about flash
orders discussed above apply both with respect to the electronic
flashing of orders and the manual flashing of orders to exchange
crowds. These concerns include particularly the danger of a two-tiered
market in which the public does not have access, through the
consolidated quotation data streams, to information about the best
available prices, and the effect on incentives to display trading
interest publicly. In addition, the Commission has sought to establish
a regulatory framework that maintains fair competition between
automated markets and manual markets. The Commission requests comment
on whether the elimination of the flash order exception for both
automated trading systems and manual trading floors would seriously
detract from the viability of trading floors in the modern, mostly
electronic, trading environment. It also requests comment on whether
Rule 602 should permit trading floors to continue manual ``flashing''
of orders if electronic ``flashing'' is prohibited and what, if any,
conditions should apply.
    In sum, the proposed amendment of Rule 602 conceivably could affect
a number of practices of both electronic exchanges and manual trading
floors. To the extent that particular practices do not raise the policy
concerns of flash orders under specific circumstances, but would be
constrained or eliminated by the proposed amendment, the Commission
requests comment on whether it should adopt a narrower regulatory
approach than the full elimination of the flash order exception.\62\ In
addition, the Commission could grant exemptions from the requirements
of Rule 602, as necessary and appropriate, pursuant to Rule 602(d).\63\
---------------------------------------------------------------------------

    \62\ See section V below for a more detailed discussion of
alternative regulatory approaches.
    \63\ Rule 602(d) provides that such exemptions may be granted
either unconditionally or on specified terms and conditions, if the
Commission determined that such exemptions were consistent with the
public interest, the protection of investors and the removal of
impediments to and perfection of the mechanism of a national market
system. See, e.g., Letter from Robert L.D. Colby, Deputy Director,
Division of Market Regulation, Commission, to Michael J. Simon,
Senior Vice President and General Counsel, ISE, dated December 8,
2004 (Commission staff acting by delegated authority to grant ISE a
limited exemption from its obligations under Rule 602(a) in
connection with ISE's Price Improvement Mechanism).
---------------------------------------------------------------------------

2. Application of Rule 301(b)
    If the Commission adopts the proposed elimination of the flash
order exception from Rule 602, the Commission would apply Rule 301(b)
of Regulation ATS in a consistent manner to ATSs that use flash orders.
Rule 301(b) sets forth requirements for ATSs, one of which is order
display and execution access. Paragraph (b)(3)(ii) of Rule 301 requires
an ATS that meets a 5% volume threshold in an NMS stock \64\ to provide
to a national securities exchange or national securities association
the prices and sizes of the orders at the highest buy price and the
lowest sell price for such NMS stock, displayed to more than one person
in the ATS, for inclusion in the quotation data made available by such
exchange or association pursuant to Rule 602 of Regulation NMS. The
Commission has sought to promote fair competition between exchanges and
ATSs, consistent with their varying regulatory responsibilities.\65\
The Commission has not applied Rule 301(b) in a manner inconsistent
with Rule 602, with respect to flash orders or otherwise.
---------------------------------------------------------------------------

    \64\ An ATS becomes subject to the Regulation ATS display
requirement if, during at least four of the preceding six calendar
months, it had an average daily trading volume of 5% or more of the
aggregate average daily share volume for such NMS stock as reported
by an effective transaction reporting plan. 17 CFR
242.301(b)(3)(i)(B).
    \65\ See, e.g., Section 11A(a)(1)(c)(ii) of the Exchange Act
(one of the objectives of the national market system is to assure
fair competition ``between exchange markets and markets other than
exchange markets'').
---------------------------------------------------------------------------

    Accordingly, if the proposed amendment to Rule 602 is adopted, the
Commission would consider orders that a threshold ATS displays to more
than one person in the ATS that either are immediately executed or
withdrawn if not immediately executed to be orders covered by Rule
301(b)(3)(ii) that must be provided to a national securities exchange
or national securities association for inclusion in the consolidated
quotation data. Such orders would be covered regardless of the
particular term that an ATS might use to characterize the order, such
as ``indication of interest.'' \66\
---------------------------------------------------------------------------

    \66\ See Securities Exchange Act Release No. 40760 (December 8,
1998), 63 FR 70844, 70850 (December 22, 1998) (``Regulation ATS
Adopting Release'') (``The label put on an order--`firm' or `not
firm'--is not dispositive. For example a system claiming it displays
only ``indications of interest'' that are not orders, may be covered
by the new interpretation of `exchange' if those indications are, in
fact, firm in practice.)
---------------------------------------------------------------------------

