[Federal Register Volume 62, Number 214 (Wednesday, November 5, 1997)]
[Notices]
[Pages 59932-59938]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-29296]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39285; File No. SR-NASD-97-26]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Approval to Proposed Rule Change and 
Notice of Filing and Order Granting Accelerated Approved to Amendment 
No. 3 Relating to an Extension and Expansion of the Pilot for the 
NASD's Rule Permitting Market Makers To Display Their Actual Quotation 
Size

October 29, 1997.

I. Background

    On April 11, 1997, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association'') filed with the Securities and 
Exchange Commission (``Commission'' or ``SEC'') 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\ to amend NASD Rule 
4613(a)(1)(C) by (a) expanding from 50 to 150 the number of securities 
in a pilot program for which market makers may quote their actual size 
by reducing the minimum quotation size requirement for market makers in 
certain securities listed on the Nasdaq Stock Market (``Nasdaq'') to 
one normal unit of trading (``Actual Size Rule''), and (b) extending 
the pilot through December 31, 1997.\3\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ November 18, 1996, the NASD filed with the Commission a 
proposed rule change to implement the Actual Size Rule on a pilot 
basis. (SR-NASD-96-43). Among other things, the filing and 
subsequent amendments proposed to allow market makers to quote in 
minimum sizes of 100 shares for a three-month pilot Program in the 
50 Nasdaq securities subject to mandatory compliance with Exchange 
Act Rule 11Ac1-4 (``Limit Order Display Rule'') on January 20, 1997. 
The remaining securities were still subject to the existing minimum 
quotation display requirements for proprietary quotes. The proposed 
rule change was intended by the NASD to facilitate the display of 
customer limit orders in accordance with the Limit Order Display 
Rule. The Commission approved the pilot through April 18, 1997. 
Securities Exchange Act Release 38512 (April 15, 1997) 62 FR 19373 
(April 21, 1997) (SR-NASD-97-25).
    On April 15, 1997, the Commission issued an order granting 
accelerated approval to a NASD proposed rule change that extended 
the pilot from April 18, 1997, to July 18, 1997. Securities Exchange 
Act Release 38512 (April 15, 1997) 62 FR 19373 (April 21, 1997) (SR-
NASD-97-25).
    On July 18, 1997, the Commission approved a rule change proposed 
by the NASD to extend the pilot from July 18, 1997 to December 31, 
1997. Securities Exchange Act Release No. 38851 (July 18, 1997) 62 
FR 39565 (July 23, 1997) (SR-NASD-97-49). The Commission did so to 
give it additional time to evaluate the economic studies and review 
the public's comments on the NASD's June 3, 1997, study. In 
addition, the Commission stated that it believed that extending the 
pilot would benefit the markets by providing more experience with 
the Actual Size Rule before a decision is made regarding approval.
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    On July 10, 1997, the NASD filed Amendment No. 1 to the proposed 
rule change proposing to extend the pilot through March 27, 1998 and 
expand it to 150 stocks.\4\ On July 17, 1997, the NASD filed with the 
Commission Amendment No. 2, to correct a technical deficiency in 
Amendment No. 1.\5\ The proposal was noticed for comment on July 24, 
1996.\6\
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    \4\ 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.
    \5\ 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.
    \6\ Securities Exchange Act Release No. 38872 (July 24, 1997) 62 
FR 40879 (July 30, 1997) (SR-NASD-97-26).
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    On September 15, 1997, the NASD filed Amendment No. 3,\7\ proposing 
to extend the pilot as previously noted and to expand the pilot by 
adding a different group of 100 securities to those 50 currently 
subject to the Actual Size Rule (``First 50'') than was proposed in 
Amendment Nos. 1 and 2. The NASD believes that this second group of 
securities will provide a better basis for comparison and economic 
analysis comparing the Actual Size Rule's effect on pilot and non-pilot 
Nasdaq securities. In addition, Nasdaq proposes to replace some of 
securities in the initial 50 stock pilot that are no longer listed on 
Nasdaq. Amendment No. 3 also proposed extending the pilot through March 
27, 1998.
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    \7\ 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 September 15, 1997.
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    For the reasons discussed below, the Commission has determined to 
approve the proposed rule change.

