[Federal Register Volume 59, Number 233 (Tuesday, December 6, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-29932]


[[Page Unknown]]

[Federal Register: December 6, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35024; File No. SR-NASD-94-13, Amendment No. 3]

 

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

November 29, 1994.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on November 21, 1994, the 
National Association of Securities Dealers, Inc. (``NASD'' or 
``Association'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC'') an amendment to a proposed rule change 
previously published for comment.\2\ The amendment is 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, as amended, from interested persons.
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    \1\15 U.S.C. 78s(b)(1).
    \2\See Securities Exchange Act Release No. 34145 (June 1, 1994), 
59 FR 29649 (June 8, 1994) (notice of filing, incorporating 
Amendment No. 1) and Securities Exchange Act Release No. 34453 (July 
28, 1994), 59 FR 39808 (Aug. 4, 1994) (notice of Amendment No. 2).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD is amending its proposed rules governing the operation of 
The Nasdaq Primary Retail Order View and Execution System 
(``NPROVE''), a new system developed by The Nasdaq Stock 
Market, Inc. (Nasdaq) for the execution of small-sized customer orders 
that provides individual investors enhanced limit order protection and 
important price improvement opportunities through an enhanced automated 
system. Specifically, the NASD is proposing a variety of amendments to 
NPROVE designed to: (1) Enhance the operational efficiency of 
the system; (2) increase the breadth of exposure of limit orders 
entered into the system priced between the inside bid or offer, which 
increased limit order exposure will facilitate greater opportunities 
for order interaction within the inside market on Nasdaq; (3) further 
improve the opportunities for price improvement available through 
NPROVE; (4) expand the types of orders (i.e., short sales) that 
may be entered into NPROVE, and, thereby, afford a broader 
spectrum of retail orders in Nasdaq an opportunity to take advantage of 
NPROVE's price improvement and limit order protection features; 
and (5) facilitate the efforts of NASD members to provide their 
customers with the same quality of order execution that they would have 
received had their orders been entered into NPROVE. Following 
is the text of the proposed rule change. (Additions are italicized; 
deletions are bracketed.)

Rules of Operation and Procedures for the NPROVE System

(1) Definitions

    a.-g. No change.
    h. The term ``preferenced order'' shall mean an order entered into 
NPROVE and directed to a particular market maker or an order 
entered by a market maker that is self-preferenced. Each market maker 
has the ability to select order entry firms from which it will accept 
preferenced orders.

