[Federal Register Volume 62, Number 9 (Tuesday, January 14, 1997)]
[Notices]
[Pages 1942-1945]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-986]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38149; File No. SR-NASD-97-01]


Self-Regulatory Organizations; Notice of Proposed Rule Changes by 
the National Association of Securities Dealers, Inc. Relating to 
SelectNet Orders

January 10, 1997.
    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 January 
8, 1997, the National Association of Securities Dealers, Inc. (``NASD'' 
or ``Association''), through its subsidiary,

[[Page 1943]]

The Nasdaq Stock Market, Inc., 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.
    Nasdaq requests the Commission to find good cause pursuant to 
Section 19(b)(2) for approving the proposed rule change prior to the 
30th day after publication in the Federal Register. The Order Execution 
Rules become effective January 20, 1997. The rule change proposed in 
this filing is essential to ensure the successful implementation and 
operation of Nasdaq's system designed to facilitate the ECN Display 
Alternative envisioned by the Order Execution Rules. Accordingly, 
Nasdaq requests the Commission to accelerate the effectiveness of the 
proposed rule change prior to the 30th day after its publication in the 
Federal Register.

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

    Pursuant to Section 19(b)(1) under the Securities Exchange Act of 
1934 (``Act'') and Rule 19b-4 thereunder, the NASD is submitting this 
rule filing to adopt certain rules regarding The Nasdaq Stock Market's 
(``Nasdaq'') SelectNet Service to clarify members' obligations 
regarding the use of the service as it will operate under the 
Commission's new limit order display rule, Rule 11Ac1-4 (``Display 
Rule'') and amendments to Rule 11Ac1-1(c)(5) (``ECN Amendment'').\1\ 
(New Text is italicized.)
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    \1\ See Securities Exchange Act Release No. 37619A (September 6, 
1996), 61 FR 48290 (September 12, 1996) (``Order Execution Rules 
Adopting Release'') adopting Rule 11Ac1-4 and amendments to Rule 
11Ac1-1 (``Quote Rule'') (collectively ``Order Execution Rules'').
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* * * * *

Conduct Rules

* * * * *
    3300. TRADING
* * * * *
    3380. SELECTNET SERVICE
    (a) Cancellation of a SelectNet Order
    No member shall cancel or attempt to cancel an order, whether 
preferenced to a specific market maker or electronic communications 
network, or broadcast to all available members, until a minimum time 
period of ten seconds has expired after the order to be canceled was 
entered. Such ten second time period shall be measured by the Nasdaq 
processing system processing the SelectNet order.
    (b) Prohibition Regarding The Entry of Conditional Orders
    No member shall enter an order into SelectNet that is preferenced 
to an electronic communications network covered by Rule 4623 that has 
any conditions regarding responses to the order, e.g., preferenced 
SelectNet orders sent to electronic communications networks shall not 
be all or none, or subject to minimum execution size above a normal 
unit of trading, or deemed non-negotiable.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    On November 18, 1996, the NASD and Nasdaq proposed several changes 
to their rules and systems to address changes to the Nasdaq Stock 
Market stemming from the Commission's adoption of the Order Execution 
Rules. \2\ The Display Rule requires the display in a market maker's 
quote of certain customer limit orders and the ECN Amendment requires a 
market maker to display in its quote any better priced order the market 
maker places into an electronic communication network (``ECN''). 
Alternatively, the ECN Amendment provides an exception to the market 
maker's display obligation that depends upon the ECN itself displaying 
its best-priced orders in Nasdaq and allowing brokers and dealers to 
access such orders (``ECN Display Alternative'').
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    \2\ See Securities Exchange Act Release No. 38008 (December 2, 
1996), 61 FR 64550 (December 5, 1996) notice of NASD filing of 
proposed rule change, file number 96-43.
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    Among the changes to Nasdaq's rules and systems to accommodate 
trading in the new environment the Order Execution Rules create, Nasdaq 
has proposed a mechanism to allow ECNs to take advantage of the ECN 
Display Alternative by providing a linkage to Nasdaq. A critical 
portion of Nasdaq's mechanism involves an existing Nasdaq system, 
SelectNet, which will be the means by which NASD members that are not 
subscribers to a particular ECN may access the ECN's orders that are 
being displayed in Nasdaq's quote montage pursuant to the ECN Display 
Alternative. To access those orders, NASD members will be permitted to 
enter SelectNet preferenced orders, i.e., orders that are directed to a 
particular ECN at its displayed price. Under the terms of agreements 
Nasdaq will enter into with each ECN choosing to utilize this SelectNet 
linkage (``ECN agreements''), the ECN will be required to respond as 
soon as possible within seconds to the preferenced order.
    In the course of working with ECNs on this access linkage via 
SelectNet, Nasdaq and the ECNs have discovered that problems occur when 
members entering orders into SelectNet, whether preferenced orders or 
broadcast, immediately cancel such orders. In addition, there are 
problems when members impose conditions, restrictions or limitations on 
the orders entered. For example, an ECN operating an automated response 
system develops response difficulties when it receives an all or none 
preferenced order. Nasdaq proposes, through this proposed rule change, 
to prohibit members from entering conditional orders into SelectNet 
when they are preferenced to an ECN. Nasdaq plans to develop system 
changes that will prevent the entry of such conditional orders as soon 
as possible.
    Additionally, the immediate cancellation of an order entered in 
SelectNet causes significant problems for the ECN that had received 
such order and was attempting to accept that order. All ECNs will be 
required, pursuant to performance standards that will be in the ECN 
agreements, to operate an automated system for accepting orders via 
SelectNet. The ECN automated system must be able to accept the 
SelectNet preferenced order and send a message to Nasdaq and to the 
ECN's own customer indicating that an execution has occurred. However, 
because an execution does not occur until the Nasdaq system processor 
receives the ECN acknowledgement that it has in fact accepted the 
order, a member's cancellation message may arrive at the Nasdaq 
processor first. Consequently, by the time the acceptance message 
arrives at Nasdaq's processor for its acknowledgement, the Nasdaq 
processor may have already accepted the cancellation. This will result 
in Nasdaq rejecting the execution acknowledgement from the ECN and 
hence harm the customer of the ECN