II. Proposed Rule Change

    The NASD proposes to amend NASD Rule 4613(a)(1)(C) to allow market 
makers to quote their actual size by reducing the minimum quotation 
size requirement for market makers in certain securities listed on 
Nasdaq to one normal unit of trading. As discussed below, the Actual 
Size Rule presently applies to a group of 50 Nasdaq securities on a 
pilot basis. The proposed rule change would expand the pilot group to 
150 stocks and extend the pilot until March 27, 1998. The text of the 
proposed rule change is as follows. (Additions are italicized; 
deletions are bracketed.)
* * * * *

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 [December 
31, 1997] March 27, 1998, 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 or identified by 
Nasdaq as being otherwise subject to the pilot program as expanded and 
approved by the Commission, must display a quotation

[[Page 59933]]

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.
* * * * *

III. Comments \8\

    The Commission received over 350 comment letters.\9\ A separate 
summary of comments has been prepared and is available in the public 
file. The relevant issues addressed by commenters are discussed in the 
appropriate sections of this order.
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    \8\ In order to give the public additional time to comment on 
the economic analysis of the pilot that the NASD filed with the 
Commission on June 3, 1997, the Commission extended the comment 
period to July 3, 1997. Securities Exchange Act Release No. 38720 
(June 5, 1997) 62 FR 38156 (June 11, 1997) (SR-NASD-97-26).
    \9\ The Commission received comment letters from numerous 
broker-dealer firms, some of which are market makers and others that 
are order entry firms. The Commission received comment letters from 
a large number of individuals who could be identified as SOES 
traders. The Commission also received comment letters from several 
academicians, individual investors, and professional associations.
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IV. Discussion

    On August 29, 1996, the Commission promulgated a new rule, the 
Limit Order Display Rule \10\ and adopted amendments to the Quote 
Rule,\11\ which together are designed to enhance the quality of 
published quotations for securities and promote competition and pricing 
efficiency in U.S. securities markets (collectively, the ``Order 
Execution Rules'').\12\ With respect to securities included on Nasdaq, 
the Order Execution Rules were implemented according to a phased-in 
implementation schedule: 50 Nasdaq securities became subject to the 
rules on June 20, 1997 (``first 50''), 50 more securities became 
subject to the rules on February 10, 1977 (``second 50''); and an 
additional 50 securities became subject to the rules on February 24, 
1997. The remaining Nasdaq securities were phased in on October 13, 
1997.\13\
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    \10\ 17 CFR 240.11Ac1-4.
    \11\ 17 CFR 240.11Ac1-1.
    \12\ See Securities Exchange Act Release No. 37619A (September 
6, 1997) 61 FR 48290 (September 12, 1996) (``Order Execution Rules 
Adopting Release'').
    \13\ See, e.g., Securities Exchange Act Release No. 38490 (April 
9, 1997); Securities Exchange Act Release No. 38870 (July 24, 1997).
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    The SEC's Limit Order Display Rule requires the display of customer 
limit orders, that: (1) Are priced better than a market maker's 
quote,\14\ or (2) add to the size associated with a market maker's 
quote when the market maker is at the best price in the market.\15\ By 
virtue of the Limit Order Display Rule, investors 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.\16\ The Order Execution Rules also 
included amendments to the SEC's Quote Rule, the most significant of 
which requires a market maker to display in its quote any better priced 
orders that it 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 
included in the public quotation; 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 
(``ECN Display Alternative'').
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    \14\ 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).
    \15\ For example, if a market maker receives a customer 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 National Best Bid or Offer (``NBBO'') 
for ABCD is 10-10\1/8\, the market maker must update its quote to 
10-10\1/4\ (1200 x 1000).
    \16\ 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 Execution 
Rules and reflect the change in the Nasdaq market that was to be 
brought about by the implementation of these rules, the Commission 
approved, on January 10, 1997, a variety of amendments to NASD Rules 
pertaining to Nasdaq's Small Order Execution System (``SOES'') and the 
SelectNet Service (``SelectNet'').\17\ In particular, one of the NASD 
Rule changes approved by the Commission provides on a temporary basis 
that Nasdaq market makers in the first 50 securities subject to the 
Commission's Limit Order Display Rule are only required to displayed a 
minimum quotation size of one normal unit of trading when quoting 
solely for their own proprietary account (i.e., the Actual Size 
Rule).\18\ They can display a greater quotation size if they so choose 
(or if required by the Limit Order Display Rule). For Nasdaq securities 
outside of the first 50, the minimum quotation size requirements of 
1,000, 500, or 200 shares remained the same.\19\
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    \17\ See Actual Size Rule Approval Order.
    \18\ Thus, the Actual Size Rule does not effect 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 
or more shares, it must display a quote size reflecting the size of 
the customer's order, absent an exception from the Limit Order 
Display Rule.
    \19\ In particular, NASD Rule 4613(a)(2) requires each market 
maker in a Nasdaq issue other than those in the first 50 to enter 
and maintain two-sided quotations with a minimum size equal or 
greater than the applicable SOES tier size for the security (e.g., 
1000, 500 or 200 shares for Nasdaq National Market issues and 500 or 
100 shares for Nasdaq SmallCap Market issues (``Mandatory Quote Size 
Requirement'').
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    The NASD submitted the proposal for the Actual Size Rule because it 
believed, and continues to believe, that the changes in Nasdaq brought 
about by the Limit Order Display Rule obviates the regulatory 
justification for minimum quote size requirements because investors now 
have the capability to display their orders on Nasdaq. The NASD 
originally imposed the Mandatory Quote Size Requirements to ensure an 
acceptable level of market liquidity and depth in an environment where 
Nasdaq market markers were the only market participants who could 
affect quotation prices. Now that the Limit Order Display Rule permits 
investors to enter orders as part of 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 Execution Rules, 
the NASD believes that Mandatory Quote Size Requirements impose 
unnecessary regulatory burdens on market makers.
    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 
NASD believes that 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