3. Application of Rule 610(d)
    Finally, if the Commission adopts the proposed amendment to Rule
602, the Commission would apply the restrictions on locking or crossing
quotations in Rule 610(d) in a consistent manner to prohibit the
practice of displaying marketable flash orders. Rule 610(d) requires
each national securities exchange and national securities association
to establish, maintain, and enforce rules that, among other things,
prohibit members from engaging in a pattern or practice of displaying
quotations that lock or cross any ``protected quotation,'' as defined
in Rule 600(b)(57), in an NMS stock.\67\ Under the proposed amendment
of Rule 602, flash orders would no longer be excepted from the
requirement to include best-priced quotations and orders in the
consolidated quotation data. If that amendment is adopted, the
Commission would consider the display by SRO members of quotations that
either are immediately executed or withdrawn if not immediately
executed to be the display of quotations that are subject to the
locking and crossing restrictions of Rule 610(d), like any other
quotation required by Rule 602(a) to be included in the consolidated
quotation data. As a result, flash orders with non-marketable prices
would not be locking or crossing quotations and would need to be
included in the consolidated quotation data. Orders with marketable
prices, however, could no longer be flashed, because if displayed they
would be subject to the locking and crossing restrictions in Rule
610(d).
---------------------------------------------------------------------------

    \67\ As noted in note 23 supra, the Options Linkage Plan
includes a prohibition of a pattern or practice of displaying
locking or crossing quotations in listed options that is analogous
to Rule 610(d). If flash orders for listed options were no longer
excepted from Rule 602 and therefore required to be included in the
OPRA quotations data, the Commission also would consider the Option
Linkage Plan's restrictions on locking or crossing quotations to
apply to the display of marketable flash orders.

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

V. Request for Comments

    The Commission seeks comment and data on all aspects of the
proposed amendment of Rule 602, including its implications for the
application of Rule 301(b) and Rule 610(d). In particular, comment and
data are requested on the effect of flash orders on the fairness and
efficiency of the markets for listed securities and on the interests of
long-term investors in these securities. If adopted, would the proposal
promote investor confidence by addressing the potential for a two-
tiered market with respect to access to information about the best
prices for listed securities? Would the proposal help to promote the
display of quotations in public markets by eliminating one type of
trading in which ``dark'' liquidity is provided that matches the prices
of previously displayed public quotations? Would the proposal reduce
the potential for information leakage that could detract from the
execution quality of marketable orders? Conversely, would the proposal
deprive investors of a trading tool that, if used beneficially, can
lead to improved quality of execution for marketable orders?
    Comment and data also are requested on the following questions.
What are some of the trading strategies that employ flash orders? Is
the use of flash orders in the best interests of these traders and how
would the inability to use flash orders affect these traders? Are there
alternatives to using flash orders in such trading strategies? How are
market participants likely to change their behavior if unable to use
flash orders? What are the likely effects of these changes? Which
market centers are likely to benefit from any changes in order routing
practices? How would the proposal affect transaction costs incurred by
various market participants? How would overall transaction costs
change? In the absence of flash orders, would the limit orders setting
the best displayed price benefit with faster or more probable
executions?
    Comment and data also are requested on the use of flash orders by
exchanges for listed options and whether concerns about flash orders
should be assessed differently in that context. For example, trades in
listed options are required to be executed on an exchange that has
public quoting responsibilities rather than at over-the-counter venues
that are not required to publish quotations. In addition, the
incentives for the display of liquidity for derivative instruments such
as listed options may be different from such incentives for cash
equities. Finally, listed options are priced largely on the value of
the underlying securities; market participants typically update
quotations prices as the underlying prices change. Given these
differences and others between equity and options trading, should the
Commission adopt a different approach for flash orders in listed
options than for flash orders in listed equities?
    The Commission also requests comment and data on narrower
regulatory approaches than a complete elimination of the exception for
flash orders from Exchange Act quoting requirements. Section IV.B.1
above, for example, requests comment on issues relating to manual
trading floors and the extent to which such floors, as they currently
operate, continue to need the exception for flash orders. In addition,
are there additional features or limitations that could be added to the
use of flash orders that would significantly alter the respective costs
and benefits discussed in this release? For example, would requiring
broader dissemination of flashed order information--such as in the
consolidated quotation data--address concerns about two-tiered access
to information about the best prices for listed securities? Could these
concerns about two-tiered access be addressed by conditioning a
market's provision of a flash order type on its making available flash
order information to anyone without charge, even though the data would
not be in a single consolidated feed? If flash order information were
more broadly disseminated, how should the Commission assess the policy
objectives behind existing restrictions on the display of locking
quotations? Also, could exchanges address concerns about the misuse of
flash order information through tailored surveillance or other
regulatory procedures? Could concerns about information leakage be
addressed by requiring brokers to provide detailed disclosure to a
customer about the risks, or requiring the customer's affirmative
consent, before allowing the customer's order to be flashed? Would
requiring the recipient of a flash order to offer price improvement
ameliorate any of the concerns discussed above?
    The Commission further seeks comment on the application of Rule
301(b) of Regulation ATS and Rule 610(d) of Regulation NMS consistent
with the proposed amendment to Rule 602, if adopted. Are there any
special considerations applicable to ATSs that would justify applying a
different standard from exchanges with respect to the inclusion of ATS
orders in the consolidated quotation data? Are there any special
considerations applicable to flash quotes that would justify applying a
different standard from other types of displayed quotations for
purposes of the locking and crossing restrictions?
    The Commission strongly encourages commenters to respond within the
designated comment period. It intends to act quickly in reviewing the
comments and assessing further action. In this regard, the Commission
also is actively reviewing other forms of ``dark'' trading interest
(that is, trading interest that is not included in the consolidated
public quotation data) that may be detrimental to the fairness and
efficiency of the national market system. Dark trading interest, as
well as the information that some undisplayed venues currently
disseminate to market participants concerning such trading interest, is
not generally available to the public.\68\ Comment and data are
requested on the use of flash orders as a mechanism to interact with
dark liquidity and whether other mechanisms for accessing dark
liquidity either do or do not raise policy concerns that are analogous
to flash orders. The Commission is developing initiatives in this area,
as well as reviewing other market structure issues, including those
concerning Regulation ATS thresholds, direct market access, high
frequency trading, and co-location.
---------------------------------------------------------------------------

