Solicitation of Comments on SEC Proposed Anti-Internalization Rule

I M P O R T A N T

TO: All NASD Members

SUMMARY

The Securities and Exchange Commission has published for comment a proposed rule addressing the issue of exchange and over-the-counter market makers internalizing customer orders in Rule 19c-3 securities and whether inter market exposure of customer orders should be required. Internalization has been defined by the Commission as a dealer executing customer transactions as principal or crossing agency transactions in-house without exposing those orders to buying and selling interest in other markets.

The Board of Governors is publishing this Notice to inform the membership of the proposed rule and to elicit members' comments. The Board believes that this is a most important issue for Association members in light of the competitive impact the rule will have on market makers, its impact on the efficiency of execution of customer orders and the possible future implications its adoption may have on the market for NASDAQ National Market System securities.

The proposed rule would apply to all broker/dealers executing transactions as principal with their customers and generally would prohibit the execution of a customer order as principal unless (1) the transaction is executed on an exchange or the broker/dealer is registered in the Association's Computer Assisted Execution System (CAES) as an ITS market maker, (2) the broker/dealer's quotations can be reached through the ITS/CAES interface, and (3) the order is executed in compliance with the proposed rule's order exposure requirements or order export requirements.

The rule's order exposure requirement would require a broker/dealer to stop (i.e., guarantee) each customer order at the proposed execution price, and then publish a bid or offer on behalf of the order for 30 seconds at a price 1/8 better than the proposed execution price. The rule's order export alternative would require the broker/dealer to "export" the order to CAES or the Cincinnati Stock Exchange's National Securities Trading System in such a manner that the order is not designated to a market maker and the broker/dealer either (1) establishes procedures reasonably designed to separate the firm's order entry and execution functions, or (2) has not improved its quotation in the 30 seconds prior to trading with a customer order.

A more detailed description of the proposed rule is provided later in this Notice and a copy of the proposed rule is attached.

The Board's views on the proposed rule are summarized as follows:

• The Board believes that adoption of the proposed rule would be a classic example of over-regulation. Both the SEC and NASD conducted studies of off-board trading and found that off-board transactions were being executed at prices at least as favorable and in some cases better than transactions on exchanges and that virtually no evidence was found that customers were being taken advantage of when their transactions were executed in the over-the-counter market. The Commission has stated in the release that "it has not observed any objectively identifiable negative impacts of internalization on Rule 19c-3 trading in the past that would justify imposition of an order exposure rule."
• The Commission has now stated that the decision to adopt an order exposure rule would have to be based on a determination that there would be incremental benefits resulting from such a rule that would outweigh the costs of the additional regulation. The Board believes that the costs of this burdensome regulation far outweigh any speculative benefits that may result. The complexity of the exposure requirement and the steps involved in complying with the rule would render the efficient execution of retail principal transactions extremely difficult, if not virtually impossible.
• The Board believes that the insignificant off-board volume in 19 c- 3 securities does not justify such an all encompassing regulation and certainly does not represent a threat to the manner of doing business on stock exchanges.
• It is the Board's view that the proposed rule will result in imposing an insurmountable burden on competition in off-board transactions and would constitute a de facto repeal of Rule 19c-3.
• The Board notes that the proposed rule would substantially reduce the efficiency of industry built systems which automatically process customer orders. The proposal would not only affect the Association's Computer Assisted Execution System, but would also require modifications to the automated systems of the regional stock exchanges. The proposed rule would impair the progress made in developing facilities to efficiently automate the execution of small orders which facilities are even more crucial today in light of the recent increase in volume in all markets.
• The Board is deeply concerned with the potential for the proposed rule applying to NASDAQ/National Market System securities. The Commission has publicly stated that it has no intention of expanding the coverage of the rule to securities traded exclusively in the over-the-counter market. The Board recognizes, however, that no firm commitment can be made as to the action of a future Commission. The Commission has already by rule designated certain NASDAQ securities as national market system securities subject to the same trade reporting and quotation display rules as listed securities. The number of NASDAQ securities designated as national market system securities will increase as the national market system evolves. The Board is concerned that at some future time more of the distinctions between listed national market securities and over-the-counter national market system securities will be eliminated. Since the rule is heavily biased against in-house principal transactions, this could substantially impact the long-term profitability of a large portion of the membership's business.

