[Federal Register Volume 63, Number 55 (Monday, March 23, 1998)]
[Notices]
[Pages 13894-13899]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-7372]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39760; File No. SR-NASD-98-21]


Self-Regulatory Organizations; Notice of Proposed Rule Change by 
the National Association of Securities Dealer, Inc., Relating to an 
Expansion of the NASD's Rule Permitting Market Makers To Display Their 
Actual Quotation Size

March 16, 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 March 5, 1998, the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association''), through its wholly-owned 
subsidiary, The Nasdaq Stock Market, Inc. (``Nasdaq''), filed with the 
Securities and Exchange Commission (``Commission'' or ``SEC'') the 
proposed rule change as described in Items I, II, and III below, which 
Items have been prepared by Nasdaq. 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. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The NASD proposes to amend NASD Rule 4613(a)(1)(C) to allow 
permanently market makers to quote their actual size by reducing the 
minimum quotation size requirement for market makers in all securities 
listed on Nasdaq to one normal unit of trading (``Actual Size Rule''). 
As discussed below, the Actual Size Rule presently applies to a group 
of 150 Nasdaq securities on a pilot basis. The text of the proposed 
rule change is as follows (additions are italicized; deletions are 
bracketed).
* * * * *
NASD Rule 4613  Character of Quotations
    (a) Two-Sided Quotations.
    (1) No change.
    (A)-(B) No change.

    (C) [As part of a pilot program implemented by The Nasdaq Stock 
Market, during the period January 20, 1997 through at least March 
27, 1998, a] A registered market maker in a security listed on The 
Nasdaq Stock Market [that became subject to mandatory compliance 
with SEC Rule 11Ac1-4 on January 20, 1997 or identified by Nasdaq as 
being otherwise subject to the pilot program as expanded and 
approved by the Commission,] must display a quotation size for at 
least one normal unit of trading (or a larger multiple thereof) when 
it is not displaying a limit order in compliance with SEC Rule 
11Ac1-4, provided, however, that a registered market maker may 
augment its displayed quotation size to display limit orders priced 
at the market maker's quotation.
* * * * *

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

    In its filing with the Commission, the NASD 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 specified in 
Item IV below. The NASD 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

1. Summary of Proposal
    Currently, quotations in most Nasdaq securities are required to be 
displayed in a minimum size of 1,000 shares (200 or 500 shares for less 
active stocks). The

[[Page 13895]]