(2)-(3) No Change

(4) Participant Obligations in NPROVE

    a. Market Makers
    1. No change.
    2. Participation as an NPROVE market maker obligates the 
firm, upon presentation of [preferenced or] a designated, unpreferenced 
market order or marketable limit order[s] (as that term is defined in 
subsection (5)c. below) through the service, to execute [those] such 
order[s]; provided, however, that for a designated, unpreferenced 
order[s], the NPROVE market maker shall have an 
opportunity,a consistent with Rule 11Ac1-1 promulgated under the 
Act 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 designated, 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. An 
NPROVE market maker that receives an undesignated, 
unpreferenced market order or marketable limit order (as that term is 
defined in subsection (5)c. below) through NPROVE also may 
decline such order consistent with Rule 11Ac1-1 promulgated under the 
Act. If a market maker rejects a designated, unpreferenced 
NPROVE order and no other market maker accepts the order within 
the 15-second period, upon expiration of the 15-second period, the 
system will automatically execute the order against the market maker 
next in rotation who received the order on an undesignated basis that 
has not rejected the order. [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 an unpreferenced 
[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 automatically 
executed against the market maker next in rotation at the new inside 
quotation. [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].
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    \a\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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    With the exception of those instances where a market order or 
marketable limit order has matched with a limit order and is processed 
according to the procedures contained in subsection (5)c. below, 
participation as an NPROVE market maker obligates the firm, 
upon presentation of a preferenced market order or marketable limit 
order through the service, to automatically execute such order at the 
inside bid or offer displayed by Nasdaq when the order is processed 
through NPROVE. NPROVE market makers are [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.
    3. Notwithstanding subsection (5)c. below, a[A]n NPROVE 
market maker that improves the best bid or offer in Nasdaq is eligible 
to receive all unpreferenced orders entered into NPROVE on an 
exclusive basis (for a specific period of time or number of executions 
as established by the NASDb) so long as the market maker manually 
accepts the orders prior to automatic execution of the orders.
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    \b\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.-6. No change.
    7. Aside from market makers entering self-preferenced orders into 
NPROVE, f[F]or 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. No change.
    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. No change.
    b. NPROVE Order Entry Firms
    1.-5. No change.
    [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 market orders will be 
automatically executed against the preferenced market maker pursuant to 
subsection (4)a.2. above. Preferenced limit orders to buy (sell) will 
not be treated as preferenced orders unless the limit order price is at 
or above (below) the inside offer (bid), in which case the orders will 
be automatically executed against the preferenced market maker pursuant 
to subsection (4)a.2. above. Preferenced odd-lot orders (orders of less 
than 100 shares) that are market orders or marketable limit orders also 
will be automatically executed against the preferenced market maker. 
[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.]
    Unpreferenced market orders and limit orders will be processed 
according to the procedures established in subsections (5)b. and c. 
below. Unpreferenced o[O]dd-lot orders [(orders of less than 100 
shares)] that are market orders or marketable limit orders will be 
automatically executed in NPROVE against the market maker next 
in rotation at the inside market 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 (e.g., the bid side for a sell 
order) when the order is delivered to an NPROVE market maker 
will be handled as a market order. Limit orders priced away from 
[outside] the Nasdaq inside bid or offer (as the case may be) [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 within [better than] the 
inside market upon entry or thereafter will establish the minimum price 
at which subsequent incoming market orders on the other side of market 
