[Federal Register Volume 60, Number 62 (Friday, March 31, 1995)]
[Notices]
[Pages 16690-16693]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-7987]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35535; File No. SR-NASD-95-8]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change To Extend Certain 
SOES Rules Through October 2, 1995

March 27, 1995.

I. Introduction

    On February 10, 1995, the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities 
and Exchange Commission (``SEC'' or ``Commission'') a proposed rule 
change pursuant to section 19(b)(1) of the Securities Exchange Act of 
1934 (``Act'')\1\ and Rule 19b-4 thereunder.\2\ The NASD proposes to 
extend through October 2, 1995 certain of the prior changes to its 
Small Order Execution System (``SOES'') that were implemented in 
January 1994 (``January 1994 Amended SOES Rules''),\3\ modified in 
January 1995 [[Page 16691]] (``January 1995 Amended SOES Rules'')\4\ 
and are scheduled to expire today. Without further Commission action, 
the SOES rules would revert to those in effect prior to the January 
1994 Amended SOES Rules.

    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1994).
    \3\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 58 
FR 69419 (Dec. 30, 1993) (approving the Interim SOES Rules on a one-
year pilot basis effective January 7, 1994). See also Securities 
Exchange Act Release No. 33424 (Jan. 5, 1994) (order denying stay 
and granting interim stay through January 25, 1994) and Securities 
Exchange Act Release No. 33635 (Feb. 17, 1994) (order denying 
renewed application for stay).
    \4\Securities Exchange Act Release No. 35275 (Jan. 25, 1995), 60 
FR 6327 (Feb. 1, 1995).
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    Although characterized by the NASD as a proposal to extend the 
January 1995 Amended SOES Rules, under this proposal, SOES will operate 
significantly different from its current operation. Most notably, the 
NASD's current proposal does not include extension of the currently 
effective 500 share maximum SOES order size limitation and, 
accordingly, the maximum order size will return to 1,000 shares on 
March 28, 1995. While the methodology for calculating the minimum 
exposure limit will remain unchanged from the January 1994 Amended SOES 
Rules, increasing the maximum order size from 500 shares to 1,000 
shares will raise the minimum exposure limit applicable to 
unpreferenced orders. For market makers electing not to use the 
automated quotation update feature, the minimum exposure limit will 
rise from 1,000 shares to 2,000 shares and, for those electing to use 
this feature, the minimum exposure limit will rise from 500 to 1,000 
shares. Moreover, the current proposal will not reinstate the short 
sale prohibition. Thus, in comparison to the January 1994 Amended SOES 
Rules, the effect of this proposal is to remove or alter every change 
made to SOES so that retail investor access to the Nasdaq market is 
improved.
    Notice of the proposed rule change appeared in the Federal Register 
on February 21, 1995.\5\ For the reasons discussed below, this order 
approves the propose rule change until October 2, 1995.

    \5\Securities Exchange Act Release No. 35364 (Feb. 13, 1995), 60 
FR 9704 (Feb. 21, 1995).
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II. Description of the Current and Prior Proposals

    The NASD proposes to extend two of the four January 1994 Amended 
SOES Rules. Specifically, the NASD proposes to extend until October 2, 
1995 changes that:
    (1) Reduce the minimum exposure limit for ``unpreferenced'' SOES 
orders from five times the maximum order size to two times the maximum 
order size, and eliminate the exposure limits for ``preferenced'' SOES 
orders; and
    (2) Add an automated function for updating market maker quotations 
when the market maker's exposure limit has been exhausted (market 
makers using this update functions may establish an exposure limit 
equal to the maximum order size for that security).
    In contrast, the January 1994 Amended SOES Rules included the above 
two changes as well as changes that:
    (1) Reduced the maximum size order eligible for SOES execution from 
1,000 shares to 500 shares; and
    (2) Prohibited short sale transactions through SOES.
    The January 1995 Amended SOES Rules continued all of the January 
1994 Amended SOES Rules except for the short sale prohibition.\6\

    \6\Thus, short sales in compliance with the NASD's short sales 
rule applicable to the Nasdaq market as a whole are permitted in 
SOES. NASD Manual, Rules of Fair Practices, Sec. 48, CCH 2200H.
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III. Comments

    The Commission received comments from seven commenters, with four 
supporting the proposal and three opposing it. The NASD responded to 
these comments in a letter dated March 22, 1995.\7\ Subsequently, two 
of the original seven commenters submitted letters reiterating their 
respective positions; one of these supported the proposal and the other 
opposed it.

