[Federal Register Volume 61, Number 208 (Friday, October 25, 1996)]
[Notices]
[Pages 55342-55345]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-27434]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37845; File No. SR-NASD-95-54]
Self-Regulatory Organizations; Notice of Proposed Rule Change by
the National Association of Securities Dealers, Inc. Relating to a
Modification of the Operation of the Small Order Execution System
(``SOES'') During Locked and Crossed Markets
October 21, 1996.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on November
15, 1995,\1\ the National Association of Securities Dealers, Inc.
(``NASD'' or ``Association'') filed with the Securities and Exchange
Commission (``Commission'' or ``SEC'') the proposed rule change as
described in Items I, II, and III below, which Items have been prepared
by the NASD. The Commission is publishing this notice to solicit
comments on the proposed rule change from interested persons.
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\1\ The NASD amended the proposed rule change four times
subsequent to its initial filing. Amendment No. 4, filed October 16,
1996, changed the narrative in the proposed rule change. Amendment
No. 3, filed October 2, 1996, replaced Amendment No. 2, which was
filed September 23, 1996. Amendment No. 2, in turn, replaced
Amendment No. 1, which was filed August 5, 1996.
The proposed rule change, as originally submitted, would have
provided market makers with a 15-second grace period following their
receipt of a SOES execution report during locked and crossed markets
in which to update their quotation in that security before being
required to execute another SOES order in that security. The filing
as amended would establish a 5 second grace period between SOES
executions in locked and crossed markets. See Letter from Robert E.
Aber, Vice President and General Counsel, The Nasdaq Stock Market to
Katherine England, Assistant Director, Division of Market
Regulation, Commission (October 2, 1996).
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The NASD proposes to modify NASD Rule 4730(b)(4) \2\ to provide
that during locked or crossed markets, the system will execute orders
in five-second intervals against a locked or crossed market maker at
the best price, regardless of whether the market maker was responsible
for the locked or crossed condition. Below is the text of the rule
change. Proposed new language is in italics. Deleted language is in
brackets.
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\2\ NASD Manual, Marketplace Rules (CCH), Rule 4730.
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Marketplace Rules
* * * * *
Rule 4730 Participation Obligations in SOES
* * * * *
b. * * *
(4) At any time a locked or crossed market, as defined in Part VI,
Section 2(e) of Schedule D to the NASD By-Laws, exists for an NNM
security, a Market Maker with a quotation for that security in the
Nasdaq System that is [causing the] locked or crossed [market] may have
orders representing shares equal to the minimum exposure limit or the
firm's exposure limit, whichever is greater, executed by SOES for that
Market Maker's account at its quoted price if that price is the best
price. Those orders will be executed irrespective of any preference
indicated by the Order Entry Firm. During locked or crossed markets,
SOES will execute orders against those Market Makers that are locked or
crossed in predetermined time intervals. This period of time shall
initially be established as five (5) seconds, but may be modified upon
necessary Commission approval and appropriate notification to SOES
participants.
* * * * *
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the NASD included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. The NASD has prepared summaries, set forth in Sections
A, B, and C below, of the most significant aspects of such statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
The NASD is proposing to modify SOES to provide that during locked
or crossed markets, the system will execute orders in five-second
intervals against a locked or crossed market maker at the best price,
regardless of whether the market maker was responsible for the locked
or crossed condition. Currently, when markets are not locked or
crossed, SOES provides market makers with a 15-second period of time
following their receipt of a SOES execution report to update their
quotation before being required to execute another order in that
security through SOES. When the market for a Nasdaq National Market
security is locked or crossed,\3\ however, SOES is currently designed
so that the market maker whose quotation is locked or crossed will have
SOES orders representing shares equal to the SOES minimum exposure
limit \4\ or the firm's exposure limit, whichever is greater, executed
by SOES against that market maker's account without any delay between
SOES executions (``locked and crossed market rule'').\5\ Thus, in such
instances, unlike the operation of SOES during non-locked or crossed
markets, the market maker's account will receive SOES executions
without any delay between executions until its exposure limit is
exhausted. In addition, during locked or crossed markets, SOES orders
are executed against market makers whose quotations are locked or
crossed irrespective of any preference indicated by the SOES order
entry firm.