will [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). All Nasdaq Level 2 and 3 subscribers [Market makers] will 
receive notification on their quote retrieval screens of the existence 
of a limit order priced better than the inside market along with an 
indication of which side of the market it is on. [on their quote 
retrieval screens,] regardless of whether the limit order is 
preferenced or unpreferenced [; provided, however, that notification of 
the existence of a preferenced limit order will only be delivered to 
the designated market maker]. A separate dissemination of 
NPROVE limit orders priced between than the inside market 
consisting of the price of the highest priced limit order to buy and 
the price of the lowest priced limit order to sell and the aggregate 
size of all orders at such prices also will be made available to 
securities information processors. A limit order priced better than the 
inside market on Nasdaq shall be automatically executed against a 
subsequent limit order on the opposite side of the market at a price 
equal or superior to the limit price of the initial limit order (a sell 
(buy) limit order priced at or below (above) a limit order to buy 
(sell)), up to the size of the initial limit order or the subsequent 
limit order, whichever is smaller, and without the participation of a 
market maker.
    c. Market orders may be entered into NPROVE. For 
preferenced market orders, if there is no limit order residing in 
NPROVE priced between the inside market on the opposite side of 
the market from the market order, the order will be automatically 
executed against the preferenced market maker at the inside bid or 
offer (buy orders will be executed at the best offer and sell orders at 
the best bid) displayed in Nasdaq when the order becomes subject to 
NPROVE's order execution methodology. For unpreferenced market 
orders, except as provided in subsection (4)a.3. above, if there is no 
limit order residing in NPROVE priced between the inside market 
on the opposite side of the market from the market order, the order 
will be broadcast to all NPROVE market makers at the applicable 
inside market (i.e., market makers at the inside bid will receive 
market orders to sell and market makers at the inside offer will 
receive market orders to buy) displayed in Nasdaq when the order 
becomes subject to NPROVE's order execution methodology for 
acceptance within 15 seconds, with the market maker next in rotation 
for an NPROVE execution receiving an indicator that the system 
will execute the order against him should be fail to reject the order 
or if no other market maker accepts the order (for purposes of these 
rules, market orders with such notifications appended to them are 
referred to as ``designated, unpreferenced orders'' and orders without 
such a notification are referred to as ``undesignated, unpreferenced 
orders''). If a market maker rejects a designated, unpreferenced 
NPROVE order and no other market maker accepts the order within 
the 15-second period, upon expiration of the 15-second period, the 
system will automatically execute the order against the market maker 
next in rotation who received the order on an undesignated basis that 
has not rejected the order. If all market makers decline the order 
consistent with Rule 11Ac1-1 promulgated under the Act, the order will 
be automatically executed against the market maker next in rotation at 
the new inside quotation. [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 has previously been entered into NPROVE at 
a price superior to the best bid or offer, the incoming market order 
will be repriced to a price equal to the limit order price plus 1/16th 
of a point in the case of a limit order to buy or the limit order price 
minus a 1/16th of a point in the case of a limit order to sell [match 
the price of the limit order] and will be displayed for 15 seconds to 
all market makers whose current quotation equals the applicable inside 
quote[, in the case of an unpreferenced market maker in the case of a 
preferenced order]. If no market maker accepts the incoming market 
order within the 15-second period, the market order will be 
automatically executed against the limit order at the limit order 
price. In addition, if adding (subtracting) 1/16th of a point to the 
price of a limit order to buy (sell) would cause the acceptance price 
of the market order to sell (buy) to be at or above (below) the current 
inside offer (bid), then the market order and the limit order will be 
automatically executed against each other at the limit order price 
without the participation of a market maker. [All market orders entered 
into NPROVE will be executed in compliance with market maker 
obligations as established in subsection (4).]

