[Federal Register Volume 59, Number 129 (Thursday, July 7, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-16370]


[[Page Unknown]]

[Federal Register: July 7, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34280; File No. SR-NASD-93-10]

 

Self-Regulatory Organizations; Order Approving a Proposed Rule 
Change by National Association of Securities Dealers, Inc. Requiring 
Participation in the Intermarket Trading System by Third Market Makers

June 29, 1994.
    The National Association of Securities Dealers, Inc. (``NASD'') 
submitted to the Securities and Exchange Commission (``Commission'') a 
proposed rule change (File No. SR-NASD-93-10) on March 1, 1993, 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\2\ and Rule 19b-4 thereunder.\2\ The purpose of the proposed 
rule change is to require third market makers registered as 
Consolidated Quotation System (``CQS'') market makers to register and 
participate in the Computer Assisted Execution System (``CAES'') and 
the Intermarket Trading System/Computer Assisted Execution System 
(``ITS/CAES'') interface.\3\
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    \1\15 U.S.C. 78s(b(1).
    \2\On June 10, 1993, the NASD amended the proposed rule change 
to clarify that only third market makers registered as Consolidated 
Quotation Service (``CQS'') market makers must register as ITS/CAES 
market makers. Letter from Robert Aber, Vice President, General 
Counsel/Corporate Subsidiaries, NASD, to Elizabeth MacGregor, Branch 
Chief, National Market System Division of Market Regulation, 
Commission, (June 10, 1993).
    \3\A CQS market marker is a dealer that, with respect to a 
reported security, holds itself out as being willing to buy and sell 
the security for its own account on a regular and continuous basis 
otherwise than on a national securities exchange in amounts less 
than block size and is registered as such. NASD Rules, Schedule D, 
Part I. CAES enables NASD member firms to direct agency orders in 
both exchange-listed and NASDAQ/NMS securities to market makers for 
automatic execution. ITS/CAES enables market makers in Rule 19c-3 
securities to direct agency and principal orders to, and receive 
orders from, the floors of the participating ITS exchanges.
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    Notice of the proposal appeared in the Federal Register on July 8, 
1993.\4\ The Commission received three comment letters opposing the 
proposal.\5\ For the reasons discussed below, the Commission is 
approving the proposal.
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    \4\Securities Exchange Act Release No. 32573 (July 1, 1993), 58 
FR 36726.
    \5\Letters from James E. Buck, Senior Vice President and 
Secretary, New York Stock Exchange, Inc. (``NYSE''), to Jonathan G. 
Katz, Secretary, Commission, (September 24, 1993); George W. Mann, 
Jr., Senior Vice President and General Counsel, Boston Stock 
Exchange, Inc. (``BSE''), to Jonathan G. Katz, Secretary, 
Commission, (September 20, 1993); and James F. Duffy, Senior Vice 
President and General Counsel, Legal & Regulatory Policy Division, 
American Stock Exchange, Inc. (``Amex''), to Jonathan G. Katz, 
Secretary, Commission, (October 22, 1993).
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I. Description

    The third market is where off-exchange, or over-the-counter 
(``OTC''), transactions in listed securities take place. Third market 
makers, registered with the NASD as CQS market makers, disseminate 
quotations through the CQS and through NASDAQ pursuant to rules 
promulgated by the NASD.\6\ CQS market makers, that are not registered 
as ITS/CAES market makers, account for approximately 17% of third 
market share volume in CQS securities. Currently, 33 registered CQS 
market makers are not registered as ITS/CAES market makers or as CAES 
market makers. Only CQS registered market makers make OTC markets in 
listed securities by disseminating quotations through CQS or NASDAQ. 
Thus, only CQS registered market makers are subject to the requirements 
of the proposal.
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    \6\See NASD Rules, Schedule D. Market makers displaying 
quotations in both CQS and in NASDAQ must maintain identical 
quotations in CQS and in NASDAQ. See NASD Rules, Schedule D, Part 
VI, Section 2.
