[Federal Register Volume 63, Number 48 (Thursday, March 12, 1998)]
[Notices]
[Pages 12124-12140]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-6340]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39718; File No. SR-NASD-98-17]


Self-Regulatory Organizations; Notice of Filing of Amendment No. 
1 to a Proposed Rule Change by National Association of Securities 
Dealers, Inc., Relating to an Integrated Order Delivery and Execution 
System

March 4, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Exchange Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby 
given that on February 19, 1998, the National Association of Securities 
Dealers, Inc. (``NASD''), through its wholly-owned subsidiary, The 
Nasdaq Stock Market, Inc. (``Nasdaq''), 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 Nasdaq.\3\ On March 3, 1998, the NASD filed Amendment 
No. 1 to the proposed rule change.\4\ The Commission is publishing this 
notice to solicit comments on the proposed rule change from interested 
persons.
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    \1\ 15 U.S.C. Sec. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On December 22, 1997, the NASD filed a proposal (SR-NASD-97-
93) that was substantially similar to the proposal discussed in this 
filing. The NASD withdrew that filing when it filed this proposal. 
See letter from Robert E. Aber, Senior Vice President and General 
Counsel, Nasdaq, to Katherine A. England, Assistant Director, 
Division of Market Regulation, dated February 18, 1998. On February 
20, 1998, the NASD filed a technical amendment adding certain 
language regarding handling of non-directed orders. See fax from 
Andrew S. Margolin, Senior Attorney, Office of General Counsel, 
Nasdaq, to Jeffrey R. Schwartz, Special Counsel, Division of Market 
Regulation, dated February 20, 1998. This technical amendment is 
discussed in footnote 42 below
    \4\ See letter from Robert E. Aber, Vice President and General 
Counsel, Nasdaq, to Katherine A. England, Assistant Director, 
Division of Market Regulation, dated March 3, 1998 (``Amendment No. 
1''). Amendment No. 1 corrected several technical errors and added 
language to Section D.3.b. noting that SR-NASD-98-05 changed the 
manner in which Nasdaq handles SOES orders.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    Nasdaq is proposing new rules and amendments to existing rules of 
the NASD to establish an integrated order delivery and execution 
system, featuring a voluntary limit order book and market maker 
sponsored direct access by non-members. The text of the proposed rule 
change is contained in an Exhibit attached to this notice.

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

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

A. General
    Nasdaq is proposing a new integrated order delivery and execution 
system (``System''). The System responds to the demands of investors 
and NASD members for a marketplace that provides for fast and efficient 
access to the best prices in the market and effective integration of 
price discovery, execution, and trade reporting. When combined with a 
broadly accessible voluntary limit order file featuring order anonymity 
and full display of limit order interest, Nasdaq's new System will 
further enhance the satisfaction of a wide range of market participant 
needs. The System represents a logical evolution of Nasdaq in light of 
the changes and growth in trading behavior, particularly as a result of 
the new SEC Order Handling Rules.\5\ The System is designed to leverage 
the benefits of these rules while complementing Nasdaq's competing 
dealer market structure.
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    \5\ See Exchange Act Release No. 37619A (September 6, 1996) 61 
FR 48290 (September 12, 1996) (``Adopting Release'').
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    While Nasdaq seeks to incorporate more order-driven features in the 
Nasdaq environment, Nasdaq will retain the benefits of a competitive 
dealer network by maintaining incentives for market makers that also 
contribute significantly to Nasdaq's liquidity. These incentives 
include a reduction in market maker exposure to unintended multiple 
executions through Nasdaq's systems, enhanced compliance with the Firm 
Quote Rule, the ability for certain market makers to sponsor access by 
institutional customers, and a means of reducing the cost of capital by 
providing a low cost limit order book sponsored by Nasdaq. Importantly, 
because the design of the System is based on the ability of market 
makers to quote their actual size, Nasdaq also believes that a 
disincentive for some market makers would be removed, thus attracting 
more liquidity and pricing efficiency in the Nasdaq market.\6\
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    \6\ Indeed, the Commission noted in its approval of the Actual 
Size Rule pilot (discussed further in Section B.3. below) that ``the 
1000 share minimum quote size represents a barrier to entry for 
market making. Lowering this barrier to entry could attract more 
market makers, thereby increasing liquidity and competition across 
the market.'' See Exchange Act Release No. 38156 (January 10, 1997) 
62 FR 2415, at 2425 (January 16, 1997) (order approving certain 
changes related to implementation of the SEC Order Handling Rules).
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    These incentives and benefits are important, in that Nasdaq 
continues to

[[Page 12125]]

believe that market makers represent a key component of Nasdaq's 
strength, providing necessary liquidity for the market in all Nasdaq 
securities, but especially for lesser known and start-up issuers. The 
new System will provide market makers with a tool that allows them 
efficient and immediate access to the best prices in the market, levels 
the competitive playing field between market makers and electronic 
communications networks (``ECNs''), and provides market makers with 
incentives to risk capital and supply liquidity. In designing this 
proposed System, Nasdaq also has been mindful that the System also 
should provide investors and other traders with immediate and automatic 
executions. The NASD and Nasdaq have attempted to fulfill Nasdaq's 
mission to provide accessible linkages to providers of liquidity as 
displayed in a centralized system, thus facilitating a more efficient 
marketplace. In summary, the System will bring together a broad range 
of participants into a single, integrated electronic system that will 
maximize the role of each participant to the ultimate benefit of all 
participants in the Nasdaq Stock Market as a whole--individual and 
institutional investors, order-entry broker-dealers, market makers, and 
ECNs.
B. Integration of Order Delivery and Execution Systems
    The new System will combine and enhance the functions of two 
distinct trading mechanisms that currently form the core of the Nasdaq 
trading environment: the Small Order Execution Service (``SOES'') and 
SelectNet. As described later in the filing, the new System will 
eliminate the two separate systems, but preserve in one integrated 
system the features and functionality of an automatic order execution 
system, SOES, and the order delivery and negotiation features of 
SelectNet. The efficiency of this new integrated system should enhance 
the ability of traders to trade, while minimizing regulatory concerns 
associated with dual, non-integrated systems that are used to 
simultaneously access the same quote.
1. Background
    SOES was developed in 1984 to provide a simple and efficient means 
to execute small agency orders at the inside quote, report trades for 
public dissemination, and send trades to clearing for comparison and 
settlement.\7\ Trading is done automatically and is negotiation-free. 
In response to the October 1987 market break, SOES was enhanced in 
several respects to provide individual investors with guaranteed 
liquidity and assured access to market makers in times of market 
disruption. In particular, SOES participation was made mandatory for 
all market makers in Nasdaq National market securities, and minimum 
quote size requirements were instituted.\8\ These minimum quote size 
requirements, generally for 1,000 shares, continue to exist today 
except for 150 designated securities for which market makers may quote 
their ``actual size'' pursuant to a pilot program approved by the 
SEC.\9\
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    \7\ See Exchange Act Release No. 21743 (February 12, 1985) 50 FR 
7432 (February 22, 1985) (order approving rule change describing 
SOES).
    \8\ See Exchange Act Release No. 25791 (June 9, 1988) 53 FR 
22594 (June 16, 1988) (order approving amendments to rules governing 
the operation of SOES).
    \9\ See Section B.3. for discussion of actual size.
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    SelectNet, originally referred to as the Order Confirmation 
Transaction Service, was approved by the Commission in January 1988 to 
provide an alternative to verbal contact among trading desks for 
negotiating trades.\10\ SelectNet also was developed in response to the 
difficulties experienced in the Nasdaq market during the market break 
of October 1987.\11\
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    \10\ See Exchange Act Release No. 25263 (January 11, 1988) 53 FR 
1430 (January 19, 1988) (order approving SelectNet on a temporary, 
accelerated basis). See also, Exchange Act Release No. 25523 (March 
28, 1988) 53 FR 10965 (April 4, 1988) (order extending temporary 
approval of SelectNet); Exchange Act Release No. 25690 (May 11, 
1988) 53 FR 17523 (May 17, 1988) (order granting permanent approval 
of SelectNet).
    \11\ The service was enhanced and renamed SelectNet in 1990. See 
Exchange Act Release No. 28636 (November 21, 1990) 55 FR 49732 
(November 30, 1990). In 1992, the service was expanded to add pre-
opening and after-hours sessions, so that today SelectNet is 
available for members to negotiate and execute orders from 9:00 a.m. 
until 5:15 p.m. (ET). See Exchange Act Release No. 30581 (April 14, 
1992) 57 FR 14596 (April 21, 1992).
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    SelectNet is an electronic, screen-based order routing system 
allowing market makers and order-entry firms (collectively referred to 
as ``participants'') to negotiate securities transaction in Nasdaq 
securities through computer communications rather than relying on the 
telephone. Unlike SOES, SelectNet offers the opportunity to negotiate 
for a price superior to the current inside quote. In addition, 
SelectNet participants may provide that an order or counter-offer will 
be in effect for anywhere from 3 to 99 minutes, specify a day order, or 
indicate whether price or size are negotiable or whether a specific 
minimum quantity is acceptable. Participants may accept, counter, or 
decline a SelectNet order. Once agreement is reached, the execution is 
``locked-in'' and reported to the tape for public dissemination and 
sent to clearing to comparison and settlement.
    SelectNet allows subscribers to direct, or ``preference'' orders to 
specified market makers or to broadcast orders to all market makers. 
Although SelectNet is an order delivery service, rather than an order 
execution service, a preferenced SelectNet order presented to a market 
maker at its displayed quote generally gives rise to a liability under 
SEC Rule 11Ac1-1 (``Firm Quote Rule'') for the market maker to execute 
the transaction at that price.\12\
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    \12\ There are two exceptions to the Firm Quote Rule: (1) prior 
to the receipt of the order, the market maker has communicated to 
its exchange or association a revised quotation size or revised bid 
or offer; or (2) prior to the receipt of the order, the market maker 
is in the process of effecting a transaction in a security when an 
order in the same security is presented, and immediately after the 
completion of such transaction, the market maker communicates to its 
exchange or association a revised quotation size or revised bid or 
offer.
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    More recently, Nasdaq established SelectNet as the link to ECNs in 
conjunction with the SEC's Order Handling Rules. Specifically, an 
amendment to SEC Rule 11Ac1-1 now requires an OTC market maker to make 
publicly available any superior prices that the market maker privately 
quotes through an ECN. A market maker may comply with this requirement 
by changing its quote to reflect the superior price, or in the 
alternative, may deliver better prices orders to an ECN provided that 
the ECN disseminates these priced order to the public quotation system 
and provides broker-dealers equivalent access to these orders (``ECN 
Display Alternative''). The SelectNet linkage was implemented to 
facilitate this dissemination and equivalent access.\13\
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    \13\ See Exchange Act Release No. 38156 (January 10, 1997) 62 FR 
2415 (January 16, 1997) (order approving certain changes related to 
implementation of the SEC Order Handling Rules).
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2. Issues Related to the Current Operation of Nasdaq's Non-Integrated 
Order Delivery and Execution Systems
    While SOES and SelectNet each provide valuable services to market 
participants for the benefit of investors, there are a number of 
problems associated with maintaining these two separate systems side-
by-side, which are well understood by the SEC, NASD, and market 
participants. Most troublesome are the problems members have in 
managing multiple points of execution. This manifests itself most 
noticeably when a market maker's quote is subject to multiple access 
virtually simultaneously, through a combination of SOES and SelectNet, 
from the same or different market participants. Because the Firm Quote 
Rule obligates a member to execute orders presented to it at its

[[Page 12126]]

