[Federal Register Volume 62, Number 250 (Wednesday, December 31, 1997)]
[Notices]
[Pages 68331-68334]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33994]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

(Release No. 34-39478; File No. SR-NASD-97-85)


Self-Regulatory Organizations; Notice of Filing and Immediate 
Effectiveness of Proposed Rule Change by the National Association of 
Securities Dealers, Inc., Relating to NASD Rule 2460 Concerning 
Payments for Market Making

December 22, 1997.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Exchange Act''),\1\ notice is hereby given that on December 1, 1997, 
the National Association of Securities Dealers, Inc. (``NASD''), 
through its wholly owned subsidiary, NASD Regulation, Inc. (``NASD 
Regulation'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by NASD 
Regulation.\2\ The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. Sec. 78s(b)(1).
    \2\ The proposal was originally filed with the Commission on 
November 18, 1997, but was withdrawn on December 1, 1997. See Letter 
from Alden S. Adkins, Vice President and General Counsel, NASD 
Regulation, to Richard C. Strasser, Assistant Director, Division of 
Market Regulation, Commission. (File No. SR-NASD-97-84). On December 
22, 1997, the NASD filed Amendment No. 1 with the Commission. See 
Letter from Alden S. Adkins, Vice President and General Counsel, 
NASD Regulation, to Richard C. Strasser, Assistant Director, 
Division of Market Regulation, Commission. In addition, several 
minor technical corrections authorized by NASD Regulation are 
included in this Notice. Telephone conversation between David A. 
Spotts, Office of the General Counsel, NASD Regulation, and Elaine 
M. Darroch, Office of Market Supervision, Division of Market 
Regulation, Commission (December 4, 1997).
---------------------------------------------------------------------------

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

    NASD Regulation, pursuant to Section 19(b)(3)(A)(i) of the Act \3\ 
and Rule 19b-4(e)(i) under the Act,\4\ is proposing this interpretation 
of NASD Rule 2460 concerning payments for market making. The text of 
the letter setting forth the interpretation is attached as Exhibit 1.
---------------------------------------------------------------------------

    \3\ 15 U.S.C. Sec. 78s(b)(3)(A)(i).
    \4\ 17 CFR 240.19b-4(e)(i).
---------------------------------------------------------------------------

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

    In its filing with the Commission, NASD Regulation included 
statements concerning the purpose of, and basis for, the proposed rule 
change and discussed any comments it received on the proposed rule 
filing. The text of these statements may be examined at the places 
specified in Item IV below. NASD Regulation 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

    NASD Regulation is proposing to issue a staff interpretation of 
NASD Rule 2460 to clarify the position of NASD Regulation with respect 
to the application of the rule to certain member broker-dealers that 
participate in a Freddie Mac Interdealer Cash Market Trading 
Initiative, as described below.
NASD Rule 2460--Payments for Market Making
    On July 3, 1997, the SEC approved NASD Rule 2460 (``Rule''),\5\ 
which explicitly prohibits an NASD member or person associated with a 
member from accepting any payment or other consideration from issuers 
or the issuers' affiliates or promoters, directly or indirectly, for: 
(1) publishing a quotation, (2) acting as a market maker, or (3) 
submitting an application in connection therewith. The rule was 
intended, among other things, to assure that members act in an 
independent capacity when publishing a quotation or making a market in 
an issuer's securities.
---------------------------------------------------------------------------

    \5\ Securities Exchange Act Release No. 38812 (July 3, 1997), 62 
FR 37105 (July 10, 1997) (File No. SR-NASD-97-29).
---------------------------------------------------------------------------

    NASD Regulation originally proposed this new rule and requested 
comment from members and the public in Notice to Members 96-83 (``NTM 
96-83'') in December 1996. As stated in NTM 96-83, it has been a 
longstanding policy and position of the NASD that a broker-dealer is 
prohibited from receiving compensation or other payments from an issuer 
for listing, quoting, or making a market in an issuer's securities or 
for covering the member's out-of-pocket

