United States: NYSE’s Proposed Hybrid System - DIRECT+

The New York Stock Exchange ("NYSE" or the "Exchange") has submitted a rule filing (the "Filing") to the SEC relating to proposed modifications to its automatic execution system, NYSE DIRECT+® ("Direct+"), which the SEC has published for public comment. SEC Release No. 34-50173 (Aug. 10, 2004), 69 FR 50407 (Aug. 16, 2004). Comments are due by September 7, 2004, but we have been advised that this deadline will be extended by two weeks at the Exchange’s request. The proposed changes to Direct+ are intended to create a "hybrid" market that will 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 changes will significantly alter NYSE’s existing auction market structure. The NYSE’s hybrid market proposal comes at a time when the SEC is encouraging exchanges to operate "fast" markets in its proposed Regulation NMS.

Direct+ has been operating as a pilot program since December of 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 ("DOT") 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. 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.

NYSE specialists assign the appropriate number of shares to the contra side trading interest when an auto-ex order has been executed against multiple orders represented by the specialist and/or the trading crowd. The specialist will also participate as a contra party to the extent that any of the interest reflected in the published quotation against which the auto-ex order was executed was in fact no longer available.

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, in its Filing, 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 Filing proposes 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. 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 ("LRP") is reached. "LRPs" and "sweeping the book" are discussed, respectively, in Sections 2(d) and 2(e) below.

Commitments to trade sent to the Exchange from another market center through the Intermarket Trading System ("ITS") will also receive automatic execution through Direct+ under the proposal, whether or not the Exchange's published bid or offer is the national best bid or offer ("NBBO"). Commitments to trade would also be executed to the extent of the volume of the Exchange's published bid or offer, but any unfilled balance would be automatically cancelled, i.e., commitments to trade do not sweep the book.

The Filing also proposes to eliminate the prohibition of automatic execution when the execution price would be more than five cents away from the last reported transaction price. The Exchange is proposing to replace that restriction with new execution price parameters (as yet unspecified) based on the price of the relevant security.

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 ("AL") 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. AL orders will be treated the same as market orders with one exception, noted below.

Under the hybrid process, a market order or AL order will be immediately executed 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 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 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:

• (i) an order is entered after the market order or AL order (on the same side as the market) and the later order is at a better price than the market order or AL order is bidding or offering at the time; or

• (ii) the contra-side bid or offer changes (narrows the spread) so that an execution at that price would give the market order or AL order price improvement.

In addition, an AL order will be automatically executed if an auto-ex order is entered after the AL order that takes some or all of the published contra-side volume. This trading protocol will not apply to market orders. The Filing does not explain the reason for this difference.

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.

An auto-ex market order or marketable limit order has priority within Direct+ over market orders and AL orders participating in the hybrid auction. 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 NYSE 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 Filing would also allow specialists to enter trading interest in the Display Book. These proposed changes are described in Section 2(g) below.

LRPs are central to the proposed operation of Direct+. LRPs are "volatility moderators" that, when reached, prohibit automatic execution of orders. The Filing describes two types of LRPs: a price-based LRP (a minimum of five cents from the Exchange bid or offer, rounded out to the nearest nickel) and a momentum-based LRP (based on a specified price movement in a specified amount of time). See Chart A in the attachment for an illustration of how the price-based LRP would be set.

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 an LRP is reached. When a limit price or an 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 LRP price, whichever is reached first.

Significantly, when an LRP is reached during a sweep, auto-ex and auto-quote functions are suspended. The three scenarios described in the Filing that govern the treatment of an auto-ex order that sweeps the market to an LRP, are:

• (i) When the LRP is reached and no residual remains, or a residual remains that is not capable of trading at the next price level because the limit price equals the LRP, autoquote would resume as soon as possible, but in no more than five seconds, unless in that time, orders came in that locked or crossed the market.

• (ii) When the LRP is triggered and a residual remains but the limit price falls between the LRP and the next price level, autoquote would remain disengaged, and automatic executions could not occur until the specialist trades or requotes the market. However, autoquote and auto executions must resume after 28 seconds.

• (iii) When a residual remains but the limit price locks or crosses the next price level or (presumably) if the order is a market order, autoquote and auto executions would not be available until a trade occurs or the specialist requotes the market.

69 FR 50407, at 50418. Although not made clear by the Filing, it would seem that the LRP rules also apply to AL orders and market orders in the hybrid auction when they became auto-executable.

