[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.
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\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.
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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.
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\17\ That is, a limit order to buy priced above the offer and a
limit order to sell priced below the bid.
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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
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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
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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.
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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.
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\25\ Order Handling Rules Release, supra note 3, 61 FR at 48314.
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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