[[Page 68332]]

expenses for making a market, or for submitting an application to make 
a market in an issuer's securities.\6\ As stated in Notice to Members 
75-16 (February 1975), such payments may be viewed as a conflict of 
interest since they may influence the member's decision as to whether 
to quote or make a market in a security and, thereafter, the prices 
that the member would quote.
---------------------------------------------------------------------------

    \6\ See Notices to Members 75-16 (February 1975) and 92-50 
(October 1992).
---------------------------------------------------------------------------

    In the past, certain broker-dealers have entered into arrangements 
with issuers to accept payments from the issuers, their affiliates or 
promoters to make a market in the issuer's securities, or for covering 
out-of-pocket expenses of the member incurred in the course of market 
making, or for submitting an application to act as a market maker. As 
stated above, NASD Regulation believes that such conduct may be viewed 
as a conflict of interest. NASD Regulation believes that a market maker 
should have considerable latitude and freedom to commence or terminate 
market making activities in an issuer's securities. The decision by a 
firm to make a market in a given security and the question of what 
price the firm will quote for that security generally are dependent on 
a number of factors, including, among others, supply and demand, the 
firm's expectations toward the market, its current inventory position, 
and exposure to risk and competition. This decision should not be 
influenced by payments to the member from issuers or promoters.
    NASD Rule 2460 establishes a fair practice standard regarding a 
particular course of conduct of a member. Members should be mindful 
that certain actions of a member in accepting a fee from an issuer for 
making a market, or accepting an unsolicited payment from an issuer 
where the member makes a market in the issuer's securities, in addition 
to violating NASD Rule 2460, could also violate the anti-fraud 
provisions of the federal securities laws and NASD Rule 2120, an NASD 
anti-fraud provision. Further, the payment by an issuer to a market 
maker to facilitate market making activities could also violate the 
registration requirements of Section 5 of the Securities Act of 1933 
(``Securities Act'').\7\
---------------------------------------------------------------------------

    \7\ 15 U.S.C. Sec. 77e.
---------------------------------------------------------------------------

Freddie Mac Interdealer Cash Market Trading Initiative
    The Federal Home Loan Mortgage Corporation (``Freddie Mac'') is a 
government-sponsored enterprise created pursuant to the Federal Home 
Loan Mortgage Corporation Act, Title III of the Emergency Home Finance 
Act of 1970, as amended, to provide a continuous flow of funds for 
residential mortgages.\8\ To finance its mortgage purchase activities, 
Freddie Mac sells its securities to investors directly and through 
securities dealers. The primary financing vehicle for its mortgage 
purchases is the sale of Mortgage Passthrough Certificates (``PCs''). 
These securities are exempt from registration under the Securities Act 
and the Exchange Act. In 1990, Freddie Mac redesigned its fixed-rate PC 
structure and issues a new type of PC, called Gold PC. Since the Gold 
PCs were entirely new and a separate product, there was limited initial 
liquidity in the Gold PC market. As a result, dealers responded to the 
initial lack of liquidity in the Gold PC market, with its potential 
volatility, by maintaining primary Federal National Mortgage 
Association (``Fannie Mae'') security positions, and by entering into 
synthetic transactions in the swap market.\9\
---------------------------------------------------------------------------

