[Federal Register Volume 59, Number 109 (Wednesday, June 8, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-13881]


[[Page Unknown]]

[Federal Register: June 8, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34145; File No. SR-NASD-94-13]

 

Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc., Relating to 
the New NPROVE System for Price Improvement and Execution of 
Small Orders

June 1, 1994.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ Notice is hereby given that on March 28, 1994,\2\ the 
National Association of Securities Dealers, Inc. (``NASD'' or 
``Association'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') 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.
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    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\The NASD initially filed the proposed rule change on March 4, 
1994. On March 28, 1994, the NASD filed Amendment No. 1, which 
expands and clarifies the description of the system.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD is proposing a rule change regarding the operations of the 
Nasdaq Primary Retail Order View and Execution System 
(``NPROVE''), a new system for execution and price improvement 
of small-sized customer orders. The ``Rules of Operation and Procedures 
for the NPROVE Service'' will replace in its entirety the 
``Rules of Practice and Procedures for the Small Order Execution 
System'' (``SOES Rules''), which the NASD proposes to withdraw 
simultaneously with the new system becoming operational.
    The NASD is also proposing conforming modifications to the NASD 
manual, including the Rules of Practice and Procedure for the Automated 
Confirmation Transaction Service (``ACT Rules'') and Schedule D to the 
NASD By-Laws (and any other places in the manual that refer to SOES) to 
delete references to SOES and/or the SOES Rules and to replace those 
references with NPROVE and/or the NPROVE Rules, as 
appropriate. These references may be found in the ACT Rules, Section 
(c)(2); in Schedule D, Part V, Section (1)(f), Section (7)(a), Section 
(7)(c), Section (8)(c), and Section (9); and Schedule D, Part XI, 
Section (2)(e)(1). Below is the text of the proposed rule change.

Rules of Operation and Procedures for the NPROVE System

(1) Definitions

    The terms used in this Section shall have the same meaning as 
those defined in the Association's By-Laws and Rules of Fair 
Practice, unless otherwise specified.
    a. The term The Nasdaq Primary Retail Order View and Execution 
System (``NPROVE'') shall mean the small order delivery and 
execution system owned and operated by The Nasdaq Stock Market, Inc. 
(a wholly owned subsidiary of the National Association of Securities 
Dealers, Inc.) which enables NPROVE participants to execute 
agency transactions of limited size in equity securities listed on 
The Nasdaq Stock Market; to have reports of the transactions 
automatically forwarded through the Automated Confirmation 
Transaction service (``ACT'') to the trade reporting system for 
dissemination to the public; to ``lock in'' those trades by sending 
both sides to the National Securities Clearing Corporation 
(``NSCC'') for clearance and settlement; and to provide 
NPROVE participants with sufficient monitoring and updating 
capability to participate in an automated order delivery and 
execution environment. The NPROVE service also offers a 
facility for storing and executing agency limit orders and an 
opportunity for improving prices that investors receive on market 
and limit orders.
    b. The term ``NPROVE participant'' shall mean either a 
market maker or order entry firm registered for participation in 
NPROVE.
    c. The term ``NPROVE eligible security'' shall mean any 
Nasdaq SmallCap or Nasdaq National Market equity security; the term 
``active NPROVE security'' shall mean an NPROVE 
eligible security in which at least one NPROVE market maker 
is currently active with an open quote.
    d. The term ``open quote'' shall mean a market maker's quotation 
price and size in an eligible security against which orders may be 
executed through the NPROVE system during normal market 
hours, as specified by the NASD. A market marker has a ``closed 
quote'' when it has not updated its quotation in Nasdaq or its 
exposure limit in NPROVE.
    e. The term ``NPROVE market maker'' shall mean a member 
of the Association that is registered as a Nasdaq market maker 
pursuant to the requirements of Schedule D to the NASD By-Laws and 
as a market maker in one or more NPROVE eligible securities. 
An ``active NPROVE market maker'' is a market maker that has 
an open quote in an NPROVE eligible security.
    f. The term ``NPROVE order entry firm'' shall mean a 
member of the Association that is registered as an order entry firm 
for participating in NPROVE which permits the firm to enter 
agency orders of limited size for delivery to and execution against 
NPROVE market makers.
    g. The term ``agency order'' shall mean an order from a public 
customer that is entered by the NPROVE order entry firm on 
an agency basis. It shall also include, for purposes of these rules:
    (1) an order entered into NPROVE on a principal basis by 
an NPROVE order entry firm that is not a market maker in the 
NPROVE security, in NPROVE or otherwise, where the 
NPROVE order entry firm has contemporaneously received an 
order from a customer and executes the transaction on a riskless 
principal basis; and
    (2) an order entered by a market maker in the security for the 
account of a public customer if the order is preferenced to the 
entering market maker (i.e., self-preferenced).
    An order will not be considered an agency order if it is for any 
account of a person associated with any member firm or any account 
controlled by such an associated person. An order will not be 
considered an agency order if it is for any account of a member of 
the ``immediate family'' (as that term is defined in the NASD Free-
Riding and Withholding Interpretation, Article III, Section 1 of the 
Rules of Fair Practice) of an associated person who has physical 
access to a terminal capable of entering orders into NPROVE.
    h. The term ``preferenced order'' shall mean an order entered 
into NPROVE and directed to a particular market maker. Each 
market maker has the ability to select order entry firms from which 
it will accept preferenced orders.
    i. The term ``unpreferenced order'' shall mean an order entered 
into NPROVE and not directed to any particular market maker 
or a preferenced order that has been directed to a market maker that 
has not identified the order entry firm as one from which it will 
accept preferencing.
    j. The term ``locked and crossed market'' shall have the same 
meaning as defined in Part V of Schedule D to the NASD By-Laws.
    k. The term ``maximum order size'' shall mean the maximum size 
of individual orders for a security that may be entered into or 
executed through NPROVE. The maximum order size for each 
security shall be published from time to time by the Association. In 
establishing the maximum order size for each Nasdaq National Market 
security, the Association will give consideration to the average 
daily non-block volume, bid price, and number of market makers for 
each security. Maximum order size for Nasdaq National Market 
securities shall be 200, 500 or 1,000 shares, depending upon the 
trading characteristics of the securities.a Maximum order size 
for Nasdaq SmallCap securities shall be 500 shares. These sizes may 
be adjusted on an issue by issue basis, depending upon trading 
characteristics of the issue as determined by the Association.
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    \a\The applicable maximum order size for each Nasdaq National 
Market security is determined generally by the following criteria:
    i. a 1,000 share maximum order size shall apply to Nasdaq 
National Market securities with an average daily non-block volume of 
3,000 shares or more a day, a bid price of less than or equal to 
$100, and three or more market makers;
    ii. a 500 share maximum order size shall apply to Nasdaq 
National Market securities with an average daily non-block volume of 
1,000 shares or more a day, a bid price of less than or equal to 
$150, and two or more market makers; and
    iii. a 200 share maximum order size shall apply to Nasdaq 
National Market securities with an average daily non-block volume of 
less than 1,000 shares a day, a bid price of less than or equal to 
$250, and that have two or more market makers.
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    l. The term ``exposure limit'' shall mean the number of shares 
of an NPROVE eligible security specified by an 
NPROVE market maker that it is willing to have executed for 
its account by unpreferenced orders entered into NPROVE on 
either side of the market.
    m. The term ``minimum exposure limit''for a security shall mean 
the aggregate number of shares of the security equal two times the 
maximum order size for that security, unless the automated quotation 
update facility is utilized by the NPROVE market maker.
    n. The term ``automated quotation update facility'' shall mean 
the facility in the NPROVE system that allows the system to 
automatically refresh a market maker's quotation in any security 
that the market maker designates when the market maker's exposure 
limit has been exhausted. The facility will update both the bid and 
offer side of the quote using a quotation interval designated by the 
market maker. When the automated quotation update facility is 
utilized, the market maker's required minimum exposure limit may be 
established to equal the maximum order size for the security.
    o. The term ``Automated Confirmation Transaction service'' 
(``Act''), for purposes of the NPROVE rules, shall mean the 
automated system owned and operated by The Nasdaq Stock Market, Inc. 
which accommodates trade reporting of transactions executed through 
NPROVE and submits locked-in trades to clearing.