For these reasons, the Board of Governors believes that the proposed rule is of vital interest to the entire membership and urges members to analyze the rule and to communicate their views to the Commission. Substantial comments have already been received by the Commission from proponents of the rule. The Board believes it essential for the membership to recognize the importance of this issue and to communicate their views in a comment letter to the Commission as soon as possible. All comments should be submitted by March 1, 1983 to:

George A. Fitzsimmons
Secretary
Securities and Exchange Commission
450 Fifth Street, N. W.
Washington, D. C. 20549

In addition, the Association would appreciate receiving a copy of your comments. Please send a copy to:

S. William Broka
Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N. W.
Washington, D. C. 20006

Sincerely,

Gordon S. Macklin
President

Attachments

DISCUSSION OF THE SECURITIES AND EXCHANGE COMMISSION'S RE-PROPOSAL OF AN ORDER EXPOSURE RULE

The SEC proposed order exposure rule is the second publication of this issue by the Commission. Last year the Commission published for comment three alternative means of dealing with internalization. The first alternative was to defer Commission action on an anti-internalization rule. The second alternative, which was based on a New York Stock Exchange proposal, would have applied only to over-the-counter market makers and would have required the exposure of customer orders and market maker principal interest in these orders to other markets prior to execution. The third alternative which was based on principles developed by a special Securities Industry Association committee would have required both exchange and over-the-counter market makers to expose customer orders to other markets prior to execution.

The Association commented to the Commission that action on an anti-internalization rule should be deferred until such time that a demonstration has been made that internalization has created a regulatory problem warranting further action. The Association reminded the Commission that this had been the Commission's longstanding policy on this issue and that it should continue to adhere to this policy.

The basis for publishing the previous anti-internalization rules was the argument put forth by stock exchanges that customer orders executed off of an exchange will result in inferior executions for those orders because of a loss of order interaction in the exchange auction crowd and the potential for dealers to overreach and take advantage of their customers. The basis for this argument is that dealers executing transactions in the over-the-counter market will execute customer buy orders at their offer price and execute customer sell orders at their bid price. The argument is made that dealer executions will be inferior to exchange auction executions because the auction process is characterized by order interaction in the auction crowd. Theoretically, a customer order when brought to the floor of an exchange and exposed in the auction crowd will have the opportunity to be matched with another customer order exposed in the crowd. The specialists' bid and ask quotation will only come into play when there are imbalances of buy or sell orders. Therefore, orders can meet in the crowd and be matched in between the specialist's bid and ask and will only be executed at the bid or ask when there is an imbalance of orders on the buy or sell side and the order cannot be matched. The argument concludes that this can only occur through an auction process and removing customer orders from this process will result in inferior executions for customer orders because it eliminates the possibility of these orders being executed in between the quotation at better prices.

The Association's response to these arguments contained an analysis of the results of the SEC's own Monitoring Report on the Operation and Effects of Rule 19c-3 as well as the NASD's surveillance and monitoring program both of which revealed that off-board transactions in these securities were being executed at prices at least as favorable and in some cases better than transactions on exchanges. In addition, the analysis concluded that virtually no evidence was found of inferior executions or that customers were being taken advantage of when their transactions were executed in the over-the-counter market. The Association concluded in its comments to the Commission:

The Commission's policy as enunciated in its various releases is a sound one. That is, added regulation and rules are not appropriate until there is some demonstrated adverse effects on the markets resulting from dealer internalization of customer orders. The limited trading which has taken place in 19c-3 securities is insufficient to form the definite conclusions necessary to resolution of the question with finality. However, this limited experience does reveal that off-board trading in 19c-3 securities has not had negative consequences and that the theoretical dangers have not materialized. Thus, no substantive case can be made at this time that the experience with off-board trading in 19c-3 securities requires regulatory action. The Commission should adhere to its historical position that regulatory action on internalization should be reserved until such time as a regulatory problem has been established and such action is demonstratably appropriate. This has been the Commission's firm position for many years. No empirical evidence exits requiring an alteration of its policy.

After several months of studying the comments received, the Commission has now republished a proposed anti-internalization rule, but the basis upon which the rule is to be adopted has changed. Previous anti-internalization rules have been proposed in an attempt to curb the potential regulatory abuses which could result from internalization. The Commission has now concluded that "it has not observed any objectively identifiable negative impacts of internalization on Rule 19c-3 trading in the past that would justify imposition of an order exposure rule." The basis for adopting the proposed rule would be the benefits that would flow from order exposure. The Commission states in its release:

The Commission recognizes the arguments made by a number of commentators that increased OTC competition in Rule 19c-3 securities inherently increases depth, liquidity, and pricing efficiency. The Commission, in adopting Rule 19c-3, made the determination that, in that limited context, these potential competitive benefits outweighed any potential concerns arising from the absence of exposure by OTC market makers. The Commission has not to date been provided any data or analysis which would cause it to reverse that determination. Therefore, any decision to adopt an order exposure rule would have to be based on a determination that there would be incremental benefits resulting from such a rule that would outweigh the costs of the additional regulation.

In this connection, the Commission believes that adoption of an order exposure rule for linked securities could possibly provide benefits for the markets for those securities and give the Commission experience with which to consider and evaluate the role of order exposure generally as a means to improve intermarket competition and best execution and thereby foster development of a national market system. The Commission is mindful, however, that some commentators have raised concerns that an order exposure rule could negate benefits already achieved through enhanced opportunities for intermarket competition and best execution afforded by adoption of Rule 19c-3. The Commission specifically requests comment on this issue.

