[Federal Register Volume 63, Number 140 (Wednesday, July 22, 1998)]
[Notices]
[Pages 39322-39333]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-19436]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40211; File No. SR-NASD-98-21]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving a Proposed Rule Change to Permanently 
Expand the NASD's Rule Permitting Market Makers to Display Their Actual 
Quotation Size

July 15, 1998.

I. Introduction

    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'') a proposed rule 
change pursuant to Section 19(b)(1) of the Securities Exchange Act of 
1934 (``Exchange Act''), \1\ and Rule 19b-4 thereunder,\2\ to amend 
NASD Rule 4613(a)(1)(C) permanently to allow market markers to quote 
their actual size by reducing the minimum quotation size requirement 
for all Nasdaq securities to one normal unit of trading (``Actual Size 
Rule'' or ``ASR'').\3\ The Commission issued the

[[Page 39323]]

proposed rule change for comment on March 16, 1998.\4\ For the reasons 
discussed below, the Commission is approving the proposed rule 
change.\5\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4
    \3\ Concurrent with the March 5, 1998, filing, NASD Economic 
Research published an economic study entitled ``Evidence from the 
Pilot Expansion on November 10, 1997, and the Market Stress of 
October 27 and 28, 1997'' (``March 1998 Study''). This study 
followed an earlier study the NASD conducted to analyze the effects 
of the Actual Size Rule entitled ``Effects of the Removal of Minimum 
Sizes for Proprietary Quotes in The Nasdaq Stock Market, Inc.'' 
(``June 1997 Study''). The findings the NASD made in each of these 
studies are discussed below. Both studies were made publicly 
available through the NASD's web site.
    On January 10, 1997, the Commission approved an NASD proposal to 
implement the Actual Size Rule on a pilot basis from January 20, 
1997 through April 18, 1997. Exchange Act Release No. 38156, 62 FR 
2415 (January 16, 1997) (SR-NASD-96-43). Under the initial three-
month pilot, Nasdaq market makers could quote in minimum sizes of 
100 shares in the 50 Nasdaq securities subject to mandatory 
compliance with Exchange Act Rule 11Ac1-4 (``Limit Order Display 
Rule''). The remaining Nasdaq securities were still subject to the 
existing minimum quotation display requirements for proprietary 
quotes.
    On April 15, 1997, the Commission approved an NASD proposal that 
extended the 50-stock pilot from April 18, 1997 to July 18, 1997. 
Exchange Act Release No. 38512, 62 FR 19373 (April 21, 1997) (SR-
NASD-97-25). On July 18, 1997, the Commission approved the NASD's 
request to extend the 50-stock pilot from July 18, 1997 to December 
31, 1997. Exchange Act Release No. 38851, 62 FR 39565 (July 23, 
1997) (SR-NASD-97-49).
    On October 29, 1997, the Commission approved the NASD's proposal 
to extend the pilot from December 31, 1997 through March 27, 1998, 
and to expand the pilot to 150 Nasdaq securities. Exchange Act 
Release No. 39285, 62 FR 59932 (November 5, 1997) (SR-NASD-97-26). 
On March 25, 1998, the Commission approved the NASD's proposal to 
extend the 150-stock pilot from March 27, 1998 through June 30, 
1998. Exchange Act Release No. 39799, 63 FR 15467 (March 31, 1998) 
(SR-NASD-97-26).
    \4\ Exchange Act Release No. 39760 (March 16, 1998) 63 FR 13894 
(March 23, 1998) (File No. SR-NASD-98-21).
    \5\ The text of the rule, as adopted, is as follows:
    NASD Rule 4613  Character of Quotations
    (a) Two-Sided Quotations
    (1) No change.
    (A)-(B) No change.
    (C) A registered market maker in a security listed on The Nasdaq 
Stock Market 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.
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II. Background

A. The SEC's Order Handling Rules and the Actual Size Rule Pilot 
Program

    On August 29, 1996, the Commission promulgated a new rule, the 
Limit Order Display Rules,\6\ and adopted amendments to the Quote Rule 
\7\ which together are designed to enhance the quality of published 
quotations for securities and promote competition and pricing 
efficiency in U.S. securities markets (collectively, the ``Order 
Handling Rule'').\8\ The SEC's Limit Order Display Rule generally 
requires a market maker to display customer limit orders that (1) are 
priced better than a market maker's quote, or (2) add to the size 
associated with a market maker's quote when the market maker is at the 
best price in the market.\9\ The Limit Order Display Rule gives 
investors the ability to directly advertise their trading interest to 
the marketplace, enabling them to trade inside the current bid-ask 
spread and thereby compete with market maker quotations and narrow the 
size of the bid-ask spread. The Order Handling Rules amended the SEC's 
Quote Rule to require a market maker to display in its quote any better 
priced orders that it places into an ECN such as the NASD's SelectNet 
service (``SelectNet'') or Instinet.\10\ 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 included in the 
public quotation, and (2) provides ``equivalent'' access \11\ to the 
ECN for brokers and dealers that do not subscribe the ECN, so that 
those brokers and dealer may trade with orders entered into the 
ECN.\12\
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    \6\ 17 CFR 240.11Ac1-4.
    \7\ 17 CFR 240.11Ac1-1.
    \8\ Exchange Act Release No. 37619A (September 6, 1996) 61 FR 
48290 (September 12, 1996). With respect to Nasdaq securities, the 
Order Handling Rules were implemented according to the following 
schedule: 50 Nasdaq securities became subject to the rules on 
January 20, 1997; 50 more securities became subject to the rules on 
February 10, 1997; and an additional 50 securities became subject to 
the rules on February 24, 1997. The remaining Nasdaq securities wee 
phased in by October 13, 1997. Exchange Act Release No. 38490 (April 
9, 1997) 62 FR 18514 (April 16, 1997); and Exchange Act Release No. 
38870 (July 24, 1997) 62 FR 40732 (July 30, 1997).
    \9\ In the alternative, a market maker may immediately execute 
the order or delivery the order to an exchange or national 
securities association sponsored system or an electronic 
communications network (``ECN'') that complies with the ``ECN 
Display Alternative,'' as described below.
    \10\ This amendment is known as the ``ECN Rule.''
    \11\ Access must be ``[e]quivalent to the ability of any broker-
dealer to effect a transaction with an exchange market maker or OTC 
market maker pursuant to the rules of the exchange or association to 
which the [ECN] supplies such bids and offers.'' SEC Rule 11Ac1-
1(c)(5)(ii)(B)(1).
    \12\ This alternative is known as the ``ECN Display 
Alternative.''
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    On January 10, 1997, the Commission approved certain amendments to 
Nasdaq's Small Order Execution System (``SOES'') and SelectNet to help 
implement the Order Handling Rules and accommodate changes in the 
Nasdaq market that these rules brought about. For instance, the 
Commission approved, on a temporary basis, the Actual Size rule for the 
first 50 securities subject to the Order Handling Rules. Under the 
Actual Size Rule pilot, Nasdaq market makers were only required to 
display a minimum quotation size of one normal unit of trading (100 
shares) when quoting solely for their own proprietary accounts in the 
first 50 securities. Market makers could display a grater quotation 
size if they chose to (or if required to do so by the Limit Order 
Display Rule). For Nasdaq securities other than the first 50, minimum 
quotation size requirements of 1,000, 500, or 200 shares continued to 
apply.\13\ Neither the minimum quotation size requirements nor the 
Actual Size Rule negate 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 or more shares, for example, it 
must display a quote size reflecting the size the customer's order, 
absent an exception to the Limit Order Display Rule.
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    \13\ In particular, NASD Rule 4613(a)(2) required each market 
maker in a Nasdaq issue other than those in the first 50 to enter 
and maintain two-sided quotations with a minimum size equal to or 
greater than the applicable SOES tier size for the security (i.e., 
1,000, 500 or 200 shares for Nasdaq National Market securities and 
500 or 100 shares for Nasdaq SmallCap Market securities).
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    In its finding with the Commission proposing the initial Actual 
Sizes Rule pilot, the NASD contended that changes to the dealer market 
brought about by the Order Handling Rules rendered mandatory minimum 
quote sizes unnecessary. The NASD also contended that economic theory 
suggested the Actual Size Rule could result in long-term benefits such 
as increased competition. Finally, the NASD's noted that empirical 
research indicated that neither investors nor the Nasdaq market would 
be adversely impacted by the Actual Size Rule. Specifically, the NASD 
argued that the Actual Size Rule would give market makers more 
flexibility to manage risk and quote prices more favorable to small 
retail investors. In addition, the NASD argued that requiring a minimum 
commitment of market maker capital while allowing ECNs and investors 
(including professional ``day traders'') to display their orders 
without imposing a similar minimum size commitment on them could 
severely impair market makers' ability to set competitive quotations.
    April 11, 1997, the NASD filed a proposal with the Commission to 
extend the pilot until at least December 19, 1997, and to expand the 
number of stocks in the pilot to include the next 100 stocks subject to 
the Order Handling Rules.\14\ In that filing, the NASD indicated that 
its research department had studied the effects of the Order Handling 
Rules and the Actual Size Rule and found that: (1) The Order Handling 
Rules dramatically improved the quality of the Nasdaq market by, among 
other things, narrowing quoted spreads; (2) among those securities 
subject to the Order Handling Rules, there was no appreciable 
difference in market quality between stocks subject to the Actual Size 
Rule and stocks subject to mandatory quote size requirements; and (3) 
implementation of the Actual Size Rule did not significantly diminish 
the ability of investors to receive automated executions through SOE, 
Select Net, or proprietary systems operated by broker-dealers.\15\ 
Based on these findings, the NASD concluded that mandatory quote size 
requirement were no longer needed.\16\
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    \14\ See Exchange Act Release No. 38513 (April 15, 1997) 62 FR 
19369 (April 21, 1997) (SR-NASD-97-26).
    \15\ Id.
    \16\ Release No. 39285, supra note 3, 62 FR at 59936-37. The 
NASD subsequently amended the filing 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. The methodology used to determine the next 100 
securities is discussed further below.