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    The proposed rule change amends Schedules D and G to the NASD By-
Laws and the Rules of Practice and Procedure for the ITS/CAES Automated 
Interface (``ITS/CAES Rules''). The proposal requires registered CQS 
market makers to: (1) register and participate in ITS/CAES and CAES; 
(2) quote minimum sizes of 200 or 500 shares (depending on trading 
characteristics of the securities);\7\ and (3) abide by excess spread 
parameters established for NASDAQ securities.\8\ The proposal also will 
enable market makers to execute principal transactions through CAES for 
those specific securities in which the market maker is registered.
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    \7\NASD By-Laws, Schedule D, Part VI. See also Securities 
Exchange Act Release No. 31678 (January 8, 1993), 58 FR 3314.
    \8\NASD By-Laws, Schedule D, Part VI. See also Securities 
Exchange Act Release No. 32419 (June 4, 1993), 58 FR 32971.
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    The NASD developed CAES to provide a more efficient mechanism for 
OTC trading in listed securities. The ITS/CAES interface commenced 
operation on May 17, 1982.\9\ ITS is a communications network designed 
to facilitate intermarket trading in exchange-listed securities by 
linking the eight national securities exchanges and the NASDAQ 
market.\10\ ITS enables a broker or dealer who is physically present in 
one market center to execute principal or agency orders in an ITS 
security on another market center.
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    \9\In 1981, the Commission issued an order which required 
implementation of an automated interface between the ITS and CAES. 
Securities Exchange Act Release No. 17744 (April 21, 1981), 46 FR 
23856. On May 6, 1982, the Commission adopted final amendments to 
the ITS Plan to provide for the inclusion of the NASD in ITS. 
Securities Exchange Act Release No. 18713 (May 6, 1982), 47 FR 
20413.
    \10\Participants to the ITS Plan include the Amex, the BSE, the 
Chicago Board Options Exchange, Inc. (``CBOE''), the Chicago Stock 
Exchange, Inc. (``CHX''), the Cincinnati Stock Exchange, Inc. 
(``CSE''), the NASD, the NYSE, the Pacific Stock Exchange, Inc. 
(``PSE''), and the Philadelphia Stock Exchange, Inc. (``PHLX'').
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    The ITS/CAES interface permits members of participant markets to 
execute transactions in Rule 19c-3 securities between the exchanges and 
the OTC market.\11\ The proposal will require registered NASD market 
makers that trade Rule 19c-3 securities to register and participate in 
ITS/CAES. For non-Rule 19c-3 securities, which are not eligible for 
trading through the ITS/CAES interface, registered market makers will 
be required to register and participate in CAES. Currently, 
participation in ITS/CAES and CAES by CQS market makers is voluntary.
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    \11\The ITS Plan limits securities eligible for trading through 
the ITS/CAES interface to Rule 19c-3 securities. Rule 19c-3 
precludes off-board trading restrictions from applying, with certain 
exceptions, to any reported security: (1) which was not traded on an 
exchange prior to April 26, 1979, or (2) which was traded on an 
exchange on April 26, 1979 but which ceased to be traded on an 
exchange for any period of time thereafter. Rule 19c-3, 17 CFR 
240.19c-3.
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    The proposal will require ITS/CAES and CAES market makers to quote 
minimum sizes of 200 or 500 shares (depending on trading 
characteristics of the securities) and to abide by excess spread 
parameters established for NASDAQ securities. ITS/CAES market makers 
currently are not required to include minimum sizes in their quotations 
or to comply with the excess spread parameters established for NASDAQ 
securities. The excess spread parameters for NASDAQ and CQS securities 
limit a dealer's spread in a security to 125% of the average of the 
narrowest three dealer spreads in that security.\12\
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    \12\See supra note 8.
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    ITS/CAES enables market makers in Rule 19c-3 securities to direct 
agency and principal orders to, and receive orders from, the floors of 
ITS participant exchanges. Currently, transactions in CAES are limited 
to agency orders. The proposal will enable market makers to execute 
principal transactions through CAES for listed securities in which the 
market maker is registered.

