[Federal Register Volume 62, Number 233 (Thursday, December 4, 1997)]
[Notices]
[Pages 64242-64245]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-31754]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39367; File No. SR-NASD-97-53]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Approving Proposed Rule Change and Notice of
Filing and Order Granting Accelerated Approval of Amendment No. 2 to
Proposed Rule Change Relating to Trading in Exchange-Listed Securities
in the Third Market
November 26, 1997.
I. Introduction
On July 28, 1997, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association''), through its wholly-owned
subsidiary, The Nasdaq Stock Market, Inc. (``Nasdaq''), 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\ The proposed rule change
relating to automated quotations in exchange-listed securities in the
third market, including Amendment No. 1, was published for comment in
Securities Exchange Act Release No. 38985 (August 27, 1997).\2\ Two
comment letters were received on the proposal.\3\ On October 10, 1997,
the NASD filed Amendment No. 2, prepared by Nasdaq, which deferred the
proposal for permissible uses of automated quotations with respect to
exchange-listed securities included in the Intermarket Trading System
(``ITS''). For the reasons discussed below, the Commission is approving
the proposed rule change and granting accelerated approval to Amendment
No. 2.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 62 FR 46787 (September 4, 1997).
\3\ See letter from Steven Alan Bennett, Senior Vice President
and General Counsel, BankOne, to Mr. Jonathan Katz, Secretary, SEC,
dated September 25, 1997 (``BankOne Letter''); and letter from James
E. Buck, Senior Vice President and Secretary New York Stock Exchange
to Mr. Jonathan G. Katz, Secretary, SEC, dated September 29, 1997
(``NYSE Letter'').
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II. Description of the Proposal
The NASD's proposal included changes to several rules governing the
trading in exchange-listed securities in the over-the-counter market,
the so-called ``third market.'' Specifically, the NASD proposedl to
amend rules of the NASD to: (1) Codify permissible uses of computer-
generated quote systems with respect to exchange-listed securities;\4\
(2) eliminate the excess spread rule for market makers in exchange-
listed securities; (3) reduce the minimum quotation size applicable to
market makers in exchange-listed securities to one unit of trading
(i.e., 100 shares), regardless of whether the CQS market maker \5\ is
displaying a customer's limit order or quoting for its own proprietary
account; (4) extend exemptive provisions of the NASD's limit order
protection rule applicable to Nasdaq-listed securities (the ``Manning
Rule'') to exchange-listed securities; and (5) reduce from 1000 to 100
the number of shares that CAES will execute automatically.
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\4\ However, with the approval of Amendment No. 2 to the
proposal, exchange-listed securities that are included in the ITS/
Computer Assisted Execution System (``CAES'') linkage are not
subject to the NASD's rule regarding permissible uses of computer-
generated quote systems.
\5\ Quotations and quotation sizes in reported securities may be
entered into the Consolidated Quotations Service (``CQS'') through
The Nasdaq Stock Market only by an Association member registered
with it as a CQS market maker. See NASD Rule 6320.
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a. Permissibility of the Use of Certain Automated Quotation Generation
Systems
The plan governing the ITS Plan currently provides that exchange
specialists and CQS market makers may use ``automated quotation
tracking systems,'' provided that the quotations generated by such
systems are for 100 shares or less (``100-Share Autoquoting
Limitation''). Despite the ITS plan's allowance of 100-share
autoquotes, the NASD currently prohibits CQS market makers from using
autoquote systems to effect automated quote updates or to track the
inside market. In addition, the NASD currently requires CQS market
makers to maintain a minimum quotation size of 500 shares, with the
exception of displaying a customer limit order, which also effectively
prohibits CQS market makers from autoquoting.
The NASD's proposal explicitly accommodates computer-generated
quotations that add value to the market and do not raise quotation
accessibility concerns or compromise the capacity or integrity of
Nasdaq. Specifically, the proposed rule change amends NASD Rule 6330 to
permit computer-generated quotations in exchange-listed securities that
generate proprietary quotes for 100 shares or more if such quote
systems equal or improve either or both sides of the NBBO. For example,
if a CQS market maker utilized a computer-generated quotation program
to match the best offer (bid) and the market responsible to the best
offer (bid) subsequently increased (decreased) its offer (bid) price,
the CQS market maker could not use the program to track such inferior
price. Thus, if the best offer is 20\1/4\, a CQS market maker could use
the program to improve its offer to 20\1/4\. If the market responsible
for the 20\1/4\ offer moved to 20\3/8\, however, the CQS market maker
could not use the program to move its offer to 20\3/8\.