    \68\ See, e.g., Oversight Hearing on Current State and Agenda,
Hearing Before the Subcomm. on Capital Markets, Insurance and
Government-Sponsored Enterprises of the House of Representatives
Comm. on Financial Services, 111th Cong. (July 14, 2009) (testimony
of Mary L. Schapiro, Chairman, Commission); Mary L. Schapiro,
Chairman, Commission, Address before the New York Financial Writers'
Association Annual Awards Dinner (June 18, 2009) (transcript
available at http://www.sec.gov).
---------------------------------------------------------------------------

VI. Paperwork Reduction Act

    The Commission believes that eliminating the flash order exception,
if adopted, would not substantively or materially change collection
burdens under the requirements of Rule 602 of Regulation NMS. If
adopted, the proposal would prohibit the practice of displaying
marketable flash orders. Exchanges would be required to handle
marketable orders that they are unable to execute at the best displayed
prices in another manner, such as by routing marketable orders away to
execute against the best displayed quotations at another exchange or
ATS. Because exchanges would not be permitted to display these orders
in the consolidated quotation data, no new collection of information
would be required under Rule 602 with regard to marketable flash
orders. In contrast, non-marketable flash orders would be required to
be displayed in the consolidated quotation data. The Commission
preliminarily

believes, however, that the additional burden of including non-
marketable flash orders with the large volume of quotations that
exchanges already include in the consolidated quotation data under Rule
602 would not be material.\69\
---------------------------------------------------------------------------

    \69\ The information collection contained in Rule 602, entitled
``Dissemination of Quotations--Rule 11Ac1-1,'' the precursor to Rule
602, has been assigned control number 3235-0461. The Commission,
however, will be updating the overall burden estimate for this
collection of information to account for an increase in the number
of exchanges subject to the Rule.
---------------------------------------------------------------------------

    In addition, the Commission does not believe that the application
of Rule 301(b) of Regulation ATS and Rule 610(d) of Regulation NMS
consistent with the proposed amendment to Rule 602 contain ``collection
of information requirements'' within the meaning of the Paperwork
Reduction Act of 1995.\70\ Rule 301(b) of Regulation ATS would apply to
the use of flash orders by alternative trading systems. The Commission
believes that this would affect fewer than ten entities. Rule 610(d) of
Regulation NMS would prohibit the practice of displaying flash orders
with prices that lock or cross previously displayed quotations. The
Commission believes that Rule 610(d) does not contain a collection of
information requirement as defined by the Paperwork Reduction Act.
Accordingly, the Commission believes that the application of Rule
301(b) of Regulation ATS and Rule 610(d) of Regulation NMS consistent
with the proposed amendment to Rule 602 imposes no new collection of
information requirements. The Commission encourages comments on this
point.
---------------------------------------------------------------------------

    \70\ 44 U.S.C. 3501, et seq.
---------------------------------------------------------------------------

VII. Consideration of Costs and Benefits

    We are sensitive to the costs and benefits of our proposal to
eliminate the exception for flash orders from Exchange Act quoting
requirements. We request comment on the costs and benefits associated
with the proposed amendment. The Commission has identified certain
costs and benefits of the proposal and requests comment on all aspects
of its preliminary cost-benefit analysis, including identification and
assessments of any costs and benefits not discussed in this analysis.
The Commission also seeks comments on the value of any of the benefits
identified and welcomes comments on the accuracy of any of the costs
described in each section of this cost-benefit analysis, as well as
elsewhere in this release. Finally, the Commission requests that
commenters provide data and any other information or statistics that
the commenters relied on to reach any conclusions on such estimates.

