[Federal Register Volume 61, Number 235 (Thursday, December 5, 1996)]
[Notices]
[Pages 64550-64561]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-31079]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38008; File No. SR-NASD-96-43]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc., 
Relating to Implementation of the SEC's Order Handling Rules

December 2, 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 
18, 1996, the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by the NASD. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.

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

    The NASD is submitting this rule filing to amend a variety of NASD 
rules and The Nasdaq Stock Market's (``Nasdaq'') Small Order Execution 
System (``SOES'') and SelectNet Service to conform to the Commission's 
new limit order display rule, Rule 11Ac1-4 under the Act 1 
(``Display Rule'') and amendments to Rule 11Ac1-1(c)(5) under the Act 
2 (``ECN Rule''). These amendments are also being proposed to 
reflect the order-driven nature of the Nasdaq market that will be 
brought about by implementation of the Display Rule and ECN Rule. 
Proposed new language is in italics. Deleted language is in brackets.
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    \1\ 17 CFR 240.11Ac1-4.
    \2\ 17 CFR 240.11Ac1-1.
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Marketplace Rules

* * * * *

4613.  Character of Quotations

    (a) Two-Sided Quotations
    (1) 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 Rule 4619.
    (A) If a market maker updates the price of its bid or offer without 
any accompanying update to the size of such bid or offer, the size of 
the updated

[[Page 64551]]

bid or offer shall be the size of the previous bid or offer.
    (B) Notwithstanding any other provision in this paragraph (a), in 
order to display a limit order in compliance with SEC Rule 11Ac1-4, a 
registered market maker's displayed quotation size may be for one 
normal unit of trading or a larger multiple thereof.
    (C) A registered market maker must display a quotation size for at 
least one normal unit of trading or a larger multiple thereof when it 
is not displaying a limit order in compliance with SEC Rule 11Ac1-4, 
provided, however, that a registered market maker may augment its 
displayed quotation size to display limit orders priced at the market 
maker's quotation.
    [(2) 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:
    (A) a 1,000 share requirement shall apply to Nasdaq National Market 
securities with an average daily non-block volume of 3,000 shares or 
more a day, a bid price of less than or equal to $100, and three or 
more market makers;
    (B) a 500 share requirement shall apply to Nasdaq National Market 
securities with an average daily non-block volume of 1,000 shares or 
more a day, a bid price of less than or equal to $150, and two or more 
market makers and
    (C) a 200 share requirement shall apply to Nasdaq National Market 
securities with an average daily non-block volume of less than 1,000 
shares a day, a bid price of less than or equal to $250, and that have 
two or more market makers.
    (3) 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:
    (A) a 500 share requirement shall apply to 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
    (B) 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.
    (4) 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.]
* * * * *
    (e) Locked and Crossed Markets
    (1) A market maker shall not, except under extraordinary 
circumstances, enter or maintain quotations in Nasdaq during normal 
business hours if:
    (A) the bid quotation entered is equal to or greater than the asked 
quotation of another market maker entering quotations in the same 
security; or
    (B) the asked quotation is equal to or less than the bid quotation 
of another market maker entering quotations in the same security.
    (2) A market maker shall, prior to entering a quotation that locks 
or crosses another quotation, make reasonable efforts to avoid such 
locked or crossed market by executing transactions with all market 
makers whose quotations would be locked or crossed. Pursuant to the 
provisions of paragraph (b) of this Rule 4613, a market maker whose 
quotations are causing a locked or crossed market is required to 
execute transactions at its quotations as displayed through Nasdaq at 
the time of receipt of any order.
    (3) For purposes of this paragraph, the term ``market maker'' shall 
include any NASD member that enters into an electronic communications 
network, as that term is defined in SEC Rule 11Ac1-1(a)(8), a priced 
order that is displayed in The Nasdaq Stock Market. Such term also 
shall include an NASD member that operates the electronic 
communications network when the priced order being displayed has been 
entered by a person or entity that is not an NASD member.
* * * * *
IM-4613  Autoquote Policy
    (a) General Prohibition--The Association has extended a policy 
banning the automated update of quotations by market makers in Nasdaq. 
Except as provided below, [T]this policy prohibits systems known as 
``autoquote'' systems from effecting automated quote updates or 
tracking of inside quotations in Nasdaq[, with two exceptions]. 
[Automated updating of quotations is permitted when the update is in 
response to an execution in the security by that firm (such as 
execution of an order that partially fills a market maker's quotation 
size) or when it requires a physical entry (such as a manual entry to 
the market maker's internal system which then automatically forwards 
the update to Nasdaq).] This ban is necessary to offset the negative 
impact on the capacity and operation of Nasdaq of certain autoquote 
techniques that track changes to the inside quotation in Nasdaq and 
automatically react by generating another quote to keep the market 
maker's quote away from the best market.
    (b) Exceptions To the General Prohibition--Automated updating of 
quotations is permitted when: (1) the update is in response to an 
execution in the security by that firm (such as execution of an order 
that partially fills a market maker's quotation size); (2) it requires 
a physical entry (such as a manual entry to the market maker's internal 
system which then automatically forwards the update to Nasdaq); (3) the 
update is to reflect the receipt, execution, or cancellation of a 
customer limit order; or (4) an electronic communications network as 
defined in SEC Rule 11Ac1-1(a)(8) is required to maintain a two-sided 
quotation in Nasdaq for the purpose of meeting Nasdaq system design 
requirements.
* * * * *

4623  Electronic Communications Networks

    (a) The Association may provide a means to permit electronic 
communications networks, as such term is defined in SEC Rule 11Ac1-
1(a)(8), to meet the terms of the electronic communications network 
display alternative provided for in SEC Rule 11Ac1-1(c)(5)(ii)(A) and 
(B). In providing any such means, the Association shall establish a 
mechanism that permits the electronic communications network to display 
the best prices and sizes of orders entered by Nasdaq market makers 
(and other entities, if the electronic communications network so 
chooses) into the electronic communications network, and allows any 
NASD member the electronic ability to effect a transaction with such 
price orders that is equivalent to the ability to effect a transaction 
with a Nasdaq market maker quotation in Nasdaq operated systems.
    (b) An electronic communications network that seeks to utilize the 
Nasdaq-provided means to comply with the electronic communications 
network display alternative shall:
    (1) demonstrate to the Association that it qualifies as an 
electronic communications network meeting the definition in the SEC 
Rule;
    (2) be registered as an NASD member;
    (3) enter into and comply with the terms of a Nasdaq Workstation 
Subscriber Agreement;

[[Page 64552]]

