United States: The ´Hybrid´ Approach: A Review of The NYSE´s Market Structure Proposal

Earlier this year, the New York Stock Exchange submitted a rule filing to the Securities and Exchange Commission proposing rules and rule changes that are intended to establish a "hybrid" market structure that blends the exchange's automatic execution system, NYSE Direct+, with its floor auction.

The SEC published the filing for public comment in August (SEC Release No. 34-50173 (10 August, 2004), 69 FR 50407 (16 August 2004) and received 15 comment letters on the filing. Based on those comments, the NYSE has amended the filing to propose additional rule changes and provide further explanation of the proposal, which the SEC has published for public comment.

Comments on the "amended filing", SEC Release No. 34-50667 (15 November, 2004), 69 FR 50667 (22 November, 2004) are due by December 13, 2004. Among other things, the amended filing defines Momentum LRP, modifies the electronic market sweep procedures to provide a degree of inter-market trade through protection, and amends the proposed rules relating to broker agency interest and specialist interest posted within Direct+.

The proposed hybrid market is intended to make "speed and execution certainty available to a wider variety of orders" and "provide an opportunity for price improvement [in an auction market environment] for those who desire it" (69 FR 50407, at 50413). If implemented, the proposal will significantly alter NYSE's existing auction market structure. The proposal comes at a time when the SEC is encouraging exchanges to operate "fast" markets in its proposed Regulation NMS.

In preparing this article, we have had conversations with exchange representatives to clarify various sections of the filings.

Direct+ has been operating as a pilot program since December 2000. Under the current system, member organizations or customers may enter limit orders (i.e., orders to buy or sell a quantity of securities at a specified or better price) into the NYSE SuperDOT system for automatic execution through Direct+. Market orders and regular limit orders entered through DOT are handled on the floor.

To be eligible to receive automatic execution, an "auto-ex" limit order must be entered into DOT with the indicator "NX." Under the current system, only orders for 1099 shares of stock or less may be submitted for automatic execution through Direct+ (with a higher threshold for investment company units and trust issued receipts).

Auto-ex orders receive automatic execution when they are "marketable," i.e., when their limit price is equal to or better than the NYSE's published bid or offer. When an auto-ex order is greater than the size of the exchange's published bid or offer, the order trades against the entire published quote and a new bid or offer is published. Non-marketable auto-ex limit orders and the unfilled balance of any partially executed auto-ex orders are displayed as limit orders in the specialist's "display book" and are handled in the floor auction market.

The display book is an electronic facility that assists the specialist in keeping track of limit orders and incoming market orders and can be viewed by floor brokers and other members on the floor of the exchange. Off-floor member organizations and the public may view information listed in the display book through the NYSE's "OpenBook," except that the data is not updated on a real time basis (note, the NYSE submitted a separate rule filing with the SEC in August proposing to update the OpenBook display each second.)

Limit orders coming through DOT or sent to the specialist through other electronic means, such as a floor broker's hand-held device, automatically enter the display book. The display book displays limit orders in price/time priority. Market orders entered through DOT are also entered into the display book and executed on the floor.

Direct+ orders may only be entered every 30 seconds by those seeking automatic execution, to prevent multiple orders from being entered in immediate succession to circumvent the size limitation. Automatic execution is not available if the execution price would be more than five cents away from the last reported transaction price in the security.

The NYSE is proposing to allow automatic execution through Direct+ of market orders (which are currently ineligible for auto-ex) and marketable limit orders, in each case regardless of their size. The NYSE is also proposing to eliminate the rule that auto-ex orders can be entered only every 30 seconds, because with the size restriction lifted this restriction is no longer necessary.

The filings propose to add the term "marketable limit order" to NYSE rule 13 to distinguish between limit orders eligible for auto-ex and those that are not. Market orders must be entered into DOT with the "NX" indicator to receive auto-execution (we use "auto-ex market order" to refer to such orders and "market order" to refer to other market orders in Direct+, which are handled as described below.) Marketable limit orders entered into DOT do not need the "NX" indicator to receive auto-execution, which is a change to existing requirements.

As proposed, an auto-ex market order or marketable limit order will be executed at the published quote, to the extent of the volume associated with that quote. Any unfilled balance will "sweep the book," automatically executing at the "clean-up" price until it is filled, its limit price, if any, is reached, or a Liquidity Replenishment Point is reached. "LRPs" and "sweeping the book" are discussed, respectively, below.

The amended filing lists other types of orders subject to automatic execution through Direct+ by expanding the definition of "auto-ex order" to include, among others, immediate or cancel orders, all or none orders, elected or converted percentage orders and elected stop or stop limit orders. Such orders could participate in market sweeps, but in the case of an immediate or cancel order any residual remaining after the sweep will automatically be cancelled.

Commitments to trade sent to the exchange from another market center through the Intermarket Trading System will also receive automatic execution through Direct+. Commitments to trade would be executed to the extent of the volume of the exchange's published bid or offer, but any unfilled balance would automatically be cancelled, i.e., commitments to trade do not sweep the book.