requirement is different from that of any of the stock exchanges, which 
require only the display of actual size of at least 100 shares. This 
difference results from the requirements of the Small Order Execution 
System (``SOES''), which was originally conceived and developed to 
provide individual investors with a fast, efficient, and cost-effective 
means of executing small orders in Nasdaq securities in a quote-based 
dealer market.
    On August 29, 1996, the SEC promulgated a new rule and adopted 
amendments to other SEC rules that are designed to enhance the quality 
of published quotations for securities and promote competition and 
pricing efficiency in U.S. securities markets (these rules are 
collectively referred to hereafter as the ``Order Handling Rules'').\3\ 
The Order Handling Rules have changed Nasdaq's market structure to a 
more order-driven hybrid market, which include quotes from investors 
(in the form of displayed limit orders), market makers, and Electronic 
Communications Networks (``ECNs''). The implementation of these rules 
has enhanced market quality and benefited investors significantly by 
substantially reducing Nasdaq quoted spreads, without evidence of a 
material reduction of liquidity or increased volatility. In connection 
with these changes, Nasdaq implemented the Actual Size Rule pilot 
program (originally including 50 Nasdaq stocks, but subsequently 
expanded to 150 stocks) to allow market makers to display their actual, 
freely-determined quotation size when not displaying a customer order.
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    \3\ See Exchange Act Release No. 37619A (September 6, 1996) 61 
FR 48290 (September 12, 1996) (``Order Handling Rules Adopting 
Release'').
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    Given the changes brought about by the Order Handling Rules, the 
economic theory suggesting several long-term benefits of the Actual 
Size Rule, and the empirical research indicating no adverse impact on 
investors or the Nasdaq market, the NASD has concluded that artificial 
minimum quotation sizes are no longer necessary and should be removed 
for all Nasdaq stock. Specifically, the Actual Size Rule affords market 
makers more flexibility to manage risk and quote prices that are more 
favorable for small retail orders. In addition, requiring a minimum 
commitment of market maker capital while allowing the display of 
customer and ECN orders without a similar commitment could severely 
impair the ability of market makers to set competive quotations. The 
adoption of sixteenths could heighten the debilitating effect of the 
quote size minimum, as could future reduction in Nasdaq's minimum quote 
price invement if the minimum size increment is not equivalent reduced. 
Moreover, rigorous empirical analysis of the original pilot program and 
the pilot as expanded, including a study of the extreme market 
conditions of October 27 and 28, 1997, demonstrate that the Actual Size 
Rule has not materially affected Nasdaq market quality, as measured by 
spread, volatility, quoted depth, and liquidity, and that investors 
continue to have substantial access to a reasonable amount of market 
maker capital in pilot stocks.
2. Background
    a. SEC Order Handling Rules. With respect to securities listed on 
Nasdaq, the Order Handling Rules were implemented according to a 
phased-in implementation schedule: 50 Nasdaq securities became subject 
to the rules on January 20, 1997 (``First Fifty''); fifty more became 
subject to the rules on February 10, 1997 (``Second Fifty''), and an 
additional fifty became subject to the rules on February 24, 1997. The 
remaining Nasdaq securities were phased in pursuant to a specified time 
table established by the Commission, with the last remaining securities 
phased in on October 13, 1997.\4\
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    \4\ See Exchange Act Release No. 38870 (July 24, 1997) 62 FR 
40732 (July 30, 1997), corrected in 62 FR 45289.
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    In particular, the SEC adopted Rule 11Ac1-4, (``Limit Order Display 
Rule''), which requires the display of customer limit orders: (1) That 
are priced better than a market maker's quote;\5\ or (2) that add to 
the size associated with a market maker's quote when the market maker 
