I. Introduction

On October 24, 2023, NYSE Group, Inc., on behalf of the Participants ^[1] to the National Market System Plan to Address Extraordinary Market Volatility (“Plan”), filed with the Securities and Exchange Commission (“Commission”), pursuant to section 11A(a)(3) of the Securities Exchange Act of 1934 (“Act” or “Exchange Act”) ^[2] and Rule 608 thereunder,^[3] a proposal (“Proposal” or “Proposed Amendment”) to amend the Plan. The Proposed Amendment was published for comment in the Federal Register on November 21, 2023.^[4] On February 15, 2024, the Commission instituted proceedings pursuant to Rule 608(b)(2)(i) of Regulation NMS ^[5] to determine whether to approve or disapprove the Proposed Amendment or to approve the Proposed Amendment with any changes or subject to any conditions the Commission deems necessary or appropriate.^[6] On May 14, 2024, the Commission designated a longer period within which to conclude proceedings regarding the Proposed Amendment.^[7] On July 18, 2024, the Commission designated a longer period for Commission action on the Proposed Amendment.^[8]

This order disapproves the Proposed Amendment.

II. Overview

The Participants adopted the Plan to address extraordinary volatility in the securities markets, i.e., significant fluctuations in individual securities' prices over a short period of time, such as those experienced during the “Flash Crash” on the afternoon of May 6, 2010. The Plan sets forth procedures that provide for market-wide limit up-limit down requirements to prevent trades in individual NMS Stocks from occurring outside of the specified Price Bands to address instances of extraordinary volatility in NMS Stocks.^[9] These limit up-limit down requirements are coupled with Trading Pauses to accommodate more fundamental price moves.

As set forth in more detail in the Plan, the single plan processor, which is responsible for consolidation of information for an NMS Stock pursuant to Rule 603(b) of Regulation NMS under the Exchange Act, calculates and disseminates a lower Price Band and upper Price Band for each NMS Stock. As set forth in Section V of the Plan, the Price Bands are based on a Reference Price for each NMS Stock that equals the arithmetic mean price of Eligible Reported Transactions for the NMS Stock over the immediately preceding five-minute period. The Price Bands for an NMS Stock are calculated by applying the Percentage Parameters, as set out in Appendix A to the Plan,^[10] for such NMS Stock to the Reference Price, with the lower Price Band being a Percentage Parameter below the Reference Price, and the upper Price Band being a Percentage Parameter above the Reference Price.

Appendix A to the Plan sets out the definitions of Tier 1 and Tier 2 NMS Stocks and the Percentage Parameters for each. Appendix A currently provides that Tier 1 includes all NMS Stocks included in the S&P 500 Index and the Russell 1000 Index, as well as “eligible” ETPs, which are ETPs that trade over $2,000,000 notional consolidated average daily volume (“CADV”) over a period from the first day of the previous fiscal half year up until one week before the beginning of the next fiscal half year. Eligible ETPs are listed in Schedule 1 to Appendix A, and the list is reviewed and updated semi-annually. All ETPs that do not meet the “eligibility” definition are currently assigned to Tier 2.

For Tier 1 NMS Stocks, Appendix A defines the Percentage Parameters as:

• 5% for Tier 1 NMS Stocks with a Reference Price more than $3.00;
• 20% for Tier 1 NMS Stocks with a Reference Price equal to $0.75 and up to and including $3.00; and
• The lesser of $0.15 or 75% for Tier 1 NMS Stocks with a Reference Price less than $0.75.

For Tier 2 NMS Stocks, Appendix A defines the Percentage Parameters as:

• 10% for Tier 2 NMS Stocks with a Reference Price of more than $3.00;
• 20% for Tier 2 NMS Stocks with a Reference Price equal to $0.75 and up to and including $3.00; and
• The lesser of $0.15 or 75% for Tier 2 NMS Stocks with a Reference Price less than $0.75.

Appendix A further provides that the Percentage Parameter for a Tier 2 NMS Stock that is a leveraged ETP is the applicable Percentage Parameter set forth above, multiplied by the leverage ratio of such product.