(2) NPROVE Participant Registration

    a. All members participating in NPROVE shall register 
and be authorized as NPROVE market makers and/or order entry 
firms. Registration as an NPROVE participant shall be 
conditioned upon the member's initial and continuing compliance with 
the following requirements: (1) Membership in, or access arrangement 
with, a clearing agency registered with the Securities and Exchange 
Commission which maintains facilities through which NPROVE 
compared trades may be settled; (2) registration as a market maker 
(if applicable) in Nasdaq pursuant to Schedule D of the NASD By-Laws 
and compliance with all applicable rules and operating procedures of 
the Association and the Securities and Exchange Commission; (3) 
maintenance of the physical security of the equipment located on the 
premises of the member to prevent the unauthorized entry of orders 
or other data into NPROVE or Nasdaq; and (4) acceptance and 
settlement of each trade that is executed through the facilities of 
the NPROVE service, or if settlement is to be made through 
another clearing member, guarantee of the acceptance and settlement 
of such identified NPROVE trade by the clearing member on 
the regularly scheduled settlement date.
    b. Upon effectiveness of the member's registration to 
participate in NPROVE, participants may commence activity 
within NPROVE for entry and/or execution of orders, as 
applicable, and their obligations as established in sections 4-10 
will commence.
    c. Pursuant to Schedule D to the NASD By-Laws, participation as 
an NPROVE market maker is required for any Nasdaq market 
maker registered to make a market in a Nasdaq National Market 
security. A market maker in a Nasdaq SmallCap security may withdraw 
from and reenter NPROVE at any time, and without 
limitations, during the operating hours of the service.
    d. Each NPROVE participant shall be under a continuing 
obligation to inform the Association of noncompliance with any of 
the registration requirements set forth above.

(3) Operating Hours of NPROVE

    The operating hours of NPROVE will the normal market 
hours specified for The Nasdaq Stock Market.