II. Discussion

    The Commission believes that the proposed rule change is consistent 
with the requirements of the Act, and in particular, with Sections 
15A(b)(6), 15A(b)(9), 15A(b)(11), 11A(a)(1)(C), and 11A(a)(1)(D) of the 
Act. Section 15A(b)(6) of the Act requires that the NASD's rules 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 an facilitating 
transactions in securities, to remove impediments to and perfect the 
mechanism of a free and open market and a national market system. 
Section 15A(b)(9) requires that the NASD's rules not impose any burden 
on competition not necessary or appropriate in furtherance of the 
Act.\13\ Section 15A(b)(11) authorizes the NASD to adopt rules 
concerning the form and content of quotations of securities sold in the 
OTC market.\14\ Section 11A grants the Commission the authority to 
facilitate the establishment of a National Market System (``NMS'') for 
securities to implement certain specified Congressional goals and 
objectives. Sections 11A(1) (C) and (D) set forth the Congressional 
finding that the linking of all markets for qualified securities 
through communication and data processing facilities would foster 
efficiency; enhance competition; increase the information available to 
brokers, dealers, and investors; facilitate the offsetting of 
investors' orders; and contribute to best execution of such orders.
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    \13\The Commission believes that any burden on competition that 
may result from the proposal, if any, is necessary and appropriate 
in furtherance of the purposes of the Act.
    \14\The Act requires these rules to be designed to produce fair 
and informative quotations, to prevent fictitious or misleading 
quotations, and to promote orderly procedures for collecting, 
distributing, and publishing quotations. Section 15A(b)(11).
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    The Commission believes that the proposal will facilitate the 
further development of the NMS by integrating all registered market 
makers with intermarket trading in listed securities. This will 
facilitate the ability of third market orders to interact with orders 
of other market participants. Other ITS participant markets currently 
cannot execute, through ITS, transactions with registered third market 
makers that are not registered as ITS/CAES market makers, even when a 
better published quotation may exist in the third market.\15\ Thus, 
despite the ITS/CAES linkage, not all third market orders are exposed 
to other ITS participants. This inhibits a broker's ability to ensure 
best execution of customer orders and impedes fair competition between 
and among different types of trading markets and market professionals.
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    \15\The quotations of all third market makers are consolidated 
into a composite third market quote and disseminated through CQS to 
the exchange floors and to quotation vendors. Therefore, while third 
market quotations are visible to other markets, they may not be 
accessible through the ITS/CAES interface.
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    The proposal will facilitate the development of a more efficient 
market linkage for concurrent exchange and OTC trading of listed 
securities. The ITS/CAES interface is designed to permit the execution 
of orders routed to exchange floors in the OTC market when more 
favorable prices are offered by OTC market makers. The ITS/CAES 
interface likewise provides OTC market makers access to rapid execution 
of their orders on exchange floors when exchange markets are quoting 
better prices. The proposal will facilitate interaction of orders in 
Rule 19c-3 securities in all market centers, and thus, will increase 
competition between the markets for order flow in Rule 19c-3 
securities. For non-Rule 19c-3 securities, CAES provides an efficient 
mechanism for OTC trading of listed securities.
    By extending application of ITS Plan provisions to all registered 
third market makers, the proposal also will provide consistent trading 
rules for multiple trading of listed securities. The ITS Plan provides 
uniform rules governing: (1) Trade-throughs, to provide price 
protection for customer orders;\16\ (2) block trades, to enable other 
markets to derive the benefit of a block without breaking it up;\17\ 
(3) pre-openings, to enable other markets to participate in the primary 
market's opening of a security;\18\ and (4) dispute resolution, to 
enable efficient resolution of disputes between market centers.\19\
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    \16\A trade-through occurs when an ITS participant initiates a 
purchase of an ITS security at a price that is higher than the price 
at which the security is being offered at another ITS participating 
market; or initiates the sale of an ITS security at a price that is 
lower than the price at which the security is being bid at another 
ITS participant.
    \17\A block trade is a trade that:
    (1) involves 10,000 or more shares of a common stock traded 
through ITS or a quantity of any such security having a market value 
of $200,000 or more (``block size'');
    (2) is effected at a price outside the bid or offer displayed 
from another ITS participating market center; and
    (3) involves either:
    (i) a cross of block size (where the member represents all of 
one side of the transaction and all or a portion of the other side), 
or
    (ii) any other transaction of block size (i.e., in which the 
member represents an order of block size on one side of the 
transaction only) that is not the result of an execution at the 
current bid or offer on the exchange.