In addition, the proposed rule change amends Rule 6330 to permit
computer-generated quotations that add size to the NBBO, or are used to
expose a customer's market or marketable limit order for price
improvement opportunities. These uses would be in addition to three
other forms of computer-enhanced quotation maintenance programs
referenced in the NASD's Autoquote Policy which are also being
incorporated into Rule 6330 with respect to exchange-listed
securities.\6\ With the exception of these
[[Page 64243]]
types of computer-generated quotation and maintenance systems, all
other types of computer-generated quotations would continue to be
prohibited. Thus, market makers could not use computer-generated
quotations to track away from the inside market (``autoquoting away'').
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\6\ See NASD IM-4613. Specifically, these three forms are: (1)
Quotation updates in response to an execution in the security by
that firm (such as execution of an order that partially fills a
market maker's quotation size); (2) quotation updates that require a
physical entry (such as manual entry to the market maker's internal
system which then automatically forwards the update to Nasdaq); and
(3) quotation updates that reflect the receipt, execution, or
cancellation of a customer limit order.
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b. Elimination of the Excess Spread Rule
The NASD also proposed to enhance the quotation flexibility of CQS
market makers by eliminating the excess spread rule for CQS securities.
The NASD determined that the potential adverse competitive consequences
on highly automated CQS market making firms who are prohibited from
autoquoting away could be minimized if the excess spread rule was
eliminated. Specifically, by eliminating the excess spread rule for CQS
securities, the NASD believes that CQS market makers will have more
flexibility in quoting, Nasdaq capacity will not be needlessly consumed
by processing voluminous quote updates autoquoting away from the
market, and the competitiveness of the third market will not be
compromised.
c. Changes to the Minimum Quote Size Rule for CQS Market Makers
In an environment where investors are able to directly impact
quoted prices in the third market by having their limit orders
displayed publicly, the NASD believes it is appropriate to treat CQS
market makers in a manner equivalent to exchange specialists and not
subject them to minimum quote size requirements. The NASD believes the
increased order-driven nature of the third market brought about by the
SEC's Limit Order Display Rule obviates the justification for the 500
Share Quote Rule. Accordingly, the NASD proposed to amend the 500 Share
Quote Rule to permit a CQS market maker to post quotations commensurate
with their own freely-determined trading interest, provided, however,
that the quotations must be for at least one normal unit of trading.
d. Modifications to CAES
The implementation of the Order Execution Rules has required market
makers to display customers limit orders, thereby compelling CQS market
makers, who are not only obligated to execute trades up to 1,000 shares
at another market maker's quote, to execute trades at superior-priced
limit orders displayed by any other CQS market maker, even if such
limit orders are only for 100 shares. In addition, because Nasdaq no
longer processes CQS quotes,\7\ CAES executes orders at the best bid or
offer price in the third market instead of the national best bid or
offer (``NBBO''). As a result, when there are no CQS market makers at
the NBBO, CAES is providing inferior executions to customer orders.
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\7\ See Exchange Act Release No. 37663, September 10, 1996 (61
FR 48725) (order approving File No. SR-NASD-96-26).
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In order to facilitate the best execution of customer orders and
not subject CQS market makers to automatic executions at prices other
than their posted quotes, the NASD believes it is imperative that CAES
be appropriately modified. Accordingly, the NASD has proposed to amend
the operation of CAES so that it automatically executes orders up to
100 shares instead of 1,000 shares. An order can be preferenced for
larger than 100 shares to a CQS market maker and, although the order
will not be automatically executed, the order will be processed by the
CQS market maker pursuant to its firm quote obligations.\8\
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\8\ See 17 CFR 240.11Ac1-1.
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e. Modifications to the Limit Order Protection Rule Applicable to CQS
Securities
NASD proposed to amend Rule 6440 to permit a member to negotiate
special terms and conditions with a customer that would enable the firm
to trade ahead of, or at the same price as, the limit order price.
Specifically, under the Manning Rule, member firms may attach terms and
conditions with respect to the handling of limit orders that are
either: (1) For institutional accounts,\9\ or (2) limit orders that are
for 10,000 shares or greater, regardless of whether they are for
institutional accounts, provided that the order is $100,000 or more in
value. The NASD proposed to extend the ``terms and conditions''
language of the Manning Rule to the CQS limit order protection rule.