displayed quote, a firm may be subject to unintended double liability 
while trying to effectively manage executions from SOES and liability 
orders from SelectNet at the same time. This is compounded further when 
market makers also are handling orders received by phone as well as 
orders within their own internal execution systems.
    The potential for this problem is exacerbated by an exponential 
increase in the use of SelectNet during the last few years, and in 
particular during the past several months. For example, for the period 
of October, 1996 through September, 1997, both the number of 
transactions and dollar volume executed through SelectNet has increased 
nearly six-fold.\14\ In addition, SelectNet has represented an 
increasing proportion of Nasdaq's total trades and dollar volume during 
the same period--from approximately 5% to nearly 15%. This trend may be 
attributed to several related factors, including: (1) The growing 
importance of electronic access within the Nasdaq market and a 
corresponding migration away from the ``phone trades'' to automated 
systems; (2) increase in the use of SelectNet by market makers as a 
vehicle for trading in size without negotiation, given that market 
makers are prohibited from using SOES for proprietary transactions; (3) 
implementation of the SEC's Order Handling Rules and the related role 
SelectNet plays in providing a link between Nasdaq and ECNs,\15\ and 
(4) a heightened awareness of trading obligations by market 
participants.
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    \14\ In comparison, average daily volume of Nasdaq during the 
same period has increased a relatively modest 30 percent.
    \15\ Growth in SelectNet usage closely tracks expansion in the 
number of Nasdaq stocks covered by the SEC Order Handling Rules.
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    As a result, there also has been a corresponding increase in 
regulatory and compliance burdens for both market participants and 
staff of NASD Regulation, Inc., (``NASDR''), who are responsible for 
investigating complaints that may involve ``backing away'' from 
published quotes, and enforcing the Firm Quote Rule.\16\ Indeed, in a 
letter from staff of the SEC's Division of Market Regulation responding 
to a request for interpretive guidance on the Firm Quote Rule in this 
context, the SEC acknowledged the difficulty in articulating a ``bright 
line'' test on what constitutes backing away, and noted that the double 
execution problem arising from Nasdaq providing two automated order 
delivery and execution systems could be eliminated by integrating these 
two systems.\17\
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    \16\ The NASD has rules similar to the SEC Firm Quote Rule. See 
NASD Rules 3320 and 4613(b).
    \17\ See letter from Richard R. Lindsey, Director, Market 
Regulation, To Richard G. Ketchum, Executive Vice President and 
Chief Operating Officer, NASD, and Mary L. Schapiro, President 
NASDR, dated July 16, 1997.
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    Given these practical and regulatory problems, the NASD and Nasdaq 
believe that it would be prudent to combine the two systems as soon as 
practicable. Integration would facilitate the orderly processing of 
electronic orders through one communications facility while easing 
associated regulatory and compliance burdens, in addition, to assist 
market makers in complying with the Firm Quote Rule, Nasdaq is 
proposing a System feature to provide market makers with a means to 
indicate to staff of NASDR that the market maker has received an order 
via the telephone to trade at the market maker's Nasd-displayed 
quotation and that for a period of time while the System market maker 
handles the telephone order, the System should not deliver additional 
orders for execution.\18\ This ``Firm Quote Compliance Facility'' will 
create an electronically time stamped record that will be critical in 
NASDR's efforts to reconstruct activity that may involve backing 
away.\19\
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    \18\ See Section D.10. below and proposed NASD Rule 4960.
    \19\ As part of the undertakings pursuant to the Commission's 
administrative proceeding, the NASD is required to upgrade 
substantially its capability to enforce the Firm Quote Rule by 
implementing a process for backing away complaints to be addressed 
as they are made during trading day do that valid complaints may be 
satisfied with a contemporaneous trade execution, and taking other 
appropriate actions. See Exchange Act Release No. 37538 (August 
8,1996), Administrative Proceeding File No. 3-9056 (Order 
Instituting Public Proceedings Pursuant to Section 19(h)(1) of the 
Securities Exchange Act of 1934, Making Findings and Imposing 
Remedial Sanctions).
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    In developing an integrated System, Nasdaq seeks to provide the 
most equitable and efficient means of access among market participants. 
A key design requirement of such a system dictates that orders 
communicated through Nasdaq be delivered in strict time priority, 
regardless of whether the order is sent to a specific participant 
(directed) or to any participant at the best available quote (non-
directed). This would be impossible in the current environment given 
the nature of two separate and asynchronous order delivery and 
execution systems. Most importantly, this also will assist market 
makers in managing their displayed quotations, further enhancing the 
efficiency of the market.
3. Relationship of Proposal To Actual Size Rule
    It is important to note that the integration of Nasdaq's order 
delivery and execution infrastructure and the ability of members to 
enter orders of virtually unlimited size, as set forth in this filing, 
is based on the ability of market makers to quote their actual size, as 
opposed to artificial minimum quote size requirements currently in 
effect for most stocks in SOES today. Under current rules, market 
makers generally are required to quote a minimum of 1,000 shares on the 
bid and the offer (for some less active issues, the minimum is 500 or 
200 shares).
    With the introduction of the SEC Order Handling Rules in January of 
1997, market makers are now obligated to display customer limit orders 
in their quotations. Given the full implementation of these rules, 
which have altered Nasdaq's structure from a predominantly quote-driven 
market toward a more order-driven market, Nasdaq believes that the 
rationale for minimum quote size requirements no longer exists. We 
believe these changes warranted consideration of eliminating the 
requirement that market makers quote artificial minimum size of 1,000 
shares. On January 20, 1997, therefore, we began a pilot covering 50 
Nasdaq securities allowing market makers to quote their actual size, 
thereby reducing minimum quotation size requirements to a least one 
normal unit of trading and allowing market makers to quote in 
accordance with their freely-determined trading interest (``Actual Size 
Rule'').\20\ On November 10, 1997, the Actual Size Rule pilot was 
expanded to include an additional 100 securities.\21\ These securities 
represent a broad range of securities listed on the Nasdaq Stock 
Market. We are monitoring this pilot and expect to report its effects 
on the market to the SEC in early 1998.\22\
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    \20\ See Exchange Act Release No. 38156 (January 10, 1997) 62 FR 
2415 (January 16, 1997) (order approving, among other things, Actual 
Size Rule pilot for first fifty stocks phased in under Order 
Handling Rules).
    \21\ See Exchange Act Release No. 39285 (October 29, 1997) 62 FR 
59932 (order approving an expansion of the Actual Size pilot to 150 
stocks and extending the pilot until March 27, 1998).
    \22\ No other equity market requires minimum quote sizes greater 
than 100 shares. Empirical analysis thus far has demonstrated that 
the removal of minimum quote size requirements under the Actual Size 
Rule pilot has not degraded market quality, and there is no basis to 
conclude that such requirements are necessary. See NASD Economic 
Research Department, Effects of the Removal of Minimum Sizes for 
Proprietary Quotes in The Nasdaq Stock Market, Inc. (June 5, 1997).
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    The changes to Nasdaq systems set forth in this proposal are 
designed to complement market makers quoting in

[[Page 12127]]

actual size. To the extent that the Actual Size Rule is not approved 
for all Nasdaq securities, an alternative proposal is being made to 
minimize the exposure to market makers at artificial quote sizes. This 
is particularly necessary given the potential under the new System to 
access market marker quotes for much larger size than the current SOES 
tier sizes would otherwise permit. Such alternative provisions are 
noted in this filing where relevant, and are also identified in the 
text of the proposed rule change accordingly.\23\
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    \23\ See, e.g., proposed rules 4940(b)(3) and 4950(c).
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    As part of the new System, Nasdaq is proposing to eliminate certain 
rules that currently are in place for the operation of SOES. As 
indicated, SOES was designed exclusively for individual retail 
customers orders restricted to a maximum size. These order sizes 
correspond to a market maker's minimum quote size requirements. 
Specifically, NASD Rule 4730(c)(3) permits only agency orders from 
public customers no larger than the maximum order size \24\ to be 
entered into SOES (``Maximum Order Size Rule''). That rule also 
prohibits large orders from being divided into smaller parts to be 
entered into SOES. A related interpretation of this rule prohibits 
behavior designed to circumvent the order size limits. Specifically, as 
set forth in Notice to Members 88-61 (August 25, 1988), trades entered 
within a five minute period are presumed to be part of a ``single 
investment decision'' and are aggregated accordingly (``Five Minute 
Rule''). Because Nasdaq is proposing to replace all the SOES rules, and 
because the System is based on the ability of market makers to quote 
actual size, the Maximum Order Rule and its related interpretation 
(including the Five Minute Rule) become unnecessary, and therefore 
those rules would be eliminated.
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    \24\ Rule 4710(g) establishes the maximum order size for a 
Nasdaq National Market security at 200, 500, or 1,000 shares, 
depending on the trading characteristics of the security, such as 
the average daily non-block volume, bid price, and number of market 
makers. The maximum order size for Nasdaq SmallCap securities is 500 
shares. The Maximum size for each security is published from time to 
time by the NADAD.
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    However, if the NASD's proposal to eliminate artificial quote size 
requirements for all Nasdaq securities is not approved by the time that 
the new integrated order delivery and execution system is approved, the 
NASD believes that certain order entry features of the new System would 
not be appropriate in an artificial quote size environment. 
Specifically, the NASD proposes in the alternative that all of the 
existing restrictions on order entry by non-market makers should 
continue. Thus, in the absence of prior approval of the Actual Size 
Rule, non-market makers should not be permitted to enter orders larger 
than 1,000 shares for non-directed orders, and the prohibition on 
splitting of orders and the Five Minute Rule be retained.\25\
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    \25\ The only exception to the elimination of the old SOES Rules 
concepts on limits on order entry is the continuation of the 
prohibition that registered persons that have access to order entry 
systems should not be permitted to enter orders for their own 
accounts. Nasdaq believes that it is appropriate to continue this 
prohibition because of the time and place advantage that such 
persons may have over others not similarly situated. As a policy 
matter, therefore, Nasdaq believes it would be inconsistent with the 
obligations of member firms and their associated persons to 
facilitate access that could potentially place the personal 
interests of registered personnel ahead of their customers. The 
prohibition, however, would no longer extend to accounts of 
immediate family members of such registered persons.
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C. Limit Order Book
    The System also will feature a voluntary limit order book (``Limit 
Order File'' or ``File'') for the display and matching of limit orders. 
Use of the Nasdaq Limit Order File will be completely voluntary on the 
part of NASD members that have customer limit orders to display or 
proprietary interest that such members may want to display anonymously. 
It should be emphasized that the NASD and Nasdaq Boards, in authorizing 
this rule filing, agreed that the NASD had not intention to create a 
regulatory environment that would mandate NASD member use of the Limit 
Order File. Furthermore, the proposal does not require members to 
protect orders in the Limit Over File beyond the member's best 
execution obligations. The new Limit Order File will simply be an 
additional means for members and their customers to display priced 
orders to the entire market. Thus, the proposed File merely provides 
another option for displaying orders and is intended to supplement, not 
supplant, the exiting options, i.e., a market maker's quotation or a 
linked ECN.
    The Limit Order File will facilitate the opportunity to obtain 
price improvement by allowing member firms to display customer limit 
orders or their own trading interest between the best dealer or ECN bid 
and offer, and by facilitating interaction with other orders within the 
File or with other participants who access the File, resulting in a 
prompt, cost-effective execution at the best available price. The best 
priced orders in the Limit Order File will be publicly displayed in 
Nasdaq's quote montage and in a separate ``Top of File'' display. When 
the Limit Order File contains the best priced orders in the market, 
such prices will be used to calculate the Nasdaq ``inside'' quote, 
providing increased transparency and pricing efficiency.
    These orders, which can be accessed by other market participants, 
will be entered and displayed anonymously. That is, the member that 
enters the order will not have its identifier (its MMID symbol) 
displayed with the order. Initially, the NASD is proposing that after 
any resulting execution of a File order, the identity of the party 
entering the order will be revealed to any counter-parties to the 
execution in an execution report that is sent immediately after 
execution to the parties to the trade. The NASD continues to analyze 
the anonymity feature and, at a future date and subject to a new rule 
proposal, may provide either anonymity of executions in the File until 
the end of the trading day or complete anonymity of executions through 
settlement. However, at this stage, the NASD believes that anonymity up 
until execution provides sufficient protection to traders from negative 
market impact costs caused by premature disclosure of trading interest. 
As explained in more detail later, the NASD believes that it would be 
useful if commenters specifically addressed the needs of traders and 
investors with respect to these differing levels of anonymity.
    Importantly, the Limit Order File can be used by market makers to 
satisfy the customer limit order display rule, SEC Rule 11Ac1-4 
(``Display Rule''), which would otherwise require a market maker to 
update its own quote immediately to reflect a customer limit order. 
Specifically, an exception to the Display Rule applies when limit order 
are immediately displayed in an NASD-sponsored system that publishes 
the best priced orders and permits access by other broker-dealers. As 
indicated, the Top of File of the Nasdaq book is included in the Nasdaq 
quote montage, and therefore a market maker may, upon receipt of a 
customer limit order, deliver it to the File immediately to satisfy the 
requirements of the Display Rule, pursuant to SEC Rule 11Ac1-4(c)(5).
    In addition, a market maker may choose to use the File to display 
orders priced better than its published quote without reflecting the 
order in its quote as would be required pursuant to recent amendments 
to SEC Rule 11Ac1-1. Specifically, this is permissible under paragraph 
(c)(5) of that rule because the best priced orders contained in the 
Limit Order File are publicly disseminated in Nasdaq and are

[[Page 12128]]