III. Summary of the Proposed Amendment  ¹¹

The Participants propose to amend Appendix A to delete the definition of ETPs “eligible” for Tier 1, and to specify that all ETPs except for single-stock ETPs would be assigned to Tier 1. The Proposed Amendment would generally result in tighter Price Bands being applied on Tier 2 ETPs than currently apply. The Participants also propose to delete Schedule 1 to Appendix A as obsolete. Under the Proposal, Appendix A, Section I, paragraph (1) would read as follows:

Tier 1 NMS Stocks shall include all NMS Stocks included in the S&P 500 Index and the Russell 1000 Index, and all exchange-traded products (“ETP”), except for single stock ETPs, which will be assigned to the same Tier as their underlying stock, adjusted for any leverage factor.

Because all leveraged ETPs (except Tier 2 single-stock ETPs) would be assigned to Tier 1, the Participants also propose to add text into Section I of Appendix A describing how the Percentage Parameters would be set for leveraged ETPs. The Participants propose to insert the following as paragraph (5) of Section I, and to renumber the paragraphs of Section I accordingly:

Notwithstanding the foregoing, the Percentage Parameters for a Tier 1 NMS ( printed page 77204) Stock that is a leveraged ETP shall be the applicable Percentage Parameter set forth in clauses (2), (3), or (4) above, multiplied by the leverage ratio of such product.

At the request of ETP issuers, the Participants conducted a study concerning the calibration of the Percentage Parameters set forth in the Plan with respect to ETPs in Tier 2.^[12] The Participants subsequently conducted additional analysis (“Supplemental Analysis”) on the narrowing of the Percentage Parameters.^[13] The Participants reached the following conclusions based on the analysis in the study and the Supplemental Analysis (collectively “Analyses”):

• Tier 1 non-ETPs are far more likely than Tier 2 ETPs to enter into Limit States and Trading Pauses due to the underlying volatility of these securities. This finding suggests that the Price Band width for Tier 2 ETPs is poorly calibrated relative to their actual trading behavior.^[14] The Supplemental Analysis performed by the Participants reached the same conclusion using two different methodologies.^[15]

• During the period looked at in the study presented in the Proposed Amendment, the notional value of trades that would have been prevented if Tier 2 ETPs had used tighter Tier 1 Price Bands would have been substantial for such thinly traded products, bounded on the lower end at $36.8 million and the upper end at $711.1 million.^[16]

• The Participants calculated theoretical Tier 1 (i.e., 5%, adjusted for the leverage factor) Price Bands for all Tier 2 ETPs in the study presented in the Proposed Amendment (“Theoretical Tier 1 Bands”).^[17] In this analysis from the study, the Participants compared the execution price to the midpoint price of the National Best Bid or Offer (“NBBO”) at five and ten minutes after such execution. Using this methodology, in the majority of cases where a trade would have been prevented by the narrower Theoretical Tier 1 Bands, prices reverted by the end of the following five- and ten-minute periods, suggesting that having these thinly traded ETPs in Tier 1 would protect investors from executing trades at inferior prices that may occur due to transitory gaps in liquidity rather than fundamental valuation changes.^[18] In the Supplemental Analysis, the Participants used a different methodology, specifically comparing the midpoint of the NBBO at five and ten minutes after the trade to the midpoint of the NBBO ^[19] at the time of execution, to demonstrate price movement after theorical block trades and again reached conclusions they state support the Proposed Amendment.^[20]

• In most cases where ETPs have been reclassified from Tier 2 to Tier 1, market quality improved as evidenced by the lower quote volatility, tighter spreads, and increased liquidity for ETPs that moved from Tier 2 to Tier 1.^[21]

• Using tighter Tier 1 bands for all ETPs would provide greater investor protection from temporary liquidity gaps, which are facilitated by the wider Price Bands in Tier 2.^[22]

• The number of Limit States and Trading Pauses decreased when Tier 2 ETPs moved to Tier 1, and increased when Tier 1 ETPs moved to Tier 2.^[23]

