[Federal Register Volume 60, Number 207 (Thursday, October 26, 1995)]
[Notices]
[Pages 54900-54904]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-26575]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36399; File No. SR-NYSE-95-14]


Self-Regulatory Organizations; New York Stock Exchange, Inc.; 
Order Granting Approval to Proposed Rule Change Relating to the 
Permanent Approval of Its Pilot Program for Stopping Stock under 
Amendments to Rule 116.30

October 20, 1995.

I. Introduction

    On March 31, 1995, the New York Stock Exchange, Inc. (``NYSE'' or 
``Exchange'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to approve permanently amendments 
to Exchange Rule 116.30 that would permit specialists to stop stock in 
minimum variation markets.

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in Securities 
Exchange Act Release No. 35908 (June 28, 1995), 60 FR 34564 (July 3, 
1995). The Commission received a total of three comment letters 
opposing the proposal, two of which were from the same commenter.\3\ 
The NYSE submitted one letter supporting its proposal and responding to 
the Peake March 1, 1995 

[[Page 54901]]
Letter.\4\ For the reasons discussed below, the Commission has decided 
to approve the NYSE's proposal.

    \3\ See letter from Junius W. Peake, Monfort Professor of 
Finance, University of Northern Colorado, to Secretary, SEC, dated 
March 1, 1995 (``Peake March 1, 1995 Letter''); letter from Junius 
W. Peake, Monfort Professor of Finance, University of Northern 
Colorado, to Secretary, SEC, dated July 21, 1995 (``Peake July 21, 
1995 Letter''); letter from Morris Mendelson, Professor Emeritus of 
Finance, The Wharton School of University of Pennsylvania, to 
Jonathan Katz, Secretary, SEC, dated August 2, 1995 (``Mendelson 
Letter''). Two of the letters were submitted by one commenter, with 
the later letter responding to NYSE's response to the commenter's 
first letter. See infra note 4. See also infra notes 13-15 and 
accompanying discussion.
    \4\ See letter from James Buck, Senior Vice President and 
Secretary, NYSE, to Jonathan Katz, Secretary, SEC, dated July 17, 
1995 (``NYSE Letter '').
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II. Description of Proposal

    The practice of stopping stock refers to a guarantee by a 
specialist that an order the specialist receives will be executed at no 
worse a price than the contra side price in the market when the order 
was received, with the understanding that the order may obtain a better 
price. Prior to the proposed rule change, Exchange Rule 116.30 
permitted a specialist to stop stock only when the quotation spread was 
at least twice the minimum variation (i.e., for most stocks \1/4\ 
point), with the specialist then being required to narrow the quotation 
spread by making a bid or offer, as appropriate, on behalf of the order 
that is stopped.
    In March 1991, the Commission approved on a pilot basis \5\ 
amendments to Exchange Rule 116.30 that permitted a specialist to stop 
stock in a minimum variation market (i.e., an \1/8\-point market 
currently).\6\ The Commission subsequently has extended the Exchange's 
pilot program several times without any modifications.\7\ The most 
recent extension of the pilot program is scheduled to expire on October 
21, 1995.