(6)-(9) No Change

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 amendment to 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

    On March 28, 1994, the NASD proposed rules governing the operation 
and procedures for a new service for the delivery, handling and 
execution of individual investors' small-sized agency orders.\3\ The 
NPROVE service, operated by Nasdaq, will provide automated 
executions of individual investors' small agency orders in Nasdaq 
equity securities, and will offer small retail investors new 
opportunities for price improvement of market orders. The new service 
will also heighten protections for individual 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.
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    \3\See Securities Exchange Act Release No. 34145 (June 1, 1994), 
59 FR 29649 (June 8, 1994).
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    The purpose of this proposal is to modify NPROVE to further 
enhance the operational efficiency of the system and enhance the limit 
order protection and price improvement benefits of NPROVE to 
retail investors. As described in more detail below, the NASD proposes 
to enhance the operational efficiency of NPROVE by collapsing 
the current proposal for three rounds of NPROVE order 
processing for unpreferenced orders into one 15-second round. With this 
streamlined order execution procedure, NPROVE will be less 
susceptible to the development of order queues during peak volume 
periods and retail investors will have greater assurance that they will 
receive a timely execution through NPROVE. The NASD also 
proposes to further enhance the price improvement opportunities 
afforded small retail investors through NPROVE by modifying 
NPROVE's order processing algorithm for the execution of 
matched market orders and limit orders. In addition, the NASD proposes 
to modify the limit order processing features NPROVE to provide 
for a broader, more detailed dissemination of NPROVE limit 
order information. With these changes, market participants will have a 
greater opportunity to interact with limit orders in NPROVE, 
thereby enhancing the limit order protection and price improvement 
features of NPROVE. Following is a more detailed description of 
these proposed changes.
1. Collapsing of NPROVE Order Processing Rounds
    As currently designed, the execution of unpreferenced market and 
marketable limit orders may involve up to three 15-second rounds in 
NPROVE.\4\ In light of these three rounds of NPROVE 
order processing, some comment letters submitted to the SEC regarding 
NPROVE have expressed concern that it may take 45 seconds to 
process each order entered into NPROVE.\5\ These commenters 
believe that executing NPROVE orders in 45-second intervals 
will create substantial order queues that will paralyze the system and 
result in investors receiving significantly delayed executions through 
NPROVE at prices wholly unrelated to the quotes that were 
displayed when their orders were entered into the system.
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    \4\ In Round 1, 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 
order or allow the system to automatically execute the order 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 under the Act, an order is rejected by 
the first market maker in rotation, the order will enter Round 2 and 
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 during Round 
2 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. This is called Round 3.
    \5\See, e.g., letters from John C. Coffee, Jr., Adolf A. Berle 
Professor of Law, Columbia University in the City of New York,to 
Jonathan G. Katz, Secretary, SEC, dated August 22, 1994 (``Coffee 
Letter''); and Simon S. Kogan, J.D., L.L.M., Attorney at Law, to 
Jonathan G. Katz, dated August 26, 1994.
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    Given market makers' obligations to adhere to Rule 11Ac1-1 
promulgated under the Act, the NASD believes most NPROVE orders 
would be executed during Round 1 and that it would be extremely rare 
for an NPROVE order to ever go beyond Round 2 order processing. 
As a result, the NASD does not believe that the commenters concerns are 
realistic. Nevertheless, while the NASD does not believe that prolonged 
order queues will develop under the current configuration of 
NPROVE, the NASD thinks it is appropriate to take prudent steps 
to ensure that such order queues do not develop. Accordingly, with one 
limited exception discussed below, the NASD proposes to collapse the 
three rounds of NPROVE order processing into one 15-second 
round.
    Specifically, under the revised order processing methodology, 
unpreferenced market orders entered into the system will be broadcast 
to all NPROVE market makers at the applicable inside market for 
acceptance within 15 seconds, with the market maker next in rotation 
for an NPROVE execution receiving an indicator that the system 
will execute the order against him should he fail to reject the order 
or if no other market maker accepts the order (market orders with such 
notifications appended to them are referred to as ``designated, 
unpreferenced orders'' and orders without such a notification are 
referred to as ``undesignated, unpreferenced orders'').\6\ If a market 
maker rejects a designated, unpreferenced NPROVE order and no 
other market maker accepts the order within the 15-second period, upon 
expiration of the 15-second period, the system will automatically 
execute the order against the market maker next in rotation who 
received the order on an undesignated basis that has not rejected the 
order. If all market makers decline the order consistent with Rule 
11Ac1-1 promulgated under the Act, the order will be automatically 