[[Page 1944]]

who believed an execution had occurred. Nasdaq believes it is 
appropriate, therefore, to require a member that has entered any order 
into SelectNet, a preferenced order or broadcast, to wait at least ten 
seconds before cancelling that same order. In this manner, the ECN or 
market maker operating a rapidly responding system will not be 
adversely disadvantaged.
    Nasdaq notes that the establishment of a minimum life of an order 
at ten seconds is its initial response to a significant concern that it 
has had with the use of SelectNet and the rapid cancellation of orders. 
The entry of large numbers of preferenced and broadcast orders into 
SelectNet that are cancelled within a very short time span creates 
serious market quality concerns. Two particular problems occur: (1) the 
rapid entry and almost immediate cancellation of SelectNet orders 
causes a misleading appearance of activity that is virtually impossible 
to access (i.e. ``flickering'' orders); and (2) because of the system 
design of SelectNet, the large number of order sent to the SelectNet 
window on Nasdaq Workstation II (``NWII'') rapidly scroll off the 
screen before a market maker can see the order and react to it (the 
``scroll-off'' problem).
    Two issues arise because of the many SelectNet orders that are 
cancelled almost as soon as they have been entered. First, the market 
may be misled by an appearance of significant activity in a particular 
issue, when, in fact, very few orders actually are accessible or carry 
any real price discovery information. The appearance of massive numbers 
of buy or sell orders first showing up on the screen could cause market 
makers and other members to believe that significant news on an issue 
is causing the order flow, leading market makers to adjust their 
quotations and order entry firms to incorrectly make order entry 
decisions based on their observation of the heavy influx of orders. The 
entry of these particular SelectNet orders is essentially a distracting 
and potentially harmful ``noise'' that disrupts the efficient price 
discovery process. Indeed, because these orders are so rapidly 
cancelled, it appears that many of these orders were not entered with 
the intention of being executed.
    Additionally, assuming that each order is entered with the 
intention that it is to be executed, the almost immediate cancellation 
often prevents other market participants from reacting effectively to 
the display of customer order interest. Nasdaq believes that the flurry 
of SelectNet orders being entered with almost immediate cancellations 
is the functional equivalent of the ``flickering quote'' problem.\3\
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    \3\ The NASD believes that the Commission has expressed concern 
over the value of `ephemeral' quotes, noting that while certain non-
specialists in the trading crowd may make bids or offers that 
temporarily change the market's quote for ``an instant in time,'' 
they do not really become part of the market quote because they are 
withdrawn immediately if not accepted. Such price information, if 
broadcast to the world via a consolidated quotation system, is 
essentially inaccessible, confusing to the market, and ultimately, 
potentially misleading. See Securities Exchange Act Release No. 
14415 (January 26, 1978), 43 FR 4342, 4345 (February 1, 1978) 
release adopting the Quote Rule. See also Securities Exchange Act 
Release No. 15771 (April 26, 1979), 44 FR 26067 (May 4, 1979) and 
Securities Exchange Act Release No. 18482 (February 11, 1982), 47 FR 
7399 (February 19, 1982) adopting amendments to the Quote Rule.
    The NASD also maintains that, in determining not to adopt its 
price improvement rule, proposed Rule 11Ac1-5, the Commission stated 
that the inaccessibility of quotes created pursuant to this proposal 
weighed against its adoption at this time. See Order Execution Rules 
Adopting Release. Lastly, the NASD notes that in recent news report 
that SEC Commissioner Wallman had concerns with flickering quotes 
and caused the Commission to rethink its proposed Rule 11Ac1-5 
regarding price improvement and a proposed safe harbor mechanism 
that would have required members to change their quotes for 30 
seconds in an effort to obtain price improvement for market orders 
when spreads are wider than a minimum increment. See Bloomberg, 
``SEC Commissioner Voices Concern About Nasdaq Access Rule Plan,'' 
August 14, 1996.
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    Nasdaq believes that the immediate cancellation of orders entered 
into SelectNet poses problems similar to those caused by flickering 
quotations. Essentially, if orders entered through SelectNet are 
immediately cancelled they are thus virtually inaccessible and 
therefore misleading. If orders entered into SelectNet are to have any 
meaning, particularly when they are broadcast to the entire market, it 
seems that such orders should have a reasonable minimum period of life 
that permits other market participants to access them.
    In addition to the problems caused by the basic inaccessibility of 
such orders, the unique design by which SelectNet orders are displayed 
is adversely effected by the heavy influx of such orders and subsequent 
cancellations. The NWII displays SelectNet orders on a four-line window 
at the bottom. Each SelectNet order occupies one line of the four-line 
window. Thus, when more than four orders are sent to a market maker 
through SelectNet, the oldest order scrolls off the display to be 
replaced by the newest order. When many SelectNet orders are sent 
through the system it causes the SelectNet window to scroll orders up 
and off the four-line window. Consequently, it is virtually impossible 
for the market maker to effectively interact with the orders. Even if a 
market maker were to observe an order that it wanted to interact with, 
it is likely that, due to the high rate of SelectNet cancellations, the 
order may be cancelled before the market maker is able to act on it. 
The scrolling, coupled with the almost immediate cancellation of 
orders, leads some market participants to regard SelectNet as a less 
viable trading mechanism.
    The large influx of orders and cancellations exacts a heavy toll on 
the capacity of Nasdaq's host processors and the Enterprise-Wide 
Network II (``EWN''). All of the components have had to be upgraded 
significantly in the last year, an upgrade driven in significant part 
by the amount of traffic caused by the SelectNet Broadcast feature and 
the requirement to process the messages generated in entry and 
cancellation of SelectNet orders.
    Nasdaq believes that the immediate cancellation of SelectNet orders 
causes a myriad of problems, any of which warrants the imposition of a 
minimum period for the life of a priced order entered into SelectNet. 
At this juncture, to prevent harmful market quality effects, Nasdaq 
believes that orders entered into SelectNet should be accessible for at 
least a 10 second minimum period of time before such order should be 
permitted to be cancelled.
    Nasdaq has reviewed other possible time periods for examples of 
minimum time periods that permit reasonable access. One such example is 
drawn from the Commission's proposed price improvement rule which 
included a proposed safe harbor.\4\ The proposed safe harbor provided 
that to obtain price improvement for a customer's market order when the 
spread in the best bid and offer was greater than the smallest quote 
increment (e.g., larger than 1/8th), the market maker should change its 
quote for 30 seconds to a price better than the current bid or offer to 
see if it could obtain a more favorable execution. Another example of a 
minimum time period is in the Intermarket Trading System (``ITS'') Plan 
where the exchanges and the NASD have agreed to minimum time periods 
for orders sent from one market center to another via ITS. ITS rules 
specifically provide that orders sent by a specialist or market maker 
in one market center to a specialist or market maker in another market 
are ``irrevocable'' for either one or two

