[Federal Register Volume 61, Number 120 (Thursday, June 20, 1996)]
[Notices]
[Pages 31574-31604]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-15448]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37302; File No. SR-NASD-95-42, Amendment No. 2]
Self-Regulatory Organizations; Notice of Filing of Amendment No.
2 to Proposed Rule Change by National Association of Securities
Dealers, Inc. Relating to the NAqcess System and Accompanying Rules of
Fair Practice
June 11, 1996.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),1 notice is hereby given that on June 6, 1996,2 the
National Association of Securities Dealers, Inc. (``NASD'' or
``Association'') filed with the Securities and Exchange Commission
(``SEC'' or ``Commission'') an amended version of 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.
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\1\ 15 U.S.C. Sec. 78s(b)(1) (1988). ..........................
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\2\ The NASD initially filed the proposed rule change on
September 22, 1995 and, on November 9, 1995, the NASD filed
Amendment No. 1. Notice of the original filing and Amendment No. 1
was provided by publication in the Federal Register. Securities
Exchange Act Release No. 36548 (Dec. 1, 1995), 60 FR 63092 (Dec. 8,
1995).
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
Pursuant to Section 19(b)(1) of the Act, the NASD and The Nasdaq
Stock Market, Inc. (``Nasdaq'') propose to amend the proposed rules
governing the operation of Nasdaq's NAqcess system, a new system that
would offer nationwide limit order protection and price improvement
3 opportunities for orders entered in the proposed system.
Specifically, the NASD is proposing several amendments to NAqcess
designed to allow the entry into NAqcess of: (1) Proprietary orders by
registered Nasdaq market makers and other specific categories of
broker-dealers performing a registered market making function
(collectively, ``market
[[Page 31575]]
makers''); and (2) limit orders by investors and market makers of up to
9,900 shares in the 250 most active Nasdaq National Market Securities
as measured by median daily dollar volume during the most recent
calendar quarter; and (3) other technical changes to the proposed rule
language. The NASD also proposes to revise the opening process for
NAqcess. Finally, in conjunction with the approval of an expanded
NAqcess by the Commission, the NASD intends to discontinue the
SelectNet service, except for the purpose of maintaining a
communications facility for use in special market conditions. Exhibit A
contains a revised version of the NAqcess Rules, Exhibit B contains the
new Interpretations and the new rule in its Rules of Fair Practice
related to NAqcess and Exhibit C contains proposed amendments to the
Schedules to the By-Laws. Additions are italicized and deletions are
bracketed. ...........................................................
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\3\ Commission Note: The NASD's use of the term ``price
improvement'' in this proposal differs from the use of the term in
recent Commission releases. Specifically, the Commission has used
the term when referring to the opportunity to receive a price that
is superior to best bid or offer. See, e.g., 17 CFR 11Ac1-3(a)(2);
Securities Exchange Act Release No. 34902 (Oct. 27, 1994), 59 FR
55006 (Nov. 2, 1994) at text accompanying n. 32. The NASD's use of
the term in this proposal, on the other hand, refers to the
opportunity to receive a price that is better than the best market
maker quotation, which may not be the best bid or offer to the
extent NAqcess limit orders are included. In its recent rule
proposal concerning the obligations of market makers executing
customer orders, the Commission asked for comment on whether
automated systems that include the possibility of the interaction of
market orders with limit orders should be deemed to satisfy the
proposal's requirement that market orders be provided with an
opportunity for price improvement. Securities Exchange Act Release
No. 36310 (Sept. 29, 1995), 60 FR 52792 (Oct. 10, 1995). ..........
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
On September 22, 1995, the NASD proposed rules governing the
operation of NAqcess, a new service for the delivery, handling and
execution of investors' agency orders.4 As originally proposed,
NAqcess would have been a new system that offers nationwide limit order
protection and price improvement opportunities for customer orders.
NAqcess was a significant advance in terms of both the transparency of
the Nasdaq Stock Market and increased access to faster executions and
better prices by retail customers. ...................................
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\4\ Securities Exchange Act Release No. 36548 (Dec. 1, 1995); 60
FR 63092 (Dec. 8, 1995). ..........................................
Subsequent to the NASD's filing of NAqcess, the SEC proposed four
significant changes to SEC rules that could have far-reaching and wide-
ranging effects on the overall U.S. equity markets, including the
Nasdaq Stock Market.5 The Commission's goals in proposing these
change are fully consistent with the views of the NASD regarding
investor protection and transparency of limit orders in the Nasdaq
Stock Market. While the NASD believes that NAqcess, as originally
filed, was consistent with the Commission's Order Exposure Release, the
NASD has determined to seek the Commission's approval of refinements of
NAqcess that are even more closely configured to the SEC's approach.
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\5\ Securities Exchange Act Release No. 36310 (Sept. 29, 1995);
60 FR 52792 (Oct. 10, 1995) (``Order Exposure Release'').
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Through this amendment, the NASD proposes to further enhance
Nasdaq's transparency and customer access to prompt executions by
increasing the size of limit orders eligible for entry and permitting
market makers to enter proprietary market and limit orders. These
proposed amendments to NAqcess closely parallel certain of the SEC's
proposals regarding order exposure and handling, in particular those
rules relating to the display of customer limit orders (proposed Rule
11Ac1-4). The changes to NAqcess that are proposed herein are
responsive to the goals of the SEC's proposed rules, and also maintain
an environment where the substantial benefits to issuers and investors
that the Nasdaq competing dealer system provides can be continued.
A. Increased Eligibility Size for Limit Orders Entered Into NAqcess
The NASD proposes to increase the size of limit orders eligible for
entry into NAqcess to 9,900 shares for the 250 most active Nasdaq
National Market securities as measured by median daily dollar volume
over the previous calendar quarter.6 The NASD believes that this
increase in the size of NAqcess-eligible limit orders should enhance
market transparency and increase the likelihood that there will be
sufficient trading interest available in NAqcess for other orders to
execute against in a timely manner. Through this change, the NASD
envisions that customer limit orders will more likely be executed
because customers with larger orders, including the institutions that
make up a significant portion of the investor base of many highly
liquid Nasdaq securities, will be able to enter orders into NAqcess. At
the same time, the approach that the NASD is taking with a revised
NAqcess (limiting the increase size eligibility to the 250 most active
National Market securities) attempts to balance the transparency
objectives against other core market and regulatory objectives, such as
maintaining market liquidity and improving market quality for all
investors.
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\6\ The NASD has chosen 9,900 shares as the largest limit order
eligible for entry into NAqcess because such size is the largest
round lot size below 10,000 shares, the order size traditionally
defined as ``block size.'' The SEC's proposed Rule 11Ac1-4, as
currently proposed, would exempt orders 10,000 shares and larger
from its display requirements. Because the NASD is attempting to
develop NAqcess to parallel the SEC's rule, it has chosen to permit
certain limit orders below 10,000 shares into NAqcess. An order size
of 9,999 shares, however, would have an odd-lot of 99 shares
embedded in it that would present difficulties in execution.
Accordingly, the NASD plans to program the system to accept orders
up to the largest round-lot below 10,000 shares, i.e., 9,900.
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As explained in greater detail below, the proposed limitation
provides the NASD and market makers with an opportunity to develop
experience with larger limit orders to determine if or when the size
requirements may be expanded to less liquid securities. The NASD
believes at this time that the trading activity in securities below the
most active 250 Nasdaq securities may not be sufficient to provide the
incentive for substantial market maker participation if limit orders up
to 9,900 shares were eligible for NAqcess. Market makers bring
significant amounts of capital to bear in support of the trading of new
and smaller-capitalized companies in which there may not be significant
natural liquidity. A market maker's willingness to sponsor new
companies is directly related to its return on capital for the risks
incurred. Market maker participation could diminish if Nasdaq did not
provide market makers a reasonable opportunity to obtain a fair return
on investment. In turn, lack of market maker sponsorship could
seriously damage the capital-raising abilities of small issuers at an
early stage in their growth. As is well-known, Nasdaq's competing
dealer market structure historically has provided strong support for
smaller issuers as they built investor interest and support. It is
appropriate, then, to permit Nasdaq to constructively refine its market
structure as it seeks to provide greater benefits to investors using
the market, while continuing to maintain market maker incentives in its
structure.7 The NASD believes that its
[[Page 31576]]
approach provides an appropriate balance of these competing objectives.
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\7\ The NASD also notes other significant benefits that a
competing dealer structure brings to the marketplace in addition to
issuer sponsorship and liquidity. Dealers also provide immediacy of
execution to persons demanding such and willing to pay the costs
associated with immediacy. Additionally, dealers provide significant
capacity to deal with unbalanced order flow in times of market
imbalances or in cases of very large trades by institutions, such as
pension funds and mutual funds, that represent large numbers of
individual investors.
The NASD notes that other markets in the U.S. and around the
world have developed special arrangements to encourage and
facilitate dealer participation to handle block trading and order
imbalances. For example, the specialist system in U.S. exchange
markets requires dealer participation in what are typically referred
to as ``auction markets.'' Block trading rules used at exchanges in
the U.S. and the Paris Bourse's special rules regarding the ``contra
partie'' system also encourage dealer participation to accommodate
block trades. The NASD refers to these hybridized market structure
approaches only to note that it is important that the regulator
allow market forces, within a strong regulatory framework, to
determine an appropriate, flexible, balanced approach to serving the
diverse needs of all market participants--issuers, retail and
institutional customers, and market professionals, including market
makers.
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Based upon an analysis of the trading activity in Nasdaq securities
for the first quarter in 1996, the 250 most active National Market
securities are significantly more liquid than other Nasdaq securities.
For instance, median daily dollar volume for the 250 most active
securities was $13,788,823.8 For the next 250 most active
securities, first quarter median daily dollar volume was $3,604,481.
The median daily dollar volume for the remaining securities in the
Nasdaq National Market list was $268,228.9
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\8\ The NASD believes that the best measure for determining
trading activity for these purposes is the median daily dollar
volume over the course of a quarter. Dollar volume provides a
clearer measure than share volume because it normalizes across
diverse share prices. Because of merger activity among Nasdaq
issuers and other phenomena that can cause temporary volume surges,
share trading statistics can be skewed. The temporary spikes in
share volume could displace from the most active list more
substantial companies that regularly trade in heavy volume. The
median is a measure of central tendency that limits the importance
of temporary volume surges.
However, even with the median daily dollar volume calculation,
the trading history in an initial public offering (``IPO'') may be
skewed to such an extent that the NASD does not have an accurate
picture of the true trading characteristics of that security. For
that reason, the NASD will exclude an IPO from the Top 250
calculation until the security has two full calendar quarters of
trading history after which a more accurate determination can be
made. The NASD will use the second full calendar quarter of trading
to determine whether an IPO falls into the list of the Top 250
securities. The first full calendar quarter will not be used in the
calculation.
\9\ These statistics were derived from the first thirteen
Thursdays of trading in 1996 (January 4-March 28, 1996). The NASD
excluded Small Cap issues and any issue that did not trade on each
day of the sample period. The calculation was derived by first
finding the median daily dollar volume for each issue and then
finding the median value across the grouping.
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These figures demonstrate a drop off in trading activity in stocks
ranked below the 250 most active securities. Market makers currently
are willing to quote in these securities on a regular and continuous
basis and will buy from or sell to any customer that seeks to trade.
Market makers may not be willing, however, to incur the substantial
risk to their capital in low liquidity securities when forced to
compete with limit orders that in effect could act as fair-weather
market makers, i.e., displaying priced orders when there is natural
investor interest on the opposite side of the market, but disappearing
as soon as market conditions turn unfavorable. Market makers that must
compete on such unfair terms would likely seek more productive uses for
their capital and would withdraw from market making in such securities.
In addition, if market makers withdraw, the NASD believes at this
time that other sources of liquidity may not provide an adequate
replacement. The liquidity provided by typical investor order flow
through limit orders in low-liquidity stocks is likely to be
overwhelmed or non-existent, and accordingly, it may be difficult to
sustain price continuity. The NASD believes volatility may increase and
investors will receive poorer executions as a result. Ultimately,
investors may seek investment opportunities in other securities and
issuers may find it more difficult to raise capital.
It is important to emphasize that these less liquid securities
would continue to have the NAqcess limit order facility available for
limit orders of 1,000 shares or less. This feature clearly permits the
average retail investor the opportunity to compete with market makers
and to seek price improvement opportunities over the dealer quote. The
NASD notes that in the SOES limit order file, the typical retail
investor limit order size (excluding day traders) averaged under 500
shares. Based on this information and information from NASD members,
for securities below the Top 250, the eligible limit order size
provision should satisfy retail investors. Accordingly, the NASD
believes it is appropriate to create two different size levels of limit
orders eligible for entry into NAqcess.
Moreover, both the NASD and the SEC, together with market
participants, will be able to learn from the experience gained in
expanding the limit order size for the most active Nasdaq securities.
The tempered approach proposed by the NASD will permit it to determine
the empirical effect that larger-sized limit order exposure has on
these securities, especially on liquidity and continued market maker
participation. After a sufficient study period of two years (if not
sooner), the NASD will be in a better position to evaluate additional
steps that may be warranted.
The NASD also notes that under the proposed rules it would permit a
continuing, gradual expansion in the list of securities eligible for
large-sized limit order entry. This gradual expansion would occur
because the NASD would not delete issues from the list even if
supplanted by other issues in subsequent recalculations of the 250 most
active securities. For example, if securities ranked 240 through 250 as
measured in the initial ranking were to be replaced by other securities
not previously ranked, the NASD would add the new most active
securities to the eligibility list but would not delete those
supplanted. In this way, the list would eventually expand in size,
providing investors with additional opportunities to place larger limit
orders.
Of course, if a security ranked in the 250 most active list were to
experience a fundamental change in trading characteristics, the NASD
would delete the security from the list. By fundamental change, the
NASD means it would examine the median daily dollar volume activity to
determine if its dollar volume had fallen below the 1,500 most active
securities, or that it no longer qualified as a National Market
security. In either case, the security would be deleted from
eligibility for larger limit orders entry into NAqcess.
B. Market Maker Proprietary Orders in NAqcess
The NASD also proposes to amend the NAqcess rules to permit broker-
dealers that are registered as NAqcess market makers, or other broker-
dealers that perform market making functions (defined as ``eligible
market makers'' in the amended rule), the opportunity to enter
proprietary orders into NAqcess. Proprietary orders are orders entered
by a market maker for the firm's own principal account or as a part of
a riskless principal trade on behalf of a customer.10 Eligible
market makers may enter proprietary orders that are priced orders
(i.e., limit orders), unpriced orders (i.e., market orders), or priced
orders entered at the current best dealer
[[Page 31577]]
bid or offer (i.e., marketable limit orders), consistent with the
general order entry requirements for NAqcess.
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\10\ Under the original NAqcess proposal, market makers would
have been able to enter ``marker orders.'' A marker order was
defined as a principal order that a market maker entered for the
purpose of effecting, in essence, a riskless principal transaction
with a customer. The proprietary order proposal eliminates the need
for the marker order concept. Under the proposed revision, market
makers may enter priced or unpriced principal orders for their own
account, or principal orders on behalf of a customer as part of a
riskless principal transaction.
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1. Proprietary Limit Orders
The entry of proprietary limit orders in NAqcess should increase
the size and depth of the limit orders in the facility and may help to
further tighten the spreads in stocks. Market maker limit orders should
permit such firms to aggressively price securities anonymously and to
attract additional orders to them through this anonymous display.
Consequently, the NASD believes that this amendment will increase the
likelihood that customer orders will be executed more quickly, more
frequently, and at better prices.
In addition, the entry of proprietary limit orders responds to the
transparency concerns that the SEC raised with respect to orders placed
in widely disseminated electronic communications networks (``ECNs'')
and will assist market makers in managing their risk by eliminating the
potential for double executions that would be possible under the SEC's
proposal. The SEC's proposed Rule 11Ac1-1(c)(5) would require that
market makers reflect in their quotes the prices of orders that they
place in ECNs. As the NASD noted in its comment letter on the
Commission's proposed rules, this part of the SEC proposal may act as a
major disincentive to market making because it would destroy the
benefit of anonymity provided by ECNs. Every quote from a market maker
in Nasdaq has the market maker's own unique identifier. The quote-
display requirement with the attached identifier increases
substantially the risk that a market maker would incur in establishing
or liquidating a larger position because it telegraphs to the entire
market the inventory position of the market maker. Moreover, displaying
a better price in both the individual quote and in an ECN exposes the
market maker to the risk of multiple executions at the same price.
The proposed revision to NAqcess that would allow proprietary limit
orders by market makers in the NAqcess file addresses both the
transparency concern and the double execution issue. NAqcess limit
orders, whether agency or principal, that establish the best prices on
the market would be reflected in the Nasdaq best bid and offer, i.e.,
the inside market.11 Because the inside market is publicly
disseminated, price discovery would be enhanced and best execution
obligations would be more readily met. In other words, small investors
would have access to the same prices that institutional and
professional traders have in ECNs. Further, because the order would be
anonymously reflected in the inside market, the problems that surface
under the SEC proposal are diminished. In sum, this change to NAqcess
should enhance the price discovery function of the Nasdaq Stock Market,
while continuing to promote the liquidity that multiple market makers
bring.
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\11\ A proprietary limit order may be entered by the firm as
principal for the firm's own account or as part of a riskless
principal transaction. In riskless principal transactions, the limit
order entered may be of representative size, i.e., it does not have
to be for as large a size as the customer order the firm holds.
However, this type of proprietary order may not be representative of
an order larger than that eligible for NAqcess in the first
instance. Entry of split orders, whether as part of an agency order
or as part of a riskless principal proprietary order transaction, is
not permitted.
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2. Proprietary Market Orders
Additionally, the NASD is amending the filing to permit eligible
market makers to enter market orders for their own accounts, i.e.,
proprietary market orders.12 Proprietary market orders would be
handled in the same manner as agency market orders. In other words,
proprietary market orders would be subject to the same maximum order
sizes and would be processed and executed in the same way agency market
orders are to be handled. The intention in this amendment is to promote
market maker participation in Nasdaq and to aid market makers in their
ability to reduce risk from inventory by laying off positions through
an automated means.
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\12\ Because marketable limit orders are the equivalent of
market orders, this amendment also permits the entry of proprietary
marketable limit orders. When used in this discussion, the term
``market orders'' encompasses marketable limit orders as well.
