[Federal Register Volume 62, Number 16 (Friday, January 24, 1997)]
[Notices]
[Pages 3725-3727]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-1681]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38180; File No. SR-NASD-96-50]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Accelerated Temporary Approval and Notice 
of Filing and Accelerated Approval of Amendment No. 1 of Proposed Rule 
Change Relating to Amendments to the NASD's Excess Spread Rule 
Applicable to Market Maker Quotations Through July 1, 1997

January 16, 1997.

I. Introduction

    On December 16, 1996, the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities 
and Exchange Commission (``SEC'' or ``Commission'') a proposed rule 
change pursuant to Section 19(b)(1) of the Securities Exchange Act of 
1934 (``Exchange Act'') \1\ and Rule 19b-4 thereunder.\2\ The NASD 
proposed to amend NASD Rule 4613(d) on a pilot basis through January 
31, 1998, to provide that a registered market maker in a security 
listed on The Nasdaq Stock Market (``Nasdaq'') shall be precluded from 
being a registered market maker in that issue for twenty business days 
if its average spread in the security over the course of any full 
calendar month exceeds 150 percent of the average of all dealer spreads 
in such issue for the month.\3\
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    \1\ 15 U.S.C. Sec. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ The NASD requested accelerated approval of its proposed rule 
change.
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    Notice of the proposed rule change was published in the Federal 
Register.\4\ No comments have been received in response to the 
Commission release.
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    \4\ Securities Exchange Act Release No. 38089 (December 27, 
1996), 62 FR 436 (January 3, 1997).
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    Subsequent to publication of the NASD filing, on January 9, 1997, 
the NASD filed with the Commission Amendment No. 1, which proposes to 
shorten the length of the pilot period from January 31, 1998, to July 
1, 1997.\5\ This order approves the proposed rule change, including 
Amendment No. 1, on an accelerated basis.
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    \5\ See Letter from Robert E. Aber, Vice President and General 
Counsel, Nasdaq, to David Oestreicher, Esq., Division of Market 
Regulation, SEC, dated January 8, 1997. A copy of this amendment is 
available for inspection and copying in the Commission's Public 
Reference Room.
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II. Description

    NASD Rule 4613(d), which is commonly known as the NASD's ``excess 
spread rule,'' presently provides that registered market makers in 
Nasdaq securities shall not enter quotations that exceed the NASD's 
parameter for maximum allowable spreads. Specifically, the rule 
provides that the maximum allowable spread for any Nasdaq security is 
125 percent of the average of the three narrowest market maker spreads 
in that issue (``125 percent test''), provided, however, that the 
maximum allowable spread shall never be less than \1/4\ of a point.\6\
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    \6\ Unrelated to the excess spread rule, there is also a dealer 
spread test that is part of the NASD's Primary Market Maker 
(``PMM'') standards that are used to determine the eligibility of 
market makers for an exemption from the NASD's short sale rule for 
short sales effected during the course of bona fide market making 
activity. Specifically, the market maker spread component of the PMM 
standards provides that a market maker must maintain a spread no 
greater than 102 percent of the average dealer spread. The NASD 
recently filed a proposed rule change related to the PMM standards. 
See Securities Exchange Act Release No. 38091 (December 27, 1996), 
62 FR 778 (January 6, 1997).
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    In its filing with the Commission, the NASD stated that the 
proposed rule change is an attempt to strike a reasonable balance 
between the need to eliminate any disincentive that the excess spread 
rule places on firms to improve their quotations and the need to avoid 
fostering a market environment where registered market makers can 
maintain inordinately wide spreads and still receive the benefits of 
market maker status. Under the amendment, a registered market maker 
will be required to maintain an average spread over the course of any 
full calendar month equal to or less than 150 percent of the average 
spread of all market makers in the issue over the course of the month 
(``150 percent test''). If a market maker fails to satisfy this 
standard with respect to a particular Nasdaq security, it will be 
forced to withdraw from market making in that issue for at least 20 
business days.
    Amended Rule 4613(d) will afford market makers that opportunity to 
request reconsideration of their withdrawal notices. Requests for 
reconsideration will be reviewed by the Market Operations Review 
Committee, whose decisions will be final and

[[Page 3726]]

binding on the members. The grounds for reconsideration will be limited 
to claims that Nasdaq's calculation of the market maker's average 
spread for the month was in error.
    This rule change will be operational for a pilot period beginning 
on January 20, 1997, and ending at the close of business on July 1, 
1997.

