[Federal Register Volume 59, Number 241 (Friday, December 16, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-30915]


[[Page Unknown]]

[Federal Register: December 16, 1994]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35080; File Nos. SR-NASD-94-13 and SR-NASD-94-68]

 

Self-Regulatory Organizations; Notice of Amendment of Proposed 
Rule Change by National Association of Securities Dealers, Inc. 
Relating to the Small Order Execution System and the Proposed Nasdaq 
Primary Retail Order View and Execution System

December 9, 1994.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that in connection with File Nos. 
SR-NASD-94-13\2\ and SR-NASD-94-68,\3\ on October 24, 1994 the National 
Association of Securities Dealers, Inc. (``NASD'') filed with the 
Securities and Exchange Commission (``SEC'' or ``Commission'') an 
econometric analysis conducted by the NASD's Economic Research 
Department. In addition, in connection with File No. SR-NASD-94-13\4\ 
on December 2, 1994 the NASD filed with the Commission an analysis of 
the potential for order queues to develop in its proposed Nasdaq 
Primary Retail Order View and Execution System (``NPROVE''). 
The econometric analysis and the NPROVE order queuing analysis 
are set forth in Items I and II below respectively, which Items have 
been prepared by the NASD. Accompanying Nasdaq's analyses were certain 
graphs, charts and tables which are not included in this notice, but 
are available for inspection in the Commission's Public Reference Room. 
The Commission is publishing this notice to solicit comments from 
interested persons.
---------------------------------------------------------------------------

    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\See Securities Exchange Act Release No. 34145 (June 1, 1994), 
59 FR 29649 (June 8, 1994) (notice of File No. SR-NASD-94-13, 
incorporating Amendment No. 1), Securities Exchange Act Release No. 
34453 (July 28, 1994), 59 FR 39808 (Aug. 4, 1994) (notice of 
Amendment No. 2) and Securities Exchange Act Release No. 35024 (Nov. 
29, 1994), 59 FR 62755 (Dec. 6, 1994) (notice of Amendment No. 3).
    \3\See Securities Exchange Act Release No. 35077 (Dec. 9, 1994) 
(notice of File No. SR-NASD-94-68).
    \4\See supra note 2.
---------------------------------------------------------------------------

I. Impact of the SOES Interim Changes on the Quality of The Nasdaq 
Stock Market

    In SEC Release No. 34-33377\5\ (the ``Release''), the SEC approved 
certain changes to the NASD's Small Order Execution System (``SOES'') 
on a pilot basis. Specifically, the SEC approved the following changes 
to SOES: (1) A reduction in the maximum size order eligible for SOES 
execution to 500 shares from 1,000 shares;\6\ (2) a reduction in the 
minimum exposure limit for ``unpreferenced'' SOES orders to two times 
the maximum exposure limit from five times the maximum exposure; (3) 
the elimination of exposure limits for ``preferenced'' orders; (4) the 
implementation of an automated function for updating market maker 
quotations when the market maker's exposure limit has been exhausted; 
and (5) the prohibition of short sale transactions through SOES. These 
changes, collectively referred to hereinafter as the ``SOES changes,'' 
went into effect on January 31, 1994.
---------------------------------------------------------------------------

    \5\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 58 
FR 69419 (Dec. 30, 1993) (approval of File No. SR-NASD-93-16 on a 
one-year pilot basis).
    \6\Thus with this change, the SOES maximum order size for Nasdaq 
National Market (NNM) securities is 200 shares or 500 shares, 
depending upon the trading characteristics of the particular 
security. All Nasdaq SmallCap securities are subject to a SOES 
maximum order size of 500 shares.
---------------------------------------------------------------------------

    Due to the pilot nature of these changes, the Commission stated 
that ``[a]ny further action the NASD seeks with respect to SOES--
extension of these modifications upon expiration, or introduction of 
other changes--will require independent consideration under Section 19 
of the Act.'' In addition, the SEC stated that, should the NASD desire 
to extend these SOES changes or modify SOES, the Commission would 
expect, ``the NASD to monitor the quality of its markets and assess the 
effects of the approved SOES changes on market quality for Nasdaq 
securities.'' Also, if feasible, the SEC instructed the NASD to provide 
a quantitative and statistical assessment of the effects of the SOES 
changes on market quality; or, if an assessment is not feasible, the 
SEC stated that the NASD should provide a reasoned explanation 
supporting that determination.\7\
---------------------------------------------------------------------------

