[Federal Register Volume 62, Number 141 (Wednesday, July 23, 1997)]
[Notices]
[Pages 39565-39568]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-19445]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38851; File No. SR-NASD-97-49]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing and Order Granting Accelerated Approval 
to Proposed Rule Change Relating to an Extension of the NASD's Rule 
Permitting Market Makers To Display Their Actual Quotation Size

July 18, 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 July 11, 
1997, 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 and is approving the 
proposal on an accelerated basis.

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

    The NASD proposes to extend the effectiveness of NASD Rule 
4613(a)(1)(C) until December 31, 1997. NASD Rule 4613(a)(1)(C) provides 
that market makers in the first fifty Nasdaq stocks subject to the 
Commission's Limit Order Display Rule are allowed to quote their actual 
quote size (``Actual Size Rule'').1 The text of the proposed 
rule change is as follows. (Additions are italicized; deletions are 
bracketed.)
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    \1\ The NASD has concurrently requested that the pilot for the 
Actual Size Rule be expanded to apply to 100 additional Nasdaq 
securities and extended until March 27, 1998. See Letter from Robert 
E. Aber, Vice President and General Counsel, The Nasdaq Stock 
Market, Inc., to Katherine England, Assistant Director, Office of 
Market Supervision, Division of Market Regulation, Commission, dated 
July 10, 1997.
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* * * * *
NASD Rule 4613  Character of Quotations
    (a) Two-Sided Quotations.
    (1) No change.
    (A)-(B) No change.
    (C) As part of a pilot program implemented by The Nasdaq Stock 
Market, during the period January 20, 1997 through at least [July 18] 
December 31, 1997,2 a registered market maker in a security 
listed on The Nasdaq Stock Market that became subject to mandatory 
compliance with SEC Rule 11Ac1-4 on January 20, 1997 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.
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    \2\ The NASD filed an amendment (``Amendment No. 1'') to extend 
the pilot to December 31, 1997, rather than September 26, 1997. See 
Letter from Robert E. Aber, Vice President and General Counsel, The 
Nasdaq Stock Market, Inc., to Katherine England, Assistant Director, 
Office of Market Supervision, Division of Market Regulation, 
Commission, dated July 17, 1997.
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* * * * *

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 August 29, 1996, the Commission promulgated a new rule and 
adopted amendments to other SEC rules that are designed to enhance the 
quality of published quotations for securities and promote competition 
and pricing efficiency in U.S. securities markets (these rules are 
collectively referred to hereinafter as the ``Order Handling

[[Page 39566]]