[[Page 1945]]

minutes, depending on the time period that the sending market 
establishes.
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    \4\ See Securities Exchange Act Release No. 36310 (September 29, 
1995), 60 FR 52792 (October 10, 1995) release proposing Order 
Execution Rules which included a proposed price improvement rule.
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    Nasdaq notes that once the Order Execution Rules become effective, 
experience may determine that the ten second time period is too brief 
to effectively address the market quality concerns that present 
problems to market markers and investors alike that are seeking to 
trade at published prices that are withdrawn before they can be 
accessed. Nasdaq will continue to review SelectNet cancellation 
patterns to determine whether a longer minimum period is necessary. If 
it determines that market quality is being harmed by cancellations that 
indicate such orders are ephemeral, not executable or perhaps 
fictitious or manipulative Nasdaq will propose additional means to 
eliminate the harm. Accordingly, Nasdaq may revisit its initial 
determination to establish 10 seconds as the minimum life of a 
SelectNet order.
    The NASD believes that the proposed rule change is consistent with 
Section 15A(b)(6) of the Act and Rule 11Ac-1. 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. Specifically, 
by imposing limits on SelectNet orders as proposed herein, Nasdaq 
believes the proposal will promote fair and orderly markets and the 
protection of investors.

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.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the publication of this notice in the Federal 
Register or within such other 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 doing so or (ii) to which 
the self-regulatory organization consents, the Commission will:
    (A) by order approve the 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 submissions should refer to the file number in the caption 
above and should be submitted by [insert date 21 days from the date of 
this publication].

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\5\
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    \5\ 17 CFR 200.30-3(a)(12) (1989).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-986 Filed 1-10-97; 12:29 pm]
BILLING CODE 8010-01-M