    (4) agree to provide for Nasdaq's dissemination in the quotation 
data made available to quotation vendors the prices and sizes of Nasdaq 
market maker orders (and other entities, if the electronic 
communications network so chooses) at the highest buy price and the 
lowest sell price for each Nasdaq security entered in and widely 
disseminated by the electronic communications network and
    (5) provide an automated execution or, if the price is no longer 
available, an automated rejection of any order routed to the electronic 
communications network through the Nasdaq-provided display alternative.
* * * * *
4700  Small Order Execution System (SOES)
4710  Definitions
* * * * *
    [(h) The term ``exposure limit'' means the number of shares of a 
security on either side of the market specified by a Market Maker that 
it is willing to have executed for its account by unpreferenced orders 
entered into SOES.
    (i) The term ``minimum exposure limit'' for a security means the 
aggregate number of shares of the security equal to two times the 
maximum order size for that security.]
    (j)-(k). Re-lettered as subparagraphs (h) and (i).
* * * * *
4730  Participant Obligations in SOES
* * * * *
    (b) Market Makers
    (1) A SOES Market Maker shall commence participation in SOES by 
initially contacting the SOES Operation Center to obtain authorization 
for the trading of a particular SOES security and identifying those 
terminals on which the SOES information is to be displayed and 
thereafter by an appropriate keyboard entry which obligates the firm, 
so long as it remains a Market Maker in SOES:
    (A) to execute individual preferenced SOES orders equal to or 
smaller than the applicable maximum order size at the best bid or offer 
as disseminated by Nasdaq in any security for which it is a SOES market 
maker;
    (B) for any NNM security for which it is a SOES market maker, to 
execute individual unpreferenced SOES orders equal to or smaller than 
the market maker's displayed quotation size in any security for which 
it is a SOES Market Maker; and
    (C) for any Nasdaq SmallCap Market security for which it is a SOES 
market maker, to execute individual unpreferenced SOES orders equal to 
or smaller than the market maker's displayed quotation size when the 
market maker's quotation is at the best bid or offer as disseminated by 
Nasdaq, and, when the market maker's quotation is inferior to the best 
bid or offer as disseminated by Nasdaq, to execute individual 
unpreferenced SOES orders up to the lessor of the market maker's 
displayed quotation size or the smallest quotation size of all the 
market makers whose quotations are at the best bid or offer as 
disseminated by Nasdaq.
    [(A) for any security for which it is a SOES Market Maker, to 
execute individual orders in sizes equal to or smaller than the maximum 
order size; and
    (B) for any NNM security for which it is a Market Maker, to execute 
individual orders equal in the aggregate to the minimum exposure 
limit.] A SOES Market Maker's displayed quotation size will be 
decremented upon the execution of an unpreferenced SOES order equal to 
or greater than one normal unit of trading; provided, however, that the 
execution of an unpreferenced SOES order that is a mixed lot (i.e., an 
order that is for more than a normal unit of trading but not a multiple 
thereof) will only decrement the SOES Market Maker's displayed 
quotation size by the number of shares represented by the number of 
round lots contained in the mixed lot order. Market Makers shall have a 
period of time following their receipt of an execution report in which 
to update their quotation in the security in question before being 
required to execute another unpreferenced order at the same bid or 
offer in the same security. This period of time shall initially be 
established as 15 seconds, but may be modified upon appropriate 
notification to SOES participants. All entries in SOES shall be made in 
accordance with the requirements set forth in the SOES User Guide.
    [(2) For each security in which a Market Maker is registered, the 
Market Maker may enter into SOES an exposure limit. For an NNM 
security, that limit may be any amount equal to or larger than the 
minimum exposure limit. If no exposure limit is entered for an NNM 
security, the firm's exposure limit will be the minimum exposure 
limit.]
    (2)[(3)] For each security in which the Market Maker is registered, 
the Market Maker may elect to have The Nasdaq Stock Market refresh its 
quotation automatically by an interval designated by the Market Maker, 
once its displayed quotation size on either side of the market 
[exposure limit] in the security has been decremented to zero due to 
SOES executions [exhausted]. The Nasdaq Stock Market will refresh the 
market maker's quotation on the bid or [and] offer side of the market, 
whichever is decremented to zero, by the interval designated, and will 
reestablish the Market Maker's displayed size for one normal unit of 
trading; provided, however, that a Market Maker may elect to have The 
Nasdaq Stock Market refresh its bid or offer at the same price if the 
Market Maker's quotation size prior to any decrementation was equal to 
or greater than the maximum SOES order size for the security. [and 
selected exposure limit. If the market maker elects to utilize The 
Nasdaq Stock Market automated update feature, it may establish an 
exposure limit equal to the maximum order size for the securities, 
regardless of the minimum exposure limit set forth in Rule 4710(i).]
    (3)[(4)] Except as otherwise provided in subparagraph (10) below, 
[A]at any time a locked or crossed market, as defined in Rule 4613(e) 
exists for a NNM security, a Market Maker with a quotation for that 
security in The Nasdaq Stock Market that is causing the locked or 
crossed market may have orders representing shares equal to the size of 
its bid or offer that is locked or crossed [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.
    (4)[(5)] For each security in which a Market Maker is registered, 
the Market Maker may not enter orders into SOES for its proprietary 
account, but may enter orders on an agency basis into SOES. [, unless a 
locked or crossed market, as defined in Rule 4613(e), exists for that 
security. This prohibition against use of SOES does not obviate the 
Market Maker's duty to give its agency orders best execution in the 
prevailing market, according to Rule 2320.]
    (5)[(6)] The Market Maker may terminate his obligation by keyboard 
withdrawal from SOES at any time. However, the Market Maker has the 
specific obligation to monitor his status in SOES to assure that a 
withdrawal has in fact occurred. Any transaction occurring prior to the 
effectiveness of the withdrawal shall remain the responsibility of the 
Market Maker. In the case of a security that is not a NNM security, a 
Market Maker whose bid or offer has been decremented to zero due to 
SOES executions [exposure limit is exhausted] will be deemed to have 
withdrawn from SOES and may reenter at any time pursuant to paragraph 
(a)

[[Page 64553]]

above; provided, however, that a market maker in a Nasdaq SmallCap 
Market security that does not reenter a quotation by the close of 
business on the day its quotation is decremented shall be deemed to 
have withdrawn as a market maker in the security and precluded from 
entering quotations in that security for twenty (20) business days 
pursuant to NASD rule 4620.
    (6)[(7)] In the case of an NNM security, a Market Maker will be 
suspended from SOES if its bid or offer has been decremented to zero 
due to SOES executions [exposure limit is exhausted] and will be 
permitted a standard grace period, the duration of which will be 
established and published by the Association, within which to take 
action to restore a two-sided quotation in the security for at least 
one normal unit of trading [its exposure limit]. A Market Maker that 
fails to re-enter a two-sided quotation [renew its exposure limit] in a 
NNM security within the allotted time will be deemed to have withdrawn 
as a Market Maker. Except as provided in subparagraph (7)[(8)] below, a 
Market Maker that withdraws in an NNM security may not reenter SOES as 
a Market Maker in that security for twenty (20) business days.
    (7)[(8)] Notwithstanding the provisions of subparagraph (6) [(7)] 
above: (A) a Market Maker that obtains an excused withdrawal pursuant 
to Rule 4619 prior to withdrawing from SOES may reenter SOES according 
to the conditions of its withdrawal; and (B) 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 SOES for NNM securities, may reenter SOES 
after a clearing arrangement has been reestablished and the market 
maker has compiled 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.
    (8)[(9)] The Rule 9700 Series of the Code of Procedure shall apply 
to proceedings brought by Market Makers seeking review of (A) their 
removal from SOES pursuant to subparagraph (6)[(7)] above, (B) the 
denial of an excused withdrawal pursuant to Rule 4619, or (C) the 
conditions imposed on their reentry.
    (9)[(10)] In the event that a malfunction in the Market Maker's 
equipment occurs, rendering on-line communications with SOES 
inoperable, the SOES Market Maker is obligated to immediately contact 
the SOES Operations Center by telephone to request withdrawal from 
SOES. For NNM securities, such request must be made pursuant to Rule 
4619. If withdrawal is granted, SOES operational personnel will enter 
the withdrawal notification into SOES from a supervisory terminal. Such 
manual intervention, however, will take a certain period of time for 
completion and the SOES Market Maker will continue to be obligated for 
any transaction executed prior to the effectiveness of his withdrawal.
    (10) In the event that there are no SOES market makers at the best 
bid (offer) disseminated by Nasdaq, market orders to sell (buy) entered 
into SOES will be rejected and returned to their respective order entry 
firms.
    (c) SOES Order Entry Firms
* * * * *
    (2) SOES will only accept [both] market and marketable limit orders 
for execution and will not accept market or marketable limit orders 
designated as All-or-None (``AON'') orders; provided, however, that 
SOES will not accept any limit orders, marketable or unmarketable, 
prior to 9:30 a.m., Eastern Time. For purposes of this subparagraph, an 
AON order is an order for an amount of securities equal to the size of 
the order and no less. Orders may be preferenced to a specific SOES 
Market Maker or may be unpreferenced, thereby resulting in execution in 
rotation against SOES Market Makers. A Market Maker may indicate order 
entry firms from which it agrees to accept preferenced orders. If an 
order is received by a Market Maker from an order entry firm from which 
it has not agreed to accept preferencing, the order will be executed at 
the inside market on an unpreferenced basis and will be subject to a 
period of time between executions for market makers to update their 
quotations.
* * * * *
6330  Obligations of CQS Market Makers
* * * * *
    (b) CQS market makers shall be required to input a minimum 
quotation size of 200 or 500 shares in each reported security (as 
established and published from time to time by the Association) 
depending on trading characteristics of the security; provided that a 
CQS market maker may input a quotation size less than such minimum 
quotation size to display a limit order in compliance with SEC Rule 
11Ac1-4. A limit order displayed in a CQS market maker's quotation 
pursuant to SEC Rule 11Ac1-4 must be for at least one normal unit of 
trading or a multiple thereof.
* * * * *