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, the published contraside 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 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 in Section 2(d). 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. See Chart B in the attachment for a more detailed explanation regarding the establishment of clean-up prices.

The Filing would change the current priority and parity rules under Direct+ to address broker agency interest and specialist interest. As today, when the published quote reflects multiple orders, that interest will be filled by an incoming order on a first in time basis. If any trading interest remains, multiple orders are deemed to be re-entered simultaneously and have equal parity. Under the Filing, though, limit orders and broker agency interest would have priority over any specialist interest, but broker agency interest and specialist interest would be on parity when there are no limit orders. When there are multiple quotes at parity that in aggregate exceed the size of the auto-ex order, the fill is divided among the quotes equally. For example:

• a customer has a limit order on the book to purchase 500 shares of XYZ at 10.05;

• there is broker agency interest to purchase 1000 shares of XYZ at 10.05;

• )there is specialist interest to purchase 1000 shares of XYZ at 10.05;

• if a market order designated for automatic execution is entered into DOT to sell 1000 shares of XYZ, the order would be automatically executed, with the customer’s limit order executed in full (sell 500 shares), the floor broker’s order partially executed (sell 500 shares), and the specialist receives no fill.

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. The Filing also proposes to eliminate the duty of a specialist to assign the number of shares to each contraparty with respect to automatic executions that include multiple orders on the specialist’s book and/or in the trading crowd, which will be done automatically through Direct+. However, as noted in the Filing, specialists will be able to place their own bids or offers ("specialist interest") into the Display Book. Unlike other orders in the Display Book, specialist interest will not be disseminated to floor brokers or members. This specialist interest may improve a sweep price, facilitate a single-price execution at the bid or offer price, or improve a quote in another market through the Direct+ system. 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. Gapping the quote not only notifies others of a trading imbalance but would suspend auto-ex and auto-quoting.

The role of floor brokers may also be diminished if the proposal is approved and implemented. The Filing proposes to create a new system whereby brokers will be able to place agency interests into the Display Book. Unless reflected in the Exchange’s published best bid or offer, broker agency interest would not be disseminated except to the specialist, who would be able to see the aggregate of broker agency interest at each price. Broker agency interests can cover various types of orders, including market orders, marketable limit orders and limit orders. 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.

Although it is not clear why, the Filing proposes a rule that a broker may only place agency interest into the book in one trading crowd at a time, and if the broker leaves the crowd, he or she must cancel the interest. A broker’s agency interest will still be handled when the broker leaves the crowd without canceling the interest; however the broker may be disciplined for violating the rule.

Chart A – Price-Based LRP

In the chart above, the Exchange’s published bid is 20.10 for 1500 shares and the published offer is 20.14 for 2000 shares. The price-based LRP is five cents from the published bid or offer, rounded out to the nearest nickel. Accordingly, in this example, one price-based LRP would be 20.05 (five cents from 20.10) and the other would be 20.20 (five cents from 20.14, rounded out to the next nearest nickel). If the published offer were instead at 20.12, the LRP would still be 20.20, because rounding is to the next nickel out, not the closest nickel increment.

Chart B- Sweep Clean-Up Price

In the chart above, the Exchange’s published quotes are the same as in Chart A. In addition, there are other bids on the Display Book awaiting execution. If a market order to sell 5000 shares is entered into DOT for automatic-execution, 1500 shares would automatically be sold through Direct+ at 20.10. The residual of the order would then sweep the book at the clean-up price until filled or the LRP is reached. (Because the order in this example is a market order there is no limit price constraint). In this example, there are only 2300 shares available to fill the order, because the 20.04 bid is below the LRP of 20.05 and thus cannot be used as the clean-up price. Instead, the market order would sell 2300 shares at the clean-up price of 20.05, i.e., at the LRP.

Chart B (continued) – Market After the Sweep

The market order to sell would still have a residual of 1200 shares. These 1200 shares would be handled in the floor auction market and, in accordance with the proposed rules, would become an offer to sell 1200 shares at the LRP of 20.05 in the Display Book. The specialist, or another party in the trading crowd, could then interact with this offer by purchasing the 1200 shares at 20.05. If this did not occur and if no new offers to sell at or below 20.04 were entered, presumably the specialist would sell the residual 1200 shares against the 20.04 bid for 3000 shares or Direct+ would effect that match automatically once auto-ex resumed. If other offers to sell at 20.04 were entered the residual of the market order and these new offers would be on parity.

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.