(4) Participant Obligations in NPROVE

    a. Market Makers
    1. An NPROVE market maker shall commence participation 
in NPROVE by initially contacting the Market Operation 
Center to obtain authorization for market making in particular 
Nasdaq securities and identifying those terminals on which the 
NPROVE trade information is to be displayed. Thereafter, on-
line registration on a security-by-security basis is permissible, 
consistent with the requirements of Schedule D to the NASD By-Laws.
    2. Participation as an NPROVE market maker obligates the 
firm, upon presentation or preferenced or unpreferenced orders 
through the service, to execute those orders; provided however, that 
for unpreferenced orders, the NPROVE market maker shall have 
an opportunityb consistent with SEC Rule 11Ac1-1 to decline the 
order; if no action is taken the order will be automatically 
executed against the market maker. The market maker may decline to 
execute the unpreferenced NPROVE order only if the market 
maker has executed an order (or is in the process of executing an 
order) in the security and has updated its quotation (or is in the 
process of updating its quotation) for the security. If a market 
maker rejects the NPROVE order, it will be displayed to all 
other market makers at the inside quotation simultaneously and 
executed against the market maker that accepts the order, or if no 
market maker accepts the order, the next market maker in rotation 
that has not rejected the order will receive the execution. If all 
market makers reject the order because they have had an execution 
(or are in the process of effecting a trade) and have updated their 
quotations (or are in the process of updating their quotations), the 
order will be delivered to the first market maker at the new inside 
quote on Nasdaq and that market maker will not be able to reject 
that order. NPROVE market makers will also not be permitted 
to reject orders preferenced to the firm pursuant to a preferencing 
arrangement acknowledged by the market maker. The system will 
transmit to the market maker on the Nasdaq Workstation screen and 
printer, if requested, or through a computer interface, as 
applicable, an execution report generated following each execution.
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    \b\This period of time shall initially be established as 15 
seconds, but may be modified upon appropriate notification to 
NPROVE participants.
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    3. An NPROVE market maker that improves the best bid or 
offer in Nasdaq is eligible to receive all unpreferenced orders 
entered into NPROVE (for a specific period of time or number 
of executions as established by the NASDc) so long as the 
market maker manually accepts the orders prior to automatic 
execution of the orders.
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    \c\The parameters for market makers receiving priority in the 
rotation when they have created an improved inside market have been 
initially established as five minutes or five executions (whichever 
occurs first) after one or more market makers have changed their 
quote to equal the improved price. The NASD may modify these 
parameters upon notification to members.
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    4. For each security in which a market maker is registered, the 
market maker shall enter into NPROVE an exposure limit. For 
a Nasdaq National Market security, that limit may be any amount 
equal to or larger than the minimum exposure limit. If no exposure 
limit is entered for a Nasdaq National Market security, the firm's 
exposure limit will be the minimum exposure limit.
    5. An NPROVE market maker may elect to use the automated 
quotation update facility in one or more securities in which it is 
registered. The facility will refresh the market maker's quotation 
automatically by a quotation interval designated by the market 
maker, once its exposure limit in the security had been exhausted. 
The facility will refresh the market maker's quotation in both the 
bid and offer side of the market by the interval designated and will 
reestablish the market maker's displayed size and the minimum 
exposure limit. If the market maker elects to utilize the automated 
quotation update feature, it may establish an exposure limit equal 
to the maximum order size for the security regardless of the minimum 
exposure limit.
    6. At any time a locked or crossed market exists for a Nasdaq 
National Market security, a market maker with a quotation for that 
security in Nasdaq that is causing the locked or crossed market will 
have orders delivered by NPROVE for that market maker to 
execute irrespective of any preference indicated by the order entry 
firm.
    7. For each security in which a market maker is registered, the 
market maker may not enter orders on an agency basis into 
NPROVE, unless a locked or crossed market exists for that 
security. This prohibition against use of NPROVE does not 
obviate the market maker's duty to give its agency orders best 
execution in the prevailing market, according to the Board of 
Governor's Interpretation on Executions of Retail Transactions, 
Article III, Section 1 of the NASD Rules of Fair Practice.
    8. The market maker may terminate its obligation by keyboard 
withdrawal from NPROVE at any time. However, the market 
maker has the specific obligation to monitor its status in 
NPROVE to assure that a withdrawal has in fact occurred. Any 
transaction occurring prior to the effectiveness of the withdrawal 
shall remain the responsibility of the market maker. In the case of 
a Nasdaq SmallCap security, a market maker whose exposure limit is 
exhausted will be deemed to have withdrawn from NPROVE and 
may reenter at any time. In the case of a Nasdaq National Market 
security, a market maker whose exposure limit is exhausted will have 
a closed quote in NPROVE and will be permitted a standard 
grace period within which to take action to restore its exposure 
limit. A market maker that fails to renew its exposure limit in a 
Nasdaq National Market security within the allotted time will be 
deemed to have withdrawn as a market maker. Except as provided in 
subsection (9) below, a market maker that withdraws from a Nasdaq 
National Market security may not re-register in NPROVE as a 
market maker in that security for twenty (20) business days.
    9. Notwithstanding the provisions of subsection (8) above, (i) a 
market maker that obtains an excused withdrawal pursuant to Part V 
of Schedule D to the NASD By-Laws prior to withdrawing from 
NPROVE may reenter NPROVE according to the 
conditions of its withdrawal; and (ii) a market maker that fails to 
maintain a clearing arrangement with a registered clearing agency or 
with a member of such an agency, and is thereby withdrawn from 
participation in ACT and NPROVE for Nasdaq National Market 
securities, may reenter NPROVE after a clearing arrangement 
has been reestablished and the market maker has complied with ACT 
participant requirements. Provided however, that if the Association 
finds that the ACT market maker's failure to maintain a clearing 
arrangement is voluntary, the withdrawal of quotations will be 
considered voluntary and unexcused pursuant to Schedule D and these 
rules.
    10. In the event that a malfunction in the market maker's 
equipment occurs rendering on-line communications with the 
NPROVE service inoperable, the NPROVE market maker 
is obligated to immediately contact the Market Operations Center by 
telephone to request withdrawal from NPROVE. For Nasdaq 
National Market securities, such request must be made pursuant to 
the requirements of Part V, Schedule D to the NASD By-Laws. If 
withdrawal is granted, Market Operations personnel will enter the 
withdrawal notification into NPROVE from a supervisory 
terminal. Such manual intervention, however, will take a certain 
period of time for completion and the NPROVE market maker 
will continue to be obligated for any transaction executed prior to 
the effectiveness of its withdrawal.
    b. NPROVE Order Enter Firms
    1. Agency orders may be entered in NPROVE by the 
NPROVE order entry firm through either its Nasdaq 
Workstation or computer interface. The system will transmit to the 
order entry firm on the Nasdaq Workstation screen and printer, if 
requested, or through a computer interface, as applicable, an 
execution report generated following each execution.
    2. NPROVE will accept both market and limit agency order 
for execution. Agency orders may be preferenced to a specific 
NPROVE market maker or may be unpreferenced, thereby 
resulting in execution in rotation against NPROVE market 
makers. If an order is preferenced to a market maker by an order 
entry firm from which it has not agreed to accept preferencing, the 
order will be executed on an unpreferenced basis.
    3. Only agency orders no larger than the maximum order size may 
be entered by an NPROVE order entry firm into NPROVE 
for execution against an NPROVE market maker. Agency orders 
in excess of the maximum order size may not be divided into smaller 
parts for purposes of meeting the size requirements for orders 
entered into NPROVE. All orders based on a single investment 
decision that are entered by an NPROVE order entry firm for 
accounts under the control of associated persons or public 
customers, whether acting alone or in concert with other associated 
persons or public customers, will be deemed to constitute a single 
order and will be aggregated for determining compliance with the 
maximum order size limits. Orders entered by the NPROVE 
order entry firm within any five-minute period in accounts 
controlled by associated persons or public customers, acting alone 
or in concert with other associated persons or public customers, 
will be presumed to be based on a single investment decision. An 
associated person or customer will be deemed to control an account 
if the account is a personal account; the person exercises 
discretion over the account; the person has been granted a power of 
attorney over the account; or the account is the account of an 
immediate family member as that term is defined in the Board of 
Governors Interpretation on Free-Riding and Withholding, Article 
III, Section 1 of the NASD Rules of Fair Practice.
    4. No order will be considered an agency order from a public 
customer if it is for any account of a person associated with any 
member firm or any account controlled by such an associated person. 
No order will be considered any agency order from a public customer 
if it is for any account of a member of the ``immediate family'' (as 
that term is defined in the NASD Free-Riding and Withholding 
Interpretation, Article III, Section 1 of the Rules of Fair 
Practice) of an associated person who has physical access to a 
terminal capable of entering orders into NPROVE.
    5. No member or person associated with a member shall utilize 
NPROVE for the execution of agency orders in a security in 
which the member is a Nasdaq market maker but is not an 
NPROVE market maker.
    6. No short sales may be entered into NPROVE.

