[Federal Register Volume 61, Number 14 (Monday, January 22, 1996)]
[Notices]
[Pages 1655-1660]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-737]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36719; File No. SR-NASD-95-60]


Self-Regulatory Organizations; Notice of Proposed Rule Change by 
the National Association of Securities Dealers, Inc. Relating to a Six-
Month Extension of the SOES Minimum Exposure Limit Rule and the SOES 
Automated Quotation Update Feature

January 16, 1996.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on December 
19, 1995, the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by the NASD. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD proposes to extend, until July 31, 1996, the effectiveness 
of certain rules governing the operation of The Nasdaq Stock Market, 
Inc.'s (``Nasdaq'') Small Order Execution System (``SOES''). 
Specifically, these SOES rules, which were previously approved by the 
Commission on a pilot basis on December 23, 1993 1 and recently 
extended through January 31, 1996,2 provide for: (1) A reduction 
in the minimum exposure limit for unpreferenced SOES orders from five 
times the maximum order size to two times the maximum order size, and 
for the elimination of exposure limits for preferenced orders (``SOES 
Minimum Exposure Limit Rule''); and (2) implementation of an automated 
function for updating market maker quotations when the market maker's 
exposure limit has been exhausted (``SOES Automated Quotation Update 
Feature''). These rules are part of a set of SOES rules approved by the 
SEC on a pilot basis known as the Interim SOES Rules.3

    \1\ See Securities Exchange Act Release No. 33377 (December 23, 
1993), 58 FR 69419 (December 30, 1993) (``Interim SOES Rules 
Approval Order'').
    \2\ See Securities Exchange Act Release No. 36311 (September 29, 
1995), 60 FR 52438 (October 6, 1995) (``Interim SOES Rules Extension 
Order'').
    \3\ As first approved by the Commission on December 23, 1993, 
the Interim SOES Rules had four components: (1) The SOES Minimum 
Exposure Limit; (2) the Automated Quotation Update; (3) a reduction 
in the maximum size order eligible for execution through SOES from 
1,000 shares to 500 shares (``SOES Maximum Order Size''); and (4) 
the prohibition of short sales through SOES. The SOES Maximum Order 
Size Rule lapsed effective March 28, 1995, and the rule prohibiting 
the execution of short sales through SOES lapsed effective January 
26, 1995.
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II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in Sections 
(A), (B), and (C) below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    The Commission originally approved the SOES Minimum Exposure Limit 
Rule and the SOES Automated Quotation Update Feature on a one-year 
pilot basis in December 1993, along with two other SOES rules which 
have since lapsed.4 Since December 1993, the SEC has approved 
three NASD proposals to extend the effectiveness of the rules, with the 
most recent approval extending the rules through January 31, 
1996.5 With this filing the NASD proposes to further extend the 
effectiveness of the SOES Minimum Exposure Limit Rule and the SOES 
Automated Quotation Update Feature until July 31, 1996, so that the 
rules can continue on an uninterrupted basis until the SEC has had an 
opportunity to 

[[Page 1656]]
consider Nasdaq's proposed NAqcess system.