available for execution by other broker-dealers.
    As indicated, the Limit Order File offers Nasdaq market makers a 
voluntary mechanism to display customer limit orders when the market 
maker chooses not to display such orders in its own quote or in an ECN. 
Because the Limit Order File is completely voluntary, market makers 
should be able to continue to attract limit orders from investors and 
other broker-dealers by offering value-added features to customers that 
a generic file such as that proposed by Nasdaq can not provide.
    The Limit Order File also responds to the needs and desires of a 
significant element of the investor community: the institutional ``buy-
side'' trader. The Institutional Committee of the Security Traders 
Association (STA) recently completed a survey of such institutional 
traders, wherein STA found that an overwhelming majority of 
institutions were aware of Nasdaq's initiative to establish a limit 
order book accessible to all market participants, and voiced strong 
support for it.\26\ As explained in Sections D.5. and D.6. below, the 
File will provide investors and others with the ability to anonymously 
display orders. STA's survey indicated that some level of anonymity was 
an important feature for institutional investors. By providing 
anonymity as to the identity of the party entering the order, the File 
can help to reduce market impact costs that may affect the ability of 
institutions to obtain low-cost executions. In addition, because the 
Limit Order File will be fully viewable to all subscribers of Nasdaq's 
Workstation service and through vendor terminals, Nasdaq will be 
providing added transparency to the market by displaying the entire 
supply and demand schedule in the File.
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    \26\ See STA Institutional Study (http://securitytraders.org/
newslett/news/release1/right.htm), October, 1997. According to STA, 
the results were based on 154 responses received from buy-side 
traders out of approximately 800 who were mailed the survey.
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    Overall, the NASD believes that the development of a Nasdaq-
operated, voluntary limit order file will benefit investors and members 
and, therefore, is in the best interest of the marketplace. The NASD 
and Nasdaq note that virtually every other major equity market around 
the world, including now the London Stock Exchange, provides a market-
run limit order facility for the display of limit orders; each of those 
markets that recently added an electronic limit order book did so to 
respond to investor needs. For investors, both retail and 
institutional, the proposed voluntary File creates an additional and 
efficient mechanism for investors to display priced orders and to 
potentially trade at reduced spreads without the intermediation of a 
dealer, a Congressional goal embedded in the Exchange Act. For retail 
investors, the Limit Order File should promote greater confidence in 
Nasdaq's market structure because it offers another vehicle for 
transparency and more efficient execution of limit orders. In addition, 
the File should work toward reducing the perception among some retail 
investors that the playing field is tilted in favor of broker-dealers 
and larger investors.
D. Description of New Rules
1. Overview and Scope
    The new System will replace completely the existing SOES and 
SelectNet systems. The functionality previously contained in these two 
separate systems will be integrated into a single system, which should 
alleviate many of the concerns market makers have had with exposure to 
multiple points of simultaneous execution liabilities. The new System 
will permit all registered participants to send orders to access either 
the best market maker quote or ECN order, or orders visible in the 
Nasdaq Limit Order File, and to obtain immediate or rapid executions of 
such orders.
    As occurs in today's environment, the new System will have three 
types of registered executing participants: market makers, ECNs and UTP 
exchange specialists. Quotations provided by these three entities will 
be displayed on Nasdaq Workstation and disseminated through information 
venders. Registered NASD members, and certain customers that are 
sponsored by NASD members, will be able to deliver orders of varying 
size through the new System to electronically access the displayed 
quotations. Market maker and ECN display obligations will be the same 
as today. As provided for in the proposed rules, market makers must 
maintain two-sided quotations and be firm up to the displayed size of 
such quotations. The System will provide for market makers an automated 
quotation update facility similar to that which is provided today.\27\
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    \27\ The automated quotation update facility will refresh a 
market maker's quotation at an increment chosen by the market maker. 
The facility will not permit a refresh at the same price as that 
being quoted when the quotation size was reduced to zero. When the 
facility refreshes the quotation, the size of the refresh quotation 
will be 1,000 shares. If the market maker wishes to quote in a size 
other than 1,000 shares, the market maker must manually enter that 
size after the quote has been refreshed.
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    The NASD and Nasdaq, however, are proposing a slight change to its 
current operation. After a market maker's quote is exhausted, that is, 
the System has decreased the displayed size to zero, if the market 
maker is not using the system-provided automated quotation update 
facility or the System's supplemental size feature,\28\ the market 
maker's quote (both the bid and the offer sides, regardless of which 
side was reduced to zero) will be placed in a closed quote state for 
three minutes, instead of the current five minutes. At the end of that 
time period, if the market maker has not on its own updated its 
quotation or voluntarily withdrawn its quote from the market, the 
System will refresh the side of the quotation that was reduced to zero 
to 1,000 shares at the lowest bid or highest offer (depending on 
whether the quote is a bid or offer, respectively) currently being 
displayed in that security and reopen the market maker's quotation. The 
NASD is proposing to make these two changes to the current approach 
because its believes that in the proposed electronic environment, five 
minutes is too long a period to have a quote closed on the Nasdaq 
screen, and because it believes that restoring the quote at the lowest 
ranked bid or highest ranked offer price and ensure that market makers 
maintain continued participation in the market and are available to 
provide liquidity in a manner consistent with their market making 
obligations.\29\
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    \28\ Supplemental size is discussed further in Sections D.3.a 
and D.4.a. See, also, proposed rules 4950(d)(6), 4950(e)(3)(D), and 
4950(f).
    \29\ Under current NASD Rule 4730, a market maker whose quote is 
decremented to zero and fails to restore its quote in the allotted 
time will be deemed to have withdrawn as a market maker (``SOESed 
out of the Box''). Subject to certain specified exceptions, the 
market maker is prohibited from re-entering quotations in that 
security for twenty (20) business days.
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2. Order Entry
    The rules permit any size order up to 999,999 shares to be entered. 
As indicated, however, it is important to note that this large size 
permitted for order entry is based on the ability of market makers to 
display actual size in their quotations.\30\ Thus, in the context of 
non-directed orders, discussed further in Section D.3.b., the System 
will permit order delivery for execution to each market maker, ECN or 
the Nasdaq Limit Order File only up to the size of the quote or order 
that is displayed.\31\
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    \30\ See Section B.3. for discussion of actual size.
    \31\ As explained below in Section D.3.a., any order entry firm 
is permitted to direct an order to a specific market maker, ECN, or 
UTP Exchange specialist. The size of such directed orders is not 
constrained by the executing participant's displayed quote size. 
However, the executing participant's liability to fill the order 
under the Firm Quote Rule is limited to the amount of shares 
publicly displayed in the quotation.

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[[Page 12129]]

    The minimum life for such orders shall be 10 seconds. The NASD 
believes that orders in the System should have a minimum life to 
alleviate potential problems that could occur with fleeting or 
ephemeral prices that are flashed to the market for brief periods of 
time and are virtually inaccessible by other market participants.
    a. Customer Orders. All members may enter orders on behalf of 
customers. If the Actual Size Rule is approved for all Nasdaq stocks on 
a permanent basis, Nasdaq would eliminate the current SOES rule 
prohibiting the splitting of orders and requiring the aggregation of 
orders within a five minute period, including orders from immediate 
family members of associated persons, to evade the maximum order size 
limits found in SOES.\32\ However, even in an actual size environment, 
the NASD plans to maintain the current restriction on the ability of 
registered representatives that have access to Nasdaq order entry 
capabilities to enter orders for their own accounts into this system. 
The NASD believes that maintaining this restriction is important to 
minimize the time and place advantages that these professionals may 
continue to have.
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    \32\ See NASD Notice to Members 88-61 (August 25, 1988).
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    If the Actual Size Rule is not approved, however, the NASD 
proposes, in the alternative, to maintain the existing restrictions and 
to limit the size of orders entered by non-market makers to 1,000 
shares. The NASD believes that this alternative, contingent approach is 
appropriate to ensure that market makers' risk is minimized and that 
their capital is not accessed in an essentially unfettered manner in an 
artificial quote size environment.
    b. Proprietary Orders. Also contingent on the expansion and 
approval of the Actual Size Rule for all Nasdaq stocks, the proposed 
rules permit any NASD member to enter proprietary orders into the 
System for immediate execution, order delivery, or display in the 
Limited Order File. The NASD believes that any NASD member, whether it 
is an order entry firm or a market maker in a particular stock, should 
be permitted to enter proprietary orders. The rationale for permitting 
a broad use of proprietary orders is that entry of such orders may 
provide additional liquidity to the market and that any member is 
currently able to enter such orders through an ECN. It would be 
illogical to limit the use of Nasdaq's Limit Order File when the same 
activity is already permissible through other vehicles. It should be 
noted, however, that the NASD intends to monitor principal trading 
activity by NASD members not registered as market makers to determine 
if it may be necessary to adopt a rule similar to that found in the 
exchange-listed market environment, where SEC rules require Third 
Market Makers that effect more than 1% of the volume of a particular 
stock to register and quote as a Third Market Maker.\33\ In any event, 
without the approval of the Actual Size Rule for all Nasdaq securities, 
the NASD is proposing an alternative to prohibit the entry of any 
principal orders by non-market makers.
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    \33\ In connection with the approval of the SEC Order Handling 
Rules, the SEC adopted an amendment to Rule 11Ac1-1 to improve 
transparency and provide the public with information about 
significant market participants. The amendment requires OTC market 
makers and exchange specialists to provide continuous two-sided 
quotations for any exchange-listed security when they are 
responsible for more than 1% of aggregated transaction volume in 
that security. See Adopting Release, at 48317. Prior to this 
amendment, mandatory quotations were only required from OTC market 
makers and exchange specialists who transacted more than 1% of the 
volume in a Rule 19c-3 security. In addition, the SEC has proposed a 
similar rule for Nasdaq securities. See Exchange Act Release No. 
37620 (August 29, 1996) 61 FR 48333 (September 12, 1996) (proposal 
to amend SEC Rule 11Ac1-1).
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3. Types of Electronic Access Orders
    The System will permit the entry of two types of orders that seek 
to access displayed prices on the Nasdaq screen: directed and non-
directed orders.
    a. Directed Orders. Directed orders are orders that an order-entry 
firm chooses to send to a specific market maker, ECN or UTP exchange 
for delivery and execution.\34\ The directed order concept is an 
attempt to preserve certain features found in SelectNet where firms 
seek to access a particular market maker's quotation and commence 
electronic negotiation. During normal market hours,\35\ these orders 
are processed in sequence with all other orders that may be sent to a 
particular market maker, ECN or UTP exchange. Therefore, a directed 
order would not enjoy any preferential delivery treatment over other, 
non-directed orders (discussed below) delivered to the same market 
maker, ECN or UTP. Directed orders do not interact with orders in the 
Limit Order File \36\ or with other quotes displayed in the Nasdaq 
quote montage. That is, all orders are time-sequenced without regard to 
their classification as directed or non-directed, and thus a directed 
order would not be delivered to, or executed against, a participant 
until any order previously delivered to that participant was processed 
first.
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    \34\ The proposed rules continue to limit the ability of a 
member to send orders to a UTP Exchange by the directed order 
mechanism only. In other words, NASD members that uses Nasdaq's 
system to access the quotation of a UTP Exchange must send that 
order as a directed order to the Exchange. The NASD plans to discuss 
with UTP Plan participants participation in the non-directed order 
handling process.
    \35\ Outside of normal market hours, e.g., from 9:00 a.m. until 
9:30 a.m. and from 4:00 p.m. until 5:15 p.m., the only means to 
reach a market maker quote or an ECN order through Nasdaq's 
electronic system will be through the directed order feature. Such 
orders must be sent to a specific quote with the appropriate MMID 
identified. Such orders will not have any Firm Quote Rule liability 
attached to them, unless during the post 4:00 p.m. period, a market 
maker or ECN intentionally re-opens its quote that is automatically 
placed in a closed quote state by Nasdaq at 4:00 p.m. A market maker 
that opens its quote momentarily, however, solely for the purpose of 
adjusting its quote to reflect the elimination of customer limit 
orders, will not be subject to Firm Quote Liability. See letter from 
Howard L. Kramer, Senior Associate Director, Market Regulation, to 
Robert E. Aber, Vice President and General Counsel, Nasdaq, dated 
August 25, 1997.
    \36\ Nasdaq will provide a system capability to reach the Limit 
Order File directly--the takeout facility. A takeout order will be a 
System-provided feature that permits a member to directly interact 
with orders displayed in the Limit Order File, but only those orders 
that were entered by that member, either for itself or its customer.
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    Upon order entry, a member that wishes to send an order to a 
specific market maker, ECN or a UTP exchange would be required to 
specifically enter the MMID for the quote that it wants to access. The 
directed order will be entered into the System and placed in a time-
sequenced queue with all other orders, both directed and non-directed, 
that have been entered for that security. Depending on the time 
sequence of the directed order, the order will be delivered to the 
particular MMID identified by the order entry firm when the order's 
turn for delivery arrives. Once delivered to that MMID, the directed 
order will be handled for execution purposes as described below in the 
non-directed order context. That is, if the order is 1,000 shares or 
less and the market maker or ECN quotation is equal to or greater than 
the size of the order, the System will automatically execute the order 
and decrease the displayed quote size by the amount executed. If the 
order is larger than 1,000 shares but less than 5,000 shares, the order 
will be delivered to the market maker or ECN for action for a period of 
17 seconds. If the order is 5,000 shares or greater, it will be 
delivered to the market maker or ECN for action for a period of 32 
seconds. If the recipient of the order has done nothing at the end of 
the applicable period, the System will execute the order up to the 
displayed quote size of the recipient. During the

[[Page 12130]]

delivery period, the recipient is permitted to accept, partially 
execute, or decline the order. Any partial execution or decline must be 
done in compliance with the Firm Quote Rule; all such actions will be 
forwarded to NASDR for its review.
    Directed orders may be sent to a particular executing participant 
at a price or size that is not being displayed by that participant. For 
example, if a market maker is quoting 20 bid for 1,000 shares (with no 
supplemental size), an order entry firm may choose to direct to that 
market maker an order for 10,000 shares at 20. The market maker has 
several options available when that order is received. First, pursuant 
to the market maker's firm quote obligation, the market maker may 
immediately choose to accept 1,000 shares and decline the balance. In 
the alternative, the market maker could choose to accept any additional 
amount up to 10,000 shares. Under another alternative, the market maker 
may choose to do nothing, in which case at the end of 32 seconds 
(because the order sent is 5,000 shares or greater) 1,000 shares will 
be automatically executed against the market maker at 20 and its quote 
will be decreased to zero.
    Directed orders (as well as non-directed orders) will be able to 
interact with a market maker's supplemental size. As explained below, 
market makers will be permitted to enter a supplemental size that will 
replenish their displayed quote sizes when the System executes an order 
against the displayed quote.\37\ If a directed order larger than a 
market maker's displayed size is sent to a market maker that is using 
supplemental size, and the market maker does not respond to that order 
within the 17 or 32 second period, depending on the size of the order 
entered, the order will execute against the market maker's displayed 
size and its supplemental size. For example, if MMA is displaying 20 
bid for 1,000 shares with a supplemental size of 10,000 shares, and 
order entry Firm B sends a directed order to sell 8,000 shares to MMA 
at 20, and MMA does not respond with an accept, partial or decline 
response within 32 seconds, the System will execute the entire order 
against MMA for 8,000 shares.
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    \37\ The amount of interest entered into supplemental size by a 
System market maker may be any amount up to 99,000 shares, provided 
that the facility will refresh quotations in a minimum increment of 
1,000 shares. There will not be an ability to maintain unlimited 
supplemental size (i.e., a ``No Dec'' feature will not be 
available).
---------------------------------------------------------------------------

    All directed orders that are delivered for a response (as opposed 
to being automatically executed), will be designated by the System as 
``liability'' or ``non-liability'' orders when delivered. A liability 
order is an order that a broker-dealer is required to respond to 
consistent with the obligations imposed by the SEC and NASD Firm Quote 
Rules.\38\ For example, if Market Maker A is quoting 20 bid for 1,000 
shares, a directed order that is sent to MMA to sell 1,000 shares at 20 
is a liability order. In other words, MMA must respond consistent with 
the Firm Quote Rule. If MMA is quoting 20 bid for 1,000 shares, and the 
order entry firm directs an order to sell 20,000 shares at 20\1/16\th 
to MMA, such an order would be a non-liability order for which MMA has 
no responsibility to respond. MMA could, however, choose to accept the 
order at the higher price. MMA also could do nothing with such order 
and at the end of 32 seconds the order would time out and be returned 
to the order entry firm. If the directed order sent to MMA were priced 
to sell at 20 for 20,000 shares, MMA would have Firm Quote Rule 
liability for 1,000 shares.
---------------------------------------------------------------------------

    \38\ Market makers that use supplemental size do not have 
liability under the Firm Quote Rule for the amount of shares 
contained in the supplemental size facility. However, the System 
will reach into a market maker's supplemental size to execute 
directed orders that are larger than displayed size, unless the 
market maker declines the order prior to the expiration of the 17 or 
32 second period normally allotted for directed orders. If the 
market maker declines any portion of the order when using 
supplemental size, the System will close the market maker's quote 
and reduce the supplemental size to zero.
---------------------------------------------------------------------------

    b. Non-Directed Orders. Non-directed orders are orders that are not 
sent to a particular market maker or ECN. That is, when the member 
entering the System does not specify the particular market maker, ECN 
or UTP exchange it wants to access, the order will be sent to the next 
available executing participant \39\ quoting at the best price 
displayed in Nasdaq. Non-directed orders may be priced orders or market 
orders. The first non-directed order in time sequence interacts with 
the best quote or order in the Nasdaq quote montage (market maker 
quotes, ECN orders, or Limit Order File orders) in price/time sequence, 
that is, with the best priced quote or order. If two or more quotes or 
orders are at the same price, then the non-directed order interacts 
with the first such quote or order in time sequence.
---------------------------------------------------------------------------