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[[Page 39324]]

    On June 3, 1997, the NASD supplemented its proposal with its first 
comprehensive study of the potential impact of the Actual Size Rule on 
stocks for which the mandatory size minimum quote requirements were 
relaxed (``pilot stocks''). The results of the study indicated that 
implementing the Actual Size Rule did not adversely affect the market 
quality of pilot stocks. The June 1997 Study analyzed standard measures 
of market quality, including spread, volatility, liquidity, and depth. 
In addition, the study examined investors' ability to access market 
maker capital through SOES and proprietary automatic execution systems. 
The study suggested that for pilot stocks, investors continued to have 
reasonable and substantial access to market maker capital through 
automatic execution systems.\17\ To provide the public with an 
opportunity to review and comment on the June 1997 Study, the 
Commission extended the comment period on the NASD's proposal until 
July 3, 1997.\18\ On July 17, 1997, the NASD amended the filing at the 
Commission's request to extend the pilot until March 27, 1998, to give 
the Commission more time to evaluate the economic studies on the 
proposal and to review comments on the June 1997 Study.\19\
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    \17\ See Exchange Act Release No. 38720 (June 5, 1997) 62 FR 
31856 (June 11, 1997).
    \18\ Id.
    \19\ 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, some commenters 
expressed concerns about the proposal to expand the Actual Size Rule. 
In particular, some commenters noted that the pilot had been limited to 
only 50 Nasdaq securities and that these securities generally represent 
the most liquid Nasdaq stocks.\20\ In addition, the proposed expansion 
of the Actual Size Rule would apply to those 100 stocks that were 
subsequently phased in under the Order Handling Rules. Those stocks 
were also drawn from the most liquid Nasdaq stocks. Thus, it was argued 
that, even an expanded pilot would still be skewed toward larger, more 
active issues.
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    \20\ See, e.g., letter from David K. Whitcomb, Professor of 
Finance, Rutgers University, to Jonathan Katz, Secretary, SEC, dated 
July 3, 1997.
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    On September 15, 1997, in response to these concerns, the NASD 
amended its proposal to change the selection methodology for the next 
group of securities to be subject to the pilot to provide an enhanced 
sample that better represents the entire Nasdaq market.\21\ 
Specifically, the remaining Nasdaq National Market issues were divided 
into deciles based on average daily dollar volume. One hundred and ten 
stocks were then chosen by randomly selecting approximately the same 
number from each decile.\22\ As expanded, the pilot provided additional 
data across a range of securities, thereby permitting an enhanced 
evaluation of the effects of the Actual Size Rule pilot.
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    \21\ See letter from Robert E. Aber, Vice President and General 
Counsel, Nasdaq, to Katherine A. England, Assistant Director, SEC, 
dated September 15, 1997.
    \22\ One hundred and ten stocks were chosen to replace four of 
the original stocks that were delisted, to accommodate possible 
delistings, and to ensure that 150 stocks would be available under 
an expanded Actual Size Rule pilot.
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    On October 29, 1997, the Commission approved the NASD proposal, as 
amended, to expand the Actual Size Rule pilot to include 150 stocks and 
to extend the pilot through March 27, 1998.\23\ In approving the 
proposal, the Commission stated its belief that the preliminary data 
indicated that the pilot had not resulted in any degradation to Nasdaq 
market quality, and that the Actual Size Rule appeared to be a 
reasonable means to provide market making obligations that reflect the 
new market dynamics produced by the Order Handling Rules.\24\ 
Nonetheless, the Commission decided that it would be appropriate to 
consider additional data that could be gathered using the more 
representative sample of Nasdaq stocks before determining whether to 
expand the Actual Size Rule to the entire Nasdaq market.\25\
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    \23\ Release No. 39285.
    \24\ Id. at 59936.
    \25\ On March 25, 1998, the Commission approved a rule change 
proposed by the NASD to extend the pilot from March 27, 1998 through 
June 30, 1998. Exchange Act Release No. 39799, 63 FR 15467 (March 
31, 998) (SR-NASD-97-26).
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    The Commission asked the NASD to continue evaluating the effects of 
the Actual Size Rule and identified several areas to be analyzed.\26\ 
The Commission also asked the NASD to compare data among deciles of 
Nasdaq stocks, focusing attention on active versus inactive stocks. In 
response, the NASD produced a second study (``March 1998 Study'') which 
addressed the effects of the Actual Size Rule, as expanded.
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    \26\ In particular, the Commission asked the NASD to analyze: 
(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; (4) the average depth by 
market maker (including limit orders) and any change in depth over 
time; (5) the fraction of volume executed by each market maker that 
is at the inside quote per stock; and (6) the amount of volume 
required to move the price of each security one increment. Release 
No. 39285, supra note 3, at 62 FR 59937.
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B. Findings of the NASD's March 1998 Study

    In the March 1998 Study, the NASD sought to determine the impact of 
the Actual Size Rule on Nasdaq market quality and on investors' access 
to automatic execution systems (including SOES). To do so, it compared 
securities subject to the Actual Size Rule's 100-share minimum quote 
size with a control group of peer stocks still subject to mandatory 
minimum quote size requirements. The March 1998 Study compared these 
two groups of securities after the Order Handling Rules had been fully 
implemented, thus, quote size was meant to be the only significant 
difference between the two groups of securities.
    The study compared measures of market quality for a group of stocks 
that joined the pilot (pilot stocks) to a control group of peer stocks 
(non-pilot stocks) that remained subject to mandatory minimum quote 
sizes.\27\ Like the June 1997 Study, the March 1998 Study concluded 
that the Actual Size Rule had no material effect on Nasdaq market 
quality or investors' access to automatic execution systems (including 
SOES).\28\
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    \27\ The study reviews data for 18 trading days between October 
13, 1997 and November 7, 1997, (October 27, 1997 and October 28, 
1997, are excluded and analyzed separately) and compares this data 
to 20 trading days between November 10, 1997 and December 9, 1997.
    \28\ See March 1998 Study at 84-89.
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1. The Actual Size Rule's Impact on the Quality of the Nasdaq Market
    The NASD analyzed several measures of market quality in the March 
1998 Study: spread, volatility, depth, and liquidity. Each of these 
measures is discussed below.
a. Spread Measures
    The NASD used two methods to calculate spreads: quoted dollar 
spread \29\ and effective spread.\30\ The ``quoted dollar spread'' of 
the pilot stocks fell 3.8% from a time before the Actual Size Rule was 
implemented to a time when it applied to the securities in the sample. 
The quoted dollar spread for the non-pilot stocks fell 4.8% over the 
same period. Based on a multivariate

[[Page 39325]]

regression analysis performed by the NASD, which controlled for stock-
specific changes in volume, price, and interday volatility, the NASD 
concluded that the decrease in the quoted dollar spreads of the two 
groups of securities is statistically insignificant.
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    \29\ Quoted dollar spread is the difference between the inside 
ask and inside bid. Individual dollar spreads were weighted by the 
amount of time each spread was in effect for the day, i.e., the 
spread's duration.
    \30\ Effective spread is twice the absolute difference between 
the trade price and the bid-ask midpoint (``BAM''). Thus, the 
effective spread is intended to account for trades executed at 
prices inside the spread.
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    The ``effective spread'' (for trades of all sizes) of the pilot 
stocks fell 2.6% post-implementation, while the effective spread for 
the non-pilot stocks fell 5.7%. The NASD performed a multivariate 
regression analysis and concluded that the difference between the 
declines in the effective spreads for the two groups of stocks is 
statistically insignificant. Thus, under either spread measure, the 
NASD's statistical data suggests that the Actual Size Rule did not have 
a material adverse impact on the spreads for ASR securities compared to 
non-ASR securities over the period of the study.
b. Volatility
    Intraday volatility decreased slightly between the pre- and post-
implementation periods for both the pilot stocks and non-pilot stocks. 
Mean volatility fell 5.8% for the pilot stocks and 3.4% for the non-
pilot stocks. Again, the NASD performed a multivariate regression 
analysis and concluded that this difference is statistically 
insignificant. Thus, the NASD's data suggests that implementing the 
Actual Size Rule did not materially adversely impact the intraday 
volatility of ASR securities compared to non-ASR securities over the 
period of the study.
c. Depth
    The NASD's study also looked at the number of shares Nasdaq market 
makers were willing to quote at the inside market using a measure 
called ``mean aggregate quoted depth.'' Using this measure, the amount 
of depth provided by market makers at the inside market dropped by 5.2% 
for the pilot stocks, and by 5.8% for the non-pilot stocks. When ECN 
quotes at the inside are included, mean aggregate quoted depth fell by 
2.0% for the pilot stocks and by 2.7% for the non-pilot stocks. Again, 
based on multivariate regression analysis performed by the NASD, these 
differences are not statistically significant. Thus, the NASD data 
suggests that the Actual Size Rule did not materially adversely impact 
the depth of pilot securities compared to non-pilot securities over the 
period of the study.
    Furthermore, neither the mean number of market makers nor the mean 
number of market makers at the inside changed significantly for either 
stock group after implementation.
d. Liquidity
    While liquidity is an important element of market quality, it is 
difficult to measure empirically. A common liquidity measure is 
``effective depth'' \31\ or the amount of volume it takes to move the 
spread a predetermined amount in one direction or the other. A 
refinement to effective depth, called ``normalized effective depth,'' 
makes the measure more precise across varying stock prices.\32\ Using 
this measure of liquidity, the NASD concluded in the March 1998 Study 
that the Actual Size Rule did not materially adversely impact the 
liquidity of pilot securities compared to non-pilot securities over the 
period of the study.
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    \31\ See. e.g., March 1998 Study at 78.
    \32\ These measures are described fully in the NASD's March 1998 
Study at 77-84.
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2. Actual Size Rule's Impact on Investors' Access to SOES
    In the March 1998 Study, the NASD also analyzed the potential 
impact of the Actual Size Rule on investors' access to market makers 
through SOES or broker-dealers' proprietary automatic execution 
systems. According to the NASD, the data suggests that implementation 
of the Actual Size Rule has not materially adversely impacted 
investors' ability to access Nasdaq market makers through these 
systems.\33\ Specifically, the NASD found that 98.5% of SOES orders in 
the pilot stocks were fully executed at a single price after these 
stocks became subject to the Actual Size Rule. The NASD also found that 
for the non-pilot stocks, 98.9% of SOES orders were fully executed at a 
single price, a statistically insignificant difference. The average 
size of an executed SOES order in the pilot stocks fell by 18 shares 
after the expansion of the pilot program; for the non-pilot stocks, the 
average size of an executed SOES order fell by 23 shares. The NASD 
concluded that this is a statistically insignificant difference.
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    \33\ Roughly 85% of orders in the tested group of pilot stocks 
during the periods analyzed by the March 1998 Study were for the 
tier size maximum, i.e., 1,000 shares. This proportion did not 
materially change after these stocks became subject to the Actual 
Size Rule.
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    The NASD also studied broker-dealer automatic proprietary execution 
systems. The March 1998 Study analyzed data from nine broker-dealers 
(``Participant Firms'') \34\ and found that these systems constitute a 
significant proportion of trading activity by the Participant Firms. 
The March 1998 Study found no evidence that the Actual Size Rule had 
any effect on these systems' activity. Specifically, the mean number of 
automatic execution trades as a percentage of all trades for 
Participant Firms increased from 37.8% to 38.4% for the pilot stocks 
and from 34.5% to 36.2% for the non-pilot stocks. The mean automatic 
execution volume as a percentage of all volume for the pilot stocks 
increased from 30.8% to 31.2%; for the non-pilot stocks, it increased 
from 27.8% to 29.5%. These differences were not statistically 
significant. Based on the March 1998 Study, the NASD concluded that the 
implementation of the Actual Size Rule did not materially adversely 
impact the average SOES trade size or investors' access to market 
makers through SOES or broker-dealer proprietary systems in pilot 
versus non-pilot stocks over the period of the study.
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    \34\ The participant firms were: Goldman, Sachs & Co.; Herzog, 
Heine, Geduld, Inc.; Knight Securities, L.P.; Bernard L. Madoff 
Investment Securities; Mayer & Schweitzer, Inc.; Prudential 
Securities, Inc.; PaineWebber, Inc.; Smith Barney, Inc.; and Troster 
Singer Stevens Rothchild Corp.
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    The extreme market conditions of October 27 and 28, 1997, provided 
another test of the potential impact of the Actual Size Rule on the 
Nasdaq marketplace. On October 27, 1997, the Nasdaq Composite Index 
fell by 7.02% and cross-market circuit breakers were implemented. On 
October 28, 1997, the Nasdaq Composite index declined by 4.37% by 9:41 
a.m. before rebounding and ending up 4.43% for the day. Both days 
experienced record trading volume. The March 1998 Study compared the 
market quality (as measured by spreads, volatility, depth, and 
liquidity, as discussed above) and investor access to SOES (and other 
automatic execution systems) for a group of the original pilot stocks 
with that of a group of peer stocks subject to minimum quote size 
requirements. The NASD concluded in the March 1998 Study that the 
Actual Size Rule had no material adverse impact on market quality 
during this period of intense market stress. Further, the NASD 
concluded that investors' ability to access market maker capital for 
pilot stocks versus non-pilot stocks was not materially adversely 
impacted during this period.