(5) Execution of NPROVE Orders

    a. Orders in Nasdaq equity securities entered into 
NPROVE may be preferenced or unpreferenced. Preferenced 
orders will be delivered to the designated market maker. Except as 
provided in subparagraph (c) below, unpreferenced orders will be 
delivered to market makers at the current inside bid or offer in 
rotation. Odd-lot orders (orders of less than 100 shares) will be 
automatically executed in NPROVE and execution reports will 
be delivered to the order entry firm and the market maker.
    b. Limit orders may be entered into NPROVE. A limit 
order priced at the Nasdaq inside market when the order is delivered 
to an NPROVE market maker will be handled as a market order. 
Limit orders priced outside the Nasdaq inside market will be stored 
in the NPROVE limit order file, and when the inside market 
equals or betters the limit price, the order will be handled as a 
market order. Limit orders priced better than the inside market upon 
entry will establish the price at which subsequent incoming market 
orders on the other side of market may be priced and executed (e.g., 
a sell order priced between the best bid and offer would improve the 
price of an incoming buy order). Market makers will receive 
notification of the existence of a limit order priced better than 
the inside market on their quote retrieval screens; provided 
however, notification of the existence of a preferenced limit order 
will only be delivered to the designated market maker. A limit order 
priced better than the inside market in Nasdaq may also be matched 
and executed against an incoming market or limit order, on the other 
side of the market, without the participation of a market maker.
    c. Market orders may be entered into NPROVE. A market 
order will be delivered to a market maker for execution at the 
current inside market (buy orders will be executed at the best offer 
and sell orders at the best bid). If a limit order previously has 
been entered into NPROVE at a price superior to the best bid 
or offer, the incoming market order will be repriced to match the 
limit order price and will be displayed for 15 seconds to market 
makers at the inside quote. That order will either be executed by a 
market maker or will be matched and executed against the limit 
order. All market orders entered into NPROVE will be 
executed in compliance with market maker obligations as established 
in subsection (4).

(6) Clearance and Settlement

    All transactions executed in NPROVE shall be transmitted 
to the National Securities Clearing Corporation to be cleared and 
settled through a registered clearing agency using a continuous net 
settlement system.

(7) Obligation to Honor System Trades

    If an NPROVE participant, or clearing member acting on 
its behalf, is reported by NPROVE to clearing at the close 
of any trading day, or shown by the activity reports generated by 
NPROVE as constituting a side of an NPROVE trade, 
such NPROVE participant, or clearing member acting on its 
behalf, shall honor such trade on the scheduled setttlement date.