    \4\ See Interim SOES Rules Approval Order, supra note 1.
    \5\ See Interim SOES Rules Extension Order, supra note 2, and 
Securities Exchange Act Release Nos. 35275 (January 25, 1995), 60 FR 
6327 (February 1, 1995); 35535 (March 27, 1995), 60 FR 16690 (March 
31, 1995).
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    As described in more detail below, because the NASD believes 
implementation of the SOES Minimum Exposure Limit Rule and the SOES 
Automated Quotation Update Feature have been associated with positive 
developments in the markets for Nasdaq securities and clearly have not 
had any negative effects on market quality, the NASD believes it is 
appropriate and consistent with the maintenance of fair and orderly 
markets and the protection of investors for the Commission to approve a 
further limited extension of the effectiveness of these rules. The NASD 
believes the SOES Minimum Exposure Limit Rule and the SOES Automated 
Quotation Update Feature reflect a reasoned approach by the NASD to 
address the adverse effects on market liquidity attributable to active 
intra-day trading activity through SOES, while at the same time not 
compromising the ability of small, retail investors to receive 
immediate executions through SOES. Specifically, these rules are 
designed to address concerns that concentrated, aggressive use of SOES 
by a growing number of order entry firms has resulted in increased 
volatility in quotations and transaction prices, wider spreads, and the 
loss of liquidity for individual and institutional investor orders.
    The NASD believes that the same arguments and justifications made 
by the NASD in support of approval of the SOES Minimum Exposure Limit 
Rule and the SOES Automated Quotation Update Feature and three 
extensions of these rules are just as compelling today as they were 
when the SEC relied on them to initially approve these rules. In sum, 
the NASD continues to believe that concentrated bursts of SOES activity 
by active order-entry firms contribute to increased short-term 
volatility, wider spreads, and less market liquidity on Nasdaq and that 
the SOES Minimum Exposure Limit Rule and the SOES Automated Quotation 
Update Feature are an effective means to minimize these adverse market 
impacts. In addition, given the increased utilization of SOES since the 
SOES Maximum Order Size Rule lapsed at the end of March 1995, the NASD 
believes it is even more imperative that the SOES Minimum Exposure 
Limit Rule and the SOES Automated Quotation Update Feature remain in 
effect to help to ensure the integrity of the Nasdaq market and prevent 
waves of SOES orders from a handful of SOES order-entry firms from 
degrading market liquidity and contributing to excessive short-term 
market volatility.
    The NASD notes that the SEC made specific findings in the Interim 
SOES Rules Approval Order that the SOES Minimum Exposure Limit Rule and 
the SOES Automated Quotation Update Feature were consistent with the 
Act. In particular, the SEC stated in its approval order that:

    a. Because the benefits for market quality of restricting SOES 
usage outweigh any potential decrease in pricing efficiency, the 
Commission concludes that the net effect of the proposal is to 
remove impediments to the mechanism of a free and open market and a 
national market system, and to protect investors and the public 
interest, and that the proposed rule changes are designed to produce 
accurate quotations, consistent with Sections 15A(b)(6) and 
15A(b)(11) of the Act. In addition, the Commission concludes that 
the benefits of the proposal in terms of preserving market quality 
and preserving the operational efficiencies of SOES for the 
processing of small size retail orders outweigh any potential burden 
on competition or costs to customers or broker-dealers affected 
adversely by the proposal. Thus, the Commission concludes that the 
proposal is consistent with Section 15A(b)(9) of the Act in that it 
does not impose a burden on competition which is not necessary or 
appropriate in furtherance of the purposes of the Act.6

    \6\ Interim SOES Rules Approval Order, supra note 1, 58 FR at 
69423.
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    b. The Commission also concludes that the proposal advances the 
objectives of Section 11A of the Act. Section 11A provides that it 
is in the public interest and appropriate for the protection of 
investors and the maintenance of fair and orderly markets to assure 
economically efficient execution of securities transactions, fair 
competition among market participants, and the practicality of 
brokers executing orders in the best market. The Commission 
concludes that the proposal furthers these objectives by preserving 
the operational efficiencies of SOES for the processing of small 
orders from retail investors.7

    \7\ Id.
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    c. The Commission believes that it is appropriate to restrict 
trading practices through SOES that impose excessive risks and costs 
on market makers and jeopardize market quality, and which do not 
provide significant contributions to liquidity or pricing efficiency 
* * * The Commission believes that it is more important to ensure 
that investors seeking to establish or liquidate an inventory 
position have ready access to a liquid Nasdaq market and SOES than 
to protect the ability of customers to use SOES for intra-day 
trading strategies.8

    \8\ Id. at 69424-25.
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    d. The Commission believes that there are increased costs 
associated with active intra-day trading activity through SOES that 
undermine Nasdaq market quality. * * * Active intra-day trading 
activity through SOES can also contribute to instability in the 
market.9

    \9\ Id.
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    e. In addition, these waves of executions can make it difficult 
to maintain orderly markets. Given the increased volatility 
associated with these waves of intra-day trading activity, market 
makers are subject to increased risks that concentrated waves of 
orders will cause the market to move away. As a result, individual 
market makers may be unwilling to narrow the current spread and 
commit additional capital to the market by raising the bid or 
lowering the offer. When market makers commit less capital and quote 
less competitive markets, prices can be expected to deteriorate more 
rapidly. Accordingly, the Commission believes that it is appropriate 
for the NASD to take measured steps to redress the economic 
incentives for frequent intra-day trading inherent in SOES to 
prevent SOES activity from having a negative effect on market prices 
and volatility.10