[[Page 59934]]

market makers. Second, it also believes that removing artificial quote 
size requirements may lead to narrower market spreads, thereby reducing 
investors' transaction costs. Third, the NASD asserts that 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 dealers 
quotations. Fourth, the NASD suggests that removing quotation size 
requirements will allowing 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 on a pilot 
basis, the Commission noted that it ``preliminary believes that the 
proposal will not adversely affect market quality and liquidity'' \20\ 
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.'' \21\ 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. 
''\22\
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    \20\ See Actual Size Approval Order, 62 FR at 2425.
    \21\ Id. 62 FR at 2423.
    \22\ Id. 62 FR at 2424.
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    Nevertheless, in light of concerns raised by commentators opposed 
to the Actual Size Rule regarding the potential adverse impacts of the 
rule on market liquidity and volatility, the Commission originally 
determined to approve the rule on a three-month pilot basis to afford 
to the Commission and the NASD an opportunity to gain practical 
experience with the rule and evaluate its effects. 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.\23\
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    \23\ See 62 FR 2415 at 2425.
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    As detailed below, the NASD has concluded that implementation of 
the SEC's Order Execution Rules has significantly improve the quality 
of the Nasdaq market by creating a market structure where customer 
limit orders provide liquidity and effectively compete with market 
maker quotations. In this type of environment, the NASD believes that 
regulatory necessity for the Mandatory Quote Size Requirements no 
longer exists. Nonetheless, the NASD determined to extend and broaden 
the pilot to gain greater experience with voluntary quotation size. The 
NASD is proposing the pilot be expanded to include an additional 100 
securities and extended until March 27, 1998.
    To evaluate that pilot, the NASD's Economic Research Department 
conducted an economic analysis of the pilot's operation and of the 
impact of the Commission's Order Handling Rules.\24\ The analyses thus 
far indicates three general findings concerning implementation of the 
SEC's Order Execution Rules and the Actual Size Rule: (1) The SEC's 
Order Execution Rules have dramatically improved the quality of the 
Nasdaq market, particularly with respect to the size of spreads: (2) 
among those securities subject to the SEC's Order Execution Rules, 
there is no appreciable difference in market quality between those 
securities subject to the Actual Size Rule and those securities subject 
to Mandatory Quote Size Requirements;\25\ 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. 
Accordingly, as is the case with 100-share minimum quotation size 
requirements applicable to exchange specialists in order-driven 
markets, the NASD believes that the Actual Size Rule has not harmed 
investors or the quality of the Nasdaq market.
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    \24\ On June 3, 1997, the NASD published an economic analysis 
entitled ``Effects of the Removal of Minimum Sizes for Proprietary 
Quotes in the Nasdaq Stock Market, Inc.'' (June Study). On September 
10, 1997, the NASD published a related study entitled 
``Implementation of the SEC Order Handling Rules'' (September 
Study). Both studies are available to the public at Nasdaq's World 
Wide Web sit at ``http://www.nasdaq.com''.
    \25\ The first 50 securities includes Nasdaq's top ten issues by 
dollar volume plus 40 issues chosen from Nasdaq's top 500 issues: 8 
ranked between 11 and 100; 8 ranked between 101 and 200; 8 ranked 
between 201 and 300; 8 ranked between 301 and 400; 8 ranked between 
401 and 500. The second 50 securities include the ten Nasdaq stocks 
and ranked between 11 and 20 by dollar volume plus 40 stocks chosen 
from Nasdaq's top 500 stocks in the same manner explained above. The 
ten largest Nasdaq stocks in the first 50 have no comparable peer 
group among Nasdaq stocks and the next ten largest Nasdaq stocks 
(i.e., Nasdaq stocks ranked 11-20 in size) included in the second 50 
are also not comparable to the ``bottom 40'' of either the first 50 
or second 50. The Nasdaq stocks ranked 1-20, therefore, have been 
excluded from the analysis comparing the first 50 and the second 50. 
Accordingly, the ``first forty'' stocks are those stocks that are 
the ``bottom 40'' within the first 50 stocks and the ``second 
forty'' stocks are those stocks that are the ``bottom 40'' within 
the second 50 stocks.
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    In the June Study, the NASD found that pilot and non-pilot stocks 
experienced virtually the same improvements in market quality since the 
implementation of the Order Handling Rules. Specifically, the NASD 
found that investors in pilot stocks continued to have substantial and 
reasonable access to market maker capital through both SOES and market 
makers' proprietary automatic execution systems.\26\
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    \26\ June Study at 2.
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A. Implementation of the SEC's Order Execution Rules Has Resulted in 
Significant Benefits to Investors and Enhanced the Quality of the 
Nasdaq Market