is at the best price in the market.\6\ By virtue of the Limit Order 
Display Rule, investors now have the ability to directly advertise 
their trading interest to the marketplace, thereby allowing them to 
compete with market maker quotations and affect the size of bid-ask 
spreads.\7\ The other rule changes adopted by the SEC involve 
amendments to SEC's firm quote rule, Rule 11Ac1-1. The most significant 
change requires market makers to display in their quote any better 
priced orders that the market maker places into an electronic 
communications network such as SelectNet or Instinet (``ECN Rule''). 
Alternatively, instead of updating its quote to reflect better priced 
orders entered into an ECN, a market maker may comply with the display 
requirements of the ECN Rule through the ECN itself, provided the ECN: 
(1) ensures that the best priced orders entered by market makers into 
the ECN are communicated to Nasdaq for public dissemination; and (2) 
provides brokers and dealers access to orders entered by market makers 
into the ECN, so that brokers and dealers who do not subscribe to the 
ECN can trade with those orders.
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    \5\ For example, if a market maker's quote in stock ABCD is 10-
10\1/4\ (1,000  x  1,000) and the market maker receives a customer 
limit order to buy 200 shares at 10\1/8\, the market maker must 
update its quote to 10\1/8\-10\1/4\ (200  x  1,000).
    \6\ For example, if a market maker receives a limit order to buy 
200 shares of ABCD at 10 when its quote in ABCD is 10-10\1/4\ (1,000 
 x  1,000) and the NBBO for ABCD is 10-10\1/8\, the market maker 
must update its quote to 10-10\1/4\ (1,200  x  1,000).
    \7\ There are seven exceptions to the Limit Order Display Rule: 
customer limit orders that are (1) executed upon receipt; (2) placed 
by customers who expressly request that they not be displayed; (3) 
odd-lots; (4) block size orders (10,000 shares or $200,000), unless 
the customer requests that the order be displayed; (5) delivered 
immediately upon receipt to an exchange or association-sponsored 
system, or an ECN that complies with Rule 11Ac1-1(c)(5)(ii) with 
respect to that order; (6) delivered immediately upon receipt to 
another exchange member or OTC market maker that complies with Rule 
11Ac1-4 with respect to that order; or (7) all-or-none orders. See 
17 CFR 240.11Ac-1-4(c).
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    b. Actual Size Rule Pilot for First Fifty Stocks. In order to 
facilitate implementation of the SEC's Order Handling Rules and reflect 
the more order-driven nature of the Nasdaq market that was brought 
about by implementation of these rules, on January 10, 1997, the 
Commission approved a variety of amendments to NASD rules and Nasdaq's 
SOES and SelectNet Service.\8\ In particular, one of the NASD rule 
changes approved by the Commission provides that Nasdaq market makers 
in the First Fifty stocks subject to the Commission's Limit Order 
Display Rule are required to display a minimum quotation size of one 
normal unit of trading when quoting solely for their own proprietary 
account (i.e., the Actual Size Rule).\9\ For Nasdaq stocks outside of 
the First Fifty, the minimum quotation size requirements remained the 
same.\10\
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    \8\ See Exchange Act Release No. 38156 (January 10, 1997) 62 FR 
2415 (January 16, 1997) (order partially approving SR-NASD-96-43) 
(``Actual Size Rule Approval Order'').
    \9\ Thus, the Actual Size Rule does not affect a market maker's 
obligation to display the full size of a customer limit order. If a 
market maker is required to display a customer limit order for 200 
shares or more, it must display a quote size of at least 200 shares 
absent an exemption from the Limit Order Display Rule.
    \10\ In particular, NASD Rule 4613(a)(2) requires each market 
maker in a Nasdaq issue other than those in the First Fifty to enter 
and maintain two-sided quotations with a minimum size equal to or 
greater than the applicable SOES tier size for the security (e.g., 
1,000 500, or 200 shares for Nasdaq National Market issues and 500 
or 100 shares for Nasdaq SmallCap Market issues).
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    The NASD submitted the proposal for the Actual Size Rule because it 
believed,