    \10\ Id. at 69425-26.
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    f. The Commission does not believe that intra-day trading 
strategies through SOES contribute significantly to market 
efficiency in the sense of causing prices to reflect information 
more accurately.11

    \11\ Id.
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    g. The Commission has evaluated each of the proposed 
modifications to SOES, and concludes that each of the modifications 
reduces the adverse effects of active trading through SOES and 
better enables market makers to manage risk while maintaining 
continuous participation in SOES. In addition, the Commission does 
not believe that any of the modifications will have a significant 
negative effect on market quality. To the extent that any of the 
modifications may result in a potential loss of liquidity for small 
investor orders, the Commission believes that these reductions are 
marginal and are outweighed by the benefits of preserving market 
maker participation in SOES and increasing the quality of executions 
for public and institutional orders as a result of the 
modifications.12

    \12\ Id.
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    h. The Commission * * * has determined that the instant 
modifications to SOES further objectives of investor protection and 
fair and orderly markets, and that these goals, on balance, outweigh 
any marginal effects on liquidity for small retail orders, and any 
anti-competitive effects on order entry firms and their customers. 
The Commission concludes that the ability of active traders to place 
trades through a system designed for retail investors can impair 
market efficiency and jeopardize the level of market making capital 
devoted to Nasdaq issues. The Commission believes that the rule 
change is an appropriate response to active trading through SOES, 
and that the modifications will reduce the effects of concentrated 
intra-day SOES activity on the market.13

    \13\ Id. at 69429.
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    The NASD believes these significant statutory findings by the SEC 
regarding the SOES Minimum Exposure Limit Rule and the SOES Automated 
Quotation Update Feature and the SEC's assessment of the likely 
benefits to the marketplace that would result from the rules have been 
confirmed and substantiated by econometric studies on 

[[Page 1657]]
the effectiveness of the Interim SOES Rules conducted by the NASD's 
Economic Research Department 14 and an independent economist 
commissioned by the NASD.15 When the SEC approved the Interim SOES 
Rules, it 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 an independent 
consideration under Section 19 of the Act.'' 16 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.

    \14\ See letter from Gene Finn, Vice President & Chief 
Economist, NASD, to Katherine England, Assistant Director, National 
Market System & OTC Regulation, SEC, dated October 24, 1994 (letter 
submitted in connection with the NASD's NPROVE filing, SR-
NASD-94-13).
    \15\ See The Association Between the Interim SOES Rules and 
Nasdaq Market Quality, Dean Furbush, Ph.D., Economists, Inc., 
Washington D.C., December 30, 1994 (``Furbush Study'').
    \16\ Interim SOES Rules Approval Order, supra note 1, 59 FR at 
69429.
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    In sum, the NASD's study found that:
     Since the SOES changes went into effect in January 1994, 
the statistical evidence indicated that when average daily volume, 
stock price, and stock price volatility are held constant through 
regression techniques, quoted percentage spreads in Nasdaq securities 
experienced a decline in the immediate period following implementation 
of the changes and have continued to decline since then. The 
statistical evidence also showed that the narrowing of quoted 
percentage spreads became more pronounced and robust the longer the 
Interim SOES Rules were in effect. In particular, quoted spreads in 
cents per share for the 500 largest Nasdaq National Market (``NNM'') 
securities experienced a sharp decline from April 28 to May 12 and from 
June 23 to July 18; 17