III. Comment Letters

    The Commission received 274 comment letters from numerous entities, 
including market makers, full service broker-dealers, order entry 
firms, SOES traders, academics, individual investors, professional 
associations, and a national securities exchange. Of these, 53 favored 
the Actual Size Rule, 218 opposed it, and three did not clearly state a 
position. Proponents included representatives of the market maker and 
institutional trading communities. Among opponents were numerous 
individuals associated with day trading

[[Page 39326]]

firms and users of the SOES system. Although opponents of the proposal 
raised concerns about the effects of the Actual Size Rule on access to 
executions and market maker capital as well as the proposal's impact on 
market factors including liquidity, volatility, and spreads, proponents 
countered that the proposal would enable market makers to manage risk 
better and to provide capital to the market more efficiently. The NASD 
also submitted a letter addressing the comments the Commission 
received.\35\
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    \35\ See NASD Response.
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    The Commission has considered all of the comments it received on 
the proposal. Due to the large number of comment letters, a complete, 
separate summary of comments has been prepared and is available in the 
public file. The most significant comments are discussed below.

A. Comments Favoring the Actual Size Rule

    Of the 274 comment letters the Commission received, 53 support 
permanent expansion of the Actual Size Rule. Among these are letters 
from trade groups such as the Security Traders Association 
(``STA''),\36\ the Securities Industry Association Industry Association 
(``SIA''),\37\ and the Investment Company Institute (``ICI''),\38\ as 
well as numerous brokerage firms.\39\ The Commission also received a 
comment letter from American Century Investment Management (``ACIM'') 
supporting the proposal.\40\ Generally, a number of market participants 
stated that the NASD's data and analysis--including its conclusions 
based on both economic theory and empirical results--is consistent with 
the marketplace's experience with the Actual Size Rule.\41\
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    \36\ The STA describes itself as having approximately 7,700 
individual members.
    \37\ The SIA describes itself as being composed of nearly 800 
securities firms, employing more than 380,000 individuals. The SIA 
also states that its members include investment banks, broker-
dealers, and mutual fund companies that are active in all markets 
and in all phases of corporate and public finance.
    \38\ The ICI describes itself as the national association of the 
investment company industry. Founded in 1940, its membership 
includes 6,976 mutual funds, 447 closed-end funds, and 10 sponsors 
of unit investment trusts. Its mutual fund members represent more 
than 63 million individual shareholders and manage more than $5 
trillion.
    \39\ The Chicago Stock Exchange, Inc. (``CHX'') also submitted a 
letter, although it neither favored nor opposed adoption of the 
Actual Size Rule. See CHX Letter.
    \40\ ACIM Describes itself as managing over $70 billion for 
investors in the Twentieth Century, Benham, and American Century 
families of mutual funds.
    \41\ See, e.g., Merrill Letter; Credit Suissee Letter; J.P. 
Morgan Letter; STA Institutional Letter; ICI Letter.
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    Proponents of the Actual Size Rule contend that the rule 
contributes to a more efficient and transparent market--a market that, 
ultimately, benefits investors. Several commenters state that the 
Actual Size Rule aids their market making activities and allows them to 
better serve their customers.\42\ One firm states that it has ``become 
more active in the stocks under the Pilot program due to [its] ability 
to properly manage [its] capital risk.'' \43\ Several commenters note 
that by cutting barriers to entry, the Actual Size Rule should 
encourage market maker participation, including that of smaller 
firms.\44\ Further, several commenters believe that market makers' 
ability to commit capital more freely will enhance pricing efficiency 
and the competitiveness of dealer quotations, and increased price 
competition and the entry of more market makers will help 
investors.\45\
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    \42\ See, e.g., M.H. Meyerson Letter, Crawford, Letter.
    \43\ See M.H. Meyerson Letter.
    \44\ See, e.g., JP Morgan Letter; Ohio Letter; Marino Letter; 
Merrill Letter; Knight Letter; 4/29 and 4/1 STA Letter; Jefferies 
Letter; Howard Letter' STANY Letter; and Weeden Letter.
    \45\ See, eg., Cantor Letter; Morgan Letter; Knight Letter; 
STANY Letter; Credit Suisse Letter; Salmon Letter; Suntrust Letter; 
3/6 and 4/1 Walters Letter; and Morgan Keegan Letter.
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    In addition, one commenter, whose company's stock was in the pilot, 
cites benefits to his company's stock from pricing efficiencies.\46\ 
Another commenter feels the Actual Size Rule is in the best interest of 
investors, including those households owning shares of equity mutual 
funds.\47\ An institutional firm commented that the Actual Size Rule 
helps give a true look at the depth and quality of markets and helps to 
ensure fairer pricing of institutional blocks.\48\
---------------------------------------------------------------------------

    \46\ 
    \47\ See ICI Letter.
    \48\ See Weeden Letter.
---------------------------------------------------------------------------

    In addition to creating a market that better represents trading 
interests, commenters feel the Actual Size Rule can make the Nasdaq 
market more competitive with other securities markets. One commenter 
notes that the Actual Size Rule could remove competitive burdens on 
Nasdaq market participants by leveling the playing field between 
primary markets in the United States.\49\ Another commenter notes that 
if Nasdaq market making requirements were made more equivalent to other 
equity markets that do not have a 1,000 share quotation minimum, Nasdaq 
market makers could more efficiently price stock absent a multitude of 
``unnatural and unwanted positions.'' \50\ One commenter posits that 
if, as studies show, market quality is maintained under the Actual Size 
Rule, Nasdaq should not be the only equity market forcing market makers 
to deploy capital to create artificial liquidity.\51\
---------------------------------------------------------------------------

    \49\ See Credit Suisse Letter.
    \50\ See Interstate Letter.
    \51\ See STA Institutional Letter.
---------------------------------------------------------------------------

    Commenters also considered the impact of the Actual Size Rule on 
the Nasdaq market and the need for the Actual Size Rule in the context 
of more general changes to markets. Some commenters discussed what they 
perceive as a move from a quote to an order driven market due to 
institution of the Ordering Handling Rules.\52\ For some, this 
perceived movement removes the need for a mandatory minimum size 
requirement.\53\ Others note that mandatory minimum quote size gave 
investors access to the market, but now, through the Limit Order 
Display Rule, they have access by being able to impact stock prices and 
the size of quotes by displaying their limit orders.\54\ In sum, 
several commenters feel that the Order Handling Rules make mandatory 
size requirements unnecessary by, among other things, providing a new 
source of liquidity.\55\ Several commenters therefore believe that in 
this new, more order driven market, if a market maker mut display size 
greater than all other market participants, it may avoid being at the 
inside, which could reduce liquidity.\56\
---------------------------------------------------------------------------