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\3\ Quotations are ``locked'' when the bid price quoted by one
market maker in a security equals the ask price quoted by another
market maker in the same security. Quotations are ``crossed'' when
the bid price quoted by one market maker in a security is greater
than the ask price quoted by another market maker in the same
security.
\4\ The minimum exposure limit for SOES is currently twice the
maximum SOES order size for a given security. Thus, the minimum
exposure limit for a NNM security in the 1,000-share tier size is
2,000 shares.
\5\ See Rule 4730(b)(4).
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The locked and crossed market rule was formulated by the NASD and
approved by the SEC in response to the operation of SOES during the
October 1987 Market Break.\6\ Specifically, the feature was added to
remedy the situation where SOES would cease executing orders in locked
and crossed market situations. The feature was designed to increase the
accuracy of displayed quotations in NNM securities by providing an
incentive for market
[[Page 55343]]
makers to reduce the frequency and duration of locked and crossed
markets.
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\6\ See Securities Exchange Act Release No. 25791 (June 9,
1988), 53 FR 22594 (order approving file No. SR-NASD-88-1).
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Unfortunately, in today's trading environment, the incentive
created by the locked and crossed market rule to avoid locked and
crossed markets has been nullified by the volume and velocity of orders
received and executed during locked and crossed markets. As set forth
below, the volume of orders executed through SOES during locked and
crossed markets clearly illustrates that the locked and crossed market
rule operates to severely penalize rather than incentivise market
makers when they have caused a locked or crossed market. As a result,
both the firm that caused the locked or crossed market and the firm
that is locked or crossed can be exposed to high levels of risk. In
sum, the rapidity with which massive amounts of SOES orders are
received and executed during locked and crossed markets provides market
makers no meaningful opportunity to rectify locked and crossed market
situations until after they have executed significant volume through
SOES.
More specifically, since the locked and crossed market rule was
implemented, there have been many instances where market makers have
received numerous, instantaneous SOES executions in the fleeting time
period during which their quotes were locked or crossed. The rule was
intended to operate as an incentive for market makers to avoid locked
and crossed markets; however, that incentive has been dissimulated and
the rule is now being used by active SOES order entry firms to execute
significant volume through SOES against market markers that have caused
locked or crossed markets, or whose quotes have been locked or crossed
by another market maker, before they have had an opportunity to respond
and rectify the locked or crossed market condition. In the NASD's view,
the rule can only operate as a true incentive to avoid locked and
crossed markets when market makers have a reasonable opportunity to
react to SOES transactions executed against them during a locked or
crossed market situation. Presently, by the time a market maker
realizes it needs to update its quote, its exposure limit often is
unknowingly exhausted.
The profound risks that market markers are exposed to because of
the locked and crossed market rule are dramatically illustrated by the
trading activity that occurred through SOES on Thursday morning,
October 19, 1995, in Cordis Corporation (CORD). On this day, the
opening in CORD was delayed until 11:15 because a hostile takeover bid
was announced for shares of the company. During a span of 3 minutes and
12 seconds just after the stock opened, the market for CORD was locked
or crossed on six occasions for a total of 2 minutes and 3 seconds.
During this 2 minutes and 3 seconds, 176 SOES executions occurred, with
170 of these trades being for 1,000 shares and 6 for 500 shares. SOES
volume in CORD during the 3 minutes and 12 seconds was 220,000 shares
and SOES volume during the 2 minutes and 3 seconds that the market was
locked or crossed was 173,000 shares. This trading volume, which took
place in just two to three minutes, represents a substantial percentage
of the average daily trading volume in CORD for the six-month period
prior to October 19, 1995. Specifically, the average daily trading
volume in CORD from April 18, 1995 to October 18, 1995 was 383,569
shares. Thus, in just 3 minutes and 12 seconds on October 19, 1995,
SOES order entry firms executed 57.3 percent of CORD's average daily
trading volume for the prior six months; and in just 2 minutes and 3
seconds SOES order entry firms executed 45.1 percent of CORD's average
daily trading volume for the prior six months. Following are several
illustrative examples of SOES activity during these instances.
A total of 13 trades for 13,000 shares were executed when
the market was locked for just 7 seconds. Of these 13 executions, 6
were against one firm for 6,000 shares during a 3-second period and 4
of them occurred within one second.
