[Federal Register Volume 63, Number 118 (Friday, June 19, 1998)]
[Notices]
[Pages 33746-33750]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-16351]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40087; File No. SR-NASD-98-23]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc; Order Granting Approval and Notice of Filing and Order 
Granting Accelerated Approval to Amendment No. 1 and Amendment No. 2 to 
Proposed Rule Change Relating to an Amendment to the NASD's Options 
Position Limit Rule

June 12, 1998.

I. Introduction

    On March 10, 1998, NASD Regulation, Inc. (``NASD Regulation'') 
submitted to the Securities and Exchange Commission (``SEC'' or 
``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Exchange Act'' or ``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend Rule 2860(b) of the 
National Association of Securities Dealers, Inc. (``NASD'') or 
``Association'') to: (1) increase the position limits on conventional 
equity options to three times the basic position limits for 
standardized equity options on the same security; (2) disaggregate 
conventional equity options from standardized equity options and FLEX 
Equity Options for position limit purposes; and (3) provide that the 
OTC Collar Aggregation Exemption shall be available with respect to an 
entire conventional equity options position, not just that portion of 
the position that is established pursuant to the NASD's Equity Option 
Hedge Exemption.
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    \1\ 15 U.S.C. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4 (1994).
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    The proposed rule change was published for comment in Exchange Act 
Release No. 39893 (April 21, 1998), 63 FR 23317 (April 28, 1998) NASD 
Regulations submitted an amendment to the proposed rule change on April 
29, 1998.\3\ A second amendment to the

[[Page 33747]]

proposed rule change was submitted on June 3, 1998.\4\ One comment 
letter was received on the proposal \5\ This order approves the 
proposed rule change, as amended.
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    \3\ See Letter to Katherine A. England, Assistant Director, 
Division of Market Regulation, Commission, from John M. Ramsay, Vice 
President and Deputy General Counsel, NASD Regulation, dated April 
29, 1998 (``Amendment No. 1''). Amendment No. 1 makes certain 
technical corrections to the text of the proposed rule change.
    \4\ See Letter to Katherine A. England, Assistant Director, 
Division of Market Regulation, Commission, from Gary L. Goldsholle, 
Assistant General Counsel, NASD Regulation, dated June 2, 1998 
(``Amendment No. 2''). Amendment No. 2 corrects a deficiency in the 
language of the proposed rule change by clarifying that the tripling 
aspect of the proposal will apply to all conventional equity 
options. Under the current rules, the position limits for 
conventional equity options overlying a security for which there is 
no standardize equity options contract is set at 4,500 contracts, or 
such higher limit for which the underlying security would qualify. 
As now written, the proposed rule language establishes position 
limits for conventional equity options at ``three times the 
applicable position limit established for standardized equity 
options overlying the security,'' but does not take into account the 
circumstance where there is no standardized equity option contract 
overlying the security. Amendment No. 2 proposes language that 
triples the position limits for all conventional equity options, 
including those for which there is no standardize equity option 
contract overlying the security.
    \5\ See Letter to Jonathan G. Katz, Secretary, Commission, from 
Deutsche Bank Securities, Inc., Merrill Lynch, Pierce Fenner & 
Smith, Inc., Morgan Stanley & Co., Inc., Salomon Brothers Inc./Smith 
Barney, Inc., and SBC Warburg Dillon Read, Inc., dated June 2, 1998 
(``Firms' Letter''). The letter supports the approval of SR-NASD-98-
23, as amended.
    The Commission notes that it received a comment letter on a 
separate NASD rule filing (SR-NASD-97-80) on January 23, 1998, that 
is relevant to present filing. The letter supported the approval of 
SR-NASD-97-80, as well a SR-NASD-97-67, which was substantively very 
similar to the present filing. SR-NASD-97-67, was withdrawn and 
replaced by the present filing. See Letter to Jonathan G. Katz, 
Secretary, Commission, from Bear, Stearns & Co., Deutsche Morgan 
Grenfell, Inc., Goldman, Sachs & Co., Lehman Brothers, Inc., Merrill 
Lynch, Pierce Fenner & Smith, Inc., Morgan Stanley & Co., Inc., 
Natwest Securities Corporation, Salomon Brothers, Inc., SBC Warburg 
Dillon Read, Inc., and Smith Barney, Inc., dated January 23, 1998.
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II. Description