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The NASD believes, at this time, that the proprietary market order
entry feature provides a significant benefit to market makers and the
marketplace as a whole. The ability to enter proprietary market orders
allows market makers the ability to swiftly access other market makers'
quotes and receive executions at those displayed prices. As a result,
the accessibility of these quotes will encourage market makers to take
positions in those securities and thereby aid in the liquidity of the
market. The NASD believes that it is appropriate to limit use of
NAqcess for proprietary trading to market maker orders. The purpose of
proprietary trading in NAqcess is to enhance price discovery and to
provide market makers with the tools to continue to function
effectively as a market maker.13 The NASD's goal is to promote
liquidity and to provide incentives to market makers to maintain that
liquidity and to continue to sponsor new issuers.
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\13\ With respect to options market makers, the NASD notes that
this approach should address the concerns expressed by the
Commission in its approval order regarding the NASD's Limit Order
Protection Interpretation (NASD Rules of Fair Practice, Article III,
Section 1, Interpretation .07). Securities Exchange Act Release No.
35751, May 22, 1995. In that order, the Commission stated that it
``recognized the importance of price discovery and market efficiency
and liquidity for options specialists and market makers to have
efficient and economical opportunities for laying off risk in the
Nasdaq market.'' Id. at 21. Because of the important options market
liquidity role that options market makers have, and because options
market makers' orders will enhance liquidity and the likelihood of
prompt executions in NAqcess, the NASD determined that proprietary
orders from these types of firms should be allowed.
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Accordingly, to the extent that proprietary trading capability is
not extended to other broker-dealers and thus considered a competitive
burden, the NASD believes that any such burden is appropriate and in
furtherance of the purposes of the Act. In particular, by quoting firm,
two-sided markets on a regular and continuous basis in addition to
entering proprietary limit orders, market makers perform an important
liquidity-provider function that is at the core of the Nasdaq Stock
Market. Non-market-makers do not provide such liquidity. In fact,
broker-dealers that seek execution of orders for their own account
without incurring any of the risks associated with the display of firm
quotes reasonably related to the current market could potentially harm
the market and investors. They are demanders of liquidity competing
with investors for a scarce commodity. It does not further the purposes
of the Act to create a market structure that could harm investors by
allowing market professionals to exhaust market liquidity for their own
gain without imposing a corresponding obligation to provide support to
the market. Any broker-dealer seeking access to this particular feature
of NAqcess may seek to register as a NAqcess market maker and
contribute to Nasdaq liquidity.14
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\14\ The NASD notes that NAqcess rules continue to allow any
NASD member to enter customer limit orders on behalf of their
customers and to enter takeout orders on behalf of customers or for
their own accounts.
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3. Proprietary Orders--Generally.
The NASD believes that it would be appropriate to extend the
capability to enter proprietary orders to registered Nasdaq market
makers and to other broker-dealers that perform Nasdaq-security-related
market-making functions in other markets. The
[[Page 31578]]
proposed amendments specify that proprietary orders may be entered by
three separate groups of market makers: (1) Registered Nasdaq market
makers that also have registered as NAqcess market makers; (2) UTP
exchange specialists; and (3) registered options market makers. Market
makers must be registered as market makers for the specific security
for which they seek to enter a proprietary order. Thus, a market maker
registered and actively quoting as a market maker in one Nasdaq
security (or, in the case of options market makers, an option on a
Nasdaq security) may not enter a proprietary market or limit order in
another Nasdaq security, unless separately registered as a market maker
in that security as well. It is important to note that mere
registration as a market maker is not sufficient to allow the entry of
proprietary orders. A market maker must also have commenced quoting the
security and the quotation must be active, i.e., the market maker may
not enter proprietary orders when it is in a closed quote state.
Additionally, all proprietary orders must be entered by an associated
person of the eligible market maker who is actively engaged in a market
making capacity for Nasdaq securities. The NASD seeks to ensure that
the entry of proprietary orders is properly managed by the eligible
market maker.
As to UTP exchange specialists, the exchange specialist must be
registered with an exchange that is a signatory to the Nasdaq/NMS/UTP
Plan and must accept responsibility for market order executions at its
quotation pursuant to the NAqcess market order execution process.
Specifically, the NASD notes that the extension of this privilege to
UTP specialists is contingent upon UTP exchanges and Nasdaq coming to
terms on access to UTP exchange quotes for the purpose of market order
executions. The best way to provide the reciprocal capability of one
market being able to access the other is through the provision of
Nasdaq Workstations to UTP Exchanges. In that way, UTP Exchange
specialists will be able to enter proprietary orders into NAqcess and
in return, NASD members can directly access exchange quotes in Nasdaq
securities through NAqcess. Until such time as NASD members can obtain
executions of market orders in NAqcess against the UTP exchange
specialist when a UTP exchange is setting the best price in a security,
the NASD believes that it would be unfair to allow UTP specialists to
enter proprietary orders into NAqcess. The NASD is fully willing to
negotiate with UTP exchanges an appropriate approach to access to all
Nasdaq systems as a part of the Nasdaq/NMS/UTP Plan. In this regard,
prior to filing this amendment to the rule filing, the NASD has
contacted the UTP Exchanges to inform them of this proposed function
and to commence discussions on reaching a successful resolution of the
access issue.
A registered options market maker that seeks to enter a proprietary
order in a security must be registered as an options market maker in
that same security on an exchange that trades options on that security.
Options market makers that are not NASD members with access to Nasdaq
Workstation II equipment may place NAqcess orders through an NASD
member, whether a market maker or a NAqcess order entry firm.15
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\15\ To clarify the rule on takeout orders, the NASD also
proposes to amend the rule to specifically allow takeout order entry
on behalf of registered options market makers, as well as customers.
In the original proposal, takeouts were described as principal
orders or orders entered as agent for a customer. Under NASD rules
generally, customer is defined not to include brokers or dealers.
The NASD has added the term ``customer'' to the list of definitions
in the NAqcess rules and have redefined ``takeouts'' to include
options market maker orders. Because UTP Exchange specialists will
have access to Nasdaq Workstations, they will be permitted to enter
takeout orders directly. In adding the definition of customer, the
NASD reiterates that agency orders entered within a five minute
period may be deemed to be based on a single investment decision. In
this regard, it also noted that entry of computer generated orders
could be considered orders based on a single investment decision.
See Securities Exchange Act Release No. 36548, at n. 16 (60 FR
63095).
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All proprietary orders will be accorded the same priorities and,
for limit orders, price protection as provided to any other order in
NAqcess. Accordingly, a proprietary limit order in NAqcess that has
price or time priority over any other limit order will be executed
ahead of all other limit orders. Further, the price protection rule
also applies to proprietary limit orders in NAqcess in the same way
that the rule would apply to an agency order.16 Proprietary limit
orders will not have any distinguishing characteristic viewable to
market participants to differentiate them from other limit
orders.17 Similarly, proprietary market orders will be handled in
the same order delivery and execution process as agency orders. In
addition, proprietary orders, both limit and market orders, may not be
entered for sizes larger than the maximum order sizes permitted under
the rules, i.e., 9,900 and 1,000 shares for limit orders, and 1,000,
500, and 200 for market orders. It should be noted, however, that
proprietary orders will not be aggregated under a single investment
concept approach when the proprietary orders are strictly for the
market maker's own account. On the other hand, to avoid allowing a
customer to circumvent the maximum order size rules, a market maker may
not enter a series of proprietary orders in order to execute as
riskless principal a customer order that is in excess of the maximum
order size. For example, if a market maker receives a customer limit
order for 20,000 shares, the firm is not permitted to enter four 5,000
share orders at that same price with the expectation that the firm will
pass along the benefit of the executions to the customer.
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\16\ The equivalent price protection rule does not apply to
proprietary limit orders because such rules only apply to customer
orders. Thus, to the extent that a member firm holds a limit order
from an options market maker outside of NAqcess, the firm is not
obligated to provide equivalent price protection for such order.
\17\ A member entering a proprietary order on behalf of an
options market maker must ensure itself that the firm placing the
order is eligible to do so. Thus, if a member receiving an order
from another firm claiming to be eligible as a registered options
market maker knew or should have known that the firm claiming the
right to enter the order did not in fact qualify, the member could
be deemed to have violated the NAqcess rules. Members entering such
orders are required to document that the order is eligible for
entry. Members will be required to place an appropriate indicator in
the order entry window on the Nasdaq Workstation to denote whether a
limit order is an agency order, a principal order, a riskless
principal order, or an order on behalf of an options market maker.
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4. Elimination of SelectNet
The entry of proprietary orders and larger sized limit orders
provides significantly greater functionality in the NAqcess system. It
is the NASD's view that this new functionality provides members with
the capabilities substantially equivalent to the most used functions in
SelectNet. Members use SelectNet in several ways. Members most
frequently broadcast smaller or medium size orders in an attempt to
obtain price improvement for a customer order over the current dealer
quotation. NAqcess provides a similar ability in a more efficient book
display and interaction environment.
Market makers also occasionally use SelectNet to send orders to
other market makers when they cannot reach them by telephone. NAqcess
will provide market makers similar capabilities and because orders will
not scroll off the screen unexecuted as occurs in SelectNet, it will
provide for more efficient executions.
Members also can use SelectNet to broadcast larger orders in an
attempt to seek negotiation or execution of those orders. NAqcess will
provide the ability to send orders up to 9,900 shares for certain
securities, but, unlike SelectNet,
[[Page 31579]]
it will not permit unlimited size for all securities. The NASD notes,
however, that although SelectNet allows the display of unlimited size
orders, it is rare that orders larger than the NAqcess size limits are
executed in SelectNet. The NASD examined certain trading days in the
first quarter of 1996 to determine a representative picture of
SelectNet use.18 Of the 250 most heavily traded issues as
determined by median dollar volume, there were 52 trades in SelectNet
larger than 9,900 shares on the days studied. Over the same time
period, the total number of trades for these securities was 2,085,544.
Thus, SelectNet trades greater than 9,900 shares accounted for .0025%
of total trades. The numbers related to other securities present a very
similar pattern. There were 27,646 SelectNet trades greater than 1,000
shares for all other Nasdaq securities in this time period, as compared
to a total number of trades of 1,827,282. This represents 1.51% of
total trades.
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\18\ NASD Economic Research examined SelectNet activity on
Thursdays in the first quarter in 1996.
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Overall, NAqcess provides a very similar opportunity for market
makers to lay off positions and to obtain a better execution for their
customer and proprietary orders. Further, and more important, NAqcess
will consolidate market information that previously was fragmented and
not transparent to the entire market. Moreover, merging SelectNet
trading activity into NAqcess should increase the likelihood that
public limit orders displayed in NAqcess will receive a quick and
advantageous execution. Because NAqcess provides capabilities analogous
to the most used capabilities permitted in SelectNet, the NASD believes
that SelectNet is no longer necessary. Accordingly, through this
filing, the NASD proposes to terminate the SelectNet service.
Finally, the NASD intends to maintain the communications capability
of SelectNet to provide an emergency communications mechanism among
members in case of market exigencies. This feature is essentially the
original SelectNet service first provided after the 1987 market break.
Nasdaq will maintain this feature running in the background on the host
processor operated by Nasdaq, and if necessary to provide additional
communications capabilities during special market circumstances, Nasdaq
will commence operation of this communications facility. Under such
limited circumstances, NASD members would be able to direct an order
through SelectNet to a particular market maker in lieu of calling on
the telephone.
C. Other Changes
The NASD has made several other changes to the NAqcess rules, in
particular with respect to the preopening procedures.
1. Opening
The NASD has revised the opening process it will use at the startup
of NAqcess to greatly simplify the process of opening NAqcess. The NASD
has deleted all of the opening procedures previously described in the
original rule filing. In its place, the NASD proposes the following
procedures: NAqcess will not accept any limit or market orders entered
into NAqcess outside of normal market hours, i.e., 9:30 a.m. to 4:00
p.m. Eastern Time. Members will be able to cancel resident GTC agency
or proprietary limit orders prior to the opening, as well as after the
market has opened. This will allow members to exercise their fiduciary
duties as to their customers when material news in a security occurs
after the market has closed on the previous day.
The rules regarding the opening will provide a special exception to
the normal mechanism for dealer quotations that match or cross orders
not executed the previous day or cancelled prior to the opening. Under
the newly proposed opening process, a dealer quotation that matches or
crosses limit orders on the file at 9:30 is subject to immediate
execution of the limit orders at its quotation price. Thus, if a market
maker were to move its opening offer at 9:30 to 19\7/8\ to set the
inside market when a limit order to buy 8,000 shares at 20 was resident
on the file at 9:30, the 8,000 share limit order would automatically
execute against the market maker at its 19\7/8\ quotation. Moreover,
the execution would not deplete the market maker's minimum exposure
limit. If multiple market makers quote through resident limit orders,
each limit order quoted through will be distributed to the market
makers at the best dealer bid or offer on a time sequence basis. In
other words, if two GTC limit orders to buy 3,000 shares each at 20 are
resident in the file at 9:30, and at 9:30, two market makers set the
inside by quoting on the asked side of the market at 19\7/8\, each
market maker will receive an execution report for 3,000 shares at 19\7/
8\ delivered to it. The executions against their quotes will not have
an effect on their exposure limits.
Orders entered at 9:30 and thereafter and any limit orders already
resident in NAqcess from the previous day will be processed according
to the normal market procedures described in the NAqcess rules.
2. Inside Market--Best Dealer Bid and Offer
The NASD revised the use of the term ``inside market'' and added
the term ``best dealer bid and offer'' throughout the proposed
rule.19 The NASD has made these revisions to provide a clearer
definitional framework for several reasons. The new definition of
``best dealer and offer'' is necessary to establish, for example, when
a limit order is to be treated as a ``marketable limit order.'' This
new definition sets the condition that a limit order is to be handled
as market order when the limit order is priced the same as or outside
the dealer bid or offer, as the case may be. Similarly, the two
definitions, working in tandem, are critical to determine when limit
orders establish the inside market and when such limit orders are to be
automatically executed against each other.
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\19\ The NASD also plans to develop a new approach to the
requirement related to updating a market maker's quotation after its
exposure limit has been exhausted. Currently, NAqcess rules provide
that a market maker has up to five minutes to update its quotation
after the exposure limit has been exhausted. The NASD plans to
submit a system and rule revision to the Nasdaq Board for review and
approval. The proposed revision would be to create a system alert
function that would advise a closed quote market maker after one
minute that it should refresh its quotation. If the market maker
does not take any action by the end of three minutes in a closed
quote status, the market maker would have a choice between system-
assisted reentry of a quotation in accordance with market maker
predetermined parameters or suspension as a market maker in the
security for 20 business days.
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3. Self-Directed Orders
Consistent with the proprietary market order change discussed
above, the NASD has also eliminated the requirement set out in the
original proposal concerning agency market orders entered by market
makers for their customers. The original proposal required that such
orders be self-directed to the market maker. The NASD does not believe
that requirement is necessary in an environment where market makers can
enter proprietary orders. Nonetheless, market makers will be able to
self-direct any market order.
4. Odd-Lot Orders
The NASD has amended the proposal regarding the eligibility of odd-
lot orders in NAqcess. The smallest normal unit of trading in Nasdaq is
a round lot of 100 shares. At least for the initial operation of
NAqcess, the NASD has determined that odd-lot orders (i.e., orders 99
shares or less) should not be handled through NAqcess, because of
[[Page 31580]]
the potential adverse cost impact that odd-lot executions may have on
round-lot customer orders. Thus, the proposed Rules are being amended
to delete references to the entry of odd-lot orders, except insofar as
a partial execution of a mixed lot order (i.e., an order consisting of
at least one round lot and an odd-lot) may occur. In the case of a
partial fill of a mixed lot order, the remaining unfilled odd-lot, if
it is a limit order, will be stored in the NAqcess limit order file.
However, it will not establish the inside market if it is the best
priced limit order, nor will it be displayed in the Top of File
display. The unfilled odd-lot will not be matched against incoming
limit or market orders. Execution of the odd-lot limit order will occur
when the best dealer bid or offer matches or crosses the odd-lot order;
the odd-lot will automatically execute against the dealer quote. If the
order was a mixed-lot market order that obtained a partial fill against
a limit order, the unfilled remainder will be automatically executed
against the next available market maker at the inside market without
the possibility of being declined. The NASD also has amended the Rules
of Fair Practice regarding the customer's discretion on NAqcess order
entry to reflect this limitation on odd-lot order entry.
The NASD will continue to assess the need for development of an
odd-lot order handling facility and may propose to revise NAqcess at a
future date to permit such a capability.
5. Agency Orders--Family Members
The NASD is proposing to change the prohibition regarding the entry
of agency orders on behalf of an immediate family member. The current
proposal retained the SOES prohibition that stated an order is not
considered an ``agency order'' if it is for any account of a member of
the immediate family of an associated person who has physical access to
a device capable of entering orders into NAqcess.20 These
provisions were intended to prevent the creation of multiple accounts
by a firm to evade the maximum order size limit in SOES.
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\20\ See changes to proposed definition I. G. and Order Entry
Restrictions IV. B. 3 and 4.
---------------------------------------------------------------------------
Upon consideration of the purpose of the restriction on immediate
family members in light of the new order delivery risk management
features in NAqcess (i.e., the ability of a market maker to decline an
order if it has just effected a trade and is in the process of updating
its quotation), the NASD has determined at this time to eliminate the
restriction. However, it should be noted that the restriction's
elimination is being done based upon preliminary views that the order
delivery function of NAqcess should provide sufficient tools to market
makers to handle multiple market orders sent for execution at a
dealer's quotation. If experience in NAqcess teaches that firms attempt
to set up multiple accounts using family members as a technique to
evade the order size restrictions, the NASD will seek to amend the
NAqcess rules to address such subterfuges.
6. Amendment to Schedule D, Part V, Section 2(a)
The NASD has amended this rule to be consistent with the criteria
for maximum market order size in NAqcess.
