[Federal Register Volume 63, Number 49 (Friday, March 13, 1998)]
[Notices]
[Pages 12559-12569]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-6528]


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

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39729; File No. SR-NASD-97-56]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendment No. 1 Thereto and Notice of Filing and Order 
Granting Accelerated Approval to Amendment Nos. 2, 3, 4, 5, and 6 to 
Proposed Rule Change by the National Association of Securities Dealers, 
Inc., To Amend Rule 3110 and to Adopt New Rules 6950 Through 6957 
Relating to the Creation of an Order Audit Rail System

March 6, 1998.

I. Introduction

    On July 29, 1997, NASD Regulation, Inc. (``NASDR''), a wholly-owned 
subsidiary of the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association''), submitted to the Securities and Exchange 
Commission (``SEC'' or ``Commission'') on behalf of the NASD, pursuant 
to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to 
adopt new rules relating to the creation of an order audit trail system 
(``Order Audit Trail System'' or ``OATS''). On August 25, 1997, the 
NASDR submitted Amendment No. 1 to the proposed rule change.\3\
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Letter from Joan C. Conley, Corporate Secretary, NASDR, 
to Katherine A. England, Assistant Director, Division of Market 
Regulation (``Division''), Commission, dated August 25, 1997 
(``Amendment No. 1''). In addition to proposing technical 
corrections, Amendment No. 1: (1) expands the proposal's definition 
of ``order,'' (2) clarified that the proposed requirements of Rule 
3110(c) (regarding required books and records) would be temporary 
and only in effect from January 1, 1999, to January 31, 2000; (3) 
conforms the discussion section to the language of the proposed rule 
regarding effective dates for orders other than electronic orders; 
and (4) notices that the NASDR consulted generally with industry 
representatives and received a number of comment letters. The 
changes proposed in Amendment NO. 1 were incorporated into the 
Commission's notice of filing of the proposal prior to its 
publication in the Federal Register.
---------------------------------------------------------------------------

    The proposed rule change was published for comment in the Federal

[[Page 12560]]

Register on September 5, 1997.\4\ The Commission received eighteen 
comments on the proposal.\5\ On October 9, 1997, the NASDR filed 
Amendment No. 2 to the proposed rule change.\6\ The NASDR filed 
Amendment No. 3 to the proposed rule change on October 29, 1997.\7\ On 
February 3, 1998, the NASDR filed Amendment No. 4 to the proposed rule 
change.\8\ The NASDR filed Amendment No. 5 to the proposed rule change 
on February 11, 1998.\9\ On March 5, 1998, the NASDR filed Amendment 
No. 6 to the proposed rule change.\10\ This order approves the proposed 
rule change and Amendment No. 1. In addition, the Commission is 
publishing this notice to solicit comments on Amendment Nos. 2, 3, 4, 
5, and 6 to the proposed rule change and is simultaneously approving 
those amendments on an accelerated basis.
---------------------------------------------------------------------------

    \4\ See Securities Exchange Act Release No. 38990 (August 28, 
1997) 62 FR 47096.
    \5\ See Letters to Jonathan G. Katz, Secretary, Commission from: 
Edward J. Johnsen, Vice President and Assistant General Counsel and 
Christopher R. Franke, Vice President and Compliance Manager, J.P, 
Morgan Securities, Inc. (``J.P. Morgan''), dated September 25, 1997; 
John B. Morgan, Director of Legal and Compliance, Mabon Securities 
Corp. (``Mabon''), dated September 24, 1997; John A. Goc, Senior 
Vice President, Equity Trading, Boston Institutional Services 
(``BIS''), dated September 19, 1997; Steven Alan Bennett, Senior 
Vice President and General Counsel, Banc One Corporation (``Banc 
One''), dated September 26, 1997; H. Michael Reese, Chief Financial 
Officer, HBK Finance L.P. (``HBK Finance''), dated September 23, 
1997; Allen J. Thomas, Vice President, A.G. Edwards & Sons, Inc. 
(``A.G. Edwards''), dated September 26, 1997; Charles R. Hood, 
Senior Vice President and General Counsel, Instinet Corporation 
(``Instinet''), dated September 26, 1997; Brooke Berstein, Vice 
President and Counsel, Morgan Stanley & Co. Inc. (``Morgan 
Stanley''), dated September 29, 1997; James M. Davis, Managing 
Director of Compliance, The Franklin Templeton Group (``Franklin 
Templeton''), dated September 26, 1997; Richard O. Scribner, 
Director for Regulation, Salomon Brothers, Inc. (``Salomon Bros.''), 
dated September 30, 1997; Timothy F. McCarthy, Charles Schwab & Co., 
Inc. (``Schwab''), dated September 30, 1997; Bernard L. Madoff, 
Chair, OATS Ad Hoc Committee, Securities Industry Association 
(``SIA''), dated October 6, 1997; James R. Orvis, Senior Vice 
President and Director of Operations, Advest, Inc. (``Advest''), 
dated October 7m 1997; John M. Ivan, Managing Director Compliance, 
Wheat First Butcher Singer (``Wheat First''), dated October 10, 
1997; Robert B. Sloan, Partner, Director/Information Services, J.C. 
Bradford & Co. (``J.C. Bradford''), dated October 8, 1997; John J. 
Sanders, Jr., Principal, BancAmerica Robertson Stephens 
(``BancAmerica''), dated October 6, 1997; Kathryn G. Casparian, 
Director of Regulatory Affairs, Oppenheimer & Co., Inc. 
(``Oppenheimer''), dated October 15, 1997; and Robert E. Maina, 
First Vice President, Merrill Lynch (``Merrill Lynch''), dated 
October 17, 1997. Two additional letters were forwarded to the 
Commission subsequent to the close of the comment period. These 
consist of a letter from Bernard L. Madoff, Chair, OATS Ad Hoc 
Committee, SIA, to Richard G. Ketchum, Executive Vice President and 
Chief Operating Officer, NASD, dated December 3, 1997 and a letter 
to James M. Cangiano, Senior Vice President, Market Regulation, 
NASDR, from Charles R. Hood, Senior Vice President and General 
Counsel, Instine, date November 25, 1997.
    \6\ See Letter from John M. Ramsay, Deputy General Counsel, 
NASDR, to Katherine A. England, Assistant Director, Division 
Commission, dated October 7, 1997 (``Amendment No. 2''). In 
Amendment No. 2, the NASDR consent to an extension of the time 
periods specified in Section 19(b)(2) of the Act.
    \7\ See Letter from Joan C. Conley, Corporate Secretary, NASDR, 
to Katherine A. England, Division, Commission, dated October 28, 
1997 (``Amendment No. 3''). In Amendment No. 3, the NASDR proposes 
to modify the numbering of the text of the proposed rules from 6900 
through 6970 to 6950 through 6957.
    \8\ See Letter from Mary N. Revell, Associate General Counsel, 
NASDR, to Howard Kramer, Associate Director, Division, Commission, 
dated February 3, 1998 (``Amendment No. 4''). In Amendment No. 4, 
the NASDR proposes to amend the proposal to, among other things: (1) 
modify the specifications for electron orders to conform to the 
industry standard of an eight character order identifier and to 
delete the requirement to pass the order origination date; (2) 
extend the phase-in of the OATS implementation schedule, as 
discussed in section III.E. below; (3) revise the definition of the 
term ``electronic order,'' (4) define the terms ``Electronic 
Communication Network'' and ``manual order,'' (5) clarify the 
treatment of bunched orders; (6) revise the test of proposed Rule 
6954 to separately address four different order transmittal 
scenarios; (7) limit the reporting requirements of ECNs; and (8) 
make technical corrections.
    \9\ See Letter from Mary N. Revell, Associate General Counsel, 
NASDR, to Howard Kramer, Associate Director, Division, Commission, 
dated February 11, 1998 (``Amendment No. 5''). In Amendment No. 5, 
the NASDR proposes to amend the text of proposed Rule 6954(c) and 
Amendment No. 4 to delete provisions stating that the information to 
be recorded by a Reporting Member operating an ECN is that 
information provided to the ECN by the transmitting Reporting 
Member.
    \10\ See Letter from Mary N. Revell, Associate General Counsel, 
NASDR, to Howard Kramer, Associate Director, Division, Commission, 
dated March 5, 1998 (``Amendment No. 6''). In addition to several 
clarifying technical amendments, the NASDR proposes in Amendment No. 
6 to: (1) reinstate and amend the books and records provisions of 
Rule 3110, previously deleted in Amendment No. 4, to require members 
to record certain information; (2) revise proposed Rule 6954(c)(1) 
to exempt from reporting to OATS orders routed from one department 
within a member to the member's trading desk; (3) revise the 
implementation date for electronic orders transmitted to a market 
maker or an ECN to March 1, 1999; and (4) clarify the proposed 
treatment of bunched orders.
---------------------------------------------------------------------------