    \39\ At this time, non-directed orders cannot be sent to UTP 
Exchanges because Nasdaq and the UTP Participants have not addressed 
order handling in the context of the proposed System. As noted 
above, Nasdaq plans to discuss the matter with the other UTP Plan 
participants to seek a resolution of order delivery and execution in 
the new System. Until such a resolution is reached, firms seeking to 
access a UTP Exchange's quote through Nasdaq systems must send a 
directed order to that exchange.
---------------------------------------------------------------------------

    For example, MMA is quoting a bid of 20 for 1,000 shares; MMB is 
also quoting a bid of 20 for 1,000 shares, but posted its quote 10 
seconds after MMA; and MMC is quoting 19\7/8\ bid for 1,000 shares. 
Another member seeks to sell 500 shares at the market in that security 
and enters a non-directed order for that amount. Upon entry into the 
System, the order is sent to MMA for execution. As explained below in 
Section D.4.a. on Order Execution Parameters, this order will 
automatically execute against MMA, and MMA's quote size will be 
decreased by the System to 500 shares at 20 bid. If two non-directed 
orders to sell 1,000 shares each had been entered, the first order 
entered (as time-stamped by Nasdaq) would be automatically executed 
against MMA, the second order would be automatically executed against 
MMB and, assuming that neither market maker was using the supplemental 
size feature provided by the System, both 20 bid quotes would be 
decreased to 0 size and MMC at 19\7/8\ would become the best bid in 
Nasdaq for this security. If an order entry firm entered a non-directed 
2,000 share sell market order, the System will split that order, and 
send 1,000 shares to MMA and 1,000 shares to MMB at the same time for 
automatic execution.
    The NASD believes that it is appropriate to place all providers of 
liquidity in the Nasdaq market on the same footing with respect to 
order executions through Nasdaq's systems. Thus, this proposal 
contemplates that ECNs, as well as market makers, should be subject to 
automatic executions of non-directed and directed orders. In the 
current environment, quotes of linked ECNs that are displayed in Nasdaq 
are accessible only through Nasdaq's SelectNet system, a system which 
is not an automatic execution system like SOES.\40\ Market makers, 
however, are accessible through both systems. As proposed, Nasdaq 
believes that quotes of linked ECNs should also be

[[Page 12131]]

automatically executed against by other market participants on the same 
terms as market makers. Without an equivalent execution mechanism, ECNs 
would have an unfair advantage. Market makers are thus placed at a 
competitive disadvantage with respect to the display and execution of 
limit orders. Further, the disparity in executions may provide market 
makers with an incentive to change their status from market makers to 
ECNs, at a cost to market liquidity. Customers seeking to obtain 
executions quickly may be placed at a disadvantage if one customer 
receives an automatic execution against a market maker, while another 
customer may have to wait for an ECN to respond.
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    \40\ To facilitate the implementation of the SEC Order Handling 
Rules at the beginning of 1997, the NASD established, on an interim 
basis, a linkage to facilitate the operation of the ECN Display 
Alternative. See Exchange Act Release No. 38156 (January 10, 1997) 
62 FR 2415 (January 16, 1997). The ECN Display Alternative relieves 
an exchange specialist or OTC market maker of the requirement to 
publicly quote any superior prices that it privately displays 
through an ECN if that ECN: (1) Ensures that the best priced orders 
entered by market makers and specialists in the ECN are communicated 
to an exchange or Nasdaq for public dissemination; and (2) provides 
brokers and dealers access to orders entered by exchange specialists 
and OTC market makers into the ECN, so that brokers and dealers who 
do not subscribe to that ECN can trade with those orders. See SEC 
Rule 11Ac1-1.
---------------------------------------------------------------------------

    The current dichotomy between ECNs and market makers in the 
execution of orders has caused other anomalies with the processing of 
orders through the SOES system. As indicated, SelectNet was chosen as 
the linkage through which participants could deliver orders to access 
orders displayed in the ECN because ECNs were unable to provide 
automated executions through participation in SOES. As a consequence, 
Nasdaq had to implement systems changes designed to suspend automated 
execution in SOES whenever an ECN or UTP Exchange is alone at the 
inside market.
    This suspension of SOES when ECNs are at the inside quote has 
resulted in an unintended consequence, however, that has caused 
significant concern. Specifically, while the ECN quote effectively 
halts executions in SOES for a security, it may also cause SOES orders 
to be rejected back to the sending firm. Thus, there is the potential 
for an ECN customer to enter an order to essentially control the inside 
price, and then create an advantage in SOES for the ECN customer or 
another order entry firm to then jump ahead of orders that would have 
been executed in that issue if they had not been returned. This has 
become problematic because the ECN then changes its quote almost 
immediately, before it can be accessed through either SelectNet or its 
own internal system. Once the ephemeral quote disappears and a new 
dealer inside has been established, a new SOES order enters the system 
which then executes as the first order against the first market maker 
at the new inside price. Customer orders of order-entry firms may be 
disadvantaged, in that orders entered earlier in time would be forced 
to go to the back of the queue. The NASD notes that it recently 
implemented a software modification intended to address this situation. 
Specifically, when an ECN or UTP participant is alone at the inside, 
orders sent through SOES are now held in queue for up to 90 seconds, 
instead of being rejected immediately, unless they become executable 
against a market maker that joins or becomes the inside quote. While 
this modification preserves the sequence in which customer orders are 
processed in SOES for a period of time, the NASD does not believe that 
this is the optimal solution.\41\
---------------------------------------------------------------------------

    \41\ See Exchange Act Release No. 39637 (February 10, 1998) 63 
FR 8242 (February 19, 1998) (notice of filing and immediate 
effectiveness of SR-NASD-98-05 relating to modifications to SOES).
---------------------------------------------------------------------------

    The NASD also is concerned about complaints from various SOES 
system users that, although difficult to verify, nonetheless allege 
that some traders may be using ECNs to affect the way the system 
handles automatic executions in that system. The NASD does not want to 
design a new system with the same potential problems. Consequently, the 
NASD believes that the fairest approach to delivery and execution of 
orders in the new System is to treat all participants equally and 
require that all participants receiving orders through the System be 
subject to the same obligations, including automatic executions of 
smaller sizes. In developing the new System and proposing this level 
playing field, Nasdaq recognizes that every effort must be made to work 
with ECNs on changing the current approach. Nasdaq will discuss with 
ECNs ways to avoid the possibility of double executions against an 
ECN's displayed order and will work closely with each ECN to provide an 
appropriate mechanism. Finally the NASD and Nasdaq note that there 
should be sufficient programming lead time provided to ECNs to permit 
them to properly program their own execution processes so as to 
coordinate those processes with Nasdaq's new order delivery and 
execution system.\42\
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    \42\ When Nasdaq and the ECNs first established the linkage 
under the Order Handling Rules in early 1997, given the very short 
time frames for implementation of the new SEC rules, Nasdaq and the 
ECNs did not have sufficient time to undertake major re-programming 
efforts. Thus, in late fall 1996, Nasdaq and the ECNs, with SEC 
approval, agreed to use the existing SelectNet system as the most 
convenient application to establish a trading link between Nasdaq 
and the ECNs. See Exchange Act Release No. 38156 (January 10, 1997) 
62 FR 2415 (January 16, 1997) (order approving certain changes 
related implementation of the SEC Order Handling Rules).
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4. Order Execution Parameters
    a. Execution Parameters For Non-Directed Orders. Non-directed 
orders that match against an order in the Limit Order File are executed 
immediately. Non-directed orders delivered to a market maker or an ECN 
will be handled in three different ways depending on the size of the 
order, or portion of the order,\43\ delivered and the size of the quote 
displayed by the market maker or ECN:
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    \43\ As discussed below, non-directed orders may be split up and 
delivered to multiple participants at the best price. Thus, an order 
that is larger than a participant's displayed quotation may be split 
such that only a portion of the original order is delivered to that 
participant, with the balance being delivered to the remaining 
participants up to their displayed size. The size of this delivered 
portion is determinative of how the System applies the execution 
parameters outlined herein. See letter from Andrew S. Margolin, 
Senior Attorney, Office of General Counsel, Nasdaq, to Jeffrey R. 
Schwartz, Special Counsel, Division of Market Regulation, dated 
February 20, 1998.
---------------------------------------------------------------------------

     If the order, or portion of an order, is 1,000 shares or 
less, an order delivered to a market maker or ECN will be executed 
automatically, up to the displayed quote size. The market maker or ECN 
will have up to 17 seconds thereafter to adjust its quote.\44\
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    \44\ If a market maker or ECN updates its quotation price before 
17 seconds has elapsed, it will be eligible immediately thereafter 
for additional order delivery. Similarly, if the original execution 
did not eliminate the entire size displayed at that price, the 
executing participant is eligible within five seconds for additional 
delivery up to the size of the quote remaining. For example, if MMA 
displayed a quote of 20 for 1,000 shares, and the System 
automatically executed 500 shares against that market maker, five 
seconds after the first execution the System would be able to 
deliver an execution for the remaining 500 shares.
---------------------------------------------------------------------------

     If the order is greater than 1,000 shares and less than 
5,000 shares, and the quote is equal to or greater than the order size, 
the order will be presented for 17 seconds for action by the market 
maker or ECN. The market maker or ECN may accept, decline, or do 
nothing.\45\ if no response is received within that time, the System 
will default to an execution against the quotation up to the displayed 
quote size.
---------------------------------------------------------------------------

    \45\ A market maker may decline the order only to the extent 
permissible under the Firm Quote Rule. Any declinations are 
forwarded to NASDR.
---------------------------------------------------------------------------

     If the order is 5,000 shares or larger and the quote 
displayed is equal to or greater than the order size, the order will be 
presented for review for 32 seconds.\46\ The market maker or ECN may 
accept, decline, or do nothing. If there is no response after this 
time, the system will default to an execution.
---------------------------------------------------------------------------

    \46\ The intent here is to provide, in effect, two periods of 15 
seconds each. Two additional seconds of communications time must be 
added to reflect the time necessary for an execution report to be 
received back from the System.
---------------------------------------------------------------------------

    These default action features allow market makers and ECNs the 
ability to act consistently with the Firm Quote Rule and decline large 
sized orders that are delivered to them while in the process of 
effecting an execution internally at their displayed quote, but before 
they have had the chance to

[[Page 12132]]

update that quote.\47\ In any event, whether the order is executed 
immediately or is delivered for review, executing participants will 
have, depending on the order size, 17 or 32 seconds between orders to 
be able to adjust their quotes before delivery of an additional order 
or execution. These time periods provide appropriate windows of time to 
permit market makers to manage their quote commensurate with the risk 
and exposure of larger sized orders.
---------------------------------------------------------------------------

    \47\ See SEC Rule 11Ac1-1.
---------------------------------------------------------------------------

    The System will split non-directed orders that are larger than 
sizes displayed in quotes to quickly execute orders and minimize issues 
related to queues of non-directed orders. For example, assume that an 
order entry firm enters a 5,000 share order to buy when five market 
makers or ECNs are each quoting 1,000 shares at the best offer. When 
the order is entered, the System will split the order into five 1,000 
share lots and automatically execute against each of the market makers 
and/or ECNs at the inside offer. Each executing participant then has up 
to 17 seconds to update its quote, although each may do so sooner, in 
which case additional orders may be delivered more quickly.
    A market maker's use of the supplemental size feature affects the 
way non-directed orders may be executed. If a market maker using 
supplemental size is alone at the inside price and a non-directed order 
larger than the market maker's displayed quote size is entered, the 
order will be delivered up to the size of the market maker's displayed 
size and supplemental size for a period of 17 or 32 seconds, depending 
on the size of the order delivered. At the end of the time period, the 
order will be executed against the market maker, unless prior to the 
end of the time period, the market maker took other action, such as 
accepting all or part of the order, or declining the order. For 
example, if a market maker is alone at the best offer of 20, and is 
displaying 1,000 shares while its supplemental size is at 5,000 shares, 
a non-directed order to buy 4,000 shares will be delivered in toto  to 
that market maker for 17 seconds. If the market maker does nothing, the 
order will be executed at the end of 17 seconds for 4,000 shares, and 
the market maker's quote will be refreshed at 1,000 shares, with 1,000 
shares remaining in supplemental size.
    Nasdaq plans to make the System flexible to allow participants to 
adjust execution parameters. Thus, all parameters for order size for 
delivery and execution that are minimum sizes can be adjusted by 
executing participants as long as such adjustments exceed the minimum 
standards established by Nasdaq in this filing. For example, an 
executing participant can adjust the parameters for automatic 
executions to allow automated executions for orders larger than 1,000 
shares.
    b. Limit Order File Executions. The matching process between orders 
displayed in the File is simple. Non-directed orders that match against 
an order in the Limit Order File are executed immediately. For example, 
assume the best bid is an ECN showing an order to buy at 20 for 1,000 
shares. Subsequently, a member enters a non-directed order to buy 100 
shares at 20\1/16\. This limit order is displayed anonymously, as 
described below, in the Nasdaq Limit Order File and sets a new inside 
bid. Thereafter, another member enters a market order to sell 100 
shares. The limit order and the market order will be matched and 
automatically executed against each other at 20 \1/16\. If the market 
order to sell were for 1,000 shares, 100 shares would execute 
automatically against the limit order and the remaining 900 shares 
would be executed automatically against the next best bid, the 20 bid 
of the ECN. The ECN's displayed size would be reduced to 100 
shares.\48\
---------------------------------------------------------------------------

    \48\ If a market maker or ECN order seeks to quote at a price 
that would lock or cross the Limit Order File, the market maker or 
ECN is required by rule to first enter a directed order that would 
execute against the order in the file.
---------------------------------------------------------------------------