    \17\ 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.
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     With the exception of a brief, market-wide period of 
volatility experienced by stocks traded on Nasdaq, the New York Stock 
Exchange, and the American Stock Exchange during the Spring, the 
volatility of Nasdaq securities appears to be unchanged in the period 
following implementation of the changes; and
     A smaller percentage of Nasdaq stocks experienced extreme 
relative price volatility after implementation of the rules and that 
these modifications, in turn, suggest a reduction in relative 
volatilities since the rules were put into effect.
    The Furbush Study found that there was a statistically significant 
improvement in effective spreads for the top 100 Nasdaq stocks (based 
on dollar volume) during the three month period following 
implementation of the rules. Moreover, the study also found that the 
most significant improvement in effective spreads for the top 100 
stocks occurred for trade sizes between 501 and 1,000 shares, precisely 
the level that was made ineligible for SOES trading by the Interim SOES 
Rules. In addition, the study found that the average number of market 
makers for the top ten Nasdaq-listed stocks increased from 44.3 to 
46.0, or 3.8 percent, and from 30.2 to 30.9 for the top 100 stocks, or 
2.3 percent. Although correlation does not necessarily imply causation, 
as noted by the SEC when it approved the Interim SOES Rules and 
extensions of the Interim SOES Rules, the NASD believes that positive 
market developments clearly have been associated with implementation of 
the Interim SOES Rules.
    The NASD also believes that these studies of the effectiveness of 
the Interim SOES Rules lend credence to another NASD study that was 
submitted to the SEC in support of approval of the Interim SOES 
Rules.18 In the May 1993 SOES Study, the NASD found that 
concentrated waves of orders entered into SOES by active order-entry 
firms resulted in discernible degradation to the quality of the Nasdaq 
market. Specifically, the study found, among other things, that: (1) 
Bursts of orders entered into SOES by active order entry firms 
frequently result in a decline in the bid price and a widening of the 
bid-ask spread; (2) that there is a significant positive relationship 
between increases in spreads and volume attributable to active order-
entry firms as it related to total SOES volume per security; and (3) 
activity by active order-entry firms resulted in higher price 
volatility and less liquidity--higher price changes are associated with 
high active trading firm volume, even after controlling for normal 
price fluctuations.

    \18\ See NASD Department of Economic Research: Impact of SOES 
Active Trading Firms on Nasdaq Market Quality (May 12, 1993) (``May 
1993 SOES Study''). See also Securities Exchange Act Release No. 
32313 (May 17, 1993), 58 FR 29647 (publication of the study for 
comment).
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    The NASD also believes market activity since the SOES Maximum Order 
Size Rule lapsed on March 28, 1995, provides further support for the 
effectiveness of the SOES Minimum Exposure Limit Rule and the SOES 
Automated Quotation Update Feature and the NASD's economic rationale 
for these rules. In particular, an analysis prepared by the NASD's 
Economic Research Department clearly illustrates that there has been a 
dramatic increase in SOES volume since the SOES Maximum Order Size Rule 
lapsed and that many market maker positions have been abandoned. These 
two phenomena appear to be linked. Those Nasdaq stocks that have 
experienced the greatest decline in the number of market makers are the 
ones that have experienced the greatest increase in SOES volume since 
the rule lapsed.19 The NASD believes these figures indicate that 
the relaxation of one of the Interim SOES Rules may have contributed to 
some of the adverse market developments that the NASD was seeking to 
avoid through implementation of the Interim SOES Rules (e.g., 
degradation in market maker participation and market liquidity).20 
Accordingly, the NASD believes that any further relaxation of the 
Interim SOES Rules by permitting the SOES Minimum Exposure Limit Rule 
or the SOES Automated Quotation Update Feature to lapse would further 
harm the Nasdaq market. In light of the significance of these figures 
and their indicated adverse ramifications upon the Nasdaq market, the 
NASD also believes that SEC reconsideration of its position with 
respect to the entry of 1,000-share orders into SOES is warranted.

    \19\ See letter from Richard G. Ketchum, Executive Vice 
President & Chief Operating Officer, NASD, to Brandon Becker, 
Director, Division of Market Regulation, SEC, dated August 1, 1995.
    \20\ The NASD believes that elimination of the ban against short 
sales through SOES did not have a dramatic negative market effect 
because the NASD's short sale rule was approved during the time that 
the ban was in effect.
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    In addition, the NASD has recently prepared another report that the 
NASD believes illustrates that the SOES Minimum Exposure Limit Rule and 
the 

[[Page 1658]]
SOES Automated Quotation Update Feature have had no adverse impact on 
the market for Nasdaq securities.21 This report was in response to 
the Commission's request in the Interim SOES Rules Extension Order that 
the NASD: 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.22