    \7\Letter from Richard Ketchum, Executive Vice President & Chief 
Operating Officer, NASD, to Jonathan G. Katz, Secretary, SEC (Mar. 
22, 1995).
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    Generally, commenters supporting the proposal argue that approval 
of the March 1995 Amended SOES Rules will limit the exposure of market 
makers to multiple executions, which will benefit retail investors by 
producing narrower spreads and more liquid markets.
    Commenters opposed to the proposal argue that the statistical and 
market quality data cited by the NASD in support of its proposal are 
not sufficient to support the NASD's position. They contend that the 
two studies on which the NASD relies fail to demonstrate any increase 
in market quality as a result of the rules and that market makers have 
ample opportunity to update their quotes in order to avoid multiple 
SOES executions. One commenter also argued that the NASD has not 
provided a sufficient basis for establishing the minimum exposure limit 
at 2,000 shares and that determining the appropriateness of the 
automated quotation update feature is not possible without information 
about the extent of its use. Commenters opposed to the NASD's January 
1994 Amended SOES Rules and January 1995 Amended SOES Rules argued that 
decreasing the minimum exposure limit will increase the potential for 
order queues to develop and, thus, result in inferior executions for 
retail customers.

IV. Discussion

    The Commission must approve a proposed NASD rule change if it finds 
that the proposal is consistent with the requirements of the Act and 
the rules and regulations thereunder that govern the NASD.\8\ In 
evaluating a given proposal, the Commission examines the record before 
it and relevant factors and information.\9\ After balancing the 
advantages and disadvantages of extension, the Commission believes that 
approval of the March 1995 Amended SOES Rules through October 2, 1995 
meets the above standards. Specifically, the Commission believes that 
returning the maximum order size to 1,000 shares, thus increasing the 
minimum exposure limit from 1,000 shares to 2,000 shares, and 
maintaining the automated quotation update feature is appropriate while 
the NASD considers other methods for handling small orders from retail 
customers.

    \8\15 U.S.C. Sec. 78s(b). The Commission's statutory role is 
limited to evaluating the rules as proposed against the statutory 
standards. See S. Rep. No. 75, 94th Cong., 1st Sess., at 13 (1975).
    \9\In the Securities Acts Amendments of 1975, Congress directed 
the Commission to use its authority under the Act, including its 
authority to approve SRO rule changes, to foster the establishment 
of a national market system and promote the goals of economically 
efficient securities transactions, fair competition, and best 
execution. Congress granted the Commission ``broad, discretionary 
powers'' and ``maximum flexibility'' to develop a national market 
system and to carry out these objectives. Furthermore, Congress gave 
the Commission ``the power to classify markets, firms, and 
securities in any manner it deems necessary or appropriate in the 
public interest or for the protection of investors and to facilitate 
the development of subsystems within the national market system.'' 
S. Rep. No. 75, 94th Cong., 1st. Sess., at 7 (1975).
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    In connection with the January 1995 Amended SOES Rules, the NASD 
submitted an econometric study conducted by the NASD's Economic 
Research Department\10\ and commissioned a consulting economist to 
provide an assessment of the effect of the January 1994 Amended SOES 
Rules.\11\ In summary, the NASD's [[Page 16692]] Economic Research 
Department found that since implementation of the January 1994 Amended 
SOES Rules: (a) spreads in Nasdaq securities have declined; and (b) 
volatility of Nasdaq securities appears to be unchanged, except for a 
brief, market-wide period of volatility in March and April 1994. The 
commissioned study reported that while percentage quoted spreads 
increased a statistically insignificant amount, percentage quoted 
spreads adjusted for other determining factors declined by a 
statistically significant, but economically insignificant, amount. From 
this data, the author concluded that the January 1994 Amended SOES 
Rules did not harm market quality. In support of its current proposal, 
the NASD also relies on these studies for the proposition that the 
January 1994 Amended SOES Rules and the January 1995 Amended SOES Rules 
collectively and individually have improved the quality of the Nasdaq 
market.