A total of 21 executions for 20,500 shares occurred when
the market was crossed for just 9 seconds. Of these 21 executions, 6
were against one firm, 4 were against another, and two firms each
received three executions. In addition, the firm that received 6
executions received 5 of them for 4,500 shares within two seconds.
A total of 5 executions for 4,500 shares occurred when the
market was locked for just 3 seconds. Of these 5 executions, 3 occurred
against the same firm within 2 seconds for 3,000 shares.
The NASD believes that this type of trading activity through SOES
exposes market makers to high levels of risk that, in turn, seriously
undermines the viability of the Nasdaq market and the commitment of
market making capital to NNM issues. Accordingly, the NASD and Nasdaq
believe it is appropriate to limit the potentially high risk exposure
of market makers in locked and crossed market situations by modifying
SOES to afford market makers a 5-second period to update their quotes
after they have received a SOES execution report during locked and
crossed market situations. The NASD believes this proposal strikes a
reasonable balance between the needs to keep SOES available to small,
retail investors during times of market turbulence and to provide
market makers with a meaningful incentive to update their quotations so
as to avoid locked and crossed markets, on the one hand, and the need
to preserve the liquidity of the Nasdaq market by not exposing market
makers to unwarranted risk simply because their quote was locked or
crossed for a brief period of time or because they are actively
adjusting their quotes to arrive at a new equilibrium price level after
a trading halt has been lifted or material news has been disseminated,
on the other hand. In addition, the NASD notes that its proposal is
consistent with the objectives underlying the locked and crossed market
rule because it still ensures that SOES will be in operation when
markets are locked or crossed and it still ensures that market makers
will have a meaningful incentive to unlock markets quickly because they
will receives SOES executions every 5 seconds if their quotes are
locked or crossed. At the same time, just as is the case when markets
are not locked or crossed, market makers will be afforded a brief
period of time to update their quotes without being subjected to
potentially high risk exposure, thereby promoting a more orderly
realignment of quotations in locked and crossed market situations. In
sum, the NASD believes the detriment to the market created by the
current configuration of SOES during locked and crossed markets could
be minimized by adding the 5-second interval between SOES executions,
without compromising the access of small investors to market maker
quotes and without eliminating the incentive for market makers to not
lock or cross markets.
For the above reasons, the NASD believes that the proposed rule
change is consistent with Sections 15A(b)(6), 15A(b)(9), 15A(b)(11) and
15A(a)(1)(C) of the Act and Rule 11Ac1-1 thereunder. Among other
things, Section 15A(b)(6) requires that the rules of a national
securities association be designed to prevent fraudulent and
manipulative acts and practices, to promote just and equitable
principles of trade, to foster cooperation and coordination with
persons engaged in regulating, clearing, settling, processing
information with respect to, and facilitating transactions in
securities, to remove impediments to and perfect the mechanism of a
free and open market
[[Page 55344]]
and a national market system and in general to protect investors and
the public interest. Specifically, the NASD believes its proposal will
promote a more orderly realignment of quotations during locked and
crossed markets by affording market makers whose quotations are locked
or crossed a 5-second interval to react to SOES orders that they have
already automatically executed, wholly consistent with the operation of
SOES during times when markets are not locked or crossed. In addition,
because market makers will still be obligated to execute SOES orders
during locked and crossed markets at 5-second intervals, market makers
will still have an incentive to rectify locked and crossed market
situations. Finally, because SOES will continue to execute trades
during locked and crossed markets, small, retail investors will
continue to have immediate access to the best prices available on
Nasdaq during locked and crossed markets.
Section 15A(b)(9) provides that the rules of the Association may
not impose any burden on competition not necessary or appropriate in
furtherance of the purposes of the Act. The proposed 5-second interval
after SOES executions during locked and crossed markets will apply
across the board and not target any particular SOES user or
participant. Accordingly, the NASD believes that its proposal is not
anti-competitive, as it is uniform in application and it seeks to
preserve the ability of SOES to provide fair and efficient automated
executions for small investor orders, while preserving market maker
participation in SOES and market liquidity.