(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. The NASD has attempted to
consider the various perspectives and competing interests and to
determine an approach that provides maximum benefits for investors
while reducing the costs to the lowest level possible. The NASD has
carefully weighed the competitive implications of these changes,
including the effect that larger orders and proprietary limit orders
will have on competing systems and markets, and has determined that the
benefits provided by greater transparency of limit orders and the
increased likelihood of execution of public limit orders resident in
NAqcess outweigh any competitive concerns. Specifically, NAqcess
provides a limit order display that drives the inside market, thereby
generally increasing competition in Nasdaq through the increased
transparency of limit orders. The changes involving proprietary limit
orders proposed in this amendment further increase the competition
among orders. Increased competition among orders and quotations is
inherently pro-competitive. Further, by permitting market makers to
enter proprietary market orders, market makers can access other market
makers' quotations more readily, resulting in an increased willingness
to provide liquidity.
Finally, the NASD believes that any adverse competitive impact
resulting from the entry of proprietary orders to market makers is far
outweighed by the positive impact that the change will have on market
liquidity and market making competition.21
---------------------------------------------------------------------------
\22\ See e.g., letter from Harold Bradley and IRC.
---------------------------------------------------------------------------
The NASD notes that NAqcess will provide new opportunities to
satisfy investor demand that Nasdaq provide an investor with an ability
to interact with another customer's order without the intermediation of
a dealer, a goal stated in Section 11A of the Act. In comment letters
on NAqcess and the SEC Order Exposure Release, institutional investors
and companies listed on Nasdaq noted that this was an important feature
that they wanted.22 The NASD believes that it is important that
every market listen to its ultimate customers and provide capabilities
that those customers request. Further, it is critical that Nasdaq
market makers, and other firms that perform market making functions in
Nasdaq securities, or options related to Nasdaq securities, maintain
incentives to continue to make markets and provide liquidity for those
securities. Opening NAqcess to proprietary orders from any broker-
dealer would permit any firm to effectively operate as a fair-weather
market maker by competing with market maker quotes through limit
orders. This would allow non-market makers to compete risk-free with
market makers and would drive market makers from the risk position they
occupy when they enter two-sided quotes on a regular and continuous
basis. Because market makers are a significant source of market
liquidity, it is essential that the system is structured to provide
incentives to continued market maker presence.
---------------------------------------------------------------------------
\21\ See changes to Section 11A(a)(1)(C)(i), (iv) and (v) of the
Act (``It is in the public interest and appropriate for the
protection of investors * * * to assure * * * economically efficient
execution of securities transactions, * * * the practicability of
brokers executing investors' orders in the best market; and an
opportunity * * * for investors' orders to be executed without the
participation of a dealer.'').
---------------------------------------------------------------------------
As to the competitive effect on ECNs, the NASD emphasizes that
NAqcess is voluntary in nature. The decision as to whether to enter
orders into NAqcess will be determined by investors seeking the best
available market in which to obtain an execution of their orders,
priced and unpriced. NAqcess does not restrict broker-dealer
opportunities to offer a competing service. Accordingly, the NASD
believes that NAqcess as revised herein provides significant investor
benefits that outweigh any competitive effects on others. Finally, as
to the general benefits that the NASD believes will result from the
implementation of NAqcess and its accompanying rules, the NASD's
Economic Research Department has developed a report regarding the
benefits NAqcess will bring to investors
[[Page 31581]]
in Nasdaq stocks. The report is attached as Exhibit D to this filing.
(C) Self-Regulatory Organization's Statement on Comments on the
Proposed Rule Change Received From Members, Participants, or Others
Written comments on the amendments were neither solicited nor
received.
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 self-regulatory organization consents,23 the Commission
will:
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\23\ The NASD has consented to an extension until August 30,
1996 for the Commission to act on the proposal. Letter from Eugene
A. Lopez, Assistant General Counsel, Nasdaq, to Michael J. Ryan,
Jr., Special Counsel, SEC (June 11, 1996).
---------------------------------------------------------------------------
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. The Commission requests comments
generally concerning whether the NASD's proposal is consistent with the
Act. In addition, the Commission invites interested persons to address
the following specific issues:
(1) The NASD proposes to allow limit orders up to 9,900 shares in
the 250 most active Nasdaq securities, determined by the median dollar
volume over the previous calendar quarter. Further, once a security is
included in the 250 most active Nasdaq securities, the NASD proposes to
continue to allow limit orders up to 9,900 shares in the security until
the security's median daily dollar volume brings it below the 1,500
most active Nasdaq National Market securities. The Commission seeks
comment on:
(a) Whether the median dollar volume is the most appropriate
measure for determining the most active Nasdaq stocks or whether a
different measure or alternative measures should also be considered;
(b) Whether it is appropriate, as the NASD has proposed, to exclude
IPOs from the quarterly assessment of which securities meet the median
dollar volume test until the second full calendar quarter after the
IPO; and
(c) Whether it is appropriate to maintain the maximum limit order
size for the top 1,500 most active securities or a lesser of greater
number of securities.
(2) As under the SOES rules, the NAqcess rules generally would
prohibit members from splitting orders to comply with the NAqcess order
size limitations. Two or more orders based on a single investment
decision would be considered one order for purposes of determining
whether an order was split. As a general rule, orders entered by an
order entry firm within any five minute interval would be presumed to
be based on a single investment decision. Notwithstanding the single
investment decision limitation, market makers would be permitted to
enter multiple proprietary orders, unless the order is a riskless
principal order. The Commission seeks comment on whether the exception
to allow market makers to enter multiple proprietary orders is
appropriate.
(3) The proposed NAqcess ``equivalent price protection'' rule would
require member firms that do not enter NAqcess-eligible customer limit
orders into NAqcess (e.g., firms that internalize) to provide these
orders price protection at least equivalent in substance to that which
the order would have received had the order been entered into NAqcess.
This rule, however, would not apply to proprietary (i.e., non-customer)
limit orders. Thus, if a firm internalizes a limit order it receives
from an options market maker, it would not be required to provide it
print protection. The Commission seeks comment on whether this
exception is appropriate. In addition, the Commission seeks comment on
the practical impact of the ``equivalent price protection'' rule.
Specifically, the Commission is interested in commenters' views on
whether this rule, in effect, would require member firms to place their
customers' limit orders in NAqcess.
(4) The NASD developed SelectNet in response to the difficulties
experienced in the Nasdaq market during the market break of October
1987. SelectNet is an electronic screen-based order routing system
allowing market makers and order-entry firms to negotiate securities
transactions in Nasdaq securities through computer communications
rather than relying on the telephone. Through SelectNet, NASD members
can either direct an order to another member or broadcast an order to
all market makers in the security or all members watching the security.
The NASD proposes to terminate its SelectNet service but intends to
maintain for ``special market conditions'' the ability of market makers
to use the directed feature in SelectNet. The Commission seeks comment
on whether the NASD should continue to operate the directed feature at
all times, rather than reserving it for ``special market conditions,''
if NAqcess is approved.
(5) At least for the initial operation of NAqcess, the NASD
proposes to prohibit the entry of odd-lot orders (i.e., orders of less
than 100 shares). The NASD is concerned that the cost imposed on a
round-lot customer order that matches with an odd-lot order might be
excessive. The NASD recognizes, however, that even though the entry of
odd-lots would be prohibited, round-lot orders might be partially
executed and result in an odd-lot remaining. Under this situation, the
NASD proposes to immediately execute the remaining odd-lot
automatically against a market maker as soon as the order becomes
marketable (i.e., immediately if the order is a market order or, if it
is a limit order, after the inside market moves so that a buy (sell)
limit order equals the inside ask (bid)). The Commission seeks comment
on whether odd-lot orders should be entered in NAqcess and the
appropriate methodology for executing these orders, including
consideration of immediate automatic execution of marketable orders.
(6) Under the proposed NAqcess rules, a limit order priced at the
quote (i.e., buy (sell) order priced at the bid (ask)) would not have
time priority over market makers' quotes. For example, if the inside
market consists of two market makers bidding $20 in a security and a
limit order to buy at $20 is placed in NAqcess after the market makers
began bidding $20, incoming market orders would be directed to the
market makers before they are matched with the limit order priced at
$20. Given that market makers would have an opportunity to decline
market orders entered into NAqcess (consistent with the Firm Quote
Rule), but market orders matched with limit orders would be executed
immediately, the Commission seeks comment on whether limit orders
should have priority over market maker quotes, so that incoming market
orders would be matched with limit orders first.
(7) Under the NASD's original NAqcess proposal (similar to current
SOES Rules), members would have been permitted to enter orders during
non-market hours (market orders: 8:30 a.m. to 9:28 a.m.; limit orders:
8:30 a.m. to 9:28 a.m. and 4:00 p.m. to 6:00 p.m.).
[[Page 31582]]
Immediately prior to the opening, NAqcess would have applied to the
orders in its book special pre-opening procedures that, generally,
would have first matched limit orders with limit orders and then market
orders with limit orders. Any orders that remained unexecuted after the
pre-opening procedure would have been subject to the normal intra-day
procedures. Under the amended proposal, the NASD proposes to prohibit
entry of any orders outside of Nasdaq market hours. The Commission
seeks comment on the appropriateness of eliminating the entry of orders
outside of Nasdaq market hours. Further, to the extent commenters
believe that pre-opening and post-closing orders should be permitted,
the Commission seeks comment on the appropriate pre-opening procedures.
(8) Like SOES, the current NAqcess proposal would provide a market
maker up to five minutes to update its quotation after its exposure
limit has been exhausted. The NASD has represented, however, that it
intends to recommend that the Nasdaq Board adopt a new approach.
Specifically, the NASD is expected to create a system alert function to
advise a closed quote market maker after one minute that it should
refresh its quotation. If the market maker does not take any action by
the end of three minutes in a closed quote status, the market maker
would have a choice between a system-assisted reentry of a quotation in
accordance with market maker predetermined parameters or suspension as
a market maker in the security for 20 business days. The Commission
seeks comments on:
(a) Whether the one minute and three minute parameters are
appropriate; and
(b) Whether, after three minutes have lapsed, the NASD should allow
a market maker to choose between having its quotation updated and being
suspended or whether the system should then automatically reestablish
the market maker's quotation, with the market maker being limited to
selecting the update parameters.
(9) The NASD proposes to allow UTP exchange specialists to enter
proprietary limit and market orders in NAqcess. To obtain access, UTP
exchange specialists must, among other things, provide electronic
access that permits NAqcess market and limit orders to be executed
against the specialist's published quote.
The Commission seeks comment on the most appropriate mechanism for
providing this electronic access.
(10) The NASD has represented that many of its member firms have
expressed an interest in integrating NAqcess into the firms' internal
order handling systems. The Commission understands the NASD has
provided its members with the technical specifications necessary to
begin integrating NAqcess. The Commission requests that commenters
provide an estimate of the time necessary from Commission approval of
NAqcess to complete the changes necessary to integrate NAqcess.
Further, the Commission seeks comment on members' and other commenters'
views on the capacity for the current Nasdaq network and Workstation to
manage expected NAqcess order flow.
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 the filing will also be available for
inspection and copying at the principal office of the NASD. All
submissions should refer to the file number SR-NASD-95-42 and should be
submitted by July 26, 1996.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.24.
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\24\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
Exhibit A--Rules of Operation and Procedures For the NAqcess System
I. Definitions
[The terms used in this Section shall have the same meaning as those
defined in the Association's By-Laws and Rules of Fair Practice, unless
otherwise specified.]
A. The term ``NAqcess'' shall mean the limit order and market order
delivery and execution system owned and operated by The Nasdaq Stock
Market, Inc. (a wholly owned subsidiary of the National Association of
Securities Dealers, Inc.).
B. The term ``NAqcess participant'' shall mean either a market
maker or an order entry firm registered for participation in NAqcess.
C. The term ``NAqcess eligible security'' shall mean any Nasdaq
National Market or Nasdaq SmallCap equity security.
D. The term ``open quote'' shall mean a market maker's quotation
price and size (up to its designated exposure limit) in an eligible
security against which orders may be executed through the NAqcess
system during normal market hours, as specified by the NASD. For the
purposes of these Rules, a market maker has a ``closed quote'' when its
exposure limit in NAqcess has been exhausted or it has been deemed
``closed'' pursuant to Section IV. A. 9 below.
E. The term ``NAqcess market maker'' shall mean a member of the
Association that is registered and quoting with an open quote as a
Nasdaq market maker pursuant to the requirements of Schedule D to the
NASD By-Laws and as a market maker in one or more NAqcess eligible
securities.
F. The term ``NAqcess order entry firm'' shall mean a member of the
Association that is registered as an order entry firm for
[participating] participation in NAqcess which permits the firm to
enter agency orders of limited size [for delivery to and execution
against] that may be (1) delivered to NAqcess market makers [and
customer limit orders in NAqcess that are included in] or UTP Exchange
specialists that are at the best dealer bid and/or offer or (2)
executed against limit orders that are at the inside market.
G. The term ``agency order'' shall mean an order from a [public]
customer that is entered by the NAqcess order entry firm or NAqcess
market maker on an agency basis.
An order will not be considered an agency order if it is for any
account of a person associated with any member firm or any account
controlled by such an associated person.
[An order will not be considered an agency order if it is for any
account of a member of the ``immediate family'' (as that term is
defined in the NASD Free-Riding and Withholding Interpretation, Article
III, Section 1 of the Rules of Fair Practice) of an associated person
who has physical access to a terminal capable of entering orders into
NAqcess.] H. The term ``customer'' shall have the same meaning as set
forth in the Rules of Fair Practice, Article II, Section 1(f).
[H] I. The term ``directed order'' shall mean an order entered into
NAqcess and directed to a particular NAqcess market maker or an order
entered by a NAqcess market maker that is self-directed. Each market
maker has the ability to select order entry firms from which it will
accept directed orders.
[[Page 31583]]
[I] J. The term ``non-directed order'' shall mean an order entered
into NAqcess and not directed to any particular market maker [,] or [a
directed] an order that has been directed to a market maker that has
not identified the order entry firm as one from which it will accept
directed orders, or a directed order sent to a [firm] member that is
not registered as a market maker in that security.
[J] K. The term ``limit order'' shall mean an order entered into
NAqcess that is a priced order.
[K] L. The term ``marketable limit order'' shall mean a limit order
that, at the time it is entered into NAqcess, if it is a limit order to
buy, is priced at the current [inside] best dealer offer or higher, or
if it is a limit order to sell, is priced at the [inside] best dealer
bid or lower.
[L] M. The term ``executable limit order'' shall mean a limit order
that, at the time a limit order, market order, or marketable limit
order on the opposite side of the market is entered, is either
[included in the inside market] within the best dealer bid and offer or
is equal in price to the inside market and has time priority over other
[limit] orders or [dealer quotations included] quotes in the inside
market.
N. The term ``proprietary order'' shall mean an order for the
principal account of a broker or dealer. A proprietary order may be a
limit order, a market order or a marketable limit order.
O. The term ``UTP exchange specialist'' shall mean a broker-dealer
registered as a specialist in Nasdaq securities pursuant to the rules
of an exchange that: (1) Is a signatory as either a participant or
limited participant in the Joint Self-Regulatory Organization Plan
Governing the Collection, Consolidation and Dissemination Of Quotation
and Transaction Information For Exchange-Listed Nasdaq/National Market
System Securities Traded On Exchanges On An Unlisted Trading Privilege
Basis (``Nasdaq/ NMS/UTP Plan''); (2) provide for electronic access
that permits a UTP exchange specialist to enter proprietary orders and
permits NAqcess market and limit order executions against a UTP
exchange specialist at its published quote; and (3) permit all
transactions to be cleared and settled through a registered clearing
agency using a continuous net settlement system.
P. The term ``registered options market maker'' shall mean an
exchange member registered with a national securities exchange as a
market maker or specialist pursuant to the rules of such exchange for
the purpose of regularly engaging in market making activities as a
dealer or specialist in an option on a Nasdaq-listed security.
Q. The term ``eligible market maker'' shall mean a NAqcess market
maker, a UTP exchange specialist or a registered options market maker.
Eligible market makers may enter proprietary orders only for those
Nasdaq securities for which they are registered as a NAqcess market
maker or an exchange specialist or for a Nasdaq security for which they
are registered as an options market maker in an option on the
underlying Nasdaq security.
R. The term ``takeout [M. The term ``marker] order'' shall mean an
order entered by an NASD member firm or a UTP exchange specialist,
acting as principal or as agent on behalf of a customer or a registered
options market maker, that executes against [NAqcess limit orders
viewable by that firm.] limit orders consolidated in the inside market
or displayed in the NAqcess Full File Display.
[O] S. The term ``inside market'' shall mean the best dealer bid,
UTP exchange bid, or NAqcess limit order(s) to buy and the best dealer
offer, UTP exchange offer or NAqcess limit order(s) to sell, as the
case may be, displayed by Nasdaq.
T. The terms ``best dealer bid,'' ``best dealer offer'' or ``best
dealer bid and/or offer'' shall mean the highest priced bid quotation
from a Nasdaq market maker or a UTP exchange specialist and/or the
lowest priced offer quotation from a Nasdaq market maker or a UTP
exchange specialist.
U [P]. The term ``UTP exchange'' shall mean any registered national
securities exchange that has unlisted trading privileges in Nasdaq
securities [.] pursuant to the Nasdaq/ NMS/UTP Plan.
[Q] V. The term ``matched or crossed file'' shall mean the entry
of: (1) a bid quotation by a market maker equal to or greater than a
limit order to sell resident in the NAqcess file in the same security;
or (2) an offer quotation by a market maker equal to or less than a
limit order to buy resident in the NAqcess file in the same security.
[R] W. The term ``maximum market order size'' shall mean the
maximum size of individual market orders for a NAqcess eligible
security that may be entered into or executed through NAqcess. The
maximum market order size for each security shall be advertised in the
system and published from time to time by the Association. In
establishing the maximum market order size for each Nasdaq National
Market security, the Association generally will give consideration to
the average daily non-block volume, bid price, and number of market
makers for each security. Maximum market order size for Nasdaq National
Market securities shall be 200, 500 or 1,000 shares, depending upon the
trading characteristics of the securities.1 These sizes may be
adjusted on an issue by issue basis, depending upon trading
characteristics of the issue and other relevant factors as determined
by the Association. Maximum market order size for Nasdaq SmallCap
securities shall be 500 shares.
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\1\ The applicable maximum market order size for each Nasdaq
National Market security is determined generally by the following
criteria:
(i) A 1,000 share maximum market order size shall apply to
Nasdaq National Market securities with an average daily non-block
volume of 6,000 shares or more a day, a bid price of less than or
equal to $100, and three or more market makers;
(ii) A 500 share maximum market order size shall apply to Nasdaq
National Market securities with an average daily non-block volume of
2,000 shares or more a day, a bid price of less than or equal to
$150, and two or more market makers; and
(iii) A 200 share maximum market order size shall apply to
Nasdaq National Market securities with an average daily non-block
volume of less than 2,000 shares a day, a bid price of less than or
equal to $250, and that have two or more market makers.