A. Benefits

    As discussed above, the proposal is intended to prevent a two-
tiered market in which the public does not have access, through the
consolidated quotation data streams, to information about the best
available prices for listed securities, to promote the goals of the
consolidated quotation system, and to help promote public confidence in
the fairness of the listed securities markets.\71\ A flash order
generally is displayed at a marketable price that will be better than
the best displayed price for the security in the consolidated quotation
data. For example, a flash order to buy would be displayed at a higher
price than the national best bid, and a flash order to sell would be
displayed at a lower price than the national best offer. Yet the public
does not receive this flash order information in the consolidated
quotation data. Instead, only the participants of a particular market
that receive the market's data feed have access to the improved price
information. The consolidated quotation data streams are intended to
provide a single source of information on the best prices from all
markets, rather than force the public to obtain data from many
different exchanges and other markets to learn the best prices. A
single source of data facilitates investor access to the best prices in
the national market system, and helps promote best execution.\72\ This
objective would be undermined if exchanges and ATSs disseminate pricing
information that is functionally quite similar to quotations, yet is
not required to be included in the consolidated quotation data.
---------------------------------------------------------------------------

    \71\ See supra notes 18 and 57.
    \72\ See supra note 18 and accompanying text.
---------------------------------------------------------------------------

    The proposal is intended to promote the public display of trading
interest and quote competition among markets. The Commission long has
emphasized the need to encourage displayed liquidity in the form of
publicly displayed limit orders.\73\ Such orders establish the current
``market'' for a stock and thereby provide a critical reference point
for investors. Flash orders, however, generally are executed by a
market at prices that match the best displayed prices for a stock at
another market. In this respect, flash orders potentially deprive those
who publicly display their interest at the best prices from receiving a
speedy execution, or any execution, at that price. The opportunity to
obtain the fastest possible execution at a price is the primary
incentive for the display of trading interest. Particularly if flash
orders were offered by all major markets for a security and greatly
expanded in trading volume, they could significantly undermine the
incentives to display limit orders and to quote competitively, and
thereby detract from the efficiency of the national market system.
---------------------------------------------------------------------------

    \73\ See supra note 47.
---------------------------------------------------------------------------

    For example, the flash process provides a vehicle for certain
market participants to match displayed prices on an order-by-order
basis by responding to flashes. It therefore gives these participants a
``last-mover'' advantage over displayed orders in other markets. Rather
than displaying their orders or quotations in advance of incoming
marketable order flow to attract an execution, these market
participants can wait to receive the flashed order and program their
systems to pick and choose when to execute. The availability of this
``flash'' alternative to quoting as a means to supply liquidity may
reduce their incentives to display liquidity.
    Moreover, the flash process diverts a certain amount of order flow
that otherwise might be routed directly to execute against displayed
orders and quotations in other markets. The Commission recognizes that
some markets route orders to dark venues rather than to displayed
trading venues.
    Certain benefits, including adding liquidity, may result from
routing orders to undisplayed venues. Given the importance of displayed
quotations for market efficiency, \74\ however, the Commission is
particularly concerned about additional marketable order flow--orders
that are immediately executable at the national best bid or offer--that
may be diverted from the public quoting markets and that could further
reduce the incentives for the public display of quotations.
---------------------------------------------------------------------------

    \74\ See supra note 10.
---------------------------------------------------------------------------

    The Commission also is concerned that the flashing of orders at
marketable prices may undermine the purposes of Rule 610(d) of
Regulation NMS, which is designed to protect displayed quotations from
being locked by equal-priced contra side quotations. Marketable prices
are, by definition, prices that at least equal the best contra side
quotation for a stock. For example, a marketable flash order to buy
will be displayed at the price of the national best offer and a
marketable flash order to sell will be displayed at the price of the
national best bid. In adopting Rule 610(d), the Commission emphasized
that ``giving priority to the first-

displayed quotation will encourage the posting of quotations and
contribute to fair and orderly markets.'' \75\ The Commission
preliminarily believes that flash orders may be inconsistent with this
goal because the flashing of orders is no longer distinguishable, in
certain key respects, from the dissemination of automated quotations.
If marketable flash orders were included in the consolidated quotation
data, for example, such orders clearly would be locking quotations in
violation of Rule 610(d). The practical result of the proposal,
therefore, would be that flash orders could no longer be displayed to
anyone at prices that equal the best priced contra side quotation in a
stock. A market that was unable to execute incoming marketable orders
at the best prices would need to handle them in another fashion, such
as by routing the order away to access the best displayed prices on
other exchanges, or cancelling the order back to the submitter. It is
also possible that the order may be routed to a dark venue.\76\
---------------------------------------------------------------------------