5. Limit Order Display
    Nasdaq will display limit orders entered into the Limit Order File 
in three separate ways. First, Nasdaq will display the Top of File, 
i.e., the best limit order to buy and the best limit order to sell, in 
the Nasdaq quote montage, where it will be ranked in price/time 
sequence with all other quotes and orders entered into Nasdaq, and 
which will be used to calculate the inside quote. Nasdaq will also 
display the Top of file in a separate window on the Nasdaq Workstation. 
Both of these displays will be dynamically updated, i.e., the System 
will automatically change the prices as orders enter and execute. 
Finally, Nasdaq will maintain for all Nasdaq Workstation subscribers 
and vendors a Full File display that will be available on a query/
response basis. in other words, the user must enter a key stroke to 
obtain information regarding all of the orders displayed in the Full 
File. To obtain new information about the status of orders in the Full 
File, the subscriber must re-inquire of the System. At the first stage 
of implementation, Nasdaq, for capacity reasons, will not dynamically 
update the Full File. All orders displayed in the Limit Order File will 
be displayed anonymously, i.e., the System will not attach the MMID of 
the member entering the order to that order for display purposes.
6. Anonymity of Executions in the File
    As proposed in this filing, Nasdaq will display all orders in the 
File on an anonymous basis. Upon execution of any such order, either 
when another limit order matches it, or when it interacts with a Nasdaq 
displayed quote, the System will provide to all parties involved in the 
execution an execution report that identifies the contra-party to the 
trade. For example, when MMA enters a limit order into the File at 20 
bid, it is displayed without an identifier indicating that MMA entered 
the order. Subsequently, MMB enters a limit order to sell at 20. 
Because the two limit orders match, they will execute against each 
other. When the execution occurs, MMA will receive a report from the 
system identifying MMB as the contra-party and MMB will receive a 
report indicating that MMA was its contra-party.
    Nasdaq is also evaluating whether additional anonymity for 
executions should be provided in the future. There are two options 
under consideration: anonymity until the end of the trading day and 
anonymity throughout the settlement cycle. End of day anonymity would 
work as follows. When an order that is displayed in the Limit Order 
File is executed, either by matching against another order entered into 
it or when a market maker or ECN executes the order, the System will 
preserve the anonymity of the firm entering the order until the end of 
the trading day provided that the party entering the order into the 
File chose to keep its order anonymous following execution. The contra-
party would receive the indicator ``NSDQ'' as the MMID for the other 
side to the trade. The true identity of the firm entering the order 
would not be revealed to the contra-party until after trading for the 
day has ceased. Nasdaq would provide to each party that received an 
anonymous execution a report after 5:15 p.m. with the identity of the 
party that entered the order into the File.
    For example, assume that the inside market for a security is 19\15/
16\-20\1/8\, 10 x 10. MMA enters a non-directed proprietary limit order 
to sell 1,000 shares at 20 into the File, and indicates upon order 
entry that it wants the order to be executed anonymously. The order

[[Page 12133]]

will be placed on the File at 20 for 1,000 shares; because the limit 
order is the best sell order in the market, the inside will change to 
19\15/16\-20, 10  x  10. At this time, order entry firm X (``OEFX'') 
enters a buy market order for 1,000 shares. OEFX's order is 
automatically executed against the limit order at 20. OEXF receives a 
report confirming that its market order was executed for 1,000 shares 
at 20 against NSDQ.
    As another example, assume the same facts as above, except that MMD 
wants to move its bid of 19\15/16\ to 20. Under the locked/crossed 
market rule, it must make an effort to avoid locking the market by 
attempting to takeout the locking offer, in this case the limit order 
to sell at 20.\49\ When MMD enters a non-directed order to buy 1,000 
shares at 20, that order will match against the limit order to sell at 
20 and MMD will receive a report indicating that it bought 1,000 shares 
at 20 from NSDQ. After 5:15, MMD will receive a report that indicated 
that this sell order was actually executed against MMA.
---------------------------------------------------------------------------

    \49\ See NASD Rule 4613(e).
---------------------------------------------------------------------------

    Under a full anonymity proposal, the NASD could create a structure 
to keep the contra-parties anonymous as to each other throughout the 
settlement cycle. The NASD continues to evaluate the means by which 
such anonymity could be provided. Before either end of day or full 
anonymity would be offered, the NASD and Nasdaq would have to propose 
any such approach as a new rule proposal or as an amendment to this 
filing. The NASD believes at this time that it would be helpful if 
commenters offered their views generally on the need for particular 
levels of anonymity in the File.
7. Sponsored Access by Non-Members
    A critical component of the new System will permit institutions and 
other customers of NASD members to obtain direct electronic links to 
the System through arrangements that are sponsored by an NASD member. 
Under such an arrangement, a customer and an NASD member will be able 
to sign an agreement that permits Nasdaq to provide the customer with 
the electronic capability to enter orders into the System directly from 
its trading desk. Such orders can be limit or market orders that access 
prices displayed in Nasdaq (if they are market orders), or are 
displayed in the Limit Order File (if they are limit orders). Only 
market makers that are Primary Market Makers under NASD Rule 4612 are 
eligible to enter into a sponsored arrangement for access by non-
members.\50\
---------------------------------------------------------------------------

    \50\ The NASD notes that under the current Primary Market Maker 
qualification rule, all Nasdaq market makers qualify as Primary 
Market Makers. Nasdaq plans to amend the qualification standards to 
establish more stringent qualifying criteria.
---------------------------------------------------------------------------

8. The Opening Process for Orders in the Limit Order File
    Limit orders can be entered as good-till-canceled (``GTC'') or 
good-till-date (``GTD''). Because of this capability, the File may 
carry over limit orders from one trading day to the next. In addition, 
the System will allow limit orders to be entered prior to the market 
opening and also will permit the entry of market orders that will be 
able to interact with limit orders in the Limit Order File at the 
opening of the file for executions. Consequently, at the opening of the 
market at 9:30, the Nasdaq Limit Order File could contain a number of 
limit and market orders.
    Nasdaq believes that the following approach to execution of all 
such orders entered into the System prior to market open best 
accommodates customer requirements that executions occur as rapidly as 
possible and at prices as near as possible to the prevailing market at 
the open. At 9:30, when quotations are first opened in the System, 
Nasdaq will take a snapshot of the best quotes (the ``9:30 Inside''). 
Thus, the 9:30 Inside includes market makers, ECNs and UTP exchanges, 
but not the Top of File of Nasdaq's Limit Order File. The opening 
process will use the 9:30 Inside to validate the executions of orders 
in the File.
    The System will process the orders in the File at 9:30 by first 
matching the best priced limit order to buy against the best contra-
side limit order to sell, bound by the 9:30 Inside. The system will 
continue to pair off matching buy and sell limit orders in the File, 
until all possible limit order matches that can take place at or within 
the 9:30 Inside have occurred. Limit orders that match other limit 
orders will be matched at a midpoint, giving price improvement to both 
where possible. If limits would match outside of the 9:30 Inside, then 
no execution takes place, as the opening match is bounded by the 9:30 
Inside. After all possible limit-to-limit matches have occurred, the 
System will then match market orders to any remaining limit orders that 
are priced at or within the 9:30 Inside and execute such matches at the 
limit order price.
    If the 9:30 Inside is locked at 9:30, the System will execute as 
many orders as it can match at that price. The remaining unmatched 
orders will be processed at 9:30 pursuant to normal business hours 
processing. For example, assume that the best bids and offers at 9:30 
are priced at 20, and four limit orders are in the File at 9:30, each 
for 1,000 shares. There are limit orders to buy at 20 and 20\1/16\, and 
limit orders to sell at 19\15/16\ and 20\1/16\. The system will execute 
the buy limit at 20\1/16\ against the sell limit at 19\15/16\ at a 
price of 20. The two remaining orders (buy at 20 and sell at 20\1/16\) 
will not be executed. If the 9:30 Inside is crossed at 9:30 for a 
particular security, the System will not perform the opening match 
process for that security. Instead, in this situation, each order will 
be matched or delivered for execution, as the case may be, according to 
normal business hours processing. That is, limit orders that are 
marketable against the 9:30 Inside, and may market orders that have 
been entered prior to 9:30 will be delivered or executed against such 
prices in time sequence, commencing at 9:30. Once the crossed market 
has been eliminated, the File will be populated as during the normal 
intra-day process and executions will continue according to normal 
processing as discussed above. Thus, immediately after the match 
process is concluded, any market or marketable limit orders that do not 
match against limit orders in the opening process shall be delivered to 
or automatically executed against (depending on the size of the order) 
executing participants or the Limit Order File according to normal 
business hours processing as set forth above for non-directed orders. 
Execution reports for orders executed during the opening process will 
be discussed starting at 9:30 a.m.
9. Odd-Lot Processing
    The new System will accept and execute orders less than one normal 
unit of trading, i.e., odd-lot orders less than 100 shares. The System 
will provide a separate mechanism for processing and executing these 
orders as distinct from normal units of trading. First, odd-lot priced 
orders will not be displayed in the Limit Order File, nor will they 
match against any displayed File orders. Instead, the System will hold 
odd-lot orders in a separate file and automatically execute such odd-
lots against market makers whenever the odd-lot order becomes 
marketable.\51\ For example, if a member enters a market order for 50 
shares into the System, it will immediately and automatically

[[Page 12134]]

execute the order against the market maker that is first in rotation 
for execution of such orders. The automatic execution will not decrease 
the market maker's displayed size.
---------------------------------------------------------------------------

    \51\ An odd-lot order becomes marketable when the best price in 
Nasdaq moves to the price of the odd-lot limit order. Odd-lot orders 
that are marketable at entry or become marketable will execute 
against the first market maker in rotation for odd-lot processing at 
the best price or at the odd-lot order's price.
---------------------------------------------------------------------------

10. Firm Quote Compliance Facility
    To assist market makers in complying with the Firm Quote Rule, 
System market makers shall be provided with a means to indicate that 
the market maker has received an order via the telephone to trade at 
the market maker's Nasdaq-displayed quotation and that for a period of 
time while the market maker handles the telephone order, the System 
should not deliver additional orders for execution.
    The market maker shall send via the System a message that records 
the time indicating when the market maker entered the message regarding 
the telephone order. When the System receives the message, the System 
shall not present an order to that market maker until 17 seconds after 
receipt of the original message. The System will provide the market 
maker with a reference number that shall be attached to the execution 
report that may occur as a result of the telephone order. A System 
market maker may only send one such message through the System for each 
telephone order necessitating the message. Sending such message without 
a corresponding transaction may be a violation of just and equitable 
principles of trade. Surveillance systems will be implemented to detect 
a pattern or practice of entering messages without corresponding 
transactions.
11. Amendments to Related Rules
    In addition to the specific new rules proposed regarding the 
operations of the System, several rules found in NASD Rule Series 4600 
and throughout the NASD Manual will have to be conformed in technical, 
non-substantive ways. In particular, Rule 4613 (Character of 
Quotations), will be amended to eliminate the references to SOES Tier 
Sizes for quotations of market makers. Rule Series 4700 (SOES Rules) 
will be rescinded entirely, and other rules referencing SOES will be 
rescinded or conformed accordingly, including Rule 4611(f) 
(Registration as a Nasdaq Market Maker), Rule 4619 (Withdrawal of 
Quotations and Passive Market Making), Rule 4620 (Voluntary Termination 
of Registration), Rules 4632 and 4642 (Trade Reporting) \52\ and Rule 
4618(c) (Clearance and Settlement).
---------------------------------------------------------------------------

    \52\ It should be noted that the rules governing the trade 
reporting of Nasdaq National Market securities found in NASD Rule 
4632 are part of an effective transaction reporting plan approved by 
the Commission under SEC Rule 11Aa3-1. Accordingly, any proposed 
amendments to these rules are proposed amendments to the transaction 
reporting plan contemplated by that SEC rule.
---------------------------------------------------------------------------

E. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
the provisions of Section 15A of the Exchange Act,\53\ in particular 
subparagraphs (b)(2), (b)(6), (b)(9), and (b)(11), and Section 11A of 
the Exchange Act, in that the proposed rule change is designed to 
enhance the protection of investors and provide for the fairest and 
most efficient mechanism for transactions in the market for Nasdaq 
securities. Section 15A(b)(6) requires that the rules of a registered 
national securities association be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system, and, in general, to 
protect investors and the public interest; and are not designed to 
permit unfair discrimination between customers, issuers, brokers, or 
dealers. The proposed rule change represents a significant effort to 
provide for an integrated order delivery and execution system where all 
market participants and investors may be brought together in a single 
system and where all orders are processed and distributed in a fair and 
orderly fashion to achieve immediate or rapid executions at the best 
available price. This also is consistent with Section 11A(a)(1)(B) of 
the Exchange Act, which sets forth findings of Congress that new data 
processing and communications techniques create the opportunity for 
more efficient and effective market operations.
---------------------------------------------------------------------------

    \53\ 15 U.S.C. Sec. 78o-3.
---------------------------------------------------------------------------

    The integrated nature of the System will address issues related to 
unintended ``double liability'' that can be incurred by market makers, 
thus reducing a disincentive for market maker participation, and, along 
with the Firm Quote compliance Facility, should significantly ease the 
associated regulatory and compliance burdens involving the Firm Quote 
Rule and related NASD rules. Importantly, this also will enhance the 
NASD's ability to assure compliance with the Firm Quote Rule. Thus, the 
proposed rule change also comports with the requirements of 
subparagraph (b)(2) of Section 15A, which requires the association to 
be organized to enforce compliance by its members and associated 
persons with the provisions of the Exchange Act, rules thereunder, and 
the rules of the association.
    In addition, the proposed rule change to establish a Nasdaq limit 
order book is designed to facilitate the display of the best priced 
limit orders in Nasdaq. Because the Top of File will be displayed in 
the quote montage, this facility is consistent with Section 15A(b)(11), 
which requires that the rules of a registered national securities 
association be designed to produce fair and informative quotations, 
prevent fictitious or misleading quotations and to promote orderly 
procedures for collecting, distributing, and publishing quotations. In 
this context, the proposed rule change also is consistent with the 
SEC's Order Handling Rules, in particular Rules 11Ac1-1 and 11Ac1-4, in 
that the book may be used by members to satisfy the requirements of the 
Display Rule with respect to customer orders, and is consistent with 
the ECN Display Alternative for market maker display of orders priced 
better than the market maker's public quote.
    Finally, the proposed rule change is consistent with Section 
11A(a)(1)(C) of the Exchange Act, which states, among other things,that 
it is in the public interest and appropriate for the protection of 
investors and the maintenance of fair and order markets to assure (1) 
economically efficient execution of securities transactions; (2) fair 
competition among brokers and dealers; (3) the availability to brokers, 
dealers and investors of information with respect to quotations for and 
transactions in securities; (4) the practicability of brokers executing 
investors' orders in the best market; and (5) an opportunity for 
investors' orders to be executed without the participation of a dealer. 
The NASD and Nasdaq believe that the System advances all of these goals 
by providing an integrated order delivery and execution system and 
Limit Order File designed to provide maximum transparency and efficient 
executions at the best price for the benefit of all investors and 
market participants.