    NASD Rule 2860(b)(3) provided that the position limit \6\ for each 
equity option is determined according to a five-tiered system whereby 
more actively traded securities with larger public floats are subject 
to higher position limits and less actively traded stocks are subject 
to lower limits.\7\ Presently, conventional and standardized equity 
options are subject to the same position limits, and all equity options 
overlying a particular equity security on the same side of the market 
are aggregated for position limit purposes, regardless of whether the 
option is a conventional, standardized or FLEX Equity Option.\8\ On 
September 9, 1997, the Commission approved a two-year pilot program 
(``Pilot Program'') to eliminate position and exercise limits for FLEX 
Equity Options, which are traded on the American Stock Exchange, Inc. 
(``AMEX''), the Chicago Board Options Exchange, Inc. (``CBOE''), and 
the Pacific Exchange, Inc. (``PCX'') (collectively ``Options 
Exchange'').\9\ In light of the Pilot Program, NASD Regulation is 
proposing to amend its rules governing position and exercise limits for 
conventional equity options. NASD Regulation previously has filed a 
proposed rule change to eliminate position and exercise limits on FLEX 
Equity Options to make its rules consistent with the Pilot Program.\10\ 
NASD Regulation believes the proposed rule change herein is necessary 
to foster competition between the over-the-counter (``OTC'') market and 
the Options Exchanges.
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    \6\ Position limits impose a ceiling on the number of option 
contracts in each class on the same side of the market (i.e., 
aggregating long calls and short puts or long puts and short calls) 
that can be held or written by an investor or group of investors 
acting in concert. Exercise limits restrict the number of options 
contracts that an investor or group of investors acting in concert 
can exercise within five consecutive business days. Under NASD 
Rules, exercise limits correspond to position limits, such that 
investors in options classes on the same side of the market are 
allowed to exercise, during any five consecutive business days, only 
the number of options contracts set forth as the applicable position 
limit for those options classes. See NASD Rules 2860(b) (3) and (4).
    \7\ Currently, the five tiers are for 4,500, 7,500, 10,500, 
20,000, and 25,000 contracts NASD rules do not specifically govern 
how a specific equity option falls within one of the five position 
limit tiers. Rather, the NASD's position limit established by an 
options exchange(s) for a particular equity option is the applicable 
position limit for purpose of the Government's rule.
    \8\ Standardized options are exchange-traded options issued by 
the Options Clearing Corporation (``OCC'') that have standard terms 
with respect to strike prices, expiration dates, and the amount of 
the underlying security. A conventional option is any other option 
contract not issued, or subject to issuance by, OCC.
    \9\ See Exchange Act Release No. 39032 (September 9, 1997) 62 FR 
48683 (September 16, 1997).
    \10\ SR-NASD-98-15. The Commission notes that SR-NASD-98-15 was 
approved on March 19, 1998. See Exchange Act Release No. 39771 
(March 19, 1998), 63 FR 14743 (March 26, 1998).
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    FLEX Equity Options are exchange-traded options issued by the OCC 
that give investors the ability, within specified limits, to designate 
certain terms of the option (i.e., the exercise price, exercise style, 
expiration date, and option type). Because they are non-uniform and 
individually negotiated, FLEX Equity Options closely resemble and are 
economically equivalent to conventional equity options. Accordingly, to 
align more closely the NASD's position limit rules for conventional 
equity options with the rules for FLEX Equity Options, NASD Regulation 
proposes to amend Rule 2860(b)(3) to provide that: (1) position limits 
on conventional equity options shall be increased to three times the 
basic position limits for standardized equity options on the same 
security, (2) conventional equity options shall be disaggregated from 
standardized equity options FLEX Equity Options for position limit 
purposes; and (3) the OTC Collar Aggregation Exemption shall be 
available with respect to an entire conventional equity options 
position, not just that portion of the position that is established 
pursuant to the NASD's Equity Option Hedge Exemption.
    The NASD's Equity Option Hedge Exemption \11\ provides for an 
automatic exemption from equity option limits for accounts that have 
established hedged positions on a limited one-for-one basis (i.e., 100 
shares of stock for one option contract). Under the Equity Option Hedge 
Exemption, the largest options position that may be established 
(combining hedged and unhedged positions) may not exceed three times 
the basic position limit. The OTC Collar Aggregation Exemption \12\ 
provides that positions in conventional put and call options 
establishing OTC collars need not be aggregated for position limit 
purposes. An OTC collar transaction involves the purchase (sale) of a 
put and the sale (purchase) of a call on the same underlying security 
to hedge a long (short) stock position.
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    \11\ Rule 2860(b)(3)(A)(vii).
    \12\ 2860(b)(3)(A)(viii).
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    At the present time, NASD Regulation believes that the prudent 
regulatory approach is to increase position limits on conventional 
equity options in conjunction with continued availability of the Equity 
Option Hedge Exemption and OTC Collar Aggregation Exemption. NASD 
Regulation proposes an incremental approach and in this case believes 
increasing position limits for conventional equity options to three 
times the position limits for standardized equity options is 
appropriate. These proposed limits correspond to the position limits in 
effect for FLEX Equity Options prior to the Pilot Program.
    NASD Regulation also believes that conventional equity options 
positions should not be aggregated with standardized and FLEX Equity 
Options on the same securities for position limit purposes. It believes 
that disaggregation of conventional and other options is necessary to 
give full effect to the proposed increase in position limits for 
conventional equity options. Without disaggregation, positions in FLEX 
Equity Option or standardized option positions would reduce or 
potentially even eliminate (in the case of FLEX