Section 15A(b)(11) empowers the NASD to adopt rules governing the
form and content of quotations relating to securities in the Nasdaq
market. Such rules must be designed to produce fair and informative
quotations, prevent fictitious and misleading quotations, and promote
orderly procedures for collecting and distributing quotations. Because
the proposed rule change will facilitate a more orderly reaction to and
rectification of locked and crossed markets, the NASD believes the rule
change will enhance the integrity and soundness of quotations in NNM
securities.
In addition, the NASD believes that the proposed rule change is
consistent with significant national market system objectives contained
in Section 11A(a)(1)(C) of the Act. This provision states it is in the
public interest and appropriate for the protection of investors and the
maintenance of fair and orderly markets to assure, among other things:
(i) economically efficient execution of securities transactions; (ii)
fair competition among brokers and dealers; and (iii) the practicality
of brokers executing investor orders in the best market. Specifically,
the NASD believes the proposed 5-second interval after SOES executions
during locked and crossed markets will advance each of these objectives
by preserving the operational efficiencies of SOES in the processing of
small investor's orders.
Finally, consistent with the SEC's finding that the 15-second
interval is consistent with the SEC's Firm Quote Rule during regular
market conditions, the NASD believes its proposal to extend a 5-second
interval during locked and crossed markets is likewise consistent with
the Firm Quote Rule. Specifically, when the SEC approved the 15-second
interval with respect to regular market conditions, it stated that it
was:
Consistent with the requirements of the SEC's Firm Quote Rule
which requires that brokers and dealers execute orders to buy and
sell securities at their published quotes unless communicating a
revised bid or offer or unless updating their quotations in response
to an execution. The proposed 15-second update period in no way
diminishes the requirement that market makers maintain firm quotes
and be willing to execute at those quotes. The 15-second update
period only will be in effect in response to an execution and only
serves to provide market makers time to react to that execution and
adjust their positions, if necessary. Market makers will continue to
be required to execute customer orders quickly and efficiently.\7\
\7\ See Securities Exchange Act Release No. 29801 (October 10,
1991), 56 FR 52098.
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The NASD believes that the Commission's legal analysis and
statutory finding that the 15-second interval is consistent with the
Firm Quote Rule applies with equal force to the proposed rule change.
Indeed, nowhere in the SEC's Firm Quote Rule does it provide that
market makers are ineligible to avail themselves of the exceptions to
the Rule because a market is locked or crossed. In fact, under Rule
11Ac1-1(b)(3)(C), when there is a level of trading activity or the
existence of unusual market conditions such that an exchange is
incapable of collecting, processing, and making available quotations in
a manner which accurately reflects the current state of the market on
the floor of an exchange, that exchange may relieve its market makers
of their firm quote obligations.\8\ Accordingly, since SOES market
makers will not in any way be relieved of any of their firm quote
obligations under the proposal, the NASD believes the proposed rule
change is wholly consistent with the SEC's Firm Quote Rule.
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\8\ Because only exchanges can declare fast market conditions
under the Firm Quote Rule, the same market event (i.e., a locked or
crossed market) can presently result in dramatically different
regulatory requirements for similarly situated market participants.
Specifically, under SOES, exceptions from the Firm Quote Rule are
eliminated when markets are locked or crossed, while exchange
specialists may be entirely relieved of their firm quote obligations
during locked and crossed markets.
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B. Self-Regulatory Organization's Statement on Burden on Competition
The NASD believes that the proposed rule change will not result in
any burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Act.
C. Self-Regulatory Organization's Statement of Comments on the Proposed
Rule Change Received From Members, Participants or Others
Comments 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 NASD consents, the Commission will:
A. By order approve such proposed rule change, or
B. Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
Copies of the submission, all subsequent amendments, all written
statements with respect to the proposed rule change that are filed with
the Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for inspection and copying in the
Commission's Public Reference Room. Copies of such filing will also be
available for inspection and copying at the principal office of the
NASD. All
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submissions should refer to SR-NASD-94-54 and should be submitted by
November 15, 1996.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\9\
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\9\ 17 CFR 200.30-3(a)(12) (1989).
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Margaret M. McFarland,
Deputy Secretary.
[FR Doc. 96-27434 Filed 10-24-96; 8:45 am]
BILLING CODE 8010-01-M