    \18\The ITS pre-opening application enables an ITS participant 
who wishes to open his or her market in an ITS security to solicit 
any pre-opening interest in that security of other market makers 
registered in that security in other participant markets. This 
allows other ITS market makers to participate as either principal or 
as agent in the opening transaction, which may ameliorate 
disparities between pre-opening orders.
    \19\The ITS Plan provides for procedures by which participants 
can obtain a non-binding opinion on a dispute between ITS 
participants on the application or interpretation of the ITS Plan 
and model rules.
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    The amendments regarding size of displayed quotations and excess 
spread parameters will improve the quality of the third market, and 
thus, will facilitate efficient OTC trading of listed securities. The 
proposal will require CQS market makers to quote a minimum size of 200 
or 500 shares, depending on price, volume, and number of market makers 
in the security; and will impose excess spread parameters comparable to 
those in the NASDAQ market.
    The proposal also allows principal market maker transactions in 
listed securities through CAES for securities in which the market maker 
is registered and active. The Commission does not perceive any basis 
for limiting CAES to agency orders. The proposal will not affect the 
provisions of the ITS Plan, which apply to both principal and agency 
transactions. The proposal will allow market makers to obtain 
electronic access to the quotations of other market makers through CAES 
and thus, will reduce reliance on telephone contact.
    The Amex, BSE, and NYSE submitted comment letters on the 
proposal.\20\ These exchanges commented that the proposal does not 
apply to all third market makers, but applies only to third market 
makers currently registered as CQS market makers with the NASD.\21\ The 
NYSE also commented that third market and exchange transaction 
reporting in listed securities are not consistent.\22\
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    \20\Supra note 5.
    \21\The NYSE commented that these firms may ``internalize'' 
customer orders by executing third market transactions ``in-house'' 
without exposing the orders to other market participants. The NYSE 
stated that NASD member firms may internalize customer orders by 
trading against such orders, or by holding themselves out, often 
through proprietary automatic execution systems, as willing to buy 
and sell listed securities. The NYSE believes that allowing 
brokerage firms to trade listed securities, without registering as 
CQS market makers or disseminating any quotations, allows trading of 
listed securities outside the provisions of ITS price protection 
rules. Id.
    \22\The NYSE believed that transaction reporting in the OTC 
market is not comparable to transaction reporting on exchanges 
because the NASD's rules require the price reported by market makers 
to be ``reasonably related to the prevailing market.'' See NASD 
Rules, Schedule G, Section 2.
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    The Commission acknowledges that brokerage firms that execute 
transactions in listed securities in the OTC market are not required, 
by Commission or NASD Rules, to register with the NASD as market 
makers. Brokerage firms not registered with the NASD as market makers 
cannot disseminate quotations in CQS or NASDAQ for listed 
securities.\23\
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    \23\As discussed above, only CQS market makers may disseminate 
quotations through CQS or Nasdaq.
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    The commentators' arguments against the current proposal, however, 
appear to based on the assumption that requiring all CQS market markets 
to register and participate in ITS will increase the extent of 
internalization in Rule 19c-3 securities. In its study of the U.S. 
equity market, the Division of Market Regulation (``Division'') 
considered concerns regarding internalization of transactions in Rule 
19c-3 securities.\24\ After examining data on off-board trading for 100 
most active NYSE issues during 1992,\25\ the division determined that 
the extent of internalization of transactions in Rule 19c-3 securities 
was not significant.\26\ In addition, in their letters in response to 
the Division's study,\27\ the Amex and the regional exchanges urged 
that all third market makers be required to become part of the ITS/CAES 
linkage and subjected to the ITS trade through rules.\28\
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    \24\Division of Market Regulation, Securities and Exchange 
Commission, Market 2000, An Examination of Current Equity Market 
Developments, (January 1994), (``Market 2000''), Study III at 8-10.
    \25\Of these stocks, 20 stocks were Rule 19c-3 stocks that are 
not subject to off-board trading restrictions and 80 were covered by 
off-board trading restrictions, NYSE Rule 390.