    \21\ See Monitoring Report of Exhaustion of SOES Exposure Limits 
and the Usage of Nasdaq Automated Quotation Update Feature, NASD 
Economic Research Department, December 18, 1995. This report is 
available for inspection and copying in the Commission's Public 
Reference Room.
    \22\ Interim SOES Rules Extension Order, supra note 2, 60 FR at 
52439, n. 12 (``December 1995 Monitoring Report'').
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In sum, the December 1995 Monitoring Report found that it is a very 
infrequent occurrence for a market maker to have its exposure limit 
exhausted in a NNM security. In particular, from the period October 2, 
1995 to November 22, 1995, there were, on average, 83 instances per day 
where a market maker's exposure limit in NNM securities was 
exhausted.23 Thus, given the fact that there was an average of 
44,062 market making positions in NNM securities and 3,932 NNM 
securities trading per day during this time period, the impact of these 
individual exposure limit exhaustions on the availability of SOES to 
investors throughout the trading day was infinitesimal. Each market 
making position experienced .0019 exposure limit exhaustions per day 
over this time period and each NNM security experienced .0211 
exhaustions per day. Moreover, while Nasdaq could not readily determine 
the extent to which the exposure limit exhaustions occurred 
simultaneously in the same security, given the stark infrequency with 
which the exposure limit exhaustions occurred, the NASD believes it is 
extremely improbable that a NNM security would experience a situation 
where the SOES exposure limits for all market makers in that stock were 
exhausted at the same time. Indeed, this conclusion is borne out by the 
extremely short time-span in which SOES orders are executed. 
Specifically, the report shows that, on average, SOES orders are 
executed 1.62 seconds after entry and that 98.5 percent of all SOES 
orders are executed within three seconds.24

    \23\ The highest number of exposure limits exhausted on any day 
during this period was 119 on November 21, 1995 and the lowest 
number was 47 on October 4, 1995.
    \24\ The report also found that SOES orders can experience brief 
execution delays in isolated instances, as one order took as long as 
87 seconds to be executed. While the NASD could not readily identify 
the reasons for these infrequent execution delays, the NASD believes 
these delays are likely the result of two factors. First, consistent 
with the NASD's short-sale rule, short sales entered into SOES 
cannot be executed on down bids. Second, waves of SOES orders 
transmitted by active SOES order-entry firms cause queues to develop 
in the processing of SOES orders, which, in turn, causes execution 
delays.
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    The report also shows that SOES exposure limit exhaustions tend to 
cluster in active NNM securities with high numbers of market makers. 
This further illustrates the extremely low probability that all market 
makers in the same security would ever have their exposure limits 
exhausted simultaneously. Lastly, examining one trading day, the report 
shows that active SOES order entry firms accounted for 92 percent of 
the exposure limit exhaustion, as might be expected given that these 
firms account for 89 percent of SOES dollar volume. Accordingly, the 
NASD and Nasdaq believe that the SOES Minimum Exposure Limit Rule has 
had a very negligible, if any, impact on the availability of SOES to 
small, retail investors.
    The report also found that the Automated Quotation Update Feature 
appears to be used extensively by some market making firms. 
Specifically, the report shows that the quote update feature is used by 
126 market makers for 10,644 market making positions. Thus, this 
feature is currently being used by 26 percent of the market makers and 
for 24 percent of all market making positions. In addition the report 
shows that, on average, 3,394 quotations a day were generated by the 
quote update feature from October 2, 1995 to November 21, 1995. 
Accordingly, the NASD and Nasdaq believe that the Automated Update 
Feature has effectively served its intended purpose helping to maintain 
continuous quotations in Nasdaq, minimize ``closed quote'' conditions, 
and avoid unexcused market maker withdrawals, thereby promoting market 
liquidity.
    Accordingly, the NASD believes the Commission should properly view 
these two SOES rules as strictures that are highly correlated with 
improvements in market liquidity, not as rules that have had or could 
have a damaging effect on liquidity. The NASD and Nasdaq also believe 
the monitoring report illustrates that implementation of the Automated 
Quotation Update Feature and the SOES Minimum Exposure Limit Rule have 
not diminished the significant benefits provided to investors through 
the automatic execution capabilities of SOES. Simply put, these two 
SOES rules have in no way altered the operation of SOES as an automatic 
execution system that affords small, retail investors immediate 
executions at the inside market. However, as noted in the NASD's 
proposed NAqcess filing, the NASD believes the limit order processing 
capabilities and order execution algorithm of SOES could be 
significantly improved upon for the benefit of small investors and the 
marketplace as a whole.
    Moreover, in the Interim SOES Rules Extension Order, an order 
approving a proposal identical to the NASD's instant proposal, the SEC 
found that the continued effectiveness of the SOES Minimum Exposure 
Limit Rule ``provides customers fair access to the Nasdaq market and 
reasonable assurance of timely executions.'' 25 With respect to 
the SOES Automated Quotation Update Feature, the SEC also stated that 
it believes ``that extending the automated update function is 
consistent with the Firm Quote Rule. The update function provides 
market makers the opportunity to update their quotations automatically 
after executions through SOES; 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.'' 26