Based on these conclusions, the Participants state that they believe that moving Tier 2 ETPs to Tier 1 would improve market quality, more effectively dampen volatility, decrease the number of unnecessary Limit States and Trading Pauses, and thereby provide greater investor protection.^[24]

IV. Discussion

A. The Applicable Standard of Review

Under Rule 608(b)(2) of Regulation NMS, the Commission shall approve a national market system plan or proposed amendment to an effective national market system plan, with such changes or subject to such conditions as the Commission may deem necessary or appropriate, if it finds that such plan or amendment is necessary or appropriate in the public interest, for the protection of investors and the maintenance of fair and orderly markets, to remove impediments to, and perfect the mechanisms of, a national market system, or otherwise in furtherance of the purposes of the Exchange Act.^[25] Under Rule 700(b)(3)(ii) of the Commission's Rules of Practice, the “burden to demonstrate that a NMS plan filing is consistent with the Exchange Act and the rules and regulations issued thereunder that are applicable to NMS plans is on the plan participants that filed the NMS plan filing.” ^[26] The Commission shall disapprove a national market system plan or proposed amendment if it does not make such a finding.^[27]

For the reasons described below, the Participants have not demonstrated that the Proposal meets the standard under Rule 608(b)(2) of Regulation NMS. As such, the Commission is disapproving the Proposed Amendment because it cannot make the finding that the Proposed Amendment is necessary or appropriate in the public interest, for the protection of investors and the maintenance of fair and orderly markets, to remove impediments to, and perfect the mechanisms of, a national market system, or otherwise in furtherance of the purposes of the Exchange Act.^[28]

B. Comments Received

Certain commenters express support for the Proposed Amendment.^[29] One commenter states that it is important to maintain the leverage factor adjustment when moving leveraged ETPs into Tier 1.^[30] Another commenter, writing on behalf of a “diverse cross-section of market participants,” states that using Tier 1 Percentage Parameters for all ETPs would better protect investors during temporary liquidity gaps.^[31] The commenter states that the risk of an inefficient execution away from the fair value of the ETP's holdings (as far as 10% away from a Tier 2 ETP's Reference Price) rises in the case of a liquidity gap resulting from an outsized or aggressive order, temporary uncertainty about any inputs into the calculation of the ETP's fair value, or lower levels of market participation.^[32] This commenter also states that the application of Tier 1 Percentage Parameters may enhance investor protection, provide a better ETP execution experience for market participants, and would improve transparency and efficiency, particularly during periods of extreme volatility.^[33] Another commenter states that the Participants' data presented in the Proposed Amendment showed that while narrow Price Bands resulted in more trading halts in the time period studied, had narrower Price Bands been in place for ETPs during periods of extreme volatility, retail investor executions at inferior prices would likely have been prevented.^[34] Some commenters that support the proposal state that ETPs are assigned to tiers based on an assumption that lower-volume ETPs are more suited for wider Price Parameters, and state that the data presented in the Proposed Amendment suggest that this assumption was wrong.^[35] Some commenters that support the Proposal state that the analysis from the study in the Proposed Amendment demonstrated that on average, Tier 2 ETPs across asset classes exhibit lower quote volatility than Tier 1 non-ETP stocks.^[36] In light of the findings derived from the study, some commenters state that the imposed semi-annual migration of ETPs from one tier to the other appears to be overly complex, arbitrary, and unnecessary.^[37] One commenter states that there is no reason to expect the Tier 1 Price Band is inappropriate for Tier 2 ETPs that are based on a single reference asset, stating that approximately 33% of single asset commodity based ETPs representing a wide range of commodity types are Tier 1 securities.^[38]

Some commenters oppose the Proposed Amendment,^[39] with some commenters stating that the proposed tighter Price Bands would effectively limit the natural price discovery process, which would infringe upon free market principles ^[40] and may lead to increased volatility.^[41] One commenter further states that leveraged derivatives, such as options and futures, allow significant positions to be taken with relatively less capital.^[42] The same commenter states that the Proposal caters to the interests of larger, institutional investors who may benefit from reduced volatility and more predictable price movements at the expense of smaller, retail investors.^[43] Some commenters state that the Proposal enables the Participants to control the price of a security inappropriately.^[44]