    \5\ See Securities Exchange Act Release No. 28999 (Mar. 21, 
1991), 56 FR 12964 (Mar. 28, 1991) (File No. SR-NYSE-90-48) (``1991 
Approval Order'').
    \6\ NYSE Rule 62 sets forth the minimum variations for stocks 
traded on the Exchange. This Rule provides that bids or offers in 
stocks above one dollar per share shall not be made at a less 
variation under \1/8\ of one dollar per share; in stocks below one 
dollar but above \1/2\ of one dollar per share, at a less variation 
than \1/16\ of one dollar per share; and in stocks below \1/2\ of 
one dollar per share, at a less variation than \1/32\ of a dollar 
per share. This Rule also provides that the Exchange may fix 
variations of less than the above for bids and offers in specific 
issues of securities or classes of securities.
    \7\ See Securities Exchange Act Release Nos. 30482 (Mar. 16, 
1992), 57 FR 10198 (Mar. 24, 1992) (File No. SR-NYSE-92-02) (``1992 
Approval Order''); 32031 (Mar. 22, 1993), 58 FR 16563 (Mar. 29, 
1993) (File No. SR-NYSE-93-18) (``1993 Approval Order''); 33792 
(Mar. 21, 1994), 59 FR 14437 (Mar. 28, 1994) (File No. SR-NYSE-94-
06) (``1994 Approval Order''); 35309 (Jan. 31, 1995), 60 FR 7247 
(Feb. 7, 1995) (File No. SR-NYSE-95-02) (``January 1995 Approval 
Order''); 36009 (July 21, 1995), 60 FR 38878 (July 28, 1995) (``July 
1995 Approval Order'').
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    The pilot program amends Rule 116.30 to permit a specialist, upon 
request, to stop individual orders of 2,000 shares or less, up to an 
aggregate total of 5,000 shares for all stopped orders (i.e., multiple 
orders) in \1/8\ point markets. A specialist may stop an order of a 
specified larger order size threshold, or a larger aggregate number of 
shares after obtaining Floor Official approval. For a specialist to 
stop an order in a minimum variation market, there must be a 
significant disparity between the bid and ask size (on the opposite 
side of the market from the order being stopped) that suggests the 
likelihood of price improvement.\8\ In the 1991 Approval Order, first 
approving the pilot, the Commission noted that a large imbalance on the 
opposite side of the market would help ensure that stops in a minimum 
variation market occur only when the likelihood of the benefits to the 
customer's order being stopped far exceeds the possibility of harm to 
customers' orders on the limit order book.\9\

    \8\ See letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Mary N. Revell, Branch Chief, Division of Market 
Regulation, SEC, dated December 27, 1990; 1991 Approval Order, supra 
note 5; NYSE information memo #1809, dated September 12, 1991.
    \9\ The 1991 Approval Order also noted NYSE's representation and 
the Commission's understanding that specialists would not routinely 
use such procedures or that Floor Officials would not routinely 
authorize the specialists to exceed the parameters of the proposal.
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    Under these limited circumstances, the pilot permitted a specialist 
to stop a buy (sell) order at the market upon request and guarantee 
that the order will receive no worse than the best then-prevailing 
offer (bid) price. The specialist would then increase the bid (offer) 
size to reflect the stopped order.\10\ If the pre-existing volume at 
the bid (offer) is exhausted and a seller (buyer) hits the bid (offer) 
made on behalf of the stopped order, the buyer's (seller's) stopped 
order would obtain price improvement. If, however, before that event 
occurs another buyer's (seller's) order is executed at the offer (bid), 
then the specialist would execute the stopped order at the stopped 
price.

    \10\ The stopped order would be placed behind the existing limit 
orders at the bid (offer) for priority purposes.
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    In the order approving the pilot procedures, the Commission 
requested that the Exchange study the effects of stopping stock in 
minimum variation markets and collect certain data to allow the 
Commission to evaluate fairly and comprehensively the pilot 
program.\11\ In the Commission's 1994 Approval Order extending the 
pilot program until March 21, 1995, the Commission requested that the 
Exchange submit a fourth monitoring report on the stopping stock 
pilot.\12\ The NYSE subsequently submitted its fourth monitoring 
report. The Commission then approved an extension of the pilot until 
October 21, 1995, so that the Commission would have additional time to 
evaluate the information provided in the fourth monitoring report and 
to ensure that Rule 116.30, as amended, provides a benefit to investors 
through the possibility of price improvement to customers whose orders 
are granted stops in minimum variation markets while unduly harming 
public customer limit orders on the specialist book.

    \11\ See supra notes 5 and 7.
    \12\ See 1994 Approval Order, supra note 7.
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III. Summary of Comments

    The Commission received three negative comment letters regarding 
the permanent approval of the Exchange's procedures for stopping stock 
in minimum variation markets.\13\ Two of the letters were submitted by 
the same commenter, Junius Peake. The NYSE Letter was in support of its 
proposal and in response to the Peake March 1, 1995 Letter.\14\ The 
third negative comment letter was submitted in support of the position 
in the Peake letters.\15\ The issues raised therein are discussed 
below.