II. Background

    OATS is intended to fulfill one of the undertakings contained in 
the order issued by the SEC relating to the settlement of an 
enforcement action against the NASD for failure to adequately enforce 
its rules.\11\ Pursuant to the SEC Order, the Association agreed to 
design and implement by August 8, 1998 (or as specified by further 
order of the Commission) an order audit trail sufficient to enable the 
Association to reconstruct markets promptly, conduct efficient 
surveillance and enforce its rules.\12\ OATS is required, subject to 
the Commission's approval, at a minimum, to (a) provide an accurate 
time-sequenced record of orders and transactions, beginning with the 
receipt of an order at the first point of contact between the broker-
dealer and the customer or counterparty and further documenting the 
life of the order through the process of execution, and (b) provide for 
market-wide synchronization of clocks used in connection with the audit 
trail.\13\
---------------------------------------------------------------------------

    \11\ See In the Matter of National Association of Securities 
Dealers, Inc.; SEC Release No. 34-37538, August 8, 1996; 
Administrative Proceeding File No. 3-9056 (``SEC Order'').
    \12\ Id.
    \13\ Id.
---------------------------------------------------------------------------

    The SEC Order was issued in response to the filings of the 
Commission's 21(a) Report.\14\ In the Appendix to its 21(a) Report, the 
Commission stated that,

    \14\ See Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market, 
Release No. 34-37543, Commission, August 8, 1996.
---------------------------------------------------------------------------

    In the course of the investigation [of the NASD], the Commission 
staff encountered significant difficulties reconstructing activity 
in the Nasdaq market. Broker-dealer order tickets, among the most 
fundamental of records, were too often unavailable or inconvenient 
to retrieve. Timestamping was often unreliable for the purposes of 
determining compliance with applicable rules, such as the firm quote 
rule and limit order protection rules.
    A further difficulty was the inadequate documentation of 
telephone orders received at [over-the-counter] trading desks. As 
noted above, order tickets if they were available at all, were not 
always reliably timestamped. Having reliable and accurate records of 
telephone orders is crucial to evaluating a market maker's 
compliance with the firm quote rule and trade reporting rule. 
Because telephone orders and transactions are a significant part of 
the activity in the Nasdaq market, the documentation of these orders 
and transactions is essential to adequate survelliance and 
compliance in the market.
    The NASD has automated surveillance capabilities with respect to 
its current audit trail, although it has not consistently maintained 
adequate routine automated surveillance capabilities over the audit 
trail. Its surveillance and enforcement responsibilities with 
respect to market conduct has increased substantially in recent 
years. The adoption of limit order protection rules in 1994 and 1995 
and the frequency of backing away from quotations and late trade 
reporting revealed by this investigation, all indicate the need for 
an improved surveillance capability. In light of the high volume of 
trading on today's Nasdaq market and the dispersed nature of that 
market, these rules cannot be efficiently enforced through current 
NASD inspections and analysis of hard copies of order tickets and 
other records. Automated surveillance is essential if there rules 
are to be effectively enforced. This surveillance capability can 
only be implemented with an improved audit trail.

[[Page 12561]]

    Hunderds of millions of share trade very day on Nasdaq, and 
effective regulation of this market requires a comprehensive 
centralized and computerized recordkeeping system. Surveillance 
methods employed in this market must keep pace with the rapidly of 
trading done with computer technology. A comprehensive audit trail, 
beginning with the time an order is placed and continuing to record 
the life of the order through the process of execution, is essential 
to maintaining the integrity of the Nasdaq market. Such an audit 
trail would feature the computerized recordation of the time and 
terms of an order, and of the sequence of steps to execute the 
order. By providing the details, the enhanced audit trail would 
allow for prompt surveillance on a scale that cannot be attained 
with traditional methods of examination.\15\
---------------------------------------------------------------------------

    \15\ See Appendix to Report Pursuant to Section 21(a) of the 
Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq 
Market, Commission, August 8, 1996, at 100-101.
---------------------------------------------------------------------------

III. Description of the Proposal

    In response to the findings in the 21(a) Report and the 
corresponding undertakings, the NASD proposed OATS. The proposed OATS 
would capture order information reported by NASD members. This 
information would be integrated with quote information and transaction 
information reported to the Automated Confirmation Transaction Service 
(``ACT'') \16\ to provide the Association with an accurate, time-
sequenced record of orders and other transactions. In general, the OATS 
would impose obligations on member firms to record in electronic form 
and to report to the NASDR certain information with respect to orders 
originated, received, transmitted, modified, canceled, or executed 
(``reportable events'') by NASD members relating to equity securities 
traded on The Nasdaq Stock Market, Inc. (``Nasdaq'').\17\ In addition, 
the proposal would require member firms to synchronize their business 
clocks and continually to keep them synchronized with a specific time 
designated by the Association.
---------------------------------------------------------------------------

    \16\ ACT is an automated system owned and operated by Nasdaq 
that captures transaction information in real-time. See Amendment 
No. 4, Supra note 8.
    \17\ The proposed rules do not apply to orders for stocks traded 
on the Bulletin Board, debt, and securities listed on national 
securities exchanges. See NASD proposed Rules 6951(j) and 6952(c).
---------------------------------------------------------------------------

    The proposed OATS would be operated by the NASDR, the operating 
subsidiary of the Association that is responsible for regulating member 
firms and conducting surveillance of Nasdaq. The NASDR would obtain ACT 
transaction data from Nasdaq on a daily basis for purposes of 
constructing an integrated audit trail of transactions and order data, 
and NASD members would be required to transmit ACT identifying 
information to the OATS.
    The OATS requirements are set forth in proposed new Rules 6950 
through 6957 \18\ of the NASD's Conduct Rules relating to an audit 
trail system owned and operated by the NASD. The proposed rules are 
summarized in subsection A below and are discussed in detail in 
subsection B-F.
---------------------------------------------------------------------------

    \18\ The original filing proposed numbering the text of the 
proposed rule 6900 through 6970. Subsequently, the numbering of the 
proposed rule was changed to 6950 through 6957. See Amendment No. 3, 
supra note 7.
---------------------------------------------------------------------------

    In addition to adopting the new OATS rules, the proposal would 
amend NASD Rule 3110 to impose recordkeeping requirements on NASD 
members that are obligated to record and report information to the NASD 
under the OATS rules. Such members would be required to record, with 
respect to an order that is received or \19\ executed at the members' 
trading department, the identification of each registered person who 
receives an order directly from a customer and the identification of 
each person who executes an order at a market maker's trading desk.\20\ 
In addition, the revised Rule 3110 would require members to record the 
identification of the department of the member that originated an order 
that is transmitted manually to another department within a member.
---------------------------------------------------------------------------

    \19\ As originally proposed, Rule 3110 would have required an 
NASD member to record information pertaining to orders received and 
executed at its trading department. [emphasis added]. This language 
has been modified to require an NASD member to record information 
relating to orders received or executed at its trading department. 
Per phone conversation between Mary Revell, Associate General 
Counsel, NASDR, and Deborah Flynn, Division, Commission, on March 6, 
1998.
    \20\ In Amendment No. 4, the NASDR deleted a proposed revision 
to NASD Rule 3110, that was proposed in the original proposed rule 
change and published for comment. The proposed provision required 
members to record the identification of each registered person who 
executes an order. See Amendment No. 4, supra note 8. In Amendment 
No. 6, the NASDR proposes to reinstate that provision. See Amendment 
No. 6, supra note 10.
---------------------------------------------------------------------------

a. Summary of Proposed New Rules

(1) NASD Rule 6951--Definitions
    Proposed NASD Rule 6951 sets forth the definitions that apply to 
the new OATS rules. For example, the term ``order'' is defined as ``any 
oral, written, or electronic instruction to effect a transaction in a 
[Nasdaq] equity security that is received by a member from another 
person for handling or execution, or that is originated by a department 
of a member for execution by the same or another member.'' Proposed 
Rule 6951 specifies that the term ``order'' does not include a market 
maker's proprietary transactions originated by a trading desk in the 
ordinary course of an NASD member's market making activities. Proposed 
new Rule 6951, as amended, distinguishes between the terms ``electronic 
order'' and ``manual order.'' An electronic order under the rule is an 
order ``captured by a member in an electronic order-routing or 
execution system.'' \21\ The term manual order is added to the amended 
proposal and is defined as ``an order that is captured by a member 
other than in an electronic order-routing or execution system.'' The 
amended definition of the term electronic order makes clear that orders 
that are received manually and subsequently entered into an automated 
system will be considered electronic orders under the proposed OATS 
rules. The proposed rule defines the term Reporting Member as an NASD 
member that receives or originates an order and has an obligation to 
record and report information about that order to the NASDR under the 
applicable provisions of the OATS rules. Finally, the term ``Reporting 
Agent'' is defined in the proposal as ``a third party member that 
enters into an agreement with another member pursuant to which the 
Reporting Agent agrees to fulfill such member's obligations under Rule 
6955.''
---------------------------------------------------------------------------