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

    Nasdaq 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 Exchange Act, as amended.

[[Page 12135]]

(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

    With 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:

A. By order approve such proposed rule change, or
B. Institute proceedings to determine whether the proposed rule change 
should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Exchange Act. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
DC 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-98-17 and should be submitted by April 2, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\54\
---------------------------------------------------------------------------

    \54\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Jonathan G. Katz,
Secretary.

Exhibit 1--Text of the Proposed Rule Change

    The text of the proposed rule change as amended is as follows. 
(Additions are italicized; deletions are bracketed.)

4611. Registration as a Nasdaq Market Maker

    (a) through (e) No Change.
    [(f) Unless otherwise specified by the Association, each Nasdaq 
market maker that is registered as a market maker in a Nasdaq 
National Market security shall also at all times be registered as a 
market maker in the Small Order Execution System (SOES) with respect 
to that security and be subject to the SOES Rules as set forth in 
the Rule 4700 Series.]
    (g) Re-designated as paragraph (f).

4613. Character of Quotations

    (a) Two-Sided Quotations
    [(1)] No Change.
    [(2) Each member registered as a Nasdaq market maker in Nasdaq 
National Market equity securities shall display size in its 
quotations of 1,000, 500, or 200 shares and the following guidelines 
shall apply to determine the applicable size requirement:
    (A) a 1,000 share requirement shall apply to Nasdaq National 
Market securities with an average daily non-block volume of 3,000 
shares or more a day, a bid price of less than or equal to $100, and 
three or more market makers;
    (B) a 500 share requirement shall apply to Nasdaq National 
Market securities with an average daily non-block volume of 1,000 
shares or more a day, a bid price of less than or equal to $150, and 
two or more market makers and
    (C) a 200 share requirement shall apply to Nasdaq National 
Market securities with an average daily non-block volume of less 
than 1,000 a day, a bid price of less than or equal to $250, and 
that have two or more market makers.
    (3) Each member registered as a Nasdaq market maker in Nasdaq 
SmallCap Market equity securities shall display size in its 
quotations of 500 or 100 shares and the following guidelines shall 
apply to determine the applicable size requirement:
    (A) a 500 share requirement shall apply to Nasdaq SmallCap 
Market securities with an average daily non-block volume of 1,000 
shares or more a day or a bid price of less than $10.00 a share; and
    (B) a 100 share requirement shall apply to Nasdaq SmallCap 
Market securities with an average daily non-block volume of less 
than 1,000 shares a day and a bid price equal to or greater than 
$10.00 a share.
    (4) Share size display requirements in individual securities may 
be changed depending on unique circumstances as determined by the 
Association, and a list of the size requirements for all Nasdaq 
equity securities shall be published from time to time by the 
Association.]
    (b) No Change.
    (c) No Change.
    (d) No Change.
    (e) No Change.

4618. Clearance and Settlement

    (a)-(b) No Change.
    [(c) All SOES transactions shall be cleared and settled through 
a registered clearing agency using a continuous net settlement 
system.]

4619. Withdrawal of Quotations and Passive Market Making

    (a) No Change.
    (b) No Change.
    (c) Excused withdrawal status may be granted to a market maker 
that fails to maintain a clearing arrangement with a registered 
clearing agency or with a member of such an agency and is withdrawn 
from participation in the Automated Confirmation Transaction 
service, thereby terminating its registration as a market maker in 
Nasdaq National Market issues. Provided however, that if the 
Association finds that the market maker's failure to maintain a 
clearing arrangement is voluntary, the withdrawal of quotations will 
be considered voluntary and unexcused pursuant to Rule 4620 [and the 
Rules for the Small Order Execution System, as forth in the Rule 
4700 Series] and Rule 4940.

4620. Voluntary Termination of Registration

    (a) A market maker may voluntarily terminate its registration in 
a security by withdrawing its quotations from The Nasdaq Stock 
Market. A market maker that voluntarily terminates its registration 
in the System in a security may not re-register as a market maker in 
that security for twenty (20) business days[.]; [Withdrawal from 
SOES participation as a market maker in a Nasdaq National Market 
security shall constitute termination of registration as a market 
maker in that security for purposes of this Rule;] provided, 
however, that a market maker that fails to maintain a clearing 
arrangement with a registered clearing agency or with a member of 
such an agency and is withdrawn from participation in the Automated 
Confirmation Transaction System and thereby terminates its 
registration as a market maker in [Nasdaq National Market issues] 
the System may register as a market maker at any time after a 
clearing arrangement has been reestablished and the market maker has 
complied with ACT participant requirements contained in Rule 6100.
    (b) No Change.
    (c) No Change.
    (d) No Change.

4632. Transaction Reporting

    (a) through (d) No Change.
    (e) Transactions Not Required To Be Reported.
    The following types of transactions shall not be reported:
    (1) transactions executed through the System or Computer 
Assisted Execution System (CAES);
    (f) No Change.

4642. Transaction Reporting

    (a) through (d) No Change.
    (e) Transaction Not Required To be Reported.
    The following types of transactions shall not be reported:
    (1) Transactions executed through the System or Computer 
Assisted Execution System (CAES) [; the Small Order Execution System 
(SOES) or the SelectNet service].
    (f) No Change.

4700. Small Order Execution System

    Rules 4710, 4720, 4730, 4740, 4750, 4760, and 4770 are being 
rescinded in their entirety.

[[Page 12136]]

4900. Nasdaq Trading System

4910. Definitions

    (a) The term ``Automated Confirmation Transaction service'' 
(``ACT''), for purposes of the System rules, shall mean the 
automated system owned and operated by The Nasdaq Stock Market, Inc. 
which accommodates trade reporting of transactions executed through 
the System and submits locked-in trades to clearing.
    (b) The term ``automated quotation update facility'' shall mean 
the facility in the System that allows the System to automatically 
refresh a System market maker's quotation in any security that the 
System market maker designates when the System market maker's 
displayed size (and supplemental size, if any has been reduced to 
zero. The facility will update either the bid or the offer side of 
the quote using a quotation interval designated by the market maker, 
depending upon the side of the market on which the execution has 
occurred and refresh the market maker's displayed size at an amount 
pre-determined by the market maker.
    (c) The term ``customer order'' shall mean an order from, or on 
behalf of, a person that is not a registered broker-dealer, except 
that for the purposes of these Rules, the term customer shall 
include registered options market makers. An order will not be 
considered an agency order if it is for any account of a person 
associated with the member firm entering the order or any account 
controlled by such an associated person.
    (d) The term ``directed order'' shall mean an order (agency or 
proprietary) entered into the System by a participant that is 
directed to a particular Executing Participant.
    (e) The term ``displayed size'' shall mean the actual size of 
the quote displayed to the market as required by Rule 4613(a).
    (f) The term ``ECN'' shall mean an electronic communications 
network that is registered and displaying orders in Nasdaq pursuant 
to Rule 4623 of the NASD Rules.
    (g) The term ``Executing Participant'' shall include any of the 
following participants: (1) System market makers; (2) electronic 
communications networks (``ECNs''); and (3) UTP Exchange 
Specialists.
    (h) The term ``Firm Quote Rules '' shall mean SEC Rule 11Ac1-1 
and NASD Rules 3320 and 4613(b).
    (i) The term ``inside market'' shall mean the best bid and 
associated size from Executing Participants and the best System 
limit order(s) to buy, as ranked by price, and the best offer and 
associated size from Executing Participants and the best System 
limit order(s) to sell, as ranked by price, displayed by Nasdaq.
    (j) The term ``liability order'' shall mean an order that when 
delivered to an Executing Participant imposes obligations on the 
Executing Participant to respond to such order in compliance with 
the Firm Quote Rules.
    (k) The term ``limit order'' shall mean an order entered into 
the System that is a priced order.
    (l) The term ``marketable limit order'' shall mean a limit order 
that, at the time it is entered into the System, if it is a limit 
order to buy, is priced at the current inside offer or higher, of if 
it is a limit order to sell, is priced at the inside bid or lower.
    (m) The term ``non-directed order'' shall mean an order entered 
into the System and not directed to any particular Executing 
Participant.
    (n) The term ``open quote'' shall mean a System market maker's 
quotation price and displayed size in an eligible security against 
which orders may be executed through the System during normal 
business hours, as specified by the NASD, or at such times that a 
market maker has notified Nasdaq pursuant to Rule 4617 that it is 
open for business. For the purposes of these Rules, a market maker 
has a ``closed quote'' when (1) it is outside of normal business 
hours; (2) its displayed quotation size has been decreased through 
System executions to zero; or (3) it has been deemed ``closed'' 
pursuant to Rule 4940 below.
    (o) The term ``Order Entry Participant'' shall mean shall mean a 
member of the Association that is registered as a participant 
authorized to enter orders on behalf of customers in the System 
pursuant to Rule 4920 below. A System market maker is deemed to be 
an Order Entry Participant in any security in which it is registered 
as a System market maker.
    (p) The term ``participant'' shall mean a person registered with 
the NASD and authorized to undertake activity in the system.
    (q) The term ``proprietary order'' shall mean an order for the 
principal account of a broker or dealer.
    (r) The term ``registered options market maker'' shall mean an 
exchange member registered with a national securities exchange as a 
market maker or specialist pursuant to the rules of such exchange 
for the purpose of regularly engaging in market making activities as 
a dealer or specialist in an option of a Nasdaq-listed security.
    (s) The term ``sponsored participant'' shall mean a customer 
that is an institution (as defined in NASD Rule 3110(c)(4)) or 
registered options market maker that has entered into a sponsorship 
arrangement accepted by Nasdaq pursuant to Rule 4920(e) below.
    (t) The term ``supplemental size'' shall mean the size that a 
System Market Maker chooses to maintain in the System-provided 
supplemental size feature that refreshes the System Market Maker's 
displayed size by the System Market Maker's pre-determined amount 
after the displayed size has been reduced to zero following a 
System-generated execution.
    (u) The term ``System'' shall mean the order delivery and 
execution system owned and operated by The Nasdaq Stock Market, Inc. 
(a wholly owned subsidiary of the National Association of Securities 
Dealers, Inc.).
    (v) The term ``System eligible security'' shall mean any 
security listed on the Nasdaq National Market or Nasdaq SmallCap 
Market.
    (w) The term ``System market maker'' shall mean a member of the 
Association that is registered and quoting with an open quote as a 
Nasdaq market maker pursuant to the requirements of Rule 4600 of the 
NASD Rules and is registered pursuant to Rule 4920 below as a market 
maker in one or more System-eligible securities.
    (x) The term ``UTP exchange'' shall mean any registered national 
securities exchange that has unlisted trading privileges in Nasdaq 
securities pursuant to the Nasdaq/NMS/UTP Plan.
    (y) The term ``UTP exchange specialist'' shall mean a broker-
dealer registered as a specialist in Nasdaq securities pursuant to 
the rules of an exchange that: (1) is a signatory as either a 
participant or limited participant in the Joint Self-Regulatory 
Organization Plan Governing the Collection, Consolidation and 
Dissemination Of Quotation and Transaction Information For Exchange-
Listed Nasdaq/National Market System Securities Traded On Exchange 
On An Unlisted Trading Privilege Basis (``Nasdaq/NMS/UTP Plan''); 
(2) provides for electronic access that permits a UTP exchange 
specialist to enter proprietary orders and permits System executions 
against a UTP exchange specialist at its published quote pursuant to 
these Rules; and (3) permits all transactions to be cleared and 
settled through a registered clearing agency using a continuous net 
settlement system.