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[S] X. The term ``maximum limit order size'' shall mean the maximum
size of a limit order for a security that may be entered into or
matched through NAqcess. The maximum limit order size for Nasdaq
National Market securities shall be 1,000 shares for each tier of
Nasdaq National Market securities, except for the [securities that
comprise the Nasdaq 100 Index 2] 250 most active Nasdaq National
Market securities as measured by a security's median daily dollar
volume over the most recent completed calendar quarter, which shall
have a maximum limit order size of [3,000 shares.] 9,900 shares. A
National Market security that is the subject of an initial public
offering (``IPO'') shall not be considered for inclusion in the list of
Top 250 securities until such security has had two full calendar
quarters of trading history on Nasdaq. Initial inclusion of an IPO in
the Top 250 category will be based on the IPO's median daily dollar
volume in its second full calendar quarter. A security designated as
eligible for the entry of limit orders of 9,900 or less shall not be
deleted from this list of eligibility if its median daily dollar volume
causes it not to be included in subsequent calculations of the 250 most
active securities, unless there is a fundamental change in its trading
characteristics that causes the median daily dollar volume to fall
below the highest 1,500 most
[[Page 31584]]
active Nasdaq National Market securities. Maximum limit order size for
Nasdaq SmallCap securities shall be 1,000 shares.
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\2\ [The Nasdaq 100 Index is an index comprised of many of the
largest capitalized issues quoted in the Nasdaq National Market. The
securities that make up the Nasdaq 100 are changed from time to time
and The Nasdaq Stock Market publishes notice of such changes as they
occur.]
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[T] Y. The term ``exposure limit'' shall mean the number of shares
of a NAqcess eligible security specified by a NAqcess market maker that
it is willing to have executed for its account by non-directed orders
entered into NAqcess on either side of the market.
[U] Z. The term ``minimum exposure limit'' for a security shall
mean an exposure limit equal to the maximum market order size for that
security.
[V] AA. The term ``automated quotation update facility'' shall mean
the facility in the NAqcess system that allows the system to
automatically refresh a market maker's quotation in any security that
the market maker designates when the market maker's exposure limit has
been exhausted. The facility will update: (1) Either the bid or the
offer side of the quote using a quotation interval designated by the
market maker, depending upon the side of the market on which the
execution has occurred and refresh the market maker's exposure limit;
or (2) close the market maker's quote for five minutes, within which
time the market maker shall update its quote or be placed in a
suspended state for [20] twenty (20) business days.a
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\a\ [Commission Note: The NASD has stated that it plans to
submit to the Nasdaq Board a proposal to revise NAqcess to create a
system alert function that would advise a closed quote market maker
after one minute that it should refresh its quotation. Under the
expected change, if the market maker does not take any action by the
end of three minutes in a closed quote status, the market maker
would have a choice between a variety of system-assisted reentry of
a quotation in accordance with market maker predetermined parameters
or suspension as a market maker in the security for 20 business
days. See supra note 19 of the Commission's notice.]
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[W] BB. The term ``Automated Confirmation Transaction service''
(``ACT''), for purposes of the NAqcess rules, shall mean the automated
system owned and operated by The Nasdaq Stock Market, Inc. which
accommodates trade reporting of transactions executed through NAqcess
and submits locked-in trades to clearing.
II. NAqcess Participant Registration
A. All members participating in NAqcess shall register and be
authorized as NAqcess market makers and/or order entry firms.
Registration as a NAqcess participant shall be conditioned upon the
member's initial and continuing compliance with the following
requirements: (1) Membership in a clearing agency registered with the
Securities and Exchange Commission which maintains facilities through
which NAqcess compared trades may be settled; or entry into a
correspondent clearing arrangement with another member that clears
trades through such clearing agency; (2) registration as a market maker
(if applicable) in Nasdaq pursuant to Schedule D of the NASD By-Laws
and compliance with all applicable rules and operating procedures of
the Association and the Securities and Exchange Commission; (3)
maintenance of the physical security of the equipment located on the
premises of the member to prevent the unauthorized entry of orders or
other data into NAqcess or Nasdaq; and (4) acceptance and settlement of
each trade [for which it is responsible] that is executed through the
facilities of the NAqcess service, or if settlement is to be made
through another clearing member, guarantee of the acceptance and
settlement of such identified NAqcess trades by the clearing member on
the regularly scheduled settlement date.
B. Upon effectiveness of the member's registration to participate
in NAqcess, participants may commence activity within NAqcess for entry
and/or execution of orders, as applicable, and their obligations as
established in this rule will commence.
C. Pursuant to Schedule D to the NASD By-Laws, participation as a
NAqcess market maker is required for any Nasdaq market maker registered
to make a market in a Nasdaq National Market security. A market maker
in a Nasdaq SmallCap security may withdraw from and reenter NAqcess at
any time, and without limitations, during the operating hours of the
service.
D. Each NAqcess participant shall be under a continuing obligation
to inform the Association of noncompliance with any of the registration
requirements set forth above.
III. Operating Hours of NAqcess
The operating hours of NAqcess will be the normal market hours
specified for The Nasdaq Stock Market.
IV. Participing Hours of NAqcess
A. Market Makers
1. A NAqcess market maker shall commence participation in NAqcess
by initially contacting the Market Operation Center to obtain
authorization for market making in particular Nasdaq securities and
identifying those terminals on which the NAqcess trade information is
to be displayed. Thereafter, on-line registration on a security-by-
security basis is permissible, consistent with the requirements of
Schedule D to the NASD By-Laws.
2. Participation as a NAqcess market maker obligates the firm, upon
presentation of a market order or marketable limit order through the
service, to execute such order as provided in Section V.A.5. below.
NAqcess market makers are not permitted to decline orders directed to
the firm pursuant to a directed order arrangement acknowledged by the
market maker.
The system will transmit to the market maker on the Nasdaq
Workstation screen and printer, if requested, or through a computer
interface, as applicable, an execution report generated following each
execution.
3. For each NAqcess eligible security in which a market maker is
registered, the market maker shall enter into NAqcess [its] an exposure
limit. For a Nasdaq National Market security, that limit shall be any
amount equal to or larger than the minimum exposure limit for the
particular security. If no exposure limit is entered for a Nasdaq
National Market security, the firm's exposure limit will be either the
default size selected by the particular market maker or the minimum
exposure limit. ``Default size'' shall mean an exposure limit equal to
or greater than the minimum exposure limit that may be selected by a
market maker for individual securities or for all securities in which
it makes a market.
4. A NAqcess market maker may elect to use the automated quotation
update facility in one or more securities in which it is registered.
The facility will [update] refresh the market maker's quotation
automatically by a quotation interval designated by the market maker,
once its exposure limit in the security has been exhausted. The
facility will [update] refresh the market maker's quotation in either
the bid or the offer side of the market by the interval designated and
will reestablish the market maker's displayed size and either the
default exposure limit size or the minimum exposure limit; or the
facility will close the market [maker] maker's quote for five
minutes.b
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\b\ [Commission Note: But see supra note a of this Appendix.]
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5. Matched or crossed file. If a market maker's quotation change
matches or crosses a limit order residing in the NAqcess limit order
file, the system will automatically provide a notification to the
market maker that informs the market maker of its obligation to protect
all limit orders residing in the NAqcess file that would be affected by
the quotation change. If the market maker enters the matching or
crossing
[[Page 31585]]
quotation change after this notification, limit orders in the file for
the particular security will be automatically executed against the
matching or crossing market maker, provided however, that if the number
of shares in the limit order file that would be matched or crossed is
greater than five times the maximum market order size for that
particular security, or if the quotation change matches and crosses
multiple price levels, the quotation change will be rejected. To effect
such quotation change, the market maker first must manually enter a
takeout order for the affected orders in the file prior to re-entering
its quotation update.
6. The NAqcess market maker may terminate its obligation by
keyboard withdrawal from NAqcess at any time. However, the market maker
has the specific obligation to monitor its status in NAqcess to assure
that a withdrawal has in fact occurred. Except as otherwise permitted
by Section 70 of the Uniform Practice Code regarding the Association's
authority to declare clearly erroneous transactions void, (``UPC
Section 70''), any transaction occurring prior to the effectiveness of
the withdrawal may remain the responsibility of the market maker. In
the case of a Nasdaq SmallCap security, a market maker whose exposure
limit is exhausted will be deemed to have withdrawn from NAqcess and
may reenter at any time. In the case of a Nasdaq National Market
security, a market maker whose exposure limit is exhausted will have a
closed quote in Nasdaq and NAqcess and will be permitted a standard
grace period of five minutes within which to take action to restore its
exposure limit, if the market maker has not authorized use of the
automated quotation update facility. A market maker that fails to renew
its exposure limit in a Nasdaq National Market security within the
allotted time will be deemed to have withdrawn as a market maker.c
Except as provided in subsection 7 below, a market maker that withdraws
from a Nasdaq National Market security may not re-register in NAqcess
as a market maker in that security for twenty (20) business days.
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\c\ [Commission Note: But see supra note a of this Appendix.]
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7. Notwithstanding the provisions of subsection 6 above, (i) a
market maker that obtains an excused withdrawal pursuant to Part V of
Schedule D to the NASD By-Laws prior to withdrawing from NAqcess may
reenter NAqcess according to the conditions of its withdrawal; [and]
(ii) a market maker that fails to maintain a clearing arrangement with
a registered clearing agency or with a member of such an agency, and is
thereby withdrawn from participation in ACT and NAqcess for Nasdaq
National Market securities, may reenter NAqcess after a clearing
arrangement has been reestablished and the market maker has complied
with ACT participant requirements, provided however, that if the
Association finds that the ACT market maker's failure to maintain a
clearing arrangement is voluntary, the withdrawal of quotations will be
considered voluntary and unexcused pursuant to Schedule D and these
rules; or (iii) Nasdaq Market Operations Review Committee may reinstate
market makers that voluntarily withdraw or fail to obtain excused
withdrawal status pursuant to Schedule D, Part V, Section 8, prior to
the expiration of twenty (20) business days in the interest of ensuring
market liquidity and the protection of investors.
8. In the event that a malfunction in the market maker's equipment
occurs rendering on-line communications with the NAqcess service
inoperable, the NAqcess market maker is obligated to immediately
contact the Market Operations Center by telephone to request a closed
quote status from NAqcess. [For Nasdaq securities, such] Such request
must be made pursuant to the requirements of Part V, Schedule D to the
NASD By-Laws. If the closed quote status is granted, Market Operations
personnel will enter such status notification into NAqcess from a
supervisory terminal. Such manual intervention, however, will take a
certain period of time for completion and, unless otherwise permitted
by the Association pursuant to its authority under UPC Section 70, the
NAqcess market maker may continue to be obligated for any transaction
executed prior to the effectiveness of its closed quote.
B. Order Entry--Agency Orders
1. [Only] Except as provided in subsection C below, only market and
limit agency orders may be entered in NAqcess by the NAqcess order
entry firm or the NAqcess market maker through either its Nasdaq
Workstation or computer interface. The system will transmit to the
market maker or order entry firm on the Nasdaq Workstation screen and
printer, if requested, or through a computer interface, as applicable,
an execution report generated following each execution. [NAqcess market
makers may enter limit agency orders in NAqcess for any NAqcess
eligible security, but may not enter agency market orders or marketable
limit orders in securities in which they make markets, unless such
orders are self-directed. As a limited exception to the prohibition of
the entry of proprietary orders into NAqcess, NAqcess market makers may
place marker orders into NAqcess. The benefit of any such marker order
execution must be passed immediately to one or more customer limit
orders held by the firm placing the marker order. Marker orders may not
be placed with respect to customer limit orders held by the firm that
exceed the maximum limit order size permitted by these rules.]
2. NAqcess will accept both market and limit agency orders of
appropriate size for execution. Agency orders may be directed to a
specific NAqcess market maker, self-directed by the NAqcess market
maker, or may be non-directed, thereby resulting in execution against
the next available NAqcess market maker. If an order is directed to a
market maker by an order entry firm from which it has not agreed to
accept [direct] directed orders, the order will be executed on a non-
directed basis.
3. [Only agency] Agency orders no larger than the maximum market
and limit order sizes may be entered by a NAqcess [order entry firm
into NAqcess for execution against an NAqcess] market maker or order
entry firm into NAqcess for execution against a NAqcess market maker or
UTP exchange specialist or against an executable limit order. [Orders]
Agency orders in excess of the maximum order sizes may not be divided
into smaller parts for purposes of meeting the size requirements for
orders entered into NAqcess. All agency orders based on a single
investment decision that are entered by a NAqcess market maker or order
entry firm for accounts under the control of associated persons or
[public] customers, whether acting alone or in concert with other
associated persons or [public] customers, shall be deemed to constitute
a single order and shall be aggregated for determining compliance with
the maximum order size limits. [Orders] Agency orders entered by the
NAqcess market maker or order entry firm within any five-minute period
in accounts controlled by associated persons or [public] customers,
acting alone or in concert with other associated persons or [public]
customers, shall be presumed to be based on a single investment
decision. An associated person or customer shall be deemed to control
an account if the account is [his or her] a personal account [or an
account in which he or she has a beneficial interest]; the person
exercises discretion over the account; or the person has been granted a
power of attorney over the account; [or the account is the account of
an immediate
[[Page 31586]]
family member as that term is defined in the Board of Governors
Interpretation on Free-Riding and Withholding, Article III, Section 1
of the NASD Rules of Fair Practice].
4. No order will be considered an agency order from a [public]
customer if it is for any account of a person associated with any
member firm or any account controlled by such an associated person. [No
order will be considered an agency order from a public customer if it
is for any account of a member of the ``immediate family'' (as that
term is defined in the NASD Free-Riding and Withholding Interpretation,
Article III, Section 1 of the Rules of Fair Practice) of an associated
person who has physical access to a terminal capable of entering orders
into NAqcess.]
5. No member or person associated with a member shall utilize
NAqcess for the execution of agency orders in a SmallCap security in
which the member is a Nasdaq market maker but is not a NAqcess market
maker in that security.
6. NAqcess will accept the following types of agency orders during
normal market hours: (a) day orders; (b) good-till-canceled (``GTC'');
and (c) good till date (``GTD'').
C. Order Entry--Proprietary Orders
1. As an exception to the general prohibition of the entry of
proprietary orders into NAqcess, eligible market makers may place
proprietary orders for their market making accounts into NAqcess. All
such proprietary orders must be entered by an associated person of the
eligible market maker who is actively engaged in a market making
capacity for Nasdaq securities. Proprietary orders placed by a
registered options market maker may be entered through a NAqcess market
maker or NAqcess order entry firm.
2. Proprietary orders may be entered only for NAqcess-eligible
securities for which the NAqcess market maker or UTP exchange
specialist is registered as a market maker or specialist. Registered
options market makers may enter such proprietary orders for NAqcess-
eligible securities for which they are registered as a market maker or
specialist in an option overlying such securities. A member that enters
a proprietary order must designate the order with the appropriate
designator for surveillance and examination purposes: ``P'' for a
proprietary order entered by a NAqcess market maker; ``E'' for a
proprietary order entered by a UTP exchange specialist; and ``D'' for a
proprietary order entered by a registered options market maker.
3. Proprietary orders will be subject to the same display and
execution requirements and protections as agency orders. Proprietary
orders will be entered and displayed anonymously, i.e., no special
indicator will be displayed. Proprietary orders entered by eligible
market makers may not exceed the maximum market or limit order sizes
for NAqcess eligible securities. Proprietary market and marketable
limit orders are not subject to the limitations regarding a single
investment decision imposed on agency market orders in subsection B.3
above, provided, however, that an eligible market maker may not enter a
series of proprietary market and/or marketable limit orders to effect
transactions on behalf of a customer order that is in excess of the
maximum order sizes. Such orders may not be divided into smaller parts
for the purposes of meeting the size requirements for orders entered
into NAqcess.
4. A member accepting and entering proprietary orders on behalf of
a registered options market maker must maintain in its records
documentation that clearly indicates that such orders are for principal
accounts of persons eligible to enter proprietary orders. A member
entering proprietary orders for a person not eligible to enter such
orders violates the terms of the NAqcess rules, unless the member can
demonstrate that the member did not know or have reason to know that
the order was in contravention of NAqcess rules.
V. Execution of Naqcess Orders
A. General Execution Procedures [:] Orders in [Nasdaq equity]
NAqcess-eligible securities entered into NAqcess may be directed or
non-directed. Non-directed market orders and non-directed marketable
limit orders will be processed according to the procedures established
below. [Non-directed odd-lot orders that are market orders or
marketable limit orders will be automatically executed in NAqcess
against the next available market maker at the inside market and
execution reports will be delivered to the order entry firm and the
market maker] NAqcess will accept orders in sizes equal to or greater
than the normal unit of trading up to the applicable maximum order
sizes. An unexecuted odd-lot portion of a mixed-lot order will be
handled according to procedures set forth below.
1. Entry of Limit Orders [:] Limit orders may be entered into
NAqcess by order entry firms and by eligible market makers up to the
maximum limit order size allowed for a particular security. Limit
orders priced away from the Nasdaq inside bid or offer (as the case may
be) as well as limit orders [consolidated in the inside market] priced
at or within the best dealer bid and offer will be stored in the
NAqcess limit order file. Limit orders in securities priced at $10 or
more shall be priced in increments of an eighth or more; limit orders
in securities that are priced at under $10 may be placed in increments
of a sixteenth or less depending upon the dealer quotation increments
permitted.
2. Display of NAqcess Limit Orders [:] (a) Consolidated Display of
Limit Orders In Inside Market: If a NAqcess limit order to buy or sell
for 100 shares or more is better than the best dealer bid or offer, the
limit order to buy or sell will be displayed in the Nasdaq inside
market. Such display will contain the limit order price, size (which
shall be aggregated if two or more limit orders are at the same best
price) and an indicator to note that the inside market consists of a
limit order rather than a market maker or UTP exchange quotation. If a
NAqcess limit order of 100 shares or more is at the same price as the
best dealer bid or offer, the size displayed in the inside market will
be an aggregation of any same-priced limit orders and a single dealer
quote at the best price.