    \26\The Division's analysis revealed that the exchange markets 
have remained the primary marketplace for securities that are not 
subject to off-board trading restrictions. In addition, the mean 
proportion of reported share volume executed OTC for the 20 Rule 
19c-3 stocks was 8% versus 5.2% for the 80 stocks subject to off-
board trading restrictions. Even if the 2.8% difference between the 
figures is wholly attributable to internalization by NYSE firms, it 
is not a large figure. It is less than the volume in these stocks 
sent by NYSE members to affiliated specialists at regional 
exchanges. Market 2000, Study III at 10.
    \27\The Division requested comments regarding its equity market 
study in Securities Exchange Act Release No. 30920 (July 14, 1992), 
57 FR 32587.
    \28\See letters to Jonathan G. Katz, Secretary, Commission, from 
James R. Jones, Chairman, Amex, (December 8, 1992); and from William 
G. Morton, Jr., BSE, John L. Fletcher, CHX, Leopold Korins, PSE, and 
Nicholas A. Giordano, PHLX, (December 11, 1992).
    The Commission believes that the ITS trade-through policy should 
apply to all third market trading. See Market 2000, Study III, at 
13, 14.
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    The NASD's proposal will increase the interaction and exposure of 
third market making activity to other markets by requiring all 
registered CQS market makers to participate in ITS/CAES. Thus, the 
proposal will increase the universe of third market trading subject to 
the ITS price protection rules. On balance, the proposal will benefit 
the market, advance the development of an NMS, and meet statutory 
goals. Thus, the Commission believes that the NASD's proposal 
represents a significant step in the interaction and exposure of 
securities in the NMS.
    The NYSE also commented that transaction reporting by third market 
makers is not comparable to transaction reporting by exchanges. Because 
the NASD's rules require the price reported by third market makers be 
``reasonably related to the prevailing market,'' the NYSE believes that 
third market makers may report a transaction price different from the 
execution price confirmed to customers.
    In 1980, the NASD amended its rules to require third market makers 
to report transactions on a ``gross'' basis, excluding any mark-up, 
mark-down, or service charge.\29\ The NASD's reporting requirements 
effectively eliminated any disparity in transaction reporting between 
the exchange and the third market.\30\ These rules are still in effect. 
In addition, Rule 10b-10 under the Act requires broker-dealers to 
report on confirmations the trade price and mark-up in principal 
transactions. Because Rule 10b-10 requires that the trade price broker-
dealers disclose on a customer confirmation be the same as that 
disseminated for transaction reporting, the rule prevents broker-
dealers from reporting a transaction price different from that 
confirmed to customers.\31\ The Commission continues to believe that 
transaction reporting by the third market is sufficiently comparable to 
transaction reporting by the exchange market.
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    \29\See Securities Exchange Act Release No. 16960 (July 7, 
1980), 45 FR 47291. To ensure adherence to the rule, the NASD also 
requires the price reported to be reasonably related to the 
prevailing market. Generally, the mark-up is the difference between 
the price the customer paid for the stock and the prevailing market 
price. Thus, the price third market makers report to the 
consolidated tape should, at all times, be the ``gross'' price 
excluding any dealer mark-up or mark-down.
    \30\In 1981, the PSE raised concerns regarding third market 
transaction reporting, similar to those of the NYSE, to oppose the 
implementation of the ITS/CAES interface. Because the NASD requires 
transaction reporting on a gross basis, the Commission stated that 
the PSE's concerns were not warranted. Securities Exchange Act 
Release No. 17744 (April 21, 1981), 46 FR 23865.
    \31\Securities Exchange Act Release No. 22397 (March 17, 1985), 
50 FR 37648.
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III. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule change is consistent with the Act and the rules and regulations 
thereunder applicable to the NASD and, in particular, Sections 
15A(b)(6), 15A(b)(9), 15A(b)(11), 11A(a)(1)(C), and 11A(a)(D) of the 
Act.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change described above be, and hereby is, 
approved.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 94-16370 Filed 7-6-94; 8:45 am]
BILLING CODE 8010-01-M