    NASD Economic Research evaluated measures of market quality in four 
main areas: spread, volatility, quoted depth, and liquidity. The Pilot 
Stocks and the second tranche of 50 stocks to become subject to the 
Order Handling Rules both include 40 stocks selected from the first 
through fifth deciles of the 1,000 most active Nasdaq stocks. 
Therefore, those from the Pilot Stocks (``First 40'') are reasonable 
peers of those from the February 10 tranche (``Second 40'').\27\ The 
NASD believes that, as shown below, the similar performance of the 
First 40 and Second 40 indicates that the Actual Size Rule did not 
impair the markets for these securities.
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    \27\ The remaining 10 stocks in the first tranche were roughly 
the top 10 stocks (``First 10''), and the remaining 10 from the 
second tranche were roughly stocks 11 through 20 (``Second 10''). 
Consistent with the Commission's request for a ``matched pairs 
analysis,'' the First 10 and Second 10 are excluded from this 
analysis, because these groups do not demonstrate similar trading 
characteristics and hence cannot be properly compared. See Actual 
Size Approval Order, 62 FR at 2425. Indeed, inclusion of the First 
10 and Second 10 would likely produce skewed results. The market 
quality improvements induced by the Order Handling Rules, however, 
are apparent in both the First and Second 10.
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1. Spreads \28\
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    \28\ See also Summary of Comments, Section B.6.
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    The NASD looked at mean spreads for the First and Second 40 and 
found that mean spreads declined by about $0.12 for both the First 40 
and the Second 40, or by about 33%. For the First 40, the mean spread 
declined from $0.41 to $0.28, and for the Second 40 the mean spread 
declined from $0.36 to $0.24. The results in the NASD's study indicate 
an equivalent spread effect across the two groups. These results 
provide no statistically significant evidence of a differential change 
in quoted spreads between the First 40 and Second 40. Therefore, the 
NASD believes there is no effect on quoted spreads associated with 
removal of the 1,000-Share Quote Size Rule.

[[Page 59935]]