III. Discussion

    In its filing, the NASD stated that the excess spread rule was 
originally designed to enhance the quality of the Nasdaq market by 
preventing firms from holding themselves out as market makers without 
having a meaningful quote in the system. Despite the regulatory 
objectives underlying the excess spread rule, however, many market 
participants believe the rule has produced a variety of unintended 
consequences that have undermined the quality of Nasdaq quotations.\7\ 
Indeed, the Commission during its investigation of the NASD found that 
the NASD's excess spread rule had undesirable effects.\8\ In 
particular, the rule created disincentives for any given market maker 
to narrow its spread because to do so would reduce the maximum 
allowable spreads for all market makers. The Commission concluded that 
the rule interferes with the free flow of prices in the market and 
impedes attempts by the market to reach the optimal competitive 
spread.\9\ The Commission also noted that the rule may create 
incentives for market makers to collaborate or harass each other to 
dissuade a market maker from changing its quote if such a change would 
narrow one of the three smallest spreads in the stock.\10\ As part of 
its settlement with the Commission, the NASD agreed to modify the 
excess spread rule to eliminate its undesirable effects, or to 
eliminate the rule in its entirely, within one year of the Commission's 
Order.\11\
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    \7\ Some market participants claim that one such consequence is 
an increase in locked and crossed markets during periods of market 
turbulence because of the constraints on quote movements created by 
the rule.
    \8\ See Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD, the Nasdaq Market, and 
Nasdaq Market Makers, Securities Exchange Act Release No. 37542 
(August 8, 1996) (``21(a) Report''), and Appendix thereto.
    \9\ Id.
    \10\ Id.
    \11\ Order Instituting Public Proceedings Pursuant to Section 
19(h)(1) of the Securities Exchange Act of 1934, Making Findings and 
Imposing Remedial Sanctions, Securities Exchange Act Release No. 
37538 (August 8, 1996) (``Order'').
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    The NASD submitted its proposal to amend the current excess spread 
rule as an initial step to comply with the Commission's Order. The NASD 
also believes that the proposed rule change is necessary in light of 
changes to the Nasdaq market that will be brought about by 
implementation of the SEC's new limit order display on January 20, 
1997.\12\ In particular, because spreads in Nasdaq securities likely 
will narrow due to the display of customer limit orders, the average of 
the three narrowest market maker spreads also will narrow. As a result, 
the Commission's concerns with the current excess spreads rule will be 
exacerbated; application of the current rule under these circumstances 
may increase the incentive for market maker collaboration. Application 
of the current excess spread rule after the effective date of the order 
Execution Rules could have other consequences. For example, the current 
rule may lead market makers to decide not to accept customer limit 
orders or only accept those limit orders priced at the inside bid or 
offer so as not to narrow the maximum allowable spread parameters.
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    \12\ SEC Rule 11Acl-4 requires the display of customer limit 
orders that are placed better than a market maker's quote or that 
add to the size associated with a market maker's quote when the 
market maker is at the best price in the market. See Securities 
Exchange Act Release No. 37619A (September 6, 1996), 61 FR 48290 
(September 12, 1996) (``Order Execution Rules Adopting Release'').
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    The NASD has tried to reduce the anticompetitive effects of the 
excess spread rule by broadening the calculations used to determine the 
maximum allowable spread. The NASD recognizes that its proposal is only 
an interim step. Consequently, the NASD has proposed that the rule 
operate on a temporary basis while it studies the effects of the rule 
and examines other alternatives.
    The Commission has determined to approve the proposed rule change 
on a pilot basis through July 1, 1997. The amended rule may reduce, to 
some degree, the Commission's concerns regarding the current excess 
spread rule. For example, the new spread parameters are based on the 
average of all market makers in an issue, rather than only the three 
market makers quoting the narrowest spreads. Moreover, this average 
will be based on a full calendar month. Further, the NASD has increased 
the current 125 percent test to a 150 percent test. These changes limit 
the effect that one market maker's quote change will have on the 
obligations of other market makers, and thereby will limit the 
incentives toward improper behavior or harassment.
    Although the amended excess spread rule may reduce some of the 
anticompetitive concerns outlined in the 21(a) Report, the Commission 
believes that the amendment approved today may not completely satisfy 
the NASD's obligations under the Commission's Order with regard to the 
excess spread rule. Specifically, it may not remove completely the 
anticompetitive incentives for market makers to refrain from narrowing 
quotes because the market makers' quotation obligation continues to be 
dependent to some extent upon quotations of other market makers in the 
stock. Nonetheless, the Commission recognizes that the NASD needs to 
amend its excess spread rule quickly in light of the implementation of 
the Commission's Order Execution Rules. Although the proposal does not 
present a permanent solution, it is preferable to the current rule. As 
a result, the Commission has approved the amendment on a pilot basis 
only through July 1, 1997.\13\ During this time period, the NASD should 
monitor the effects of the pilot, as well as study alternative methods 
that would enhance market making performance while completely 
fulfilling the NASD's obligation regarding the excess spread rule 
before the August 8, 1997 deadline contained in the Commission's 
Order.\14\
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    \13\ In the Securities Acts Amendments of 1975, Congress 
directed the Commission to use its authority under the Exchange Act, 
including its authority to approve self-regulatory organization 
(``SRO'') rule changes, to foster the establishment of a national 
market system and promote the goals of fair competition and best 
execution. See S. Rep. No. 75, 94th Cong., 1st Sess. (1975) 
(``Senate Report''). Congress granted the Commission broad 
discretionary authority and maximum flexibility to carry out the 
objectives outlined in the 1975 Amendments. Id.
    \14\ The Commission notes that one possible approach is to 
delete entirely the excess spread methodology and instead develop 
alternative measures to ensure adequate market maker performance.
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    Accordingly, the Commission finds that the rule change is 
consistent with the Exchange Act and the rules thereunder applicable to 
the NASD and, in particular, Sections 15A(b)(6), 15A(b)(9), and 
15A(b)(11). The Commission finds good cause for approving the proposed 
rule change and Amendment No. 1 prior to the 30th day after the date of 
publication of notice of filing thereof in the Federal Register. The 
Commission believes that accelerated approval of the NASD's proposal is 
appropriate given the fact that the Order Execution Rules become 
effective on January 20, 1997. These rules will likely result in a more 
order driven environment in which market makers' quotes frequently 
reflect customer limit orders. This could make compliance with the 
current excess spread rule difficult and thus exacerbate the concerns 
outlined by the Commission in its 21(a) Report

[[Page 3727]]

regarding the current excess spread rule's effect on price competition 
in the Nasdaq market.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1 to the proposed rule change. 
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 Amendment No. 1 that 
are filed with the Commission, and all written communications relating 
to Amendment No. 1 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 file 
number SR-NASD-96-50 and should be submitted by February 14, 1997.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act, that the proposed rule change SR-NASD-96-50 be, and 
hereby is, approved effective January 20, 1997 through July 1, 1997.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\15\
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    \15\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 97-1681 Filed 1-23-97; 8:45 am]
BILLING CODE 8010-01-M