    \13\ See Peake March 1, 1995 Letter, supra note 3; Peake July 
21, 1995 Letter, supra note 3: Mendelson Letter, supra note 3. 
Although the comment letters referred to File No. SR-NYSE-95-02, the 
Commission will treat them as comments to this rule proposal because 
the comments relate to the permanent approval of amendments to NYSE 
Rule 116.30.
    \14\ See NYSE Letter, supra note 4.
    \15\ See Mendelson Letter, supra note 3.
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    Professor Peake states that the NYSE's proposal should not be 
approved and that all rules allowing specialists to stop stock should 
be repealed. In his initial letter, Professor Peake states that a 
specialist has inherent conflicts of interest as auctioneer, fiduciary 
(or agent for investors on each side of the market), and provider of 
immediate liquidity. Professor Peake argues that the practice of 
stopping stock aggravates a specialist's conflict of interest by 
pitting the specialist's obligation as agent to the investors who have 
entrusted him with limit orders against his obligation to a market 
order that normally would be filled against such limit orders.
    Moreover, Professor Peake states that when the specialist is the 
only source of the quotation against which the stop is given, the 
specialist is improving his chance of avoiding an unwanted trade 
because the specialist is hoping that another customer order will 
arrive at a better price than at which the specialist is willing to 
trade. Professor Peake also asserts that a specialist as a competitor 
in the stocks in which he makes a market should not be given such 
latitude in setting execution prices.
    Professor Peake believes that the conflicts inherent in the 
specialist's role could be avoided and the need for the stopping stock 
rules obviated if the 

[[Page 54902]]
competitiveness of the exchanges and the over-the-counter markets was 
increased. Professor Peake believes that the easiest method to 
accomplish this would be to reduce the minimum price variation between 
trades to one cent. Professor Peake also believes that the entire limit 
order book should be displayed and accessible to all market 
participants.
    In response to Professor Peake, the Exchange characterizes his 
letter as a broad attack on the concept of stopping stock that fails to 
analyze the specific aspects of the Exchange's proposal.\16\ The 
Exchange argues that, notwithstanding Professor Peake's assertions of a 
theoretical conflict of interest in a specialist's role in representing 
both buyer and seller, the procedures utilized in the pilot have proven 
effective in providing opportunities for price improvement. The 
Exchange states that its studies show that more than half of eligible 
orders (i.e., orders for 2,000 shares or less) stopped in minimum 
variation markets received price improvement, resulting in savings of 
millions of dollars to public investors. The Exchange reiterates that 
the proposal enables specialists to better serve investors through the 
ability to offer price improvement to stopped orders while having 
relatively little impact on the other orders on the book.

    \16\ See NYSE Letter, supra note 4.
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    In response to the NYSE Letter, Professor Peake states that 
contrary to the NYSE's position, a specialist stopping stock faces 
conflicts of interest. Moreover, Professor Peake argues that for every 
investor for whom price is improved when stock is stopped, there is 
always another investor who will receive a worse price or be unable to 
complete the trade at all. Professor Peake suggests that the Commission 
might be able to remedy the situation by conditioning approval of the 
NYSE's proposal on requiring neutral exchange employees, rather than 
specialists, to take the responsibility for stopping stock against 
other investors' orders. Professor Peake admits, however, that this 
alternative might be awkward and overly expensive.
    Finally, in his letter, Professor Mendelson agrees with Professor 
Peake and believes that the proposed rule change permits the specialist 
to violate his fiduciary responsibility. Moreover, he believes that the 
proposed rule change hampers price discovery because a stop delays the 
execution of an order.

IV. Discussion

    After careful consideration of the comments, the NYSE response 
thereto, and the data submitted by the NYSE over the course of the 
pilot, the Commission has determined to approve permanently the 
proposed rule change. For the reasons discussed below, the Commission 
finds that the proposed rule change is consistent with the requirements 
of the Act and the rules and regulations thereunder applicable to a 
national securities exchange, and, in particular, with Section 6(b)(5) 
\17\ and Section 11(b) \18\ of the Act.