2. Volatility \29\
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    \29\ See also Summary of Comments, Section B.5.
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    The NASD looked at the volatility of the First and Second 40 and 
found that volatility slightly increased following the imposition of 
the Order Handling Rules for both the First 40 and the Second 40. For 
the First 40, average volatility rose from 1.16% to 1.25%, an increase 
of 7.6%. For the Second 40, volatility rose from 0.98% to 1.24%. It 
also found that the increase in volatility does not, however, appear to 
be attributable to the Order Handling Rules, because volatility also 
increased for other stocks in the top 500 that had not become subject 
to the Order Handling Rules during the sample period.
    On the surface, the results indicate a general increase in 
volatility, in particular for the Second 40 stock group. In order to 
correct for stock-specific characteristics such as price, volume, and 
interday volatility, the NASD used a multivariate regression analysis. 
The multivariate regression results show that the differential increase 
in volatility for the Second 40 can be attributed to volume, price, and 
interday volatility.\30\ In the presence of these factors, the 
differential volatility effect on the Second 40 is statistically 
insignificant. The NASD found that these results demonstrate that there 
is no statistically significant evidence of a differential change in 
intraday volatility between the First 40 and Second 40.
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    \30\ June Study at 31.
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3. Quoted Depth Measures
    The NASD examined the impact of the Actual Size Rule on quoted 
depth. First the NASD studied the percentage change in number of market 
makers and the percentage change in number of market makers at the 
market maker inside market. After performing a regression analysis, it 
found no statistically significant difference between the First 40 and 
the Second 40.\31\ For both measures, the marginal impact of the 
removal of the 1,000-Share Quote Size Rule is negligible. The NASD also 
studied the distribution of the sizes of all dealer quote updates. It 
found that quote updates for 100 and 1,000 share stocks were similar 
for the First 40 and the Second 40.\32\
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    \31\ June Study at 35 and Table B.5 of Appendix B.
    \32\ June Study at 34.
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    Based on this evidence, the NASD concluded that the changes in 
quoting behavior induced by the implementation of the Order Handling 
Rules have been qualitatively similar for both the First 40 and Second 
40.
4. Liquidity \33\
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    \33\ See also Summary of Comments, Section B.4.
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    The NASD looked at effective depth in order to measure liquidity. 
Similar to the sections on spread, volatility, and quoted depth 
measures above, the change in normalized effective depth \34\ after 
implementation of the Order Handling Rules was calculated for the First 
40 and Second 40. Effective depth is calculated for each Bid-Ask 
Midpoint (``BAM'') movement category, and mean values across all stocks 
and days in the sample for each category were calculated. The NASD 
applied multivariate regression analysis and found that there is no 
statistically significant association between the removal of the 1,000-
Share Quote Size Rule and any change in normalized effective depth.
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    \34\ Normalized effective depth is defined as the dollar volume 
required to move the BAM one percentage point, calculated for BAM 
moves of the following percentage movements; all movements, 0.5%, 
1%, 1.5%, 2%, 2.5%, and 3%.
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    After accounting for changes in stock price, trading volume, and 
interday volatility, the NASD found no evidence of a statistically 
significant association between the removal of the regulatory minimum 
size for proprietary quotes and a change in liquidity.

B. Implementation of the Actual Size Rule Has Not Resulted in any 
Diminution in the Ability of Investors To Receive Automated Executions 
Through SOES, SelectNet, or Other Proprietary Systems Operated by 
Broker Dealers \35\
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    \35\ See also Summary of Comments, Section B.9.
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    For some market participants, Nasdaq's SOES system is the primary 
means they use to obtain executions. Use of the SOES system has 
increased over the past few years. SOES executions accounted for 8.3% 
of all Nasdaq share volume in 1996, up from 5.6% in 1995 and 3.0% in 
1993. Much of the SOES activity is derived from day traders. The 
majority of SOES orders are for 1,000 shares, the maximum tier size for 
stocks.
    As detailed above, the SOES system was changed on January 20 to 
execute orders based on market maker quoted size. The NASD examined 
SOES activity to determine if the removal of the 1,000-Share Quote Size 
Rule diminished the ability of the SOES system to provide executions.
    First, the NASD examined whether the incidence of ECNs alone at the 
inside market was different for the First 40 and Second 40 stocks. When 
an ECN is alone at the inside, SOES is unavailable. The NASD found that 
ECNs were alone at the inside market only 9.2% of the time after 
implementation of the Order Handling Rules for the First 40 stocks, and 
only 9.4% of the time for the Second 40.\36\ Second, the NASD examined 
how often all market makers at the inside market were quoting a size of 
100. The NASD found that this occurred only 1.6% of the time in the 
First 40 stocks and only 0.8% of the time in the Second 40.
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    \36\ The NASD also found that between August 11 and 29, 1997, 
SOES access was restricted to 100 shares only 1.2% of the time. That 
is, only 1.2% of the trading day was it the case that there was no 
market maker at the inside quoting an amount greater than 100 
shares. September Study at 4.
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    Both measures provide evidence from which the NASD concluded that 
times during which SOES is unavailable are uncommon and that the degree 
of any degradation of the effectiveness of SOES due to the Actual Size 
Rule is statistically insignificant. Moreover, the NASD concluded that 
only certain measures of SOES performance (e.g., multiple price SOES 
executions, average SOES trade size) have experienced any marginal 
change between the First 40 and the Second 40.\37\ To the extent a 
marginal difference exists, the NASD found it to be slight and 
therefore concluded that the removal of the 1,000-Share Quote Size Rule 
has had no meaningful effect on the SOES system's ability to provide 
reasonable access to executions.
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    \37\ See June Study at 42-46. For example, for the First 40, 
average SOES trade size fell by 15.0% and by 6.0% for the Second 40. 
It is important to note, however, that given that the mean price of 
stocks in the First 40 was roughly $35, the average SOES trade size 
of 753 shares represents a trade of approximately $26,000. Compared 
to most retail activity, the average SOES trade in the First 40 
continues to be quite large. Given that the average SOES trade size 
is still large and that SOES continues to account for a substantial 
proportion of Nasdaq dollar volume, it is unlikely that the decrease 
in average trade size of SOES executions has negatively impacted the 
ability of the SOES system to provide executions for retail-size 
orders.
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C. Response to Electronic Traders Association (``ETA'') Study \38\

