[Federal Register Volume 60, Number 194 (Friday, October 6, 1995)]
[Notices]
[Pages 52438-52440]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-24909]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36311; File No. SR-NASD-95-34]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Temporary Approval of Proposed Rule 
Change to Extend Certain SOES Rules Through January 31, 1996

I. Introduction

    On August 11, 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 January 31, 1996 certain changes to its Small Order Execution 
System (``SOES'') that were originally implemented in January 1994 for 
a one-year pilot period (``January 1994 Amended SOES Rules'').\3\ These 
rules subsequently were modified in January 1995 (``January 1995 
Amended SOES Rules'') \4\ and further modified in March 1995 (``March 
1995 Amended SOES Rules'').\5\ The March 1995 Amended SOES Rules are 
scheduled to expire on October 2, 1995, and the NASD seeks to extend 
these until January 31, 1996. Without further Commission action, the 
SOES rules would revert to those in effect prior to January 1994.

    \1\ 15 U.S.C. Sec. 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).
    \5\ Securities Exchange Act Release No. 35535 (Mar. 27, 1995), 
60 FR 16690 (Mar. 31, 1995).
    The March 1995 Amended SOES Rules did not include the two 
features found in the January 1994 Amended SOES Rules 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 and, 
as noted, the March 1995 Amended SOES Rules continued only the first 
two January 1994 Amended SOES Rules.
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    Notice of the proposed rule change appeared in the Federal Register 
on August 31, 1995.\6\ Eleven comments were received in response to the 
Commission release. For the reasons discussed below, this order 
approves the proposed rule change until January 31, 1996.

    \6\ Securities Exchange Act Release No. 36154 (Aug. 25, 1995), 
60 FR 45502 (Aug. 31, 1995).
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II. Description of the Current and Prior Proposals

    The NASD proposes to extend until January 31, 1996 the March 1995 
Amended SOES Rules. Specifically, the NASD proposes to extend until 
January 31, 1996 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) Maintain the availability of an automated function for updating 
market maker quotations when the market maker's exposure limit has been 
exhausted (market makers using this update function may establish an 
exposure limit equal to the maximum order size for that security).

III. Comments

    The current proposal attracted eleven comments, eight supporting 
the proposal and three opposing it. The comments raised issues similar 
to those raised in connection with previous amendments to the SOES 
Rules.
    Generally, commenters supporting the proposals have argued that the 
various amendments to the SOES Rules have been necessary to limit the 
exposure of market makers to multiple SOES executions, which benefits 
retail investors by producing narrower spreads and more liquid markets. 
Some commenters supporting the proposal also argued for additional 
limits on market makers' SOES exposure, such as a reduction in the SOES 
maximum order size to 500 shares.
    Commenters opposed to the proposals have argued that the 
statistical and market quality data cited by the NASD \7\ in support of 
the various amendments to the SOES Rules are not sufficient to 

[[Page 52439]]
support the NASD's position. They contend that the studies on which the 
NASD relies fail to demonstrate any increase in market quality as a 
result of the various amendments to the rules and that market makers 
have ample opportunity to update their quotes in order to avoid 
multiple SOES executions.

    \7\ See infra notes 16-20 and accompanying text.
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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\ The Commission believes 
that approval of the proposal through January 31, 1996 meet the above 
standards. Specifically, the Commission believes that the current 
minimum exposure limit and automated quotation update feature are 
appropriate while the NASD considers other methods for handling small 
orders from retail customers.\10\

    \8\ 25 U.S.C. 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).
    \10\ See letter from Joan C. Conley, Secretary, NASD, to Mark 
Barracca, Branch Chief, Division of Market Regulation, SEC (Sept. 
22, 1995) (submission of File No. SR-NASD-95-42, the NASD's NAqcess 
proposal which is designed to replace SOES).
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    The Commission believes that a sufficient basis exists for 
approving the NASD's proposal to continue the current operation of 
SOES. The system provided and continues to provide retail investors 
enhanced opportunity to obtain execution of orders in size up to 1,000 
shares and, accordingly, has improved access to the Nasdaq market.
    In addition, the March 1995 Amended SOES Rules resulted in an 
increase in the SOES minimum exposure limit from 1,000 shares to 2,000 
shares. Moreover, the March 1995 Amended SOES Rules continued the 
methodology for calculating a market maker's outstanding exposure limit 
that excluded 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 under 
certain conditions compared to the pre-January 1994 Amended SOES Rules' 
5,000 share minimum exposure limit.
    The Commission continues to believe that the current operation of 
SOES has eliminated the economically significant restrictions imposed 
on order entry firms by the January 1994 Amended SOES Rules. 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 equals the 
size requirement prescribed under the Firm Quote Rule and NASD rules 
governing the character of market maker quotations.\11\ Moreover, 
market maker's minimum exposure limit for unpreferenced orders is 
double its minimum size requirement prescribed under these rules.\12\

    \11\ NASD Manual, Schedules to the By-Laws, Schedule D, Part V, 
Sec. 2(a), (CCH) para. 1819.
    \12\ 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. The Commission expects the NASD to report back to the 
Commission on these issues by December 1, 1995.
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    The Commission also believes that extending the automated update 
function is consistent with the Firm Quote Rule.\13\ The update 
function provides market makers the opportunity to update their 
quotations automatically after executions through SOES; \14\ 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.\15\