[[Page 13896]]

and continues to believe, that the new and more order-driven nature of 
Nasdaq brought about by the Limit Order Display Rule obviates the 
regulatory justification for minimum quote size requirements. In 
particular, while the NASD believed it was once desirable and 
appropriate to impose the mandatory quote size requirements to ensure 
an acceptable level of market liquidity and depth in an environment 
where Nasdaq market makers were the only market participants who could 
impact quotation prices, the Limit Order Display Rule now permits 
investors to directly impact quoted prices. As a result, the NASD 
believes that it is no longer necessary to subject market makers to 
minimum quote size requirements when they are not representing customer 
orders. In addition, economic theory indicates that permitting dealers 
to quote in size commensurate with their true trading interest could 
further narrow quoted spreads and enhance the pricing efficiency of the 
Nasdaq marketplace.
    Furthermore, Nasdaq believes that a disincentive for some market 
makers would be removed, thus attracting additional liquidity and 
pricing efficiency in the Nasdaq market. Indeed, the Commission noted 
in its approval of the Actual Size Rule pilot that ``the 1,000 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.'' \11\ 
This is especially important for smaller market making firms, which may 
otherwise have difficulty competing on a price basis in an environment 
with minimum quote size requirements.
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    \11\ See Actual Size Rule Approval Order, supra, note 8, at 
2425.
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    In sum, with the successful implementation of the SEC's Order 
Handling Rules, the NASD believes that mandatory quote size 
requirements impose unnecessary regulatory burdens on market makers 
that are not consistent with the Exchange Act.
    At the same time, the NASD does not believe that implementation of 
the Actual Size Rule in an environment where limit orders are displayed 
has or will compromise the quality of the Nasdaq market. First, the 
display of customer limit orders enhances the depth, liquidity, and 
stability of the market and contributes to narrower quoted spreads, 
thereby mitigating the effects of the loss of displayed trading 
interest, if any, by market makers. Second, removing artificial quote 
size requirements may lead to narrower market maker spreads, thereby 
reducing investors' transaction costs. Third, permitting market makers 
to quote in size commensurate with their own freely-determined trading 
interest will enhance the pricing efficiency of the Nasdaq market and 
the independence and competitiveness of dealers' quotations. Fourth, 
removing quotation size requirements will facilitate greater quote size 
changes, thereby increasing the information content of market maker 
quotes by facilitating different quote sizes from dealers who have a 
substantial interest in the stock at a particular time and those who do 
not.
    Indeed, in its order approving the Actual Size Rule, the Commission 
noted that it ``preliminarily believes that the proposal will not 
adversely affect market quality and liquidity'' \12\ and that it 
``believes there are substantial reasons * * * to expect that reducing 
market makers' proprietary quotation size requirements in light of the 
shift to a more order-driven market would be beneficial to investors.'' 
\13\ In addition, the Commission stated that, ``based on its experience 
with the markets and discussions with market participants, [it] 
believes that decreasing the required quote size will not result in a 
reduction in liquidity that will hurt investors.'' \14\
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    \12\ Id.
    \13\ Id. at 2423.
    \14\ Id. at 2424.
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    Nevertheless, in light of concerns raised by commentators opposed 
to the Actual Size Rule regarding the potential adverse impacts of the 
rule on market liquidity and volatility, the Commission determined to 
approve the rule on a three-month pilot basis to afford the Commission, 
the NASD and Nasdaq an opportunity to gain practical experience with 
the rule and evaluate its effects.\15\ The factors identified by the 
Commission to be considered in this evaluation include, among others, 
the impact of reduced quotation sizes on liquidity, volatility and 
quotation spreads.\16\
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    \15\ See Actual Size Rule Approval Order, supra note 8.
    \16\ Specifically, the Commission stated that the NASD's study 
should include an analysis of (1) The number of market makers in 
each of the 50 securities, and any change in the number over time; 
(2) the average aggregate dealer and inside spread by stock over 
time; (3) the average spread for each market maker by stock; (4) the 
average depth by market maker (including limit orders), and any 
change in the depth over time; (5) the fraction of volume executed 
by a market maker who is at the inside quote by stock; and (6) a 
measure of volume required to move the price of each security one 
increment (to determine the overall liquidity and volatility in the 
market for each stock). The Commission also stated its expectation 
that these factors should be contrasted over the time period 
immediately preceding the pilot and after the beginning of the 
pilot. In addition, the Commission stated that the NASD should 
compare the First Fifty stocks (to which the Rule applied) with the 
Second Fifty stocks (stocks subject to the SEC's Order Handling 
Rules but not the Actual Size Rule).
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    c. Findings of NASD Economic Research and Proposal to Expand Actual 
Size Rule Pilot to 150 Stocks. On April 11, 1997, the NASD filed with 
the Commission Filing No. SR-NASD-97-26 to extend and expand the Actual 
Size Rule.\17\ Specifically, the NASD proposed to extend the pilot 
until at least December 19, 1997, and to expand the number of stocks to 
include the next 100 stocks subject to the Order Handling Rules. The 
filing was subsequently amended to change the extension date from 
December 19, 1997, to March 27, 1998, and to change the selection 
methodology for the next group of 100 stocks to be subject to the 
pilot, discussed further below.
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    \17\ See Exchange Act Release No. 38513 (April 15, 1997) 62 FR 
19369 (April 21, 1997) (``Notice of Proposal to Expand Actual Size 
Rule to 150 Stocks'').
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    This finding cited findings of research concerning the 
implementation of the Order Handling Rules and the Actual Size Rule 
pilot. Specifically, the NASD found that implementation of the Order 
Handling Rules had significantly improved the quality of the Nasdaq 
market by creating a market structure where customer limit orders 
provide liquidity and compete effectively with market maker quotations. 
In this type of environment, the NASD stated its belief that the 
regulatory necessity for the mandatory quote size requirements no 
longer exists. Accordingly, the NASD proposed to both extend and expand 
the rule.
    In particular, the research conducted by the NASD's Economic 
Research Department in early 1997 indicated three general findings 
concerning implementation of the Order Handling Rules and the Actual 
Size Rule: (1) The Order Handling Rules have dramatically improved the 
quality of the Nasdaq market, particularly with respect to the 
narrowing of quoted spreads; (2) among those securities subject to the 
Order Handling Rules, there is no appreciable difference in market 
quality between those stocks subject to the Actual Size Rule and those 
stocks subject to mandatory quote size requirements; \18\

