[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