C. Participants' Findings and Commission Response

The Commission approved the Plan in 2012 on a pilot basis, recognizing that after the Participants and the public gain experience with the operations of the Plan, modifications may be necessary or appropriate.^[45] At the time the Commission permanently approved the Plan in 2019, the Commission recognized that robust, data-driven assessments of the Plan's effectiveness are important to ensure that the Plan remains designed to achieve its objective,^[46] and the Commission supports continuing efforts to improve the operation of the Plan consistent with Rule 608 of Regulation NMS under the Exchange Act.^[47]

The Participants state that assigning all ETPs, except for single stock ETPs, to Tier 1 would improve market quality, more effectively dampen volatility, provide greater investor protection, and decrease the number of unnecessary Limit States and Trading Pauses for Tier 2 ETPs.^[48] For these reasons, the Participants state that the Proposed Amendment is consistent with Rule ( printed page 77206) 608(b)(2). As discussed in detail below, the Participants have not carried their burden of demonstrating why the Proposed Amendment is consistent with Rule 608 of Regulation NMS.

In the Proposal, the Participants state that, except for single-stock, commodity, and foreign exchange-based ETPs, ETPs are diversified instruments and that the analysis in the Proposal supports the modern portfolio theory that portfolios of securities exhibit lower volatility than individual securities, unless those products are perfectly correlated. At the same time, the Participants acknowledge that the ETPs studied cover several asset classes, including domestic equities, international equities, fixed income, currency, commodity, and digital currency ETPs.^[49] The Participants' Analyses, however, provide aggregate statistical information with respect to all Tier 2 ETPs despite securities within this group having different trading characteristics. These Analyses and the resulting aggregate statistical information concern the volatility characteristics of Tier 2 ETPs and the potential costs ( i.e., trading activity disruption) and benefits ( i.e., protecting investors from trading at inferior prices that may occur because of transitory gaps in liquidity rather than fundamental value changes; market quality improvement) of designating all Tier 2 ETPs as Tier 1 securities. The Commission is concerned that these aggregate statistical analyses for Tier 2 ETPs do not reflect the trading characteristics and potential effects of the Proposed Amendment for many Tier 2 ETPs.

According to the Annual Report for 2023 by the Operating Committee of the Plan, in 2023 there were over two thousand ETPs designated as Tier 2 securities.^[50] While the Proposed Amendment would exclude single stock ETPs from automatically being designated as Tier 1 securities,^[51] the Proposal would not exclude other Tier 2 ETPs, including those based on other single reference assets,^[52] that may exhibit substantially different trading characteristics than those reflected in the Proposal's aggregate statistical analysis concerning the over two thousand Tier 2 ETPs or otherwise provide data demonstrating why these Tier 2 ETPs would be appropriately designated as Tier 1 securities regardless of their different trading characteristics. The above-mentioned issues were raised by the Commission in the Notice and OIP.^[53]