    \8\ Freddie Mac's statutory purpose is to, among other things, 
promote access to mortgage credit throughout the Nation by 
increasing the liquidity of mortgage investments and improving the 
distribution of investment capital available for residential 
mortgage financing (12 U.S.C. Sec. 1451(b)).
    \9\ In the years following 1990, Freddie Mac has built a supply 
of tradable Gold PCs in an attempt to achieve a liquid market of 30-
year Gold PCs ($152 billion as of September 1, 1997). The dealer 
response, however, has primarily remained unchanged in maintaining 
Fannie Mae Mortgage-Backed Security (``MBS'') positions and entering 
into synthetic transactions in the swap market despite the 
availability of a sizable amount of tradable Gold PCs. Broker-
dealers primarily enter into Gold PC transactions synthetically as 
opposed to direct transactions in the Gold PC cash market. The 
synthetic transactions are structured generally as follows: A dealer 
will first purchase a 30-year Fannie Mae MBS in the cash market with 
a forward delivery (with a fixed settlement date in the future). The 
dealer will enter into another separate transaction in the swap 
market. The dealer will swap the obligation to buy the Fannie Mae 
MBS for a commitment to purchase (accept delivery at settlement) 
Gold PCs.
    To gain an understanding of the relative size of the cash market 
for MBS, the following statistics are provided. In 1996, the average 
cash market volume on the interdealer broker screens for MBS was 
approximately $20 billion per month. Of this, approximately 96% was 
conducted in Fannie Mae MBS transactions and approximately 4% was 
conducted directly in the cash market in 30-year Gold PCs.
---------------------------------------------------------------------------

    As a result of the above, Freddie Mac launched a program to 
encourage dealers to purchase Gold PCs directly, rather than through 
the swap market mechanism (the ``Initiative''). Freddie Mac and The 
Bond Market Association (``BMA'') submitted to the staff of NASD 
Regulation a letter dated October 7, 1997, regarding the application of 
NASD Rule 2460 to members participating in the Initiative.
    The Initiative includes offering dealers ``credits'' for trading 
directly on the interdealer cash market, as opposed to the swap market. 
Freddie Mac has developed procedures and internal controls to calculate 
trading volume credits monthly to the dealers and assure proper 
administration of the program. According to the October 7, 1997 letter 
from Freddie Mac and the BMA, this Initiative is intended to be 
temporary, and the value of the credits were selected so as to provide 
a nominal economic incentive over the transaction costs on the swap 
market, while not providing so much of an incentive as to alter pricing 
of the securities in the open market.\10\ The credits awarded under 
this Initiative may only be redeemed through transactions with Freddie 
Mac, that is, the credits are utilized by participating broker-dealers 
to reduce the fees associated with future transactions with Freddie 
Mac.
---------------------------------------------------------------------------

    \10\ To normalize the environment for dealers to accumulate 
credits) so as not to favor larger dealers who naturally conduct a 
higher volume business), a system for accumulation of credits was 
established that would be based on the individual dealer's level of 
participation. Credits are awarded on the current volume traded on 
the cash screens. Credits are awarded at an increasing rate when 
dealers exceed their previous monthly cash trading volume, as 
calculated since the beginning of the Initiative, that the dealers 
have traded on the cash screens. This feature was designed to limit 
the duration of the Initiative by creating momentum in moving 
dealers progressively away from the swap market.
    Under this Initiative, credits are redeemable at a value of \1/
64\th of a point (or $156.25 per million). This value was selected 
so as to provide nominal economic incentive over the additional \1/
4\th to \3/8\ths of a 32nd (or $78.13 to $117.20 per million) in the 
transaction cost of executing a synthetic Gold PC in the MBS cash 
and swap markets.
---------------------------------------------------------------------------

    Due to unique characteristics of the Initiative, Freddie Mac 
presented principally three arguments why NASD Rule 2460 was not 
intended to cover the Initiative: (1) The Initiative promotes Freddie 
Mac's statutory purpose; (2) the Initiative does not affect the 
integrity of the marketplace; and (3) the Initiative is intended to be 
temporary.
    First, Freddie Mac represents that the Initiative appears to 
promote Freddie Mac's statutory purpose, in that, Freddie Mac was 
created by Congress to provide a conduit for ensuring a continuous 
supply of funds from the capital markets to the mortgage markets. 
Freddie Mac purchases mortgages daily and finances them primarily with 
the issuance of MBS. The prices Freddie Mac pays for its mortgage 
purchases is based directly on the prices at which its sells its PCs. 
Freddie Mac represents that this Initiative was developed to eliminate 
certain unnecessary costs in the mortgage finance system by improving 
interdealer PC liquidity through