The Board of Governors believes that under this new basis for adopting an anti-internalization rule, the costs involved in complying with the rule results in substantial inefficiencies in executing transactions and anti-competitive impacts which far outweigh any potential benefits. The Board is also very concerned as to the future application of the proposed rule. As proposed, the rule only applies to 19c-3 securities, that is, those securities which have listed on an exchange since April 26, 1979. There are currently 484 19c-3 securities and 53 members making markets in these securities. The Commission has publicly stated that it has no intention of expanding the coverage of the rule to securities traded exclusively in the over-the-counter market. The Board recognizes, however, that no firm commitment can be made as to the action of a future Commission. In addition, as the national market system evolves and the number of NASDAQ stocks designated as national market system securities increases, the potential exists for an anti-internalization rule to be expanded to cover NASDAQ securities. This could occur either through the granting of unlisted trading privileges on NASDAQ stocks to exchanges or the adoption of the view that all national market system stocks and exchange listed stocks should trade under the same rules. Following is a brief description of the proposed rule and we suggest that the membership keep in mind the possible extension of the rule to NASDAQ securities when analyzing its provisions. A copy of the proposed rule is attached to this notice.

The rule provides that no broker/dealer may buy a 19c-3 security from a customer or sell such security to a customer for the broker/dealer's account unless:

Order Exposure Requirements

Before a broker/dealer could execute a customer's order as principal it would be required to:

If the broker/dealer receives an order from the published offer l/8th above the stop price, the customer will receive the improved price. If no one takes the published offer after 30 seconds, the broker/dealer can execute the order at the stop price.

The requirement to publish at l/8th above the stop price will not be required if:

If a broker /dealer is publishing an offer on behalf of a customer order at l/8th above the stop price, and a second order is received, the second order may be executed immediately as principal at the stop price of the first order in any size up to 1,000 shares more than the size of the first order.

If a broker/dealer is publishing an offer on behalf of a customer order at l/8th above the stop price, that order may be immediately executed as principal at the stop price if:

Order Export Requirements

A broker/dealer need not comply with the order exposure requirements if it complies with the order export requirements. The broker/dealer can enter the customer's order in the Computer Assisted Execution System (CAES) on a neutral basis, i.e., not directed to a particular market maker, or enter the order in the Cincinnati Stock Exchange's National Securities Trading System (NSTS) provided that the broker/dealer either:

The rule also provides that agency cross transactions executed off of an exchange or CAES may only be executed at a price between the best ITS bid and offer if the spread is 1/4 or more or at the best ITS bid or offer if the spread is 1/8.

The rule also provides a number of exclusions, the most important of which relates to block transactions. The rule would require the ITS participants to submit to the Commission within 18 months of the effective date of the rule a plan providing for an effective means of exposing blocks to other markets. Until the adoption of such a plan, block transactions would be excluded from the rule. The rule defines a block as 10,000 shares or more or a quantity of a security having a market value of $200,000 or more.

* * * * * *

The Commission has stated that the decision to adopt an order exposure rule would have to be based on a determination that there would be incremental benefits resulting from such a rule that would outweigh the costs of the additional regulation. They have specifically requested comments on this issue. The Board of Governors believes that the costs of this burdensome regulation far outweigh any speculative benefits that may result. The Board believes that the complexity of the exposure requirement and the mechanical steps involved in complying with the rule would render the efficient execution of retail principal transactions extremely difficult, if not virtually impossible. Each retail principal transaction would require separate mechanical input entries and display through the firm's terminal and a waiting period of up to 30 seconds prior to execution of the order. In addition, the process of determining what price to expose, when the firm's quotation would have to be altered, a determination of the applicable holdout period and whether the various exceptions are available creates a process for executing each transaction that is extremely cumbersome and inefficient. A firm with a steady flow of retail orders would simply be physically unable to execute customer orders with any degree of efficiency.

With respect to the order export alternative, it would not, under any circumstances, result in a customer receiving a better execution than if the firm executed the transaction internally. Conversely, the customer could receive an inferior price taking into consideration commissions and costs of execution. First, since the firm is currently obligated under NASD rules to achieve best execution, the execution price to the customer, if executed internally, would be required to be the best bid or offer. Therefore the blind routing of the order would not result in an improved execution price. Secondly, firms dealing directly with their customers are able to execute such transactions at a lesser cost than if the order were routed to another market. There are significant costs savings (e.g., clearing costs, resolving questioned trades) resulting from the internalization of customer orders which could be passed on to the customer in the form of reduced commissions and/or markups. We, therefore, do not view the order export alternative as having any advantages for customers and could result in disadvantages. The alleged conflict of interest on the part of the dealer is dealt with by existing rules and regulations. More importantly, this conflict is controlled by the widespread disclosure of current quotations and transaction reports and the active competition in the market for these securities. From the data available with respect to customer executions in 19c-3 securities, this alleged conflict has resulted in virtually no evidence of overreaching or inferior executions.