    \21\ See Amendment No. 4, supra note 8. In the original 
proposal, the term electronic order was defined as an order 
``captured by members in electronic form upon or promptly after 
receipt.''
---------------------------------------------------------------------------

(2) NASD Rule 6952--Applicability
    Proposed Rule 6952 establishes the scope of the proposed OATS 
rules. Specifically, proposed Rule 6952 clarifies that the proposed 
rules would apply to all NASD member brokers and dealers and to their 
associated persons and to all executed and unexecuted orders for equity 
securities traded on Nasdaq. In addition, proposed Rule 6952 makes 
clear that, notwithstanding their obligations under the proposed OATS 
rules, NASD members would be required to continue to comply with the 
other requirements contained in the Association's rules and By-Laws.
(3) NASD Rule 6953--Synchronization of Member Business Clocks
    Proposed Rule 6953 would require each NASD member to synchronize 
its business clocks used for purposes of recording the date and time of 
any event that must be recorded pursuant to the By-Laws or other rules 
of the Association, with reference to a time source designated by the 
Association for this purpose, and to maintain the synchronization of 
business clocks in

[[Page 12562]]

conformity with procedures that the Association may prescribe.
(4) NASD Rule 6954--Recording of Order Information
    Proposed Rule 6954 delineates the specific information that must be 
recorded, in terms of hours, minutes, and seconds, by NASD members in 
connection with the origination, receipt, transmission, modification, 
cancellation, or execution of an order for a Nasdaq equity security. 
The proposed rule would establish varying requirements, which are 
discussed in detail in section III.B. below, depending on, for 
instance, how the order is transmitted to the Reporting Member (i.e., 
electronically or manually) and the intended recipient of the 
transmission (i.e., another department within the same member, an ECN, 
or another member).
(5) NASD Rule 6955--Order Data Transmission Requirements
    Proposed rule 6955 would mandate that the data required to be 
recorded under proposed Rule 6954 be transmitted by each Reporting 
Member or its designated Reporting Agent to the OATS in electronic 
form. The proposed rule would require the requisite information to be 
transmitted on the day the reportable event occurred, or the day that 
such information first becomes available. In addition, proposed Rule 
6955 would specifically allow members to enter into written agreements 
with Reporting Agents under which such agents agree to fulfill the 
Reporting Member's reporting obligations arising under the proposed 
rule. Such agreements would not, however, relieve the member that 
originally receives or originates the order from its regulatory 
responsibilities under OATS.
(6) NASD Rule 6956--Violation of Order Audit Trail System Rules
    Penalties for noncompliance with the OATS requirements are set 
forth in proposed Rule 6956. This provision makes clear that members' 
or associated persons' failure to comply with the proposed OATS rules 
would be considered conduct in violation of NASD Rule 2110. As a 
result, penalties that result from violations of NASD Rule 2110 also 
could apply to violations of the OATS rules.
(7) NASD Rule 6957--Effective Date
    Finally, proposed Rule 6957 would establish the implementation 
schedule for the proposed new OATS rules.

B. Information That Must Be Recorded

    Proposed Rule 6954 would require certain identifying information to 
be recorded at various important points during the life of an order. In 
addition to uniquely identifying the order, this information would 
assist the NASDR in carrying out its regulatory responsibilities with 
respect to that order. The required information items relate to: (1) 
the origin of an order (i.e., in-house, customer, or another member); 
(2) whether the member relies upon a Reporting Agent to fulfill its 
reporting obligations; (3) how the order was received (i.e., manually 
or electronically); (4) the terms of the order; (5) whether the order 
was transmitted for execution to another department within the member 
(other than to the trading department),22 to another member, 
or to an electronic communications network (``ECN'') and how it was 
transmitted (i.e., manually or electronically); and (6) whether the 
order was modified, canceled or executed.
---------------------------------------------------------------------------

    \22\ The NASDR proposes to revise proposed Rule 6954(c)(1) to 
require members to report to OATS only orders transmitted to 
departments within the firm other than to the trading department. 
See Amendment No. 6, supra note 10. OATS will assume that 
transmissions for which there is no routing report have been 
transmitted to the member's trading desk.
---------------------------------------------------------------------------

(1) Origin of the Order
    At the point that an order is received or originated, the Reporting 
Member must record certain information items to identify where the 
order came from and when it was received or originated, including: an 
order identifier assigned by the Reporting Member for the date the 
order was received; 23 the market participant symbol 
assigned by the Association to the Reporting Member; 24 the 
date and time the order was originated or received; 25 an 
identification of any department or the identification number of any 
terminal where an order is received directly from a customer; 
26 and where an order is originated by a Reporting Member, 
an identification of the department of the member where the order 
originated.27
---------------------------------------------------------------------------

    \23\ See proposed Rule 6954(b)(1).
    \24\ See proposed Rule 6954(b)(3).
    \25\ See proposed Rule 6954(b)(16).
    \26\ See proposed Rule 6954(b)(4).
    \27\ See proposed Rule 6954(b)(5).
---------------------------------------------------------------------------

(2) Reliance Upon a Reporting Agent
    Under the terms of the proposal, a member would be required to 
record, at the time of origination or receipt of an order, the 
identification of the Reporting Agent if the member relies upon a 
Reporting Agent to fulfill its reporting obligations arising under the 
OATS rules.28
---------------------------------------------------------------------------

    \28\ See proposed Rule 6954(b)(6).
---------------------------------------------------------------------------

(3) How an Order is Received
    The proposed rules would not require specific information items to 
be recorded to identify how the original Reporting Member received the 
order (i.e., electronically or manually). Nonetheless, as discussed in 
section III.A.(1) above, proposed Rule 6951 distinguishes between 
electronic and manual orders. For purposes of the OATS rules, the 
distinction between electronic and manual orders is particularly 
significant as it relates to the implementation schedule set forth in 
proposed Rule 6957, details of which are provided in section III.E. 
below.
(4) Terms of the Order
    Proposed Rule 6954 also would require certain information items 
directly related to the terms of the order itself to be recorded at the 
time of origination or receipt of an order. These information items 
include: the identification symbol assigned by the Association to the 
security; 29 the number of shares to which the order 
applies; 30 the designation as a buy or sell order; 
31 the designation as a short sale order; 32 the 
designation as a market order, limit order, stop order or stop limit 
order; 33 any limit or stop price prescribed in the order; 
34 the time limit during which the order is in force; 
35 any special handling requests 36 contained in 
the order; 37 any request by a customer that an order not be 
displayed, or that a block size order be displayed pursuant to Rule 
11Ac1-4(c); 38 the date on which the order expires, and if 
less than one day, the time when the order expires; 39 the 
type of account for which the order is placed; 40 and 
whether the order is related to a Program Trade or an Index Arbitrage 
Trade.41
---------------------------------------------------------------------------

    \29\ See proposed Rule 6954(b)(2).
    \30\ See proposed Rule 6954(b)(7).
    \31\ See proposed Rule 6954(b)(8).
    \32\ See proposed Rule 6954(b)(9).
    \33\ See proposed Rule 6954(b)(10).
    \34\ See proposed Rule 6954(b)(11).
    \35\ See proposed Rule 6954(b)(13).
    \36\ According to the NASDR, examples of special handling 
requests include the following types of requests: Kill or Fill, All 
or None, Not Held, Immediate or Cancel, Market at Open, Market at 
Close, Over the Day, Scale, Work, Minimum Quantity, and Peg. See 
Amendment No. 4, supra note 8.
    \37\ See proposed Rule 6954(b)(15).
    \38\ See proposed Rule 6954(b)(14).
    \39\ See proposed Rule 6954(b)(12).
    \40\ See proposed Rule 6954(b)(18).
    \41\ See proposed Rule 6954(b)(17). Transaction data for trades 
that are part of a program trade or index arbitrage strategy is 
required by the New York Stock Exchange to be transmitted to ACT 
with respect to securities listed on that exchange.