    \10\Securities Exchange Act Release No. 35080 (Dec. 9, 1994), 59 
FR 65109 (Dec. 16, 1994). The NASD's Economic Research Department 
examined Nasdaq bid-ask spreads in specific stocks and price 
volatility on two sample days each month from November 1993 (three 
months prior to the effective date of the rules) through August 
1994.
    \11\Letter from John F. Olson, Counsel for the NASD, Gibson, 
Dunn & Crutcher, to Jonathan Katz, Secretary, SEC (Dec. 30, 1994) 
(submitting in connection with File No. SR-NASD-94-68 analysis 
entitled The Association Between the Interim SOES Rules and Nasdaq 
Market Quality prepared by Dean Furbush, Ph.D., Economists 
Incorporated (Dec. 30, 1994)). This analysis compared sample days in 
the three months prior to and three months after the effective date 
of the January 1994 Amended SOES Rules.
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    In its order approving the January 1995 Amended SOES Rules, 
however, the Commission expressed its belief that the empirical data 
submitted by the NASD demonstrated neither significant improvement to 
nor serious deterioration in the quality of the Nasdaq market 
subsequent to the adoption of the January 1994 Amended SOES Rules.\12\ 
Since Commission approval of the January 1995 Amended SOES Rules, no 
data concerning the impact of the January 1994 Amended SOES Rules or 
the January 1995 Amended SOES Rules has been submitted. The Commission, 
therefore, continues to believe that empirical evidence submitted by 
the NASD demonstrates neither a significant improvement to nor serious 
deterioration in the quality of the Nasdaq market subsequent to the 
adoption of the January 1994 Amended SOES Rules. Moreover, the 
Commission believes this is true whether the amended SOES rules are 
viewed collectively or individually.

    \12\Securities Exchange Act Release No. 35275 (Jan. 25, 1995), 
60 FR 6327 (Feb. 1, 1995).
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    The absence of negative implications for market quality must be 
considered in conjunction with other effects of the recent changes to 
SOES on the investing public. The current proposal, in conjunction with 
termination of the short sale prohibition in January 1995, restores 
much of the access retail investors with small orders enjoyed prior to 
the January 1994 Amended SOES Rules and, thus, the Commission believes 
that a sufficient basis exists for approving the NASD's proposal. 
Effective March 28, 1995, the 1,000 share maximum order size in effect 
prior to the January 1994 Amended SOES Rules will be restored. This 
will provide retail investors enhanced opportunity to obtain execution 
of transactions between 500 and 1,000 shares and, accordingly, will 
improve access to the Nasdaq market. The Commission believes that the 
net effect of the instant proposal and the January 1995 Amended SOES 
Rules is a substantial departure from the January 1994 Amended SOES 
Rules, and would eliminate the economically significant restrictions 
imposed on order entry firms by the prior rules.
    The NASD's proposal will continue the methodology for calculating a 
market maker's minimum exposure limit; that is, two times the maximum 
order size rather than the pre-January 1994 Amended SOES Rules 
calculation of five times the maximum order size. Restoring the pre-
January 1994 Amended SOES Rules maximum order size of increasing the 
minimum exposure limit from 1,000 shares to 2,000 shares.
    Moreover, the current methodology for calculating a market maker's 
outstanding exposure limit will continue to exclude orders executed 
pursuant to a preferencing arrangement. Under the SOES Rules prior to 
the January 1994 Amended SOES Rules, both preferenced and unpreferenced 
orders were considered when calculating a market maker's remaining 
exposure limit. Thus, in relative terms, the 2,000 share exposure limit 
potentially provides greater liquidity compared to the pre-January 1994 
Amended SOES Rules' 5,000 share minimum exposure limit. This assures 
enhanced access to Nasdaq market makers by both firms with and without 
preferencing arrangements.
    The Commission believes that while the proposal does not restore 
the pre-January 1994 Amended SOES Rules minimum exposure limit, it 
provides customers fair access to the Nasdaq market and reasonable 
assurance of timely executions. In this regard, the maximum order size 
will equal the size requirement prescribed under the Firm Quote Rule 
and NASD rules governing the character of market maker quotations.\13\ 
Moreover, market maker's minimum exposure limit for unpreferenced 
orders will be double its minimum size requirement prescribed under 
these rules.\14\