executed against the market maker next in rotation at the new inside 
quotation. Thus, with this proposal, Rounds 1 and 2 would be 
effectively collapsed into one round and Round 3 would be eliminated 
because orders rejected by all market makers would be executed 
automatically at the new inside market.
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    \6\Market orders matched against limit orders (preferenced or 
unpreferenced) priced between the inside bid or offer also will be 
processed pursuant to this one-round order processing procedure. See 
infra Section 5 for a more detailed description of how market orders 
matching with limit orders will be processed under the NASD's 
proposed revision to NPROVE.
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    Accordingly, with this one-round order processing format, the NASD 
believes even more strongly that significant order queues will not 
occur in NPROVE, during normal trading days or peak volume 
days, and that investors will receive timely executions at prices at or 
superior to the quotes displayed when they entered their orders into 
NPROVE.
    The NASD proposes, however, to retain the ability of NPROVE 
market makers to improve upon the inside bid or offer and achieve a 
``priority market maker'' status; thus, providing a meaningful 
incentive for market makers to narrow their spreads. In particular, as 
currently proposed, when a market maker improves its bid or offer to 
better the inside best bid or offer and it becomes a ``priority market 
maker.'' Thereafter, for a short period of time (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) all unpreferenced NPROVE orders will be directed only to 
that market maker for acceptance within 15 seconds. The priority market 
maker will retain its ``priority'' status only if it does not reject an 
order, allow the system to automatically execute an order after 15 
seconds, or a new inside has been established. Even if other market 
makers adjust their quotes to match the new inside quote established by 
the priority market maker, the priority market maker will be able to 
maintain its priority status, provided the priority market maker 
manually accepts each order within 15 seconds.
    Because of the retention of the ``priority market maker'' feature, 
it is conceivable that an order rejected by a priority market maker 
could take 30 seconds to receive an execution in NPROVE. The 
NASD notes, however, that this potential delay will be limited to a 
single order directed to a priority market maker and that a delay will 
occur only if the market maker declines the order in compliance with 
Rule 11Ac1-1 promulgated under the Act. If a priority market maker 
allows one order to execute against him automatically after 15 seconds 
or it manually accepts all orders, all orders sent to the market maker 
on a priority basis will receive an execution within 15 seconds. 
Moreover, unless the priority market maker declines an order at the 
last second, the maximum length of time the order will be delayed will 
be less than 30 seconds. Accordingly, in weighing the de minimis costs 
to the marketplace resulting from the possibility that a maximum of one 
order directed to any given priority market maker will be delayed for 
no more than 30 seconds, if at all, against the benefits to the 
marketplace derived from providing market makers with an incentive to 
narrow their spreads and improve the prices at which individual 
investors may execute their orders, the NASD believes it is appropriate 
and consistent with the maintenance of fair and orderly markets to 
retain the priority market maker feature of NPROVE.
2. Automatic Execution of Preferenced Market Orders
    Consistent with the NASD's desire to minimize the potential for 
order queues in NPROVE, the NASD is proposing to modify 
NPROVE to provide that preferenced market orders or marketable 
limit orders will be automatically executed against the preferenced 
market maker at the inside bid or offer displayed on Nasdaq when the 
order is processed through NPROVE.\7\ As explained in more 
detail in Section 5 below, preferenced market orders will only be 
automatically executed if they did not match against a limit order 
residing in NPROVE.
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    \7\Previously, preferenced market makers had 15 seconds to 
accept a preferenced market order. They could not decline the orders 
and, if they failed to accept them within 15 seconds, the orders 
would be automatically executed against them.
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3. Modifications to NPROVE's Execution Algorithm for Limit 
Orders to Provide Greater Limit Order Protection and Enhanced Price 
Improvement Opportunities
    As currently proposed, if a limit order is entered into 
NPROVE at a price between the spread, 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 a limit order resides in the 
file at a superior price, then the market order will be flashed on the 
screen at that superior price for acceptance within a brief 15-second 
period, instead of at the inside bid or offer. 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.
    Several comment letters submitted to the SEC regarding 
NPROVE have expressed concern that this order processing 
methodology places limit orders at an unfair disadvantage.\8\ In 
particular, these commenters maintain that the limit orders, which 
provide liquidity to the marketplace at prices inside the best bid or 
offer, are disadvantaged because market makers can trade through them 
by taking out the market order at the limit order price within 15 
seconds and deprive the limit order of an execution for an indefinite 
period of time. To address this concern, the NASD is proposing to 
