[Federal Register Volume 59, Number 45 (Tuesday, March 8, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-5205]
[[Page Unknown]]
[Federal Register: March 8, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-33697; File No. SR-NASD-93-58]
Self-Regulatory Organizations; Proposed Rule Change by National
Association of Securities Dealers, Inc. Relating to Handling of
Customer Limit Orders
March 1, 1994.
Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on October
13, 1993 the National Association of Securities Dealers, Inc. (``NASD''
or ``Association'') filed with the Securities and Exchange Commission
(``Commission'' or ``SEC'') the proposed rule change as described in
Items I, II, and III below, which Items have been prepared by the NASD.
The Commission is publishing this notice to solicit comments on the
proposed rule change from interested persons.
I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The Association is proposing an Interpretation to the Rules of Fair
Practice to require that member firms not trade ahead of their
customers' limit orders in their market making capacity. The
Interpretation would make it a violation of just and equitable
principles of trade for member firms to hold unexecuted customer limit
orders and trade ahead of those orders in the firm's market making
capacity without filling the orders under the specific terms and
conditions with which the orders had been accepted.
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the NASD included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. The NASD has prepared summaries, set forth in sections
(A), (B), and (C) below, of the most significant aspects of such
statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
The Association is proposing an Interpretation to the Rules of Fair
Practice that would make it a violation of just and equitable
principles of trade for member firms that hold unexecuted customer
limit orders to trade ahead of those orders in the firm's market making
capacity. In July 1993, the NASD solicited member comment on
eliminating a disclosure safe harbor for members trading ahead of
customer limit orders.\1\ In September 1993, the Board reviewed
comments received from members and others and took action to eliminate
the disclosure safe harbor and to replace it with a prohibition against
members' trading ahead of their own customer limit orders.
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\1\See Notice to Members 93-49 (July 23, 1993).
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The issue of limit order protection in the NASDAQ market was
brought to the forefront in 1985 when a customer alleged that a member
firm had accepted his limit order, failed to execute it, and failed to
discharge its fiduciary duties by trading ahead of the customer's
order. In the Manning decision, the NASD found that upon acceptance of
a customer's limit order, a member undertakes a fiduciary duty and
cannot trade for its own account at prices more favorable than the
customer's limit order unless clear disclosure is provided and there is
an understanding by the customer as to the priorities that will govern
the order. The SEC affirmed the NASD decision.\2\ After input from a
number of members, the NASD proposed a ``safe harbor'' for members to
fulfill their fiduciary obligations with disclosure when the customer's
account was first opened and periodically thereafter.\3\ The language
set out in the proposed safe harbor put customers on notice that the
firm accepting a limit order would execute that order only when the
inside bid or offer on Nasdaq reached the limit price and that the
member might, in its market making capacity, trade ahead of that order.
The membership approved the proposed language, and the NASD submitted
the rule to the SEC.\4\
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\2\In the Matter of E.F. Hutton & Co., Securities Exchange Act
Release No. 25887 (July 6, 1988), 41 SEC Doc. 473.
\3\See Notice to Members 90-37 (June 1990).
\4\SR-NASD-89-10 (March 16, 1989). With submission of this rule
proposal, the NASD, under separate cover, is withdrawing SR-NASD-89-
10.
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In July 1993, the NASD Board of Governors reviewed the handling of
limit orders in NASDAQ securities and concluded that the continuation
of the disclosure exception appeared inappropriate. Because of the
significance of this change to The NASDAQ Stock Market, a notice was
issued soliciting input on how elimination of the safe harbor would
impact the operation of member firms and the treatment of investors'
orders. The NASD also solicited comment on what if any unintended
effects or unacceptable consequences would ensue if rules prohibiting
trading ahead of customer limit orders were imposed on member firms.
Specifically, comment was requested on the impact of applying the
requirements on integrated broker-dealers handling their own customer
order flow; on customer limit orders received from other member firms
(so-called member-to-member trades); and on market liquidity.
In response to the notice, the NASD received 29 comment letters
from members and trade associations, including the Security Traders
Association (``STA''), STA of New York (``STANY''), and Securities
Industry Association (``SIA''). The vast majority of comments supported
elimination of the disclosure safe harbor for market makers trading
ahead of their own retail, or ``commission paying,'' clientele.