[[Page 13897]]

and (3) implementation of the Actual Size Rule has not resulted in any 
significant diminution of the ability of investors to receive automated 
executions through SOES, SelectNet, or proprietary systems operated by 
broker-dealers. The specific findings of this analysis were published 
in the original notice of filing SR-NASD-97-26.\19\
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    \18\ The First Fifty stocks include Nasdaq's top ten issues by 
dollar volume plus 40 issues chosen from Nasdaq's top 500 issues; 8 
ranked between 11 and 100; 8 ranked between 101 and 200; 8 ranked 
between 401 and 300; 8 ranked between 401 and 500. The ``second 
fifty'' stocks include the ten Nasdaq stocks ranked between 11 and 
20 by dollar volume plus 40 stocks chosen from Nasdaq's top 500 
stocks in the same manner explained above. Because the ten largest 
Nasdaq stocks have no comparable peer group among Nasdaq stocks and 
the next ten largest Nasdaq stocks included in the Second Fifty 
(i.e., Nasdaq stocks ranked 11-20 in size) are not comparable to the 
``bottom 40'' of either the First Fifty or Second Fifty, those 
stocks have been excluded from the analysis comparing the First 
Fifty and the Second Fifty. Accordingly, the ``first forty'' stocks 
are the ``bottom 40'' stocks within the First Fifty stocks and the 
``second forty'' stocks are the ``bottom 40'' stocks within the 
``second forty'' stocks.
    \19\ See Notice of Proposal to Expand Actual Size Rule to 150 
Stocks, at note 15.
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    On June 3, 1997, the NASD supplemented its proposal to extend and 
expand the Actual Size Rule by submitting to the SEC a study entitled 
``Effects of the Removal of Minimum Sizes for Proprietary Quotes in The 
Nasdaq Stock Market, Inc.'' (``June 1997 Study''). The June 1997 Study, 
which provides greater detail of the NASD's analysis, became a part of 
the NASD filing with the Commission and was made available to the 
public through Nasdaq's web site. The June 1997 Study presented a 
thorough empirical analysis that produced no evidence that the 
implementation of the Actual Size Rule had affected the market quality 
of pilot stocks. This study analyzed standard measures of market 
quality, including spread, volatility, and depth. In addition, the 
study reflected an examination of the ability of investors to access 
market maker capital through SOES and proprietary autoexecution systems 
and calculated the normalized effective depth, a measure of market 
liquidity. The study revealed that for stocks subject to the Actual 
Size Rule, investors continued to have reasonable and substantial 
access to market maker capital through automatic execution systems.
    To provide the public with an opportunity to review and comment on 
the June 1997 Study, the Commission extended the comment period on 
Filing No. SR-NASD-97-26 until July 3, 1997.\20\ On July 17, 1997, the 
NASD amended the filing at the Commission's request to extend the pilot 
until March 27, 1998, to provide the Commission with additional time to 
evaluate economic studies on the proposal and to review comments on the 
June 1997 Study.\21\
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    \20\ See Exchange Act Release No. 38720 (June 5, 1997) 62 FR 
31856 (June 11, 1997).
    \21\ See Exchange Act Release No. 38872 (July 24, 1997) 62 FR 
40879 (July 30, 1997).
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    Notwithstanding the results of the June 1997 Study, commenters 
expressed concerns on the proposal to expand the Actual Size Rule. In 
particular, it was noted that the pilot had been limited to only 50 
Nasdaq securities. Further, these securities generally represent the 
most liquid Nasdaq stocks. In addition, the proposed expansion of the 
Actual Size Rule would apply to the 100 stocks that were next to be 
phased in under the Order Handling Rules. These stocks were also drawn 
from the most liquid Nasdaq stocks. Thus, it was argued, even an 
expanded pilot would still be skewed toward larger, more active issues.
    In response to these concerns expressed by SEC staff and 
commenters,\22\ the NASD amended the proposed rule change on September 
15, 1997, to change the selection methodology for the next group of 
securities to be subject to the pilot to provide an enhanced sample 
more representative of the entire Nasdaq market.\23\ Specifically, the 
remaining Nasdaq National Market issues were divided into deciles based 
on average daily dollar volume, and 110 stocks were chosen by randomly 
