[Federal Register Volume 63, Number 4 (Wednesday, January 7, 1998)]
[Notices]
[Pages 897-899]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-290]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 39490, File No. SR-NASD-97-50]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change By the NASD To 
Extend From 15 Seconds to 17 Seconds the Amount of Time a Market Maker 
Has To Update Its Quote After an Order Execution in SOES Before Being 
Required To Execute a Subsequent Order

December 24, 1997.
    On July 14, 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\ The proposal 
amends NASD Rule 4730(b)(1) to indicate that once the Nasdaq Stock 
Market, Inc.'s (``Nasdaq'') Small Order Execution System (``SOES'') 
executes an unpreferenced market order or a marketable limit order 
against a SOES market maker, that market maker is not required to 
execute another unpreferenced SOES order at the same bid or offer in 
the same security until 17 seconds have elapsed, absent a quotation 
update by the market maker within such 17-second period. On July 24, 
1997, notice of the proposed rule change, including the substance of 
the proposal, was published for comment in the Federal Register.\3\ The 
Commission received 64 comment letters, which are discussed below. The 
Commission is hereby approving the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 38849 (July 17, 1997) 62 
FR 39883 (July 24, 1997).
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I. Description

    The proposed rule change specifies the obligations of SOES market 
makers during non-locked and non-crossed market situations. As amended, 
NASD Rule 4730(b)(1) would provide that once SOES executes an 
unpreferenced market order or a marketable limit order against a SOES 
market maker, that market maker is not required to execute another 
unpreferenced SOES order at the same bid or offer in the same security 
until 17 seconds have elapsed, absent a quotation update by the market 
maker within that 17-second period.
    Currently, NASD Rule 4730(b)(1) provides that:

    Market Makers shall have a period of time following their 
receipt of an execution report in which to update their quotation in 
the security in question before being required to execute another 
unpreferenced order at the same bid or offer in the same security. 
This period of time shall initially be established as 15 seconds, 
but may be modified upon appropriate notification to SOES 
participants.

    This language was originally added to the NASD's rules in October 
1991 to give a SOES market maker a brief opportunity to update its 
quotations in response to executions it received through SOES (``15-
Second SOES Execution Response Period''). As the current language of 
NASD Rule 4730(b) reflects, the ``15-Second SOES Execution Response 
Period'' commences when a market maker has received notification of a 
SOES execution through the system.\4\ Because SOES does not have the 
capability to determine the exact time when a market maker receives a 
SOES execution report, at the time this rule was implemented Nasdaq 
estimated that it took up to five seconds for SOES to execute an order 
against a market maker and for the market maker to receive a report of 
the execution (the ``SOES Execution Report Communication Period''). As 
a result, SOES was programmed to add uniformly a five-second period to 
the ``15-Second SOES Execution Response Period,'' with the effect that 
the system executes unpreferenced market orders against a market maker 
in twenty-second intervals, absent a quotation update by the market 
maker.
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    \4\ See Exchange Act Release No. 29810 (October 10, 1991) 56 FR 
52098, 52099 (October 17, 1991) (order approving file no. SR-NASD-
91-18) (``[f]ollowing receipt of an execution report of an 
unpreferenced purchase or sale through SOES, a market maker will 
have a period of time (15 seconds) to update its quote prior to 
executing any subsequent transaction on the same side of the market 
at the same price.'' [Footnote omitted].).
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    Nasdaq now estimates that on average, the SOES Execution Report 
Communication Period is between two and three seconds, although the 
actual time may vary depending on activity and communications traffic 
during different periods of the day. Based on this data, the NASD 
determined that it was appropriate to assign a two-second period to the 
SOES Execution Report Communications Period for purposes of the rule.
    The NASD proposes to incorporate explicitly this two-second period 
into NASD Rule 4730. The proposed rule change is designed to retain the 
ability of a market maker to respond to SOES executions while 
recognizing that,

[[Page 898]]

under normal circumstnaces, a minimal period of time is necessary for 
reports of those executions to be received by the market maker. The 
proposed amendments to NASD Rule 4730(b) also would clarify that:

    (1) A market maker becomes immediately eligible to receive 
another execution through SOES if it updates its quote (its bid, 
offer, or size) during the 17-second period,\5\ and
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    \5\ The proposed amendments to NASD Rule 4730(b) do not change 
in any way the current functionality of SOES whereby preferenced 
orders are continuously executed against a market maker without any 
delay between executions. In addition, as is presently the case 
during locked and crossed markets, SOES will execute orders (both 
preferenced and unpreferenced against a market maker that is locked 
or crossed in five second intervals. See NASD Rule 4730(b)(3).
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    (2) The 17-second period arises regardless of whether the market 
maker executes an unpreferenced market order or an unpreferenced 
marketable limit order.

This rule change is intended to eliminate ambiguities in Nasdaq's 
implementation of this rule and among market participants concerning 
the manner in which unpreferenced orders are executed in SOES.

II. Summary of Comments

    The Commission received 64 comment letters from the public. Of 
these, 58 letters concerned other NASD filings, and thus were 
irrelevant and one comment letter was submitted twice. Of the five 
remaining comment letters, three were in favor of the proposed rule 
change and two were against it. None of these comment letters contained 
any reason for the positions taken.