    \52\ See Kinnard Letter; R. King Letter; Marino Letter; Singh 
Letter; STA Institutional Letter; and Lehman Letter.
    \53\ See, e.g., NAIB Letter; Morgan Letter; Knight Letter; 
Salomon Letter; Morgan Keegan Letter; 4/29 and 4/1 STA Letters; 
Interstate Letter; STANY Letter; STA Institutional Letter; ICI 
Letter; Wood Letter; Credit Suissee Letter; and ITAP Letter.
    \54\ See Mortgan Letter; Interstate Letter; and Barone Letter.
    \55\ See, e.g., M.H. Meyerson Letter.
    \56\ See Kaplowitz Letter.
---------------------------------------------------------------------------

    Commenters also evaluated the Actual Size Rule's impact on market 
quality. For instance, several commenters argued that the Actual Size 
Rule enhances liquidity. Notwithstanding the NASD's data to the 
contrary, some commenters believe that liquidity improved for pilot 
stocks and can be further improved by expanding the Actual Size 
Rule.\57\ One commenter believes that if the Actual Size Rule is 
permanently expanded, market makers should be able to make markets in 
more issues.\58\ Another states that lower barriers to entry and fewer 
reasons to exit will increase liquidity.\59\
---------------------------------------------------------------------------

    \57\ See American Century Letter; Anonymous Letter; and Morgan 
Keegan Letter.
    \58\ See Ohio Letter.
    \59\ See e.g., Howard Letter; Lopez-Rodriguez Letter; TD Letter; 
and STANY Letter.
---------------------------------------------------------------------------

    Some commenters believe that mandatory size requirements (which

[[Page 39327]]

adoption of the Actual Size Rule would serve to reduce) increase 
volatility.\60\ One commenter compares mandatory size to a free option 
for professional day traders using SOES that exacerbates the direction 
and velocity of price moves during times of high volatility.\61\ A 
commenter from a company whose stock was in the pilot stated that when 
his company's stock became subject to the Actual Size Rule, SOES 
activity decreased, thus lessening volatility.\62\ A similar comment 
was made by an official of a brokerage firm about securities subject to 
the Actual Size Rule.\63\ Others felt that SOES abuses along with 
mandatory size cause volatility,\64\ and that the Actual Size Rule 
could help reduce this excess volatility.\65\
---------------------------------------------------------------------------

    \60\ See ITAP Letter; and Weeden Letter.
    \61\ See American Century Letter.
    \62\ See Crawford Letter.
    \63\ See Edward Letter.
    \64\ See Crowell Letter; and Weedon & Co. Letter.
    \65\ See NAIB Letter.
---------------------------------------------------------------------------

    Commenters also contemplate the legal justifications for approving 
the proposal. Some commenters note that neither the Exchange Act nor 
Commission rules require quote sizes larger than 100 shares.\66\ 
Another notes that since the NASD's research indicates no harm to 
investors or the market by the Actual Size Rule, the absence of the 
Actual Size Rule renders market makers less competitive than ECNs and 
customer orders, neither of which have a minimum size requirement.\67\ 
The commenter contends that this disparity violates Exchange Act 
Section 15A(b)(9), which prohibits NASD rules imposing burdens on 
competition that are not necessary or appropriate.\68\
---------------------------------------------------------------------------

    \66\ See Salomon Letter; and TD Letter.
    \67\ See JP Morgan letter; See also, Bandler Letter; Barone 
Letter; Wilson-Davis Letter; M.H. Meyerson Letter; French Letter; 
Hughes Letter; and Knight Letter.
    \68\ See JP Morgan Letter; see also note 73 and accompany text.
---------------------------------------------------------------------------

    Finally, proponents focus on empirical research from the pilot to 
support their contentions. Several commenters found the NASD's March 
1998 Study reassuring because it found no adverse effects on market 
quality for the 150 securities subject to the Actual Size Rule 
pilot.\69\ Another commenter notes that the pilot was well 
documented.\70\ Another notes that the March 1998 Study is good because 
it was conducted after the implementation of the Order Handling Rules 
and assessed only one significant policy change for the pilot stocks--
the implementation of the Actual Size Rule.\71\ In addition, the March 
1998 Study's finding of no adverse effect on market quality and 
investor access to capital led a commenter to conclude that the next 
logical step is an Actual Size Rule for all stocks.\72\ In fact, 
commenters believed that given Nasdaq's findings, no justification 
exists under the Exchange Act, including Section 15A, for continued 
mandatory size.\73\ Another commenter feels that because the study 
shows no harm to the market by the Actual Size Rule, no reasonable 
basis exists for the Commission to adopt larger and more punitive 
minimum quote requirements for Nasdaq market makers.\74\
---------------------------------------------------------------------------

    \69\ See Barone Letter; Kinnard Letter; Howard Letter; Lopez-
Rodriquez Letter; M.H. Meyerson Letter; SIA Trading Letter; STA 
Institutional Letter; 4/29 and 4/1 STA Letters; and ITAP Letter.
    \70\ See American Century Letter.
    \71\ See Credit Suisse Letter.
    \72\ See Hughes Letter.
    \73\ See JP Morgan Letter; and Knight Letter.
    \74\ See Credit Suisse Letter.
---------------------------------------------------------------------------

B. Comments Opposing the Actual Size Rule

    Two hundred and eighteen letters opposed permanent expansion of the 
Actual Size Rule. Many are from day-traders who regularly place SOES 
orders. The Electronic Traders Association (``ETA'') \75\ and David 
Whitcomb (``Whitcomb''),\76\ Professor of Finance at Rutgers 
University, also opposed permanent expansion. The positions of ETA and 
Whitcomb are largely based upon Whitcomb's independent research on the 
impact of the Actual Size Rule.\77\ Whitcomb and ETA each attached to 
their respective comment letters a December 31, 1997, economic study 
(``Simaan-Whitcomb Study'') prepared by Yusif Simaan and Whitcomb.\78\ 
This study is discussed in detail in part III.C. below.
---------------------------------------------------------------------------

    \75\ ETA is an association of about 50 order entry firms and 
others interested in trading via computer.
    \76\ Whitcomb is also President and CEO of Automated Trading 
Desk, Inc. (``ATD''). ATD provides software and services for 
automated and computer-assisted limit order trading.
    \77\ The ETA and Whitcomb each submitted several comment letters 
concerning the Actual Size Rule proposal and each incorporated these 
letters by reference in the last submission. The Commission has 
carefully considered all of the comment letters the ETA and Whitcomb 
submitted, but for ease of reference, only the last letter each 
submitted has been cited.
    \78\ Simaan is an Associate Professor of Finance at Fordham 
University. Simaan's research was supported by a grant from ETA. ATD 
supplied the data for and supported Whitcomb's research.
---------------------------------------------------------------------------

    Opponents of the Actual Size Rule question the proposal's ability 
to improve the market's transparency and efficiency. One commenter 
notes that when the Commission originally approved the NASD's mandatory 
quote size requirements, it criticized market makers for not quoting 
for more than 100 shares and believed that a mandatory quote size 
requirement would give investors greater access to market information 
on the depth of the market for a particular security.\79\ Some 
commenters expressed concern that market makers underrepresent share 
size available.\80\ Another was concerned that market makers do not 
fill their entire quoted size.\81\
---------------------------------------------------------------------------

    \79\ See CHX Letter.
    \80\ See Klug Letter; Paracha Letter; and White Letter.
    \81\ See Leland Letter.
---------------------------------------------------------------------------

    Some commenters feel that if the elimination of the excess spread 
rule and the concomitant cut in market maker exposure did not encourage 
a market maker influx, then the Actual Size Rule will not.\82\ Others 
do not see mandatory size as a barrier to market makers, but a way to 
eliminate ``fair weather'' market makers,\83\ and fell that market do 
not need an incentive to take risks for which they already receive 
compensation.\84\
---------------------------------------------------------------------------

     \82\See 4/2/98 Getz Letter; see also Marungo Letter; Williams 
Letter; Yoon Letter; ETA Letter; and Whitcomb Letter.
     \83\ See G. Hunter Letter.
     \84\See Ghazi-Moghadam Letter.
---------------------------------------------------------------------------

    Some commenters view the Actual Size Rule as unfair because it 
removes a market maker responsibility while market markers continue to 
receive the same benefits for performing that function. In particular, 
some commenters note that market markers get several benefits, 
including the ability to sell short, special margin requirements, 
prestige and advertisement, spreads, and profits, and the possibility 
of more privileges from new systems in exchange for fulfilling their 
responsibility of providing liquidity and market stability, especially 
during volatile markets.\85\ Some commenters argue that if the 
mandatory quote size requirement is eliminated, then market maker 
benefits also should be discontinued.\86\ A commenter notes that market 
maker advantages allow them to profit or hedge long positions during 
declining markets, while individual investors rely solely on liquidity 
from market makers.\87\
---------------------------------------------------------------------------

    \85\See e.g., Andrews Letter; Gardner Letter; Ripoll Letter; 
Spencer Letter; Teitelman Letter; Thiagarajah Letter; Tieu Letter; 
Tom Letter; Truong Letter; Woods Letter; and Whitcomb Letter.
    \86\ See Bunda Letter, Klug Letter; and Truong Letter.
    \87\ See 4/2/98 and 3/23/98 Getz Letters.
---------------------------------------------------------------------------

    Some commenters also worried that the Actual Size Rule could hurt 
Nasdaq's reputation, perhaps leading investors to turn away from 
Nasdaq.\88\ Some commenters argued that the Actual Size Rule could also 
discourage

[[Page 39328]]

companies, particularly small, innovative ones, from coming to Nasdaq, 
for fear that their stocks would not be adequately supported.\89\
---------------------------------------------------------------------------

    \88\ See Carpenter Letter and Dubey Letter.
    \89\ See A. Friedman Letter and Maschler Letter.
---------------------------------------------------------------------------