selecting approximately the same number from each decile.\24\ Thus, as 
expanded, the pilot would provide the Commission, NASD, and market 
participants with additional data across a range of securities, thereby 
allowing a more enhanced evaluation of the effects of the rule.
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    \22\ See e.g., letter from David K. Whitcomb, Professor of 
Finance, Rutgers University, to Jonathan Katz, Secretary, SEC, dated 
July 3, 1997.
    \23\ See letter from Robert E. Aber, Vice President and General 
Counsel, to Katherine A. England, Assistant Director, Market 
Regulation, dated September 15, 1997.
    \24\ 110 stocks were chosen to make up for four of the original 
stocks that were delisted, and as reserves in case any others delist 
in the interim. This ensured that a total of 150 stocks were 
available under an expanded Actual Size Rule.
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    d. SEC Approval to Expand Actual Size Rule Pilot to 150 Stocks. On 
October 29, 1997, the Commission approved the NASD proposal to expand 
the Actual Size Rule pilot to include 150 stocks, as amended to provide 
for a sample more representative of the entire Nasdaq market.\25\ The 
pilot also was extended until at least March 27, 1998. In approving the 
proposal, the Commission stated its belief that the data preliminarily 
indicates that the pilot has not resulted in any degradation to Nasdaq 
market quality, and that the Actual Size Rule appears to be a 
reasonable means to provide market making obligations that reflect the 
new market dynamics produced by the Order Handling Rules.\26\ 
Nonetheless, the Commission decided that it would be appropriate to 
gather further data using the more representative sample of Nasdaq 
stocks before reaching a final decision as to whether or not to extend 
the Actual Size Rule to the entire Nasdaq market.
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    \25\ See Exchange Act Release No. 39285 (October 29, 1997) 62 FR 
59932 (November 5, 1997) (``Actual Size Rule Expansion Approval 
Order'').
    \26\ Actual Size Rule Expansion Approval Order, at 59936.
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    The Commission requested that the NASD continue to evaluate the 
effects of the Actual Size Rule and identified several areas of 
analysis to be covered.\27\ The Commission also requested that the NASD 
compare data among deciles, focusing attention on active versus 
inactive stocks. In response, the NASD conducted an additional study of 
the effects of the Actual Size Rule, as expanded (``January 1998 
Study'')
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    \27\ In particular: (1) The number and composition of the market 
makers in each stock; (2) the average aggregate dealer and inside 
spread; (3) the average spread of each market maker by stock; (5) 
the fraction of volume executed by a market maker who is at the 
inside quote per stock; and (6) a measure of volume required to move 
the price of each security one increment.
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3. January 1998 Study
    Summary results of the January 1998 Study are described below. The 
complete study is attached as Exhibit 2 to this filing and will be 
available through Nasdaq's web site.
    a. Methodology of January 1998 Study. To assess the effect of the 
expansion of the pilot, this study compared measures of market quality 
for a group of stocks that joined the pilot (the ``Next 103'') to a 
control group of peer stocks (the ``Non-ASR 3,207'') that remained 
subject to mandatory minimum quote sizes.\28\ Similar to the June 1997 
Study, a thorough analysis reveals the Actual Size Rule has had no 
material effect on Nasdaq market quality.
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    \28\ The study reviews data for 18 trading days between October 
13 and November 7 (October 27 and 28 are excluded and analyzed 
separately) and compares it to 20 trading days between November 10 
and December 9.
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    Importantly, it should be noted that the January 1998 Study may be 
viewed as a more straightforward analysis of the Actual Size Rule. This 
is because in the June 1997 Study, the analysis was complicated by the 
fact that, with respect to the First 40 stocks presented therein, the 
Order Handling Rules were implemented at the same time as the Actual 
Size Rule. Thus, the pre-Actual Size Rule implementation period of 
review for those stocks did not reflect the impact of the Order 
Handling Rules. In contrast, in the January 1998 Study,