Commenters noted that elimination of the safe harbor would level the
playing field for investors, enhance the image of The NASDAQ Stock
Market, and instill greater confidence with investors that their NASDAQ
limit orders would be handled fairly. Some commenters noted that the
NASD should distinguish between retail and institutional customer limit
orders, so that a market maker's ability to commit capital to large
institutional orders would not be impaired by a narrow reading of
``trading ahead.'' Members believed that the new rule language might
interfere with a market maker's ability to commit capital to large
institutional orders as filling these orders might necessarily involve
a trading strategy to cover short positions or to buy stock along with
the institution that on its face might appear to be trading in front of
those or other customer limit orders. Other commenters believed that
distinguishing between institutional and retail customers was not
necessary because the proposed rule language that allows members to
establish specific terms and conditions on each order adequately covers
handling of institutional orders.
Many commenters, including STA, SIA and STANY, argued that the NASD
should draw a distinction between orders from a member's own customers
and orders from another broker/dealer. They pointed out that unlike an
integrated firm which may charge a mark-up or commission to its
customers, the only profit potential for orders received from other
members lies in trading revenues derived from the spread. If the effect
of the NASD's proposed rule were to require a market maker to satisfy a
limit order sent from another broker/dealer when the market maker
traded at the same price, these commenters agreed that the NASD would
be in effect forcing the market makers to handle the order at no profit
or indeed at a loss net of processing costs. These commenters also
argued that alternative means of compensating market makers, such as
sharing the order entry firm's commission, were infeasible given the
structure of the NASDAQ market. As a result, these commenters argued
that extension of the Interpretation to member-to-member orders would
dramatically reduce market maker commitment. Further, several members
argued that by extending the requirements to other members' customer
limit orders, the NASD would be inappropriately expanding the
requirements of a fiduciary in the securities markets.
Many also commented on the new rule's potential for unintended
consequences on market liquidity, including a significant increase in
limit orders as opposed to market orders, loss of market maker
commitment, wider spreads and increased volatility. Members pointed out
that the NASD had not yet fully explored the economic ramifications of
the new requirements and noted that further economic analysis should be
undertaken prior to rulemaking.\5\
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\5\Some members also argued that procedural due process was
being by-passed by framing the new requirement as an Interpretation
to the just and equitable principles of trade standards of Article
III, Section 1 of the NASD Rules of Fair Practice. The NASD notes
that these comments misconstrue the regulatory process involved with
NASD Interpretations. All NASD Interpretations are submitted to the
SEC for review, publication in the Federal Register and public
comment prior to SEC action.
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After full consideration of the concerns articulated in the comment
process, the NASD is proposing to eliminate the disclosure safe harbor
for member firms that hold their own customer limit orders and trade
ahead of those orders and to make such actions a violation of just and
equitable principles of trade. The language of the Interpretation
establishes that a member holding its customers' limit order may not
continue to trade its market making position without executing that
limit order under the specific terms and conditions that the customer
understands and accepts. If the member does trade ahead of its
customer, it will be in violation of article III, section 1 of the
Rules of Fair Practice regarding just and equitable principles of
trade.
The NASD believes that it is inappropriate to distinguish between
the limit order protection provided fee-paying, or retail customers,
and non-fee paying, institutional clientele. The NASD recognizes,
however, that filling institutional-sized orders generally involves
best-effort commitments and trading strategies other than a straight
acceptance of a limit order. Firms accepting institutional orders on a
best-efforts basis, that may involve trading to a cover short position
or buying stock along with the institution, would not be in violation
of the rule as long as the firm maintains a clear understanding with
its institutional clientele of the terms under which the order is being
executed. Accordingly, the NASD does not distinguish between
institutional and retail customers in the Interpretation because the
proposed language that allows members to establish specific terms and
conditions on each order clearly encompasses institutional orders. This
language recognizes that institutions generally do not leave standard
limit orders with market makers. Instead, in return for the willingness
of member firms to put up substantial capital to provide liquidity for
large orders, institutions generally only hold market makers to a best-
efforts standard in attempting to execute their order at a specific
price. The ability of the member firm and the institution to reach
agreement on the terms and conditions of the order would allow them to
negotiate these arrangements without subjecting the member firm to the
requirements of the proposed rule.