4920. Registration Requirements

    (a) Prior to entering or executing orders into the System, 
participants seeking to participate in the System shall register and 
be authorized by Nasdaq as Executing Participants, Order Entry 
Participants or sponsored participants, provided that each such 
participant meets the conditions set forth below:
    (1) Executing Participants: Registration as an Executing 
Participant shall be conditioned on the participant's initial and 
continuing compliance with the following requirements:
    (A) Membership in a clearing agency registered with the 
Securities and Exchange Commission which maintains facilities 
through which system-compared trades may be settled; or entry into a 
correspondent clearing arrangement with an NASD member that clears 
trades through such clearing agency;
    (B) registration as: (i) a market maker or an ECN (as the case 
may be) in Nasdaq pursuant to the Rule 4600 series of the NASD Rules 
and compliance with all applicable rules and operating procedures of 
the Association and the SEC; or (ii) as an exchange specialist in 
good standing with an exchange that is a participant in the Nasdaq/
UTP Plan and compliance with all applicable rules and operating 
procedures of the Association, its UTP Exchange and the SEC;
    (C) maintenance of the security of any system that allows access 
to Nasdaq systems so as to prevent improper use or access of Nasdaq 
Systems, such as the unauthorized entry of orders or other data into 
Nasdaq-operated systems; and
    (D) acceptance and settlement of each trade that is executed 
through the facilities of the System, or if settlement is to be made 
through another clearing member, guarantee of the acceptance and 
settlement of such identified System trades by the clearing

[[Page 12137]]

member on the regularly scheduled settlement date.
    (2) Order Entry Participants: Registration as an Order Entry 
Participant shall be conditioned upon the participant's initial and 
continuing compliance with the following requirements:
    (A) membership in a clearing agency registered with the 
Securities and Exchange Commission which maintains facilities 
through which System-compared trades may be settled; or entry into a 
correspondent clearing arrangement with an NASD member that clears 
trades through such clearing agency;
    (B) compliance with all applicable rules and operating 
procedures of the Association and the Securities and Exchange 
Commission;
    (C) maintenance of the security of any system that allows access 
to Nasdaq systems so as to prevent Nasdaq systems from being 
improperly used or accessed; such as the unauthorized entry of 
orders or other data into the System or Nasdaq; and
    (D) acceptance and settlement of each trade that is executed 
through the facilities of the System, or if settlement is to be made 
through another clearing member, guarantee of the acceptance and 
settlement of such identified System trades by the clearing member 
on the regularly scheduled settlement date.
    (3) Sponsored Participants: Registration as a sponsored 
participant shall be conditioned on the participant's and the 
participant sponsor's initial and continuing compliance with the 
following requirements:
    (A) execution of, and continuing compliance with, at least one 
valid sponsorship agreement, as set forth in paragraph (e);
    (B) membership of the sponsoring NASD member in a clearing 
agency registered with the Securities and Exchange Commission which 
maintains facilities through which System-compared trades may be 
settled; or such sponsoring NASD member's entry into a correspondent 
clearing arrangement with an NASD member that clears trades through 
such clearing agency;
    (C) the sponsoring NASD member's acknowledgment that the 
sponsored participant will maintain the security of any system that 
allows access to Nasdaq-operated systems so as to prevent Nasdaq 
systems from being improperly used or accessed, such as through the 
unauthorized entry of orders or other data into Nasdaq-operated 
systems;
    (D) the sponsoring NASD member's acceptance and settlement of 
each trade that is executed by the sponsored participant through the 
facilities of the System, or if settlement is to be made through 
another clearing member, guarantee of the acceptance and settlement 
of such identified System trades by the clearing member on the 
regularly scheduled settlement date.
    (b) Upon effectiveness of a participant's registration to 
participate in the System, participants may commence activity within 
the System for entry and/or execution of orders, as applicable, and 
their obligations as established in this rule will commence.
    (c) Pursuant to Rule 4600 of the NASD Rules, participation as a 
System Market Maker is required by any Nasdaq market maker 
registered to make a market in a Nasdaq security. Pursuant to Rule 
4623 of the NASD Rules, when an ECN is displaying an order in 
Nasdaq, such displayed order must be accessible for execution 
through the System.
    (d) Each system participant shall be under a continuing 
obligation to inform the Association of noncompliance with any of 
the registration requirements set forth above.
    (e) Sponsorship agreements:
    (1) A System Market Maker that is a Primary Market Maker 
pursuant to Rule 4612 in a particular security may establish for 
such security a sponsorship arrangement with customers that permits 
the customer to enter directly from the customer's facility orders 
for display, delivery, or execution in Nasdaq's System and receive 
execution reports by means of a Nasdaq-authorized protocol provided 
by the System Market Maker, the customer or a third party vendor of 
such services.
    (2) Sponsorship arrangements must be pursuant to Nasdaq-
authorized sponsorship agreements. A Sponsored Participant may enter 
into sponsorship agreements with more than one sponsoring NASD 
member. A sponsorship agreement shall include, among other things, 
terms establishing the customer's agreement to comply with all 
applicable NASD Rules governing the entry, execution, reporting, 
clearing and settling of orders in System-eligible securities;
    (3) The sponsoring member must agree that it is responsible for 
all orders entered into the System by the sponsored participant that 
identify the sponsoring NASD member as the sponsor and that any 
execution that occurs in the System as a result of such order is 
binding in all respects on the sponsoring member so identified;
    (f) Limitations on liability for System malfunctions: The 
Association and its subsidiaries shall not be liable for any losses 
or damages arising out of the use of the System. Any loss or damages 
related to a failure of the System to deliver, display, execute, 
compare, submit for clearance and settlement, or otherwise process 
an order or message entered in the System shall be absorbed by the 
member entering the message, or the member sponsoring the customer 
that entered the message.

4930. Operating Hours of The System

    Subject to any trading halt imposed by the SEC or NASD, or any 
system malfunction or emergency condition that warrants interruption 
of the operation of the System, the operating hours of the System 
shall be as follows:
    (a) For directed orders, the System shall be open and capable of 
permitting the execution of such orders from 9:00 a.m. (ET) to 5:15 
p.m. (ET).
    (b) For non-directed orders, the System will commence normal 
operations at 9:30 a.m. (ET) and close at 4:00 p.m. (ET), i.e., 
normal business hours as defined in Rule 4617, except as provided 
for in the opening procedures set forth below. Non-directed orders 
that are limit orders may be entered at any time from 8:00 a.m. (ET) 
until 6:00 p.m. (ET) for processing in the System during normal 
operations. Non-directed market orders may be entered at any time 
from 8:00 a.m. (ET) until 4:00 p.m. (ET).

4940. Participant Obligations in the System

    (a) Executing Participants
    (1) A System Market Maker, ECN, or UTP Exchange Specialist shall 
commence participation in the System by initially contacting Nasdaq 
Market Operations to obtain authorization for order delivery and 
execution purposes in particular Nasdaq securities and identifying 
those devices through which such delivery and executions shall 
occur. Thereafter, on-line registration on a security-by-security 
basis is permissible, consistent with the requirements of Rule 4600 
of the NASD Rules.
    (2) Participation as a System Market Maker, ECN, or UTP Exchange 
Specialist obligates the participant, upon presentation of a market 
order or marketable limit order through the service, to execute such 
order as provided in Rule 4950 below. The System will transmit to 
the participant on the Nasdaq Workstation Service, or through a 
computer interface, as applicable, an execution report generated 
following each execution.
    (3) A System Market Maker may elect to use the Nasdaq-provided 
automated quotation update facility in one or more securities in 
which it is registered. The facility will refresh the market maker's 
quotation automatically by a quotation price and size interval 
designated by the market maker, once its displayed size in the 
security has been reduced to zero size by executions that occur 
against the market maker in the System. The facility will refresh 
the market maker's quotation on either the bid or the offer side of 
the market, depending on the side that was reduced to zero size, by 
the price interval and size designated by the market maker.
    (4) A System Market Maker may terminate its obligation by 
withdrawal from the System at any time. However, the market maker 
has the specific obligation to monitor its status in the System to 
assure that a withdrawal has in fact occurred. Except as otherwise 
permitted by Rule 11890 regarding the Association's authority to 
declare clearly erroneous transactions void, any transaction 
occurring prior to the effectiveness of the withdrawal will remain 
the responsibility of the market maker. A System Market Maker whose 
displayed size is reduced to zero on one side of the market will 
have a closed quote in Nasdaq and the System with respect to both 
sides of its market and will be permitted a standard grace period of 
three minutes within which to take action to restore its displayed 
size, if the market maker has not authorized use of the automated 
quotation update facility. A market maker that fails to renew its 
displayed size in a security within the allotted time will have its 
quotation on the side of the market that has been reduced to zero 
restored by the System at the lowest bid price (for a bid) or the 
highest offer price (for an offer) displayed in that security. 
Except as provided in subparagraph (5) below, a market maker that 
withdraws from a security may not re-register in the System as a 
market maker in that security for twenty (20) business days.

[[Page 12138]]

    (5) Notwithstanding the provisions of subparagraph (4) above:
    (A) a market maker that obtains an excused withdrawal pursuant 
to Rule 4619 of the NASD Rules prior to withdrawing from the System 
may reenter the System according to the conditions of its 
withdrawal;
    (B) a market maker that fails to maintain a clearing arrangement 
with a registered clearing agency or with a member of such an 
agency, and its thereby withdrawn from participation in ACT and the 
System, may reenter the System after a clearing arrangement has been 
reestablished and the market marker has complied with ACT 
participant requirements, provided however, that if the Association 
finds that the ACT market marker's failure to maintain a clearing 
arrangement is voluntary, the withdrawal of quotations will be 
considered voluntary and unexcused pursuant to Rule 4620 and these 
rules.
    (6) In the event that a malfunction in the participant's System 
devices occurs rendering electronic communications with the System 
inoperable, the System participant is obligated to immediately 
contact Nasdaq Market Operations by telephone to request a closed 
quote status. If the closed quote status is granted, Market 
Operations personnel will enter such status notification into the 
System from a supervisory terminal. Such manual intervention, 
however, will take a certain period of time for completion and, 
unless otherwise permitted by the Association pursuant to its 
authority under Rule 11890, the System participant will continue to 
be obligated for any transaction executed prior to the effectiveness 
of its closed quote.
    (b) Order Entry Participants
    (1) An NASD member that is not registered as a market maker or 
as an ECN in a particular security must register as an Order Entry 
Participant to be able to enter orders into the System. Order Entry 
Participants can enter orders into the System only after an 
application for registration is reviewed and accepted by Nasdaq.
    (2) Entry of Customer Orders: Executing Participants and Order 
Entry Participants are permitted to enter customer orders.
    (3) Entry of Proprietary Orders: Provided that System market 
makers are permitted to enter quotations for actual size pursuant to 
Nasdaq market maker quotation rules, any Order Entry participant is 
permitted to enter proprietary orders into the System for display, 
delivery, and execution purposes. If, however, at the time that the 
new system is available for use, System market makers are not 
permitted to quote in actual size for all Nasdaq securities, only 
System market makers, UTP Exchange specialists, and registered 
option market makers may place proprietary orders for their market 
making accounts into the System. Proprietary orders may be entered 
only for securities for which the market maker or specialist is 
registered as a market maker or specialist. Any such proprietary 
order must be entered by an associated person of the market maker or 
specialist who is actively engaged in a market making capacity for 
that particular security.
    (4) Proprietary Orders:
    (A) Display and Execution--Proprietary orders are subject to the 
same display and execution processes and requirements as agency 
orders.
    (B) Surveillance Requirements--A member that enters a 
proprietary order must designate the order with the appropriate 
designator to identify the order as proprietary.
    (5) Time In Force Orders: The following types of orders may be 
entered into the System:

(A) day orders;
(B) good-till-canceled (``GTC''); and
(C) good-till-date (``GTD'').

    The System will not accept all or none (``AON'') orders; orders 
with minimum size of executions; or other conditioned orders.

4950. Entry, Display, and Execution of Orders

    (a) Types of Orders That May be Entered: The System will accept 
limit orders, marketable limit orders, market orders, and odd-lot 
orders. All such orders have a minimum life of 10 seconds during 
which period such orders may not be canceled by the participant 
entering the order.
    (b) Order Price Increments: All priced orders submitted for 
execution in the System are subject to the same policy for price 
increments as market maker quotes. For securities priced at $10 or 
more, the minimum order increment shall be \1/16\th. For stocks 
priced less than $10, the minimum order increment shall be \1/32\th.
    (c) Order Size: Any round or mixed lot order up to 999,999 
shares may be entered into the System for normal display and 
execution processing provided that System market makers may quote in 
actual size. If market makers are not permitted to quote in actual 
size, Order Entry Participants that are not System Market Makers or 
registered options market makers may only enter orders up to 1000 
shares for non-directed orders. Odd-lot orders are subject to a 
separate display and execution process set forth below.
    (d) Directed Orders:
    (1) General Provisions--During normal business hours (i.e., 9:30 
a.m. to 4:00 p.m.), orders entered into the System may be directed 
to a particular Nasdaq Market Maker, ECN, or UTP Exchange Specialist 
for execution.
    (2) No Display of Directed Orders--Directed orders are not 
displayed in the Nasdaq Limit Order File and do not interact with 
any order displayed there, i.e., directed orders do not match 
against limit orders in the Nasdaq Limit Order File.
    (3) Price and Size of Directed Orders--Directed orders must be 
priced orders in round or mixed lots and can be of any size 
permitted in the System in accordance with paragraph (c) above.
    (4) Processing of Directed Orders: Directed orders will be 
processed in time sequence with non-directed orders entered into the 
System; that is, a directed order will be queued with all other 
orders (directed and non-directed) and will not be delivered to a 
particular Executing Participant designated by the Order Entry 
Participant until orders in sequence ahead of it are delivered for 
execution.
    (5) Liability for Directed Orders: Nasdaq Market Makers and ECNs 
that receive directed orders at or better than their quoted price 
(e.g., an order to sell at a price equal to or below their bid) are 
obligated to execute such orders up to their size displayed at the 
time that the order is delivered, in accordance with the same 
parameters for processing executions for non-directed orders in Rule 
4950(e)(3), unless an exception to the SEC and NASD Firm Quote Rules 
applies. Directed orders that are sent at a price inferior to the 
price displayed (e.g., an order to sell at a price higher than their 
quoted bid) at the time of delivery or for a size greater than that 
currently displayed size do not obligate the Executing Participant 
to execute at that price or for any amount greater than the 
displayed size, except as provided for when the System Market Maker 
makes use of the supplemental size feature. All directed orders that 
impose liability on the Executing Participant will be designated as 
such on the order message delivered to such participant.
    (6) Interaction of Directed Orders With Market Maker 
Supplemental Size: If a System Market Maker has elected to use 
supplemental size, and it receives a directed order greater than its 
displayed size, and such order is equal to or less than its 
supplemental size, the system shall either automatically execute 
such order if it is 1000 shares or less, or wait for a response from 
the market maker for either 17 seconds, if the order delivered is 
more than 1,000 shares, but less than 5,000 shares, or 32 seconds, 
if the order is 5,000 shares or greater, before executing the order 
up to the amount of its displayed size and its supplemental size. If 
the market maker accepts a partial amount or declines the order 
within the allotted time period, the market maker's supplemental 
size above the partial acceptance or the decline shall be eliminated 
by the System.
    (7) Time In Force and Execution Process for Directed Orders: 
Order Entry Participants may cancel any directed order 10 seconds 
after entry. Directed orders will be delivered to or executed 
against an Executing Participant, except for a UTP Exchange 
Specialist, in the same manner as non-directed orders, as described 
in subparagraph (e)(3) below, except that non-liability orders 
priced inferior to the displayed price or at size larger than 
displayed size will be delivered for interaction by the Executing 
Participant. All orders directed to a UTP Exchange Specialist shall 
be delivered for the UTP Exchange Specialist's response. Delivery 
and/or execution of a directed order shall reduce the displayed size 
of the Executing Participant by the amount delivered or executed 
against the displayed size. Time in force for all delivered directed 
orders shall be the time parameters set forth in subparagraph (e)(3) 
below.
    (8) Directed Orders Outside of Normal Market Hours: From 9:00 
a.m. to 9:30 a.m. (ET) (pre-open directed orders) and from 4:00 p.m. 
to 5:15 p.m. (ET) (post-close directed orders) the System will 
permit the entry of directed orders. As long as an Executing 
Participant's quotation is in a closed quote state, the Executing 
Participant has no liability for that directed order. If an 
Executing Participant has chosen to open its quote after market 
close and a directed order is delivered, the order is treated as a 
liability