    \7\The SEC also expressed the view that it is not possible to 
determine from the correlation and regression analyses submitted in 
support of the SOES changes whether increased stock price volatility 
definitely leads to trading by SOES active trading (SAT) firms or 
trading by SAT firms results in additional stock price volatility. 
The SEC further determined that it is not possible to differentiate 
between the effects on spreads and stock price volatility 
attributable to active SOES trading and the effects attributable to 
other factors such as stock-specific news or volatility.
---------------------------------------------------------------------------

    Accordingly, in order to facilitate and support approval of the 
Nasdaq Stock Market's Nasdaq Primary Order View and Execution 
(NPROVE) system, or an extension of the SOES changes, should 
the Commission not approve NPROVE before termination of the 
SOES changes, the NASD is submitting this economic study conducted by 
the NASD's Economic Research Department on the impacts of the SOES 
changes on the quality of the markets for Nasdaq securities.
    In sum, the study found that:
     Since the SOES changes went into effect in January 1994, 
quoted spreads in Nasdaq securities experienced a decline in the 
immediate period following implementation of the changes and have 
continued to decline since then. In particular, quoted spreads for the 
500 largest Nasdaq National Market securities experienced a sharp 
decline from April 28 to May 12 and from June 23 to July 18.\8\
---------------------------------------------------------------------------

    \8\Some press reports have attributed the recent decline in 
spreads for Nasdaq stocks to the publication, on May 26 and 27, 
1994, of newspaper articles in The Wall Street Journal, The Los 
Angeles Times and other publications reporting the results of an 
economic study conducted by two academicians that illustrated the 
lack of odd-eighth quotes for active Nasdaq stocks. Contrary to 
these press reports, this study shows that spreads had indeed 
narrowed before publication of these articles (from April 28 to May 
12), stabilized at these narrower levels from mid-May until June 23, 
and declined again from June 23 to July 18.
---------------------------------------------------------------------------

     With the exception of a brief, market-wide period of 
volatility experienced by stocks traded on Nasdaq, the New York Stock 
Exchange, and the America Stock Exchange during the Spring, the 
volatility of Nasdaq securities appears to be unchanged in the period 
following implementation of the changes.
    The SOES changes were designed to correct a major market quality 
problem caused by the establishment in mid-1988 of: (1) a requirement 
that market makers in NNM securities must participate in SOES and (2) 
minimum market maker exposure limits of 5000 shares for the most active 
group of NNM securities (1988 SOES changes). While the 1988 SOES 
changes were intended to ensure that order entry firms could obtain 
executions for their customers in volatile markets, the changes also 
had the unintended consequence of dramatically changing the dynamics 
and economics of intra-day trading by investors in Nasdaq. 
Specifically, the assurance of automatic order execution afforded 
investors through SOES spawned trading by SAT firms that resulted in 
market makers receiving multiple executions in brief periods of time 
without the ability to update their quotes. This rapid-fire, intra-day 
trading by SAT firms increased the cost of market making and, in turn, 
resulted in a dramatic widening of displayed quotation spreads as 
market makers avoided the trading risks associated with the mandated 
5,000-share exposure limit in SOES.
    The SOES changes noted above were an attempt by the NASD to 
preserve the benefits of SOES for small retail investors and eliminate 
the negative market impacts created by abuses of SOES. As detailed 
below, the NASD's analysis illustrates that the SOES changes have been 
associated with substantive improvements in the quality of the markets 
for Nasdaq securities and that these positive improvements have become 
more pronounced the longer the changes have been in effect, as market 
makers have adjusted their trading practices to reflect the lower costs 
and risks associated with SOES trading.
    As the SEC stated in the release, market factors other than SOES 
changes may be jointly or singly responsible for changes in market 
quality. However, market quality measures are useful in indicating 
whether the SOES changes have been associated with non-negative or 
positive changes in market quality. Even though cause and effect cannot 
be statistically proven, as pointed out succinctly in the Release, the 
absence of negative market developments associated with the 
implementation of the SOES changes, coupled with the apparent positive 
market improvements associated with the SOES changes, provides useful 
support for the SEC's evaluation of its decision to approve the SOES 
changes.
    Given the SEC's prior determination that it is virtually impossible 
to measure the impacts on market quality of changes in SAT firm 
activity and given the applicability of the SOES changes to all NNM 
securities, NASD monitoring has focused on a before-and-after analysis 
of commonly accepted measures of market quality, without trying to 
distinguish the impacts of trading by SAT firms. The SOES changes are 
treated as a partial reversal of a microstructure change made in mid-
1988 (the 1988 SOES changes) and analyzed on a before-and-after basis.
    The impacts of such structural changes do not occur completely on 
the immediate day after their introduction. For example, spreads did 
not widen immediately after the mandatory SOES exposure limits were put 
in place in mid-1988. Rather, adjustments to such changes and their 
impacts are gradual and distributed out over a period of time. 
Competitive forces cannot be expected to reverse instantaneously the 
quality of market conditions that evolved from microstructure 
restrictions and related arrangements that were in place for nearly six 
years.
    Moreover, the SOES changes impact indirectly the measures of market 
quality. Each change, while important, can be expected to have 
different adjustment time periods. While a change in the maximum size 
order permitted to be entered into SOES is immediate, changes to 
market-maker exposure limits require adjustments by traders, as they 
reevaluate their quotation and inventory management procedures and 
their use of order-driven systems (rather than displayed quotations) to 
adjust inventories. Also the new automated quotation update, permitted 
after a transaction, cannot be implemented without varying time lapses 
by the many different market makers.
    Nonetheless some improvement in the quality of the market for 
Nasdaq stocks has occurred in the period following the SOES changes. 
The analysis of the impact of the SOES changes on market quality 
focuses on the associated movements in Nasdaq market spreads, stock-
price volatility, volume of SOES trading, the average size of SOES 
trades, and other indicators of market quality. The objective is to 
determine whether any apparent changes in market quality measures 
followed the reduced SOES regulations on market makers.
    To evaluate the impact of these changes, the NASD established a 
data set for the one-year pilot, beginning with November 11, 1993, and 
including complete audit trail information for a sample of days that 
includes approximately two days each month during the pilot. Although 
the pilot period is not over, enough data is available to derive some 
findings as to the changes in market quality that followed these SOES 
changes.