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

1. Introduction and Background
    On August 29, 1996, the Commission promulgated a new rule and 
adopted amendments to other Commission rules that have the effect of 
transforming The Nasdaq Stock Market (``Nasdaq'') into a combined 
order-driven market and a competing dealer market.3 Specifically, 
the Commission adopted the Display Rule, which requires the display of 
customer limit orders: (1) that are priced better than a market maker's 
quote; 4 or (2) that add to the size associated with a market 
maker's quote when the market maker is at the best price in the 
market.5 By virtue of the Display Rule, investors will now have 
the ability to directly advertise their trading interest to the 
marketplace, thereby allowing them to compete with market maker 
quotations and affect the size of bid-ask spreads.6 In sum, with 
the Display Rule, Nasdaq will have order-driven aspects akin to an 
auction market while retaining its

[[Page 64554]]

competing dealer market structure to provide price continuity and 
market depth and liquidity.7
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    \3\ See Securities Exchange Act Release No. 37619A (September 6, 
1996), 61 FR 48290 (September 12, 1996) (``Order Handling Rules 
Adopting Release'').
    \4\ For example, if a market maker's quote in stock ABCD is 10-
10\1/4\ (1000 x 1000) and the market maker receives a customer limit 
order to buy 200 shares at 10\1/8\, the market maker must update its 
quote to 10\1/8\-10\1/4\ (200 x 1000).
    \5\ For example, if a market maker receives a limit order to buy 
200 shares of ABCD at 10 when its quote in ABCD is 10-10\1/4\ (1000 
x 1000) and the NBBO for ABCD is 10-10\1/8\, the market maker must 
update its quote to 10-10\1/4\ (1200 x 1000).
    \6\ There are eight exceptions to the Display Rule: (1) customer 
limit orders executed upon receipt; (2) limit orders placed by 
customers who request that they not be displayed; (3) limit orders 
for odd-lots; (4) limit orders of block size (10,000 shares or 
$200,000); (5) limit orders routed to a Nasdaq or exchange system 
for display; (6) limit orders routed to a qualified electronic 
communications network for display; (7) limit orders routed to 
another member for display; and (8) limit orders that are all-or-
none orders.
    \7\ The Display Rule requirements will become effective on 
January 10, 1997, for all exchange-listed securities and for the 
1,000 Nasdaq securities with the highest average daily trading 
volume. On March 28, 1997, the Rule will apply to the next 1,500 
Nasdaq securities, and on June 30, 1997, the next 2,000 Nasdaq 
securities. The final phase-in date is August 28, 1997, when the 
Rule will apply to all remaining Nasdaq securities.
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    The other rule changes adopted by the Commission involve amendments 
to the Commission's firm quote rule, Rule 11Ac1-1 under the Act.8 
The ECN Rule requires market makers to display in their quote any 
better priced orders that the market maker places into an electronic 
communications network (``ECN'') such as SelectNet or Instinet. 
Alternatively, instead of updating its quote to reflect better priced 
orders entered into an ECN, a market maker may comply with the display 
requirements of the ECN Rule through the ECN itself, provided the ECN 
meets two conditions.9
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    \8\ 17 CFR 240.11Ac1-1
    \9\ Specifically, in order for a market maker to comply with the 
rule via an ECN, the ECN must: (1) ensure that the best priced 
orders entered by market makers into the ECN are communicated to 
Nasdaq for public dissemination; and (2) provide brokers and dealers 
access to orders entered by market makers into the ECN, so that 
brokers and dealers who do not subscribe to the ECN can trade with 
those orders. This access must be equivalent to the access that 
would have been available had the market makers reflected their 
superior priced orders in their quotes.
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    This rule filing addresses the changes to the NASD's rules and 
systems that the NASD and Nasdaq believe must be made to implement the 
Display Rule and ECN Rule by January 10, 1997. The rule filing also 
discusses a variety of proposed rule changes that the NASD and Nasdaq 
believe are necessary in light of the order-driven nature of the Nasdaq 
market that will be brought about by implementation of the Display Rule 
and ECN Rule.
2. Proposed Rule Changes to Implement the Display Rule
    i. Minimum Quotation Size Requirements.
    a. Quote Size When Displaying Customer Limit Orders.
    In order to facilitate the display of customer limit orders in 
accordance with the Display Rule, the NASD and Nasdaq propose to amend 
NASD Rules 4613 and 6330 to provide that Nasdaq market makers and CQS 
market makers may display a quotation size for one normal unit of 
trading or a larger multiple thereof to reflect the actual size of a 
customer limit order.10 Thus, if a market maker's quote for ABCD 
is 20-20\1/4\, 10 x 10, and it receives a customer limit order to buy 
100 shares at 20\1/8\, the market maker may update its quote to 20\1/
8\-20\1/4\, 1 x 10. By permitting market makers to display the actual 
size of limit orders in their quotes, market makers will not be 
responsible for executing any additional shares above the size of the 
limit order. The NASD and Nasdaq believe this proposed rule change will 
help to promote the acceptance of limit orders priced inside quoted 
markets, thereby furthering the investor protection and market 
transparency objectives sought by the Commission in the Order Handling 
Rules Adopting Release. Moreover, without these rule changes, in 
instances where customer limit order are smaller than the applicable 
minimum quotation size requirement and a market maker's quote is 
inferior to the limit order price, market makers would be obligated to 
execute trades at prices superior to their proprietary quotations. The 
NASD and Nasdaq believe that subjecting market makers to such an order 
execution requirement would be unfair and create a disincentive for 
firms to function as market makers.
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    \10\ NASD Rule 4613 requires each market maker in a Nasdaq issue 
to enter and maintain two-sided quotations with a minimum size equal 
to or greater than the applicable SOES tier size for the security 
(e.g., 1,000, 500, or 200 shares for Nasdaq National Market 
(``NNM'') issues and 500 or 100 shares for Nasdaq SmallCap Market 
issues). NASD Rule 6330 requires registered market makers in 
exchange-listed securities to display a minimum quotation size of 
200 or 500 shares in each reported security (as established and 
published from time to time by the Association) depending on trading 
characteristics of the security.
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    b. Quote Size When Displaying Proprietary Market Maker Quotes.In an 
environment in which Nasdaq market makers are the only market 
participants who can impact quotation prices, the NASD and Nasdaq 
believe it is desirable and appropriate to impose minimum quotation 
size requirements to ensure an acceptable level of market liquidity and 
depth. However, now that the Display Rule will permit investors to 
directly impact quoted prices, the NASD and Nasdaq believe it would be 
appropriate to treat Nasdaq market makers in a manner equivalent to 
exchange specialists and not subject them to minimum quote size 
requirements. In sum, the NASD and Nasdaq believe the new order-driven 
nature of Nasdaq brought about by the Display Rule will obviate the 
regulatory justification for minimum quote size requirements because 
investors will have the capability to display their own orders in the 
marketplace. The ability for limit orders and ECN orders to be included 
in Nasdaq quotations should also ensure that market liquidity and price 
continuity will not be harmed by the elimination of minimum quotation 
size requirements. In this new environment, the NASD and Nasdaq believe 
that mandatory quote size requirements impose unnecessary regulatory 
burdens on market makers which are not consistent with the Act. 
Accordingly, the NASD and Nasdaq recommend that NASD Rule 4613 be 
amended to remove any requirements on market maker quotation sizes.
    The NASD and Nasdaq also believe that permitting market makers to 
quote in sizes commensurate with their own freely-determined trading 
interest will enhance the pricing efficiency of the Nasdaq market. In 
this connection, several recent economic studies have concluded that 
exchange specialists rely on quotation size movements just as much as 
quotation price movements to manage their risk.11 Indeed, a recent 
analysis by Nasdaq of quotation size updates by specialists on the New 
York Stock Exchange (``NYSE'') revealed that 62 percent of the 
quotation updates involved changes only to the size of the specialist's 
quotation and that 32 percent involved changes to both price and size. 
Thus, 94 percent of all quotation updates involved a change in 
quotation size. The analysis also found that the bid and offer sizes 
were the same for only 11 percent of the updates.12 Accordingly, 
just as exchange specialists rely on quotation size updates in an 
order-driven market to manage their risk, the NASD and Nasdaq believe 
Nasdaq market makers should be able to use quotation size updates to 
effectively manage their risks in Nasdaq's order-driven/competing 
dealer market structure that will be brought about by the Display Rule. 
Moreover, the NASD and Nasdaq believe that eliminating artificial 
constraints on quotation size movements by Nasdaq market makers will 
enhance the independence and competitiveness of dealers quotations in 
the Nasdaq market.
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    \11\ See, e.g., Lee, C., Mucklow, B., and Ready, M, 1993, 
``Spread, Depth, and the Impact of Earnings Information: An Intraday 
Analysis,'' The Review of Financial Studies, 6, 345-74; K. Kavajecz, 
1995, ``A Specialist's Quoted Depth and the Limit Order Book,'' 
Working Paper, J.L. Kellogg Graduate School of Management, 
Northwestern University; and K. Kavajecz, 1996, ``A Specialist's 
Quoted Depth as a Strategic Choice Variable,'' Working Paper, The 
Wharton School of the University of Pennsylvania.
    \12\ The source of the data used in Nasdaq's analysis was the 
Trade and Quote (``TAQ'') Database produced by the NYSE. The 
analysis reviewed over 750,000 quotation updates occurring over four 
days in 1996 (June 19, July 17, August 14, and September 18).
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    The NASD and Nasdaq also believe that elimination of the minimum 
quotation size requirements is necessary