    \13\ The SOES automated update function is also consistent with 
the NASD's autoquote policy which generally prohibits autoquote 
systems, but allows automatic updating of quotations ``when the 
update is in response to an execution in the security by the firm.'' 
NASD Manual, Schedules to the By-Laws, Schedule D, Part V, Sec. 2 
(CCH para. 1819).
    \14\ The NASD has indicated that 21 percent of market makers in 
Nasdaq National Market securities use the automated quotation update 
feature for 38 percent of all market making positions in Nasdaq 
National Market securities. Letter from Richard Ketchum, Executive 
Vice President and Chief Operating Officer, NASD, to Jonathan G. 
Katz, Secretary, SEC (Mar. 22, 1995).
    \15\ 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 given quote. 17 CFR 240.11Ac1-1(c)(2). See also, 
Securities Exchange Act Release No. 14415 (Jan. 26, 1978), 43 FR 
4342 (Feb. 1, 1978).
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    In connection with its proposal, the NASD submitted data it 
believes supports extending the current minimum exposure limit and the 
automated quotation update feature.\16\ In addition, in connection with 
the Commission's consideration of the NASD's proposal, the Commission 
requested that the NASD provide any industry-wide or firm-specific data 
that market maker firms have provided the NASD concerning the effect 
SOES has had on profitability or the market making function.\17\ 
According to the NASD, since the restoration in March 1995 of the 
maximum order size of 1,000 shares, the volume of trading through SOES 
has increased both in absolute terms and relative to overall Nasdaq 
volume. As a result, the NASD believes, some market makers have 
withdrawn from making a market in certain Nasdaq securities. The NASD 
argues that failure to extend the March 1995 Amended SOES Rules would 
exacerbate this withdrawal.

    \16\ Letter from Richard G. Ketchum, Executive Vice President 
and Chief Operating Officer, NASD, to Brandon Becker, Director, 
Division of Market Regulation, SEC (Aug. 1, 1995).
    \17\ Letter to Richard G. Ketchum, Executive Vice President and 
Chief Operating Officer, NASD, from Brandon Becker, Director, 
Division of Market Regulation, SEC (Aug. 25, 1995). As of the 
issuance of this order, the NASD has not provided any data in 
response to this request.
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    The Commission is not convinced, however, that the data submitted 
by the NASD demonstrates a casual relationship between the change in 
the operation of SOES as a result of the March 1995 Interim SOES Rules 
and the decline in the number of market makers in the selected 
securities. Rather, the Commission believes the NASD's data 
demonstrates, at best, a correlation between the two. The NASD did not 
control for other factors that may have affected the number of market 
makers in the securities covered by their study (e.g., decreased 
spreads; increased volatility; seasonality; and increased capital 
requirements associated with increased prices). Such factors could 
potentially explain the decline in the number of market makers 
independent of SOES activity. In addition, the NASD 

[[Page 52440]]
selected securities with the largest decline in the number of market 
makers. From an economic and statistical basis, this introduces severe 
statistical problems and a bias toward those securities with the 
largest number of market makers. This selection, under any 
circumstance, would find the largest absolute changes in the number of 
market makers.
    In further support of its proposal, the NASD continues to rely on 
studies previously submitted to the Commission in support of the 
amendments to SOES.\18\ In its order approving both the January 1995 
and March 1995 Amended SOES Rules, however, the Commission expressed 
its belief that this 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.\19\ The information submitted since does not alter 
the Commission's original assessment. The Commission, therefore, 
continues to believe that the data 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.\20\ Moreover, the Commission believes this is 
true whether the amended SOES rules are viewed collectively or 
individually. Thus, the Commission's evaluation of the data submitted 
by the NASD does not change its determination to approve the proposal 
to extend the March 1995 Amended SOES Rules through January 31, 1996.

    \18\ Securities Exchange Act Release No. 35080 (Dec. 9, 1994), 
59 FR 65109 (Dec. 16, 1994) and 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)).
    \19\ Securities Exchange Act Release No. 35275 (Jan. 25, 1995), 
60 FR 6327 (Feb. 1, 1995).
    \20\ Nonetheless, the Commission continues to be interested in 
data and studies demonstrating the effect, if any, of the SOES rule 
changes on the Nasdaq market.
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V. Conclusion

    As indicated above, the Commission has determined to approve the 
October 1995 Amended SOES Rules through January 31, 1996. In light of 
the balance of factors described above and the limited duration of the 
current proposal, the Commission believes extension of the reduction in 
the minimum exposure limit, the limitation of the exposure limit to 
unpreferenced orders, and the addition of an automatic quotation 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 these 
temporary changes to the SOES Rules until January 31, 1996 is 
consistent with maintaining investor protection and fair and orderly 
markets, and that these goals, on balance, outweigh 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-95-34 be, and hereby is, approved, 
effective October 3, 1995 through January 31, 1996.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 95-24909 Filed 10-5-95; 8:45 am]
BILLING CODE 8010-01-M