III. Discussion

    The Commission finds the proposed rule change, by helping to ensure 
that market makers stand willing to buy and sell securities at all 
times, is consistent with the Exchange Act and in particular with 
Sections 15A(b)(6), 15A(b)(9), 15A(b)(11) and 11A(a)(1)(C) of the 
Exchange Act.
    Among other things, Section 15A(b)(6) requires that the rules of a 
national securities association be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, and processing 
information with respect to, and facilitating transactions in 
securities. Section 15A(b)(6) also requires that the rules of a 
national securities association be designed to remove impediments to 
and perfect the mechanism of a free and open market and a national 
market system and in general to protect investors and the public 
interest. Section 15A(b)(9) provides that the rules of the association 
may not impose any burden on competition not necessary or appropriate 
in furtherance of the purposes of the Exchange Act. Section 15A(b)(11) 
requires the NASD, as an association, to adopt rules governing the form 
and content of quotations relating to securities in the Nasdaq market. 
Such rules must be designed to produce fair and informative quotations, 
prevent fictitious and misleading quotations, and promote orderly 
procedures for collecting, distributing, and publishing quotations. 
Section 11A(a)(1)(C) provides that, among other things, it is in the 
public interest to assure the economically efficient execution of 
securities transactions and the availability to brokers, dealers, and 
investors of information with respect to quotations for and 
transactions in securities.
    The Commission believes that the proposed amendments will help to 
ensure that a market maker has no more time than necessary after 
execution--i.e., 17 seconds--before it must update its quotes. This 
requirement will help ensure that a market maker cannot attempt to 
avoid its market making obligations by waiting a lengthy period of time 
after a SOES execution before entering an updated quote.\6\ As a 
result, the proposed rule change should increase a market maker's 
compliance with its obligation to make continuous, two-sided markets 
and promote quote competition among market makers. Such competition 
among market makers should, in turn, enhance the integrity of the 
Nasdaq market by helping to ensure the best execution of customer 
orders and improving the price discovery process for Nasdaq securities.
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    \6\ A market maker that can avoid updating its quote for a 
period of time can take advantage of its temporary ability to avoid 
SOES executions and wait to see how other market makers update their 
quotes. This delay could serve to lessen competition among market 
makers.
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    The Commission also notes that the NASD filed the proposed rule 
change in response to concerns about the rule the Commission raised in 
its Report Pursuant to Section 21(a) of the Securities Exchange Act of 
1934 Regarding the NASD and the Nasdaq Market (``SEC Report''). In 
relevant part, the SEC Report notes that the

October 1991 SOES rule amendments as filed with the Commission also 
allowed for the modification of the SOES operating software to 
provide for a fifteen-second delay between executions by a 
particular market maker. The purpose of this delay was to give the 
SOES market maker an opportunity to update its quotations after 
receiving a report of a trade executed through SOES. In fact, the 
NASD implemented an effective delay of twenty seconds, which reduced 
the ability of SOES users to obtain executions.\7\ The purported 
rationale for the additional five-second delay was to allow for the 
time taken for the electronic transmission of execution reports and 
quote updates. According to internal NASD studies, however, any 
delays in transmission occurred only at the opening of busy trading 
days and the vast majority of any such delays were no more than two 
to three seconds in length. The NASD should have set forth in its 
filings with the Commission seeking approval for the delay that the 
time between executions had been set at twenty seconds, but did not 
do so. The existence of the additional five second delay was 
discovered by the Commission staff during the investigation [that 
led to the issuance of the SEC Report].\8\

    \7\ The Release by the Commission approving the proposed rule 
changes explicitly noted that the delay function was set at fifteen 
seconds and stated that ``[a]ny change in the time period must be 
submitted to the Commission for review pursuant to Section 19(b) of 
the [Exchange] Act.'' Exchange Act Release No. 29810 (October 10, 
1991) 56 FR 52098 (October 17, 1991) n.10. The NASD had never made 
any such submission. (This footnote conforms to footnote 160 in the 
Appendix to the SEC Report.)
    \8\ Appendix to SEC Report at A-62-63.
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    The proposed rule change addresses the concerns of the SEC Report 
by clearly establishing the time delay between SOES executions against 
a market maker. Moreover, the delay includes, in addition to the 
previously established 15-second period, only the time measured by the 
NASD for electronic transmission of an execution report.
    Thus, the proposal to change NASD Rule 4730 is consistent with the 
Exchange Act and in particular with the following sections of that Act:

    (1) Section 15A(b)(6), because it is designed to prevent a 
market maker from failing to meet its obligation to make a 
continuous, two-sided market;
    (2) Section 11A(a)(1)(C)(i)-(iii), because it assures: 
economically efficient execution of securities transactions; fair 
competition among brokers and dealers by encouraging timely, fair, 
and accurate quotations; and the availability to brokers, dealers, 
and investors of timely information concerning these fair and 
accurate quotations.

Further, the proposed change to NASD Rule 4370 is consistent with 
Section 15A(b)(9) of the Exchange Act, because it does not impose any 
burden on competition not necessary or appropriate in furtherance of 
the purposes of the Exchange Act, but merely alters, slightly, a timing 
requirement for market makers.
    Finally, the Commission believes that the proposal is consistent 
with Exchange Act Section 15A(b)(11). In particular, by helping to 
ensure that

[[Page 899]]

SOES market makers update their quotes promptly after executions, the 
proposal should help to produce fair and informative quotations and 
prevent fictitious and misleading quotations.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act, that the proposed rule change (SR-NASD-97-50) be, and 
hereby is, approved.\9\

    \9\ 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 change likely will enhance 
the efficiency and fairness of the process by which market makers 
update their quotes. It likely also will enhance the ability of 
investors to obtain updated market maker quotes quickly, thus 
increasing Nasdaq's transparency. The net effect of approving the 
proposed rule change will be positive. 15 U.S.C. 78c(f).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\10\
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    \10\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-290 Filed 1-6-98; 8:45 am]
BILLING CODE 8010-01-M