[[Page 64555]]

to ensure that market makers who do not have access to an ECN will not 
be placed at a competitive disadvantage vis-a-vis those market makers 
who do have access to an ECN. In particular, since an ECN is not 
subject to minimum quotation size requirements, market makers with 
access to an ECN will be able to publicly display a quote/order for as 
small as 100 shares and maintain their Nasdaq market maker quotation 
away from the inside market, while market makers without access to an 
ECN would have no such option. As a result, unless market makers can 
quote in the same size as ECNs, there will be a disincentive for some 
firms, particularly smaller firms, to make markets in Nasdaq 
securities. Finally, allowing market makers to quote smaller markets 
would likely result in narrower spreads, thereby lowering transaction 
costs for investors.
    ii. Operation of SOES.
    At present, all market makers in NNM securities must be registered 
as SOES market makers. SOES is voluntary for market makers in Nasdaq 
SmallCap securities. The maximum SOES order size for a NNM security is 
either 1,000, 500, or 200 shares depending on the price and volume of 
the issue; and the maximum order size for a Nasdaq SmallCap Market 
security is 500 shares. SOES automatically executes unpreferenced 
orders in rotation against those market makers who are at the best 
quoted bid or offer on Nasdaq at the time the order is entered.13 
SOES orders may be routed or ``preferenced'' to a particular market 
maker for execution at the inside market, regardless of what price the 
preferenced market maker is quoting. A SOES market maker is obligated 
to execute SOES orders up to the minimum SOES exposure limit for that 
stock or such greater exposure limit established by the market maker. 
The minimum exposure limit for a particular stock is two times the 
applicable maximum SOES order size (e.g. 2,000 shares for stocks in the 
1,000 share tier size). If a market maker's exposure limit is 
exhausted, it is suspended from SOES and placed in a ``closed quote 
state'' and permitted a five-minute period to restore its exposure 
limit. If a market maker does not restore its exposure limit within 
five minutes it is automatically withdrawn from the stock and can not 
re-enter quotes in the issue for at least twenty business days.
---------------------------------------------------------------------------

    \13\ For Nasdaq SmallCap securities, SOES market makers must 
execute unpreferenced orders at the inside price regardless of 
whether they are at the inside market.
---------------------------------------------------------------------------

    Thus, SOES is currently designed to execute orders against market 
makers based on the tier size for a particular stock, without regard to 
the quotation size displayed by a market maker. Because the minimum 
quotation sizes for market makers are presently aligned with the 
maximum SOES order sizes, the current design of SOES does not obligate 
market makers to execute SOES orders larger than their quote size.
    Because market maker quotes will at times reflect customer limit 
orders under the Display Rule, the NASD and Nasdaq believe SOES should 
be modified to allow market orders to be executed against market 
makers' displayed quotation sizes instead of SOES tier sizes. Following 
are discussions of other proposed changes to SOES that relate to the 
implementation of the Display Rule and the ECN Rule.
    a. Decrementation of Displayed Quotation Sizes After SOES 
Executions. In order to avoid instances where a market maker could 
automatically receive multiple SOES executions because it displayed a 
customer's limit order at a price superior to the market maker's 
proprietary quote or increased its quote size because of the limit 
order, the NASD and Nasdaq propose that SOES be modified to decrement a 
market maker's displayed quote size upon the execution of unpreferenced 
SOES orders. For example, if a market maker's quote in ABCD is 10 x 
10\1/4\, 10 x 10, and it receives a customer limit order to buy 500 
shares at 10\1/8\, it would update its quote to 10\1/8\ x 10\1/4\, 5 x 
10. Thereafter, if the market maker received a SOES execution at 10\1/
8\ for 500 shares, the size of its bid would be depleted to 0 and the 
market maker would have to reenter a quotation. With this change, the 
NASD and Nasdaq believe market makers will be more inclined to accept 
and display customer limit orders because they will not be subject to 
mandatory SOES executions larger than the size of the limit orders that 
they display.14 In addition, if market makers' displayed quotation 
sizes are not decremented after SOES executions, market makers would be 
unfairly subject to the risk and obligation of automatically executing 
orders at prices superior to their own quotation. Such a requirement 
would create a disincentive for firms to be market makers and threaten 
to diminish the liquidity of the Nasdaq market.
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    \14\ The NASD and Nasdaq also propose that displayed quotations 
not be decremented after the execution of odd-lots and that the 
execution of a mixed lot order will only decrement a market maker's 
quotation by the number of shares represented by the number of round 
lots contained in the mixed lot order.
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    b. Split Order Execution. As noted above, because SOES presently 
executes orders based on SOES tier sizes and not market makers' 
displayed quotation sizes, SOES orders are not subject to partial 
executions. By decrementing market makers' displayed quotation sizes 
due to SOES executions, however, the NASD and Nasdaq believe it will be 
necessary to modify SOES so that it can execute one order against 
multiple market makers to ensure that SOES orders are automatically 
executed. As a result, the NASD and Nasdaq also recommend that SOES be 
amended to not accept ``all-or-none'' orders. For example, if the 
inside market for ABCD is 10-10\1/4\ and two market makers are each at 
the inside bid for 500 shares, a SOES market order to sell 1,000 shares 
of ABCD would be executed at 10, with both market makers selling 500 
shares. In addition, because all market maker quotations at the inside 
could be depleted by the execution of a SOES order, the NASD and Nasdaq 
believe it is necessary to modify SOES so that market orders may be 
filled at multiple price levels. For example, if the inside market for 
ABCD is 10-10\1/4\ and Market Makers A and B are each at the inside bid 
for 100 shares, with Market Maker C at 9\7/8\ for 800 shares, a SOES 
market order to sell 1,000 shares of ABCD would be executed against all 
three market makers. Specifically, Market Makers A and B would each 
sell 100 shares at 10 and Market Maker C would sell 800 shares at 9\7/
8\.
    c. Displayed Quotation Sizes Will Constitute Exposure Limits. A 
corollary impact of decrementing market maker quotes after SOES 
executions is that a market maker's displayed quotation size will 
become its exposure limit. Exposure limits function by capturing and 
monitoring the amount of SOES volume executed by a market maker at its 
quoted price, without such SOES volume effecting the market maker's 
quotation size. Accordingly, by decrementing market maker quotations 
after SOES executions, a market maker's displayed quotation size will 
become its exposure limit because SOES will cease executing orders 
against a market maker once its quote size has gone to zero. Thus, the 
NASD and Nasdaq propose that the SOES rules be amended to replace 
references to exposure limits with references to a market maker's 
displayed size.
    d. Prohibition Against the Entry of Non-Marketable Limit Orders 
into SOES. SOES currently accepts both market orders and limit orders. 
If a limit order is not immediately executable, or non-marketable, 
(i.e., a limit order to buy (sell) priced below (above) the offer

[[Page 64556]]