    \75\ See supra note 52.
    \76\ As noted in section V above, the Commission's staff is
reviewing other forms of dark trading interest that are not included
in the consolidated public quotation data, and the Commission
expects to consider initiatives in this area in the near future.
---------------------------------------------------------------------------

    The elimination of flash orders would also change markets'
competitive strategies to maximize trading volume and revenues.
Currently, the availability of the flash order type benefits markets
that do not have available contra side trading interest at the best
displayed prices when an order arrives by giving them a second chance
to execute the order. In this respect, the current rule tends to
benefit those markets that have the least available trading interest at
the best prices, including displayed limit orders. If adopted, the
proposal would give markets even greater incentives to attract trading
interest at the best displayed prices, including displayed limit
orders, in advance of the arrival of marketable orders. It thereby
would promote competition for the displayed liquidity that is so vital
to the fairness and efficiency of the listed securities markets.
    Finally, the flashing of orders to many market participants creates
a risk that recipients of the information could act in ways that
disadvantage the flashed order. With today's sophisticated order
handling and execution systems, those market participants with the
fastest systems are able to react to information in a shorter time
frame than the length of the flash order exposures. As a result, such a
participant would be capable of receiving a flashed order and reacting
to it before the flashed order, if it did not receive a fill in the
flash process, could be executed elsewhere. For example, a recipient of
a flash order that was quoting on another exchange could adjust its
quotes to avoid being hit by the flash order if it subsequently were
routed to that exchange. Alternatively, a recipient rapidly could
transmit orders that would take out trading interest at other exchanges
before an unfilled flash order could be routed to those exchanges. In
both cases, a flashed order that did not receive an execution in the
flash process would also be less likely to receive a quality execution
elsewhere.
    At the same time, because flash orders are voluntary on the part of
order routers, they involve a willing decision on the part of order
routers to disseminate the order information to a group that generally
will include highly sophisticated professional traders. Those who
choose to use the flash order type (which often will be a broker that
owes a duty of best execution to its customer for the routing decision)
probably already consider the extent to which flashed orders may
contain significant information content that could lead the recipients
of flash order information to act contrary to the interests of the
orders. Stated another way, those who are highly concerned about
information leakage generally would be unlikely to flash their order
information to a large number of professional traders. As a result,
there is an inverse relationship between the extent to which flash
orders are used beneficially by order submitters and the extent to
which the recipients of flash orders could gain an information
advantage. If used beneficially, the information leakage and
information advantage would be minimized. If not used beneficially,
however, the flash order type appears to raise particular risks for
customers whose order information is flashed.
    The Commission seeks comment on the anticipated benefits of the
proposal, including whether the proposal will: (1) Help prevent a two-
tiered market in terms of access to information about the best
available prices for listed securities; (2) promote the public display
of trading interest; (3) help prevent displayed quotations from being
locked by equal-priced contra-side quotations; (4) promote competition
among markets for displayed liquidity; (5) reduce the risk of
detrimental information leakage about customer orders. The Commission
further seeks comment on whether the anticipated benefits differ
between the equity markets and the options markets.

B. Costs

    The proposed elimination of the exception for flash orders from
Exchange Act quoting requirements could preclude potential benefits
that flash orders offer to certain market participants. For those
seeking liquidity, the flash mechanism may attract additional liquidity
from market participants who are not willing to display their interest
publicly. Flash orders thereby may provide an opportunity for a better
execution than if they were routed elsewhere. There is no guarantee,
for example, that an order routed to execute against a displayed
quotation will, in fact, obtain an execution. The displayed quotation
may already be executed against or cancelled before the routed order
arrives. Of course, the delay in routing during a flash period may
further decrease the likelihood of an execution for the flash order
elsewhere because prices may move away from the flash order during the
flash process. Those who route flash orders, however, may use them
selectively in those contexts where they believe an order is less
likely to receive a full execution if routed elsewhere.
    Another potential cost to market participants is that many markets
that display quotations charge fees (often known as ``take'' fees) for
accessing those quotations. Flash orders may be executed through the
flash process for lower fees than the fees charged by many markets for
accessing displayed quotations. Professional short-term traders with
large trading volume may be particularly sensitive to the level of
these fees.
    For example, the Commission estimates an average daily volume in
listed equities of 8.8 billion shares per day \77\ and that flash
volume accounts for 0.8% of this volume.\78\ The Commission believes
that access fees for executed flash orders in the equities markets
range from $0.0010 per share to $0.0029 per share.\79\ It estimates
that the average access fee is $0.0015 per share. In contrast, it
estimates that the average access fee for accessing a displayed
quotation is $0.0029 per share.\80\ The total cost from increased fees
for all flash order users on a yearly basis in listed equities,
therefore, would be approximately $24,837,120 (8.8 billion

shares x .8% x $0.0014 per share increase in access fee x 252 trading
days). The Commission believes this estimate is an upper bound since
market participants would adapt their strategies to minimize
transaction costs under the new conditions.
---------------------------------------------------------------------------