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

[[Page 12563]]

(5) Transmission of an Order
    Proposed Rule 6954 also requires information to be recorded 
regarding how and to whom an order is transmitted.
    Transmitted to Another Department Within the Member-Firm--Pursuant 
to proposed Rule 6954(c)(1), when a Reporting Member transmits an order 
to another department within the member other than to the trading 
department,\42\ the member would be required to record the following 
information: the order identifier assigned to the order by the member; 
the market participant symbol assigned by the Association to the 
member; the date the order was first received or originated by the 
member; an identification of the department to which the order was 
transmitted; and the date and time the order was received by that 
department.
---------------------------------------------------------------------------

    \42\ See note 22, supra.
---------------------------------------------------------------------------

    Electronically Transmitted to Another Member--When an order is 
electronically transmitted to another member, other than for execution 
on an ECN, proposed Rule 6954(c)(2) would require certain information 
to be recorded by the transmitting and receiving members. The 
transmitting Reporting Member must record the following information: 
the order identifier assigned to the order by that firm; the respective 
market participant symbols assigned by the Association to the 
transmitting member and to the member to which the order is 
transmitted; the date the order was originally received or originated 
by the Reporting Member; the date and time the order is transmitted; 
and the number of shares to which the transmission applies.
    The receiving member would be required to capture all of the 
elements prescribed in proposed Rule 6954(b) that apply with respect to 
the order. In addition, the receiving member would be required to 
record: the order identifier assigned to the order by the transmitting 
member; and the transmitting member's market participant symbol 
assigned by the Association.
    Electronically Transmitted to an ECN--Pursuant to proposed Rule 
6954(c)(3), when a member electronically transmits an order for 
execution on an ECN, the transmitting member would be required to 
record: the fact that the order was transmitted to an ECN; the order 
identifier assigned to the order by the transmitting member; the 
respective market participant symbols assigned by the Association to 
the transmitting member and to the ECN; the date the order was first 
originated or received by the transmitting Reporting Member; the date 
and time the order is transmitted; and the number of shares to which 
the transmission applies.
    The receiving Reporting Member operating the ECN would be required 
to record, in addition to the applicable information items specified in 
proposed Rule 6954(c)(3)(B)(iii), the fact that the order was received 
by an ECN and the market participant symbol assigned by the Association 
to the member transmitting the order to the ECN.
    Manually Transmitted to Another Member Other Than and ECN--Proposed 
Rule 6954(c)(4) sets forth the recording obligations for manual 
transmissions of orders between members other than ECNs. Pursuant to 
the proposal, transmitting members would be required to record: the 
fact that the order was transmitted manually; the order identifier 
assigned to the order by the transmitting member; the respective market 
participant symbols assigned by the Association to the transmitting and 
receiving members; the date the order was first originated or received; 
the date and time the order is transmitted; the number of shares to 
which the transmission applies; and for each order to be included in a 
bunched order, the bunched order route indicator.\43\
---------------------------------------------------------------------------

    \43\ See Amendment No. 6, supra note 10. In Amendment No. 6, the 
NASDR proposes to clarify the rule language with respect to bunched 
orders. Amendment No. 6 revises the rule language to make clear that 
a bunched order route indicator must be reported for each manual 
order included in a bunch.
---------------------------------------------------------------------------

    The member receiving a manual transmission would be required to 
record, in addition to all other applicable information items set forth 
in proposed Rule 6954(b), the fact that the order was received manually 
and the market participant symbol assigned by the Association to the 
transmitting member.
    Manually Transmitted to an ECN--Proposed Rule 6954(c)(5) specifies 
the obligations that would arise under the rules when a member manually 
transmits an order to an ECN. The transmitting member would be required 
to record: the fact that the order was transmitted manually; the order 
identifier assigned to the order by the transmitting member; the 
respective market participant symbols of the transmitting member and 
the ECN; the date the order was first originated or received; the date 
and time the order is transmitted; the number of shares to which the 
transmission applies; and for each order to be included in a bunched 
order, the bunched order route indicator.\44\
---------------------------------------------------------------------------

    \44\ Id.
---------------------------------------------------------------------------

    The receiving ECN would be required to report: the fact that the 
order was received manually; the market participant symbol assigned by 
the Association to the transmitting member; and all other applicable 
information with respect to the order as set forth in proposed Rule 
6954(c)(5)(B)(iii).
(6) Modifications, Cancellations, and Executions
    Proposed Rule 6954 also requires NASD members to record certain 
information to identify the disposition of the order (i.e., whether it 
was modified, canceled, or executed).
    Modifications--Pursuant to proposed Rule 6954(d), whenever an NASD 
member modifies the terms of an order that it has originated, or 
receives a modification to the terms, the OATS would treat the 
modification effectively as a cancellation of the original order and a 
replacement by the modified order. Accordingly, all information 
prescribed by the rule would need to be recorded pursuant to proposed 
Rule 6954(b) as if the order was originated or received at the time of 
the modification. In addition, to permit the linkage by the OATS of the 
modified order to the original one, the proposal would require the 
member to record the following information: the order identifier that 
was assigned to the order by the member prior to the modification; the 
date and time the modification was originated or received; and the date 
the original order was first originated or received by the member.
    Cancellations--In the event of a cancellation of an existing order, 
whether it is a total or partial cancellation, the following elements 
would be required to be recorded pursuant to proposed Rule 6954(d)(2): 
the order identifier assigned by the member; the market participant 
symbol assigned to the Reporting Member by the Association; the date 
the order was first originated or received by the member; the date and 
time the cancellation was originated or received; if the open balance 
of an order is canceled after a partial execution, the number of shares 
canceled; and whether or not the order was canceled at the instruction 
of the member, or a customer.
    Executions--For executed orders, members would be required, under 
proposed Rule 6954(d)(3), to record: the order identifier assigned by 
the member; the market participant symbol assigned

[[Page 12564]]

by the Association to the member; the date the order was first 
originated or received by the member; the member's number assigned for 
purposes of identifying transaction data in ACT; the designation of the 
order as fully or partially executed; the number of shares to which a 
partial execution applies and the number of unexecuted shares 
remaining; the identification number of the terminal where the order 
was executed; and the date and time of execution.

C. Information That Must Be Reported to the OATS

    Proposed Rule 6955 requires that all applicable order information 
that must be recorded under proposed rule 6954 be reported to the OATS 
by either the member or by a Reporting Agent under a written agreement, 
as described in paragraph (c) of proposed Rule 6955.\45\ The proposal 
would require order information to be submitted to the OATS in either 
single or multiple electronic file transmissions on the same day that 
the order was received, originated, canceled, modified, transmitted to 
another department within the member or to another member, or executed. 
Where information concerning a particular order is not complete or 
changes, proposed Rule 6955 would require the additional information to 
be reported to the OATS on the day that the information first becomes 
available.
---------------------------------------------------------------------------

    \45\ As discussed above, proposed Rule 6955(c) contains a 
special provision that allows a member to enter into a written 
agreement with a Reporting Agent pursuant to which such agent agrees 
to report order information to OATS on its behalf. However, the 
member that actually receives or originates the order would remain 
primarily responsible for fulfilling each of its obligations under 
the proposal.
---------------------------------------------------------------------------

D. Synchronization of Clocks

    In addition to the recordkeeping and reporting requirements 
discussed above, proposed Rule 6953 would require that the business 
clocks of all member firms that are used for purposes of recording the 
date and time of any event that must be recorded pursuant to the By-
Laws or other rules of the NASD be appropriately synchronized to one 
time source designated by the NASD. Market-wide synchronization of 
business clocks was included as a element of one of the undertakings 
contained in the SEC Order.\46\ Proposed Rule 6953 would require 
members to initially synchronize their clocks and to follow procedures 
prescribed by the NASD to continuously maintain synchronization.
---------------------------------------------------------------------------

    \46\ SEe note 11, supra.
---------------------------------------------------------------------------

E. Effective Dates

    The proposed effective dates for the requirements of the proposal 
are set forth in proposed Rule 6957. As amended, the proposal would 
require all members to synchronize their computer system clocks and all 
mechanical clocks that record times for regulatory purposes by August 
7, 1998, and July 1, 1999, respectively.\47\ In addition, the 
implementation schedule, as amended,\48\ would require that electronic 
orders received at the trading department of a member that is a market 
maker in the subject securities and those received by ECNs be entered 
into the OATS \49\ as of March 1, 1999 (``Phase One'').\50\ Information 
items relating to all electronic orders would be required to be 
reported to the OATS by August 1, 1999 (``Phase Two'').\51\ Further, 
the proposed OATS rules would apply to all manual orders as of July 31, 
2000 (``Phase Three'').\52\ With respect to manual orders and all 
orders received by ECNs, however, the data required to be 
electronically recorded and transmitted to the OATS is limited to 
information that is expected to be readily available at the trading 
desk.\53\
---------------------------------------------------------------------------