[[Page 68333]]

encouraging dealers to purchase Gold PCs directly, as opposed to 
entering into transactions in the swap market.\11\
---------------------------------------------------------------------------

    \11\ Currently, broker-dealers enter into gold PC transactions 
synthetically, first by conducting a transaction in a 30-year Fannie 
Mae MBS followed by a subsequent swap transaction into or out of 
Gold PCs. This process subjects Gold PCs to an additional bid-ask 
spread (that of the cash market and that of the swap market) of \1/
8\th to \1/4\th of a 32nd (or up to $78.13 per million). In 
addition, the two-step process results in broker fees for the 
trading on the interdealer screens of an additional \1/16\th to \1/
8\th of a 32nd (or up to $39.07 per million). Thus, this persistent 
trading pattern creates additional costs in the marketplace, 
preventing investors from obtaining up to \3/8\ths of \1/32\nd (or 
$117.20 per million) of the true economic value of the Gold PCs that 
an efficient market would produce.
    As of May 1997, the average monthly dollar volume of cash trades 
in Fannie Mae MBS and Gold PCs approximated $19,239 million, $1,021 
million, respectively. As of that date, the average monthly swap 
trades in Gold PCs and MBS approximated $4,177 million.
---------------------------------------------------------------------------

    Second, Freddie Mac represents that the Initiative does not appear 
to affect the integrity of the marketplace, since the nature and 
characteristics of the agency mortgage pass-through securities market 
is unique and appears outside of the intended scope of NASD Rule 2460. 
The dealers in this market trade PCs and similar securities essentially 
as fungible products and trade these securities indiscriminately on the 
interdealer broker screens to meet customer demand. As a result, the 
concept of market making a particular security in this market has 
little application. In addition, Freddie Mac represents that the 
incentives which lead a broker-dealer to make a quotation on a PC 
differ from traditional equity trading. Customer demand in fixed-income 
securities is based primarily on changes in interest rates, supply and 
demand, and the quality of the credit backing the security. In the 
agency MBS market, the credit of the three primary agencies (Freddie 
Mac, Fannie Mae and Government National Mortgage Association) is 
considered comparable, the supply of the securities is considered 
plentiful, and a well-developed forward trading market permits ready 
hedging of positions. This market differs from the characteristics of 
the traditional equity market. Accordingly, Freddie Mac represents 
that, given the number of comparable securities in the yield-driven 
debt market, it is unlikely that certain dealer credits to purchase 
Gold PCs would mislead market participants to purchase the Gold PCs 
versus other comparable securities.
    Further, Freddie Mac represents that this Initiative is intended to 
be temporary. It is expected that dealer behavior will eventually 
become self-sustaining and no further incentives will be required.
    Based on the above information and representations presented by 
Freddie Mac, and the importance of the role of Freddie Mac in promoting 
liquidity of these instruments under statutory mandate, it is NASD 
Regulation's opinion that the participation of member firms in the 
Freddie Mac Initiative as described in the letter would not be deemed 
in violation of NASD Rule 2460.
    NASD Regulation believes that this interpretation maintains 
investor protection and clarifies a member's obligations under NASD 
Rule 2460 while participating in the Freddie Mac Interdealer Cash 
market Trading Initiative. Accordingly, NASD Regulation believes that 
the interpretation is consistent with the provisions of Section 
15A(b)(6) in that it protects investors and the public interest, and is 
designed to promote just and equitable principles of trade.

(B) Self-Regulatory Organization's Statement on Burden on Competition

    NASD Regulation does not believe that the proposed rule change will 
result in any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received from Members, Participants, or Others

    Written comments were neither solicited nor received.