    \25\ Interim SOES Rules Extension Order, supra note 2, 60 FR at 
52439.
    \26\ Id. (footnotes omitted).
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    Therefore, in light of the above-cited statutory findings made by 
the SEC when it first approved the SOES Minimum Exposure Limit Rule and 
the SOES Automated Quotation Update Feature and extensions of these 
rules, coupled with the NASD's findings that these rules have been 
associated with positive market developments in terms of lower spreads 
on Nasdaq and less stocks with extreme relative price volatility, the 
NASD believes it would be consistent with the Act for the Commission to 
extend the effectiveness of the SOES Minimum Exposure Limit Rule and 
the SOES Automated Quotation Update Feature for a six-month period. 
Moreover, even if the Commission is unwilling to find positive 
significance in the NASD's statistical analyses, at the very least, 
these studies indicate that the market has not been harmed by 
implementation of these rules.27 Indeed, the Commission 

[[Page 1659]]
clearly stated in the Interim SOES Rules Extension Order that the SOES 
Minimum Exposure Limit Rule and the SOES Automated Quotation Update 
Feature have not had a detrimental effect on the Nasdaq market: ``the 
Commission * * * continues to believe that the data submitted by the 
NASD demonstrates * * * [no] serious deterioration in the quality of 
the Nasdaq market subsequent to the adoption of the January 1994 
amended SOES Rules.'' 28