For example, key elements of the Analyses aggregate all trades of Tier 2 ETPs together.^[54] Such a method will effectively ignore Tier 2 ETPs that trade infrequently—this is because any analysis that uses aggregate trading statistics will be driven by the ETPs with a high level of trading activity, while ETPs with a low level of trading will have a low weight in the statistical analysis. This result is compounded by combining leveraged and non-leveraged Tier 2 ETPs in the same group because trading activity among Tier 2 ETPs is highly skewed by leveraged ETPs. All leveraged ETPs are in Tier 2 regardless of their trading volume, and some have a high level of volume.^[55] In contrast, a non-leveraged ETP is only in Tier 2 if it has less than $2 million CADV per day over the past six months. This implies that an aggregate analysis of all Tier 2 ETP trades will be driven by a relatively small number of high-volume leveraged ETPs, and such analysis will effectively ignore the vast majority of Tier 2 ETPs.^[56] Because elements of the Analyses are driven by a small number of high-volume leveraged ETPs, it is not appropriate to extend the conclusions from the Analyses to the nearly 2,000 non-leveraged Tier 2 ETPs with substantially less volume; therefore, key analyses—such as the analysis of price dynamics around the Price Bands—do not support moving all 2,000 Tier 2 ETPs into Tier 1. A more granular statistical analysis could show that, for certain ETPs that are currently in Tier 2, the move to Tier 1 and resultant narrower Price Bands would result in excessive Straddle States, Limit States and Trading Pauses that are not due to extraordinary volatility caused by transitory gaps in liquidity, which these measures are designed to mitigate, but instead would unduly interrupt trading activity driven by fundamental value changes. For this reason, the Participants' Analyses do not provide sufficient detail and specificity concerning these securities for the Commission to make an affirmative finding that the Proposed Amendment meets the standard for approval.^[57]

In addition to the issues discussed above, in the Notice and OIP the Commission addressed potential issues with respect to the Participants' statements regarding the Proposed Amendment's benefits and analysis concerning the volatility characteristics of Tier 2 ETPs as compared to Tier 1 ( printed page 77207) securities that are not ETPs.^[58] The Participants state that the Proposed Amendment would protect investors from executing trades at inferior prices that may occur due to transitory gaps in liquidity rather than fundamental valuation,^[59] and some commenters state their support for this element of the Proposal's analysis.^[60] However, as discussed further below, the study presented in the Proposed Amendment and the Supplemental Analysis supporting this investor protection benefit are not robust or compelling. The Participants rely on the Analyses, which documented price reversion after Theoretical Tier 1 Bands had been breached in Tier 2 ETPs, as evidence that investors transacted at inferior prices and would have benefited from tighter Price Bands.^[61]

There are three concerns with the price reversion analysis provided in the study presented in the Proposed Amendment and the Supplemental Analysis. First, as stated above, the price reversion analyses in the study in the Proposed Amendment and Supplemental Analysis are done on an aggregate basis for all Tier 2 ETPs. Many Tier 2 ETPs may show different price reversion results than reflected in the Analyses. Second, the conclusions from the study's price reversion analysis are not robust because that price reversion analysis compared trade prices that occurred outside of the Theoretical Tier 1 Bands to subsequent midpoint prices. This methodology is flawed because by comparing the execution price to a subsequent midpoint price, the methodology could incorrectly identify a price reversion—which is cited as evidence of inferior trades—even if nothing else changes with respect to the security ( e.g., fundamental value, bid and ask prices stay constant) or even if the midpoint price continues to move in the same direction.^[62] The Commission requested comment concerning the analysis included with the Proposal in the Notice and OIP,^[63] and the Participants performed a Supplemental Analysis to address concerns that the Proposal's analysis could overestimate the degree of price reversion.^[64] In particular, the Participants performed a price reversion analysis that compared the midpoint of the NBBO at five and ten minutes after the trade to the midpoint of the NBBO at the time of execution.^[65] While this methodology in the Supplemental Analysis ^[66] is more robust than the methodology of the study included in the Proposed Amendment, it also showed a decrease in the amount of price reversion experienced by Tier 2 ETPs. This raises a third concern. In particular, the additional price reversion analysis reflects some reversion metrics dropping from 74% in the Proposal to 52% in the Supplemental Analysis. Given that prices fluctuate unpredictably over such short horizons, prices should revert 50% of the time and continue in the same direction 50% of the time; therefore, this estimated reversion probability of 52% in the Supplemental Analysis is little better than chance and does not support the Participants' statement that investors would have been protected by the tighter band.^[67] The reduction in the estimated amount of price reversion also increases the likelihood that some individual Tier 2 ETPs experience price continuation—rather than reversion—near the Theoretical Tier 1 Bands, but this possibility cannot be detected when all two thousand Tier 2 ETPs are included in the aggregate statistical analysis.