Impact of the SOES Change on the Level of SOES Activity

    The average daily share volume of SOES transactions and the number 
of SOES trades declined sharply following the SOES changes (see Chart 
1). The immediate decline in average daily SOES volume approximated 52 
percent from January to February, and the decline in the number of SOES 
trades was 17 percent. Moreover, the average SOES trade size declined 
43 percent from January to February. The average trade size, which had 
risen from 310 shares in mid-1988, when the mandatory minimum exposure 
limits were instituted (see Chart 2) to 581 shares in January 1994, 
dropped sharply to 332 in February.
    It is the average trade size in SOES that appears to best reflect 
SOES activist trader presence in the data. It is apparent from Chart 2 
that SOES activists entered the market as proprietary traders 
immediately after the imposition of the mandatory SOES exposure limits 
in mid-1988. Because this activity violated SOES rules however, the 
NASD took action to preclude such trading through SOES and they 
withdrew as proprietary traders. Later, in 1989, these SAT firms began 
coaching individuals to trade through SOES in a similar fashion. As a 
result the average size of a SOES trade began its long uptrend in 1989, 
ending in January 1994, with a resulting substantial widening of 
spreads of large, actively traded stocks (See Chart 6).
    Whether some SOES activist volume merely shifted to one of the many 
alternative execution systems following the January 1994 SOES changes 
or whether some trading activities ceased because they were only 
profitable in a regulatory environment with higher market-maker 
exposure requirements has not been determined. Some traders apparently 
have resumed using SOES at the 500 share level even with the lower 
exposure limits. This is suggested by the fact that the SOES average 
trade size continues above the mid-1988 level and the decline in the 
number of SOES trades was much less than the decline in SOES share 
volume. SOES activist traders generally trade in the maximum order size 
permitted in SOES.