(b) Top of the file display: The Nasdaq Stock Market, Inc. will
make available via Nasdaq Workstations and to securities information
processors the prices and aggregate size of the best limit order(s) to
buy and the best limit order(s) to sell. This top of the file display
will be displayed separately from the inside market and will be
dynamically updated.
(c) Full Limit Order File Display: All Nasdaq market makers in a
particular security may request via Nasdaq Workstations a display of
all limit orders in such security entered in the NAqcess limit order
file. Such displays will be available on a query basis only to a
registered market maker in a particular security.
3. Execution of Limit Orders [: A limit order that matches or
crosses a limit order on the opposite side of the market will be
automatically executed against the matching or crossing order when such
orders are at the inside market or better, and have priority over the
dealer quotation] Matching or crossing limit orders on opposite sides
of the market priced better than the best dealer bid or offer on Nasdaq
upon entry or thereafter will be automatically executed against each
other. The priority rules for limit order interaction shall be that
orders that are best in price shall be executed against each other
first. If two or more
[[Page 31587]]
orders are at the same price on the same side of the market, then the
order that was received first in time shall be accorded priority over
other orders at the same price. Limit orders that cross each other in
price shall be executed at the price of the order that entered the file
first. A limit order matches a limit order on the file when: the limit
orders are [consolidated in the inside market] within the best dealer
bid and offer on Nasdaq; are on opposite sides of the market; and are
equal in price. A limit order crosses a limit order on the file when:
[both limit orders are either consolidated in the inside market or
better than the inside market;] one limit order is within the best
dealer bid and offer; they are on opposite sides of the market from
each other; and the subsequent limit order is at a superior price to
the existing limit order (i.e., the sell (buy) limit order is priced
below (above) a limit order to buy (sell)). Execution of limit orders
will occur up to the size of the initial limit order or the subsequent
limit order, whichever is smaller, and without the participation of a
market maker. The unexecuted balance of a limit order is entered into
the NAqcess file for subsequent matching, unless such balance is less
than 100 shares, in which case the balance is automatically executed
against the next available market maker, if equal to the [inside
quotation] best dealer bid or offer.
If there is a limit order at the same price as the best dealer
[quotation] bid or offer (i.e., if a limit order to buy is the same as
the best dealer bid, or a limit order to sell is the same as the best
dealer offer), the order or quote that has time priority shall be
matched against the incoming limit order.
4. Takeouts of Limit Orders [:] Any NASD member firm or UTP
exchange specialist, acting as principal or as agent on behalf of a
customer or a registered options market maker, may enter into NAqcess
an order or orders that execute(s) any limit order(s) [consolidated in
the inside market or otherwise] displayed in the NAqcess limit order
file. Such orders shall be known as ``takeout'' orders. A takeout order
may be for any size up to the aggregate amount of shares displayed in
the NAqcess limit order file at a particular price. Takeout orders must
be executed against limit orders on the opposite side of the market in
order of price and time. A firm entering a takeout order for limit
orders at multiple prices may enter a single takeout order at a price
either at or above or below the NAqcess limit orders, as the case may
be, and each limit order will be executed at each such price. Unfilled
takeout orders have no standing in the system. Takeout orders do not
reduce a firm's exposure limit.
5. Entry and Execution of Market Orders[:] (a) Market orders up to
the maximum market order size for a NAqcess eligible security may be
entered into NAqcess. If at the time a market order is entered into
NAqcess there is a limit order on the opposite side of the market that
resides in the NAqcess limit order file [and is reflected in] at a
price superior to the best dealer bid or offer, the incoming market
order will be automatically executed against the limit order at the
limit order price without the participation of a market maker. If a
market order is not fully executed against the limit order file, the
balance of such market order will be treated as any other market order
as set forth in subparagraph (b) below, provided that if the balance of
the market order is odd-lot size, the balance will be automatically
executed against the next available market maker at the [inside
quotation] best dealer bid or offer. If there is a limit order
[consolidated in the inside market] at the same price as [a] the best
dealer bid or offer (i.e., if a limit order to buy is the same as the
best dealer bid, or a limit order to sell is the same as the best
dealer offer), the order or quote that has time priority shall be
matched against the incoming market order.
(b) If there is no limit order residing in NAqcess [that has been
consolidated in the inside market] priced at or within the best dealer
bid or offer on the opposite side of the market from the market order,
each market order will be assigned to a market maker at the inside
market and will be executed against the next available market maker at
the current inside market after a [display] period of [15-]20 seconds.
The market maker to which a market order is displayed may decline the
market order within the [15-]20 second period if the market maker has
contemporaneously executed another transaction and is in the process of
updating its quotation pursuant to SEC Rule 11Ac1-1 ____. The quotation
update should be entered prior to declining the order. If a market
order or a marketable limit order is declined by a market maker, the
order is returned to the system for distribution to the next available
market maker. If that market maker is at the same price level as the
first market maker who declined the order, the second market maker has
[15] 20 seconds to react to the order. If the originally declined order
is re-presented to a market maker at a price level different from its
original presentation(s), the order is automatically executed at that
price level without any market maker ability to decline.
(c) If the NAqcess limit order file does not have any executable
limit orders at the time a directed market order is entered, the
directed market [orders] order will be automatically executed at the
inside market price against the directed order market maker without a
[15-second] decline capability. Directed limit order that are not
matched by incoming limit or market orders will be automatically
executed against the directed order market maker when the inside market
is changed to match the directed limit order price. [Directed odd-lot
orders (orders of less than 100 shares) that are market orders or
marketable limit orders also will be automatically executed against the
directed order market maker. Non-directed odd-lot orders that are
market orders or marketable limit orders will be automatically executed
against the next available market maker at the current inside market.
An odd-lot limit order that is not executable at time of entry will be
stored and executed against the best dealer bid or offer, as the case
may be, when such quotation reaches the limit order price.]
6. Entry and Execution of A Marketable Limit Order [:] Marketable
limit orders that meet the maximum market order size requirements will
be accepted and treated as market orders. Marketable limit orders
greater than the maximum market order size will be returned to the
order entry firm for handling outside of NAqcess.
7. NAqcess Opening [Procedures: NAqcess will permit the entry of
limit orders and market:] NAqcess will commence the processing of
orders at 9:30. The system will not accept orders outside of normal
market hours. Limit orders not executed or cancelled during normal
market hours (``resident limit orders'') may be cancelled at any time
that the system is opened for the purpose of entering quotations prior
to the opening. If the best opening dealer bid or offer matches or
crosses resident limit orders not cancelled prior to the open, then the
market maker that quoted through the limit order(s) must execute the
full share size of the order(s) at its quoted price. If multiple market
makers change their quotations to match or cross the NAqcess file at
the open, resident limit orders will be distributed to each market
maker at the best dealer bid or offer for immediate execution at their
quotation in time sequence. Quote-through executions at the opening do
not deplete a market makers's exposure limit. Resident limit orders at
market open and limit orders and market orders entered into NAqcess
[[Page 31588]]
at market open will be processed according to normal market processing
rules set forth in Section V, above[, except that market orders will
not be accepted between 4:00 and 6:00 p.m. Orders entered at such times
will not be executed but will be stored for matching and execution at
the next market opening. NAqcess permits the entry of such orders
between 4:01 p.m. to 6:00 p.m. and 8:00 a.m. to 9:28 a.m. (Orders
entered from 9:28 to 9:30 will be stored and handled according to
normal market procedures after the opening procedures are concluded.)
Matching and execution at the NAqcess opening will occur according
to the following procedures:
At 9:28 a.m., NAqcess will stop accepting orders for execution in
the NAqcess file for opening purposes. At 9:30 a.m., NAqcess will
commence execution procedures for opening orders in NAqcess by first
ranking and matching limit orders in NAqcess in sequence of the highest
price buy order against the lowest price sell order. When all available
limit orders are matched and executed, market orders on a time priority
basis will be matched and executed against any remaining limit orders
in the NAqcess file within the inside quotation at the limit order
price(s). Any remaining market limit orders will be stored in the
NAqcess file. Any remaining orders will be subject to normal order
execution processes].
VI. Clearance and Settlement
All transactions executed in NAqcess shall be transmitted to the
National Securities Clearing Corporation to be cleared and settled
through a registered clearing agency using a continuous net settlement
system.
VII. Obligation To Honor System Trades
If a trade reported by a NAqcess participant, or clearing member
acting on its behalf, is reported by NAqcess to clearing at the close
of any trading day, or shown by the activity reports generated by
NAqcess as constituting a side of a NAqcess trade, such NAqcess
participant, or clearing member acting on its behalf, shall honor such
trade on the scheduled settlement date.
VIII. Compliance With Procedures and Rules
Failure of a NAqcess participant or person associated with a
NAqcess participant to comply with any of the rules or requirements of
NAqcess may be considered conduct inconsistent with high standards of
commercial honor and just and equitable principles of trade, in
violation of Article III, Section 1 of the Rules of Fair Practice. No
member shall effect a NAqcess transaction for the account of a
customer, or for its own account, indirectly or through the offices of
a third party, for the purpose of avoiding the application of these
rules. Members are precluded from doing indirectly what is directly
prohibited by these rules. All entries in NAqcess shall be made in
accordance with the procedures and requirements set forth in the
NAqcess User Guide. Failure by a NAqcess participant to comply with any
of the rules or requirements applicable to NAqcess shall subject such
NAqcess participant to censure, fine, suspension or revocation of its
registration as a NAqcess market maker and/or order entry firm or any
other fitting penalty under the Rules of Fair Practice of the
Association.
IX. Termination of NAqcess Service
The Association may, upon notice, terminate NAqcess service to a
participant in the event that a participant fails to abide by any of
the rules or operating procedures of the NAqcess service or the
Association, or fails to pay promptly for services rendered.
Exhibit B--Interpretations Related to Member Firm Responsibilities
Regarding Orders in NAqcess
In its efforts to maximize the protection of investors and to
enhance the quality of the marketplace, the NASD and [The] the Nasdaq
Stock Market, Inc. have developed a nationwide limit order protection,
price improvement, and market order handling facility of The Nasdaq
Stock Market. This nationwide facility is herein referred to as
``NAqcess''.
The NASD Board of Governors is issuing these Interpretations to the
Rules of Fair Practice to provide: (1) Customers the right to have
their orders entered and protected in NAqcess; and (2) member firm
provision of equivalent protection for limit orders held in a member
firm's proprietary limit order system. These Interpretations are based
upon a member firm's obligation to provide best execution to customer
orders under Article III, Section 1 of the Rules of Fair Practice and a
member firm's obligations in dealing with customers as principal or
agent to buy and sell at fair prices and charge reasonable commissions
or service charges under Article III, Section 4 of the Rules of Fair
Practice. Accordingly, it shall be deemed a violation of Article III,
Section 1 of the Rules of Fair Practice for a member or a person
associated with a member to violate the following provisions:
1. Member Firm Obligation Regarding Investors Directions on Order
Handling
NAqcess will provide individual investors with significant
opportunities to achieve limit order protection and price improvement.
The NASD recognizes that member firms operating as market makers also
operate trading systems which offer significant protection and
execution opportunities for customer limit orders. Accordingly, nothing
herein is intended to limit a member's ability to recommend use of its
own or another member firm's proprietary system for handling limit and
market orders where equivalent protection is afforded. In light of the
significant benefits offered to customers by the NAqcess system,
however, members must abide by the directions of its customers who
request that the firm enter their eligible orders in NAqcess.
Further, nothing in this Interpretation requires a member firm to
accept any or all customer limit orders. Member firms accepting limit
orders that are placed in NAqcess or otherwise may charge fair and
reasonable commissions, commission-equivalents, or service charges for
such handling, provided that such commissions, commission-equivalents,
or service charges do not violate Article III, Section 4 of the Rules
of Fair Practice. In no event, however, shall a member impose any fee
or charge that effectively operates as a disincentive to the entry of
orders in the nationwide facility and thereby interferes with the
investor's ability to choose order handling alternatives.
2. Equivalent Protection for Orders Held Outside of NAqcess
As a further adjunct to a member firm's best execution obligations,
the NASD Board of Governors has interpreted Article III, Section 1 of
the Rules of Fair Practice to require member firms that do not enter
customer limit orders into NAqcess, but hold such protectible orders in
their own proprietary system, to provide such orders with price
protection at least equivalent in substance to that which the order
would have received had the order been entered into NAqcess. For the
purposes of this Interpretation, a ``protectible limit order'' shall
mean a limit order that meets the maximum limit-order size criteria as
set forth in the Rules of Operation and Procedure for NAqcess at
Section [I.S] I(s). For the purposes of this Interpretation, equivalent
price protection shall mean:
[[Page 31589]]
A. Print Protection
If a transaction in a Nasdaq security is reported via the Automated
Confirmation Transaction Service (``ACT'') at a price inferior to the
price of customer limit order(s) that the firm is holding (i.e., if the
reported price is a price lower than a buy limit order or higher than a
sell limit order being held by the firm), the firm holding the limit
order(s) is required on a contemporaneous basis to execute the limit
order(s) at the limit price(s) up to the size of the reported
transaction.
B. Matching Limit Orders
If the firm holds a customer buy (sell) limit order in its
proprietary limit order file and that limit order matches a sell (buy)
limit order in NAqcess, the firm holding the limit order must either
provide its customer with an immediate execution at the limit order
price or must immediately direct the order to NAqcess. A limit order
held by a firm would match a limit order in NAqcess when the limit
order in NAqcess is at the same price or is priced lower than the
firm's customer's limit order to buy or higher than the firm's customer
limit order to sell (``offsetting limit orders'').
C. Matching Limit Order Interaction Within A Firm's File
If the firm holds two or more offsetting customer limit orders
within its own proprietary file, the firm must execute the offsetting
limit orders.
D. Interaction Between Limit and Market Orders Held Within a Firm's
File
While holding a customer limit order that is priced equal to or
better than the best bid or offer in the security disseminated in
Nasdaq, if a firm accepts customer market orders for automated
execution against the best bid or offer in the security disseminated in
Nasdaq, the firm, pursuant to its obligation set forth in the
Interpretation to the Rules of Fair Practice, Article III, Section 1,
(the so-called ``Manning Interpretation''), must first permit the
market orders to execute against any applicable limit orders it holds
before the firm may execute the market orders for its own account.
E. Examples of Equivalent Protection
The NASD Board of Governors has provided the following examples to
further explain a member firm's equivalent protection obligation for
orders held outside of NAqcess:
Print Protection The best dealer bid and offer in Nasdaq [(the]
(``the inside price[)]'') is 20 bid--20\1/4\ offer. Firm ABCD holds a
customer limit order of 1,000 shares to buy at 20\1/8\ in its own
proprietary file. Firm MNOP reports a transaction in the subject
security via ACT, disseminating a price of 20\1/16\ for 500 shares.
Contemporaneous with the dissemination of the trade report, firm ABCD
is required to provide an execution of its customer limit order for at
least 500 shares at 20\1/8\.
Matching Limit Orders The inside price is 20 bid--20\1/4\ offer.
NAqcess is displaying a 1,000 share customer limit order to buy at
20\1/8\ for customer X. Firm ABCD thereafter receives from customer Y a
1,000 share limit order to sell at 20\1/8\ that the firm ABCD retains
for handling outside of NAqcess. Upon receipt of the limit order, firm
ABCD must execute customer Y's limit order for 1,000 shares at 20\1/8\.
Matching Limit Order Interaction Within a Firm's File The inside
price is the same as above. Firm ABCD holds a customer limit order to
buy 1,000 shares at 20\1/8\. Firm ABCD thereafter receives a customer
limit order to sell 1,000 shares at 20\1/8\. Firm ABCD must match the
orders and execute the trade.
Interaction Between Limit and Market Orders Held Within A Firm's File
The inside price is the same as above. Firm ABCD holds a customer
limit order to buy 1,000 shares at 20\1/8\. Firm ABCD thereafter
receives a customer market order to sell 1,000 shares. Firm ABCD must
match the two orders and execute the trade at 20\1/8\. Similarly, if
the limit order to buy were priced at 20, the firm would have to
execute the market order against the limit order at 20.
Price Protection for NAqcess Limit Orders Rules of Fair Practice,
Article III, Section [XX]
No member firm shall execute an order as principal or as agent at a
price inferior to any limit order(s) viewable in NAqcess to the member
firm, provided however, that a member firm executing a transaction that
is larger than the limit order(s) viewable in NAqcess at an inferior
price must contemporaneously satisfy the limit order(s) viewable in
NAqcess. An ``inferior price'' means an execution price that is lower
than a buy limit order or higher than a sell limit order that is
viewable in NAqcess. The term ``limit orders viewable in NAqcess''
shall mean those orders that the member firm is able to view either as
consolidated in the Nasdaq inside market or as reflected in the Full
Limit Order File Display as the firm is authorized to view under the
Rules of Operation and Procedure.
Exhibit C--Schedule D, Part V
Sec. 1. No Change
Sec. 2. Character of Quotations
(a) Two-Sided Quotations. For each security in which a member is
registered as a market maker, the member shall be willing to buy and
sell such security for its own account on a continuous basis and shall
enter and maintain two-sided quotations in The Nasdaq Stock Market
subject to the procedures for excused withdrawal set forth in Section 8
below. Each member registered as a Nasdaq market maker in Nasdaq
National Market equity securities shall display size in its quotations
of 1,000, 500, or 200 shares and the following guidelines shall apply
to determine the applicable size requirement: (i) A 1,000 share
requirement shall apply to Nasdaq National Market securities with an
average daily non-block volume of [3,000]6,000 shares or more a day, a
bid price of less than or equal to $100, and three or more market
makers; (ii) a 500 share requirement shall apply to Nasdaq National
Market securities with an average daily non-block volume of
[1,000]2,000 shares or more a day, a bid price of less than or equal to
$150, and two or more market makers and (iii) a 200 share requirement
shall apply to Nasdaq National Market securities with an average daily
non-block volume of less than [1,000]2,000 shares a day, a bid price of
less than or equal to $250, and that have two or more market makers.