The Participants also state that Tier 2 ETPs are less volatile than Tier 1 non-ETP securities, and that this lesser volatility is evidence that the current Price Bands for Tier 2 ETPs are poorly calibrated.^[68] Some commenters supported this element of the Proposal's analysis.^[69] However, that volatility analysis is also flawed.^[70] First, as discussed above, the Participants' Analyses are insufficiently granular as they combine nearly two thousand non-leveraged Tier 2 ETPs into a single group and compare them to all Tier 1 non-ETPs. Yet there may be many non-leveraged Tier 2 ETPs that reflect substantially different trading characteristics, and the Participants' Analyses do not provide sufficient detail and specificity concerning these securities for the Commission to make an affirmative finding that the Proposed Amendment meets the standard for approval.^[71]

Some non-leveraged Tier 2 ETPs—due to their relatively low trading volume—may experience trades that are spread out over time. When the time between trades is longer, the amount of new information in the market since the last trade will generally be higher, resulting in greater price changes— i.e., greater volatility—from trade-to-trade.^[72] A tighter Price Band for these securities will be likely to inhibit this new information from being incorporated into trade prices and the Participants' Analyses do not address this possibility and its potential impact.^[73] Second, volatility is an imprecise metric for determining Price Bands. This is because volatility is averaged over many days and many stocks, while the Price Bands are meant to curb extraordinary volatility ( e.g., the velocity of significant price moves).^[74] Average levels of volatility, therefore, are a coarse metric in determining whether a stock can sustain tighter Price Bands.^[75] Third, the ( printed page 77208) Proposal's analysis measured volatility using changes in the midpoint price of Tier 2 ETPs from second-to-second. This method of analysis is not robust for studying the volatility of securities that trade infrequently or have low quoting activity because the estimated volatility will be biased toward zero for these securities.^[76] As part of the Supplemental Analysis the Participants provided a new analysis of the volatility Tier 2 ETPs.^[77] While this analysis uses a more robust method for evaluating the volatility of Tier 2 ETPs as compared to Tier 1 non-ETPs, it presents the same concerns discussed above. In particular, it is an insufficiently granular statistical analysis of all Tier 2 ETP volatility, and there may be many Tier 2 ETPs that exhibit different trading characteristics, which the Analyses do not take into consideration. This possibility is evident in the distributional statistics in the Supplemental Analysis: the average quote volatilities for Tier 2 ETPs (both leveraged and non-leveraged) are multiples of the median quote volatilities, implying that the distribution is skewed by observations with volatility far higher than the average. Tier 1 ETPs exhibit less evidence of skewness. Therefore, the supplemental volatility analysis does not support moving all Tier 2 ETPs into Tier 1.

Accordingly, based on the study in the Proposal and the Supplemental Analysis and for the reasons discussed throughout this order, the Commission cannot find that designating over two thousand ETPs as Tier 1 securities and subjecting them to tighter Price Bands is necessary or appropriate in the public interest, for the protection of investors and the maintenance of fair and orderly markets, to remove impediments to, and perfect the mechanisms of, a national market system, or otherwise in furtherance of the purposes of the Act, as required for approval of a plan amendment pursuant to Rule 608(b)(2). Designating Tier 2 ETPs as Tier 1 securities based on an aggregate statistical analysis could result in excessive Straddle States, Limit States and Trading Pauses in certain affected ETPs due to tighter Price Bands, and thus unduly impede trading in many securities for market participants that trade in these securities.

V. Conclusion

For the reasons set forth above, the Commission does not find, pursuant to Section 11A of the Act,^[78] and Rule 608(b)(2) thereunder,^[79] that the Proposed Amendment is necessary or appropriate in the public interest, for the protection of investors and the maintenance of fair and orderly markets, to remove impediments to, and perfect the mechanisms of, a national market system, or otherwise in furtherance of the purposes of the Act.

It is therefore ordered, pursuant to Section 11A of the Act, and Rule 608(b)(2) thereunder, that the Proposed Amendment (File No. 4-631) be, and it hereby is, disapproved.