[[Page 13898]]

the pre-Actual Size Rule implementation period of review did reflect 
the Order Handling Rules, which were fully phased in by October 13, 
1997. In other words, the January 1998 Study assessed only one 
significant policy change for the subject securities, that being the 
implementation of the Actual Size Rule. Furthermore, as indicated above 
in Section A.3., the NASD amended Filing No. SR-97-26 to change the 
sample design to a more representative cross section of Nasdaq 
securities.
    b. Actual Size Rule Has No Material Effect on Nasdaq Market 
Quality. Several measures of market quality were analyzed in the 
January 1998 Study: spread, volatility, depth, and liquidity. Each of 
these measures are discussed below.
    i. Spread Measures. The quoted dollar spread \29\ of the Next 103 
fell 3.8% post implementation, while the quoted spread for the control 
group Non-ASR 3,207 similarly fell 4.8%. Multivariate regression 
analysis, which is used to control for stock-specific changes in 
volume, price, and interday volatility, shows that this differential is 
immaterial. Thus, there is no statistically significant evidence of a 
differential change in quoted spreads associated with implementation of 
the Actual Size Rule.
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    \29\ Quoted dollar spread is the difference between the inside 
ask and inside bid. Individual dollar spreads are weighted by the 
amount of time each spread was in effect for the day, i.e., the 
spread's duration.
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    The effective spread \30\ (for trades of all sizes) of the Next 103 
fell 2.6% post implementation, while the effective spread for the 
control group Non-ASR 3,207 fell 5.7%. Multivariate regression analysis 
shows that, consistent with the effect on quoted dollar spreads, 
effective spreads have not changed materially for either group. Thus, 
there is no statistically significant evidence of a differential change 
in effective spreads associated with implementation of the Actual Size 
Rule.
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    \30\ Effective spread is a trade-based measures defined as twice 
the absolute difference between the trade price and the bid-ask 
midpoint (``BAM''). Thus, effective spread accounts for trades 
executed at prices inside the spread.
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    ii. Volatility. Volatility \31\ decreased slightly between the pre- 
and post-implementation periods for both the Next 103 and the Non-ASR 
3,207. For the Next 103, mean volatility fell 5.8%, while volatility 
for the Non-ASR 3,207 fell 3.4%. Again, based on multivariate 
regression analysis, the differential cannot be attributed to 
implementation of the Actual Size Rule.
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    \31\ Intraday volatility is measured using the standard 
deviation of the logarithm of the BAM.
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    iii. Depth. Mean aggregate depth \32\ provided by market makers at 
the inside market dropped by 5.2% for the Next 103, and 5.8% for the 
Non-ASR 3,207. When ECNs are included, aggregate depth fell by 2.0% for 
the Next 103 and 2.7% for the Non-ASR 3.207. Again, based on 
Multivariate regression analysis, these differentials are not 
statistically significant. Thus, implementation of the Actual Size Rule 
is not associated with a change in aggregate quote depth.
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    \32\ Quoted depth is the size of a market maker quote, or the 
number of shares at the quote that a market maker is required to 
transact under the Firm Quote Rule. Aggregated quoted depth is the 
sum of the quoted depths of all market makers quoting at the 
prevailing inside market.
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    Furthermore, neither (1) the mean number of market makers, nor (2) 
the mean number of market makers at the inside changed significantly 
for either stock group after implementation.
    iv. Liquidity. While liquidity is an important market quality 
concept, it is difficult to measure empirically. One such measure of 
liquidity is ``effective depth,'' and a refinement called ``normalized 
effective depth'' that makes the measure more robust across varying 
stock prices. These measures integrate the spread, or price, and depth 
components of the liquidity concept using trading activity in place of 
quoted depth. These measures are described fully in the study, which 
indicate that there was no statistically significant association 
between effective depth and the Actual Size Rule.
    c. Actual Size Rule Does Not Impair Ability of SOES to Provide 
Access to Market Maker Capital. An analysis of measures of market maker 
accessibility via Nasdaq's SOES system or proprietary systems shows 
that the implementation of the Actual Size Rule has not impacted the 
operation of these systems. Specifically, 98.5% of SOES orders in Next 
103 stocks were fully executed after these stocks became subject to the 
Actual Size Rule. Indeed, the average size of a SOES trade in Next 103 
stocks fell only 18 shares after the expansion of the pilot program. 
Clearly, the effect of the Actual Size Rule on the ability of investors 
to achieve executions via SOES has been minimal.
    The extreme market conditions of October 27 and 28, 1997 provided 
another test of the effect of the Actual Size Rule on the Nasdaq 
marketplace. This study includes a comparison of both the market 
quality and SOES accessibility of a group of the original pilot stocks 
(the First 36) to a group of peer stocks subject to minimum quote size 
requirements (the Second 36). There is no significant evidence that the 
Actual Size Rule impacted either market quality or SOES accessibility 
during these periods of market stress.
4. Conclusion and Proposal To Expand the Actual Size Rule to All Nasdaq 
Stocks on a Permanent Basis
    The implementation of the Order Handling Rules, which have moved 
Nasdaq toward a more order-driven market by integrating customer and 
ECN limit orders into the marketplace, called into question the 
propriety of requiring market makers to post a minimum depth for 
proprietary quotes. No other equity market requires such a minimum.
    The NASD believes that the Actual Size Rule will have a positive 
impact on market quality. First, removing artificial quote size 
requirements may lead to narrower market maker spreads, thereby 
reducing investors' transaction costs. This could result because market 
makers would be afforded more flexibility to manage risk and quote 
prices that are more favorable for small retail orders. Second, 
permitting market makers to quote in size commensurate with their own 
freely-determined trading interest should enhance the pricing 
efficiency of the Nasdaq marketplace and the independence and 
competitiveness of dealer quotations. Third, removing quotation size 
requirements will facilitate greater quote size variability, which 
would increase the information content of market maker quotes by 
facilitating different quote sizes from dealers who have a substantial 
interest in the stock at a particular time and those who do not. In 
addition, removal of minimum quote size requirements may also eliminate 
a barrier to entry into the market for smaller market making firms, 
thus attracting more firms into the market, increasing both price 
competition and liquidity, thereby benefiting investors.
    Furthermore, requiring a minimum commitment of market maker capital 
while allowing customer and ECN orders entry without a similar 
commitment could severely impair the ability of market makers to set 
competitive quotations. The adoption of quotation increments of 
sixteenths could have heightened the debilitating effect of the quote 
size minimum, as could future reductions in Nasdaq's minimum quote 
price increment if the minimum size increment is not equivalently 
reduced.
    Finally, while economic theory suggests there may be several long 
term benefits derived from the removal of minimum quotation size, 
empirical research indicates that removal of the