Displayed Quotation Spreads

    Displayed Quotation Spreads declined in the six months following 
the January 31 SOES changes. The improvement in displayed spreads\9\ is 
evident in the pattern of average bid/ask spreads of the largest NNM 
stocks (see Chart 3). Average spreads of the largest 500 NNM stocks, 
those most affected by SOES trading, appear flat immediately following 
the SOES changes; but they then decline sharply (see Chart 4) as market 
makers became aware of the lower risks involved in moving their 
displayed spreads closer to the actual trade-to-trade price changes 
that were occurring in the order-driven segments of the market. The 
first sharp decline in spreads is evident between the April 28 and May 
12 sample days (see Chart 4). A second sharp break occurred between the 
June 23 and July 18 sample days. However spreads appear to be narrowing 
throughout the post-SOES change period.
---------------------------------------------------------------------------

    \9\Measure of spread used is the average of the observed market 
displayed spread each time a trade occurs.
---------------------------------------------------------------------------

    Confirmation of the improvement in displayed quotation is the 
proportion of share volume occurring in stocks with closing displayed 
bid/ask spreads of one-quarter or less. The percentage of volume 
accounted for by such stocks fluctuated around 61 percent until May 
1994, when it rose to 62.5 percent, another clear indication that 
spreads were tightening (see Table 1). It rose further to 65.6 percent 
in June, to 66.2 percent in July, and to 68.7 percent by September.
    Additional supporting information, in Charts 5 and 6, shows SOES 
average trade size and the number and percentage of NNM stocks with 
end-of-day quotation spreads less than 50 cents. SOES average trade 
size reflects the entry and activity of SOES activist traders. Firms 
effecting proprietary trades through SOES caused the average to rise 
briefly in 1988, but SOES volume attributable to individual traders 
active in SOES started in 1989 and expanded until January 1994. A major 
decline in the percentage of NNM stocks with end-of-month spreads less 
than 50 cents per share is apparent as SOES traders took advantage of 
the mid-1988 institution of the 5,000-share minimum exposure limit for 
SOES active stocks. An uptrend in that percentage has emerged following 
the January reduction in market-maker exposure minimums.
    To examine further these quotation spread patterns, regressions 
were prepared using NNM stocks grouped by various characteristics. The 
regressions controlled for market factor influences on spread including 
volume, stock price, and intra-day price volatility. A dummy variable 
(0,1) was used to reflect the periods before (0) and after (1) the SOES 
changes. Regressions were run using all NNM stocks, the largest 500 NNM 
stocks, 1,000- share tier, 500-share tier and 200-share tier stocks and 
stocks with a proportionate decline in SOES activity after the January 
1994 changes. These regressions confirm that spreads narrowed in the 
six months following the SOES changes for all groups of stocks except 
for those stocks in the 500- and 200-tier categories, even after 
controlling for volume, price and intra-day price volatility. For the 
500-and 200-tier groups the before and after changes overall were not 
statistically significant.
    A negative beta coefficient for the dummy variable indicates a 
decrease in spreads from the period before the changes to the periods 
after the SOES changes. For the first three months after the changes, 
the beta coefficient for the dummy variable is generally negative but 
statistically insignificant. However, by the second three-month period 
the coefficients were negative and statistically significant for all 
NNM stocks, the 1,000 share tier group and the largest 500 group, 
indicating that quotation spreads were indeed narrowing. Because SOES 
volume for the largest 500 NNM stocks represents 65 percent to 75 
percent of the total SOES volume, the significance of the statistical 
results is critical for this group.
    Successive regressions then were for the largest 500 group using 
for each stock the average of the pre-change days, and separately the 
average for each of the post-change days to observe changes in the beta 
coefficient of the dummy variable. The negative value of beta depicts a 
negative difference between the pre-change average spreads and the 
post-change individual day observation sets for every day in the post-
change period. Beta coefficients are negative for each day and 
statistically significant for each day except for February 17, April 
14, April 28, and May 26, 1994.
    It is clear that the changes is SOES reduced uncontrollable or 
mandated market-maker risk exposure across all NNM stocks and the 
changes appear to have resulted in significantly lower spreads for the 
largest 500 group.