Rules'').3 With respect to securities listed on Nasdaq, the 
Order Handling Rules are being implemented according to a phased-in 
implementation schedule. In particular, fifty Nasdaq securities became 
subject to the rules on January 20, 1997 (``first fifty) 4 
and an additional 650 Nasdaq securities have been phased in under the 
Order Handling Rules since that time.5 The remaining Nasdaq 
securities will become subject to the rules according to time tables 
established by the Commission.6
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    \3\ See Securities Exchange Act Release 37619A (September 6, 
1996), 61 FR 48290 (September 12, 1996) (``Order Handling Rules 
Adopting Release'').
    \4\ See Securities Exchange Act Release No. 38139 (January 8, 
1997), 62 FR 1385 (January 10, 1997).
    \5\ See Securities Exchange Act Release No. 38490 (April 9, 
1997), 62 FR 18514 (April 16, 1997); Securities Exchange Act Release 
No. 38246 (February 5, 1997), 62 FR 6468, (February 12, 1997).
    \6\ See Securities Exchange Act Release No. 38490 (April 9, 
1997), 62 FR 18514 (April 16, 1997).
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    In particular, the SEC adopted Rule 11Ac1-4, the ``Display Rule,'' 
which requires the display of customer limit orders: (1) That are 
priced better than a market maker's quote; 7 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.8 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.9 The other rule changes adopted by the SEC involve 
amendments to the SEC's Firm Quote Rule, Rule 11Ac1-1. The most 
significant of these amendments 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 (``ECN Rule''). 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: (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.
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    \7\ 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).
    \8\ 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).
    \9\ There are eight exceptions to the immediate display 
requirement of the Limit Order 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. See Rule 
11Ac1-4(c).
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    In order to facilitate implementation of the SEC's Order Handling 
Rules and reflect the order-driven nature of the Nasdaq market that 
will be brought about by implementation of these rules, on January 10, 
1997, the Commission approved a variety of amendments to NASD rules and 
Nasdaq's Small Order Execution System (``SOES'') and SelectNet 
Service.\10\ In particular, one of the NASD Rule changes approved by 
the Commission as a temporary pilot provides that Nasdaq market makers 
in the ``first fifty'' stocks subject to the Commission's Limit Order 
Display Rule are required to display a minimum quotation size of one 
normal unit of trading when quoting solely for their own proprietary 
account.\11\ For Nasdaq stocks outside of the ``first fifty,'' the 
minimum quotation size requirements remain the same.\12\
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    \10\ See Securities Exchange Act Release No. 38156 (January 16, 
1997), 62 FR 2415 (order partially approving SR-NASD-96-43) 
(``Actual Size Quote Rule Approval Order'').
    \11\ Thus, the Actual Size Rule does not affect a market maker's 
obligation to display the full size of a customer limit order. If a 
market maker is required to display a customer limit order for 200 
shares or more, it must display a quote size of at least 200 shares 
absent an exemption from the Display Rule.
    \12\ In particular, NASD Rule 4613(a)(2) requires each market 
maker in a Nasdaq issue other than those in the ``first fifty'' 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 issues 
and 500 or 100 shares for Nasdaq SmallCap Market issues) 
(``Mandatory Quote Size Requirements'').
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    The NASD submitted the proposal for the Actual Size Rule because it 
believed, and continues to believe, that the new order-driven nature of 
Nasdaq brought about by the Display Rule obviates the regulatory 
justification for minimum quote size requirements because investors 
will have the capability to display their own orders on Nasdaq. The 
NASD believed it was appropriate to impose the Mandatory Quote Size 
Requirements to ensure an acceptable level of market liquidity when 
Nasdaq market makers were the only market participants who could quote. 
Now that the Display Rule permits investors to set the quote, the NASD 
believes it is appropriate to treat Nasdaq market makers in a manner 
equivalent to exchange specialists and not subject them to minimum 
quote size requirements when they are not representing customer orders. 
In sum, with the successful implementation of the SEC's Order Handling 
Rules, the NASD believes that mandatory quote size requirements impose 
unnecessary regulatory burdens on market makers which are not 
consistent with the Act.
    At the same time, the NASD does not believe that implementation of 
the Actual Size Rule in an environment where limit orders are displayed 
has or will compromise the quality of the Nasdaq market. First, the 
display of customer limit orders enhances the depth, liquidity, and 
stability of the market and contributes to narrower quoted spreads, 
thereby mitigating the effects of the loss of displayed trading 
interest, if any, by market makers. Second, removing artificial quote 
size requirements may lead to narrower market maker spreads, thereby 
reducing investors' transaction costs. Third, permitting market makers 
to quote in size commensurate with their own freely-determined trading 
interest will enhance the pricing efficiency of the Nasdaq market and 
the independence and competitiveness of dealer quotations. Fourth, 
removing quotation size requirements will facilitate greater quote size 
changes, thereby increasing the information content of market maker 
quotes by facilitating different quote sizes from dealers who have a 
substantial interest in the stock at a particular time and those who do 
not.
    Indeed, in its order approving the Actual Size Rule, the Commission 
noted that it ``preliminarily believes that the proposal will not 
adversely affect market quality and liquidity'' \13\ and that it 
``believes there are substantial reasons * * * to expect that reducing 
market makers' proprietary quotation size requirements in light of the 
shift to a more order-driven market would be beneficial to investors.'' 
\14\ In addition, the Commission stated that, ``based on its experience 
with the markets and discussions with market participants, [it] 
believes that decreasing the required quote size will not result in a 
reduction in liquidity that will hurt investors.'' \15\
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    \13\ See Actual Size Rule Approval Order, supra note 5 at 2425.
    \14\ Id. at 2423.
    \15\ Id. at 2424.
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    Nevertheless, in light of concerns raised by commenters opposed to 
the Actual Size Rule regarding the potential adverse impacts of the 
Rule on market liquidity and volatility, the Commission determined to 
approve the Rule on a

[[Page 39567]]