[[Page 13899]]

regulatory minimum has not had any adverse impact on investors or the 
Nasdaq market. In the absence of a compelling reason to the contrary, 
economic theory clearly indicates that the imposition of a potentially 
damaging regulatory constraints, such as the minimum quote size, on the 
market is inadvisable. This position is consistent with Section 15A of 
the Exchange Act, which prohibits the NASD from imposing ``any burden 
on competition not necessary or appropriate'' in furtherance of the 
purposes of the Exchange Act. This Section, among others within the 
Exchange Act, codifies a Congressional intent that the U.S. securities 
markets be free from competitive restraints to the furthest extent 
possible consistent with the other goals of the Exchange Act.\33\ 
Accordingly, the NASD believes that these minimums should be removed 
via the implementation of the Actual Size Rule for all Nasdaq 
securities on a permanent basis.
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    \33\ See Senate Comm. on Banking, Housing & Urban Affairs, 
Report to Accompany S.249, S.Rep. No. 94-75, 94th Cong., 1st Sess. 
7, 13, reprinted in 1975 U.S. Code Cong. & Admin. News 179.
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5. Statutory Basis
    For the reasons noted above, the NASD believes the proposed rule 
change is consistent with Sections 11A(a)(1)(C), 15A(b)(6), 15A(b)(9), 
and 15A(b)(11) of the Exchange Act. Section 11A(a)(1)(C) provides that 
it is in the public interest to, among other things, assure the 
economically efficient execution of securities transactions and the 
availability to brokers, dealers, and investors of information with 
respect to quotations for and transactions in securities. Section 
15A(b)(6) requires that the rules of a national securities association 
be designed to prevent fraudulent and manipulative acts and practices, 
to promote just and equitable principles of trade, to foster 
cooperation and coordination with persons engaged in regulating, 
clearing, settling, 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. 
Section 15A(b)(9) requires that rules of an Association not impose any 
burden on competition not necessary or appropriate to furtherance of 
the purposes of the Exchange Act. Section 15A(b)(11) requires the NASD, 
as a registered securities association, among other things, to 
formulate rules designed to produce fair and informative quotations.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD believes that the proposed rule change will not result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Exchange Act.

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

    Comments were neither solicited nor received.

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

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission 
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 NASD 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., 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. 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-98-21 and should 
be submitted by April 13, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\34\
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    \34\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-7372 Filed 3-20-98; 8:45 am]
BILLING CODE 8010-01-M