(bid) price), it is placed in the SOES limit order file and will be 
subsequently executed if the limit price becomes equal to the best bid 
or offer. SOES also has a limit order processing facility that matches 
limit orders priced inside the spread. Limit orders placed into SOES 
are never publicly disseminated, they are not included in the 
calculation of the best bid or offer, and they are not matched against 
incoming market orders. Accordingly, the NASD and Nasdaq believes that 
the current processing of non-marketable limit orders through SOES and 
the SOES limit order facility are in direct conflict with the Display 
Rule.15 If Nasdaq were to retain these SOES features, Nasdaq 
believes it would be operating a system that would result in NASD 
members systematically violating the federal securities laws. In 
addition, by not matching market orders against limit orders, the NASD 
and Nasdaq do not believe the current operation of SOES is consistent 
with the Commission's statements regarding best execution in its Order 
Handling Rule approval order.16 Thus, the NASD and Nasdaq propose 
that non-marketable limit orders be prohibited from SOES. As is 
currently the case, a marketable limit order will continue to be 
processed like a market order.
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    \15\ The NASD notes that Nasdaq's proposed NAqcess system would 
provide for limit order display and execution capabilities 
consistent with the Commission's Order Handling Rules and hopes that 
the Commission will act favorably on the proposed system. See 
Securities Exchange Act Release No. 37302 (June 11, 1996), 61 FR 
31574 (June 20, 1996).
    \16\ See Order Handling Rules Adopting Release, supra note 1, 61 
FR at 48324.
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    e. Modifications to the SOES Automated Quotation Update Feature. 
The ``auto-refresh'' feature of SOES moves both sides of a market 
maker's quotation by a pre-determined amount when its exposure limit 
has been exhausted. Accordingly, because a market maker's displayed 
quotation size will become its exposure limit under the proposed 
changes to SOES, the NASD and Nasdaq propose that the auto-refresh 
feature be modified so that it is activated when a market maker's 
quotation size is depleted. In addition, because of the possibility 
that a market maker's quotation at the next price level up or down 
could be comprised exclusively of customer limit orders and in light of 
the proposal to eliminate minimum quotation sizes for proprietary 
market maker quotes, the NASD and Nasdaq propose that market maker 
quotes be refreshed for 100 shares instead of the SOES tier size. The 
NASD and Nasdaq also recommend that the auto-refresh feature be 
modified so that it only updates the side of a market maker's quote 
that has been decremented. By updating the bid or the offer, but not 
both, the NASD and Nasdaq believe the auto-refresh feature will not 
exacerbate or contribute to locked or crossed markets, as has been the 
case with the current update feature during turbulent market 
conditions.
    The NASD and Nasdaq also propose to amend the auto-refresh feature 
to allow a market maker to maintain its quote at the inside market. 
With this auto-refresh feature, those market makers seeking to buy or 
sell more stock than their displayed quotation can continue to remain 
at the inside market. Accordingly, only those market makers entering a 
quotation size equal to or greater than the maximum SOES order size 
would be able to utilize this feature.
    f. Allowing SOES Market Makers to Enter Agency Orders into SOES. 
Currently, absent a locked or crossed market, a SOES market maker is 
prohibited from entering agency orders into SOES. This rule was 
implemented to prevent market makers from engaging in ``fair weather'' 
market making by entering orders into SOES that they do not want to 
execute themselves during turbulent market conditions. With the Display 
Rule, however, the quotations disseminated by market makers will at 
times reflect customer limit orders. Accordingly, in order to ensure 
that all small investors have access to better-priced customer limit 
orders displayed in market maker quotes and enhance the price 
improvement opportunities for all small investors, the NASD and Nasdaq 
believe it would be appropriate to allow SOES market makers to enter 
agency orders into SOES.
    g. Processing of Marketable Limit Orders. Currently, SOES is 
designed so that marketable limit orders are processed ahead of market 
orders queued up in SOES. Because a marketable limit order is 
economically equivalent to a market order as long as the limit price is 
superior to the inside market,17 the NASD and Nasdaq believe this 
system feature unnecessarily advantages investors placing marketable 
limit orders over investors placing market orders. This is particularly 
true since investors placing market orders to buy (sell), unlike 
investors placing marketable limit orders, have placed no upper (lower) 
limit on price at which they are willing to purchase (sell) the stock. 
Accordingly, the NASD and Nasdaq recommends that SOES be amended to 
execute market and marketable limit orders on a time priority basis.
---------------------------------------------------------------------------

    \17\ That is, a limit order to buy priced above the offer and a 
limit order to sell priced below the bid.
---------------------------------------------------------------------------

    h. Market Maker Withdrawal from Nasdaq SmallCap Market Securities. 
Because SOES is voluntary for Nasdaq SmallCap Market securities, when a 
market maker's exposure limit is exhausted in one of these securities 
it does not mean that the market maker has voluntarily withdrawn from 
the stock because the market maker can continue to quote the issue 
without participating in SOES. If market maker quotations are 
decremented after SOES executions, however, it will now be possible for 
a market maker in a SmallCap security to go into a ``closed quote'' 
state because its quotation size has been depleted. Accordingly, the 
NASD and Nasdaq propose that the SOES rules be amended to specify that 
a market maker in a SmallCap security shall be deemed to have 
voluntarily withdrawn from a stock if its quote size remains at zero at 
the close of the trading day, thereby precluding the market maker from 
being a market maker in the issue for twenty business days.
3. Proposed Rule Changes To Implement the ECN Rule
    The NASD and Nasdaq also are amending certain rules and the SOES 
and SelectNet systems to facilitate the development of a means for ECNs 
to comply with the requirements of the ECN display alternative 
permitted under the ECN Rule. As noted above, the ECN Rule provides 
that market makers and specialists must make publicly available any 
superior prices that the market maker or specialist privately quotes 
through certain ECNs. The Commission also adopted an alternative 
display means to the ECN Rule, the ECN display alternative. Under this 
alternative, instead of updating its quote to reflect better priced 
orders entered into an ECN, a market maker may comply with the display 
requirements of the ECN Rule through the ECN itself, provided that the 
ECN: (1) ensures that the best priced orders entered by market makers 
into the ECN are communicated to Nasdaq for public dissemination; and 
(2) provides brokers and dealers access to orders entered by market 
makers into the ECN, so that brokers and dealers who do not subscribe 
to the ECN can trade with those orders. This access must be equivalent 
to the access that would have been available had the market makers 
reflected their superior priced orders in their quotes. The Commission 
stated that it expected the SROs to work cooperatively with the ECNs to 
display the prices in the

[[Page 64557]]