Each member registered as a Nasdaq market maker in Nasdaq SmallCap
Market equity securities shall display size in its quotations of 500 or
100 shares and the following guidelines shall apply to determine the
applicable size requirement: (i) A 500 share requirement shall apply
Nasdaq SmallCap Market securities with an average daily non-block
volume of 1,000 shares or more a day or a bid price of less than $10.00
a share; and (ii) a 100 share requirement shall apply to Nasdaq
SmallCap Market securities with an average daily non-block volume of
less than 1,000 shares a day and a bid price equal to or greater than
$10.00 a share. Share size display requirements in individual
securities may be changed depending upon unique circumstances as
determined by the Association, and a list of the size requirements for
all Nasdaq equity securities shall be published from time to time by
the Association.
[[Page 31590]]
Exhibit D--The Introduction of NAqcess into the Nasdaq Stock Market:
Intent and Expectation *
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\*\ Prepared by the NASD's Economic Research Staff.
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I. Introduction
The Nasdaq Stock Market proposes NAqcess with the intent of
increasing investor access to the market by providing a new mode for
investors and dealers to trade among each other. Individual investors
and market makers, willing to supply liquidity to the market, will be
able to display priced limit orders in a central public file. Orders in
the central file will compete directly with other orders and with
market maker quotes, and other investors and market makers will have
the ability to access orders and quotes electronically. NAqcess is
intended to augment, not replace, Nasdaq's dealer market, which Nasdaq
and NASD staff (the Staff) believe has been central to the success of
the Nasdaq Stock Market.1
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\1\ Since 1971, the Nasdaq Stock Market has grown to become the
second largest equity market worldwide. Share volume on Nasdaq has
increased over 4,000 percent since its inception, while dollar
volume has grown over 5,000 percent. In 1995, share volume broke 100
billion shares and dollar volume exceeded $2.4 billion. Over the
last ten years, Nasdaq's share volume has grown over 380 percent
compared to 212 percent for the NYSE and Amex combined. Nasdaq's
share volume has grown 200 percent over the last five years versus
115 percent for the NYSE and Amex combined. Dollar volume on Nasdaq
has grown at an even greater rate: over 900 percent for the last ten
years and 430 percent for the last five years, compared to 216
percent and 132 percent for the NYSE and Amex combined. In 1994
Nasdaq share volume exceeded NYSE share volume for the first time;
as of March 1996 Nasdaq share volume was 121 percent of NYSE share
volume for the year, comprising 54 percent of the volume traded in
all U.S. equity markets combined.
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NAqcess constitutes a major step in the evolution of the Nasdaq
market. The principles that guided the design of NAqcess build upon the
Nasdaq market's tradition of innovation and include the intent to
provide greater market access across participant categories.
Application of these principles now and beyond the initiation of
NAqcess should simplify market rules and expand the options available
to both retail and institutional investors.
All of the effects of introducing NAqcess into the Nasdaq Stock
Market cannot be measured with precision. But the Staff believe that
the effects of NAqcess will be valuable to investors. The Staff base
that belief on (1) the practical experience of other equity markets
with limit order files; (2) theory and evidence in the economic
literature regarding limit order trading; (3) evidence regarding the
use of limit orders in the pre-NAqcess Nasdaq Stock Market; and (4) the
results of research conducted by and for the NASD.
Following a brief description of the changes to the Nasdaq Stock
Market that will be effected by the introduction of NAqcess, this
report presents a discussion of the four bases on which the Staff rely
in forming its expectation that NAqcess will benefit investors in
Nasdaq stocks.
II. Description of NAqcess
In the spring of 1996, Nasdaq is primarily a dealer-based, quote-
driven market. Much of the liquidity that is available in the market is
communicated through dealer quotes and provided through dealer
involvement. In general, retail limit order information is not
explicitly broadcast to all other market participants. Limit orders
placed and executed through alternative systems such as Instinet,
however, are important sources of liquidity and reduce the costs
associated with market making.
NAqcess is intended to maintain the strength of Nasdaq's dealer
market while augmenting the market with a system that allows all
customer orders to meet each other directly. The balance between dealer
quotes and customer orders under NAqcess can be seen by comparing time
and size priority rules. A dealer system thrives in the absence of time
priority rules; 2 the viability of an order-based system, on the
other hand, is enhanced by time priority rules, because standing orders
take precedence over new orders at a given price, increasing the
incentive to enter them. In introducing NAqcess, Nasdaq balances these
competing objectives by instituting strict price/time priority for
unpreferenced orders within NAqcess, while allowing time priority (but
not price priority) to be suspended for trades that occur on Nasdaq but
outside of NAqcess.3
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\2\ It is the absence of time priority that allows preferencing
on Nasdaq, which is likely to enhance a stock's sponsorship and
liquidity characteristics. Preferencing can improve competition
among market makers by allowing small brokerage firms to achieve the
same cost advantages as those experienced by large, vertically-
integrated brokerage firms. Since many of the brokers that use
preferencing arrangements are discount-commission brokers, customers
can benefit from preferencing through reduced commission costs.
Empirical research on the topic of preferencing suggests that it may
improve market quality. Battalio, et. al. study the short-term
effects of the introduction of preferencing programs by the
Cincinnati Stock Exchange and the Boston Stock Exchange on market
share, displayed spreads, and liquidity. The study finds no adverse
market effects as the market share of these two markets increases in
conjunction with the introduction of preferencing programs.
Marketwide, displayed spreads and liquidity premiums decline with
the introduction of preferencing programs, suggesting a possible
improvement in market quality. Also, since retail brokers use
preferencing and internalization to reduce commissions to customers,
investor welfare may be improved as a result. (See Robert Battalio,
Jason Greene, and Robert Jennings, ``How Do Competing Specialists
and Preferencing Dealers Affect Market Quality? An Empirical
Analysis,'' unpublished manuscript, 1995.)
\3\ For example, if the market in a stock is 20-20\1/4\ on the
basis of market maker quotes and an investor or a market maker
places a buy order for 500 shares at 20\1/8\, then the market
becomes 20\1/8\-20 \1/4\. A 500 share market sell order placed in
NAqcess will execute strictly against the limit buy order at 20\1/8\
on the basis of its price and time priority, regardless of whether
market maker quotes had subsequently joined the buy order at 20\1/
8\. On the other hand, the same 500 share market order communicated
outside of NAqcess, say over the phone, can execute against any
market maker at 20\1/8\ but cannot trade through the limit buy order
at a lower price. It is important to note that a firm placing a
customer order into NAqcess is still subject to the NASD's Limit
Order Protection Rule (Article III, Section 1, Rules of Fair
Practice): the firm cannot trade at a price equal or inferior to
that of the customer limit order it holds without filling the
customer order. So, if the limit order in the example is the market
maker's customer order, other firms can buy the stock at 20\1/8\,
but the firm that placed the order into NAqcess cannot buy at 20\1/
8\ without filling the order.
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Table 1 on the following page details the NAqcess time and size
priority rules, by market participant type. These rules are summarized
in Sections A and B, following Table 1.
BILLING CODE 1810-01-M
[[Page 31591]]
[GRAPHIC] [TIFF OMITTED] TN20JN96.002
BILLING CODE 8010-01-C
[[Page 31592]]
In essence, NAqcess is an order delivery system with features that
augment the extant multiple dealer market system with a public limit
order file. NAqcess guarantees execution of market orders against
posted dealer quotes; it allows customer orders to interact with each
other and displays limit orders that are not executed.
A. Order Entry
NAqcess provides market participants with a central file that
facilitates the ability of investor and dealer orders to compete with
market maker quotes in supplying liquidity.4 This facilitation,
via the dissemination of the top of the limit order file of investor
and dealer orders, is intended to enhance price improvement
opportunities, lowering the price of immediacy and liquidity for the
investors and dealers who demand it.5 That is, in the NAqcess
environment, limit orders are expected to execute more frequently and
inside market spreads are expected to narrow.
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\4\ The following information is presented as an aid in defining
the terms, ``NASD Member,'' ``Nasdaq Dealer,'' and ``Nasdaq Market
Maker.'' As of March 29, 1996, the NASD had 5,468 members; 531 of
them were dealers in the Nasdaq Stock Market; a dealer that makes a
market in a particular stock is a registered market maker in that
stock. For example, Intel had 46 registered market makers.
\5\ Market makers will be allowed to query the entire limit
order file. All other market participants will be allowed to see the
top of the limit order file.
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Non-marketable limit orders, which will compete directly with
market maker quotes, can be placed into NAqcess by entities that have
direct, interactive access to a Nasdaq workstation.6 While any
dealer can enter these orders on an agency basis, only broker-dealers
making a market in a stock may enter proprietary orders.7 Limit
orders can be placed for up to 9,900 shares for the top 250 dollar
volume Nasdaq National Market stocks and for 1,000 shares for all other
Nasdaq stocks, including SmallCap.8 These limits are consistent
with an incremental approach to NAqcess' implementation, affording
Nasdaq staff the opportunity to evaluate whether it is appropriate to
expand the system.
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\6\ Direct entry into NAqcess is open to all members and,
pending current negotiations, to non-member market makers at
regional exchanges. Options market makers and other non-member
market makers will not have direct entry capability under NAqcess,
nor will non-member buy-side firms, who will have access only
through a member firm.
\7\ Proprietary orders are orders for a broker-dealer's own
account.
\8\ For both National Market and SmallCap agency orders, a
single order may not be separated into many orders for purposes of
NAqcess execution.
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B. Automated Execution
In the pre-NAqcess Nasdaq Stock Market, firms not making a market
in a stock may enter customer orders into the SOES system for automatic
execution at the inside quotes against those market makers at the
inside or against market makers with which a preferencing agreement
exists. These orders are for a maximum size of 1,000, 500, or 200
shares, depending on the stock's SOES tier size. These executions occur
automatically, with the market maker being informed of the trade that
has just occurred. Following the trade, a market maker may adjust its
quotes (1) ``manually'' with a 20-second opportunity to update its
quotes; 9 (2) via Nasdaq's automatic update system, following
trading activity equal to the maximum order size for the security at
the original quote; or (3) with an internal automatic update system,
following trading activity equal to the maximum order size for the
security at the original quote. In practice, those market makers who
use an automatic update feature frequently set their exposure levels
such that several trades are accepted before quotes are adjusted.
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\9\ NASD SOES Rules state that a market maker has 15 seconds
following an automatic trade to update its quotes, yet an additional
5 second allowance for communications transmission is made.
Therefore, a market maker is actually given up to 20 seconds
following an automatic trade in the pre-NAqcess environment to
update its quotes, depending on messaging time.
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In contrast, NAqcess provides for automated executions. Instead of
market makers having 20 seconds following an automatic trade to adjust
their quotes, they have 20 seconds, upon receipt of the marketable
order (a market or marketable limit order), to accept or decline
it.10 A market maker may not decline an order at its quote unless
it has just traded and is in the process of updating its quotes.11
The execution will occur automatically if the market maker takes no
action within 20 seconds. This constitutes a change to the ``manual''
quote update method. In the NAqcess environment, both internal and
Nasdaq automated update systems will continue to allow quote
adjustments to be made following trading activity of one or more times
the maximum order size for the security at the original quote.
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\10\ Though preferenced marketable orders cannot be declined,
they may be accepted during the 20 second review period. Otherwise,
they are automatically executed after 20 seconds.
\11\ Nasdaq Market Surveillance will police this policy with a
process that uses a set of parameters to determine if a trade was
legitimately declined.
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If a market maker declines a marketable order, it is delivered (in
time precedence) to the next available market maker (i.e. not currently
reviewing another marketable order) at that price, with the same
obligations. If all market makers decline the order at that price, the
trade is automatically executed by the first market maker quoting at
the next price level with no waiting period.12
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\12\ If the marketable order was a limit order and the execution
price is inferior to the order's price, then the arriving limit
order becomes the new inside. For example, if all market makers at
20 bid decline a marketable limit order to sell at 20, revising
their bids to 19 7/8, the sell order is no longer marketable and
becomes the market at the inside ask; i.e. the market is now 19 7/8
to 20.
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Because NAqcess limit orders will be integrated with dealer quotes
by time priority within price levels, a marketable order may be
delivered to a NAqcess limit order, in which case it is automatically
executed. If the marketable order is delivered to a limit order of a
smaller size, the order is partially executed against the limit order,
and a marketable order for the residual size is delivered to the next
quote or limit order in time priority.
In the NAqcess environment, market makers will continue to maintain
two-sided quotes and Nasdaq market surveillance will ensure that the
quotes are firm. Because a market maker has liquidity provision
obligations, it will be authorized to enter proprietary market orders
(including marketable limit orders) into NAqcess for sizes commensurate
with the pre-NAqcess SOES tier sizes.13 This puts market makers on
a par with other users of the automation technology, facilitating
liquidity provision. Unlike SOES, NAqcess can be used for agency market
orders by any Nasdaq dealer, making a market in a stock or not.
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\13\ Non-member market markers from regional exchanges that
permit automated orders access to their quotes will be able to enter
limit orders as well as proprietary marketable orders.
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C. Other Changes to the Status Quo
Because most of the services provided to investors through SOES and
SelectNet are subsumed within and improved upon by NAqcess, these
systems will be eliminated upon implementation of NAqcess. As with
SOES, participation in NAqcess by market makers will be mandatory for
National Market stocks and voluntary for SmallCap stocks.14 While
SOES is used almost exclusively to execute market orders and marketable
limit orders, SOES also has a limit order processing facility that
stores limit orders priced off the inside market, executing them if
they become
[[Page 31593]]
marketable. This facility also matches offsetting limit orders and will
execute matched orders if no market maker executes either order within
five minutes of the match. The limit order processing features of
NAqcess are superior to those of SOES.
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\14\ Market makers in SmallCap issues may opt out of the order
delivery and execution features of NAqcess on a stock-by-stock
basis.
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SelectNet is a system that permits NASD members to direct buy or
sell orders in Nasdaq securities to a single market maker (preferenced
orders) or broadcast such orders to all market makers in the security.
Accordingly, SelectNet provides investors and members with an automated
means to facilitate the communication of trading interest among members
and to seek price improvement. SelectNet also serves as an alternative
mechanism to telephone communication between members, especially in
times of market stress. Because limit orders placed in NAqcess will be
incorporated in the calculation of the inside market and immediately
executable upon the entry of a ``takeout'' order or offsetting market
or limit orders, the price improvement and order communication and
execution features of NAqcess are far superior to those of SelectNet.
While SelectNet allows the display of unlimited size orders and NAqcess
will not, SelectNet orders larger than the NAqcess size limits are
rarely executed, so the restriction will have a minimal effect.15
Moreover, limit orders entered into NAqcess will be accessible to and
executable by a broader spectrum of market participants than currently
is the case with SelectNet.
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\15\ For the 13 Thursdays in the first quarter of 1996, there
were 52 SelectNet trades of more than 9,900 shares in the top 250
dollar volume stocks, accounting for .003% of all trades for these
stocks. For all other Nasdaq stocks, there were 27,646 SelectNet
trades of more than 1,000 in this time period, representing 1.513%
of all trades for these stocks. Combined, the 27,698 SelectNet
trades that could not be achieved via NAqcess constitute .708% of
all Nasdaq trades in the period.
---------------------------------------------------------------------------
Critics of NAqcess have argued that it would be harmful to small
investors to replace SOES, an immediate automatic execution system,
with NAqcess, an automated execution system. The NASD believes these
arguments are invalid for the following reasons. First, though an
automated execution system, automatic executions may still occur in
NAqcess. In fact, of the four means by which an order can be executed
through NAqcess, three of them involve an automatic execution process.
Specifically, automatic executions occur when: (1) a market order
matches a limit order; (2) a limit order matches a limit order; and (3)
a takeout order matches limit orders residing on the NAqcess file.
Second, to the extent that NAqcess is functioning as an automated order
execution system (i.e. marketable orders delivered to market makers at
the inside market), it has a short-term (20 second) automatic execution
default feature. Third, the NAqcess order execution algorithm is wholly
consistent with the SEC's firm quote rule, Rule 11Ac1-1: a market maker
can decline a marketable order only in cases consistent with the
exceptions to Rule 11Ac1-1. Specifically, a market maker will only be
allowed to decline a NAqcess order if it received the order while in
the process of effecting a transaction and updating its quotation. To
ensure that market makers are not declining orders in violation of the
firm quote rule, the NASD has developed on-line, real-time surveillance
systems.
In essence, through its enhanced limit order execution and display
capabilities, NAqcess builds upon the core market order execution
features of SOES and limit order facilities of both SOES and SelectNet,
to enhance the transparency of Nasdaq and to provide investors with
increased opportunities for price improvement and limit order
protection.
With the implementation of NAqcess, Nasdaq will add a market-wide
print protection policy to its Rules of Fair Practice. A firm holding a
NAqcess-eligible limit order outside of NAqcess will be required to
protect (execute) the order if an unmodified (e.g. not a .SLD) trade in
the stock is reported at an inferior price. NAqcess print protection
augments, but does not replace, Manning order protection, which does
not allow a firm to trade ahead of an internally-held customer limit
order (i.e. trade at a price equal or inferior to that of the customer
order). Additionally, Manning will apply to orders placed in NAqcess;
the firm placing the order into NAqcess cannot trade at the price level
of the order without protecting it.
D. NAqcess in Historical Perspective
It is useful to view NAqcess in historical perspective, where it
can be seen as a logical step in the evolution of Nasdaq. The precursor
to Nasdaq existed as a completely decentralized dealer market for
trading non-listed stocks. The inauguration of the computerized system
for the dissemination of quotes that constituted the start of Nasdaq in
1971 was a major step towards allowing dealers to interact more
closely. Since that time, Nasdaq has used technology to continually
improve the dissemination of information and the execution of orders in
the Nasdaq market. These improvements have created an ever-increasing
degree of centrality to the marketplace, not in physical space, but in
cyberspace.
A major step forward for Nasdaq came in 1982 with the advent of
last-sale reporting in certain Nasdaq National Market Securities. This
change allowed traders to depend more on the Nasdaq system as their
window to the world. Computerized trading started with the Computer
Assisted Execution System (CAES), used for the first time in 1983, to
execute transactions in Nasdaq National Market issues. In 1984, the
implementation of Nasdaq's Small Order Execution System (SOES)
represented another step toward facilitating execution of market
orders. Subsequent to the market break in 1987, Nasdaq took steps to
significantly increase the number of orders executed over the computer,
without the need for a telephone. To enhance liquidity and execution
capabilities during heavy volume periods, participation in SOES became
mandatory for all Nasdaq National Market market makers.