It is the Association's view that the anti-internalization proposal will clearly result in imposing an insurmountable burden on competition in off-board transactions in 19c-3 securities and would constitute a de facto repeal of Rule 19c-3. Firms participating in the 19c-3 experiment have indicated that they could not continue trading 19c-3 securities under the proposed rule. Not only would it effectively repeal Rule 19c-3, but the rule would also impose an insurmountable burden on non-exchange member market makers who have been trading listed securities for many years. In effect, the rule would eliminate the over-the-counter market in 19c-3 securities. We believe this result would be clearly inconsistent with the '75 Act Amendments, eliminate the recent gains that have been made in promoting competition in listed securities and be contrary to the public interest.

We believe that the objectives of the '75 Act could best be achieved by establishing an industry-wide best execution rule applicable to all markets and equally enforced in all markets. Customers ought to receive the best price displayed from any market. We do not believe the current ITS trade through rule goes far enough due to its many exceptions, its unequal treatment of market centers and the fact that only a complaint by a market center within five minutes of an execution gives rise to action under the rule. We believe that the focus of the national market system should be on the execution of customer orders and insuring that customers receive the best price displayed from any market center.

The Board of Governors believes that this proposed anti-internalization rule is a classic example of overregulation. The Commission itself has stated that no regulatory abuses are evident which would justify adoption of a rule. We believe that the burdens imposed by the rule not only clearly outweigh any benefits, but would stifle competition among market makers. For the past 10 years the securities industry has spent a considerable amount of time and money to develop automated systems which have resulted in the establishment of more efficient facilities to automatically process customer orders. These facilities are even more crucial today in light of the recent increase in volume in all markets. The Board believes that adoption of the proposed rule would not only impair the progress made so far, but would require modifications to these systems and their use by members to such an extent as to substantially reduce their efficiency. It should be noted that the proposed rule would not only affect the Association's Computer Assisted Execution System, but would also require modifications to the automated systems of the regional stock exchanges which are specifically covered by the proposed rule.

Finally, the Board urges members to consider the potential of this rule applying to the trading of NASDAQ NMS securities. Despite the assurances from the Commission that this will not happen, the Board is very concerned that at a future date it will occur. This concern is based on the evolution of the national market system as envisaged by the '75 Act Amendments as a unified trading system for all national market system securities. The Commission has already by rule designated certain NASDAQ securities as national market system securities subject to the same trade reporting and quotation display rules as listed securities. The Board is concerned that at some future time more of the distinctions between listed national market securities and over-the-counter national market system securities will be eliminated.

The Board believes that there has clearly been no demonstration of a need for an anti-internalization rule. Such a rule would eliminate competition among market makers; would be harmful to existing industry automated facilities; and poses a dangerous threat to the manner in which securities are traded. In addition, since the rule is heavily biased against in-house principal transactions, it could substantially impact the long-term profitability of a large portion of the membership's business.

PART 240—GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934

§ 240.11A-1 Exposure of principal and agency cross transactions.

Preliminary Note to Rule 11A-1— Rule 11A-1 applies both to broker-dealer principal transactions with customers and agency cross transactions in specified securities. With respect to broker-dealer principal transactions, the rule applies both to broker-dealer purchases from customers and broker-dealer sales to customers. In order to make the substantive requirements of the rule as easy to follow as possible, only subparagraph (a)(l) of the ruler refers both to broker-dealer purchases and sales. Throughout the remainder of the rule, the text of the rule refers only to the situation where the broken dealer buys from the customer. With respect to broker-dealer sales to a customer, the requirements of the rule parallel the requirements specified for broker-dealer purchases, but on the opposite side of the market. For example, while the rule provides the broker-dealer with the alternative requirement of "exposing" a customer sell order at a price 1/8 dollar higher than the stop price with respect to broker-dealer purchases, the broker-dealer would have to expose customer buy orders at a price 1/8 dollar lower than the stop price. As a general matter in interpreting requirements with respect to broker-dealer purchases from customers, unless the context requires otherwise, terms such as "purchase," "offer," "higher," "sell," "lowered," "bid," and "raised" used with respect to broker-dealer purchases, should be road as "sale," "bid," "lower," "purchase," "raised" "offer," and "lowered" with respect to broker-dealer sales.

By the Commission.

December 23, 1982.

George A. Fitzsimmons,
Secretary.

[FR Doc. 82-35493 Filed 12-29-82; 8:45 am]

BILLING CODE 8010-01-M

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