(8) Compliance With Procedures and Rules

    Failure of an NPROVE participant or person associated 
with an NPROVE participant to comply with any of the rules 
or requirements of NPROVE may be considered conduct 
inconsistent with high standards of commercial honor and just and 
equitable principles of trade, in violation of Article III, Section 
1 of the Rules of Fair Practice. No member shall effect an 
NPROVE transaction for the account of a customer, or for its 
own account, indirectly or through the offices of a third party, for 
the purpose of avoiding the application of these rules. Members are 
precluded from doing indirectly what is directly prohibited by these 
rules. All entries in NPROVE shall be made in accordance 
with the procedures and requirements set forth in the NPROVE 
User Guide. Failure by an NPROVE participant to comply with 
any of the rules or requirements applicable to NPROVE shall 
subject such NPROVE participant to censure, fine, suspension 
or revocation of its registration as an NPROVE market maker 
and/or order entry firm or any other fitting penalty under the Rules 
of Fair Practices of the Association.

(9) Termination of APROVE Service

    The Association may upon notice, terminate NPROVE 
service to a participant in the event that a participant fails to 
abide by any of the rules or operating procedures of the 
NPROVE service or the Association, or fails to pay promptly 
for services rendered.

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 NASD is proposing rules of operation and procedures for a new 
service for the delivery, handling and execution of investors' small-
sized agency orders. The ``NPROVE'' service, operated by The 
Nasdaq Stock Market, Inc., will provide automated executions of 
investors' small agency orders in Nasdaq equity securities, and will 
offer new opportunities for price improvement of market orders. The new 
service will also heighten protections for investors' limit orders 
while enhancing the ability of market makers to monitor and maintain 
competitive quotations accessible to investors participating in an 
automated execution environment.
    NPROVE has been developed to improve the communication and 
handling of small investor orders so they will receive a prompt, cost 
effective execution at the best price available in the marketplace at 
any particular point in time. NPROVE will facilitate delivery 
and execution of small-sized investor orders in Nasdaq equities to 
market makers participating in NPROVE. Participation is 
required for all market makers registered in Nasdaq National Market 
securities but is voluntary with respect to Nasdaq SmallCap issues. 
Orders entered into the service may be preferenced to a particular 
market maker that agrees to accept preferencing or neutrally routed on 
an unpreferenced basis to the appropriate market maker at the inside 
quotation (best bid or offer) in the Nasdaq market. As discussed in 
more detail below, the NPROVE service will deliver orders to 
market makers for execution and has been designed with default 
execution parameters if the market maker does not manually accept the 
order within a 15-second time frame. NPROVE will also, 
consistent with the Commission's quote rule, Rule 11Ac1-1, permit 
market makers to decline to execute unpreferenced orders if the market 
maker has effected, or is in the process of effecting, an execution in 
the security and has updated (or is in the process of updating) its 
quote in Nasdaq. When such a decline takes place, the order is passed 
on to other market makers in the issue for prompt execution.
    Significantly, NPROVE will provide an interactive limit 
order processing capability that will facilitate price improvement for 
incoming market (or limit) orders and price protection for limit 
orders. The limit order file will store priced orders in time priority 
as they enter the system and will deliver the orders for execution as 
the inside market reaches the limit price. Where limit orders residing 
in NPROVE are at prices superior to the best bid or offer, 
subsequent incoming market orders will be priced for execution at the 
limit order price and will either be executed at the improved price by 
a market maker or will be matched and executed against the limit order 
without the participation of a market maker.
    NPROVE has been developed to respond more effectively to 
the respective needs of three constituencies--individual investors 
seeking timely execution of small market orders at the best available 
price; individual investors seeking a different price over that readily 
available in the market by using limit orders; and market makers 
needing a cost effective alternative to the negotiation and manual 
processing of small investor orders. Accordingly, NPROVE will 
provide what each party needs--a reliable, optimally priced execution 
for the customer with opportunities for price improvement together with 
a cost effective, automated execution system with trade reporting and 
locked-in trades that obviates the need for individual order 
negotiation and processing.
    NPROVE will replace the Small Order Execution System 
(``SOES''), which does not offer the opportunity for price improvement 
of customer orders or afford market makers the opportunity to interact 
with orders in a manner consistent with their firm quote obligations. 
The new NPROVE service constructively responds to concerns that 
automatic, quote-based execution systems do not provide sufficient 
opportunities for price improvement. NPROVE's enhanced 
processing of limit orders and market orders will significantly expand 
public customers' abilities to achieve price improvement--an important 
benefit identified in the SEC's recent Market 2000 study.\3\ 
NPROVE's price improvement features will significantly expand 
the ability of member firms to achieve a better-priced execution for 
their small customer orders and will enhance the protections offered to 
limit orders priced between the spread.
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    \3\Market 2000; An Examination of Current Equity Market 
Developments; Division of Market Regulation, SEC (January 1994).
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    Additionally, the new NPROVE service will enable market 
makers to manage risk effectively. The NASD is concerned that the lack 
of opportunity for a market maker to respond to an order as it is 
presented through the existing SOES system seriously interferes with 
participants' ability to manage risk and undermines market makers' 
control of their capital and trading positions. By enabling market 
makers to accept or reject orders (if they are in the process of 
trading or have already traded and are updating their quote), the 
NPROVE service permits market makers to engage in effective 
risk management while providing price discovery in an automated 
execution environment. NPROVE has been designed as an order 
delivery system with default execution parameters to ensure the 
continuation of market depth, liquidity, and price discovery mechanisms 
in the Nasdaq market. The new delivery and execution functionality will 
more accurately reflect market makers' affirmative obligations to 
provide liquidity to the market, while not depriving market makers of 
the exceptions from the firmness requirements contained in Rule 11Ac1-
1, the Commission's firm quote rule.
1. System Operations
    The new NPROVE system will feature the following 
operations:
     Enhanced market making functionality.
    The order processing functions in NPROVE will provide 
market makers with several options for handling incoming orders. The 
market maker may either accept the order immediately or allow the 
system to execute the order automatically after a short time period (15 
seconds). In addition, the market maker may reject the order if it has 
effected a trade (or is in the process of executing a transaction in 
the security) and has updated its quote (or is in the process of 
updating its quote). This procedure allows dealers to more effectively 
monitor and react to market movements, to timely update their 
quotations following the execution of NPROVE and other orders, 
or to reject an NPROVE order if they are in the process of 
trading or have already traded at that price. As the SEC acknowledges 