Further, the NASD has determined to temporarily defer application
of the Interpretation to member-to-member orders in order to avoid any
unintended consequences from a broader application of the rule. The
NASD will form a special task force to examine ramifications of
extending limit order protections to include member-to-member
transactions. The task force will analyze the effect of the proposal on
market liquidity, volume of limit orders, market maker commitment,
spreads and volatility. The NASD believes that the issues raised by
customer limit orders passed from one member firm to a second member
firm are very complex. Dealers that trade as ``wholesale'' market
makers, whether exclusively or as a part of an integrated firms'
business, have profit potential only in the trading revenues received--
they do not rely on commissions or commission equivalents as revenue to
support their trading activities. Relying on pure trading profit and
loses is unique to a dealer market and cannot be compared to a
specialist that executes transactions for members on an exchange while
charging a fee for that service. Accordingly, requiring a market maker
to execute such limit orders any time it trades for its own account at
the same price effectively eliminates any opportunity for that market
maker to profit on that trade. The NASD is concerned that the economic
implications for market makers and the potential impact on liquidity
and spreads in the NASDAQ stock market have not fully been reviewed.
For these reasons, the NASD will form a task force composed of diverse
industry and investor interests to review the issues raised by limit
orders passed from one member to another.
In the Interpretation, the NASD also emphasizes that brokers
forwarding orders to dealers for execution continue to be subject to
their duties of best execution. Firms owe fiduciary duties of best
execution to their customers and the NASD emphasizes that order entry
firms should continue to routinely monitor the handling of their
customer limit orders for quality of execution.
The NASD believes that elimination of the safe harbor for a broker/
dealer's own customer orders is squarely in line with the original
Manning decision which was premised on a firm's fiduciary duty not to
trade ahead of its own customer order.\6\ Feedback from members
commenting on the new rules indicates that integrated market makers on
the whole do not trade ahead of their own customer orders, and
accordingly, eliminating the safe harbor would not materially or
adversely affect the way these market makers conduct their business
today.
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\6\In this regard, the NASD Interpretation on the obligation to
protect the firm's customer limit orders will also apply to firms
that control or are controlled by another member firm, e.g., where
the order entry firm is a broker that owns or controls the executing
dealer.
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Finally, as the handling of customer limit orders entails duties
that are not subject to a disclosure safe harbor, nothing in the rule
compels market makers to accept limit orders from their customers or
from other broker/dealers.
The NASD believes the proposed rule change is consistent with
section 15A(b)(6) of the Act. Section 15A(b)(6) requires that the rules
of a national securities association be designed to prevent fraudulent
and manipulative acts and practices, to promote just and equitable
principles of trade, to foster cooperation and coordination with
persons engaged in regulating, clearing, settling, processing
information with respect to, and facilitating transactions in
securities, to remove impediments to and perfect the mechanism of a
free and open market and a national market system and in general to
protect investors and the public interest. The new requirement ensures
protection of investor's limit orders when placed with market making
firms and enhances the quality of the marketplace. The affirmative
obligation for firms to protect their customer limit orders and to give
them standing over their own market making activity also enhances
opportunities for price improvement which is a benefit for public
investors.
B. Self-Regulatory Organization's Statement on Burden on Competition
The NASD believes that the proposed rule change will not result in
any burden on competition that is not necessary or appropriate in
furtherance of purposes of the Act.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
Comments were solicited in Notice To Members 93-49 and the content
of those comments are summarized in the description of the rule
proposal in part II(A) above.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
Within 35 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if it finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which the NASD consents, the Commission will: A. By order approve such
proposed rule change, or
B. Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing. In this regard, the Commission
notes that in the recently issued Market 2000 study, the Division of
Market Regulation recommends that the NASD revise its proposal to
prohibit broker-dealers from trading ahead of all customer limit orders
for NASDAQ/NMS securities.
Persons making written submissions should file six copies thereof
with the Secretary, Securities and Exchange Commission, 450 Fifth
Street, NW., Washington, DC 20549. Copies of the submission, all
subsequent amendments, all written statements with respect to the
proposed rule change that are filed with the Commission, and all
written communication relating to the proposed rule change between the
Commission and any person, other than those that may be withheld from
the public in accordance with the provisions of 5 U.S.C. 552, will be
available for inspection and copying in the Commission's Public
Reference Room. Copies of such filing will also be available for
inspection and copying at the principal office of the NASD. All
submissions should refer to the file number in the caption above and
should be submitted by March 29, 1994.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority, 17 CFR 200.30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-5205 Filed 3-7-94; 8:45 am]
BILLING CODE 8010-01-M