    \47\ As originally filed, the proposal required NASD members to 
synchronize their business clocks by February 2, 1998. In Amendment 
Nos. 4 and 6, the NASDR proposed to delay the effective date of the 
implementation of this requirement. See Amendment Nos. 4 and 6, 
supra notes 8 and 10.
    \48\ In response to concerns raised by commenters that the 
proposed implementation dates did not provide sufficient time for 
necessary systems changes, the NASDR proposes to amend the 
implementation schedule to allow NASD member firms additional time 
to develop and test their systems' capabilities to record and 
transmit orders to the OATS. See Amendment No. 4, supra note 8.
    \49\ Not all information relating to electronic orders received 
by market makers will be required to be reported to the OATS as of 
this date. Specifically, the NASDR proposes that market makers be 
required to report information item (18) (type of account for which 
the order is submitted) of Rule 6954(b) only to the extent that such 
information item is available. Market makers would not be required 
to report information items (5) (identification of the department of 
the member originating an order) and (18) (type of account for which 
the order is submitted) of proposed Rule 6954(b) and information 
items (2)(A) (recordkeeping requirements of the transmitting member 
for an order electronically transmitted to another member), 
(2)(B)(i) (order identifier assigned to the order by the 
transmitting member), (3)(A) (recordkeeping requirements of the 
transmitting member for an order electronically transmitted to an 
ECN), (4)(A) (recordkeeping requirements of the transmitting member 
for an order manually transmitted to another member) and (5)(A) 
(recordkeeping requirements of the transmitting member for an order 
manually transmitted to an ECN) of Rule 6954(c) until August 1, 
1999. See Amendment No. 4, supra note 8.s, 4 and 6, supra notes 8 
and 10.
    \50\ In Amendment No. 6, the NASDR proposes to implement Phase 
One by March 1, 1999, rather than February 1, 1999, as proposed in 
Amendment No. 4, See Amendment Nos. 4 and 6, supra notes 8 and 10.
    \51\ See Amendment No. 5, supra note 8.
    \52\ Id.
    \53\ Specifically, with respect to manual orders, information 
item (18) (type of account for which the order is submitted) of Rule 
6954(b) would be required to be reported only to the extent that 
such information item is available. Information items (4) 
(identification of any department or the identification number of 
any terminal where an order is received) and (5) (identification of 
the department of the member originating an order) of proposed Rule 
6954(b) and (1) (recordkeeping requirements for orders transmitted 
to another department within the member) specified in proposed Rule 
6954(c) would not be required to be recorded and reported with 
respect to manual orders. In addition, information items (4) 
(identification of any department or identification number of any 
terminal where an order is received), (5) (the identification of the 
department of the member that originates the order), (9) (the 
designation of the order as a short sale), (14) (any request by a 
customer that an order not be displayed or that a block size order 
be displayed, pursuant to Rule 11Ac1-4(c)), (17) (the identification 
of the order as related to a Program Trade or an Index Arbitrage 
Trade), and (18) (the type of account for which the order is 
submitted) specified in proposed Rule 6954(b) would not be required 
to be recorded and reported by ECNs receiving orders either 
electronically or manually. See Amendment Nos. 4 and 6, supra notes 
8 and 10.
---------------------------------------------------------------------------

    The proposed books and records requirements, set forth in Rule 
3110(c)(1) and (2), pertaining to the identification of the registered 
representative who receives an order directly from a customer and the 
identification of each registered person who executes the order, would 
be effective on March 1, 1999.\54\ The proposed recordkeeping 
requirements, set forth in Rule 3110(c)(3), applicable to orders 
originated by a member and manually transmitted to another department 
within the member firm, would be effective on July 31, 2000.\55\
---------------------------------------------------------------------------

    \54\ See Amendment No. 6, supra note 10.
    \55\ Id.
---------------------------------------------------------------------------

F. Penalties for Noncompliance

    Finally, pursuant to proposed Rule 6956, a member's failure to 
comply with any of the requirements set forth in the proposed rules may 
be considered conduct that is inconsistent with high standards of 
commercial honor and just and equitable principles of trade, in 
violation of NASD Rule 2110.

IV. Summary of Comments

    The Commission received 18 comment letters on the proposed rule 
change, 16 of which were submitted by broker-dealers.\56\ One comment 
letter was submitted by a trade association representing securities 
firms, and one was submitted by an ECN.\57\ The commenters generally 
supported the proposal, recognizing the importance to the NASD's 
surveillance efforts of a

[[Page 12565]]

reliable mechanism for reconstructing orders from the time of receipt 
through execution. As discussed below, however, the commenters 
expressed a number of concerns regarding the feasibility of the 
proposal, as originally submitted.
---------------------------------------------------------------------------

    \56\ See note 5, supra.
    \57\ Id.
---------------------------------------------------------------------------

A. Implementation Schedule

    Twelve commenters stated that the proposed implementation schedule 
was unrealistic and overly ambitious and should be delayed.\58\ 
Thirteen commenters believed the industry would be unable to meet the 
proposed deadlines due to the existing burdens on the industry's 
technical resources caused by the Year 2000 conversion, the 
implementation of the Commission's Order Handling Rules, the move to 
trading in sixteenths and efforts to prepare for the move to decimal-
based pricing.\59\ Four commenters noted that the Association's failure 
to provide timely technical specifications made the proposed 
implementation dates unworkable.\60\ Two commenters recommended that, 
similar to the implementation of the Order Handling Rules, the 
implementation of the new OATS rules should be phased-in incrementally, 
beginning with a small group of issues.\61\ A moratorium on enforcement 
for some specified period of time also was suggested by one 
commenter.\62\
---------------------------------------------------------------------------

    \58\ See Letters from J.P. Morgan, Mabon, Banc One, A.G. 
Edwards, Instinet, Morgan Stanley, Salomon Bros., Schwab, SIA, 
Advest, BancAmerica, and Oppenheimer, supra note 5.
    \59\ See Letters from J.P. Morgan, Mabon, A.G. Edwards, 
Instinet, Morgan Stanley, Salomon Bros., Schwab, SIA, Advest, Wheat 
First, J.C. Bradford, BancAmerica, and Oppenheimer, supra note 5.
    \60\ See Letters from J.P. Morgan, HBK Finance, SIA, and J.C. 
Bradford, supra note 5.
    \61\ See Letters from SIA and Merrill Lynch, supra note 5.
    \62\ See SIA Letter, supra note 5.
---------------------------------------------------------------------------

    In response to the commenters, the NASDR has proposed to delay the 
implementation schedule for the proposed rules, as discussed above in 
section III.E.\63\ However, the NASDR has neither proposed to modify 
the implementation schedule to phase-in a certain number of stocks 
incrementally nor proposed a moratorium on enforcement.
---------------------------------------------------------------------------

    \63\ See Amendment Nos. 4 and 6, supra notes 8 and 10.
---------------------------------------------------------------------------

B. Costs of Proposal

    As noted above, thirteen commenters noted the significance of the 
existing burdens on the industry's technical and financial resources 
associated with the Year 2000 conversion, the implementation of the 
Commission's Order Handling Rules, the move to trading in sixteenths 
and efforts to prepare for the move to decimal-based pricing.\64\ 
Similarly, six commenters expressed concerns regarding the substantial 
initial costs to be incurred as a result of the implementation of the 
proposal.\65\ The commenters complained that such costs were not 
justified by the NASD in its proposal. Several commenters also 
expressed concerns that OATS would reduce market liquidity, increase 
costs to investors and place smaller firms at a competitive 
disadvantage.\66\ In addition, two commenters complained that the 
proposed OATS would slow customer executions.\67\
---------------------------------------------------------------------------

    \64\ See note 59, supra.
    \65\ See Letters from Mabon, Banc One, HBK Finance, Instinet, 
Morgan Stanley, and Franklin Templeton, supra note 5.
    \66\ See Letters from Mabon, BIS, Banc One, and Schwab, supra 
note 5.
    \67\ See Letters from Instinet and Morgan Stanley, supra note 5.
---------------------------------------------------------------------------

    In response to cost concerns, the NASDR notes that while it has 
considered the costs to firms of implementing the system, the proposed 
OATS is directly responsive to a mandate issued by the Commission.\68\ 
In addition, the NASDR notes that the proposed modifications to the 
recordkeeping and reporting requirements, coupled with the proposed 
delay in the implementation schedule and the OATS' reliance on 
historical, rather than real-time data, should help to reduce the cost 
of the proposal.\69\
---------------------------------------------------------------------------

    \68\ See note 11, supra.
    \69\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------

C. Technological Interface Concerns

    Three commenters cited potential problems created by the 
incompatibility of different order routing and execution systems used 
both within firms and between firms.\70\ One of those commenters 
further noted potential issues arising from the fact that within 
certain firms, orders received electronically (which would have fit 
within the definition of ``electronic order'' as originally proposed) 
may be dealt with manually at some point and therefore, should not be 
considered electronic for purposes of the proposal.\71\ In response to 
concerns regarding the distinctions between electronic and manual 
orders, the NASDR amended proposed Rule 6951 to revise the definition 
of the term ``electronic order'' and add a definition of the term 
``manual order.'' \72\ In addition, the NASDR proposes to amend 
proposed Rules 6954 and 6957 to modify the recordkeeping requirements 
and the implementation dates, respectively, applicable to manual 
orders.\73\
---------------------------------------------------------------------------