Volatility

    As the SEC pointed out in the release, differentiating between the 
effects on spreads and stock-price volatility attributable to active 
SOES traders and the effects attributable to other factors may not be 
possible. Market volatility, in particular, surges and recedes. This 
makes exceedingly difficult measurement of temporary impacts on price 
volatility of unnecessary market-maker risk exposures that provide 
profitable trading situations to opportunistic traders.
    It is apparent from the volatility of the various indexes (see 
Chart 7) that dramatic changes occurred in market volatility during the 
six months following the SOES changes. The average absolute value of 
daily percent changes of the Nasdaq Composite Index fluctuates from 
over 0.03 percent in January 1994 to practically no change in February 
and March. Then it jumps to nearly 0.07 percent in April.
    Substantial effort would be required to empirically sort out the 
effects on volatility of the SOES changes, if indeed it is possible to 
sort them out. NASD attempts to isolate these effects statistically 
have not been successful. Nonetheless an analysis was performed of 
stock volatility distributions on the sample days. Valatilty is 
calculated by taking the standard deviation of the absolute percent 
changes in the bid price. A frequency distribution of each stock's bid 
volatility was constructed for each day in the analysis, and the 
skewness of these distribution curves was computed.
    Skewness is a measure that describes to what extent a curve 
deviates from a normally distributed bell shape. The distribution of 
stock volatilities is found a contain a smaller right tail in the post-
change period than in the pre-change period as evidenced from the 
declining measure of skewness (see Chart 8). The smaller right tail 
reflects a smaller percentage of stocks with extreme relative price 
volatility in the post-change period. Also the measures of dispersion 
of the individual stock volatilities are smaller for the post-change 
days. These distributional differences suggest a reduction in relative 
volatilities in the post-change period.

Other Considerations

    Major improvements, other than the SOES changes in January 1994, 
are being instituted in Nasdaq trading to enhance market quality. New 
requirements affecting the handling of customer limit orders were 
adopted on July 9, 1994; a shore-sale bid test took effect in early 
September; and the proposed NPROVE system to replace SOES is 
awaiting SEC action.
    As a result, identifying the delayed impacts of the SOES changes 
may not be possible beyond the first few months included here.

Conclusion

    The reduction in the mandatory minimum exposure limits and SOES 
order sizes, which in turn decrease market-maker risk exposure, clearly 
have been associated with positive changes in market quality. In 
particular, displayed spreads have narrowed. More importantly, there is 
no evidence of negative impacts on market quality.
    While the impacts of the SOES changes cannot be precisely 
segregated from the impacts of other factors with 100 percent 
certainty, the absence of negative changes in measures of market 
quality and the presence of positive changes in such measures following 
the introduction of the SOES changes in late January 1994 support a 
conclusion that the changes resulted in improved market quality. The 
higher mandated exposure requirements and larger order sizes in place 
from mid-1988 to January 31, 1994, in retrospect, were not necessary 
and appear to have caused wider spreads as market makers adjusted their 
activities to avoid the transactions of active traders in SOES.

II. Analysis of Potential for Order Queues to Develop in 
NPROVE

    In a letter dated August 16, 1994, Commission staff requested that 
Nasdaq provide an assessment of the potential for queues to develop and 
the basis for this assessment.\10\ In a letter dated December 7, 1994, 
Nasdaq responded in writing to the request. The relevant portions of 
Nasdaq's letter are as follows:

    \10\Letter from Katherine A. England, Assistant Director, SEC, 
to Robert E. Aber, Vice President and General Counsel, Nasdaq (Aug. 
16, 1994).
---------------------------------------------------------------------------

    In sum, as the attached graphs and tables indicate, Nasdaq 
believes the potential for sustained, lengthy order queues to 
develop in NPROVE for any given security is minimal.\11\ In 
fact, for the days analyzed by the staff, the data shows that over 
98 percent of the orders transmitted by non-SOES activist firms\12\ 
would have received an execution within 30 seconds. In addition, 
while our analysis illustrates that queues for a given security will 
develop for brief periods of time, our analysis also indicates that 
these occasional queues appear likely to abate in a matter of 
minutes. Moreover, and perhaps most importantly, our analysis 
demonstrates that, to the extent that there would be noticeable 
queues in NPROVE, these queues would be directly 
attributable to a narrow segment of orders originating from SOES 
activists that were transmitted in waves during discreet, short 
periods of time. When these queues do develop, however, a small 
percentage of retail customer orders (2 percent) may be delayed by 
the queue created by the SOES activists' orders. Aside from these 
episodic queues attributable to SOES activists, the data indicates 
that lengthy queues in NPROVE would be rare. Accordingly, 
Nasdaq does not believe it is very likely that significant, on-going 
order queues will develop in NPROVE during peak volume days.