in Rule 11Ac1-1, it is appropriate to give market makers an opportunity 
after an execution to adjust their quotations to reflect new 
information or in consideration of their inventory position.
    Order entry firms have two alternatives when entering orders in 
Nasdaq stocks into NPROVE--they may preference the order to a 
particular market maker (with whom they have established a preferencing 
arrangement through the system) or they may enter an unpreferenced 
order into NPROVE.\4\ A preferenced order will be delivered to 
the designated market maker who may manually execute the order or let 
the system automatically execute the order after 15 seconds. Once a 
market maker agrees to accept preferencing from an order entry firm, 
the market maker effectively waives the ability to reject an order, 
although the market maker may use the 15-second time period following 
receipt of the preferenced order to update its quotation so that a 
second order will not be presented for execution at the same quote.\5\
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    \4\Odd-lot orders (orders of less than 100 shares) entered into 
NPROVE will be executed automatically at the best bid or 
offer in Nasdaq and market makers will receive execution reports 
rather than orders.
    \5\Preferencing arrangements are common throughout the 
securities industry and reflect agreements to accept order flow for 
execution from specific order entry firms. Accordingly, a 
preferenced order may not be rejected.
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    An unpreferenced order will be routed to the market maker at the 
inside bid or offer that is next in line for an NPROVE 
execution. The market maker may manually execute the trade or allow the 
system to automatically execute the trade after 15 seconds. If the 
market maker has effected a trade (or is in the process of executing a 
trade in that security) and has updated its quotation (or is in the 
process of updating), it may reject the NPROVE unpreferenced 
order. When, consistent with the requirements of Rule 11Ac1-1, an order 
is rejected by the first market maker in rotation, the order will 
automatically be displayed to all remaining market makers at the inside 
quote. All of these market makers will have the opportunity to execute 
the order during a 15 second period. If no market maker manually 
accepts the order, it will be automatically executed against the first 
market maker in rotation. In the unlikely event that all of these 
market makers reject the order pursuant to a valid exception from Rule 
11Ac1-1, the order will be executed automatically by the first market 
maker in rotation quoting at the new inside market. As the system only 
allows a few seconds for each of these steps, every NPROVE 
order is assured a timely execution, usually within 15 seconds of it 
being delivered to the first market maker. Once the execution has been 
accomplished, whether on a preferenced or unpreferenced basis, the 
order entry firm and market maker will each receive an execution report 
on their NPROVE message area on the Nasdaq Workstation.
    An additional feature in NPROVE allows market makers to 
receive additional order flow if they establish a new quotation that 
betters the current inside quote in the Nasdaq market. When a market 
maker improves its bid or offer to better the inside bid or offer, it 
is placed first in rotation to receive NPROVE unpreferenced 
orders. When other market makers adjust their quotes to match the new 
inside quote, the initial market maker at that quote will be able to 
maintain its priority status, receiving all unpreferenced orders 
regardless of the delivery mechanisms that usually send orders to the 
market makers at the inside quote in rotation, if the initial market 
maker manually accepts each order. For a short period (initially 
established as five minutes or five executions, whichever comes first), 
all unpreferenced orders will be routed to the market maker first in 
rotation, until such time as that market maker rejects an order, allows 
the system to automatically execute an order, or a new inside has been 
established. When any of these events occur, the usual order delivery 
routines will commerce.
     Price improvement and limit order protection.
    The operation of the NPROVE system facilities price 
improvement of incoming NPROVE market orders while providing 
price protection for limit orders placed in between the spread in 
Nasdaq.\6\ Price improvement could occur whenever a limit order between 
the spread was placed in the system. All market makers in the issue 
will be alerted when such a limit order has been entered between the 
spread to permit the market maker immediate access to the order for 
execution.\7\ If the limit order remains open, the next incoming market 
order on the opposite side of the market (e.g., the limit order is to 
sell stock and the market order is to buy stock) would automatically 
``pass over'' or read the limit order file to see if there are any 
orders residing in the limit order file at prices superior to the best 
bid or offer in the Nasdaq marketplace. If limit orders at a superior 
price exist, then the market order will be displayed on the screen at 
that superior price, rather than at the inside bid or offer, as the 
case may be. In that event, all market makers at the inside quotation 
would have the opportunity for 15 seconds to execute the market order 
at the superior limit price. If no market maker elected to execute the 
order at that improved price, the system would execute the orders 
against each other at the limit price. Thus, Nasdaq market makers would 
retain the ability to interact with orders and improve market prices 
through the system while providing customers that place limit orders 
between the spread price protection and the possibility of an execution 
within seconds of a market order entering the system. A limit order 
priced better than the inside Nasdaq market continues to set the price 
for incoming market orders until it is executed, whether as a match 
against a market order (or another limit order priced in between the 
spread), or as an execution from a market maker. Thus customers placing 
market orders receive price improvement and customers placing limit 
orders will be assured that NPROVE executions will not occur at 
prices inferior to their limit prices.
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    \6\The system also includes a matching and/or price improvement 
feature for limit orders entered in between the spread. For example, 
if the inside bid and offer were 20--20\1/2\, and two limit orders 
were entered to buy and sell at 20\1/4\, the system would allow the 
orders to match against each other within 15 seconds. If two limit 
orders crossed each other in between the inside spread (i.e., a buy 
order priced at 20\3/8\ and a sell order priced at 20\1/8\), the 
orders would be matched after 15 seconds and the price averaged 
between the orders (each would receive 20\1/4\).
    \7\If the limit order is preferenced to a single market maker, 
only that market maker would receive the limit order alert. The 
incoming market orders would still receive the benefits of price 
improvement, however, regardless of preferencing.
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    For example, if the inside market on a Nasdaq security is 20--20\1/
4\ and a limit order to buy at 20\1/8\ is entered, the next incoming 
sell order will be priced at 20\1/8\ and will be displayed to the 
market makers at the inside quote. If the market order is executed by a 
market maker at 20\1/8\, that customer receives \1/8\ point more than 
the current best quoted price, and each subsequent incoming market 
order is priced at the limit order price until the limit and market 
orders execute against each other or the limit order is executed 
independently by a market maker. If no market maker manually accepts an 
improved market order trade, the two investor orders are matched 
against each other at a price of 20\1/8\.
2. Scope
    The requirements of the NPROVE service would mirror those 
currently in place for the SOES system, with the modifications 
described above to facilitate price improvement and risk management 
features.\8\ The following changes have also been proposed: (1) To 