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\9\ Institutional limit orders are orders for institutional
accounts. NASD Rule 3110(c) defines an institutional account as an
account for: (1) Banks, savings and loan associations, insurance
companies, or registered investment companies; (2) investment
advisers registered under Section 203 of the Investment Advisers Act
of 1940; and (3) any other entity (whether a natural person,
corporation, partnership, trust, or otherwise) with total assets of
at least $50 million.
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III. Discussion
In August 1996, the Commission adopted new Rule 11Ac1-4 (``Limit
Order Display Rule'') and amendments to Rule 11Ac1-1 (``Quote
Rule'').\10\ As amended, the expanded definition of ``subject
security'' \11\ within the Quote Rule obligates any NASD member that
acts in the capacity of an over-the-counter (``OTC'') market maker \12\
to provide continuous two-sided quotations for any exchange-listed
security \13\ in which that member, during the most recent calendar
quarter, comprised more than 1% of the aggregate trading volume for
such security as reported in the consolidated system (``1% Rule'').\14\
An OTC market maker must, within 10 business days of the end of each
calendar quarter, compute its trading volume for each subject security,
and if the volume exceeds 1%, the market maker must begin publishing
two-sided quotations.
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\10\ See Exchange Act Release No. 37619A (September 6, 1996), 61
FR 48290 (September 12, 1996) (``Adopting Release'') adopting the
Limit Order Display Rule and amendments to the Quote Rule
(collectively the ``Order Execution Rules'').
\11\ Rule 11Ac1-1(a)(25).
\12\ See Rule 11Ac1-1(a)(13).
\13\ See Rule 11Ac1-1(a)(10) which defines ``exchange-traded
security'' to mean any covered security or class of covered
securities listed and registered, or admitted to unlisted trading
privileges, on an exchange; provided, however, that securities not
listed on any exchange that are traded pursuant to unlisted trading
privileges are excluded.
\14\ The 1% Rule, prior to being expanded in the Order Execution
Rules, applied only to 19c-3 securities. Exchange Act Rule 19c-3
prohibits the application of off-board trading restrictions to
securities that: (1) Were not traded on an exchange on or before
April 26, 1979; or (2) were traded on an exchange on April 26, 1979,
but ceased to be traded on an exchange for any period of time
thereafter. Accordingly, exchange-traded securities not subject to
off-board trading restrictions are referred to as Rule 19c-3
securities, and exchange-traded securities subject to off-board
trading restrictions are referred to as non-Rule 19c-3 securities.
The 1% Rule was expanded to include all exchange-listed securities,
both Rule 19c-3 and non-Rule 19c-3.
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The Commission began implementing the Order Execution Rules on
January 20, 1997. The Commission, however, deferred implementation of
the expanded 1% Rule until September 30, 1997.\15\ In light of the
implementation of the 1% Rule to all exchange-listed securities, the
NASD proposed the aforementioned amendments to its rules governing
trading in exchange-listed securities in the third market.
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\15\ See Securities Exchange Act Release Nos. 38110 (January 2,
1997), 62 FR 1279 (January 9, 1997); 38490 (April 9, 1997), 62 FR
18514 (April 16, 1997); and 38870 (July 24, 1997), 62 FR 40732 (July
30, 1997). Therefore, until September 30, 1997, OTC market makers
were only obligated to publicly disseminate quotations when they
were responsible for 1% or more of the trading volume in a 19c-3
security.
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The Commission received two comment letters on the proposed rule
change. The BankOne comment letter supported the NASD's proposal. The
[[Page 64244]]
NYSE comment letter did not address the specifics of the NASD proposal.
Nevertheless, the NYSE was concerned with the NASD proposal to amend
Rule 6330 to effectively lift its ban on autoquoting because of the
conflict with the ITS Plan. Although the ITS Participants are currently
discussing whether to amend the ITS Plan with regard to permissible
uses of computer-generated quotations, the current ITS Plan limits
computer-generated quotations to 100 shares. The ITS Plan governs all
ITS Participants, including the NASD. Therefore, the NYSE does not
believe the NASD Rule permitting the use of computer-generated
quotations should be extended to those exchange-listed securities that
are included in the ITS.