    \11\To analyze the potential for order queuing in NPROVE 
Nasdaq staff used actual trading data for Nasdaq's Small Order 
Execution System (``SOES'') for certain trading days. To simulate 
trading in NPROVE with this SOES data, the staff ``spaced 
out'' the SOES orders so that, at a minimum there was at least a 15 
second interval between the execution of these orders. For example, 
if three orders in the same security were sent simultaneously into 
SOES, fifteen seconds were inserted between the orders. In light of 
the recent amendments to NPROVE submitted to the Commission 
on December 1, 1994, Nasdaq notes that fifteen seconds will be the 
maximum length of time it will take for an order to be executed in 
NPROVE once that order becomes subject to NPROVE's 
order execution methodology, although in very limited circumstances 
NPROVE orders directed to a priority market maker may take 
between fifteen and thirty seconds to be executed. Moreover, market 
makers will have the ability to affirmatively execute against market 
orders any time during the fifteen-second display period. See 
Securities Exchange Act Release No. 35024 (November 29, 1994). Thus, 
the insertion of fifteen seconds between SOES orders facilitates an 
extremely conservative replication of how such orders would have 
been processed through NPROVE.
    \12\See text accompanying note 16 for the definition of a SOES-
activist firm for purposes of this study.
---------------------------------------------------------------------------

    In addition, Nasdaq notes that the recent proposed amendments to 
NPROVE will further help to ensure that significant, on-going 
order queues will not develop in NPROVE.\13\ Specifically, 
under the proposed order processing methodology for NPROVE, 
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 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'').\14\ If a market 
maker rejects a designated, unpreferenced NPROVE order and no 
other market maker accepts the order within the 15-second period, the 
system will automatically execute the order against the market maker 
next in rotation that has not rejected the order upon expiration of the 
15 second period. If all market makers decline the order consistent 
with Rule 11Ac1-1 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 are effectively 
collapsed into one round and Round 3 is eliminated because orders 
rejected by all market makers would be executed automatically at the 
new inside market. 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.
---------------------------------------------------------------------------

    \13\Id. As previously designed, the execution of unpreferenced 
market and marketable limit orders through NPROVE may have 
involved up to three 15-second rounds. In Round 1, an unpreferenced 
order would have been routed to the market maker at the inside bid 
or offer that was next in line for an NPROVE execution. The 
market maker could have manually executed the order or allowed the 
system to automatically execute the order after 15 seconds. If the 
market maker had effected a trade (or was in the process of 
executing a trade in that security) and had updated its quotation 
(or was in the process of updating), it could have rejected the 
unpreferenced NPROVE order. When, consistent with the 
requirements of Rule 11Ac1-1 under the Act, an order was rejected by 
the first market maker in rotation, the order would have entered 
Round 2 and would have been automatically displayed to all remaining 
market makers at the inside quote. All of these market makers would 
have had the opportunity to execute the order during a 15 second 
period. If no market maker manually accepted the order, it would 
have been automatically executed against the first market maker in 
rotation. In the unlikely event that all of these market makers had 
rejected the order during Round 2 pursuant to a valid exception from 
Rule 11Ac1-1, the system would have automatically executed the order 
against the first market maker in rotation quoting at the new inside 
market after fifteen seconds. This was called Round 3.
    \14\Market orders matched against limit orders (preferenced or 
unpreferenced) priced between the inside bit or offer also will be 
processed pursuant to this one-round order processing procedure.
---------------------------------------------------------------------------

    It is important to note that our response is not intended to be a 
subjective commentary on the activities of SOES activists; rather it is 
an objective reflection of the source of potential order queues in 
NPROVE. It is axiomatic that episodic surges in order volume on 
one or the other side of the market will impact the timing and price of 
execution of these orders by virtue of fundamental economic principles 
of supply and demand.
    Following is a more detailed description of the attached graphs and 
tables and the analytical process Nasdaq used to reach its conclusion 
that significant order queuing likely will not occur with 
NPROVE.
    To analyze potential order queuing in NPROVE, the staff 
examined SOES activity on two trading days--February 4, 1994 and July 
13, 1994\15\ Exhibit 1 contains charts that provide aggregate data on 
the extent to which order queuing would have occurred in NPROVE 
on these days. Specifically, the charts identify all NASD members that 
transmitted more than 50 orders into SOES on these days, with a 
breakdown of how many of these orders would have been executed within 
30 seconds, between 30 and 45 seconds, between 45 seconds and one 
minute, and longer than a minute if NPROVE were in operation. 
On February 4, 93 percent of these orders would have been executed with 
30 seconds, and on July 13, 77 percent of the orders would have been 
executed within 30 seconds. The staff also used these charts to 
identify firms that are considered to be SOES activists. Specifically, 
if a firm's ``OLIM'' percentage was greater than 75 percent it was 
identified as a SOES activist.\16\ By differentiating between SOES 
activists and non-activists, the staff was able to produce the summary 
statistics at the bottom of the charts in Exhibit 1. These statistics 
demonstrate that orders entered by SOES activists would have 
experienced greater delays in execution than orders entered by non-
activists. Specifically, on February 4, 99.3 percent of all orders 
entered by non-activists would have been executed within 30 seconds, 
while 80.7 percent of all orders entered by SOES activists would have 
been executed within 30 seconds. Similarly, on July 13, 98.4 percent of 
all orders entered by non-activists would have been executed with 30 
seconds, and 63.7 percent of all SOES activists' orders would have been 
executed within 30 seconds.
---------------------------------------------------------------------------