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

    The foregoing rule change has become effective upon filing pursuant 
to Section 19(b)(3)(A)(i) of the Exchange Act \12\ and Rule 19b-4(e)(1) 
\13\ thereunder in that it constitutes a stated policy, practice or 
interpretation with respect to the meaning, administration, or 
enforcement of an existing rule.
---------------------------------------------------------------------------

    \12\ 15 U.S.C. Sec. 78s(b)(3)(A)(i).
    \13\ 17 CFR 240.19b-4(e)(1).
---------------------------------------------------------------------------

    At any time within 60 days of the filing of the proposed rule 
change, the Commission may summarily abrogate such rule change if it 
appears to the Commission that such action is necessary or appropriate 
in the public interest, for the protection of investors, or otherwise 
in furtherance of the purposes of the Act.

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. Sec. 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 No. SR-NASD-97-85 and should 
be submitted by January 21, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
---------------------------------------------------------------------------

    \14\ 17 C.F.R. 200.30-3(a)(12).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.

Exhibit 1

November 25, 1997.
Ms. Gail Vance, Associate General Counsel, Freddie Mac, 8200 Jones 
Branch Drive, McLean, VA 22102-3110.
Mr. George P. Miller, Vice President and Deputy General Counsel, The 
Bond Market Association, 40 Broad Street, New York, NY 10004-9400.

Re: Interpretive Guidance Under NASD Rule 2460.

    Dear Ms. Vance and Mr. Miller: We are in receipt of your letter 
dated October 7, 1997 in which you request interpretive guidance of 
NASD Rule 2460 (Rule) and its potential application to Freddie Mac's 
Interdealer Cash Market Trading initiative (``Initiative''). As 
represented in your letter, Freddie Mac launched this Initiative on 
June 2, 1997 in an attempt to encourage dealers to purchase Gold PCs 
directly, as opposed to entering into swap market transactions.

Background

    As stated in your letter, Freddie Mac is a government-sponsored 
enterprise created pursuant to the Federal Home Loan Mortgage 
Corporation Act, Title III of the Emergency Home Finance Act of 
1970, as amended, to provide a continuous flow of funds for 
residential mortgages.\1\ To finance its mortgage purchase 
activities, Freddie Mac sells its securities to investors directly 
and

[[Page 68334]]

through securities dealers. The primary financing vehicle for its 
mortgage purchases is the sale of Mortgage Passthrough Certificates 
(PCs). These securities are exempt from registration under the 
Securities Act of 1933 and the Exchange Act of 1934. In 1990, 
Freddie Mac redesigned its fixed-rate PC structure and issued a new 
type of PC, called Gold PC. Since the Gold PCs were entirely new and 
a separate product, there was limited initial liquidity in the Gold 
PC market. As a result, dealers responded to the initial lack of 
liquidity in the Gold PC market, with its potential volatility, by 
maintaining primary Fannie Mae security positions, and by entering 
into synthetic transactions in the swap market.
---------------------------------------------------------------------------

    \1\ Freddie Mac's statutory purpose is to, among other things, 
promote access to mortgage credit throughout the Nation by 
increasing the liquidity of mortgage investments and improving the 
distribution of investment capital available for residential 
mortgage financing (12 U.S.C. Section 1451(b)).
---------------------------------------------------------------------------

    As a result of the above, Freddie Mac launched this Initiative 
to encourage dealers to purchase Gold PCs directly, rather than 
through the swap market mechanism. The Initiative includes offering 
dealers ``credits'' for trading directly on the interdealer cash 
market, as opposed to the swap market. Freddie Mac has developed 
procedures and internal controls to calculate trading volume credits 
monthly to the dealers and assure proper administration of the 
program. According to your letter, this Initiative is intended to be 
temporary, and the value of the credits were selected so as to 
provide a nominal economic incentive over the transaction costs on 
the swap market, while not providing so much of an incentive as to 
alter pricing of the securities in the open market. More important, 
the credits awarded under this Initiative may only be redeemed 
through transactions with Freddie Mac.