    Some commenters feel that past and current instances of market 
maker manipulation militate against giving market makers the benefits 
of the Actual Size Rule. They worry that the Actual Size Rule system 
may harm the markets generally by permitting market makers to post 
small sized quotes during large supply/demand imbalances when depth and 
liquidity are at a premium.\90\ One commenter envisioned market makers 
manipulating the system to cut risk exposure \91\ and another noted 
that thinly traded issues are the most likely to be subjected to abuse 
as a result of the Actual Size Rule.\92\ Some commenters cite various 
past events indicating market maker problems like the publication of 
the Commission's Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD and The Nasdaq Stock Market 
(``21(a) Report'') and litigation and settlements involving the Nasdaq 
market and market Makers. Such a history of market maker abuses, they 
contend, undermines markets maker arguments relating to a competitive 
disadvantage resulting from mandatory size.\93\ Moreover, commenters 
claims that historic and continuing abuses by market markers counsel 
against taking a change on the Actual Size Rule or providing further 
opportunities for manipulation.\94\ For example, some commenters 
suggest that market makers use 100 share ``customer order'' at the 
inside to hold stocks,\95\ and that they hinder the momentum of stock 
movements and give themselves time to back away from quotes.\96\ In 
addition, some commenters contend that market have modified their 
trading behavior during the Actual Size Rule pilot and in bigger stocks 
to mask what may be the true adverse impact of the Actual Size Rule, 
should the Commission permanently approve it for all Nasdaq stocks.\97\
---------------------------------------------------------------------------

    \90\ See Arakawa Letter, Baldante Letter; Bhattacharyya Letter; 
Cook Letter; and Finn Letter.
    \91\See Cianfrani Letter.
    \92\See Carlsson Letter.
    \93\See Aunio Letter and Samarasinghe Letter.
    \94\See Downing Letter; Garza Letter; Klarsfeld Letter; Maschler 
Letter; Rock Letter; Romanow Letter; Rosen Letter; Singh Letter; 
Taub Letter; Wilson Letter; and Woods Letter.
    \95\See Gallagher Letter; 4/2/98 Getz Letter; and Haber Letter.
    \96\See Downing Letter; Mesh Letter; Roffman Letter; Rosenberg 
Letter; Stolker Letter; and Villanueva Letter.
    \97\See Gussin Letter; Levin Letter; Nadan Letter; and Romanow 
Letter.
---------------------------------------------------------------------------

    Opponents of the Actual Size Rule also focused on specific factors 
related to market quality. For instance, one commenter is uncertain 
whether the Commission should approve the Actual Size Rule at this 
time, arguing that liquidity is the near-exclusive function of market 
marker proprietary trading, unlike at exchanges where liquidity is 
mostly from persons other than specialists effecting transactions in 
their own accounts.\98\ Some question the basic premise of an order-
driven market, indicating that the market still is and needs to be a 
quote-driven, dealer market.\99\
---------------------------------------------------------------------------

    \98\ See CHX Letter.
    \99\ See Andrews Letter; Barry Letter; and Davar Letter.
---------------------------------------------------------------------------

    One commenter contended that in an order driven environment, 
mandatory quote size requirements coupled with SOES ensure investors 
receive fair executions in extreme market conditions.\100\ Another 
posited that customer orders cannot sustain the market, especially in 
times of duress.\101\ Even if there is an order-driven market, some 
commenters reject removing market makers' basic quote size 
responsibility.\102\ Other commenters claimed the NASD shows the ASR 
does not contribute to the narrowing of market maker spreads.\103\ 
Commenters also expressed concern that the Actual Size Rule will harm 
market liquidity, perhaps leading to price fluctuations and unfair 
prices.\104\ Commenters also question the NASD's evidence that the 
Actual Size Rule helps to lower barriers to market maker participation 
and thus aids liquidity and pricing efficiency.\105\ In addition, 
commenters are concerned that the Actual Size Rule's effect on heavily-
traded issues would differ from its effect on thinly-traded 
issues.\106\ One commenter expressed concern about mysterious 
fluctuations of size with changed volume in particular stocks.\107\ 
There was also concern about lesser known and start up issues where 
liquidity is low and volatility is high.\108\ Some commenters suggest 
the Actual Size Rule can or does increase volatility.\109\ Another 
commenter notes that volatility is particularly problematic for thinly 
traded securities.\110\ Some commenters emphasize that the Actual Size 
Rule decreases liquidity in an especially negative way when volatility 
is high and market makers would likely take actions like dropping to a 
100 share size.\111\ Commenters worry that during volatile times, large 
sized orders would be executed at unfair prices on different tier 
levels as prices rise or fall.\112\ Some commenters viewed the Actual 
Size Rule as legitimizing ``backing away'' by market makers.\113\ Some 
felt the events of October 1997 illustrate the need for market makers 
to quote mandatory minimum size.\114\
---------------------------------------------------------------------------

    \100\ See Fennell Letter.
    \101\ See Tom Letter.
    \102\ See Angelica Letter; Atreya Letter; Cianfrani Letter; 
Gleeson Letter; and Ripoll Letter; see also ETA Letter and Whitcomb 
Letter.
    \103\ See ETA Letter and Whitcomb Letter.
    \104\ See, e.g., Andrews Letter; Crabb Letter; CHX Letter; ETA 
Letter; Foster Letter; Gorman Letter; Hollander Letter; M. Kallman 
Letter; Leffler Letter; Maschler Letter; Nemeroff Letter; Walker 
Letter; and Whitcomb Letter.
    \105\ See ETA Letter and Whitcomb Letter.
    \106\ See, e.g., Arakawa Letter; Eisner Letter; Israel Letter; 
Rock Letter; Rudd Letter; and Williams Letter.
    \107\ See Valentine Letter.
    \108\ See Francis Letter.
    \109\ See e.g., Downing Letter; Haber Letter; Letter; M. Lu 
Letter; Teitelman Letter; and Woods Letter.
    \110\ See A. Friedman Letter.
    \111\ See e.g.,Andrews Letter; J. Goldstein Letter; Pak Letter; 
Teitelman Letter; Wei Letter; Williams Letter; and CHX Letter.
    \112\ See e.g.,Atreya Letter; Pflugfelder Letter; Tom Letter; 
Truong Letter; Weber Letter; and West Letter.
    \113\ See Barry Letter and Kiefer Letter.
    \114\ See e.g., Maschler Letter; McDonald Letter; Nadan Letter; 
Ryan Letter; Verbeke Letter; Weber Letter; Williams Letter; and Yoon 
Letter.
---------------------------------------------------------------------------

C. The Simaan-Whitcomb Study

    Because letters from the ETA and Whitcomb were the only letters 
that provided empirical data that conflicts with that in the NASD's 
studies, the Commission thought it appropriate to address these 
comments in greater detail. The ETA and Whitcomb comment letters make 
three basic assertions regarding the Actual Size Rule; (1) the body of 
empirical evidence suggests that both market quality and the ability of 
investors to use SOES has been adversely affected by the Actual Size 
Rule; (2) Nasdaq market making is not fully competitive, and hence 
conclusions that assume marketplace competition are invalid; and (3) 
the methodology employed in the analyses conducted by the NASD is 
flawed. Both letters rely heavily on the Simaan-Whitcomb Study, which 
states that its purpose is to present preliminary evidence on: (1) the 
percentage of the time that ECNs are alone at the inside bid or offer; 
(2) the aggregate ``inside'' quotation size of market makers and ECNs; 
and (3) the ``odd-sixteenths'' quotation behavior of ECNs and selected 
market makers.
    The Simaan-Whitcomb Study first discusses its preliminary findings 
concerning the percentage of time ECNs are alone at the inside bid or 
offer.\115\

[[Page 39329]]

The Simaan-Whitcomb Study states that:
---------------------------------------------------------------------------

    \115\ If one or more ECNs (and no market makers) are the only 
firms quoting the best bid or offer for a particular security, then 
ECNs may be said to be alone at the inside (bid or offer) for that 
security.
---------------------------------------------------------------------------

    On the one hand, this is evidence of the power of the Order 
Handling Rules, since any market maker filling a retail customer order 
(e.g., pursuant to a payment for order flow arrangement with the 
customer's broker) must match the ECN price under ``best execution'' 
rules. On the other hand, retail customers whose brokers do not have 
preferencing arrangements with a dealer can be disadvantaged. Most 
retail brokers do not have direct order entry interfaces with ECNs, and 
orders sent to Nasdaq's SOES are rejected when no market maker is at 
the inside. Brokers seeking automated execution of customer orders must 
use SelectNet to ``preference'' the ECN, a somewhat cumbersome and 
time-consuming process. In a sense, the percentage of time ECNs are 
alone at the inside is a measure of a remaining imperfection in the 
Nasdaq market.\116\
---------------------------------------------------------------------------

    \116\ Simaan-Whitcomb Study at 6.
---------------------------------------------------------------------------

    Next, the Simaan-Whitcomb Study posits that the aggregate 
``inside'' quotation size of market makers and ECNs (a measure of 
liquidity) has been harmed by the Actual Size Rule. The Simaan-Whitcomb 
Study relies on ``aggregate truncated size'' and ``aggregate quoted 
size'' to measure liquidity. The Simaan-Whitcomb Study claims that the 
NASD's liquidity measure is flawed for the following reason:

    The problem with [using the NASD's liquidity measure] is that 
infrequent very large bid sizes can have an inordinate impact on 
sample mean aggregate sizes. This might be fine if these large 
quotes were ``real'', but NASD rules permit a dealer to decline to 
fill an order larger than 1000 shares even if the dealer's quote 
exceeds the order size. Thus a more realistic measure of aggregate 
electronic liquidity is what we call ``Aggregate Truncated Size'', 
the sum over market makers of the portion of their quote sizes not 
exceeding 1000 shares. (Footnote omitted, emphasis added.) \117\

    \117\ Id. at 9.
---------------------------------------------------------------------------

    The ultimate point the Simaan-Whitcomb Study makes is that

market makers will reduce their quotes on the side of the market 
that is experiencing stress when they are free to do so. Putting it 
differently, it appears that mandatory minimum quotation sizes to 
effectively force market makers to provide more liquidity to the 
market, especially in times of stress.\118\
---------------------------------------------------------------------------

    \118\ Id. at 13.
---------------------------------------------------------------------------