    \15\On February 4, 1994, total Nasdaq share volume was 
376,034,700 shares and on July 13, 1994, total Nasdaq share volume 
was 342,162,600 shares. Both of these days were identified in your 
August 16, 1994 letter as high volume days.
    \16\``OLIM'' indicates the percentage of the firm's SOES order 
that were entered at the maximum order size.
---------------------------------------------------------------------------

    Based on the finding illustrated in the charts in Exhibit 1 that 
orders entered by SOES activists constitute the vast majority of orders 
that would experience queues, the staff then identified those stocks 
that received the highest number of orders from SOES activists that 
would have been queued. Specifically, the tables in Exhibit 2 identify 
those stocks that received more than 20 orders from SOES activists that 
would have been queued. The staff then conducted a more detailed, 
stock-by-stock analysis of the four ``top'' stocks on each of these 
days.\17\ This analysis, as reflected in the NPROVE Order 
Traffic & NPROVE Order Queues'' graphs contained in Exhibit 3, 
reveals that the queues in these stocks would have occurred in 
discreet, short-term clusters throughout the day, not in a random 
fashion. The multi-colored bars in these graphs also illustrate that 
orders entered by non-activists would only experience queuing when they 
are tangled up in a queue created by a SOES activist. With the 
exception of these isolated queues, the graphs also clearly illustrate 
that orders entered by non-activists and activists would not have 
experienced queuing throughout the remainder of the day. In addition, 
as would be expected, the ``NPROVE Order Traffic'' graphs in 
Exhibit 3 illustrate that these queues would have coincided with spikes 
in transaction volume.
---------------------------------------------------------------------------

    \17\Specifically, the four stocks identified on February 4, 1994 
were: (1) Lotus Development (LOTS); (2) DSC Communications Corp. 
(DIGI); (3) 3COM Corp. (COMS); and (4) Cisco Systems, Inc. (CSCO). 
The four days identified on July 13, 1994 were: (1) COMS; (2) Altera 
Corp. (ALTR); (3) Adobe Systems, Inc. (ADBE); and (4) Microsoft 
Corp. (MSFT).
---------------------------------------------------------------------------

    Accordingly, Nasdaq believes this information, along with the 
NASD's proposed revisions to NPROVE to collapse the three 
rounds of NPROVE order processing into one, illustrate that 
queuing in NPROVE will not occur for sustained periods of time 
in any one security and that only a very small percentage of retail 
customer orders will be exposed to the risk that the market could move 
against them while they are pending in NPROVE. In sum Nasdaq 
believes the benefits that will be afforded small retail investors 
through the price improvement and limit order protection features of 
NPROVE, as well as the improvements to the integrity, 
liquidity, and stability of Nasdaq that NPROVE likely will 
produce, far outweight the potential costs to investors that may arise 
from sporadic, short-lived order queues in NPROVE.\18\
---------------------------------------------------------------------------

    \18\Letter from Robert E. Aber, Vice President and General 
Council, Nasdaq, to Katherine England, Assistant Director, SEC (Dec. 
7, 1994).
---------------------------------------------------------------------------

III. 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, 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 Numbers SR-NASD-94-13 and/or 
SR-NASD-94-68 and should be submitted by January 6, 1995.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
---------------------------------------------------------------------------

    \19\17 CFR 200.30-3(a)(12) (1994).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-30915 Filed 12-15-94; 8:45 am]
BILLING CODE 8010-01-M