establish a maximum order size for the most liquid tier of 
NPROVE securities at 1,000 shares; (2) to modify the handling 
of preferenced orders when the market is locked or crossed and (3) to 
prohibit short sales in the system.
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    \8\The current SOES limit order file has also been modified (as 
discussed above) to permit limit orders to interact with market 
orders and to narrow the time frame for matching orders within the 
file from the current five minute period to 15 seconds.
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    The current maximum order size for SOES is 500 shares; the NASD 
believes that with the risk management features of the new service 
implemented, it is appropriate to allow the entry of agency orders up 
to 1,000 shares. Market makers in the most liquid tier of Nasdaq 
securities are currently required to post size in their quotations of 
1,000 shares, and the ability to execute such sizes in NPROVE 
will facilitate executions of agency orders in compliance with a market 
maker's firm quote obligations.
    When markets in a Nasdaq security are locked or crossed, the new 
delivery mechanisms of NPROVE will facilitate quick resolution 
of the condition by sending each incoming NPROVE order to the 
market maker locking or crossing the market, whether the orders are 
preferenced to that market maker or not. The automated default 
executions will continue to occur until the market maker updates its 
quotation, depletes its exposure limits, or rejects a trade (and 
updates its quote). In this regard, possible receipt of multiple 
executions will encourage the market maker to respond quickly to 
correct the aberrant quote condition.\9\
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    \9\Additional modifications in the NPROVE rules pertain 
to regulatory controls over what is considered an agency order 
eligible for entry into the system. For example, the new rules state 
that: ``No order will be considered an agency order from a public 
customer if it is for any account of a person associated with any 
member firm or any account controlled by such an associated person. 
No order will be considered an agency order from a public customer 
if it is for any account of a member of the ``immediate family'' (as 
that term is defined in the NASD Free-Riding and Withholding 
Interpretation, Article III, Section 1 of the Rules of Fair 
Practice) of an associated person who has physical access to a 
terminal capable of entering orders into NPROVE.'' See 
Section 5(b)(4) of the proposed NPROVE Rules.
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    Finally, one of the NPROVE rules prohibits the entry of 
short sales into the service. The SEC approved this restriction in the 
SOES system for a one year pilot period\10\ because of experience with 
excessive short-term trading occurring in SOES. In its approval for the 
``interim'' SOES rules, the SEC stated that prohibiting short selling 
through SOES was a means reasonably designed to reduce the costs to 
market makers and investors that result from active intra-day trading 
activity through SOES. Having identified the costs associated with 
intra-day trading, the Commission went on to say that any burden placed 
on short sellers was outweighed by the benefits of potentially narrower 
spreads and enhanced liquidity in Nasdaq securities. Further, the SEC 
took into consideration the fact that short sales among typical retail 
investors are infrequent and broker/dealers rarely execute short sales 
through an automated system such as SOES. Accordingly, the Commission 
believed that prohibiting the execution of short sales through SOES was 
an effective means of limiting intra-day trading with little 
concomitant effect on retail investors.
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    \10\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 
58 FR 69419 (Dec. 30, 1993).
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    The NASD believes that the NPROVE service, while offering 
enhanced facilities for market makers to handle exposure to 
transactions such as short sales by enabling them to reject trades if 
they have already traded, still provides an automated execution 
environment that may be susceptible to active intra-day traders. While 
the NPROVE service does provide a 15 second period for a market 
maker to react to an NPROVE order, that time period is 
sufficiently short that there remains a risk of destabilizing short 
term trading through the service. Having identified and analyzed the 
costs associated with active intra-day trading scenarios using the SOES 
system, the NASD believes that prohibiting short sales in 
NPROVE is an appropriate action as it prohibits a narrow, 
generally non-retail type of trading activity from an automated 
execution system, rather than limiting a type of investor or active 
trader from the system. The NASD concurs with the Commission that 
limiting short sales in an automated execution environment is a means 
reasonably designed to assure continued market maker participation and 
liquidity in the market. It is appropriate to exclude discernable 
trading practices that impose excessive risks and costs on market 
makers and jeopardize market quality. Accordingly, the NASD believes 
that prohibiting short sales in NPROVE is necessary and 
appropriate and consistent with requirements of the Act.
    The new NPROVE service addresses the concerns that 
customers cannot achieve price improvement in quote-based execution 
systems and that market makers cannot effectively manage risk in an 
automated execution environment. By allowing market makers to see 
orders prior to their execution, NPROVE is facilitating risk 
management; by alerting members to the existence of a limit order 
between the spread and using that limit price to establish the new 
market price, NPROVE is facilitating price improvement in an 
automated facility. The NASD believes the proposed rule change is 
consistent with sections 15A(b)(6), 15A(b)(9), 15A(b)(11), and 
11A(a)(1)(C) 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. Section 15A(b)(9) requires 
that rules of an Association not impose any burden on competition not 
necessary or appropriate in furtherance of the purposes of the Act. 
Section 15A(B)(11) requires the NASD to formulate rules governing the 
quality of fair and informative quotations. Section 11A(a)(1)(C) finds 
that it is in the public interest to, among other things, assure 
economically efficient execution of securities transactions. The 
fundamental purpose of NPROVE is to assist investors in 
achieving prompt, efficient executions of their small orders and to 
provide an opportunity for price improvement within an automated 
execution environment. The integrity and efficiency of Nasdaq for 
public investors and market-making participants is critical and the 
NASD believes that NPROVE will provide benefits to both 
consistencies. The design of NPROVE is not anti-competitive as 
it treats all unpreferenced orders uniformly; to the extent that 
preferenced orders are distinguished, by entering into preferencing 
arrangements with known customers, market maker's effectively waive the 
protections offered by the system. NPROVE may also enhance the 
quality of quotations in the Nasdaq marketplace as market makers 
participating in the service may be encouraged to narrow the spread and 
improve the best inter-dealer quotations in Nasdaq in order to be first 
in priority and continue to receive unpreferenced order flow through 
NPROVE.
    The new proposals are also fully consistent with the significant 
national market system objectives contained in Section 11A of the Act. 
The facilities of NPROVE would advance these objectives by 
offering efficient execution of investors' small orders, by maintaining 
market maker participation through the automated delivery of orders 
with the ability to reject those orders if trades have already 
occurred, and by offering the opportunity for price improvement to 
NPROVE orders. The system's functionality will more accurately 
reflect market makers' affirmative obligations to provide liquidity to 
the market, without depriving market makers of legitimate exceptions 
from the firmness requirements contained in Rule 11Ac1-1.