    \70\ See Letters from Morgan Stanley, Schwab, and BancAmerica, 
supra note 5.
    \71\ See Morgan Stanley Letter, supra note 5.
    \72\ See Amendment No. 4, supra note 8. These definitions are 
discussed above in section III.A.
    \73\ See Amendment Nos. 4 and 6, supra notes 8 and 10.
---------------------------------------------------------------------------

D. Bunched Orders

    Three commenters expressed concerns that the proposed prohibition 
on bunching of orders or aggregation of order flow would result in 
decreased market efficiency and increased transaction costs.\74\ In 
response, the NASDR proposes to amend its proposal to explicitly allow 
for bunched orders, aggregated prior to execution.\75\ As discussed 
above, the NASDR proposes to amend Rule 6954 to require members 
transmitting manual orders in a bunch to record and report for each 
order to be included in a bunched order, the bunched order route 
indicator assigned by the transmitting member.\76\
---------------------------------------------------------------------------

    \74\ See Letters from A.G. Edwards, Instinet, and J.C. Bradford, 
supra note 5.
    \75\ See Amendment Nos. 4 and 6, supra notes 8 and 10.
    \76\ See Amendment No. 6, supra note 10.
---------------------------------------------------------------------------

E. Preferred Stock

    One commenter noted that because of its similarity to debt 
instruments, many member firms trade preferred stock in their fixed 
income departments.\77\ The commenter recommended that, as a result, 
preferred stock should be excluded from the proposed OATS 
requirements.\78\ The NASDR has not amended its proposal to provide a 
specific exemption from the requirements of the OATS rules for 
preferred stock.\79\
---------------------------------------------------------------------------

    \77\ See Salomon Bros. Letter, supra note 5.
    \78\ Id.
    \79\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------

F. Unique Order Identifier and Other Order Transmission Issues

    With respect to technical concerns raised by the proposal, three 
commenters recommended that the proposal be amended to allow the unique 
order identifier to consist of the eight characters currently 
recognized by the industry as the Common Message Switch's standard 
order format.\80\ One commenter stated that the mandated disclosure of 
a unique order identifier, which may contain proprietary information 
relating to a trader's strategies, would compromise the trader's 
ability to work the market to receive the best execution for the

[[Page 12566]]

customer.\81\ Two commenters suggested that the OATS include a 
mechanism to provide a recap or acknowledgment of the transmission to 
be sent to the member firm.\82\ Another commenter noted that 
transmission of data to the OATS must occur after-hours to allow member 
firms adequate time to process all business transactions.\83\
---------------------------------------------------------------------------

    \80\ See Letters from J.P. Morgan, SIA, and Merrill Lynch, supra 
note 5.
    \81\ See A.G. Edwards Letter, supra note 5.
    \82\ See J.P. Morgan and SIA Letters, supra note 5.
    \83\ See A.G. Edwards Letter, supra note 5.
---------------------------------------------------------------------------

    In response to the expressed concerns, the NASDR proposes to 
provide technical specifications that permit the order identifier for 
orders transmitted electronically other than to ECNs to contain the 
industry standard of only 8 characters, rather than the 12 characters 
initially proposed.\84\ With respect to orders transmitted manually, 
the NASDR proposes to amend proposed Rule 6954 to eliminate the 
requirement that the order identifier and the order origination date be 
passed when the order is transmitted.\85\
---------------------------------------------------------------------------

    \84\ See Amendment No. 4, supra note 8. According to the NASDR, 
where two or more orders share the same order identifier, additional 
order details including information items in proposed Rule 6954(b) 
can be used to uniquely identify a particular order.
    \85\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------

G. Synchronization of Business Clocks

    Several comments were addressed to the proposed synchronization of 
business clocks. One commenter stated that it would be impossible for 
member firms both to initially synchronize their manual business clocks 
and to maintain synchronization of all business clocks.\86\ The same 
commenter also cited the difficulties inherent in requiring each 
registered representative to time-stamp and date every order, 
particularly those orders received when the representative is not in 
the office.\87\ Another commenter recommended that synchronization of 
business clocks should be industry-wide and should include the 
automatic order entry and execution systems operated by the various 
exchanges.\88\
---------------------------------------------------------------------------

    \86\ See A.G. Edwards Letter, supra note 5.
    \87\ Id.
    \88\ See Merrill Lynch Letter, supra note 5.
---------------------------------------------------------------------------

    Other than to delay the implementation date of mandatory 
synchronization to August 7, 1998, for computer system clocks and July 
1, 1999, for mechanical clocks, the NASDR has not modified its proposal 
in response to these comments.\89\
---------------------------------------------------------------------------

    \89\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------

H. ECNs

    One commenter noted the special problems the proposal would create 
for ECNs.\90\ Specifically, this commenter observed that the proposal 
would require ECNs to distinguish between market maker proprietary 
orders and other orders, which existing technology does not currently 
permit.\91\ In addition, this commenter noted that the proposed 
treatment of order modifications as canceled or replaced is contrary to 
ECN users' practice of negotiating and trading directly with each 
other.\92\
---------------------------------------------------------------------------

    \90\ See Instinet Letter, supra note 5.
    \91\ Id.
    \92\ Id.
---------------------------------------------------------------------------

    In recognition of the unique characteristics of ECNs and in 
response to the concerns expressed in the comment letter from Instinet, 
an ECN, the NASDR proposes to limit ECN reporting to the OATS to the 
events that occur within the ECN. ECNs would be required to record and 
report only those information items that the member transmitting the 
order to the ECN has provided. The NASDR proposes that all orders 
transmitted to ECNs, regardless of how such orders were transmitted to 
the ECN, be treated like manual orders.\93\
---------------------------------------------------------------------------

    \93\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------

I. Modifications to ACT and Other Alternatives to the OATS

    Several alternatives to OATS were recommended by the commenters. 
For example, eight commenters recommended that rather than creating 
OATS, the Association should focus its efforts on improving the 
existing ACT system to incorporate the additional required 
information.\94\ One commenter proposed that rather than requiring 
further development, the NASD should recognize existing electronic 
audit trails relied upon by member firms as appropriate vehicles for 
surveillance.\95\ In addition, one commenter recommended that the NASD 
develop a uniformly available technology platform to be used by all 
industry participants for non-electronic orders.\96\
---------------------------------------------------------------------------

    \94\ See Letters from J.P. Morgan, BIS, HBK Finance, Morgan 
Stanley, SIA, BancAmerica, Oppenheimer, and Merrill Lynch, supra 
note 5.
    \95\ See Instinet Letter, supra note 5.
    \96\ See J.P. Morgan Letter, supra note 5.
---------------------------------------------------------------------------

    The NASDR has not modified the proposal in response to these 
comments. The NASDR stated that modifying ACT would be detrimental to 
the current function or capacity of the ACT system and might degrade 
the performance or trade reporting function of ACT.\97\
---------------------------------------------------------------------------

    \97\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------

V. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities 
association.\98\ Specifically, the Commission believes the proposal is 
consistent with the requirements of Section 15A(b)(6) of the Act.\99\ 
That section requires that the rules of a national securities 
association be designed to prevent fraudulent and manipulative acts and 
practices, to promote just and equitable principles of trade, to foster 
cooperation and coordination with persons engaged in regulating, 
clearing, settling, processing information with respect to, and 
facilitating transactions in securities, and in general, to protect 
investors and the public interest.
---------------------------------------------------------------------------

    \98\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \99\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

    As discussed in section II above, pursuant to the SEC Order, the 
NASD agreed to design and implement by August 8, 1998 or such later 
time as the Commission may order,\100\ an order audit trail system that 
would enable the NASD to reconstruct markets promptly, conduct 
efficient surveillance and enforce its rules. At a minimum, the audit 
trail is required to: (a) provide an accurate, time-sequence record of 
orders and transactions which documents the receipt and life of the 
order and (b) market-wide synchronization of member firms' business 
clocks. In the Appendix to its 21(a) Report, the Commission stated that 
``[a] comprehensive audit trail, beginning with the time an order is 
placed and continuing to record the life of the order through the 
process of execution, is essential to maintaining the integrity of the 
Nasdaq market.'' \101\ The Commission further noted that the 
implementation of an enhanced audit trail would ``allow for prompt 
surveillance on a scale that cannot be attained with traditional 
methods of examination'' and ``would greatly facilitate the ability of 
the NASD and the Commission to protect the interests of investors.'' 
\102\ The Commission believes that, as proposed, the OATS will satisfy 
both conditions of the SEC Order and is consistent with the 
requirements of Section 15A(b)(6) of the

[[Page 12567]]