 consolidated quote systems and to provide equivalent access to them.
    The NASD and Nasdaq agree with the Commission that the ECN Rule and 
the ECN display alternative should enhance the transparency of prices 
in Nasdaq and other markets and can assist broker-dealers in obtaining 
the best prices for their customers. Indeed, in its comment letter to 
the Commission during the proposal phase of the ECN Rule, the NASD 
stated that it supported the broad dissemination of ECN best prices. 
The NASD also stated, however, that it was concerned that the rule as 
originally proposed could have the potential to harm market liquidity, 
because the original proposal could adversely affect the anonymity 
features of ECNs. The ECN display alternative as adopted by the 
Commission appears to substantially address this concern. Accordingly, 
since the Commission adopted its new rule, the NASD and Nasdaq have 
sought to develop a linkage to any ECN recognized as an ECN by the 
Commission and that seeks to avail itself of the ECN display 
alternative.
    In order to meet the short time frame between the Commission's 
adoption of the rule and its effective date, the NASD is proposing to 
develop an interim approach \18\ to a linkage that is based on existing 
Nasdaq system platforms, SOES and SelectNet. Because the linkage relies 
in substantial part on SelectNet as the means of accessing the ECN 
prices, the NASD has called this approach the ``SelectNet Linkage'' 
approach. The methodology for establishing the SelectNet Linkage and 
the rule changes required are described below.
    \18\ The NASD and Nasdaq continue to examine other means to 
develop a longer-term mechanism that would provide a permanent means 
to establish an ECN display alternative that meets every aspect of 
the Commission's rule. Any such permanent approach will be proposed 
separately at the appropriate time.
    i. Overview of the Operation of the SelectNet Linkage. To provide a 
means for ECNs to substantially comply with the requirements of the ECN 
display alternative by January 13, 1996,\19\ Nasdaq has developed an 
interim approach that substantially meets the terms of Commission Rule 
11Ac1-1(c)(5)(ii). The SelectNet Linkage is a display and access 
linkage that, for purposes of meeting the display requirement of the 
ECN display alternative, utilizes the methodology currently used for 
displaying Unlisted Trading Privileges (``UTP'') exchange quotes,\20\ 
and for access purposes, builds upon the existing SelectNet system to 
---------------------------------------------------------------------------
reach the priced orders available in the ECN.
    \19\ The NASD and Nasdaq note that to comply with prudent 
standard industry practices regarding the implementation of new or 
substantially revised software, Nasdaq does not normally introduce 
extensive new or revised software into production on a Friday. 
Indeed, pursuant to previous discussions with Commission staff 
regarding the procedures for implementation of significant, non-
emergency software changes, Nasdaq and Commission staff have agreed 
that significant changes should be implemented over a weekend. Thus, 
Nasdaq plans to introduce the software on Monday, January 13th. This 
means that unless the Commission temporarily delays the January 10, 
1997 effective date for the ECN Rule, market makers entering priced 
orders into ECNs on January 10th will be required to operate under 
the ECN Rule without any ECN display alternative.
    \20\ Pursuant to 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 Privileges Basis (``Nasdaq/NMS/UTP Plan''), Nasdaq acts as 
the facilities manager for itself and the UTP Exchanges in 
collecting, consolidating and disseminating quotes from Nasdaq 
market makers and UTP exchange specialists that trade Nasdaq 
securities pursuant to Section 12(f) of the Act. UTP exchange 
specialists are not subject to SOES executions, nor do UTP exchange 
specialists have access to SelectNet.
    Under this approach, ECNs will function in a manner equivalent to 
UTP exchanges and/or Nasdaq market makers. This allows these ECNs to 
enter their best-priced orders into Nasdaq for display on the Nasdaq 
Workstation. To effect transactions against these displayed prices, 
NASD members that are subscribers to Nasdaq Workstation II service will 
be permitted to access the ECN prices through the delivery of orders 
directed to the ECN via the SelectNet system. Accordingly, the NASD and 
Nasdaq have proposed to establish a new provision within Rule 4600, the 
Nasdaq Market Maker Requirement section of the NASD Rules, that 
provides for Nasdaq's display of ECN price information and access to 
such prices, as well as the minimal obligations required of ECNs that 
seek to take advantage of the SelectNet Linkage to meet the 
---------------------------------------------------------------------------
Commission's ECN display alternative requirements.
    Specifically, any ECN seeking to avail itself of the SelectNet 
Linkage, or any future system Nasdaq develops to meet the ECN display 
alternative requirements, must: (1) demonstrate to the Association that 
it qualifies as an ECN meeting the ECN definition found in the 
Commission's Rule; (2) be registered as an NASD member; (3) enter into 
and comply with the terms of a Nasdaq Workstation Subscriber Agreement; 
(4) agree to provide for Nasdaq's dissemination in Nasdaq's quotation 
data stream that it makes available to quotation vendors the prices and 
sizes of Nasdaq market maker orders \21\ at the highest buy price and 
the lowest sell price for each Nasdaq security entered in and widely 
disseminated by the ECN; and (5) provide an automated execution of 
priced orders displayed through the linkage or, if the price is no 
longer available, an automated rejection of any order routed to the ECN 
through the Nasdaq-provided display alternative.
    \21\ The ECN Rule does not require an ECN to provide non-market 
maker interest in the data that would be provided under the ECN 
display alternative. Nasdaq has been informed, however, by several 
ECNs that have non NASD member participants, e.g., institutions, 
that these ECNs will deliver to Nasdaq the best prices for each 
security for which they permit orders to be entered, whether those 
best prices are from a market maker subject to the rule or an entity 
not subject to the rule. If the ECN so chooses, it may send priced 
orders from other entities that are not Nasdaq market makers. Nasdaq 
will display such prices as it does the other ECN-provided prices.
    a. Display of ECN Prices. For quotation display purposes, Nasdaq 
will collect the actual prices contained in an ECN's system delivered 
by ECNs that agree to deliver such prices to Nasdaq, and display and 
disseminate rounded prices.\22\ Assuming that ECNs meet the standards 
set forth in new Rule 4623, Nasdaq will furnish ECNs that identify 
themselves to Nasdaq as meeting the terms of the ECN definition in the 
ECN Rule with market maker identifiers (``MMIDs''). While ECNs will be 
assigned MMIDs, ECNs will not be registered as market makers. With the 
exception of certain rules such as the firm quote rule, the two-sided 
quote requirement,\23\ and the locked or

[[Page 64558]]

crossed rule discussed below, ECNs will not be subject to standard 
market maker requirements in the NASD's Rules. Nasdaq will include the 
ECN prices and sizes in the Nasdaq Workstation II quote montage with 
the ECN MMID and incorporate the ECN price in the Nasdaq best price 
calculation, i.e., when it is at the best bid or offer in the market, 
its price will be included in the inside price.
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    \22\ Nasdaq currently allows the dissemination of quotations in 
\1/8\ths for securities priced over $10 and quotations in \1/16\ths 
and \1/32\nds for securities priced under $10. ECNs, however, often 
have priced orders that are quoted in finer increments. Under the 
ECN Rule, Nasdaq is not required to display the actual price of the 
finer-incremented order; instead, it is permitted to round the order 
to the nearest standard quote increment (rounding down for 
increments on the better-priced bids and up for better-priced 
offers). The Commission stated that Nasdaq should develop a 
capability in its quote dissemination system to flag or specially 
denote that an ECN priced order is rounded, but noted that this 
capability does not currently exist. Nasdaq is developing a rounding 
indicator for implementation as soon as possible.
    In the interim before such an indicator is available, the NASD 
and Nasdaq believe that it would be appropriate for the Commission 
to permit the operation of the SelectNet Linkage without a rounding 
indicator. Balancing considerations of additional price information 
being made available in Nasdaq, together with the development of a 
means of readily accessing such prices, against a temporary 
inability to flag rounded quotes as such, it appears to the NASD and 
Nasdaq that the improved transparency of ECN prices and greater 
electronic access to these prices clearly outweigh the minimal 
negative transparency effects that may flow from the inability to 
flag a rounded price. Moreover, because Nasdaq has enhanced 
SelectNet's access feature to permit ECNs to easily accept a 
directed order at an improved price, those using the linkage will 
obtain the price improvement benefits that are among the ECN Rule's 
goals.
    \23\ The requirement for ECNs to display two-sided quotes is a 
temporary requirement, contingent on Nasdaq's development of a 
capability that permits ECNs to display a one-sided quote. Nasdaq 
recognizes that ECNs often have orders only on one side of the 
market. Currently, however, because Nasdaq's quote display system 
was built to display market maker quotations and market makers are 
required by rule to furnish both a bid and offer, Nasdaq's system 
would be unable to recognize an ECN price unless that price were 
also entered with a corresponding bid or offer. Accordingly, until 
such time that Nasdaq can build a one-sided ECN priced order display 
capability, ECNs must enter two-sided ``quotations.'' The NASD and 
Nasdaq believes that the one-sided ECN order entry capability should 
be available in the first quarter of 1997.
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    As it currently does with UTP exchanges, Nasdaq will not include 
the ECN as a SOES market maker. Consequently, an ECN utilizing the 
SelectNet Linkage will not be subject to SOES executions. Because ECNs 
act solely as agents on behalf of customers, the NASD and Nasdaq 
believe that ECNs should not be required to have their ECN orders 
exposed to SOES executions because it exposes the ECN to the risk of 
double executions and the consequent need to take a principal position. 
The risk of double executions arises because, with electronic order 
entry capabilities, once an order is displayed in multiple execution 
systems, the same order can be nearly simultaneously accessed by 
different counterparties. For example, an ECN could have a single 
customer order to buy 1,000 shares displayed in its own system to its 
own subscribers. If the ECN were also accessible at that price in SOES, 
the ECN could have the single 1,000 share order executed simultaneously 
in SOES and in its own system. This double execution would means that 
the ECN would be required to take a principal position for one of the 
executions. Exposure to proprietary executions would change the model 
under which ECNs have operated and would likely have a serious negative 
effect on ECNs, causing them to change the approach that they typically 
take.
    As the NASD has noted in its comment letter to the Commission, ECNs 
provide an important liquidity function in the markets and any adverse 
effect on them could cause a shift in the way the markets operate. The 
NASD believes that the approach that it is taking in allowing ECNs to 
function in a mode similar to UTP exchanges on this interim basis 
permits the ECN to continue to provide liquidity, while enhancing the 
degree of price information available to ECN subscribers and non-
subscribers alike. Moreover, as discussed immediately below, the NASD 
and Nasdaq believe that the electronic access capability that it will 
provide NASD members that are not subscribers to a particular ECN 
almost immediate execution of orders delivered to the ECN through this 
linkage.
    b. Access to ECN Prices. Access to ECN prices displayed in Nasdaq 
would be achieved through SelectNet. NASD members could direct orders 
up to the size displayed in the ECN quote. The ECN would have the 
ability to accept at the displayed price, or accept at an improved 
price if its actual price is at an increment better than that actually 
displayed.\24\ Alternatively, the ECN, subject to firm quote rule 
obligations, could decline to act on the order, if the order has 
already been executed in its own system. The NASD and Nasdaq believe 
that, regardless of the specific action taken by the ECN on Nasdaq's 
delivery of an order through SelectNet, the ECN should automate these 
functions to provide virtually immediate responses to members entering 
orders seeking to access the ECN orders. The Nasdaq Workstation 
Subscriber Agreement will establish specific system performance 
standards generally requiring the ECN to respond to the orders within a 
few seconds of delivery. The only purpose in providing this decline 
capability is to permit the ECN the briefest time possible for its 
electronic system to review its own file to determine whether the 
priced order displayed in Nasdaq has already been executed in the ECN's 
own system. There is no intent in providing this capability to allow 
the ECN to decide whether it wants to accept a particular delivered 
order because it may find a better order elsewhere.
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    \24\ See discussion below regarding the execution of SelectNet 
orders at rounded ECN prices when such orders are priced at 
increments finer than those permitted to be displayed in the 
consolidated quote system.
---------------------------------------------------------------------------