Discussion

    NASD Rule 2460 prohibits NASD members from receiving payments or 
other consideration from an issuer for publishing a quotation or 
acting as a maker in a security, or for submitting an application to 
make a market in the issuer's securities. The definition of 
``consideration'' specifically includes offering securities products 
on terms that are more favorable than those granted or offered to 
the public. The Rule was intended to prevent certain conflicts of 
interest that may influence a broker-dealer's decision regarding 
whether to quote or make a market in a security and prices that are 
quoted and to prevent a misleading appearance of market activity 
based on such conflicts. Paragraph (b) of the Rule also provides an 
exemption, among others, for certain payment to members for ``bona 
fide'' services, including, but not limited to, investment banking 
services.
    Due to unique characteristics of the Freddie Mac Initiative, you 
principally present three arguments why the Rule was not intended to 
cover your Initiative: (1) the Initiative promotes Freddie Mac's 
statutory purpose; (2) the Initiative does not affect the integrity 
of the marketplace; and (3) the Initiative is intended to be 
temporary.
    First, you represent that the Initiative appears to promote 
Freddie Mac's statutory purpose, in that, Freddie Mac was created by 
Congress to provide a conduit for ensuring a continuous supply of 
funds from the capital markets to the mortgage markets. Freddie Mac 
purchases mortgages daily and finances them primarily with the 
issuance of mortgage-backed securities. The prices Freddie Mac pays 
for its mortgage purchases is based directly on the prices at which 
it sells its PCs. It has been represented in your letter that this 
Initiative was developed to eliminate certain unnecessary costs in 
the mortgage finance system by improving interdealer PC liquidity 
through encouraging dealers to purchase Gold PCs directly, as 
opposed to entering into transactions in the swap market.
    Second, you represent that the Initiative does not appear to 
affect the integrity of the marketplace, since the nature and 
characteristics of the agency mortgage pass-through securities 
market is unique and appears outside of the intended scope of the 
Rule. Since the dealers in this market trade these securities as 
fungible products (i.e., PCs, Mortgage-backed securities, Ginnie 
Maes) and trade on the interdealer broker screens daily as a matter 
of course to meet their customer's demand, the concept of market 
making a particular security has little application in this 
marketplace.
    In addition, you represent that the incentives which lead a 
broker-dealer to make a quotation on a PC differ from traditional 
equity trading. Customer demand in fixed-income securities is based 
primarily on changes in interest rates, supply and demand, and the 
quality of the credit backing the security. In the agency mortgage-
backed securities market, the credit of the three primary agencies 
(Freddie Mac, Fannie Mae and Ginnie Mae) is considered comparable, 
the supply of the securities is considered plentiful, and a well-
developed forward trading market permits ready hedging of positions. 
This market differs from the characteristics of the traditional 
equity market. Accordingly your letter represents that, given the 
number of comparable securities in the yield driven debt market, it 
is unlikely that certain dealer credits to purchase Gold PCs would 
mislead market participants to purchase the Gold PCs versus other 
comparable securities.
    Lastly, you represent that this Initiative is intended to be 
temporary. According to your letter, it is expected that dealer 
behavior will eventually become self-sustaining and no further 
incentives will be required.
    Based on the above information and the representations presented 
by Freddie Mac, and the importance of the role of Freddie Mac in 
promoting liquidity of these instruments under statutory mandate, it 
is the staff's opinion that the participation of member firms in the 
Freddie Mac Initiative as described in your letter would not be 
deemed in violation of Rule 2460.
    I hope this letter is responsive to your inquiry. Please note 
that the opinions expressed herein are staff opinions only and have 
not been reviewed or endorsed by the Board of Directors of NASD 
Regulation. This letter responds only to the issues that you have 
raised based on the facts as described, and does not address any 
other rule or interpretation of the Association, or all the possible 
regulatory and legal issues involved.

        Sincerely,
David A. Spotts,
Office of General Counsel, NASD Regulation, Inc.
[FR Doc. 97-33994 Filed 12-30-97; 8:45 am]
BILLING CODE 8010-01-M