    \77\ Source: www.arcavision.com (consolidated volume in July
2009).
    \78\ The estimate of the volume of flash order trading is based
on discussions with markets that continue to offer flash orders as
of September 2009.
    \79\ See Direct Edge Fee Schedule, http://www.directedge.com/
fee_schedule.aspx; CBSX Fee Schedule, http://www.cboe.com/publish/
cbsxfeeschedule/cbsxfeeschedule.pdf.
    \80\ Id.
---------------------------------------------------------------------------

    In addition, some options exchanges offer lower access fees for
market participants using flash orders. The Commission estimates an
average daily volume in listed options of 13,898,735 contracts per day
\81\ and that flash volume accounts for 1.9% of this volume.\82\ The
Commission believes that access fees for executed flash orders in the
options markets range from $0.00 per contract to $0.15 per
contract.\83\ It estimates that an average access fee is $.01 per
contract.\84\ In contrast, the average access fee for accessing a
displayed quotation costs the market participant $0.21 per
contract.\85\ The total cost from increased fees for all flash order
users on a yearly basis in listed options, therefore, would be
approximately $13,309,429 (13,898,735 contracts x 1.9% x $0.20 per
contract increase in access fee x 252 trading days) . As noted above,
the Commission expects the actual cost may be lower as market
participants would minimize the impact by refining their trading
strategies.
---------------------------------------------------------------------------

    \81\ The Options Clearing Corporation, Volume Statistics, http:/
/www.optionsclearing.com/market/vol_data/2009/daily/jul_09.jsp.
    \82\ The Commission estimates average daily volume of executed
flash orders in July at 265,052 contracts. This figure reflects
discussions with the relevant markets.
    \83\ See BOX, CBOE, and ISE fee schedules.
    \84\ See BOX, CBOE, and ISE fee schedules.
    \85\ This figure represents the approximate charge for a Linkage
Order derived from discussions with the relevant markets.
---------------------------------------------------------------------------

    The Commission recognizes that some market participants that choose
to receive and respond to flash orders may represent large
institutional investors that are not willing to display their interest
to avoid revealing their trading interest to the market, but are
willing to step up on an order-by-order basis and provide liquidity to
flash orders. Such investors may have the sophisticated systems
themselves to respond to flash orders or may rely on the systems of
their brokers. Executions against flash orders could help lower the
transaction costs of these institutional investors. In addition, as
discussed below in Section VIII, flash orders give markets an
additional opportunity to execute marketable orders even if they do not
have available contra trading interest at the best displayed prices
when the flash order arrives. In this respect, flash orders can be
viewed as a market's competitive strategy to maximize trading volume
and revenues that would be eliminated by adoption of the proposed
amendments.
    The Commission expects that any negative effect of the elimination
of the exception for flash orders from Exchange Act quoting
requirements would be mitigated by the ability of market participants
to adapt their trading strategies to the new rules. Also, higher
incentives to display liquidity and alternative forms of competition
for order flow additionally could mitigate any negative effect of the
proposal.
    The markets with five trading systems that offer an electronic
flash order functionality would need to make systems changes to comply
with the proposed elimination of the exception for flash orders from
Exchange Act quoting requirements. The Commission estimates that a
programming change for a market requires approximately 20-30 hours per
market of coding \86\ at an average hourly cost of $193 to eliminate
the flash order functionality.\87\ The Commission estimates that the
aggregate cost of programming changes for these markets to be
approximately $19,300-$28,950.
---------------------------------------------------------------------------

    \86\ This figure reflects discussions with the relevant markets.
    \87\ $ 193 per hour figure for a Programmer Analyst is from
SIFMA's Management & Professional Earnings in the Securities
Industry 2008, modified by Commission staff to account for an 1800-
hour work-year and multiplied by 5.35 to account for bonuses, firm
size, employee benefits and overhead.
---------------------------------------------------------------------------

    In addition, the Commission believes that three exchanges currently
have rules in place that provide for flash orders on five trading
systems. The Commission estimates that these markets will each need to
file proposed rule changes to remove the flash order functionality from
their respective rule books for each system, for a total of five rule
changes. The Commission estimates that a routine rule change requires
approximately 34 hours for an exchange to complete \88\ at an average
hourly cost of $305.\89\ The Commission estimates that the aggregate
cost of one proposed rule change for each trading system would total
approximately $51,850.
---------------------------------------------------------------------------