In 1988, the Order Confirmation Transaction (OCT) system was
introduced to automatically direct priced orders of any size to
specific market makers, where they could then reject or accept the
order. This was the first step in facilitating the execution of priced
orders on Nasdaq. As an additional step towards the enhancement of
limit order execution on Nasdaq, the SOES limit order file was
introduced in 1990. The SOES limit order file allowed for the input of
priced retail orders and the matching of these orders. This system
provided small, retail orders with a facility to get executions within
the best bid and best ask prices. SelectNet, a screen-based negotiation
and execution service with major enhancements to OCT's broadcast and
negotiation features, was introduced in 1990 to replace OCT and also
provide for enhanced limit order execution ability.\16\
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\16\ Other improvements to the trading of Nasdaq securities
include the following: In 1988, Nasdaq introduced the Advanced
Computerized Execution System (ACES) which allowed a participant to
automatically direct retail orders to any designated ACES market
maker with which it had an established business arrangement. In
1989, Nasdaq introduced Automated Confirmation Transaction (ACT) to
automate the trade comparison and clearing process and enhanced OCT
by allowing market makers to counter-offer. In 1992, Nasdaq
introduced a new Nasdaq Workstation, Workstation II, that allowed
Nasdaq traders to use windows, hot buttons, and programmable
features to facilitate trading in Nasdaq securities. Also in 1992,
SelectNet service hours were expanded to be available from 9:00 a.m.
to 5:15 p.m. EST. In 1994, the NASD Board approved the dissemination
of SelectNet orders and executions to non-members to increase the
transparency of Nasdaq.
---------------------------------------------------------------------------
In 1993, the NASD Board proposed a Rule to the SEC, subsequently
approved,
[[Page 31594]]
giving priority to customer limit orders over the member firm's orders.
In 1995, this limit order protection rule was extended to include limit
orders sent to a market maker from another member firm. In 1994, the
NASD Board proposed to replace SOES with Nasdaq Primary Retail Order
View and Execution System (N*PROVE), which provided enhanced execution
capabilities for small, retail limit orders. In 1995, Nasdaq proposed
NAqcess, a fully-automated, centralized limit and market order
facility.
III. The Value of NAqcess for Nasdaq
Many commenters to the SEC on the NAqcess proposals expressed
concern with the proposal due to what they perceived as the NASD's
apparent lack of economic analysis of the effects of the proposals. In
fact, the NASD has analyzed these proposals through a review of
economic literature, an internal empirical study, and simulation
research of a limit order file environment. A summary of these analyses
is provided in this section. The key innovation provided by NAqcess is
the establishment of a central limit order file. The value of NAqcess
therefore depends on the value of such a file. This section of the
report first considers NAqcess in the context of other equity markets
worldwide. Then, it discusses the current state of Nasdaq in a pre-
NAqcess setting, pointing out the limit order functionality that is
currently present. Finally, the results of internal and sponsored NASD
research regarding the use of limit orders is reported.
A. Experiences of Other Equity Markets \17\
---------------------------------------------------------------------------
\17\ Sources for this section include the following articles:
Domowitz, Ian (1993). ``A Taxonomy of Automated Trade Execution
Systems,'' Journal of International Money and Finance 12:607-631.
Eisenhammer, John. ``OFT Calls For Fresh Curbs on Market-
Makers,'' The Independent, 24 April 1996, p. 19.
Harris, Lawrence and Joel Hasbrouck (1992). ``Market vs. Limit
Orders: The SuperDOT Evidence on Order Submission Strategy,'' NYSE
Working Paper 92-02. Forthcoming in the Journal of Financial and
Quantitative Analysis.
Hedvall, Kaj (1994). ``Essays on the Market Microstructure of
the Helsinki Stock Exchange,'' Ph.D. Dissertation at the Swedish
School of Economics and Business Administration, Helsinki.
Stoll, Hans R. (1992). ``Principles of Trading Market
Structure,'' Journal of Financial Services Review 6:75-107.
Stoll, Hans R. and Roger Huang (1991). ``Major World Equity
Markets: Current Structure and Prospects for Change London, Toronto,
Paris and Tokyo,'' Working Paper 90-32.
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Nasdaq's adoption of a central limit order file is consonant with
systems in place in equity markets around the world. Many of the
world's largest equity markets rely on the operation of a central limit
order file to route and execute orders, including New York, Toronto,
Paris, Australia, and Tokyo. Although this is not an exhaustive list,
its breadth signals that world exchanges have acknowledged the utility
of central limit order files and have incorporated them into their
markets.
Every stock and options exchange in the United States operates
central limit order files to facilitate trade execution.\18\ The New
York Stock Exchange's SuperDOT system routes orders in price and time
priority to the specialist for execution against other SuperDOT orders,
the specialist's inventory, or orders from the exchange floor. An
analysis of 1991 SuperDOT orders by Harris and Hasbrouck (1992) shows
that SuperDOT orders account for about 50% of total orders, and because
SuperDOT orders are smaller than average, about 30% of share volume.
Most limit orders are day orders (82%), and limit orders tend to be
larger than market orders. Orders that are part of program trades are
more likely to be market orders, especially index arbitrage orders,
which are virtually always market orders. This finding makes sense
given the high priority for execution for index arbitrage trades. The
Philadelphia, Pacific, and Boston Stock Exchanges also operate
centralized order files with automated execution features.
---------------------------------------------------------------------------
\18\ While this description focuses on equities markets, futures
and options markets in the United States have also incorporated
central limit order files, including the Chicago Board Options
Exchange and the Chicago Mercantile Exchange.
---------------------------------------------------------------------------
Internationally, the presence of limit order books is even more
pronounced. A handful of those systems is described below.
The Toronto Stock Exchange operates a fully automated execution
system called CATS (Computer Assisted Trading System), accounting for
about 27 percent of the Exchange's volume. CATS is a central limit
order file with a unitary price opening mechanism, operating on price
and time priority. Market orders entered into CATS are converted into
limit orders at the current price. For example, a market order to sell
becomes a limit order at the best bid. CATS handles trading for about
half of the stocks listed on the TSE, although the TSE's ``Equity Floor
Closure'' project will create a central limit order file for all listed
stocks, thus eliminating all floor trading. Toronto's CATS system has
served as a prototype for other exchanges. Paris, Brussels, and
Barcelona have adapted the CATS system while Stockholm, Helsinki, and
Tokyo have developed systems resembling CATS.
The Paris Bourse converted from a periodic call market system to a
fully computerized central limit order file when it launched the CAC
(Cotation Assiste en Continu) system in the mid-1980s. Relevant to
Nasdaq's joint order and quote capability with NAqcess, Paris
determined that CAC alone could not best meet the needs of all trade
types, particularly block orders. Block orders trade on London's SEAQ
system, a dealer-based, quote-driven system, rather than through CAC.
In response, Paris has instituted procedures allowing for an
``upstairs'' for block trade negotiations as well as more formal market
making for less active stocks. Similarly, Amsterdam responded to
diminishing block volume business by adding a negotiation facility to
complement its limit order file system.
The London Stock Exchange, a dealer-based market, plans the
creation of a central limit order file. It is expected that the order
file will be used on a limited basis upon introduction, to evaluate the
system's impact incrementally. The dealer market will continue to play
an important role in the market, for instance, by meeting the liquidity
needs of larger trades.
In 1995, the Deutsche Borse AG (DBAG) announced Project ZEUS, a
plan to automate and centralize all German bourse trading. Although the
particulars are still in the formation stages, a major component of the
project is the creation of an open order book with market maker
participation.
One criticism of the NAqcess proposal has been that the mixing of
dealer quotes and the limit order file in one display is misleading and
disruptive. Another criticism has been that the inclusion of limit
orders in the Nasdaq inside quote would give NAqcess an unfair
competitive advantage over other execution systems. The New York Stock
Exchange specialist, however, has been disseminating a mixed quote for
many years with no significant informational difficulties. Also,
execution systems, such as Madoff's, have developed and expanded over
time to trade NYSE-listed securities even with the eligibility of limit
orders being included in the NYSE inside quotes. The dissemination of
the top-of-the-file, reflecting limit orders at the best prices, and
the consolidated inside market, reflecting orders and quotes at the
best prices, will provide investors in the Nasdaq market with more
information than is currently available. When one or more NAqcess
orders join the dealer quotes to create the consolidated inside market,
a market identifier is displayed to alert market
[[Page 31595]]
participants that these orders are part of the current inside
market.\19\ The participation of orders in the Nasdaq inside market
will give all Nasdaq investors, not just proprietary system users, the
chance to get better execution prices.
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\19\ A ``Z'' identifier will appear when an inside bid or offer
represents NAqcess orders only, and a ``Y'' identifier will appear
when the inside bid or offer represents both NAqcess orders and
dealer quotes.
---------------------------------------------------------------------------
In sum, many other world markets have recognized the importance of
limit orders and have responded by incorporating central order files
into their market structures, as Nasdaq plans to do with NAqcess. In
fact, most world equity markets are, at their foundation, limit order
books, without an explicit role for dealers. In this regard, Nasdaq is
something of an exception. It is interesting to note, however, from the
experience of Paris and Amsterdam, that the need for a dealer market
modality exists even when a strong order book foundation exists. This
point suggests the appropriateness of alternative (and competing)
market modalities within a single market. With these experiences in
mind, NAqcess is intended to strengthen Nasdaq's limit order modality
without weakening the dealer market modality.
B. Theory and Evidence from the Economic Literature on Limit Order
Trading
The economic literature supports the view that limit order trading
can be a superior form of trading for some types of investors. This
section briefly discusses some examples of this literature as it
relates to (1) the rationale for order-driven trading, and (2) the
international experience with order driven trading.
1. The Rationale for Order-Driven Trading
The key question motivating the academic limit order trading
literature concerns the relative advantages of market and limit orders.
The question is addressed in two recent papers written by well-known
market microstructure academics: ``Limit Order Trading'' by Handa and
Schwartz \20\ and ``Market vs. Limit Orders: The SuperDOT Evidence on
Order Submission Strategy'' by Harris and Hasbrouck,\21\ discussed
previously.
---------------------------------------------------------------------------
\20\ Handa, Puneet and Robert A. Schwartz (1996). ``Limit Order
Trading,'' forthcoming in Journal of Finance.
\21\ Harris, Lawrence and Joel Hasbrouck (1992). ``Market vs.
Limit Orders: The SuperDOT Evidence on Order Submission Strategy,''
NYSE Working Paper #92-02. Forthcoming in the Journal of Financial
and Quantitative Analysis.
---------------------------------------------------------------------------
Handa and Schwartz analyze the fundamental rationale for limit
order trading. They point out that when the market price is driven
solely by information, placing a limit order is a lose-lose strategy.
The opportunity for profitable limit order trading arises when short-
term, self-reversing price movements take place in a stock. This type
of fluctuation can occur when demanders of liquidity enter market
orders that require immediate execution. In this case, limit orders,
like market maker quotes, supply liquidity to the market, and can be
rewarded for doing so by obtaining favorable trading terms.
Handa and Schwartz use the terms ``information traders'' and
``liquidity traders'' to describe the two types of counterparties that
placers of limit orders face. The limit order loses when the
counterparty is an information trader, but can win when the
counterparty is a liquidity trader. Thus, an investor contemplating the
placement of a limit order must weigh the probabilities of facing each
of these two types of traders. Further, the investor needs to determine
the importance of completing his trade. In the extreme case, an
investor who absolutely must trade should not use a limit order
strategy since there is some probability that the order will not be
filled. On the other hand a ``patient'' investor, one whose current
portfolio is already near optimal, and for whom the lack of execution
of the order is not a serious concern, may find a limit order strategy
to be superior to a market order strategy. Handa and Schwartz envision
a natural ``ecology'' in the marketplace, wherein a paucity of limit
orders would result in price movement, which compensates limit order
placement and thus induces the placement of limit orders. Limit orders
would work towards reducing volatility, up to the point where no new
flow of limit orders is induced.
Handa and Schwartz use actual 1988 trade data from the 30 NYSE
stocks in the Dow-Jones Industrial Average to compare strategies. They
calculate the average purchase price for hypothetical buy limit and
market orders. They consider a number of limit order strategies
differentiated by the aggressiveness of the strategy. In general, when
the limit order is filled, the purchase price is lower than that of a
comparable market order. But when it is not filled after some period of
time, it must be substituted for a market order at the then prevailing
price, the average purchase price of which is usually higher. The
authors find that, for buy limit orders placed 2% below the market, the
average purchase price, taking into account what happens when the limit
order does not execute, is only 0.2% lower than the price of a
comparable market order. For a three-day holding period, a limit order
set at 2% below the market earns on average a return of about 0.48%
higher than that of a comparable market order, though there is
substantial variability (risk) in this return. The strategy of placing
the order 2% below the market appears to be optimal relative to the
other percentages considered in the study.
In sum, Handa and Schwartz find sufficient short-term liquidity-
driven price changes in their data to make limit order trading a
potentially superior strategy to market order trading. The more patient
the investor, the more likely a limit order strategy is superior.
Harris and Hasbrouck also analyze data from NYSE stocks. Using
order data derived from the SuperDOT order-processing system in 1991,
they are able to compare the relative performance of limit and market
orders that were actually submitted.
For each order, Harris and Hasbrouck compute the ``fill'' price,
which is either the limit order price if the order was filled, or an
imputed price if the order was canceled or expired. Comparing the fill
price with the appropriate quote (ask for buy orders, bid for sell
orders) provides a measure of trading strategy value appropriate for
traders who are precommitted to transacting. Limit order performance is
compared to market order performance, with limit orders categorized
according to aggressiveness of the order price.
Consider stocks with quoted spreads of \1/8\. The authors find that
limit orders placed at the market quotes placed at the bid for buy
orders and at the ask for sell orders tend to do better than market
orders. For small orders, such limit orders execute at prices on
average of about three cents better per share than market orders. Limit
orders placed away from the market tend to do worse than market orders.
As the trade size increases, the relative advantage of at-the-quote
limit orders diminishes to about one and a half cents. When stocks with
quoted spreads of \1/4\ are considered, the possibility of setting a
limit order between the quotes emerges. In fact, this strategy tends to
be optimal, providing price improvement of around two cents a share.
The authors are careful to note, however, that their measure of
performance is not necessarily valid for any given trader. The key
imponderable factor is the priority the investor places on execution,
and the corresponding action
[[Page 31596]]
taken by the investor when a limit order does not execute.
Together, these two papers provide a basic rationale for limit
order. Sufficient liquidity trading seems to occur on the NYSE,
creating the short-term price volatility such that a relatively patient
investor can be consistently rewarded for supplying liquidity.
Application of these results to NAqcess suggests that the creation of a
facility that enhances a limit order trading strategy can benefit
certain types of investors.
2. Performance of Other Markets
Options exchanges combine the elements of competing market makers
with a central limit order file, which is of particular interest since
this is the model for Nasdaq under NAqcess. Berkman examines the
European Options Exchange in Amsterdam.22 At this exchange,
dealers interact with each other in an open outcry manner, typical of
options exchanges, as opposed to interacting through a computer
network. Berkman seeks to determine the influence of the limit order
file on spreads. His results indicate that when the number of
transactions executed against limit orders as a percentage of total
transactions is high, the spread is low. Berkman views this percentage
as an indication of the competition faced by dealers from the limit
order file. Applying this result to NAqcess suggests that limit orders
create competition even in an environment characterized by competition
among market makers.23
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\22\ Berkman, Henk (1991). ``The Market Spread, Limit Orders and
Options,'' Working Paper, Department of Finance, Erasmus University,
Rotterdam.
\23\ In the U.S. the Chicago Board Options Exchange (CBOE) also
exemplifies a multi-modal market by combining a dealer system, a
floor-based system, and a central limit order file. Dealers may
engage in proprietary or customer trading while floor officials
execute trades on behalf of customers only. The CBOE maintains two
limit order books, RAES (Retail Automatic Execution System) the
EBook (the Electronic Book), which automatically match options
orders. The latter handles orders that arrive prior to the opening
and are outside the current market quotes. This information is
provided by the Chicago Board Option Exchange's Internet home page--
http://www.cboe.com.
---------------------------------------------------------------------------
A number of academic studies analyze the characteristics and
performance of equity markets outside the U.S. As mentioned above, the
Paris Bourse and the Tokyo Stock Exchange operate fundamentally as
centralized limit order files without an explicit role for dealers.
Lehmann and Modest, and Hamao and Hasbrouck study the Tokyo Stock
Exchange.24 Both studies consider the performance of a market that
relies exclusively on limit orders to provide liquidity. By custom,
brokers do not engage in proprietary trading on both sides of these
markets. The authors perform a variety of analyses which demonstrate
the viability of the Tokyo Stock Exchange's order-driven market.
---------------------------------------------------------------------------
\24\ Lehmann, B.N. and D.M. Modest (1994). ``Trading and
Liquidity on the Tokyo Stock Exchange: A Bird's Eye View,'' Journal
of Finance 49: 951-984. Hamao, Yasushi and Joel Hasbrouck (1995).
``Securities Trading in the Absence of Dealers: Trades and Quotes on
the Tokyo Stock Exchange,'' The Review of Financial Studies 8, 3
(Fall).
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Biais, Hillion, and Spatt study the operation of the Paris Bourse,
in particular the flow of orders in response to market
developments.25 They find that when the current bid-ask spread (as
determined from the limit order book) is relatively high or the order
book thin, investors are more likely to submit limit orders.
Conversely, when the spread is tight, investors tend to trade against
existing limit orders. ``Thus, the investors provide liquidity when it
is valuable to the marketplace and consume liquidity when it is
plentiful'' (pg 1657). The market response to market orders is rapid,
reflecting competition in the supply of liquidity. They also find that
the flow of order placements tends to be concentrated at or inside the
best market quote, again reflecting competition in the supply of
liquidity.
---------------------------------------------------------------------------
\25\ Biais, Bruno, Pierre Hillion and Chester Spatt (1995). ``An
Empirical Analysis of the Limit Order Book and the Order Flow in the
Paris Bourse,'' The Journal of Finance 50, 5 (December): 1655-1689.
---------------------------------------------------------------------------
These two examples illustrate that limit orders can be the primary
or even sole source of liquidity in a market. For some types of trades
and some types of stocks, however, dealer markets appear to provide an
additional dimension of market quality beyond that found in a pure
limit order market.