    Accordingly, as NASD members and subscribers to the Nasdaq 
Workstation II service, ECNs will be subject to contractual obligations 
to demonstrate that their systems are properly designed to operate in 
high volume trading environments and that they have adequate security 
and other operational procedures in place to maintain the integrity of 
Nasdaq systems. Additionally, each ECN will be required as a subscriber 
to meet response time performance standards when orders are delivered 
through SelectNet for ECN action. ECNs that are not willing or are 
unable to comply with such system requirements will not be permitted to 
establish a SelectNet Linkage for ECN display alternative purposes.
    ii. Other Rule Changes Necessitated By The Development of the 
SelectNet Linkage. As explained in greater detail below and in addition 
to the ECN display alternative rule described above, the following rule 
changes are necessary to implement the SelectNet Linkage approach by 
January 13, 1996:
    a. SelectNet Changes. The NASD and Nasdaq are proposing several 
changes to the current operation of Nasdaq's SelectNet system to 
provide access to the ECN priced orders that is equivalent to the 
access that would have been available if such prices were published in 
the market maker's own quotation in Nasdaq. SelectNet is an automated 
order routing and execution system that allows a member to direct buy 
or sell orders in Nasdaq securities to a single market maker 
(preferenced orders) or broadcast orders to all market makers in the 
security. Upon receiving a SelectNet order, a member can accept the 
order, decline it, or send a counter-offer to the originating member. 
The NASD and Nasdaq believe that the SelectNet system as modified 
through these rule changes meets the ECN display alternative equivalent 
access requirement. As the Commission noted in its Adopting Release for 
the ECN Rule, equivalent automated access ``could be achieved either 
through an electronic linkage to SOES or by other means agreed upon 
with the NASD.'' 25 As to be designed, SelectNet will allow any 
NASD member to access electronically the best prices available in ECNs. 
This access to ECN prices is the same as that which an NASD member has 
via SelectNet, and in fact, under the performance standards that ECNs 
must agree to be permitted to take advantage of the SelectNet Linkage, 
ECN response time will be much more rapid than that required of market 
makers.
---------------------------------------------------------------------------

    \25\ Order Handling Rules Release, supra note 3, 61 FR at 48314.
---------------------------------------------------------------------------

    To establish the equivalent access link, the NASD and Nasdaq 
propose to eliminate the SelectNet Broadcast feature and allow only the 
entry of a SelectNet order directed to a specific market maker or ECN. 
The NASD and Nasdaq believe that it is necessary to eliminate the 
Broadcast feature for several reasons. The Broadcast feature of 
SelectNet brings the system within the Commission's definition of an 
ECN.26

[[Page 64559]]

Under the Commission's ECN Rule, an ECN is defined to include ``any 
electronic system that widely disseminates to third parties orders 
entered therein by an exchange specialist or OTC market maker, and 
permits such orders to be executed against in whole or in part.'' The 
SelectNet Broadcast feature meets the terms of the Commission's 
definition and accordingly, market makers that entered priced orders 
into SelectNet would be required to display such prices in their Nasdaq 
quotes or Nasdaq would be required to develop an ECN linkage for 
SelectNet to display those orders in the Nasdaq inside. Nasdaq cannot 
develop an ECN linkage for SelectNet Broadcast by January 10th and 
accordingly, market makers that entered priced orders into SelectNet 
Broadcast would be required to change their quotes in the Nasdaq 
Workstation display. Moreover, the SelectNet Broadcast feature is a 
very significant drain on network capacity resources that are more 
appropriately devoted to establishing the ECN linkage for directed 
orders.
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    \26\ ECN Rule 11Ac1-1(a)(8).
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    The NASD and Nasdaq also propose to change SelectNet to permit an 
ECN or market maker receiving an order through SelectNet at a specific 
price to execute that order at a price reflecting price improvement 
without having to go through the currently designed counter-offer 
mechanism. Today, when a market maker receives a SelectNet order, it 
can do one of several things. For example, it can accept at the price 
sent by the order entry firm; or it can counter with a different price 
or size. As soon as the market maker puts in a different price, 
however, the currently-operating system treats the new price as a 
counteroffer message. Because ECNs are likely to hold orders at 
increments that can not be shown in Nasdaq, when it attempts to accept 
the order at a better price, e.g., a 1/16th better, the SelectNet 
system would treat the new price as a counter offer. Accordingly, to 
comply with the ECN Rule requirement that orders be executed at their 
actual prices, Nasdaq will change SelectNet to prevent the counter 
mechanism from operating in such a situation and will deliver to the 
order entry firm and the ECN an execution report at the improved price.
    b. SOES Rule Change. The NASD and Nasdaq also propose to amend the 
SOES Rules to permit the system to reject orders entered when an ECN or 
UTP Exchange alone sets the inside market. Specifically, the NASD and 
Nasdaq propose to add a new subsection to the SOES Rules (Rule 
4730(b)(10)) to state that when there are no SOES market makers at the 
best bid or offer that is being disseminated by Nasdaq, orders entered 
into SOES will be returned to the order entry firm to permit the order 
entry firm to direct the order to the entity establishing the best 
price. This situation arises because although UTP exchanges and ECNs 
can establish the best price in the Nasdaq inside, they are not 
required to participate in SOES as market makers and therefore are not 
accessible through SOES.
    Because the ECN quote is incorporated in Nasdaq's inside price but 
is not accessible through SOES under this approach, and SOES is 
programmed to execute at the best price displayed, SOES, as currently 
designed and operating, executes orders against the next available 
Nasdaq market maker whether that Nasdaq market maker is at that price 
or at an inferior price. This execution process exacerbates the current 
problem surrounding the lack of market maker and UTP exchange 
specialist parity of execution obligations in SOES and raises a 
possibility for ``gamesmanship,'' where a person could enter an order 
into an ECN that drives the Nasdaq inside and obtain multiple SOES 
automated executions against Nasdaq market makers that are not even 
displaying the ECN price. The NASD and Nasdaq do not believe that any 
approach that lends itself to this type of serious trading abuse should 
be pursued.
    To resolve this potential for abuse, Nasdaq's SOES system could be 
revised to ignore the ECN or UTP quote and execute SOES orders at the 
Nasdaq market maker's inferior price. While this approach eliminates 
gaming concerns, it raises best execution concerns--the customer's 
order entered in SOES would be executed at a price inferior to the best 
price displayed in Nasdaq's inside market. Consequently, the NASD and 
Nasdaq will not revise SOES to execute market orders at prices that are 
inferior to the best market prices.
    Instead, the NASD and Nasdaq believe that the best available 
interim response to potential gaming is to return unexecuted SOES 
orders to the entering member during such time that a SOES-inaccessible 
price drives the inside. Although brokers who automatically route 
orders to SOES initially could find any significant number of 
rejections caused by this approach to be problematic, the ``order 
rejection'' solution to the gaming problems clearly eliminates the 
gaming concern and therefore eliminates serious market quality 
concerns. Moreover, to the extent that order entry firms are concerned 
with the return of market orders, the NASD and Nasdaq believe that the 
handling of rejected orders can be dealt with satisfactorily by order 
entry firms through the firms' development of automated means to 
determine when an ECN or UTP exchange is alone at the inside and to 
deliver orders at such times through the SelectNet directed order 
capability. Order entry firms that enter orders into SOES during the 
period when an ECN is alone at the inside market will be informed that 
the order has been rejected and they may choose to route that order 
into SelectNet to access the ECN order driving the inside market or 
take other measures, such as routing the order to a market maker that 
guarantees the best price.27
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    \27\ The NASD and Nasdaq recognize that it would be preferable 
to integrate the market order system more closely with the display 
of prices. Consequently, the NASD and Nasdaq continue to develop a 
longer-term approach to the ECN display alternative that would 
better integrate the two systems. When such system is available, the 
NASD and Nasdaq will submit a new rule filing to replace the current 
SelectNet Linkage approach with a seamlessly integrated system that 
would not require the rejection of orders in a market order delivery 
system.
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    c. Locked or Crossed Market Rule Amendments. The NASD and Nasdaq 
also propose to amend the locked or crossed market rule, Rule 4613(e), 
to clearly indicate that the locked or crossed market rule applies to 
NASD members, including the ECN itself, when prices entered into ECNs 
and provided to Nasdaq for dissemination in the consolidated quote 
stream would be locked or crossed through the entry of a priced order 
into an ECN. Locked or crossed markets can cause investor confusion 
because investors seeing the bid or the offer at the same price or at 
crossed prices do not know the true price of the security at that 
moment. Further, because broker-dealers that operate internal automated 
execution systems drive those execution systems by means of a data 
stream based on the Nasdaq best bid and offer, those systems may not 
operate when the inside is locked or crossed.
    Accordingly, the NASD and Nasdaq propose to make clear that market 
makers using ECNs must continue to comply with Rule 4613(e). Further, 
the NASD and Nasdaq propose to extend the scope of the locked or 
crossed rule to clarify that its requirements apply to the ECNs and 
other NASD members when the ECN, as an NASD member acting as agent, 
represents an institutional order or other non-NASD member order the 
price of which would lock or cross the best bid or offer in 
Nasdaq.28 In other words, under the