D. The NASD's Response to Comments

    By letter, the NASD responded to comments submitted with regard to 
the ASR proposal.\119\ The NASD's letter primarily focused on the 
comments from the ETA and Whitcomb. The NASD argues that those 
commenters' empirical evidence is ``incomplete,'' and that the Simaan-
Whitcomb Study does not appropriately analyze the improved sample 
provided by the expansion of the pilot program. The NASD also disputes 
ETA's and Whitcomb's conclusions that the ASR reduced liquidity during 
extreme market conditions on October 27 and 28, 1997, and that the ASR 
diminished access through SOES to market maker capital.
---------------------------------------------------------------------------

    \119\ See NASD Response.
---------------------------------------------------------------------------

    The NASD also questions the basis for the commenters' beliefs about 
the marketplace, particularly the notion that it is not competitive. 
For instance, the NASD cites a lack of empirical evidence for the 
commenters' claims that the ASR would increase order flow preferencing. 
Moreover, the NASD emphasizes the experience of market participants 
suggesting an increasingly order driven market.
    In addition, as discussed below, the NASD points out perceived 
flaws in the studies producing the research relied upon by Whitcomb and 
the ETA. Finally, the NASD defends the methodology employed for its own 
research as being more representative and complete than that used by 
its detractors.\120\
---------------------------------------------------------------------------

    \120\ Id.; see also March 1998 Study at 64 for a detailed 
description of the methodology the NASD employed.
---------------------------------------------------------------------------

IV. Discussion

    The Commission approved the Actual Size Rule on a pilot basis so 
that it could assess the effects of the rule on Nasdaq market quality 
and investor access to automatic execution systems over a several month 
long period. At the time the pilot was adopted, the Commission noted 
that it ``preliminarily believes that the proposal will not adversely 
affect market quality and liquidity'' \121\ 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.'' \122\ 
The Commission also 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.'' \123\
---------------------------------------------------------------------------

    \121\ Id.
    \122\ See Release No. 38156, supra note 3, 62 FR at 2423.
    \123\ Id. at 2424.
---------------------------------------------------------------------------

    During the pilot, the Commission assessed the potential impact of 
the Actual Size Rule on the Nasdaq market and on investors over periods 
of relative market calm as well as over a period of sudden market 
volatility (i.e., October 27-28, 1997). It also reviewed the NASD's two 
comprehensive studies on the Actual Size Rule. In these studies, the 
NASD analyzed the Actual Size Rule's impact on market quality and 
investors' access to capital, both before and after the full 
implementation of the Order Handling Rules. The Commission also 
reviewed studies funded by the ETA and hundreds of comment letters from 
investors, broker-dealers, trade groups, and others representing all 
constituencies in the marketplace. Based on this detailed record of 
empirical data and comments regarding the impact of an expanded Actual 
Size Rule, the Commission still believes that the Actual Size Rule will 
not adversely affect the quality of the Nasdaq market. Indeed, the 
Commission remains convinced that the Actual Size Rule removes a 
barrier to market making in the Nasdaq market, as well as a requirement 
that has been rendered unnecessary by the Commission's Order Handling 
Rules. As a result, the Commission believes that removing Nasdaq's 
minimum quote requirements is consistent with the Exchange Act. In 
particular, as discussed below, the Actual Size Rule is consistent with 
Sections 11A and 15A of the Exchange Act.
    In 1990, the Commission approved an NASD proposal to require Nasdaq 
market makers to quote size ``at least equal to the maximum size of an 
order eligible for automatic execution in SOES.'' \124\ In doing so, 
the Commission noted that ``[m]arket makers presently are willing to 
execute trades well in excess of the 100 share size that is typically 
displayed on NASDAQ'' \125\ and that size was not being reflected in 
their quotes to the public. In approving the proposal, the Commission 
noted that the minimum quote size requirements could help provide ``a 
more realistic picture of the actual size of execution available and 
the depth of the market in each security.'' \126\ This rationale for 
requiring Nasdaq market makers to quote at least 1,000 shares (or 200 
or 500 shares for less active stocks) when exchange specialists need 
only quote 100 shares was pertinent to Nasdaq in 1990 when only market 
maker quotes established the Nasdaq inside spread and customer limit 
orders were rarely reflected in market maker quotes. The rationale has 
been removed by the successful implementation of the Order

[[Page 39330]]

Handling Rules. The Order Handling Rules enable investors' limit orders 
and limit orders displayed on ECNs to set the Nasdaq inside quote, so 
that reliance solely on market makers' quotes is no longer necessary. 
Data has demonstrated that the Order Handling Rules have helped to 
narrow Nasdaq spreads considerably.\127\
---------------------------------------------------------------------------

    \124\ See Exchange Act Release No. 28450 (September 18, 1990) 55 
FR 39221 (September 25, 1990).
    \125\ Id.
    \126\ Id.
    \127\ See March 1998 Study; see also NASD Economic Research, 
``Implementation of the SEC Order Handling Rules,'' October 14, 1997 
(``October 1997 Study''); and Simaan-Whitcomb Study at 4.
---------------------------------------------------------------------------

    As detailed by the NASD in the March 1998 Study, by permitting 
dealers to quote their true trading interest, the Actual Size Rule 
affords market makers more flexibility to manage risk. Removing minimum 
quote size requirements also will enable market makers to reflect size 
in their quotations based on business and market factors instead of 
regulatory imposed minimums. This, over time, should increase the 
information content of market makers' quotations. Further, requiring 
market makers to maintain a minimum quote size without imposing a 
similar commitment on ECNs or investors, which also may display quotes, 
could impair the ability of market makers to set competitive 
quotations. Such a result is antithetical to the intent of the Order 
Handling Rules: That market maker quotes, limit orders, and limit 
orders displayed on ECNs all compete to set the Nasdaq inside spread. 
The 1,000 share minimum also can be viewed as a barrier to entry of new 
firms to market making in Nasdaq securities.\128\
---------------------------------------------------------------------------

    \128\ The Commission believes there are substantial reasons to 
expect that once the Actual Size Rule reduces regulatory constraints 
on market maker capital commitment for all Nasdaq securities, it 
will become increasingly likely that, over time, barriers to entry 
for market making will be reduced.
---------------------------------------------------------------------------

    After reviewing the June 1997 Study, the Commission concluded that 
it ``preliminarily believes that the data indicates that the pilot has 
not resulted in harm to the Nasdaq market.'' \129\ Nevertheless, the 
commission decided that it would be appropriate to gather further data 
before determining whether to extend the Actual Size Rule to the entire 
Nasdaq market.\130\ The Commission also noted that certain concerns 
raised by some commenters could be addressed by extending the pilot and 
expanding it to 150 securities. The Commission determined that based 
``upon the expanded pilot, the Commission will be in a better position 
to evaluate the impact of the Actual Size rule upon the Nasdaq 
market.'' \131\ The Commission specifically asked the NASD to conduct a 
second study to analyze market quality measures (i.e., spreads, 
volatility, depth, and liquidity) as well as investor access to market 
maker capital. The pilot was expanded to 150 Nasdaq securities on 
November 10, 1997, and extended to March 27, 1998.\132\
---------------------------------------------------------------------------

    \129\ See Release No. 39285, supra note 3, 62 FR 59936.
    \130\ Id.
    \131\ Id.
    \132\ Id.
---------------------------------------------------------------------------

    As the Commission requested, in this second study (the March 1998 
Study) the NASD analyzed each market quality measure. This expanded 
pilot study permitted a more definitive comparison of pilot and non-
pilot securities as a whole, providing a basis for a final conclusion 
concerning the Actual Size Rule's effect on Nasdaq securities and its 
effect on relatively active versus inactive securities. In response to 
concerns that the Actual Size Rule would cause a ``reduction of 
liquidity during periods of stress,'' \133\ the NASD also included in 
the March 1998 Study an empirical analysis of trading on October 27 and 
28, 1997, a period in which the U.S. securities markets experienced a 
significant degree of volatility.
---------------------------------------------------------------------------

    \133\ See Letter from Richard Y. Roberts, on behalf of the ETA, 
to Jonathan G. Katz, Secretary, SEC, dated October 30, 1997.
---------------------------------------------------------------------------

    The NASD's March 1998 Study led the NASD to conclude that there is 
no empirical evidence that the implementation of the Actual Size rule 
is associated with any degradation of Nasdaq market quality or of 
investors' access to automatic execution systems. Specifically, the 
NASD found no statistically significant empirical evidence that the 
Actual Size Rule negatively impacted spreads, depth, volatility, 
liquidity, or investors' access to automatic execution systems, even 
during October 27 and 28, 1997. These findings were consistent with 
those the NASD made in its June 1997 Study.
    The Commission has analyzed carefully the NASD's methodologies and 
analyses and finds that they are reasonable, rigorous, and credible. 
The NASD's decision to study the expanded group of pilot stocks is 
appropriate, as is the NASD's choice of time periods used to study the 
Actual Size Rule's potential effects. The NASD analyzed various 
measures of market quality and investor access to automatic execution 
systems and explained in great detail how the data was generated, 
analyzed, and how it controlled for changes in stock-specific trading 
characteristics such as price, volume, and intraday volatility. 
Commenters were given ample opportunity to critique the NASD's studies 
and to conduct their own studies.
    The Commission extended and expanded the pilot to give the NASD 
time to produce data that could be used to address concerns about the 
representatives of the original 50-stock pilot. The Commission is 
satisfied that the March 1998 Study has adequately addressed those 
concerns by studying a wider range of securities over a longer period. 
Based on those studies, the Commission is satisfied with the NASD's 
determination that the implementation of the Actual Size Rule did not 
cause any degradation of the Nasdaq marketplace or of investors' access 
to automatic execution systems.
    In determining whether to approve the Actual Size Rule on a 
permanent basis, the Commission gave careful consideration to the many 
comments it received in addition to the empirical studies produced by 
the NASD. Many of the positive comment letters were from firms that 
either engage in market making activities or have retail or 
institutional customers they believe will benefit from perceived gains 
in competition. They believe that the Actual Size Rule aids their 
market making activities and allows them to better serve their 
customers. One firm states that it has ``become more active in the 
stocks under the Pilot program due to [its] ability to properly manage 
[its] risk.''\134\ Several commenters note that by cutting barriers to 
entry, the Actual Size Rule should encourage market maker 
participation, including that of smaller firms.\135\ These comments 
reflect the burdens of a minimum share requirement on market making and 
the potential benefits of the Actual Size Rule.
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    \134\See M.H. Meyerson Letter.
    \135\ See, e.g., JP Morgan Letter; Ohio Letter; Marino Letter; 
Merrill Letter; Knight Letter; 4/29 and 4/1 STA Letter, Jefferies 
Letter; Howard Letter; STANY Letter; and Weeden Letter.
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    The Commission also received a comment letter from the ICI, a 
national association of the investment company industry, favoring the 
rule proposal. The ICI's membership includes 6,976 mutual funds, 447 
closed-end funds, and 10 sponsors of unit investment trusts. It mutual 
fund members represent more than 63 million individual shareholders and 
manage more than $5 trillion.
    Manyu of the Opposing comment letters were form firms or 
associations that benefit in some way from the mandatory minimum quote 
size requirements. For instance, the ETA--which represents about 40 
order entry firms and others interested in trading via computer--
opposes the Actual Size Rule.