    \17\ 15 U.S.C. 78f.
    \18\ 15 U.S.C. 78k.
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    Historically, the Commission has had mixed reactions about the 
practice of stopping stock. The 1963 Report of the Special Study of the 
Securities Markets found that unexecuted customer limit orders on the 
specialist's book might be bypassed by the stopped orders.\19\ The 
Commission, nevertheless, has allowed the practice of stopping stock in 
markets where the spread is at least twice the minimum variation 
because the possible harm to orders on the book is offset by the 
reduced spread that results and the possibility of price improvement.

    \19\ See SEC, Report of the Special Study of Securities Markets 
of the Securities and Exchange Commission, H.R. Doc. No. 95, 88th 
Cong., 1st Sess., Pt. 2 (1963) (``Special Study'').
    When stock is stopped, limit book orders on the opposite side of 
the market do not receive an immediate execution. Consequently, if 
the stopped order then receives an improved price, limit orders at 
the stop price are bypassed and, if the market turns away from that 
limit, may never be executed.
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    Although the procedures for stopping stock in minimum variation 
markets do not reduce the spread between the quotes the Commission has 
allowed, on a pilot basis, the practice in limited circumstances where 
there is a substantial imbalance on the opposite side of the market 
from the order being stopped. This limitation is intended to assure 
that specialists would stop stock in minimum variation markets only in 
situations where the likelihood of price improvement outweighs the 
possibility that contra-side limit orders would be bypassed.\20\ 
Moreover, the order size restrictions would act to ensure that most 
stops are granted to public customers with small orders, whose orders 
could most benefit from the professional handling by specialists.\21\ 
In addition, limiting the total stops to 5,000 shares is intended to 
ensure that the amount of stopped stock does not become so large that 
there would, in effect, cease to be an imbalance on the opposite side 
of the market from the order being stopped (i.e., less likelihood of 
price improvement for the stopped orders). Finally, although the spread 
cannot be reduced by stopping stock in minimum variation markets, 
specialists must change the quote bid or offer size to reflect the size 
of the order being stopped. This should ensure that the stopped stock 
will be shown in the quote.

    \20\ As for limit book orders on the same side of the market as 
the stopped stock, the Commission believes that Rule 116.30's 
requirements make it unlikely that these limit orders would not be 
executed. Under the NYSE pilot program, an order can be stopped only 
if a substantial imbalance exits on the opposite side of the market. 
In those circumstances, the stock would probably trade away from the 
large imbalance, resulting in execution of orders on the limit order 
book.
    \21\ As part of its initial proposed rule change, the NYSE 
provided the following example illustrating the relationship between 
quote size imbalance and the likelihood of price improvement: Assume 
that the market for a given stock is quoted 30 to 30\1/8\, with 
1,000 shares bid for and 20,000 shares offered. The large imbalance 
on the offer side of the market suggests that subsequent 
transactions will be on the bid side. Accordingly, the NYSE states 
that it might be appropriate to stop a market order to buy, since 
the delay might allow the specialist to execute the buyer's order at 
a lower price. After granting such a stop, under NYSE rules the 
specialist would be required to increase his quote by the size of 
the stopped buy order, thereby adding depth to the bid side of the 
market.
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    To examine whether specialists have been using the pilot program as 
intended, the Commission had asked the Exchange to provide data on the 
stopping stock program in a minimum variation market.\22\ The Exchange 
has submitted to the Commission four monitoring reports regarding the 
amendments to Rule 116.30. The commission believes that the monitoring 
reports, especially, the fourth (and latest) monitoring report, provide 
useful information regarding the effectiveness of the program during 
the pilot period.

    \22\ See supra notes 5 and 7.
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    Specifically, according to the NYSE's fourth report, approximately 
half of eligible orders (i.e., orders for 2,000 shares or less) stopped 
in minimum variation markets received price improvement. Moreover, 
according to the NYSE report, stops in minimum variation markets 
generally have been granted when there was a significant disparity (in 
both absolute and relative terms) between the number of shares bid for 
and the number offered. In particular, the Exchange reports that for a 
substantial majority of stops granted, the size of the stopped order 
was less than, or equal to, 25% of the size of the opposite side quote. 
The Exchange also reports that only approximately a third of the limit 
orders on the opposite side of the market from all market orders 
stopped in eighth point markets were 

[[Page 54903]]
not executed by the end of the day.\23\ Finally, with respect to Floor 
Official approval of waivers to the numerical limitations, the Exchange 
reports that, after some problems in the earlier phases of the pilot, a 
very high percentage of orders requiring Floor Official approval 
received such an approval.

