- within Privacy, International Law and Consumer Protection topic(s)
Originally published in: Investment Management Developments
The Securities and Exchange Commission (the "SEC") recently adopted two sets of rule changes, which take effect at the beginning of April, 2001.
New Rules 11Ac1-5 and 11Ac1-6 require (1) market centers, e.g., exchanges, electronic trading systems and market makers, to disclose information regarding the quality of trade executions; and (2) broker-dealers to disclose the identity of, and their relationship to, the market centers to which they route customer orders. These rules were promulgated to address the SEC’s concerns over market fragmentation – the trading of orders in multiple locations without any interaction among those orders – and are designed to help investors understand what happens to their orders once they have been submitted for execution.
Amended Rule 11Ac1-1 and new Rule 11Ac1-7 (1) impose a market-wide firm quote obligation on options market participants; and (2) require broker-dealers, who are not participants in an approved inter-market linkage plan, to disclose when a customer’s order is not executed for the best published quote (a practice known as "trading through"). These rules were adopted in response to the increases in multiple listing of options that were previously listed on a single exchange, and are intended to "encourage the removal of barriers to access to . . . better prices on another market."
Order Executions And Routing Practices
Because trading is "widely dispersed among many different market centers," the SEC intends to ensure that investors receive the best possible prices for their orders. At present, although consolidated quote information reflecting the best bid and offer prices among the different market centers is available to investors, at the time orders are received many market centers execute orders at prices that are less favorable than the consolidated quote. Additionally, broker-dealers do not generally disclose to investors the names of the market centers to which the broker-dealer routes its orders. Consequently, the SEC concluded that market fragmentation has led to industry practices that (1) prohibit most investors from knowing which market center will execute their orders; and (2) result in orders not always being executed at the best available prices.
Rule 11Ac1-5 requires market centers to disclose information on a monthly basis regarding the execution of customer orders. The information required to be disclosed includes how orders are actually executed in relation to the public quotes, the spreads actually paid by investors and the extent to which limit orders are executed at prices better than public quotes. The SEC believes that the adoption of this rule should provide investors and broker-dealers with useful information that will allow them to direct their orders to market centers on the basis of the market centers’ order execution performance, and will provide investors with the tools needed to better assess the execution quality of different market centers. In order to address the concern that unless investors are informed as to where their broker-dealers route their orders the information provided by the market centers will be of little use to them, the SEC adopted Rule 11Ac1-6 as a complement to Rule 11Ac1-5.
Rule 11Ac1-6 requires broker-dealers to disclose, on a quarterly basis, the identity of the market centers to which their customers orders are routed and the nature of any relationship with such market centers that could pose a conflict of interest between the broker-dealer and its customers. The SEC believes that this rule should help investors monitor the routing practices of broker-dealers, equip them with useful information that will enable them to make informed decisions when choosing a broker-dealer and enable them to be more involved in order routing decisions. The SEC believes that investors will then be the beneficiaries of expanded competition between broker-dealers (i.e., lower execution costs), which will be inevitable as a result of greater investor knowledge and involvement.
Taken together, these rules effectively increase the visibility of order execution and routing practices and should arm investors with the tools necessary to make better informed decisions when purchasing securities in the public market. While the SEC admits that these disclosure rules are only a small step in addressing the market fragmentation problem, the SEC believes the rules will help to provide the best possible prices for orders and lead to substantial investor savings.
The first phase-in compliance date for these rules is April 2, 2001.
Options Firm Quote And Trade-Through Disclosure Rules
In 1975, when the SEC took its first major steps toward establishing an integrated, standardized national market system, options trading was relatively new. In order to give the options markets the opportunity to develop, the SEC did not promote integration initiatives for the options markets as it did for other markets, e.g., the stock market. Now that the options market has become more fully developed, the SEC has adopted Rules 11Ac1-1 and 11Ac1-7 in order to address concerns resulting from the fragmentation of the options markets which it believes is "one of the key components of a national market system."
Currently, best execution problems face broker-dealers because of the variety of exchanges on which options are being traded. The lack of adequate access to published prices on other exchanges prohibits broker-dealers from ensuring that their customers will receive the best available prices. Consequently, many orders are being executed at prices that are inferior to prices quoted on other exchanges (a practice known as "intermarket trade-through"). New Rule 11Ac1-7 addresses this concern by requiring, in most cases, broker-dealers who do not participate in an intermarket linkage plan approved by the SEC to disclose to their customers when their options orders have been executed at prices inferior to other published quotes. The broker-dealers must also disclose the better published quotes. By requiring broker-dealers to disclose to customers that their orders were victims of intermarket trade-throughs, the SEC intends to limit intermarket trade-throughs and promote "price priority" among broker-dealers.
In another step toward integrating the options markets, the SEC amended the current Quote Rule (Rule 11Ac1-1) to include both options market makers and options exchanges. Currently, all of the options markets require their market makers to have firm quotes for some, but not all, orders. Additionally, while the current markets’ rules extend only to each market’s public customers, they do not extend to other market participants. In order to address these concerns, the Quote Rule will require securities markets to collect quotations, (and sizes associated with those quotations), from their responsible broker-dealer members and make such quotations and sizes available to quotation vendors for each subject security.
These rules have a compliance date of April 1, 2001.
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