[[Page 39331]]

    A number of the opposing comment letters were submitted by or on 
behalf of day traders. Not surprisingly, these commenters oppose the 
Actual Size Rule, which limits their ability to affect SOES executions 
large enough to maximize day trading strategies. Although the 
Commission weighed this small group of professional investors' concerns 
very carefully in determining whether to approve the proposal, 
ultimately the Commission has concluded that it is in the best 
interests of the majority of investors, as well as the markets, to 
permit Nasdaq to remove the minimum mandatory quote size 
requirements.\136\ Thus, even though the Actual Size Rule may alter 
somewhat the dynamics of electronic trading in Nasdaq securities 
(offset, however, by the Order Handling Rules), the Commission believes 
that the Actual Size should operate evenhandedly to all investors, 
should not impose discriminatory or anti-competitive costs, and should 
not impair transparency. There is no basis for concluding that the 
Actual Size Rule was designed to benefit market makers at the expense 
of the Nasdaq market.
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    \136\ The Commission recognizes that, under one possible 
economic theory, SOES day traders may have an impact on pricing 
efficiency (while imposing certain costs on market making). 
According to this theory, SOES day traders' ability to exploit a 
price disparity between different market makers' quotations may 
provide an incentive for market makers to monitor closely market 
information and to incorporate quickly that information into their 
quotations. An NASD study suggests, however, that day traders have a 
reduced role to play in pricing efficiency due to the SEC's Order 
Handling Rule. See October 1997 Study. Further, based on the NASD's 
March 1998 Study, the Actual Size Rule's impact on day traders--as 
measured by the percentage of SOES orders fully executed at a single 
price and by the average size of an executed SOES order--appears to 
be minimal. Finally, any minor impact the Actual Size Rule may have 
on day traders should be outweighed by the Actual Size Rule's likely 
long-term benefits to investors and the Nasdaq market, as discussed 
throughout this order.
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    Nevertheless, the Commission gave serious consideration to the 
negative comment letters. First the Commission notes that several 
comment letters allege market maker abuses any try to relate them to 
the need for a minimum quote sized requirement. The Commission takes 
allegations of market maker abuse very seriously and has and will 
continue to monitor the NASD's surveillance of market-making activity 
very closely. None of the comment letters, however, provide any 
concrete evidence to suggest that such abuses are on-going or occur 
more frequently in securities subject to the Actual Size Rule than in 
the non-ASR securities. Moreover, the Order Handling Rules are a much 
more effective and market-oriented approach to prevent abusive quoting 
behavior than artificial quote size minimums, especially when combined 
with the NASD's enhanced market maker surveillance.
    Some commenters expressed concern that the Actual Size Rule could 
hurt Nasdaq's reputation, perhaps leading investors to turn away from 
Nasdaq. Nasdaq's reputation and ability to compete without other 
markets will likely rest, however, on measures of market quality such a 
liquidity, volatility, depth, and spreads. As discussed above, the 
NASD's March 1998 Study suggests that such measures are not materially 
affected by the Actual Size Rule.
    The Commission gave careful scrutiny to the Simaan-Whitcomb Study 
(which was attached to comments from Whitcomb and the ETA). Ultimately, 
however, the Commission finds the NASD's analysis more complete and 
persuasive. For example, for the reasons discussed below, the data 
analyzed in the NASD's March 1998 Study differs significantly from that 
analyzed in the Simaan-Whitcomb Study, as do the conclusions drawn by 
the NASD and the Simaan-Whitcomb Study's authors and the ETA.\137\ In 
determining which conclusions deserve greater credence, the Commission 
compared the data sets the studies analyzed. The Commission also 
compared the economic analyses undertaken by the NASD and Professors 
Whitcomb and Simaan. As discussed below, the Commission gave greater 
weight to the NASD's study because it analyzed more securities for a 
longer period of time and used, the Commission believes, more rigorous 
economic tools to reach its conclusions.
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    \137\ In addition, both the ETA and Whitcomb take issue with the 
economic theory discussed in the March 1998 Study. Briefly, Whitcomb 
argues that Nasdaq is an oligopolistic market and both the ETA and 
Whitcomb posit that the Actual Size Rule will not benefit Nasdaq as 
the NASD believes. The ETA and Whitcomb base these arguments 
primarily on their assertions that Nasdaq market makers do not 
engage in quotation price competition because of preferencing 
arrangements, among other things. They also argue that because 
Nasdaq market making is already very profitable there is no threat 
that market makers will drop Nasdaq stocks and therefore no need to 
provide the Actual Size Rule as an incentive. Neither the ETA nor 
Whitcomb offer any evidence, however, concerning either Nasdaq 
market makers' profitability or about preferencing.
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    The Simaan-Whitcomb Study analyzes Nasdaq trades and quotes for 
two, ten-day periods, one in September 1997 and one in October 1997. 
The NASD's March 1998 Study compares 18 trading days between October 13 
and November 7, 1997, with 20 trading days between November 10 and 
December 9, 1997--a significantly larger sample of trading days.
    Further, the Simaan-Whitcomb Study generally compares the ``First 
40'' stocks (for which mandatory 1,000 share proprietary quote sizes 
were waived) with the ``Second 40'' (which are subject to minimum 
proprietary quote sizes of 1,000 shares).\138\ The March 1998 Study 
compares a much larger sample of securities: the pilot stocks and a 
control group of peer stocks (the non-pilot stocks) that remained 
subject to mandatory minimum quote sizes. The pilot stocks group was a 
stratified random sample that was more representative of the entire 
Nasdaq marketplace than the 50 stocks that became subject to the Actual 
Size Rule on January 20, 1997.\139\ The Simaan-Whitcomb Study does not 
analyze this improved sample, even though Whitcomb, one of the Simaan-
Whitcomb Study's authors, earlier requested such sample improvements, 
urging the Commission to ``insist that [the] NASD pick a stratified 
random sample that is balanced across stock groups.'' \140\
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    \138\ The first 50 stocks subject to the Order Handling Rules 
were also the first 50 stocks subject to the Actual Size Rule 
(``First 50''). The second group of 50 stocks subject to the Order 
Handling Rules (``Second 50'') were used as a control group, since 
they were not initially subject to the Actual Size Rule. Both groups 
include 40 stocks selected from the first through fifth deciles of 
the 1,000 most active Nasdaq stocks. These two groups were used as 
peers by the NASD in its June 1997 Study and by Professors Simaan 
and Whitcomb in the Simaan-Whitcomb Study and are referred to as the 
``First 40'' and the ``Second 40.'' The remaining 10 stocks in the 
first tranche were roughly the top 10 stocks (``First 10'') based on 
median daily dollar volume, and the remaining 10 from the second 
tranche were roughly stocks 11 through 20 (``Second 10''). 
Consistent with the Commission's request for a ``matched pairs 
analysis,'' the First 10 and Second 10 are excluded from this 
analysis, because these groups do not demonstrate similar trading 
characteristics and hence cannot be properly compared. See Release 
No. 38156, supra note 3, at 62 FR 2425. Indeed, including the First 
10 and Second 10 would likely produce skewed results. The market 
quality improvements produced by the Order Handling Rules, however, 
are apparent in both the First 10 and the Second 10. See June 1997 
Study at 22.
    \139\ See March 1998 Study at Section III.C.2; see also Release 
No. 39285, supra note 3, 62 FR at 59937 (In that order, the 
Commission stated that 100 securities added to the pilot ``include 
securities with significantly different trading volumes, so the NASD 
will be better able to assess the impact of the Actual Size Rule on 
the full panoply of Nasdaq stocks. This will further the evaluation 
of the Actual Size Rule and will assist the SEC in its determination 
as to whether to expand the pilot ultimately to all Nasdaq 
securities or to end it.'').
    \140\ See Letter from David K. Whitcomb to Jonathan G. Katz, 
Secretary, SEC, dated July 3, 1997.
---------------------------------------------------------------------------

    The Commission also discounted the Simaan-Whitcomb Study because it 
ignores significant changes to the NASD's rules. Specifically, the 
Simaan-

[[Page 39332]]

Whitcomb Study expresses concern that many investors do not have 
adequate access to SOES trades while an ECN is alone at the 
inside.\141\ As an initial matter, this concern could exist whether or 
not the Actual Size Rule was approved, and its relevance to the size of 
a market maker's quote is questionable. Nevertheless, this concern was 
reduced by subsequent Nasdaq rule changes. In particular, on February 
10, 1998, the Commission noticed a proposed change to NASD Rule 
4730(b)(1) that became effective immediately, pursuant to Section 
19(b)(3)(A) of the Exchange Act and Rule 19b-4(e)(5) thereunder.\142\ 
The NASD proposed the rule change to address problems associated with 
the rejection of orders in SOES when there is no market maker at the 
inside quote. Previously, under NASD Rule 4730(b)(10), an ECN quote 
that was the best bid or offer in a security would effectively halt 
executions in SOES. Orders that had execution priority before the ECN 
order became the inside bid or offer were rejected. Now, these orders 
will be held in a queue for 90 seconds to allow the market to create a 
new inside bid or offer.
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    \141\ See Simaan-Whitcomb Study at 6-9.
    \142\ Exchange Act Release No. 39637 (February 10, 1998) 63 FR 
8242 (February 18, 1998) (SR-NASD-98-05).
---------------------------------------------------------------------------