The NYSE proposes to eliminate the prohibition of automatic execution when the execution price would be more than 5 cents away from the last reported trade price. Instead, the NYSE is proposing flexibility to set execution price parameters from time to time based on the price of the relevant security. The LRPs also act to suspend automatic executions, as explained below.

The NYSE is proposing a new hybrid auction structure that seeks to provide parallel price improvement opportunities to eligible orders on the floor and through Direct+. This hybrid auction model would be available to a new order type, the auction limit order, and to market orders entered through DOT without the NX designation. An AL order must be a marketable limit order and entered through DOT.

Under the hybrid process, a market order or AL order will be executed immediately if there is a one-cent spread on the quote, i.e., the spread is at the minimum quote variation. If the market order or AL order is not executed immediately (which could occur on the floor), it is quoted in the display book at a minimum variation better than the prevailing bid or offer, as applicable, and is disseminated as the exchange's published quote. The quote will also be available through OpenBook, without any designation as a market or AL order. That information will be available to the specialist, though, including the limit price on an AL order.

The market or AL order is held open for up to 15 seconds for potential price improvement. During that 15 seconds, the order can be executed on the floor or automatically within Direct+ under the following circumstances:

In addition, the order may participate in an automatic execution through Direct+ against a contra-side auto-ex market order or market sweep.

If the order is not executed during the 15 second hybrid auction, at the end of that period it will automatically trade against the published contra-side quote through Direct+ unless, in the case of an AL order, the market has moved away from its limit price. In that case, the order will be included in the display book at its limit price and treated as a regular limit order.

While orders participating in the hybrid auction have an opportunity for price improvement, they also face the risk of a worse execution in terms of price or quantity than if they were submitted for auto-ex.

Member organizations and customers will still be able to transmit orders, including market orders and marketable limit orders, to floor brokers for execution on the trading floor. Similarly, floor brokers and member firms will continue to be able to send orders to a specialist. Orders entered in these ways will be executed through the NYSE's floor auction process, but under proposed revisions that will allow floor brokers to enter agency interest in the display book. The filings would also allow specialists to enter their own trading interest in the display book. These proposed changes are described in Section 3. below.

Liquidity replenishment points are central to the proposed operation of Direct+. LRPs are "volatility moderators" that, when reached, suspend automatic execution of orders. The filings describe two types of LRPs: (i) price-based LRPs, also called sweep LRPs, and (ii) momentum LRPs.

The price-based LRP is relevant with respect to market sweeps. As proposed, a security's price-based LRP is set at a minimum of five cents from the exchange bid or offer, rounded out to the nearest nickel.

When an auto-ex order has been executed and there is a remaining, unfilled balance (or "residual"), the residual sweeps the book until the order is filled, its limit price (if applicable) is reached, or a price-based or momentum LRP is reached. When a limit price or LRP is reached, the balance remaining will be handled in the floor auction market, where it will become a bid or offer at its limit price or the (if applicable) price-based LRP price, whichever is reached first.

Significantly, when a price-based LRP is reached during a sweep, auto-ex and auto-quote functions are suspended (auto-quote refers to the NYSE's automated display of the exchange's best bid or offer and, if suspended, the specialist must manually quote.) The filings describe three scenarios that govern the treatment of an auto-ex order that sweeps the market to a price-based LRP (although described in the filings, the proposed rules do not expressly set out the requirements described below with respect to suspension of auto-ex functionality.)

Although not made clear by the filings, it would seem that the price-based LRP rules also apply to AL orders and market orders in the hybrid auction when they became auto-executable and sweep the contra side.

If an MLRP is unchanged for more than 30 seconds, a trade at or through the MLRP will not trigger a suspension of auto-quote or auto-ex.

As noted above, when an order eligible for automatic execution through Direct+ is executed, but there is residual remaining, the residual sweeps the book. When that occurs, the order will receive two fill prices on the NYSE, the published contra-side quote that was lifted and, for the residual, a "clean-up" price.

The "clean-up" price would be established based on the depth of the contra side interest available in the display book and the price-based LRP. The clean-up price is set at the first to occur of the price-based LRP or the price of the quote that allows the residual to be filled completely against the cumulative size out through that quote. When the LRP is the clean-up price, auto-ex and auto-quote will be halted as described above. Quotes in the display book between the initial fill price and clean-up price trade against the order sweeping the book at the clean-up price.

The amended filing modifies the sweep procedures to address inter-market trade through concerns. As proposed, if another market center participating in ITS publishes a better bid or offer than the clean-up price, and such bid or offer is immediately available for automatic execution or is otherwise protected against trade-through by SEC rule or the ITS Plan, a portion of the residual sweeping the NYSE market will automatically be routed as a commitment to trade to that other market to satisfy that better quote. Thus, the order could receive three fill prices: the NYSE's published best quote, the away market's published best quote and the clean-up price.

The residual remaining on an auto-ex order after a sweep, other than on an immediate or cancel order, will as applicable be bid at the lower of the order's limit price (if any) or price-based LRP or offered at the higher of the order's limit price (if any) or price-based LRP. The remaining residual on an immediate or cancel order will be automatically cancelled.