    \23\ The NYSE report finds that approximately 40% of the limit 
orders on the opposite side of the market from the stopped orders 
were canceled and approximately 30% were executed by the end of the 
day.
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    The Commission, therefore, believes that the data on stopping stock 
in minimum variation markets show that the pilot has operated as 
intended and should be approved permanently. Moreover, for the reasons 
discussed below, the Commission believes that the commenters' 
criticisms of the proposals have been adequately addressed.
    First, although the Commission recognizes that a specialist 
potentially may have multiple responsibilities with respect to limit 
orders on the book and to market orders, the stopping stock program in 
minimum variation markets is a reasonable approach to the balancing of 
interests.\24\ The program attempts to maximize the possibility of 
price improvement for market order customers while minimizing the 
possibility that limit orders may be bypassed. This is accomplished by 
permitting the use of the stopping stock procedures in minimum 
variation markets in limited circumstances: Where the disparity between 
the bid and offer size appears to be significant enough that there is 
likelihood of price improvement. Moreover, as discussed above the data 
indicates that the pilot has fulfilled its expectations in that 
customers, for the most part, have been stopped only in markets with 
substantial disparities and have received price improvement in many of 
these situations.

    \24\ Cf. Securities Exchange Act Release No. 36310 (Sept. 29, 
1995), 60 FR 52792, 52807 (Oct. 10, 1995), where the Commission 
requests comment on order exposure procedures in minimum variation 
markets and how price improvement procedures would operate in such 
situations.
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    Second, the Commission disagrees with Professor Peake that the 
specialist is using the stopping stock procedures to avoid making an 
unwanted trade with his own quote. The requirement that there be a 
large imbalance on the opposite side of the stopped order for a 
specialist to stop stock makes it unlikely that the specialist would be 
the only source of a quote.
    Third, Professor Peake states that the specialist should not be 
given latitude in setting execution prices through stopping stock. 
Given that there must be a significant imbalance between the bid and 
offer that strongly suggests the likelihood of price improvement, the 
Commission does not believe that a specialist stopping stock and 
providing price improvement is provided with unfettered discretion in 
setting prices or unduly influencing market trends.\25\

    \25\ The Commission notes that to the extent there is a large 
price discrepancy between sequential orders, the NYSE surveillance 
procedures would review whether orders were executed consistent with 
price parameters for continuity and depth.
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    Fourth, Professor Peake suggests that the decimalization of quotes 
and full disclosure of the limit order book would make the practice of 
stopping stock unnecessary.\26\ Such a possibility, however, should not 
preclude the NYSE from developing price improvement procedures based 
upon existing spread parameters. Moreover, in regard to market 
structure concerns over order handling and transparency, the Commission 
recently proposed rules designed, among other things, to improve the 
display of limit orders.\27\ The Commission does not believe that the 
proposed stopping stock procedures for minimum variation markets should 
be disapproved pending further action on the other proposals.