[[Page 64560]]

newly-expanded locked or crossed rule, ECNs must comply with Nasdaq's 
rule that before a market is locked or crossed the locking or crossing 
party must first make reasonable efforts to execute the quote that 
would be locked.29
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    \28\ The NASD and Nasdaq believe that an ECN should be required 
to hold an order in its system and not enter it into Nasdaq's quote 
dissemination system until it has made a reasonable effort to reach 
the entity represented on the other side of the market.
    \29\ It should be noted that if an ECN locks or crosses the 
market, is alone at that price, and a SOES order is entered against 
the ECN price that is causing the lock or cross, SOES will be 
programmed to reject such orders, rather than executing them against 
a Nasdaq market maker at a different price level.
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4. Modifications to Autoquote Policy
    Currently, the NASD's Autoquote Policy does not explicitly state 
that it is permissible for a market maker to autoquote to display a 
customer limit order. Because of the requirements of the Display Rule 
and the benefits to investors and the marketplace to be derived from 
the Display Rule, the NASD and Nasdaq believe the Autoquote Policy 
should be amended to clarify that it is permissible to autoquote to 
display a customer limit order. In this connection, the NASD has 
previously issued an interpretation stating that it is permissible to 
autoquote to display a customer limit order. In addition, in order to 
eliminate any ambiguity as to whether the effectiveness of the NASD's 
Autoquote Policy lapsed upon completion of the roll-out of Nasdaq 
Workstation II, the NASD and Nasdaq propose to extend the effectiveness 
of the Autoquote Policy until such time as Nasdaq has had an 
opportunity to respond to the Commission's questions and concerns 
regarding autoquoting raised in its order adopting the Display Rule and 
the ECN Rule and implement any changes to the Policy as a result of 
such analysis.
    In addition, the NASD and Nasdaq are amending the Autoquote Policy 
to make clear that on a temporary basis, for as long as Nasdaq requires 
ECNs to enter two-sided quotes because of existing systems limitations, 
ECNs are permitted to autoquote to maintain a continuous two-sided 
market. As explained above, the requirement for ECNs to display two-
sided quotes is a temporary requirement, contingent on Nasdaq's 
development of a system capability that permits ECNs to display a one-
sided quote. Until such time that Nasdaq can build a one-sided ECN 
priced order display capability, ECNs must enter two-sided 
``quotations.'' The NASD and Nasdaq believes that the one-sided ECN 
order entry capability should be available in the first quarter of 
1997. Thus, on a temporary basis, an ECN as defined in SEC Rule 11Ac1-
1(a)(8) will be permitted to autoquote to maintain a two-sided 
quotation in Nasdaq. When Nasdaq system design requirements are 
changed, this exception to the autoquote policy will lapse.
    Because the proposed rule changes and Nasdaq system modifications 
contained in this filing are designed to implement the Display Rule and 
ECN Rule, the NASD and Nasdaq believe they are consistent with Sections 
11A(a)(1)(C), 15A(b)(6), 15A(b)(9) and 15A(b)(11) of the Act and Rules 
11Ac1-1 and 11Ac1-4 thereunder. Section 11A(a)(1)(C) provides that it 
is in the public interest to, among other things, assure the 
economically efficient execution of securities transactions and the 
availability to brokers, dealers, and investors of information with 
respect to quotations for and transactions in securities. Section 
15A(b)(6) requires that the rules of a national securities association 
be designed to prevent fraudulent and manipulative acts and practices, 
to promote just and equitable principles of trade, to foster 
cooperation and coordination with persons engaged in regulating, 
clearing, settling, processing information with respect to, and 
facilitating transactions in securities, to remove impediments to and 
perfect the mechanism of a free and open market and a national market 
system and in general to protect investors and the public interest. 
Section 15A(b)(9) requires that rules of an Association not impose any 
burden on competition not necessary or appropriate to furtherance of 
the purposes of the Act. Section 15A(b)(11) requires the NASD to, among 
other things, formulate rules designed to produce fair and informative 
quotations. Finally, as described above, effective January 10, 1996, 
the Display Rule and ECN Rule will require the display of customer 
limit orders and certain orders placed by Nasdaq market makers into 
ECNs.
    Specifically, by facilitating the display and accessibility of 
customer limit orders and orders placed by market makers into ECNs, the 
NASD and Nasdaq believe the proposed rule changes will enhance the 
transparency of the Nasdaq market, facilitate the best execution of 
investors' orders, and promote the integrity of the Nasdaq market. In 
addition, with more robust quotations, the NASD and Nasdaq believe 
there will be greater quote competition, improved price discovery, and 
greater market depth and liquidity. Moreover, the NASD and Nasdaq 
believe the proposed rule changes will increase the likelihood that 
customer limit orders will be executed, improve the opportunities for 
investors to receive best execution of their orders, and strengthen the 
ability of investors to monitor the quality of their order executions. 
Accordingly, the NASD and Nasdaq believe the proposed rule changes are 
consistent with all of the above-cited Sections of the Act and the 
rules thereunder.

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

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

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

    Comments were neither solicited nor received by the self-regulatory 
organization.

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

[[Page 64561]]

submissions should refer to the file number in the caption above and 
should be submitted by December 26, 1996.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\30\
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    \30\ 17 CFR 200.30-3(a)(12) (1989).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-31079 Filed 12-3-96; 1:39 pm]
BILLING CODE 8010-01-P