[[Page 12139]]

order subject to the same obligations described in subparagraph 
(d)(5) above, except that a market maker that opens its quote 
momentarily, solely for the purpose of adjusting its quote to 
reflect the elimination of customer limit orders, will not be 
subject to Firm Quote Liability. Directed orders outside of normal 
market hours cannot be canceled within 10 seconds; the time in force 
shall be one minute.
    (e) Non-directed Orders:
    (1) General Provisions: Unless an order is directed to a 
particular Executing Participant pursuant to paragraph (d) above, an 
order entered into the system shall be considered a non-directed 
order that shall be displayed and/or executed according to the 
provisions of this subparagraph. If a non-directed order is 
executable at the time it is ready to be delivered for execution 
(i.e., it is a market order or marketable limit order), it shall be 
delivered for execution in time sequence based on the time the order 
is received in the System. Delivery for execution shall occur 
against the next available participant (either an Executing 
Participant or the Nasdaq Limit Order File) based on a price and 
time priority ranking. If a non-directed order is a limit order that 
is not executable at the time it is received in Nasdaq's System, it 
shall be delivered to the Nasdaq Limit Order File for immediate 
display in the File.
    (2) Entry of Non-Directed Orders: Round lot and mixed lot orders 
of any size permitted pursuant to paragraph (c) of this rule may be 
entered into the System on a non-directed basis. Orders will be 
processed in the time sequence that they are received in Nasdaq's 
System. Orders will be delivered to the best price quoted in 
Nasdaq's System for execution purposes. Market orders and marketable 
limit orders that are larger than the displayed size of a 
participant will be split by the System and will be delivered to 
multiple participants to obtain an execution at the best prices 
available. Similarly, market orders and marketable limit orders 
priced through the best prices will be executed against multiple 
Executing Participants until the orders are fully executed. 
Marketable limit orders that cannot be fully executed because all 
displayed size at the marketable limit order's price is exhausted 
shall become a limit order displayed in the Nasdaq Limit Order File 
and subject to execution as described below.
    (3) Processing of Non-Directed Orders: Non-directed orders shall 
be delivered to the Executing Participant or the Nasdaq Limit Order 
File at the best price on a time priority basis. Non-directed orders 
delivered in this process are delivered in size up to the size 
displayed by the Executing Participant or Limit Order File, except 
as provided when a market maker chooses to use supplemental size as 
described below in paragraph (f). Executing Participants are 
responsible for executing orders delivered at their prices and up to 
their displayed size, unless an exception to the Firm Quote Rules 
applies. The System will take the following actions based on the 
prices and size displayed and the execution parameters chosen by the 
Executing Participants:
    (A) Minimum Parameters For Automatic Execution: If the size of 
an order, or part of an order, presented to an Executing Participant 
is 1,000 shares or less, the System will deliver the order in a size 
amount that is either (i) up to the displayed size of the Executing 
Participant's quotation or (ii) the full size of the order if such 
displayed quotation size is greater than the order size, and 
immediately execute the order against the participant at the time of 
delivery and decrease the displayed quote by the size of the order 
executed. The system will permit up to a 17-second delay after 
execution to permit the Executing Participant to update its 
quotation before another non-directed order is delivered to that 
participant.
    (B) Default Execution: If the size of an order, or part of an 
order, presented is greater than 1,000 shares but less than 5,000 
shares, and an Executing Participant is displaying a quotation size 
of 1,000 shares or greater but less than 5,000 shares, the System 
will deliver an amount of the order up to the Executing 
Participant's displayed size for execution and will decrease the 
displayed size by the amount delivered immediately upon action by 
the Executing Participant. The executing party has up to 17 seconds 
from delivery to accept, decline, partial, price improve, or do 
nothing with the delivered order. If the Executing Participant 
declines the order, the Executing Participant's quotation shall be 
immediately placed in a closed quote state. If the Executing 
Participant does not respond to the order, the System will 
automatically execute the order.
    (C) Large Size Default Execution: If the size of an order, or 
part of an order, presented is 5,000 shares or greater, and an 
Executing Participant is displaying a quotation size of 5,000 shares 
or greater, the System shall deliver the order to the Executing 
Participant for execution and will decrease the displayed size by 
the amount delivered immediately upon action by the Executing 
Participant. The executing party has up to 32 seconds from delivery 
to accept, decline, partial, price improve, or do nothing with the 
delivered order. If the Executing Participant declines the order, 
the Executing Participant's quotation shall be immediately placed in 
a closed quote state. if the Executing Participant does not respond 
to the order, the System will automatically execute the order.
    (D) Non-Directed Order Interaction with Market Maker 
Supplemental Size: If a market maker using supplemental size is 
alone at the inside price, and a non-directed order larger than its 
displayed size becomes available for delivery, the entire order, up 
to the market maker's displayed size and its supplemental size, 
shall either be automatically executed if it is up to 1000 shares, 
or presented to the market maker for its action for up to 17 
seconds, if the order is greater than 1,000 shares but less than 
5,000 shares, or up to 32 seconds if the order is 5,000 shares or 
greater. If the market maker accepts a partial amount less than its 
remaining supplemental size or declines the order, the remainder of 
the market maker's supplemental size shall be eliminated and the 
market maker's quote shall be placed in a closed quote state until 
the market maker updates its quote, or three minutes, whichever time 
period is shorter. If the market maker does nothing within 17 or 32 
seconds, depending on the size of the order presented, the amount of 
the order presented to the market maker shall be executed against 
the market maker.
    (f) Supplemental Size: The System will permit System market 
makers to establish supplemental size to their displayed size, i.e., 
a System market maker may establish additional, undisplayed size 
that becomes displayed in market maker-established size increments 
in the market maker's quotation after the System has executed an 
order that decreases the market maker's displayed size to zero. The 
amount of interest entered into the supplemental size feature may be 
any amount established by the market maker, up to 99,000 shares, 
provided that a market maker may not use the supplemental size 
feature unless it is quoting in size of at least 1,000 shares and 
the refreshed size of the quotation maintained by the supplemental 
size facility is in a minimum increment of 1,000 shares.
    (g) Limit Order File: The System will maintain a Limit Order 
File that will hold and display limit orders entered on a voluntary 
basis by participants. The System will display and execute limit 
orders entered into the File in the following manner:
    (1) Display of Limit Orders: Limit Orders entered into the Limit 
Order File will be ranked according to price and time sequence. The 
best-ranked limit order to buy and the best-ranked limit order to 
sell in the file and the aggregate size of such orders associated 
with such prices (i.e., the ``Top of File'') will be displayed 
dynamically in a window on Nasdaq presentation devices and in the 
Nasdaq quote montage where it will be ranked in price and time 
sequence with market maker quotations and ECN-displayed orders. In 
addition, Nasdaq will maintain for all Nasdaq subscribers a full 
file display that will contain the prices and aggregate sizes of all 
limit orders contained in the file. This full file display is not 
updated dynamically and must be accessed on a query basis. 
Marketable limit orders shall not be displayed in the Limit Order 
File.
    (2) Execution of Limit Orders Displayed In The Limit Order File: 
When orders that are entered into the Nasdaq Limit Order File are 
ranked first in priority in the System, the System will match non-
directed market and marketable orders against the best-priced limit 
orders and immediately execute the orders and report such executions 
to the consolidated trade reporting System for trade reporting and 
the appropriate clearing agency as a locked-in trade.
    (3) Short Sale Limit Orders: The System will permit the entry 
and execution of limit orders that are short sales. The System will 
not permit the execution of short sale orders that would violate the 
NASD's Short Sale Rule, Rule 3350 of the NASD's Conduct Rules.
    (4) Mixed Lot Orders: The System will display only the round lot 
portion of a mixed lot order in the Top of File and Nasdaq Quote 
Montage. The System will match the full size of a mixed lot order 
only when such order can match exactly against another mixed lot 
order. In cases where there is no exact match of mixed lot orders, 
the System will match the round lot portions of such matching 
orders, and maintain the remaining odd lot

[[Page 12140]]

portions of such orders for odd-lot processing.
    (5) Opening Process: At 9:30 a.m. (ET) the System will commence 
an opening match process as follows to attempt to execute as many 
limit orders as possible held on the Limit Order File as of 9:30 
together with any market orders also held at that time. At 9:30, the 
System will first match limit orders to limit orders, based on 
price/time priority, by providing executions bounded by the 9:30 
inside quotation until all possible executions are exhausted. The 
9:30 ``inside'' for this purpose includes quotations of ECNs and UTP 
exchanges, but does not include the Top of File, Limits that cross 
other limits, where both limits are outside the 9:30 inside, will be 
executed at the mid-point of the 9:30 inside,. Limits that cross 
other limits where one limit is at or within the 9:30 inside but the 
other is outside will be executed at a price that would provide 
price improvement for both orders if possible, provided the 
execution is at or within the 9:30 inside. Any remaining limits that 
cross other limits, both of which are within the 9:30 inside, will 
be executed at the midpoint of the two limit orders, providing price 
improvement to both. Next, the System executes as many market orders 
as possible against any remaining limit orders, provided the limit 
order is for a price at or within the 9:30 inside. If the inside 
quotation is locked at 9:30, the System will execute as many orders 
as can match at that price, with the remaining unmatched orders to 
be processed at 9:30 pursuant to normal business hours processing. 
If the inside quotation is crossed at 9:30 for a particular 
security, the System will not execute the File orders in that 
security. In this situation, each order will be matched or delivered 
for execution, as the case may be, according to normal business 
hours processing. Any market orders that do not match against limit 
orders in the opening shall be delivered, starting 9:30, to 
Executing Participants or the Limit Order File for execution 
purposes according to normal business hours processing as set forth 
above for non-directed orders. Execution reports for orders executed 
during the opening will be disseminated starting at 9:30 a.m.
    (6)(A) Display of limit orders: All orders entered and displayed 
in Limit Order File shall be displayed anonymously.
    (B) Execution of Limit Orders: When limit orders are executed, 
the System shall provide an execution report to any participant that 
participates in the execution and shall include the identifier of 
each such participant.
    (h) Odd-Lot Processing:
    (1) Acceptance and Display: Odd lot orders, and the remainder of 
mixed lot orders that could not be executed in the normal manner, 
and are less than 100 shares, (market, limit, and marketable limit) 
shall be accepted and processed by the System in a separate process. 
Odd lot limit orders will not be displayed or matched in the Nasdaq 
Limit Order File.
    (2) Execution Process: An odd lot order shall be executed 
automatically against the next available Nasdaq market maker in 
rotation, when such odd lot order becomes executable. When the odd 
lot order becomes executable, it will execute at the best price 
available in the market against the market maker even if that market 
maker is not quoting that price. Odd lot executions shall not 
decrease the market maker's displayed size.

4960. Firm Quote Compliance Facility

    (a) To assist System Market Makers in complying with the Firm 
Quote Rules, System Market Makers shall be provided with a means to 
indicate the NASD Regulation's Market Regulation that the System 
Market Maker has received an order via the telephone to trade at the 
System Market Maker's Nasdaq-displayed quotation and that for a 
period of time while the System Market Maker handles the telephone 
order, the System should not deliver additional orders for 
execution.
    (b) The System Market Maker shall send via the System a message 
that creates a time record indicating when the Market Maker entered 
the message regarding the telephone order. When the System receives 
the message, the System shall not present an order to that Market 
Maker until 17 seconds after receipts of the original message. The 
System will provide the System Market Maker with a reference number 
that shall be attached to the execution report that may occur as a 
result of the telephone order. A System market maker may only send 
one such message through the System for each telephone order 
necessitating the message. Entering messages without corresponding 
transactions shall be a violation of just and equitable principles 
of trade.

4960. Clearance and Settlement

    All transactions executed in the System shall be transmitted to 
the National Securities Clearing Corporation to be cleared and 
settled through a registered clearing agency using a continuous net 
settlement system.

4970. Obligation to Honor System Trades

    If a trade reported by a participant, or clearing member acting 
on its behalf, is reported by the System to clearing at the close of 
any trading day, or shown by the activity reports generated by the 
System as constituting a side of a System trade, such System 
participant, or clearing member acting on its behalf, shall honor 
such trade on the scheduled settlement date.

4980. Compliance With Procedures And Rules

    Failure of a participant or person associated with a participant 
to comply with any of the rules or requirements of the System may be 
considered conduct inconsistent with high standards of commercial 
honor and just and equitable principles of trade, in violation of 
the Conduct Rules. No member shall effect a System transaction for 
the account of a customer, or for its own account, indirectly or 
through the offices of a third party, for the purpose of avoiding 
the application of these rules. Members are precluded from doing 
indirectly what is directly prohibited by these rules. All entries 
in the System shall be made in accordance with the procedures and 
requirements set forth in the User Guide. failure by a non-member 
participant to comply with any of the rules or requirements 
applicable to the System shall subject the NASD member sponsoring 
such non-member to censure, fine, suspension or revocation of its 
registration as a participant or any other fitting penalty under the 
Rules of the Association.

4990. Termination of System Service

    The Association may, upon notice, terminate System service to a 
participant in the event that a participant fails to abide by any of 
the rules or operating procedures of the System or the Association, 
or fails to pay promptly for services rendered.

[FR Doc. 98-6340 Filed 3-11-98; 8:45 am]
BILLING CODE 8010-01-M