three-month pilot basis to afford the Commission, the NASD and Nasdaq 
an opportunity to gain practical experience with the rule and evaluate 
the effects of the Rule. The factors identified by the Commission to be 
considered in this evaluation include, among others, the impact of 
reduced quotation sizes on liquidity, volatility and quotation spreads. 
\16\
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    \16\ The Commission stated that ``the NASD study should include 
an analysis of: (1) The number of market makers in each of the 50 
securities, and any change in the number over time; (2) the average 
aggregate dealer and inside spread by stock over time; (3) the 
average spread for each market maker by stock; (4) the average depth 
by market maker (including limit orders), and any change in the 
depth over time; (5) the fraction of volume executed by a market 
maker who is at the inside quote by stock; and (6) a measure of 
volume required to move the price of each security one increment (to 
determine the overall liquidity and volatility in the market for 
each stock). The Commission expects that these factors should be 
contrasted over the time period immediately preceding the pilot and 
after the beginning of the pilot.'' Id. at 2425. In addition, the 
Commission stated that the NASD should conduct a similar study to 
compare the ``first fifty'' stocks (to which the Rule applied) with 
the ``second fifty'' stocks (stocks subject to the SEC's Order 
Handling Rules but not the Actual Size Rule). Id.
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    On April 11, 1997, the Commission approved an NASD rule filing that 
extended the duration of the pilot program until July 18, 1997.\17\ In 
this filing, the NASD and Nasdaq provided statistical information 
prepared by the NASD's Economic Research Department concludes that: (1) 
The SEC's Order Handling Rules have dramatically improved the quality 
of the Nasdaq market, particularly with respect to the size of quoted 
spreads; (2) among those securities subject to the SEC's Order Handling 
Rules, there is no appreciable difference in market quality between 
those stocks subject to the Actual Size Rule and those stocks subject 
to Mandatory Quote Size Requirements; and (3) implementation of the 
Actual Size Rule has not resulted in any significant diminution of the 
ability of investors to receive automated executions through SOES, 
SelectNet, or proprietary systems operated by broker-dealers.\18\ 
Subsequently, on June 3, 1997, the NASD submitted a formal study to the 
Commission on the Actual Size Rule that, among other things, reiterated 
these findings and provided more detailed information on the NASD's 
analysis of the Rule.\19\
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    \17\ See Securities Exchange Act Release No. 38512 (April 15, 
1997), 62 FR 19373 (April 21, 1997).
    \18\ See id. at 19375-77.
    \19\ See Securities Exchange Act Release No. 38720 (June 5, 
1997), 62 FR 31856 (June 11, 1997). A copy of the executive summary 
of this report is available at Nasdaq's World Wide Web site at 
``http://www.nasdaq.com''. Members of the public may also download a 
file containing the entire report at this site.
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    The NASD is proposing a further extension of the 50 stock pilot for 
the Actual Size Rule until December 31, 1997. The NASD and Nasdaq 
believe that experience with the Actual Size Rule has clearly 
demonstrated that the Rule has not harmed investors or the quality of 
the Nasdaq market and, thus, that the Rule should be permanently 
approved and expanded to all Nasdaq securities. Nevertheless, the NASD 
and Nasdaq believe it is prudent, in response to suggestions made by 
Commission staff, to extend the 50 stock pilot program for the Rule 
until December 31, 1997. Specifically, with the additional experience 
with the Actual Size Rule that extension of the pilot period will 
provide, the NASD and Nasdaq believe the Commission's analysis of the 
NASD's proposal for expansion of the Rule will be more comprehensive.
    For the reasons noted above, the NASD believes the proposed rule 
change is consistent with Sections 11A(a)(1)(C), 15A(b)(6), 15A(b)(9), 
and 15A(b)(11) of the Act. 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.

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. 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 file number SR-NASD-97-49 and 
should be submitted by August 13, 1997.

IV. Commission's Findings and Order Granting Accelerated Approval of 
Proposed Rule Change

    The Commission finds that the NASD's proposal is consistent with 
the Act and the rules and regulations thereunder applicable to a 
national securities association and has determined to approve the 
extension of the pilot through at least December 31, 1997.\20\ The 
Commission approved the Actual Size Rule on a pilot basis so that the 
effects of the rule could be assessed. When approving the Actual Size 
Rule on a pilot basis, the Commission stated that it believed that a 
reduction in the quotation size requirement could reduce the risks that 
market makers must take, produce accurate and informative quotations, 
and encourage market makers to maintain competitive prices even in the 
changing market conditions resulting from the Order Execution Rules. 
The NASD has produced an extensive economic analysis of the pilot, and 
several commentators have provided their own economic analysis in 
rebuttal. An extension of the pilot

[[Page 39568]]

will provide the Commission with an additional period of time to 
evaluate the economic studies and review the comments on the NASD's 
study. In addition, the Commission believes that the proposed rule 
change will benefit the markets by providing more experience with the 
rule before a decision is made regarding permanent approval. The 
Commission will consider the NASD's further proposals regarding the 
Actual Size Rule in the coming months, as well as the future of the 50 
stock pilot itself. Accordingly, the Commission believes that the pilot 
is consistent with Sections 15A(b)(6) and 15A(b)(9) of the Act and 
should be extended beyond the July 18, 1997, expiration date. The 
Commission finds good cause for approving the proposed rule change 
prior to the thirtieth day after the date of publication of notice of 
filing thereof in the Federal Register in order to continue the pilot 
on an uninterrupted basis while it evaluates the NASD's proposal for 
expansion of the pilot.
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    \20\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (SR-NASD-97-49) be, and hereby is, 
approved.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\21\
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    \21\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-19445 Filed 7-22-97; 8:45 am]
BILLING CODE 8010-01-U