    The ETA is an association representing SOES order entry firms whose 
customers use SOES for day trading. The ETA conducted its own study of 
the Actual Size Rule. Its study found that SOES orders in pilot stocks 
are less likely to be executed than for non-pilot stocks; that the mean 
time between entry and execution of a SOES order is longer for pilot 
than for non-pilot stocks; and that the mean price concession is larger 
for pilot stocks than for non-pilot stocks.
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    \38\ See also Summary of Comments, Section B. 10.
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    The NASD examined the ETA study and found it seriously flawed. The 
NASD noted that the ETA study is based on a small sample of data from 
three of

[[Page 59936]]

the 425 firms that enter orders through SOES; the ETA does not 
distinguish between SOES orders that were actively canceled by the 
order entry firm and those that were returned to the order entry firm; 
and the ETA report does not account for considerable differences in the 
average trading characteristics (e.g., price, volume) between pilot and 
non-pilot stocks. The NASD found that the ETA study provides ``no basis 
to conclude that the Actual Size Rule has adversely affected the 
ability of the SOES system to provide investors with reasonable access 
to market maker capital.'' \39\
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    \39\ September study at 3.
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D. The Pilot Justifies an Expansion and Extension of the Actual Size 
Rule

    While some market participants may maintain that the Actual Size 
Rule should be abandoned because it has not had a demonstrably positive 
market impact, the NASD believes, in light of the pilot experience and 
its economic research, that the Rule should be retained. The NASD 
believes it eliminates an unnecessary regulatory requirement and, 
moreover, it has not had any adverse market impacts. In particular, 
with respect to the first 50 securities, the NASD believes that 
competitive forces in the marketplace, be they the result of displaying 
customer limit orders, ECN quote display, or market maker competition 
for order flow, have driven the Nasdaq market to perform at least as 
well, if not better, than if the artificial 1,000 share minimum 
quotation size requirement was in place.\40\ As a result, given the 
conclusion that the market performs the same with or without the Actual 
Size Rule, the NASD believes it is far preferable for the protection of 
investors and the efficiency of the capital formation process to 
promote a regulatory environment for Nasdaq that achieves its results 
through aggressive competition rather than artificial regulatory fiat. 
In sum, in light of the performance of the first 50 securities, the 
NASD believes there is no regulatory basis to justify the retention of 
artificial quotation size requirements for Nasdaq market makers.
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    \40\ Some market participants have asserted that the lack of 
difference in performance between the First 40 and the Second 40 is 
attributable to the operation of several features of SOES. 
Specifically, these market participants claim that the SOES Auto-
Refresh Feature, which refreshes a market maker quote to the 
applicable SOES tier size once its quote has been completely 
decremented, along with the ``No Decrementation'' and ``Supplemental 
Size'' features of SOES, artificially increase the number of 1000-
share quotes in the first 50 securities. The ``No Decrementation'' 
feature of SOES allows a market maker to provide that its quote 
shall not be decremented after the execution of SOES orders. To use 
this feature, a market maker's quote size must be equal to the 
applicable SOES tier size. The ``Supplemental Size'' feature of SOES 
allows a market maker to establish a ``supplemental size'' that is 
used to automatically replenish a market maker's quote once it has 
been completely decremented. When a market maker's quote is 
replenished from the supplemental size, it is replenished to 1000 
shares. In order to use this feature, a market maker must initially 
enter a quote size equal to or greater than the applicable SOES tier 
size. The NASD notes that market maker's use of each of these system 
features is completely voluntary and they are available for all 
Nasdaq securities. Accordingly, the NASD believes it would be 
inaccurate to assert that these SOES features have obfuscated the 
impact of the Actual Size Rule. Id. 62 FR at 19371.
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    The NASD is proposing to expand the pilot to 150 stocks in order to 
provide a better sample of stocks to use in studying the effects of the 
Actual Size Rule upon the Nasdaq Market. Further, to address criticism 
by several commentators that the group of stocks making up the pilot 
(both currently and as the NASD initially proposed to expand it) is not 
an ideal sample of Nasdaq stocks upon which to base a decision on the 
future of the Actual Size Rule, the NASD altered the group of 100 
stocks it is proposing to add to the current pilot.
    The NASD has selected stocks that are representative of the entire 
Nasdaq market by sampling across dollar volume categories. Within 
dollar volume categories, it sought variation across SOES tier sizes of 
1,000 and 500 shares. The NASD then randomly chose 100 stocks.\41\
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    \41\ Ten additional stocks were chosen to make up for delistings 
within the first 50 stocks in the pilot and as reserves in case 
other pilot stocks delist. Only domestic common stocks were chosen.
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V. Conclusion