C. The Role of Limit Orders in the Pre-NAqcess Nasdaq Stock Market
In contemplating the role of a central limit order file, it is
important to recognize that limit orders are currently placed in the
Nasdaq market. NAqcess constitutes an enhancement in limit order
trading capabilities, not the establishment of limit order trading. The
following two sections discuss the submission of limit orders in the
current environment as well as the use of two existing limit order
facilities.
1. Evidence of Implicit (Internal) Limit Order Use on Nasdaq
Although the NASD has never conducted a comprehensive survey of
limit order activity in the Nasdaq market, a 1994 review by an NASD-
appointed task force demonstrates that limit orders account for a
significant amount of order flow between broker-dealers. As part of its
review of limit order protection rules in 1993, the NASD Board of
Governors (the Board) created the Limit Order Task Force (the Task
Force) to explore issues related to limit orders sent from one broker-
dealer to another for execution. The Task Force included
representatives from integrated broker-dealers, wholesale market
makers, regional firms, firms with a large institutional clientele, and
a Nasdaq issuer.
During roundtable discussions, one member of the Task Force,
representing the interests of wholesale firms, stated that of all
orders entering the firm's trading systems daily, as many as 40 percent
were limit orders for other broker-dealers' customers.26 Another
Task Force member, who represented a full service firm, stated that 20
to 25 percent of its orders were limit orders.
---------------------------------------------------------------------------
\26\ The member of the Task Force did not specify whether the 40
percent included marketable limit orders.
---------------------------------------------------------------------------
In the summer of 1994, the Task Force's work prompted the NASD to
survey market makers to estimate the flow of Nasdaq limit orders from
broker-dealer to broker-dealer. The NASD asked market makers for daily
percentages of orders received from unaffiliated brokers for execution
that were limit orders, exclusive of marketable limit orders. Survey
information was requested for five specified days in both January, 1994
and July, 1994. Eight market maker firms, four multi-service and four
wholesale, responded to the survey. Limit order flow from other broker-
dealers ranged from less than 10 percent to 30 percent for multi-
service firms and from 20 percent to 50 percent for wholesale firms.
The survey data show that limit orders accounted for a significant
amount of member-to-member order flow.
2. Evidence of Explicit Limit Order Use on Nasdaq
Two well-known limit order facilities for trading Nasdaq securities
are Instinet and SelectNet. Instinet is a proprietary trading system
owned by Reuters Holdings PLC. Traders equipped with Instinet terminals
or Instinet feeds can place limit orders into the system and
anonymously take out existing orders on the file. Instinet executions
are sent directly to ACT, Nasdaq's clearing facility. Users of Instinet
have traditionally been institutional traders and market makers. Though
Instinet is integrated into the Nasdaq system, it competes with other
Nasdaq trading
[[Page 31597]]
modes in the sense that it offers an alternative trading venue. In
January 1996, Instinet share volume was about 15% of total Nasdaq
volume. This share appears to have been roughly constant during the
last three years, indicating that limit orders have been and continue
to be an important part of Nasdaq trading activity.27 Instinet
share volume for the top 250 Nasdaq issues accounted for almost 20% of
total share volume in these stocks during January, 1996.28
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\27\ January 1996 data are from the Nasdaq Market Data Server.
Data from this relatively new source provide more detail than was
previously available for calculating Instinet volume. Data from the
Nasdaq Equity Audit Trail extend back to January 1993, but are
incomplete regarding Instinet trading. Incomplete as it is, however,
this source indicates no trend in the Instinet share of volume
during the last three years.
\28\ The 250 stocks with the highest median dollar volume over
the first quarter of 1996 were selected.
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As described in section II.C., Nasdaq's SelectNet service, which
broadcasts priced orders, will be discontinued when NAqcess is
implemented, as NAqcess provides considerable improvements to the
SelectNet facility. SelectNet volume has averaged about 4% of total
Nasdaq volume over the last three years. In January, 1996, SelectNet
accounted for 5% of total share volume in the top 250 Nasdaq
issues.29 SelectNet's use provides further evidence that limit
order use is not foreign to the current Nasdaq market.
---------------------------------------------------------------------------
\29\ The 250 stocks are the same as those mentioned in the
previous footnote.
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As noted above, limit order trading, by supplying liquidity to the
market, allows investors the opportunity to trade at prices superior to
those represented by the prevailing inside bid and offer. During
January 1996, Instinet trades occurred inside the spread 65% of the
time, and SelectNet trades occurred inside the spread 36% of the time.
These figures contrast with the rest of Nasdaq trading (excluding SOES,
ACES, SelectNet, and most Instinet trades) which for the same month
executed between the quotes about 22% of the time.
D. Research Conducted by and Sponsored by the NASD
1. Replication of Handa and Schwartz Study on Nasdaq Stocks
NASD Economic Research staff have conducted a study similar in
purpose to the Handa and Schwartz study discussed above. The purpose of
the study is to assess the potential profitability of limit order
trading in Nasdaq stocks. Like the Handa and Schwartz study, the method
was to construct hypothetical limit and market orders for a stock, and
compare the relative profitability of the two order types using actual
historical trade price data.
Using internal trade and quote data for each Thursday from January
4 to April 11, 1996, the performance of an array of hypothetical limit
orders at various price levels was measured against that of a
hypothetical market order.30 All hypothetical orders were placed
at the open, so the hypothetical market buy (sell) order was executed
at the opening inside ask (bid).31 The array of hypothetical limit
buy (sell) orders consisted of limit orders at each \1/8\ interval
between the opening ask (bid) and the opening ask (bid) plus (minus)
$2. For example, if the opening bid was $20, the performance of
hypothetical sell limit orders at $20\1/8\, $20\1/4\, $20\3/8\, . . .
to $22 would be compared to that of a sell market order executed at the
opening bid, $20. Hypothetical limit order executions occurred if any
execution at an inferior price was reported during normal trading
hours. For example, a sell limit order of $20\1/4\ would be assumed
executed if a price greater than $20\1/4\ were observed during the day.
This approach is conservative in that, given Manning protection and the
fact that limit orders with time priority may become the market, some
executions at prices equal to the limit order price would yield an
execution. If no execution occurs, the limit order converted to a
market order which was executed at the prevailing inside market at the
time of the last trade in the stock that day.
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\30\ The sample is limited to those stock-days (a stock-day is a
unique combination of a stock and trading day) having 20 or more
trades; thus a stock may not be included in the sample for all
trading days over the period. The 20 or more trades criterion
necessarily means that trading activity for the sample is higher
than for the Nasdaq market as a whole. Daily share volume for stock-
days in the sample averages 252,300 shares compared to 106,108
shares for the Nasdaq market over the same time period. Average
trade sizes are 1,916 and 1,980 for the sample and the Nasdaq
market, respectively.
\31\ Note that this approach may bias our results in the limit
orders favor, because in theory, the worst price at which a market
order can be executed is the inside quote. Many firms offer market
orders opportunities for price improvement or match them with orders
on an internal file, so market orders can be executed at prices
inside the dealer quotes.
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Each combination of a stock during a given day (stock-day) in the
sample was classified by two variables, spread class and price range. A
stock-day's spread class is determined by rounding the trade-weighted
average spread to the nearest \1/8\ (though some spread class
categories contain multiple \1/8\s). Price range classification is made
using the opening bid for the stock-day. Stock-days with less than 20
trades were excluded from the analysis. For each of the hypothetical
limit orders, the following measures were calculated: the probability
of execution, nominal differential performance versus the hypothetical
market order, percentage differential performance versus the
hypothetical market order, and the cost of non-execution. For example,
a buy order \1/4\ below the opening ask might have a 90 percent
probability of execution. If executed, this order outperforms the
market buy order by $0.25. If not executed, the order is converted to
an end-of-day market order. As the limit order was not executed, it is
likely the market moved against it, i.e., it rose. Suppose that a
stock's price rises throughout the day, never trading at a price
inferior to the limit order, and that the closing price exceeds the
opening price by $2. Then an unexecuted limit order, converted to an
end-of-day market order, underperforms the original market order by $2.
The limit order investor then weighs the 90 percent probability of
saving $0.25 against a 10 percent probability of losing $2.00 and forms
the expectation that, on average, the limit order will out perform the
market order by $.025.32
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\32\ E(Limit Order Advantage) = P(Execution) * Outperformance -
P (Non-Execution) * Cost of N-E = (.9 * .25) - (.1 * 2.00) = .025
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Table 2 presents results for 2 cross-sections: spread classes \1/8\
and \1/4\ both for stock-days in the $10 to $20 price range. The first
column shows the limit order price increment, with an increment of zero
representing a market order. The second column shows probability of
execution, which is the likelihood that a limit order will execute at
the given increment level. For example, in the \1/8\ spread class, a
limit sell (buy) order placed \1/8\ above (below) the bid (ask) has a
68.9% chance of execution on an average day. The limit order's value of
execution is $0.125, which represents the savings the investor gains by
selling (buying) \1/8\ above (below) the bid (ask). The probability of
non-execution is simply 100% minus the execution probability, which
equals 31.3%. The cost of non-execution, found in the fifth column of
the table, represents the opportunity cost associated with placing a
limit order that is not filled during the day. As stated previously, if
the hypothetical limit sell (buy) order is not filled during the day,
it is executed at the closing inside bid (ask). The cost of non-
execution is computed as the difference between the closing inside bid
(ask) and the opening inside bid (ask), conditional on the fact that
the order was not filled during the day. On average, this cost is just
under $0.24 for a limit sell (buy)
[[Page 31598]]
order placed \1/8\ above (below) the bid (ask). The expected dollar
value of the limit order, shown in the sixth column, represents the
savings of executing the limit order minus the opportunity cost of non-
execution, taking the probability of both events into account. It is
computed as follows:
(column 6) expected dollar value of limit order = (column 2)
probability of execution * (column 3) value of execution--(column 4)
prob. of non-execution * (column 5) cost of non-execution.
The expected dollar value of the limit order is the overall summary
measure of what an investor might gain, on average, from placing a
limit order. Finally, the seventh column divides the expected value of
the strategy by the opening price of the stock. The resulting figure is
the percentage gain of the strategy, and can be added to the overall
investment return from holding the stock. While the discussion has
focused on savings for the investors placing limit orders, it should be
noted that a savings exists for the investors whose market orders
execute against the limit orders. For example, say a limit buy order is
placed at $15 \1/8\ for 500 shares when the inside market is $15 to $15
\1/4\. If a market sell order for 500 shares executes against the limit
order, both the limit order and the market order realize an execution
value of $0.125.
Table 2 shows that, on average, for stocks priced between $10 and
$20 in the \1/8\ spread class, the only scenario in which a limit order
outperforms a market order executed at the opening bid or ask, is
placing a buy (sell) limit order \1/8\ below (above) the inside ask
(bid). Because this cross-section of stock-days are in the \1/8\ spread
class, limit orders outperform market orders even though they have been
placed at levels equivalent (on average) to inside dealer quotes (i.e.
buy orders at the bid, sell orders at the ask). For a spread class of
\1/4\, however, the optimum level at which limit orders can be placed
is \1/8\ below (above) the inside ask (bid); as might be expected,
limit orders that ``split'' the dealer spread outperform market orders.
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[[Page 31600]]
Table 3 contains results for the \1/8\ spread class and the \3/8\
and \1/2\ spread classes for stock-days in the $20 to $30 price range.
Interestingly, no limit orders placed near the market outperform a
market order on average for stock-days in the \1/8\ spread class. For
spread classes \3/8\ and \1/2\, a number of price levels at which limit
orders outperform market levels exist. Those of note are between the
spread for these stock-days, i.e. at \1/8\, \1/4\, and \3/8\ off the
inside quotes. A limit order \3/8\ off the inside market does best;
these orders will be either at (for \3/8\ spread stock-days) or \1/8\
inside (\1/2\ spread stock-days) the inside dealer market.
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[[Page 31602]]
Figure 1 plots the relative performance of the limit order array
for 5 spread classes of stock-days in the $10 to $20 price range. The
graph shows that for all but the \1/8\ spread class (where no orders
can be placed inside the quotes), the optimum limit order strategy is
to place ordes at prices \1/8\ better than the inside dealer market.
This analysis shows the when possible, limit orders placed within the
inside dealer market can outperform market orders on average.
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This analysis suggests potential benefits for investors from
enhanced limit order activity on the Nasdaq Stock Market. Investors who
do not require immediate transactions will have an incentive to place
limit orders in NAqcess, and may receive superior prices as a result.
Since these limit orders augment the supply of liquidity, those
investors who demand immediacy through the placement of market orders
may pay less for it.
While this study finds that limit order strategies can result in
gains for investors, its implications for NAqcess must take several
factors into consideration. The study examines performance of
hypothetical limit orders in the current, pre-NAqcess trading
environment, which does not represent what will exist in the NAqcess
environment. It is expected that the introduction of a central limit
order file in the Nasdaq Stock Market will alter the dynamics of the
market, including the performance of limit orders, although the precise
changes cannot be known with certainty. For example, this study
measures savings relative to a stock's spread without taking
commissions into account. This is a reasonable approach given the
current Nasdaq environment. In the NAqcess environment, however,
spreads could become less relevant while commissions become more so.
Secondly, some trading in the pre-NAqcess environment does occur inside
the spread, meaning that some investors already realize the type of
savings identified in the study.
2. Preliminary Simulation Analysis
Beginning in 1995, Nasdaq retained Robert A. Schwartz and Bruce W.
Weber, both with the Leonard N. Stern School of Business, New York
University to develop a model of Nasdaq trading that could be used to
simulate next-generation trading on Nasdaq as exemplified by NAqcess.
Professors Schwartz and Weber are experts in the field of market
microstructure and simulation. Schwartz has written extensively and has
many published papers on market microstructure. Weber, prior to his
work for Nasdaq, developed a simulation model of London Stock Exchange
trading for the London Stock Exchange.
The Schwartz-Weber model is a simplified representation of Nasdaq
order placement and execution. Liquidity traders, momentum traders,
informed traders, market maker quote setting, and inventory management
behavior are mechanically generated by computer algorithms. Live
traders representing order entry firms interact with the computer-
generated environment.33 The behavior of the live traders can be
analyzed under different market structures. As an initial test of their
simulation model, Schwartz and Weber conducted experiments with live
subjects on the usage of limit orders in a Nasdaq limit order facility
similar to NAqcess and measured the impact that a limit order facility
had on limit order usage, displayed spreads, and dealer profitability.
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\33\ Sixteen graduate business school students and eight NASD
employees participated the simulation as live traders. No
professional traders participated.
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Three different market structures were used in the
experiments.34 The first market structure allowed live traders,
given a predetermined set of buy orders, to use market orders and trade
at the quoted prices of market makers. The second market structure
allowed live traders, given a predetermined set of buy orders, to use
market orders or input limit orders in the limit order facility with
dealers uninformed to the information available to them in order flow.
The third market structure allowed live traders, given a predetermined
set of buy orders, to use market orders or input limit orders in the
limit order facility with dealers partially informed by the information
available to them in order flow. The uninformed dealers in the second
market structure had wider spreads than in the third market structure
due to the
[[Page 31604]]
increased risk of transacting with more informed traders.
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\34\ A fourth market structure, allowing live participants to
act as day traders, was also developed and tested for use in an
experimental setting. In this environment, participants could use
market orders or input limit orders in the limit order facility.
Controlled experiments under this market structure, however, have
not been conducted to date.
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The experimental results suggest that the introduction of a limit
order facility narrows the displayed spread and increases order
placements. Under the uninformed dealer scenario, the displayed spread
narrows by about 25 percent. Under the informed dealer scenario, the
displayed spread narrows by about 50 percent. The addition of a limit
order facility increased limit order placement to about 50 percent of
all orders and reduced market order placement to about 50 percent of
all orders. Limit orders were executed 45 percent of the time under the
uninformed dealer scenario and about 50 percent of the time under the
informed dealer scenario. The addition of a limit order facility
increased overall orders placed by about 18 percent but decreased
overall orders executed by about 5 percent.
The experimental results also suggest that the introduction of a
limit order facility is particularly important to investors in stocks
when spreads are greater than \1/4\. There is some evidence, although
not consistent over all categories, that the greater the size of the
displayed spread, the greater the use of limit orders. For three out of
four categories, a larger percentage of limit orders were placed when
displayed spreads were \3/8\ and \1/2\ than when displayed spreads were
\1/8\ and \1/4\.
The simulation also measured dealer profitability. The results on
dealer profitability changes after the introduction of a limit order
facility were mixed. The marginal rate of dealer profits in basis
points decreased under the uninformed dealer scenario but increased
under the informed dealer scenario.
The results are taken from a small sample of 24 experimental
subjects. Since subjects had a limited amount of training in the
simulated trading environment, better trained subjects may have led to
different results. The simulation model makes simplifying assumptions
about order flow characteristics, dealer quote setting behavior, and
price movements in the Nasdaq market. For instance, the exact structure
of NAqcess was not completely determined when the experiments were
conducted. Thus, the limit order book structure tested is not identical
to the structure ultimately proposed. If any assumptions made by the
model are not valid, then the results may not be representative of the
impact of NAqcess on the Nasdaq market.
IV. Conclusion: NAqcess Should Benefit Investors
NAqcess represents a major development for the Nasdaq Stock Market.
Its key feature is a central limit order file with broad access to
market participants. Investors will have the opportunity to place limit
orders directly into the file, and execute trades against orders in the
file in an automated fashion. This central order file will replace the
current SelectNet facility. The automated execution system, fully
consistent with the firm quote rule, will allow investors to execute
market orders without need of explicit market maker interaction. This
system will replace the current SOES facility.
Nasdaq staff believe that NAqcess will represent a significant
benefit for investors, as enhanced capabilities for a limit order-
oriented market modality are created. This determination is amply
supported by the global experience of equity trading, by economic
theory and evidence, by the current experience within the Nasdaq
market, and by research conducted by and for the NASD's Department of
Economic Research.
As has been the experience with the Paris Bourse, however, the
dealer-oriented market modality has distinct advantages of its own.
NAqcess is in no way intended to replace the dealer market. It can be
expected that some issues will tend to be traded within NAqcess more
than others, and that some types of trades will be more likely to be
placed on NAqcess than others. The forces of competition will
ultimately determine the usage of the various modalities offered within
the Nasdaq Stock Market.
[FR Doc. 96-15448 Filed 6-19-96; 8:45 am]
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