If the Direct+ proposal is approved and implemented, the volume of automatic executions will likely increase and the role of specialists on the floor may diminish, by shifting much of the control over the auction to Direct+ under the hybrid auction. A specialist, however, could place its own bids or offers ("specialist interest") into the display book on an automated basis through an external quote application interface ("Quote API"). Unlike other orders in the display book, specialist interest will not be disseminated to floor brokers or members.

A specialist would use its own proprietary algorithm to place or cancel its specialist interest. The amended filing sets out parameters that the specialist's algorithm must meet. The algorithm employed by the specialists may only be used to:

• generate a bid or offer that improves the NYSE's best bid or offer, except in response to an order entering the book;
• withdraw specialist interest at the NYSE's best bid or offer, except in response to an order entering the book;
• add to the size of an existing best bid or offer;
• match another market center's best bid or offer;
• layer specialist interest at prices outside the published quote to participate in or add price improvement to a sweep;
• give price improvement to a retail auto-ex market or marketable limit order under the terms described below; or
• facilitate single-priced execution at the bid or offer price if it would fill the entire order, which is the only circumstance when specialist interest may lift the best bid or offer. For a specialist to provide price improvement under (vi), the following conditions must exist:
• the quote spread is at least 3¢;
• the specialist is represented in the NYSE published bid or offer for at least the lower of 10,000 shares or 20 per cent of the bid or offer size;
• the order receiving price improvement is a "retail" order, i.e., an order for 2,000 shares or less;
• the specialist fills the entire order; and
• the specialist provides price improvement of at least 2¢ when the quote spread is 3¢ to 5¢; at least 3¢ when the quote spread is 6¢ to 10¢; at least 4¢ when the quote spread is 11¢ to 20¢; and at least 5¢ when the quote spread is more than 20¢.

The specialist's Quote API and algorithm may only generate a message in reaction to one order at a time as such order enters the system and must identify the order to which it is reacting. In addition, specialist interest generated by an incoming order does not receive any special priority to trade with that order.

Specialist interest that does not trade with the identified order would be cancelled automatically. Although unclear, presumably the foregoing requirements apply only with respect to specialist interest covered by clauses (vi) (provide price improvement) and (vii) (facilitate single price execution).

Specialists will also retain their duty to "gap" the quote when there is an order imbalance caused, for instance, by a sudden influx of orders or by entry of a very large order without much offsetting interest. By gapping the quote, specialists signal potential price improvement in order to attract contra-side trading interest. Gapping the quote not only notifies others of a trading imbalance but would suspend auto-ex and auto-quoting.

When another market center has established the national best bid or offer, and there is a minimum variation between that bid or offer and the exchange's best bid or offer, an AL or market order would be sent to that other market center for execution automatically, unless the specialist matches the price of the better away bid or offer.

The role of floor brokers may also be diminished if the proposal is approved and implemented, in that it may create pressures for floor brokers to represent their customer orders electronically as "broker agency interest" in Direct+. As proposed, broker agency interest can cover various types of orders, including market orders, marketable limit orders and limit orders.

A broker may only place agency interest into the book when he is present in the trading crowd, which under the amended filing means he is standing within five contiguous panels of the post where the security trades. The broker may continue to trade on behalf of customer orders in the crowd, but only for size not included in his broker agency interest or excluded as described below from the aggregate broker agency file information available to the specialist.

The broker must cancel his interest when he leaves the crowd. His agency interest will still be handled in Direct+ if the broker fails to do so, but the broker may be disciplined for violating the rule.

Broker agency interest is disseminated only when it becomes or is at the exchange's published best bid or offer. The amended filing adds a "reserve" feature for broker agency interest above 1000 shares. When a broker's agency interest exceeds 1000 shares, it is only that amount that will be included in the aggregate size of the displayed quote, unless the broker elects to display more than 1000 shares in his agency interest.

If the broker receives a partial fill on his displayed broker agency interest, the amount in reserve will be added to the size of the new display of his residual agency interest up to 1000 shares (or more as the broker elects).

The specialist will see the aggregate size of the broker agency interest file at each price level. Under the amended filing, though, a floor broker may at his discretion remove any portion of his agency interest from the aggregate broker interest file information that the specialist sees, but this will not affect the displays of broker agency interest at the exchange best bid or offer described above. Broker agency interest excluded from the aggregate file will participate in auto-executions and electronic sweeps and may also be filled manually if the broker is orally representing the interest in the crowd.

To the extent broker agency interest improves the quote it would trigger automatic execution of any contra-side market order or AL order in the hybrid process and may also be lifted by a contra-side auto-ex order when the agency interest establishes or joins the exchange's published best bid or offer.

If the broker places a customer order with the specialist and it is added to the display book, that order may also receive an execution through Direct+ in these ways. Given the increased importance of the automated auction, floor brokers may have little choice but to reflect orders in the display book as agency interest or by giving the order to the specialist.

The amended filing would change the current priority and parity rules under Direct+ to address broker agency interest and specialist interest. Specifically:

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.