    The Commission approved the Actual Size Rule on a pilot basis so 
that the effects of the rule could be assessed. In doing so, 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.
    As discussed above, the NASD has produced an extensive economic 
analysis of the pilot, and several commentators have provided their own 
economic analysis as well. These economic analyses have proved useful 
in assessing the pilot Program's impact on the Nasdaq market. Although 
the economic studies arrive at conflicting results on the value of the 
Actual Size Rule, the Commission preliminarily believes that the data 
indicates that the pilot has not resulted in harm to the Nasdaq market. 
Indeed, as discussed above, the Actual Size Rule appears to be a 
reasonable means to provide market making obligations that reflect the 
new market dynamics produced by the Order Execution Rules. 
Nevertheless, as several commenters noted, the pilot Program was 
limited to 50 out of over 5,000 securities. Moreover, the Commission 
had decided that it would be appropriate to gather further data before 
reaching a final decision as to whether or not to extend the Actual 
Size Rule to the entire Nasdaq market. The Commission notes that there 
has been some disagreement as to how to interpret the data the NASD and 
others have published concerning the pilot Program. This is due in part 
to the limited nature of the pilot Program and the need for commenters 
to extrapolate data concerning these 50 securities to the entire Nasdaq 
market. These problems can be reduced if the pilot is expanded as 
proposed. An extension and expansion of the pilot will provide the 
Commission, the NASD, and market participants with additional data and 
time to study the Order Execution Rules' effects on the Nasdaq market. 
Based upon the expanded pilot, the Commission will be in a better 
position to evaluate the impact of the Actual Size Rule upon the Nasdaq 
market.
    The NASD initially proposed to expand the pilot Program by adding 
the 100 securities that were next to be phased-in under the Order 
Execution Rules earlier this year. Although the first 50 securities 
were chosen to provide a broad cross section of the most liquid Nasdaq 
securities,\42\ the NASD filed Amendment No. 3 to select an additional 
110 securities \43\ from an enhanced sample more representative of the 
entire Nasdaq market. This was done in response to a number of the 
comment letters which suggested that the First 50 securities were not 
representative of the Nasdaq Market. Specifically, it was suggested 
that, because all 30 of the largest Nasdaq stocks were subject to the 
100 share minimum, it was impossible to gauge the Actual Size Rule's 
effect on large Nasdaq stocks, since there were no sufficiently large 
non-pilot stocks with which to compare.
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    \42\ Actual Size Approval Order, 62 FR 2415.
    \43\ As discussed above, ten additional stocks were chosen to 
replace those pilot stocks that have already delisted or that may 
delist in the future. The proposal still calls for the pilot to 
expand from 50 to 150 stocks.
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    These additional 100 securities were chosen from those domestic 
Nasdaq National Market (``NNM'') stocks with a

[[Page 59937]]