    \88\ See Securities Exchange Act Release No. 50486 (October 4,
2004), 69 FR 60287, 60294 (October 8, 2004) (File No. S7-18-04)
(adopting release requiring SROs to file proposed rule changes
electronically with the Commission).
    \89\ $ 305 per hour figure for an Attorney is from SIFMA's
Management & Professional Earnings in the Securities Industry 2008,
modified by Commission staff to account for an 1800-hour work-year
and multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead.
---------------------------------------------------------------------------

    Finally, the five exchanges that operate trading floors for
equities or options may need to reflect manual trading interest at non-
marketable prices in the consolidated quotation data if they currently
rely on the flash order exception for any such floor activity. The
Commission preliminarily believes that the five exchanges currently
have systems and procedures for floor members to include trading
interest in the exchanges' automated systems. Accordingly, the
elimination of the flash order exception should not impose a material
new systems burden on these exchanges.
    The Commission requests comment on any direct or indirect costs of
the proposed amendment and asks commenters to quantify those costs,
where possible. Specifically, the Commission requests comments on the
following questions:
     What are some of the trading strategies that employ flash
orders? Is the use of flash orders in the best interest of these
traders and how would the inability to use flash orders impact these
traders?
     How are market participants likely to change their
behavior in the absence of flash orders? What are the likely costs of
these changes?
     How will the proposal impact transaction costs incurred by
various market participants? On net, how will overall transaction costs
change?
     How would the proposal affect competition between trading
venues? What costs will be imposed as a result?
     In the absence of flash orders, will the limit orders
setting the best price benefit with faster or more probable executions?

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

    Section 3(f) of the Exchange Act \90\ requires the Commission,
whenever it engages in rulemaking and is required to consider or
determine whether an action is necessary or appropriate in the public
interest, to consider whether the action would promote efficiency,
competition, and capital formation. In addition, Section 23(a)(2) of
the Exchange Act requires the Commission, when making rules under the
Exchange Act, to consider the impact such rules would have on
competition. Exchange Act Section 23(a)(2) also prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.\91\ As discussed below, the Commission's
preliminary view is that the proposed amendment should promote
efficiency and competition and

will have minimal impact, if any, on promotion of capital formation.
---------------------------------------------------------------------------

    \90\ 15 U.S.C. 78c(f).
    \91\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The proposed elimination of the exception for flash orders from
Exchange Act quoting requirements would affect the competition among
exchanges and ATSs for trading volume. Much of a market's revenue is
generated, directly or indirectly, through the execution of trading
volume. Accordingly, markets have strong incentives to maximize their
volume, both by attracting the largest possible volume of order flow
and by executing as much of that order flow as possible after it
arrives at the exchange. Flash orders give markets an additional
opportunity to execute marketable orders even if they do not have
available contra trading interest at the best displayed prices when the
flash order arrives. In this respect, flash orders can be viewed as a
market's competitive strategy to maximize trading volume and revenues
that would be eliminated by adoption of the proposed amendments.
    The Commission preliminarily believes, however, that any limitation
on a market's competitive choices would be justified by other effects
of the proposal that would promote competition and enhance efficiency.
As an initial matter, it is important to recognize that, both currently
and if the proposal were adopted, all markets (including exchanges and
ATSs) would operate under the same rules for flash orders. Currently,
the availability of the flash order type benefits markets that do not
have available contra side trading interest at the best displayed
prices when an order arrives by giving them a second chance to execute
the order. In this respect, the current rule tends to benefit those
markets that have the least available trading interest at the best
prices, including displayed limit orders. If adopted, the proposal
would give markets even greater incentives to attract trading interest
at the best displayed prices, including displayed limit orders, in
advance of the arrival of marketable orders.\92\ It thereby would
promote competition for the displayed liquidity that is vital to the
fairness and efficiency of the listed securities markets. Encouraging
the use of displayed limit orders should help improve the price
discovery process, and in turn, contribute to increased liquidity and
depth in the markets.\93\ The deeper and more liquid the markets are,
the more willing the public may be to invest its capital, thus
promoting capital formation.
---------------------------------------------------------------------------

    \92\ See NMS Release, supra note 10, at 37516 (``Displayed limit
orders benefit all market participants by establishing the best
prices * * * '').
    \93\ See supra note 47.
---------------------------------------------------------------------------

    The proposal also is designed to promote efficiency by giving a
further incentive for markets to compete to attract displayed limit
orders and generally to encourage the public display of trading
interest.\94\ Given that the overwhelming majority of trading volume in
listed securities is routed and executed through highly automated
systems, flash orders are no longer clearly distinguishable from the
best bids and offers for listed securities that are required to be
collected and disseminated in the consolidated quotation stream. There
is little practical reason to treat flash orders differently from other
bids and offers with respect to Exchange Act quoting requirements.
---------------------------------------------------------------------------

    \94\ See Order Handling Rules Release, supra note 10, at 48293
(``[T]he display of customer limit orders advances the national
market system goal of the public availability of quotation
information, as well as fair competition, market efficiency, best
execution, and disintermediation.'').
---------------------------------------------------------------------------