[[Page 33748]]

Equity Options) the available position limits for conventional equity 
options.
    To illustrate how these proposed amendments would work, consider 
the following example of stock ABCD, which is subject to a position 
limit of 25,000 standardized equity option contracts. In this example, 
a market participant could establish a position of 25,000 standardized 
option contracts on ABCD and an additional 75,000 conventional option 
contracts on ABCD on the same side of the market, since conventional 
and standardized option positions would be disaggregated. In addition, 
the market participant also may have a position of any size in FLEX 
Equity Options overlying ABCD, since such FLEX Equity Options would not 
be aggregated with either the conventional equity options or 
standardized equity options overlying ABCD. Further, by taking 
advantage of the Equity Option Hedge Exemption, which permits a market 
participant to assume a hedged options position that is three times the 
otherwise applicable position limit, a market participant could 
increase the number of conventional equity options to 225,000 
contracts.
    NASD Regulation proposes to modify the terms of the OTC Collar 
Aggregation Exemption to apply to an entire conventional equity option 
position, not just the portion that is established pursuant to the 
Equity Option Hedge Exemption. NASD Regulation believes such an 
amendment is consistent with the economic logic underlying the OTC 
Collar Aggregation Exemption, i.e., that if the terms of the exemption 
are met, the segments of an OTC collar will never both be in-the-money 
at the same time or exercised. Under current rules, assuming that stock 
ABCD is subject to a basic position limit of 25,000 contracts, a market 
participant taking advantage of the Equity Option Hedge Exemption could 
establish a hedged position on ABCD involving a total of 75,000 
conventional equity option contracts (three times the basic limit), 
including 50,000 contracts that are established under the Equity Option 
Hedge Exemption. A market participant using the OTC Collar Aggregation 
Exemption could then establish a conventional position of 50,000 long 
(short) calls and 50,000 short (long) puts, for a total of 125,000 
contracts overlying ABCD. The proposed rule change to the OTC Collar 
Aggregation Exemption would allow a market participant to establish a 
collar consisting of two segments, each of which involves a position 
three times greater than the basic position limit. Consequently, using 
the example above, a market participant could establish an OTC collar 
on ABCD involving 75,000 long (short) calls and 75,000 short (long) 
puts, for a total of 150,000 contracts.\13\
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    \13\ While the OTC Collar Aggregation Exemption is self-
effectuating with respect to the hedged components of conventional 
options positions, NASD Regulation has also permitted members to 
include non-hedged positions within OTC collars under the terms of 
the OTC Collar Aggregation Exemption on a pre-approval basis. 
Accordingly, the instant rule change would turn this pre-approval 
process for non-hedged components of OTC collars into a self-
effectuating process.
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    If, however, the basic position limits for conventional options 
were tripled, as proposed above, the permissible options position 
established under the OTC Collar Aggregation Exemption would be 
correspondingly increased. For example, if the market participate in 
the above example had increased the size of its conventional options 
position to 225,000 contracts pursuant to the Equity Option Hedge 
Exemption as proposed above (based upon a limit of three times the 
75,000 conventional equity options position limit), the market 
participant could establish an OTC collar on ABCD involving 225,000 
long (short) calls and 225,000 short (long) puts, for a total of 
450,000 contracts.
    Finally, in addition to the proposed rule changes discussed above, 
the NASD is proposing to clarify and update the examples contained in 
IM-2860-1 so that they are consistent with the instant proposal and 
prior increases in the hedge exemption.

III. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to the Association, and, in particular, with the 
requirements of Section 15A(b)(6).\14\ Specifically, the Commission 
believes that the proposed rule change is designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and is not designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers.
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    \14\ 15 U.S.C. 78o-3(b)(6).
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    The Commission also believes that the proposed rule changes is 
consistent with Section 11A of the Act in that it will increase the 
position limits on conventional equity options, disaggregate 
conventional equity options from exchange-traded equity options for 
position limit purposes, and provide that the OTC Collar Aggregation 
Exemption may be utilized with respect to any conventional equity 
options position, not just that part of the position that is 
established pursuant to the NASD's Equity Option Hedge Exemption, and 
thereby allow market participants in the OTC options market to compete 
effectively with the participants using standardized options or with 
entities not subject to position limit rules.
    Since the inception of conventional equity options trading, the 
NASD has had rules imposing limits on the aggregate number of options 
contracts that a member or customer could hold or exercise.\15\ These 
rules are intended to prevent the establishment of options positions 
that can be used or might create incentives to manipulate or disrupt 
the underlying market so as to benefit the options position. In 
particular, position and exercise limits are designed to minimize the 
potential for mini-manipulation \16\ and for corners or squeezes of the 
underlying market. In addition, they serve to reduce the possibility 
for disruption of the options market itself, especially in illiquid 
options classes.
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    \15\ As stated earlier, under NASD rules conventional and 
standardized equity options currently are subject to the same 
position limits, and all equity options overlying a particular 
equity security on the same side of the market are aggregated for 
position limit purposes, regardless of whether the option is a 
conventional, standardized of FLEX Equity Option.
    \16\ Mini-manipulation is an attempt to influence, over a 
relatively small range, the price movement in a stock to benefit a 
previously established derivatives position.
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    The Commission has been careful to balance two competing concerns 
when considering a self-regulatory organization's position and exercise 
limits. The Commission has recognized that the limits must be 
sufficient to prevent investors from disrupting the market for the 
underlying security by acquiring and exercising a number of options 
contracts disproportionate to the deliverable supply and average 
trading volume of the underlying security. At the same time, the 
Commission has realized that limits must not be established at levels 
that are so low as to discourage participation in the options market by 
institutions and other investors with substantial hedging needs or to 
prevent specialists and market makers from adequately meeting their 
obligations to maintain a fair and orderly market.\17\
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    \17\ See H.R. Rep. No. IFC-3, 96th Cong., 1st Sess. at 189-91 
(Comm. Print 1978) (``Options Study'').
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    The Commission believes that the proposed rule change will improve 
the conventional equity options market for several reasons. First, the 
Commission notes that the NASD's current reporting requirements for all 
conventional equity options transactions establishing large options 
positions will apply to such transactions effectuated under the new 
rule. Rule 2860(b)(5)(ii) imposes

[[Page 33749]]