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. When fashioning a rule proposal for 
SEC review, an SRO is not required to find the least anti-competitive 
means to achieve a desired result, but the SRO and the SEC must 
determine that the means chosen are necessary or appropriate to achieve 
the objectives of the Act. In its recent approval of the interim 
modifications to the SOES system, the SEC found that it may be 
appropriate to exclude discernable trading practices that impose 
excessive risks and costs on market makers and jeopardize market 
quality. The NASD concurs with this evaluation and accordingly, has 
proposed some of the same restrictions in NPROVE. The design of 
NPROVE is not anti-competitive as it treats all unpreferenced 
orders uniformly; to the extent that preferenced orders are 
distinguished, by entering into preferencing arrangements with known 
customers, market maker's effectively waive the protections offered by 
the system. Accordingly, the NASD believes that the new proposals are 
fully consistent with the requirements of the Act.

c. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received.

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 self-regulatory organization 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. The Commission specifically 
requests that commenters address the handling of limit and market 
orders. The proposal includes the opportunity for price improvement for 
limit and market orders. Limit orders entered in NPROVE priced 
away from the inside market will reside in a limit order file. If 
another limit order on the opposite side of the market is entered that 
either matches or crosses the first limit order, the two limit orders 
will be matched for execution (at either the matching price or, when 
two limit orders cross, at the average price). If a market order on the 
opposite side of the market is entered in NPROVE, it will be 
repriced to match an existing limit order if the limit order provides 
price improvement over the current inside market. Under either 
scenario, however, prior to execution, the system will allow a 15-
second period within which a market maker in the security can execute 
one side of the match at the improved price. While the proposal will 
provide both orders the opportunity for price improvement, it could 
also result in one public order that otherwise would have been executed 
at the improved price to remain unexecuted.
    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 communications 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 file number SR-NASD-94-13 and should be 
submitted by June 29, 1994.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\11\
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    \11\17 CFR 200.30-3(a)(12) (1993).
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Jonathan G. Katz,
Secretary.
[FR Doc. 94-13881 Filed 6-7-94; 8:45 am]
BILLING CODE 8010-01-M