    \13\NASD Manual, Schedules to the By-Laws, Schedule D, Part V, 
Sec. 2(a), (CCH) 1819.
    \14\17 CFR 240.11Ac1-1(c). Nonetheless, the Commission is 
concerned about the potential for delayed and/or inferior 
executions. In this regard, the Commission expects the NASD to 
monitor the extent to which exposure limits are exhausted, the 
extent to which the automated quotation update feature is used, and 
the effects these two aspects have on liquidity. Moreover, the 
Commission expects the NASD to consider the possibility of 
enhancements to eliminate the potential for delayed and/or inferior 
executions.
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    The Commission also believes that extending the automated update 
function is consistent with the Firm Quote Rule. The update function 
provides market makers the opportunity to update automatically their 
quotations after executions through SOES;\15\ under the Commission's 
firm Quote Rule, market makers are entitled to update their quotations 
following an execution and prior to accepting a second order at their 
published quotes.\16\

    \15\In its response to commenters, the NASD indicated that 21 
percent of market makers in Nasdaq National Market securities use 
the automated quotation update feature resulting in 38 percent of 
all market making positions in Nasdaq National Market securities. 
Letter from Richard Ketchum, Executive Vice President & Chief 
Operating Officer, NASD, to Jonathan G. Katz, Secretary, SEC (Mar. 
22, 1995).
    \16\The Firm Quote Rule requires market makers to execute orders 
at prices at least as favorable as their quoted prices. The Rule 
also allows market makers a reasonable period of time to update 
their quotations following an execution, allows market makers to 
reject an order if they have communicated a quotation update to 
their exchange or association, and provides for a size limitation on 
liability at a given quote. 17 CFR 240.11Ac1-1(c)(2). See also, 
Securities Exchange Act Release No. 14415 (Jan. 16, 1978), 43 FR 
4342 (Feb. 1, 1978).
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    The Commission notes commenter views that the NASD's proposal does 
not go far enough in restoring access available to investors prior to 
the January 1994 Amended SOES Rules. As discussed above, however, the 
current proposal does offer investors significantly wider latitude than 
the January 1994 Amended SOES Rules and the January 1995 Amended SOES 
Rules. Moreover, the limited duration of the proposal will give the 
NASD and interested persons an opportunity to assess the broader 
implications of immediate execution of orders between 500 and 1,000 
shares through SOES.

V. Conclusion

    As indicated above, the Commission has determined to approve the 
March 1995 Amended SOES Rules through October 2, 1995. In light of the 
balance of factors described above and the limited duration of the 
current proposal, the Commission believes extension of the changed 
methodology for calculating the minimum exposure and the addition of an 
automatic quotation [[Page 16693]] update feature is consistent with 
the Act.
    The Commission, in the exercise of the authority delegated to it by 
Congress, and in light of its experience regulating securities markets 
and market participants, has determined that approval of the March 1995 
Amended SOES Rules until October 2, 1995 is consistent with maintaining 
investor protection and fair and orderly markets, and that these goals, 
on balance, outweigh any possible anti-competitive effects on order 
entry firms and their customers.
    Accordingly, the Commission finds that the 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), and 15A(b)(11). In addition, the Commission finds that the 
rule change is consistent with the Congressional objectives for the 
equity markets, set out in Section 11A, of achieving more efficient and 
effective market operations, fair competition among brokers and 
dealers, and the economically efficient execution of investor orders in 
the best market.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the instant rule change SR-NASD-95-8 be, and hereby is, approved, 
effective March 28, 1995 through October 2, 1995.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 95-7987 Filed 3-30-95; 8:45 am]
BILLING CODE 8010-01-M