    \27\ Even if the Commission concludes that the SOES Minimum 
Exposure Limit Rule and the SOES Automated Quotation Update Feature 
have had no impact on market quality, the NASD believes the 
Commission's approval of New York Stock Exchange (``NYSE'') Rule 80A 
on a permanent basis illustrates that the Commission would still 
have a sufficient basis to approve an extension of the rules for a 
four-month period. In particular, the SEC's discussion of the 
statutory basis for approval of NYSE Rule 80A focused in large part 
on the fact that Rule 80A did not have any adverse impacts on market 
quality on the NYSE and that, as a result, the NYSE should be given 
the latitude to take reasonable steps to address excessive 
volatility in its marketplace. See Securities Exchange Act Release 
No. 29854 (October 24, 1994), 56 FR 55963 (October 30, 1994). 
Accordingly, the NASD believes the SEC should afford the NASD the 
same regulatory flexibility that it afforded the NYSE to implement 
rules reasonably designed to enhance the quality of Nasdaq and 
minimize the effects of potentially disruptive trading practices.
    \28\ Interim SOES Rules Extension Order, supra note 2, 60 FR at 
52439.
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    The NASD believes that the proposed rule change is consistent with 
Sections 15A(b)(6), 15A(b)(9), 15A(b)(11) and 11A(a)(1)(C) of the Act. 
Among other things, Section 15A(b)(6) requires that the rules of a 
national securities association be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system and in general to 
protect investors and the public interest. Specifically, the NASD is 
proposing to extend the effectiveness of the SOES Minimum Exposure 
Limit Rule and the SOES Automated Quotation Update Feature for six 
months because of concerns that concentrated, aggressive use of SOES by 
a growing number of order entry firms has resulted in increased 
volatility in quotations and transaction prices, wider spreads, and the 
loss of liquidity for individual and institutional investor orders, all 
to the detriment of public investors and the public interest. The NASD 
believes the SOES Minimum Exposure Limit Rule and the SOES Automated 
Quotation Update Feature have operated to rectify this situation while 
continuing to provide an effective opportunity for the prompt, reliable 
execution of small orders received from the investing public. 
Accordingly, in order to protect investors and the public interest, the 
NASD believes the SEC should approve an additional six-month extension 
of the SOES Minimum Exposure Limit Rule and the SOES Automated 
Quotation Update Feature through July 31, 1996, so that small 
investors' orders will continue to receive the fair and efficient 
executions that SOES was designed to provide.
    Section 15A(b)(9) provides that the rules of the Association may 
not impose any burden on competition not necessary or appropriate in 
furtherance of the purposes of the Act. The SOES Minimum Exposure Limit 
Rule and the SOES Automated Quotation Update Feature apply across the 
board and do not target any particular user or participant, as all 
dealers may set their exposure limits at two times the tier size and 
all dealers may elect to utilize the automated quote update feature. 
Accordingly, the NASD believes that these rule changes are not anti-
competitive, as they are uniform in application and they seek to 
preserve the ability of SOES to provide fair and efficient automated 
executions for small investor orders, while preserving market maker 
participation in SOES and market liquidity.
    Section 15A(b)(11) empowers the NASD to adopt rules governing the 
form and content of quotations relating to securities in the Nasdaq 
market. Such rules must be designed to produce fair and informative 
quotations, prevent fictitious and misleading quotations, and promote 
orderly procedures for collecting and distributing quotations. The NASD 
is seeking to continue the effectiveness of the SOES Minimum Exposure 
Limit Rule and the SOES Automated Quotation Update Feature so that SOES 
activity may not result in misleading quotations in the Nasdaq market. 
Market makers place quotes in the Nasdaq system and these quotes 
comprise the inside market and define the execution parameters of SOES. 
When volatility in the SOES environment causes market makers to widen 
spreads or to change quotes in anticipation of waves of SOES orders, 
quotes in the Nasdaq market become more volatile and may be misleading 
to the investing public. Accordingly, absent continuation of the SOES 
Minimum Exposure Limit Rule and the SOES Automated Quotation Update 
Feature, the quotations published by Nasdaq may not reflect the true 
market in a security and, as a result, there may be short-term 
volatility and loss of liquidity in Nasdaq securities, to the detriment 
of the investing public. Further, the continuation of the automated 
refresh feature will ensure that a market maker's quotation is updated 
after an exposure limit is exhausted. Uninterrupted use of this 
function will maintain continuous quotations in Nasdaq as market makers 
exhausting their exposure limits in SOES will not be subject to a 
``closed quote'' condition or an unexcused withdrawal from the market.
    Finally, the NASD believes that the proposed rule change is 
consistent with significant national market system objectives contained 
in Section 11A(a)(1)(C) of the Act. This provision states it is in the 
public interest and appropriate for the protection of investors and the 
maintenance of fair and orderly markets to assure, among other things: 
(i) Economically efficient execution of securities transactions; (ii) 
fair competition among brokers and dealers; and (iii) the practicality 
of brokers executing investor orders in the best market. Specifically, 
the SOES Minimum Exposure Limit Rule and the SOES Automated Quotation 
Update Feature advance each of these objectives by preserving the 
operational efficiencies of SOES for the processing of small investors' 
orders, by maintaining current levels of market maker participation 
through reduced financial exposure from unpreferenced orders, and by 
reducing price volatility and the widening of market makers' spreads in 
response to the practices of order entry firms active in SOES.
    In addition, for the same reasons provided by the SEC when it 
approved the Interim SOES Rules that are cited above in the text 
accompanying footnotes 6 through 13, the NASD believes that the 
proposed rule change is consistent with Sections 15A(b)(6), 15A(b)(9), 
15A(b)(11) and 11A(a)(1)(C) of the Act.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD believes that the proposed rule change will not result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Comments were neither solicited nor received. 
    
[[Page 1660]]


III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the NASD consents, the Commission will:
    A. by order approve such proposed rule change, or
    B. institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to file number SR-NASD-95-60 and 
should be submitted by January 26, 1996. The SOES Minimum Exposure 
Limit Rule and the SOES Automated Quotation Update Feature expire after 
January 31, 1996 and, therefore, the Commission requests that 
interested parties comment by January 26, 1996, so as to allow the 
Commission sufficient time to consider the views of interested persons 
prior to the expiration of the rules.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.29

    \29\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-737 Filed 1-19-96; 8:45 am]
BILLING CODE 8010-01-P