    Yet those who display bids and offers appear to be harmed by the
disparity in regulatory treatment between flash orders and displayed
bids and offers. For example, the flash order process permits market
participants to wait to receive the flashed orders and program their
systems to pick and choose when to execute. The exception for flash
orders may thereby undermine the incentives for market participants to
display their trading interest. If adopted, the proposal could lead
market participants to display more of their trading interest. Such a
result would be consistent with the Commission's emphasis on the need
to encourage displayed liquidity--a critical reference point for
investors.\95\ Additionally, because the flash order process diverts a
certain amount of order flow that might otherwise be routed directly to
execute against displayed quotations in other markets, the exception
for flash orders may further reduce the incentives for the public
display of quotations.\96\ While some flash orders may be cancelled or
routed to trading venues that do not display their trading interest in
the consolidation quotation stream, the Commission preliminarily
believes that eliminating the exception for flash orders would result
in more order flow being routed to execute against displayed trading
interest and would promote the fairness and efficiency of the listed
securities markets.\97\
---------------------------------------------------------------------------

    \95\ See supra note 58.
    \96\ See supra note 49.
    \97\ See NMS Release, supra note 10, at 37505 (``[M]arket orders
need only be routed to markets displaying quotations that are truly
accessible'').
---------------------------------------------------------------------------

    Based on the analysis above, the Commission preliminarily believes
that the proposed elimination of the exception for flash orders from
Exchange Act quoting requirements would not impose any burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act. The Commission requests comment on all aspects of
this analysis and, in particular, on whether the proposed elimination
of the exception for flash orders would place a burden on competition,
as well as the effect of the proposal on efficiency, competition, and
capital formation. Commenters are requested to provide empirical data
and other factual support for their views if possible.

IX. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \98\ the Commission must advise the OMB as
to whether the proposed regulation constitutes a ``major'' rule. Under
SBREFA, a rule is considered ``major'' where, if adopted, it results or
is likely to result in: (1) An annual effect on the economy of $100
million or more (either in the form of an increase or a decrease); (2)
a major increase in costs or prices for consumers or individual
industries; or (3) significant adverse effect on competition,
investment or innovation.
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    \98\ Public Law No. 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
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    The Commission requests comment on the potential impact of the
proposed rule amendment on the economy on an annual basis. Commenters
are requested to provide empirical data and other factual support for
their view to the extent possible.

X. Regulatory Flexibility Act

    The Commission hereby certifies, pursuant to 5 U.S.C. 603(b), that
the proposed amendment to the Exchange Act quoting requirements and
consistent application of Rule 610(d), if adopted, would not have a
significant economic impact on a substantial number of small entities
to which it applies. The proposed amendment to Rule 602 and consistent
application of Rule 610(d) would apply to national securities
exchanges, none of which is a small entity as defined by Commission
rules.\99\ The consistent application of Rule 610(d) also would affect
one national securities association, which is not a small entity as
defined by 13 CFR

121.201. In addition, the consistent application of Rule 301(b) would
only affect ATSs, none of which are small entities as defined by
Commission Rules.\100\
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    \99\ See 17 CFR 240.0-10(e).
    \100\ See 17 CFR 240.0-10(c).
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    The Commission encourages written comments regarding this
certification. The Commission requests that commenters describe the
nature of any impact on small entities and provide empirical data to
support the extent of the impact.

XI. Statutory Authority

    Pursuant to the Exchange Act and particularly, Sections 2, 3(b), 5,
6, 11, 11A, 15, 15A, 17(a) and (b), 19, 23(a), and 36 thereof, 15
U.S.C. 78b, 78c(b), 78e, 78f, 78k, 78k-1, 78o, 78o-3, 78q(a) and (b),
78s, 78w(a), and 78mm, the Commission proposes to amend Rule 602 of
Regulation NMS.

XII. Text of Proposed Rule Amendment

List of Subjects in 17 CFR Part 242

    Brokers, Reporting and recordkeeping requirements, Securities.

    For the reasons set out in the preamble, Title 17, Chapter II, of
the Code of Federal Regulations is proposed to be amended as follows.

PART 242--REGULATIONS M, SHO, ATS, AC, AND NMS AND CUSTOMER MARGIN
REQUIREMENTS FOR SECURITY FUTURES

    1. The authority citation for Part 242 continues to read as
follows:

    Authority:  15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.

Sec.  242.602   [Amended]

    2. Section 242.602 is amended by removing and reserving paragraph
(a)(1)(i)(A).

    By the Commission.

    Dated: September 18, 2009.
Elizabeth M. Murphy,
Secretary.
[FR Doc. E9-22911 Filed 9-22-09; 8:45 am]

BILLING CODE 8010-01-P