Act \103\ in that it will greatly assist both the NASD's and the 
Commission's efforts to more rapidly detect and punish fraudulent and 
manipulative acts and practices involving Nasdaq equity securities. 
OATS is designed to capture the type of information that the NASDR can 
use to prevent the trading abuses that threatened to undermine the 
integrity of its market and which harmed investors. In short, OATS is 
an integral part of the NASD's efforts, as mandated by its settlement 
with the Commission, to uphold its self-regulatory responsibilities to 
enforce its rules.
---------------------------------------------------------------------------

    \100\ The Commission notes that the NASDR is prepared to meet 
the established August 1998 deadline. The implementation schedule 
was delayed not to accommodate the NASDR, but rather, at the request 
of the industry. The Commission finds the delayed implementation to 
be reasonable to enable the industry to effect the necessary systems 
conversions in an efficient and smooth manner.
    \101\ See note 14, supra.
    \102\ Id.
    \103\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

    To the extent that commenters' suggestions could lessen the costs 
of OATS without diminishing its effectiveness, they have been adopted 
by the NASD in amendments to its proposal, as described below. As 
discussed in section IV above, a number of commenters stated that the 
proposed implementation schedule was unrealistic and should be delayed 
to allow member firms to prepare to comply with the OATS rules. The 
Commission notes that the NASDR responded to such comments by delaying 
the effective dates of the proposal and by phasing in the requirements 
more gradually. For example the Commission notes that under the 
original proposal, all electronic orders were subject to the OATS rules 
as of August 8, 1998. The amendment implementation schedule would apply 
the OATS rules as of March 1, 1999 only to electronic orders received 
by ECNs and the trading departments of members that are market makers 
in the securities that are the subject of the orders. All electronic 
orders will not be subject to the OATS rules until August 1, 1999, 
pursuant to Amendment No. 4.
    The Commission believes that the proposed changes to the 
implementation schedule for the Order Audit Trail System are reasonable 
as the additional time provided should allow member firms ample 
opportunity to develop and test their systems to ensure compliance with 
the requirements of the proposed rules. The Commission notes that 
delaying the final effective date of the initial phase-in of the system 
by six months should provide the NASDR, market-makers, and ECNs 
adequate time for testing of the Order Audit Trail System prior to 
March 1, 1999. Member firms not subject to the March 1999 deadline may 
be expected to benefit from observing the implementation process and 
thereby, to better focus their own efforts to successfully prepare 
prior to their scheduled implementation dates.
    Further, the Commission believes that, given the critical role that 
market makers play in the market for Nasdaq equity securities, it is 
appropriate that the requirements of OATS would be effective first for 
the electronic orders received by market makers in those securities. In 
addition, the Commission notes that, although the March 1, 1999 
effective date also applies to electronic orders received by ECNs, 
neither ECNs nor market makers will have to report any information to 
the OATS that is not readily available at trading desks by March 1, 
1999. Therefore, the Commission believes that both the NASDR and Nasdaq 
market participants should have a sufficient opportunity to obtain 
important insight into the OATS process and to make any necessary 
systems changes prior to the August 1, 1999 effective date for all 
electronic orders.
    As discussed in the Summary of Comments section above, member firms 
were particularly concerned about their ability to capture the required 
information regarding orders that are received manually. The Commission 
believes the proposed delay in implementing the requirements for manual 
orders until July 31, 2000 should provide adequate time for all member 
firms to either develop the necessary systems in-house or make 
arrangements to have their reporting obligations arising under the OATS 
rules fulfilled on their behalf by a Reporting Agent.
    Several comment letters addressed the proposed synchronization of 
business clocks. The Commission notes that the requirement for 
synchronization of members' business clocks is a specified element of 
the undertakings contained in the SEC Order.\104\ The Commission 
believes the reliability and usefulness of the OATS is contingent upon 
the synchronization of all applicable business clocks of all member 
firms. Determining whether members have complied with the OATS rules 
depends critically on establishing with confidence the time at which 
order information is received as measured by a source that is standard 
throughout the industry.\105\ As discussed in section IV.G. above, the 
Commission notes that one commenter recommended that the proposed 
synchronization of business clocks should be truly industry-wide and 
should include the automatic order entry and execution systems operated 
by the various exchanges.\106\ The Commission supports a move toward 
industry-wide synchronization of clocks and believes the 
synchronization requirement in OATS is an important first step.
---------------------------------------------------------------------------

    \104\ See note 11, supra.
    \105\ Synchronization of all business clocks also is important 
in evaluating compliance with other rules to which member firms are 
subject, including, among others, best execution obligations, firm 
quote rules, and prohibitions on frontrunning customer orders.
    \106\ See note 88, supra.
---------------------------------------------------------------------------

    The Commission notes that NASD's members' obligation to maintain 
the synchronization of business clocks will be ongoing. The technical 
specifications proposed by the NASDR will require that the accuracy of 
clocks be resynchronized every day before the market opens. The 
proposed technical specifications further contemplate that business 
clocks would be checked against the standard clock periodically 
throughout the day at pre-determined intervals and re-synchronized, if 
necessary. The Commission further notes that compliance examinations, 
conducted by both the NASDR and the Commission, will include a review 
of member firms' compliance with these requirements, including the 
adequacy of procedures and the degree of accuracy of all business 
clocks. The Commission believes the proposed procedures should ensure 
the accuracy and reliability of business clocks that are used for 
trading and reporting purposes. Accordingly, the Commission believes 
that the proposed requirements relating to the synchronization of 
member business clocks is consistent with the requirements of Section 
15A(b)(6) of the Act \107\ insofar as a reliable record of the timing 
of reportable events should greatly assist the NASDR's efforts to 
detect and to punish fraudulent and manipulative activity more quickly.
---------------------------------------------------------------------------

    \107\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

    The Commission also notes that a number of commenters expressed 
concerns regarding the original proposal to use a non-industry standard 
12 character order identifier and problems with passing the order 
origination date. The proposed rules, as amended, would conform the 
requirements of the unique order identifier to comply with the industry 
standard, eight-character alphanumeric field and eliminate the 
requirement to pass the order origination date. According to the NASDR, 
the eight alphanumeric character order identifier will suffice to 
gather the needed information required by OATS. In situations where the 
unique order identifier is not transmitted, other order data required 
to be reported should allow orders to be uniquely identified. The 
Commission believes the proposed modifications to

[[Page 12568]]

the requirements relating to the unique order identifier should reduce 
the requisite number of program changes and the amount of testing 
required of member firms without jeopardizing the usefulness of the 
data to be received by the NASDR. In turn, this amendment should lower 
the cost of the proposal and thereby, address, to some extent, the 
concerns expressed by several commenters relating to the costs 
associated with implementation of the proposal.\108\
---------------------------------------------------------------------------

    \108\ See discussion in section IV.B. above. The Commission 
recognizes that OATS will require some degree of systems changes by 
NASD members that will vary depending upon the business mix of the 
particular firm. These changes will entail costs for all NASD firms. 
Nevertheless, the Commission believes any costs are far outweighed 
by the substantial benefit to NASDR surveillance and enforcement 
that will arise from OATS. Without the implementation of OATS, it 
would be harder to detect and deter the types of trading abuses 
described in the Commission's 21(a) Report.
---------------------------------------------------------------------------

    Moreover, the Commission notes that for orders transmitted manually 
and all orders transmitted to ECNs, neither an order identifier nor an 
order origination date will be passed when the order is routed. In 
addition, in response to concerns expressed by several commenters,\109\ 
only certain information items would be required to be recorded and 
reported to OATS. As these information items generally correspond to 
data that is expected to be readily available at trading desks at the 
time that the orders are received, the Commission believes that the 
proposal acknowledges the unique challenges OATS presents to member 
firms that handle manual orders and to ECNs. The Commission believes 
that the proposal, as amended, appropriately addresses these concerns 
as delineated above, while continuing to allow NASDR to track these 
orders through the OATS. The Commission further believes that, so long 
as manual orders and orders transmitted to ECNs can be manually matched 
by the NASDR, the proposed elimination of these requirements is 
appropriate.
---------------------------------------------------------------------------

    \109\ See discussion in section IV.H. above.
---------------------------------------------------------------------------

    In addition, the Commission believes the provisions of proposed 
Rule 6954(c) permitting a Reporting Agent to fulfill a member's 
reporting obligations should provide member firms with needed 
flexibility. These provisions, which require a written agreement and 
make clear that the member firm retains primary compliance 
responsibility for recording and reporting order information, should 
benefit smaller member firms by providing them with the option to rely 
on third parties to comply with the reporting obligations arising under 
the proposed rules. The Commission believes that the provisions 
contained in proposed Rule 6955(c) should alleviate some of the 
concerns expressed by commenters that OATS would place smaller firms at 
a competitive disadvantage.\110\
---------------------------------------------------------------------------

    \110\ See note 66, supra.
---------------------------------------------------------------------------