modify NPROVE to provide that market makers must improve upon 
the limit order price if they want to execute the matched market 
order.\9\ Specifically, under the proposal,\10\ if a limit order is 
residing in NPROVE priced superior to the best bid or offer, 
any incoming market order on the opposite side of the market will be 
repriced to a price equal to the limit order price plus 1/16th of a 
point in the case of a limit order to buy or the limit order price 
minus a 1/16th of a point in the case of a limit order to sell. The 
market order will then be displayed for 15 seconds to all market makers 
whose current quotation equals the applicable inside quote.\11\ If no 
market maker accepts the incoming market order within the 15-second 
period, the market order will be automatically executed against the 
limit order at the limit order price. In addition, if adding 
(subtracting) 1/16th of a point to the price of a limit order to buy 
(sell) would cause the acceptance price of the market order to sell 
(buy) to be at or above (below) the current inside offer (bid), then 
the market order and the limit order will be automatically executed 
against each other at the limit order price without the participation 
of a market maker.\12\
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    \8\See, e.g., letter from Lawrence R. Glosten, Associate 
Professor, Columbia University Graduate School of Business, to 
Jonathan G. Katz, Secretary, SEC, dated August 24, 1994; and Coffee 
Letter, supra note 3.
    \9\As discussed infra at Section 5, preferenced limit orders 
matching against market orders will be processed the same way as 
unpreferenced limit orders.
    \10\In this connection, the NASD notes the contribution of the 
Board of the Securities Traders Association in the formulation and 
endorsement of this concept.
    \11\For example, if the inside market for a security is 10--
10\1/4\ and a limit order to buy at 10\1/8\ is residing in the 
NPROVE limit order file when a market order to sell is 
entered into the system, NPROVE will reprice the market 
order to 10\3/16\ for flash display and acceptance to all market 
makers in that security at the inside bid or offer.
    \12\For example, if the inside market for a security is 10--
10\1/4\ and a limit order to buy at 10\3/16\ is residing in the 
NPROVE limit order file when a market order to sell is 
entered into the system, these orders will be automatically executed 
against each other at a price of 10\3/16\.
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    The NASD believes the proposal strikes a reasonable balance between 
the concern that matched limit orders could remain unexecuted while 
market makers are able to trade at the limit order price without 
executing the limit order and the need to preserve the liquidity of the 
market by ensuring that market makers have an ability to interact with 
customer orders. In this connection, the NASD notes that one of the 
cornerstones of the success of Nasdaq's competing dealer system has 
been the availability of market maker capital to satisfy investors' 
liquidity demands and that this capital is critically dependent on the 
ability of market makers to interact with customer order flow. The NASD 
also notes that the proposal will provide an even greater opportunity 
for price improvement for market orders matching against limit orders, 
as market makers will have to accept them at a price at least a \1/
16\th of a point superior to the price at which they otherwise would 
have matched against the limit orders. In sum, the NASD believes the 
proposal significantly enhances the price improvement and limit order 
protection features of NPROVE and eliminates the possibility 
that a pending limit order will remain unexecuted while other public 
customer orders receive executions at the order's limit price, while 
preserving the liquidity and orderliness of Nasdaq by allowing a 
minimal, yet essential, opportunity for market makers to interact with 
retail order flow.
4. Broader Dissemination of NPROVE Limit Order Information
    The NASD is proposing several amendments to NPROVE and 
other Nasdaq services to achieve a broader, more detailed dissemination 
of NPROVE limit order information. The NASD believes these 
system modifications will facilitate the ability of market participants 
to readily observe and react to limit orders entered into 
NPROVE priced better than the inside market, which, in turn, 
will maximize order interaction in NPROVE and maximize the 
price improvement and limit order protection benefits available to 
investors through NPROVE.
    First, the NASD proposes to create a separate feed of 
NPROVE limit order information to vendors. This feed will 
consist of the price of the highest priced limit order to buy and the 
price of the lowest priced limit order to sell that are inside the best 
bid or offer displayed in Nasdaq, along with the aggregate size of all 
limit orders at such prices. Second, the NASD proposes to modify the 
``NPRV'' indicator displayed when a limit order is residing in 
NPROVE between the spread to indicate which side of the market 
the limit order is on. Third, the NASD is proposing to modify the 
functionality of Nasdaq Workstation I and Nasdaq Workstation II so that 
subscribers can readily obtain information on all limit orders residing 
in NPROVE, including those limit orders priced within the 
inside market on Nasdaq. This ready display of NPROVE limit 
order information will be accomplished with one key stroke in the 
Nasdaq Workstation I environment and one mouse click in the Nasdaq 
Workstation II environment. Fourth, the NASD is proposing to develop a 
separate feed of NPROVE transaction information and limit order 