In response to the NYSE comment letter, and in recognition of the
lack of unanimous consensus from ITS Participants, the NASD filed
Amendment No. 2 to the proposal requesting the Commission to proceed
with the proposed rule change with respect to non-Rule 19c-3
securities. The NASD also noted that they are concerned that market
makers may experience difficulty in using enhanced automation support
if they are only permitted to do so for a portion (i.e., non-Rule 19c-3
securities) of the exchange-listed securities they maintain quotations
in. Therefore, the practical result of removing the burdens of
complying with the 1% Rule would be lost.
In expanding the 1% Rule, the Commission recognized that it raised
an issue with respect to the ability of NASD members to autoquote. The
Commission stated that ``a total prohibition on the use of computer
generated quotes is not appropriate'' and that ``[s]uch an approach
excessively limits the use of sophisticated trading strategies that
rely on automation in the quotation process for their success, and it
also may act as a competitive disadvantage to market makers and
specialists that would otherwise rely on technology to meet their
quotation obligations more efficiently.'' \16\ While the Commission
noted that it ``recognizes traditional concerns related to the
accessibility of computer generated quotes and the impact of such
quotes on system capacity, it believes that more can and should be done
in this area.'' \17\ The Commission stressed that more should be done
particularly ``given the enhanced quotation obligations that will be
imposed on some market participants under the revised Quote Rule.''
\18\ The Commission, therefore, urged the ``NASD, ITS Participants, and
other interested market participants to develop revised standards that
would permit the use of computer generated quotes that contribute value
to the market.'' \19\
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\16\ See Adopting Release at Section III.B.3.c.i.
\17\ Id.
\18\ Id.
\19\ Id.
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The Commission believes the NASD proposal provides its members with
the ability to use computer-generated quotations that add value to the
market and do not raise quotation accessibility concerns. The NASD
proposal does not permit autoquoting away which would subject Nasdaq to
capacity constraints as well compromise the value of quotations. The
Commission believes the proposal facilitates the implementation of the
Order Execution Rules, specifically, the 1% Rule by providing OTC
market makers with the ability to use computer-generated quotations.
The Commission notes, however, that permitting computer-generated
quotations for only non-Rule 19c-3 securities may inhibit some market
makers because they may not be able to distinguish those quotations
from their quotations in other exchange-listed securities. The
Commission expects that the ITS Participants will continue in their
discussions to amend the ITS Plan to permit computer-generated
quotations. In approving this rule, the Commission notes that it has
also considered the proposed rule's impact on efficiency, competition,
and capital formation.\20\
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\20\ 15 U.S.C. 78c(f).
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For the foregoing reasons, the Commission finds that the proposed
rule change is consistent with the Exchange Act and the rules and
regulations thereunder applicable to the NASD and, in particular,
Sections 11A(a)(1)(D), 11A(a)(2) and 15A(b)(6) of the Exchange Act.\21\
Section 11A(a)(1)(D) of the Exchange Act states that the linking of all
markets for qualified securities through communications and data
processing facilities will foster efficiency, enhance competition,
increase the information available to brokers, dealers and investors,
facilitate the offsetting of investor's orders and contribute to best
execution of such orders, and subsection (a)(2) thereunder directs the
Commission to facilitate the establishment of a national market system
for qualified 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 an 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.
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\21\ In addition, the Commission notes that it has considered
the proposed rule's impact on efficiency, competition, and capital
formation. The proposed rule will likely contribute to more accurate
and informative quotations because market makers are able to use
automated measures to produce accessible quotations that add value
to the market. The Commission believes that permitting the use of
automated quotations by CQS market makers allows them to utilize
technology to fulfill their quotation obligations efficiently.
Moreover, allowing CQS market makers to utilize technology in this
manner reduces any competitive disadvantage that the previous auto-
quote ban may have created. 15 U.S.C. Sec. 78c(f).
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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, 450 Fifth Street, N.W., Washington,
D.C. 20549. 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 should be submitted by
December 29, 1997.
V. Conclusion
For the reasons discussed in this order, pursuant to Section
19(b)(2) of the Exchange Act,\22\ the Commission finds good cause for
approving the proposed rule change, as amended, prior to the thirtieth
day after the date of publication of notice filing thereof in the
Federal Register.
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\22\ 15 U.S.C. 78s(b)(2).
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Exchange Act,
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that the proposed rule change (NASD-97-53) be, and hereby is, approved.
For the Commission, by the Division of Market Regulations,
pursuant to delegated authority.\23\
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\23\ 17 CFR 200.30-3(A)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-31754 Filed 12-3-97; 8:45 am]
BILLING CODE 8010-01-M