    The Commission notes that in response to concerns express by 
several commenters, the NASDR clarified that reporting of bunched 
orders would be permitted and required additional information to be 
recorded and reported with respect to such orders. The Commission 
believes the NASDR's proposed treatment is appropriate as it will allow 
those members that are accustomed to bunching their orders to continue 
to do so while permitting those manual orders that are bunched to be 
easily identified by the OATS.
    The Commission notes that one commenter recommended that preferred 
stock be excluded from the proposed requirements.\111\ The Commission 
believes that the NASDR's decision to not provide a specific exemption 
from the OATS, requirements for preferred stock is appropriate because 
the preferred stock is an equity security that poses many of the same 
surveillance concerns as common stock.
---------------------------------------------------------------------------

    \111\ See note 78, supra.
---------------------------------------------------------------------------

    The Commission recognizes that there may be, particularly with 
respect to manual orders, information items not required to be recorded 
and reported by the proposal that could prove helpful to the NASD or 
the Commission in carrying out their regulatory responsibilities. 
Nonetheless, the Commission believes that the NASDR's proposal 
represents a significant and appropriate effort to satisfy the 
Commission mandate to develop and implement OATS, while attempting to 
minimize the costs imposed on the industry by such an undertaking. The 
Commission expects that during the process of implementing and 
reviewing OATS, the Commission and the NASDR will identify ways in 
which to improve OATS. The Commission fully expects the NASDR to submit 
proposals to modify the requirements of OATS, as needed, to enhance the 
effectiveness of OATS as a regulatory tool.
    The Commission notes that the proposed revisions to NASD Rule 3110 
would impose recordkeeping requirements on Reporting Members in 
addition to the recordkeeping and reporting requirements set forth in 
the OATS rules. Proposed Rule 3110(c) would require members to record 
the identification of the registered representative who receives an 
order directly from a customer, the identification of each registered 
person who executes the order, and the identification of the department 
that originates an order that is manually transmitted to another 
department within the member firm. The Commission notes that the 
proposal, as originally submitted, required the identification of the 
individual receiving and the department originating an order to be 
recorded and reported to OATS. Although this information may be 
critical to the Commission and the NASDR for surveillance and 
enforcement purposes, the Commission believes, as noted above, that it 
is reasonable to require this information to be recorded, but not 
reported to OATS, to allow the implementation of OATS to proceed as 
quickly as possible. Again, after the Commission and the NASDR have 
gained experience with OATS, further modification to these requirements 
may be deemed necessary.
    The Commission finds good cause for approving proposed Amendment 
Nos. 2, 3, 4, 5, and 6 prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. The 
Commission notes that Amendment Nos. 2 and 3 involve technical and 
procedural matters relating to the extension of the Commission's 
statutory review process and the numbering of the proposed rules. 
Accordingly, the Commission believes that Amendments Nos. 2 and 3 raise 
no issues of regulatory concern.
    With respect to Amendment No. 4, the Commission notes that the 
Amendment, among other things, clarifies the proposal and extends the 
implementation schedule for the proposed changes. In Amendment No. 4, 
the NASDR clarifies its original proposal by redefining certain terms, 
such as ``electronic order,'' and adding defined terms, such as 
``manual order,'' to more accurately reflect current industry 
understanding of those terms. Amendment No. 4 also revises proposed 
Rule 6954 to separately address four different order transmittal 
scenarios. The Commission supports these clarifications and believes 
they should assist member firms in their efforts to comply with the new 
requirements. The NASDR also proposes to delay the phase-in of the OATS 
implementation schedule to provide member firms with additional time to 
develop and test their systems prior to the mandatory implementation 
date. The Commission notes that the proposed extension of the effective 
dates is directly responsive to the comment letters submitted on the 
proposed rule.

[[Page 12569]]

    In addition, Amendment No. 4 contains several proposed 
modifications to the proposed rule change, the majority of which will 
facilitate member compliance, often at a lower cost. For example, in 
response to a number of commenters' concerns, Amendment No. 4 proposes 
to modify the specifications for electronic orders to conform the 
unique order identifier requirement to the industry standard of eight 
characters and to delete the requirement to pass the order origination 
date. The Commission believes that the proposed modifications relating 
to the technical specifications for electronic orders should 
substantially ease the compliance burden imposed on NASD members by the 
proposed rule without undermining the purpose of the OATS. Further 
proposed modifications contained in Amendment No. 4 would facilitate 
the reporting requirements relating to bunched orders. Amendment No. 4 
also proposes to modify the proposal by limiting the reporting 
requirements applicable to ECN's to conform to those requirements 
applicable to manually transmitted orders.
    Moreoever, Amendment No. 5 proposes to delete the provisions in the 
proposed rule text stating that the information required to be recorded 
by the Reporting Member operating an ECN is that information provided 
to the ECN by the transmitting Reporting Member. The Commission notes 
that Amendment No. 5 proposes to conform the language of the text to 
the technical specifications for OATS developed by the NASDR. 
Consequently, the receiving ECN will be required to record the 
applicable information items specified in Rule 6954(c) at the time the 
order is received from the transmitting member. As discussed above, the 
Commission notes that the proposed modifications to the proposed rule 
change contained in Amendment Nos. 4 and 5 are directly responsive to 
the concerns expressed in comment letters submitted to the Commission.
    Finally, Amendment No. 6 provides a number of clarifying and 
technical amendments which raise no issues of regulatory concern. 
Amendment No. 6 clarifies the treatment of bunched orders, and modifies 
the language of the proposed rule both to eliminate inapplicable 
references and to make the rule text easier to understand. Amendment 
No. 6 also revises the implementation date of Phase One of OATS to 
allow market participants additional time to implement the required 
systems changes and to conduct necessary testing.
    Further, Amendment No. 6 eliminates the requirement under proposed 
Rule 6954(c)(1) that an order that is transmitted from one department 
to the trading desk of the same firm must be reported to OATS. As OATS 
will assume that transmissions for which there is no routing report 
have been transmitted to the member's trading desk, the Commission 
believes that this amendment will allow OATS to obtain sufficient 
information while reducing unnecessary recordkeeping and reporting 
burdens imposed on member firms.
    In addition, Amendment No. 6, by amending NASD Rule 3110, 
reinstates the recordkeeping requirements initially proposed by the 
NASDR and published for comment by the Commission. In particular, 
Amendment No. 6 amends Rule 3110 to require information items 
pertaining to the identification of persons and departments receiving 
or originating orders to be recorded by Reporting Members. The 
Commission notes that such items were initially proposed to be recorded 
and reported to OATS and thus, Amendment No. 6 minimizes the reporting 
obligations of member firms while ensuring that vital identifying 
information continues to be available for regulatory purposes. 
Accordingly, the Commission believes that it is consistent with the Act 
in general and with Section 15A(b)(6) of the Act \112\ in particular to 
approve Amendment Nos. 2, 3, 4, 5, and 6 to the proposed rule change on 
an accelerated basis.
---------------------------------------------------------------------------

    \112\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

VI. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendments Nos. 2, 3, 4, 5, and 6, including 
whether the proposed Amendments are consistent with the Act. Persons 
making written submissions should file six copies thereof with the 
Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., 
Washington, D.C. 20549. Copies of the submission, all subsequent 
amendments, all written statements with respect to the proposed rule 
change that are filed with the Commission, and all written 
communications relating to the proposed rule change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. 552, will be 
available for inspection and copying in the Commission's Public 
Reference Section, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of all such filings will also be available for inspection and 
copying at the principal office of the NASD. All submissions should 
refer to File No. SR-NASD-97-56 and should be submitted by April 3, 
1998.

VII. Conclusion

    The Commission believes that the proposal, as amended, should 
significantly assist the NASDR's efforts in fulfilling its regulatory 
responsibilities. The Commission further believes the proposed rules 
meet the minimum requirements for an order audit trail system imposed 
by the Commission in the SEC Order, which required a time-sequenced 
record of orders and market-wide synchronization of all member firms' 
business clocks. In addition, the OATS should provide a useful 
surveillance tool that will allow earlier detection of fraudulent 
activity for the benefit of investors and the public. Therefore, the 
Commission believes the approval of the proposed Order Audit Trail 
System, as amended, is appropriate and consistent with the requirements 
of the Act applicable to a national securities association, and in 
particular, with the requirements of Section 15A(b)(6) of the Act \113\ 
and the rules and regulations thereunder.
---------------------------------------------------------------------------

    \113\ 15 U.S.C. 78o-3.
---------------------------------------------------------------------------

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\114\ that the proposed rule change (SR-NASD-97-56), including 
Amendment Nos. 1, 2, 3, 4, 5, and 6, is approved.

    \114\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\115\
---------------------------------------------------------------------------

    \115\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Jonathan G. Katz,
Secretary.
[FR Doc. 98-6528 Filed 3-12-98; 8:45 am]
BILLING CODE 8010-01-M