    \26\ See Securities Exchange Act Release No. 33026 (Oct. 6, 
1993), 58 FR 36262 (Oct. 13, 1993) (seeking comment regarding 
decimal pricing in the Commission's proposal to require disclosure 
of payment for order flow).
    \27\ See Securities Exchange Act Release No. 36310 (Sept. 29, 
1995), 60 FR 52792 (Oct. 10, 1995) (proposing a minimum standard for 
all markets that would require the display of customer limit orders 
under certain circumstances). In addition, as noted above the 
stopping stock pilot provides, to a certain extent, market 
transparency by requiring that the stopped orders be reflected in 
the quote. See also Division of Market Regulation, SEC, ``Market 
2000, An Examination of Current Equity Market Developments'' (Jan. 
1994) (``Market 2000'') Study IV at 5-6.
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    Fifth, Professor Mendelson states that the practice of stopping 
stock hampers price discovery because a stop delays the execution of an 
order. The Commission believes that although stopping stock might delay 
the execution of an order somewhat, the opportunity for price 
improvement for the order that is stopped outweighs concerns regarding 
the delay of an order execution. Moreover, the Commission believes that 
the practice of stopping stock may further the price discovery process 
of a stock because the stopped stock may receive an improved price, 
which might be a more accurate reflection of the interests in the 
market.
    For all of the above reasons, the Commission believes that the NYSE 
proposal is consistent with Section 6(b)(5) of the Act. In addition to 
a determination that the NYSE proposal is consistent with Section 6 of 
the Act and adequately addresses the commenters' concerns, the 
Commission also believes that the proposal is consistent with the 
prohibition in Section 11(b) against providing discretion to a 
specialist in the handling of an order.\28\ Section 11(b) was designed, 
in part, to address potential conflicts of interest that may arise as a 
result of the specialist's dual role as agent and principal in 
executing stock transactions. In particular, Congress intended to 
prevent specialists from unduly influencing market trends through their 
knowledge of market interest from the specialist's book and their 
handling of discretionary agency orders.\29\ The Commission has stated 
that, pursuant to Section 11(b), all orders other than market or limit 
orders are discretionary and therefore cannot be accepted by 
specialists.\30\

    \28\ Section 11(b) permits a specialist to accept only market or 
limit orders.
    \29\ See H. Rep. No. 1383, 73d Cong. 2d Sess. 22, S. Rep. 792, 
73d Cong. 2d Sess. 18 (1934).
    \30\ See Special Study, supra note 19.
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    As previously noted in the 1991 Approval Order, the Commission 
believes that it is appropriate to treat stopped orders, even those 
under the pilot procedures, as equivalent to limit orders. The NYSE's 
rules define a limit order as an order to buy or sell a stated amount 
of a security at a specified price, or at a better price if 
obtainable.\31\ The Commission believes that stopped orders are 
equivalent to limit orders, in this instance, because the orders would 
be automatically elected at the best bid or offer, or better if 
obtainable. Although the proposed amendments permit the specialist to 
employ his judgment to some extent, the Commission believes that the 
requirements imposed on the specialist for granting stops in minimum 
variation markets provide sufficiently stringent guidelines to ensure 
that the specialist will only implement these provisions in a manner 
consistent with his market making duties and Section 11(b).\32\

    \31\ See NYSE Rule 13.
    \32\ Moreover, stopped orders as ``limit orders'' would not 
bypass pre-existing limit orders on the same side of the market. 
Under the NYSE's procedures, specialists may not execute a stopped 
order before the limit order interest on the Exchange (at the same 
price as the stopped order) is exhausted. See supra note 20.
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    In permanently approving the stopping stock procedures for minimum 
variation markets, the Commission is relying on three aspects of the 
program and expects the NYSE to reiterate these requirements in an 
Information Memo to members. First, the Commission continues to believe 
that the requirement of a sufficient market imbalance is important to 
the proper application of the program. This 

[[Page 54904]]
requirement should help the NYSE ensure that stops are only granted in 
a minimum variation market when the benefit (i.e., price improvement) 
to orders being stopped far exceeds the potential for harm to orders on 
the specialist's book. Second, the Commission expects the NYSE to take 
appropriate action in response to any instance of specialist non-
compliance with the stopping stock procedures in minimum variation 
markets. Third, the Commission emphasizes that Floor Official approval 
of an increase in the size of the stopped order or stopping more than 
5000 shares must not be routine. The Commission expects the NYSE to 
continue to monitor compliance with these aspects of the stopping stock 
program through its special surveillance procedures.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\33\ that the proposed rule change (SR-NYSE-95-14) is approved.

    \33\ 15 U.S.C. 78s(b0(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\34\

    \34\ 17 CFR 200.30-3(a0(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-26575 Filed 10-25-95; 8:45 am]
BILLING CODE 8010-01-M