information to registered market makers. Specifically,, the feed to the 
market makers will include all NPROVE orders, cancellations, 
corrections, and executions. With this information, which is in 
response to a comment letter received by the SEC regarding 
NPROVE,\13\ market makers will be able to assure their 
customers that they are receiving the same quality of execution that 
they would have received had their orders been entered into 
NPROVE. Accordingly, with this feed, while a market maker's 
customer order may not interact directly with a limit order in 
NPROVE, it would benefit indirectly from the existence of the 
limit order in NPROVE. In sum, the NASD believes these changes 
will enhance the limit order protection and price improvement benefits 
available to retail investors through NPROVE.
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    \13\See letter from Leonard Mayer, Vice President & Chief 
Operating Officer, Mayer & Schweitzer, Inc., to Jonathan G. Katz, 
Secretary, SEC, dated July 13, 1994.
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5. Modifications to the Processing of Preferenced Limit Orders
    As currently proposed, while preferenced limit orders are able to 
take advantage of the limit order protection feature of NPROVE, 
the existence of these orders are known only to the preferenced market 
makers. Unlike unpreferenced limit orders, when a preferenced market 
order is entered between the spread, it does not activate the 
NPROVE limit order indicator and it is not retrievable by other 
market makers in the summary scan of pending NPROVE limit 
orders. In addition, when a preferenced limit order is matched against 
an incoming market order, the matched market order is only displayed to 
the preferenced market maker for acceptance. Accordingly, in order to 
afford preferenced limit orders the same opportunity for order 
interaction that is afforded unpreferenced limit orders, the NASD 
proposes to amend NPROVE to provide that preferenced limit 
orders priced within the inside bid or offer on Nasdaq will be 
processed the same way as unpreferenced limit orders.\14\ However, once 
the price of a preferenced limit order to buy (sell) is at or above 
(below) the inside offer (bid), it will be automatically executed 
against the preferenced market maker. The NASD also proposes to amend 
the NPROVE rules to reiterate and clarify that market makers 
may enter orders into NPROVE on self-preferenced basis and that 
these orders will be processed like preferenced orders.
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    \14\Arguably, only flashing matched market orders to the 
preferenced market maker may increase the likelihood that the limit 
order will be executed because the market order is not exposed to 
multiple market makers for acceptance. It would be inappropriate and 
confusing to market participants, however, to disseminate 
information about preferenced limit orders and at the same time 
preclude investors from interacting with them.
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6. Inclusion of Short Sales in NPROVE
    As currently proposed, short-sales would be prohibited through 
NPROVE, just as they are prohibited through the NASD's Small 
Order Execution System rules currently in effect. In light of the SEC's 
approval of the NASD's proposed short-sale rule in June 1994,\15\ 
coupled with NPROVE's order acceptance feature that enables 
market makers to handle exposure to transactions such as short sales by 
permitting them to reject trades if they have already traded, however, 
the NASD believes it is appropriate to permit short sales through 
NPROVE. By so doing, the NASD will expand the spectrum of 
retail orders that are available to take advantage of NPROVES's 
price improvement and limit order protection benefits. Nevertheless, 
while NPROVE will provide a 15-second period for a market maker 
to react to an NPROVE order, the NASD remains concerned that 
this 15-second period is sufficiently short the there remains a risk of 
destabilizing short term trading through the service. Accordingly the 
NASD will review the volume and impact of short sales effected through 
NPROVE on an on-going basis to determine whether it is 
appropriate in the interests of maintaining fair and orderly markets to 
continue to allow short-sales through NPROVE.
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    \15\Securities Exchange Act Release No. 34277 (June 29, 1994), 
59 FR 34885 (July 7, 1994).
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    The NASD believes that the proposed NPROVE system, as 
amended, is consistent with Section 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 individual investors 
in achieving prompt, efficient executions of their small orders, to 
provide individual investors an opportunity for price improvement 
within an automated execution environment, and to afford individual 
investors an automated and effective means to protect their limit 
orders. 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 constituencies. 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 market 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.
    Lastly, the NASD believes that NPROVE is 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 promulgated under the Act.

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 the 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 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 it 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.

Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 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 December 27, 1994.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-29932 Filed 12-5-94; 8:45 am]
BILLING CODE 8010-01-M