reporting obligations on ``each account in which the member has an 
interest * * * and each customer account, which has established an 
aggregate position of 200 or more option contracts * * *.'' Information 
reported to the NASD is used by the NASD Regulation Market Regulation 
staff as part of their ongoing market surveillance operations and helps 
to minimize the risk of any market manipulation or disruption related 
to the accumulation or disposition of large options positions. It also 
enables NASD Regulation to identify large positions held or written by 
a member that could pose a financial risk to the member or its clearing 
firm.
    Second, the tripling of the position limits on conventional equity 
options will help those investors who utilize conventional equity 
options, typically large, sophisticated institutional investors, or 
persons of extremely high net worth, with their extensive hedging 
needs.\18\
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    \18\ In the Firms' Letter, the commenters indicate that they 
``have experienced an overwhelming interest by institutional and 
other accredited investors to enter into collar transactions and 
other hedging transactions involving conventional options.'' On 
several occasions they have been unable ``to meet the demand for 
this hedging activity due to the relatively low [applicable] 
conventional option position limits.'' See Firms' Letter, supra, 
note 5.
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    Third, the Commission also believes that the proposed tripling of 
position limits for conventional equity options will expand the depth 
and competitiveness of the conventional equity option market without 
significantly increasing concerns regarding intermarket manipulations 
or disruptions of the options or the underlying securities. Broker-
dealers and banks act as dealers in the OTC derivatives market, and 
compete with each other for counterparty business. The proposal will 
enable broker-dealers to compete more effectively with banks that are 
not subject to NASD rules for OTC options transactions. It will also 
enable NASD members to accommodate better their clients' risk 
management strategies. The Commission recognizes, however, that the 
proposal presents substantial increases in OTC options transactions. It 
will also enable NASD members to accommodate better their clients' risk 
management strategies. The Commission recognizes, however, that the 
proposal present substantial increases in OTVC options positions. 
Although the proposed rule change increases threefold the position 
limits for conventional equity options, those markets that are 
relatively less active and not as deep in trading interest will remain 
subject to the lowest existing position limit, i.e., 4,500 x 3, or 
13,500 option contracts. Moreover, as noted above, the large positions 
will be reported to the NASD for monitoring. Finally, the Commission 
notes that the proposed positions for conventional equity options are 
still capped at a fixed level, whereas there are no position limits for 
FLEX Equity options.
    Fourth, the Commission believes that the disaggregation of 
conventional equity options from standardized equity options is 
warranted given that the tripling provision will otherwise be of 
limited effect. That is, if an investor has reached the limit for 
standardized equity options and is required to aggregate those options 
with his conventional equity options, he will reach the total position 
limit for conventional equity options sooner than if the standardized 
and conventional equity options were not aggregated. The Commission 
also notes that, under the rules of the Options Exchanges, FLEX Equity 
Options, which are very similar to conventional equity options, are not 
aggregated with standardized equity options for position limit 
purposes.\19\
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    \19\ Positions in FLEX Index Options generally are also not 
aggregated with options on any stocks included in the index or with 
FLEX Index Option positions on another index. See, e.g., CBOE Rule 
24A.7(c).
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    Fifth, the Commission notes that in September 1997, it approved the 
elimination of position and exercise limits for FLEX Equity Options on 
a two year pilot basis.\20\ As stated above, FLEX Equity Options are 
exchange-traded options issued by the OCC that give investors the 
ability, within specified limits, to designate certain terms of the 
option (i.e., the exercise price, exercise style, expiration date, and 
option type). Conventional equity options are very similar to FLEX 
Equity Options given that they are also non-uniform and individually 
negotiated.\21\ Traditionally, the Commission has taken a gradual, 
evolutionary approach toward expansion of position and exercise limits. 
The Commission believes that increasing position limits for 
conventional equity options to three times the position limits for 
standardized equity options is appropriate given the Commission's 
previous approach to the expansion of position and exercise limits. The 
Commission also believes that the proposed rule change will help to 
foster competition between the OTC market and the Options Exchanges, as 
well as ensure that OTC market participants are not placed at a 
competitive disadvantage vis-a-vis the Options Exchanges.
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    \20\ See supra note 9.
    \21\ Conventional equity options are not, however, issued or 
subject to issuance by OCC.
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    The Commission finds good cause to approve Amendment No. 1 to the 
proposed rule change prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Amendment No. 1 makes minor technical changes to the text of the 
proposed rule. Specifically, Amendment No. 1 clarifies in the rule 
language that the Equity Option Hedge Exemption program was approved by 
the Commission on a pilot basis only until December 31, 1998. Amendment 
No. 1 also makes certain clerical corrections. Accordingly, the 
Commission believes that it is consistent with Section 15A(b)(6) of the 
Act to approve Amendment No. 1 to the proposed rule change on an 
accelerated basis.
    The Commission finds good cause to approve Amendment No. 2 to the 
proposed rule change prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Amendment No 2 corrects a deficiency in the text of the proposed rule. 
Specifically, Amendment No. 2 clarifies in the rule language that 
position limits for conventional equity for which there is not 
standardized equity option contract overlying the security are also to 
be tripled. Under the current rules, the position limits for 
conventional equity options overlying a security for which there is no 
standardized equity options contract is set at 4,500 contracts, or such 
higher limit for which the underlying security would qualify. As now 
written, the proposed rule language establishes position limits for 
conventional equity options at ``three times the applicable position 
limit established for standardized equity options overlying the 
security,'' but does not take into account the circumstance where there 
is no standardized equity option contract overlying the security. 
Amendment No. 2 proposes language that triples these limits. The 
Commission believes that accelerated approval of Amendment No. 2 is 
appropriate given that it clarifies the application of the new position 
limits in a manner that is consistent with the approach established in 
the original rule filing. Accordingly, the Commission believes that it 
is consistent with Section 15A(b)(6) of the Act to approve Amendment 
No. 2 to the proposed rule change on an accelerated basis.
    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 1 and Amendment No. 2 to the 
proposed rule change, including whether the amendments are consistent

[[Page 33750]]

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. Sec. 552, will 
be available for inspection and copying at the Commission's Public 
Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the Exchange. All 
submissions should refer to File No. SR-NASD-98-23 and should be 
submitted July 10, 1998.

IV. Conclusion

    For the foregoing reasons, the Commission finds that NASD 
Regulation's proposal, as amended, is consistent with the requirements 
of the Act and the rules and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\22\ that the proposed rule change (SR-NASD-98-23) is approved, as 
amended.

    \22\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\23\
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    \23\ 17 CFR 200.30-3(a)(12) (1994).
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-16351 Filed 6-18-98; 8:45 am]
BILLING CODE 8010-01-M