SOES tier size of either 1,000 or 500 shares that were not included in 
the First 50. These stocks were ranked by average (mean) daily dollar 
volume over the first seven months of 1997, and then divided into 
deciles, each containing approximately the same number of stocks. 
Eleven stocks were chosen at random from each decile, for a total of 
110 stocks. Ten extra stocks were chosen to make up for four stocks of 
the First 50 that no longer trade on Nasdaq, and as reserves should any 
delist in the interim. This ensures that a total of 150 stocks will be 
ultimately subject to the Actual Size Rule is approved. The chosen 
stocks will be identified in a fax or Notice to Members published after 
SEC approval of the proposed rule change.
    The Commission believes that the proposed amendment is consistent 
with the Exchange Act because it will provide for a more representative 
group of securities under an expanded Actual Size Rule pilot. The next 
100 stocks include securities with significantly different trading 
volumes, so the NASD will be better able to assess the impact of the 
Actual Size Rule on the full panoply of Nasdaq stocks. This will 
further the evaluation of the Actual Size Rule and will assist the SEC 
in its determination as to whether to expand the pilot ultimately to 
all Nasdaq securities or to end it. In addition, Amendment No. 3 
responds to the commentators who expressed concern that an expansion of 
the pilot to 150 stocks would capture stocks that account for a large 
majority of Nasdaq trading volume and SOES activity, and thus act as a 
de facto implementation of the Actual Size Rule. Regardless of the 
validity of this concern, the modified additional 100 stocks no longer 
contain only the next 100 most active stocks.
    The Commission requests that the NASD continue to evaluate the 
effects of the reduction in the minimum quotation size for those Nasdaq 
stocks included in the pilot. Specifically, the NASD should continue 
its analysis of. (1) The number and composition of the market makers in 
each of the 50 securities, and any change 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 per 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). Finally, the 
NASD should compare data for each decile of securities, focusing 
particular attention on relatively active versus inactive securities 
that are among the lower tier of NNM securities, by daily dollar 
trading volume.

VI. 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, NW., Washington, DC 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to Amendment No. 3 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-97-26 and should be submitted by November 26, 1997.

VII. Commission's Findings and Order Granting Accelerated Approval of 
Amendment No. 3 to the Proposed Rule Change

    For the reasons discussed above, the Commission finds that the 
NASD's proposal is consistent with the Exchange Act and the rules and 
regulations thereunder applicable to a national securities association 
and has determined to approve the expansion of the pilot to 150 Nasdaq 
securities and to extend the pilot through March 27, 1998.\44\
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    \44\ The Commission also has determined to approve the 
replacement of those securities in the pilot that are no longer 
listed on Nasdaq with others from the list of securities provided by 
the NASD.
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    The Commission also is approving Amendment No. 3 on an accelerated 
basis. In Amendment No. 3, the NASD has addressed criticism by several 
commentators who believe that the current pilot is not well designed to 
study effects of the Actual Size Rule. These commentators believe that 
the 50 stock pilot is not sufficiently representative of the entire 
Nasdaq Market and cannot form the basis for an adequate economic study. 
In particular, the commenters stated that most of the 20 largest Nasdaq 
stocks are subject to Actual Size Rule and that very few small stocks 
are subject to rule, and thus it is impossible to gauge the rule's 
effect on the largest and smallest stocks without similar groups of 
nonpilot stocks to use in comparison.
    The Commission finds that the 150 stock pilot the NASD is now 
proposing is a reasonable sampling of the Nasdaq market, calculated to 
allow the NASD and others to study the effects of the Actual Size Rule. 
The Commission also believes that approving Amendment No. 3 to the 
proposed rule change will provide it with additional data for use in 
determining whether to expand the Actual Size Rule to cover the entire 
Nasdaq market or to take another course of action. The Commission finds 
good cause in approving the extension element of Amendment No. 3 to the 
proposed rule change on an accelerated basis in order to give the NASD 
sufficient time to collect data on the expanded pilot, analyze that 
data, and publish a report on its findings. By allowing the NASD to 
begin its analysis quickly so that it may publish its findings 
promptly, commentators will have more time to examine the study and the 
Commission will be in a better position to make a determination on the 
future of the Actual Size Rule in a timely manner. An additional three 
months is designed to provide the Commission and the public time to 
fully consider the results of the NASD's economic study and is merely a 
technical change to prevent a rushed study and comment period. The 
Commission therefore finds good cause for approving the proposed rule 
change prior to the thirtieth day after the date of publication of 
notice of filing thereof.
    Accordingly, the Commission believes that the proposed rule change 
(SR-NASD-97-26) is consistent with Sections 15A(b)(6) and (b)(9) of the 
Exchange Act \45\ and
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    \45\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. The proposed rule likely will produce more 
accurate and informative quotations and encourage market makers to 
maintain competitive prices. It will also provide the Commission 
with additional data, enabling it to evaluate better the impact of 
the Actual Size Rule on the Nasdaq market and market participants. 
Since the Commission believes that the data discussed above 
indicates that the pilot has not resulted in harm to the Nasdaq 
market thus far, the net effect of approving the proposed rule 
change will be positive. 15 U.S.C. 78c(f).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,\46\ that the proposed rule change, SR-NASD-97-26, be and 
hereby is approved through March 28, 1998.

    \46\ 15 U.S.C. 78s(b)(2).

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[[Page 59938]]

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\47\
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    \47\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 97-29296 Filed 11-4-97; 8:45 am]
BILLING CODE 8010-01-M