    The rule change operates when an ECN or a market participant with 
unlisted trading privileges is alone at the inside in a Nasdaq National 
Market security. In this situation, executable SOES orders that are in 
queue or received at that moment will be held for a specified period of 
time. This ``hold time,'' initially set at 90 seconds, is the maximum 
life of an order. Holding the queued orders for 90 seconds will give 
other market makers time to adjust their quotes to create a new inside, 
join the ECN at its price, or allow the ECN to move away from the 
inside. If one of these conditions is met and the order is still 
executable, it will execute. If any of these conditions do not occur, 
however, the order will time out, under normal time-out processing, and 
be returned to the entering firm at the end of the 90-second maximum 
life of the order. Nasdaq SmallCap securities will continue to execute 
against the next available SOES market maker at the ECN price. This 
concern raised by the ETA and Whitcomb, while not a result of the 
Actual Size Rule, therefore has been reduced, because SOES orders have 
a longer opportunity to be executed when an ECN is at the inside 
market.\143\
---------------------------------------------------------------------------

    \143\ The Commission also notes that in criticizing the NASD's 
liquidity measure in favor of the Simaan-Whitcomb Study's 
methodology, the Simaan-Whitcomb Study mischaracterizes a dealer's 
obligations under the Firm Quote Rule and NASD Rule 4613(b). See SEC 
rule 11Ac1-1 (Firm Quote Rule) and NASD Rule 4613(b). Both rules 
require market makers to honor their quotes even if those quotes 
exceed the mandatory minimum quotation size. The Simaan-Whitcomb 
Study's rationale for claiming that the liquidity measures it uses 
are better than the ones the March 1998 Study uses is therefore 
suspect.
---------------------------------------------------------------------------

    The Simaan-Whitcomb Study also asserts that ``market makers will 
reduce their quotes on the side of the market that is experiencing 
stress when they are free to do so.'' This assertion, which is provided 
without empirical support, is in conflict with the March 1998 Study's 
data and the NASD's analysis showing that liquidity and depth for both 
Actual Size Rule and non-ASR stocks was substantially the same.\144\ 
Given that the better analysis of the data produced by the pilot 
indicates that the Actual Size Rule affected the liquidity and depth of 
pilot and non-pilot securities similarly, the Simaan-Whitcomb Study's 
concerns about liquidity appear unfounded.
---------------------------------------------------------------------------

    \144\ See March 1998 Study at 92-100.
---------------------------------------------------------------------------

    The March 1998 Study and the Simaan-Whitcomb Study also differ in 
their analysis of data concerning market quality measures. For example, 
as the NASD notes in its June 1, 1998, letter responding to commenters 
that criticized the NASD proposal,

    Both the ETA and Whitcomb Letters cite evidence contained in the 
Simaan-Whitcomb Study that purports to demonstrate that the Actual 
Size Rule reduced liquidity during the extreme market conditions of 
October 27 and 28, 1997. The analysis is based solely on aggregate 
quoted size--a limited measure of liquidity--and a flawed derivative 
measure, ``aggregate truncated size.'' Based on these limited 
measures, the ETA and Whitcomb Letters conclude that investors 
experienced a reduction in access to market maker capital during 
October 27 and 28, 1997 due to the Actual Size Rule. A more direct 
analysis of the issue--involving actual SOES orders--was included in 
the [NASD's] March 1998 Study, which found that 98.1% of SOES orders 
in a group of Actual Size Rule stocks were fully executed at a 
single price during October 27 and 28, 1997, compared to 98.3% of 
SOES orders in a group of stocks not subject to the Actual Size 
Rule. (Footnotes omitted.)

    In addition, the NASD notes that the liquidity measure called 
``aggregate truncated size'' used in the Simaan-Whitcomb Study assumes 
quotes above 1,000 shares are not real. Use of this measure is based on 
a misunderstanding that ``NASD rules permit a dealer to decline to fill 
an order larger than 1,000 shares even if the dealer's quote exceeds 
the order size.'' \145\ As discussed above, market makers must honor 
their quotes even if they are for 1,000 shares or more.\146\
---------------------------------------------------------------------------

    \145\See Simaan-Whitcomb Study at 9.
    \146\See note 143, supra.
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    Moreover, as noted by the NASD in its June 1, 1998, letter, the 
Simaan-Whitcomb Study compares levels of quoted aggregate depth without 
controlling for stock price. Citing the Simaan-Whitcomb Study, the 
Whitcomb letter states that the average quoted depth of a group of 
stocks subject to the Actual Size Rule (i.e., the First 40) constituted 
80% to 85% of the average quoted depth for a comparable group of stocks 
not subject to the Actual Size Rule (i.e., the Second 40). As the NASD 
notes, the Simaan-Whitcomb Study fails to consider that the First 40 
stocks are more expensive than the Second 40 Stocks. According to the 
NASD, in January 1997, the average share price of the First 40 stocks 
was $39 and the average share price for the Second 40 stocks was only 
$34. The NASD concludes that the depth quoted by market makers is, 
therefore, similar for both groups in terms of dollars of capital 
committed. The Commission believes this conclusion is reasonable.
    In addition, the letters from both the ETA and Whitcomb cite the 
Simaan-Whitcomb Study as well as a report submitted by the ETA 
regarding automatic executions in the Nasdaq marketplace (``ETA 
Report'').\147\ Whitcomb cites the ETA Report for the proposition that 
the completion rate for SOES orders fell for ASR securities but rose 
for non-ASR securities. The NASD argues that the ETA Report's measure 
is seriously flawed because it (1) includes orders that were actively 
canceled by the order-entry firm, which were a substantial majority of 
unexecuted orders, and (2) fails to account for substantial differences 
between trading characteristics of stocks included in the 
analysis.\148\ The NASD concludes, and the Commission believes this 
conclusion is reasonable, that the evidence presented in the NASD's 
June 1997 and March 1998 Studies demonstrates that a substantial 
majority of SOES orders are fully executed at a single price level.
---------------------------------------------------------------------------

    \147\ See ETA and DRI/McGraw-Hill, ``Analysis of Automatic 
Executions on the Nasdaq Stock Market,'' May 1997, submitted as 
Attachment I of Letter from Richard Y. Roberts, on behalf of the 
ETA, to Jonathan G. Katz, Secretary, SEC, dated May 12, 1997.
    \148\ See Letter from Richard Ketchum, Chief Operating Officer, 
NASD, and Dean Furbuth, Chief Economist and Senior Vice President, 
NASD, to Jonathan G. Katz, Secretary, SEC, dated June 17, 1997.

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[[Page 39333]]

    This conclusion rebuts some commenters' assertions that it is 
difficult to fill orders over 100 shares close to the inside market 
without multiple executions, potentially occurring at different price 
---------------------------------------------------------------------------
levels.\149\ The NASD concluded in the March 1998 Study, however, that

    \149\ See, e.g., R. Chung Letter; Eisner Letter; Meurer Letter; 
Sanbeg Letter; Sherwood Letter; Wieser Letter; Wilson Letter; and 
Zatorski Letter.
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98.5% of SOES orders (98.3% of volume) were fully executed at a 
single price for pilot stocks after implementation of the Actual 
Size Rule. For non-pilot stocks, 98.9% of orders (98.8% of volume) 
were executed at a single price during this period. Multiple price 
SOES executions are rare for both groups; only 1.3% and 0.9% of SOES 
orders (1.5% and 1.1% of volume) were executed at multiple prices 
for the pilot stocks and non-pilot stocks, respectively, post-
implementation. Clearly, the Actual Size Rule has had no measurable 
impact on SOES order disposition. (Footnotes omitted.) \150\

    \150\ March 1998 Study at 87-88.
---------------------------------------------------------------------------

    The March 1998 Study also made important findings that rebutted 
claims that investors' access to automatic executions was compromised 
by the Actual Size Rule. The March 1998 Study found that

    As with Nasdaq's SOES system, proprietary autoexecution systems 
provide investors with immediate access to market maker capital 
through automatic executions at the inside market. Unlike SOES, 
however, these systems often automatically execute orders for sizes 
well above 1,000 shares, which is the largest SOES tier size. Also 
unlike SOES, these systems are operated at the discretion of the 
market maker, which generally sets size parameters for proprietary 
autoexecution systems. Parameters usually vary by stock and 
customer. Further, market makers determine which customers may use 
the systems. Accordingly, these systems are not perfect substitutes 
for SOES. The importance of these systems to individual investors 
should not be underestimated, however, because a number of the 
largest national brokerage houses use them to provide immediate, 
automated access to market maker capital.\151\
---------------------------------------------------------------------------

    \151\ Id. at 89.
---------------------------------------------------------------------------

* * * * *
    Like Nasdaq's SOES system, proprietary autoexecution systems 
provide investors immediate access to market maker capital. Indeed, 
the analysis of data provided by Participant Firms underscores the 
importance of these systems to the marketplace. The survey conducted 
by NASD Economic Research and empirical analysis of these data 
demonstrates that the Actual Size Rule has not impacted these 
important systems in any way.\152\

    \152\ Id. at 90.
---------------------------------------------------------------------------

    In sum, the Commission approved the NASD's rule change (to require 
Nasdaq market makers to quote at least 1,000 shares) in 1990 out of 
concern that market maker quotations at that time did not provide a 
realistic picture of execution size available and the depth of the 
market. The NASD's data shows that this is no longer the case. Thus, in 
light of the changes brought about by the Order Handling Rules, which 
have served to make the Nasdaq market significantly more order-driven, 
and the empirical research indicating no material adverse impact of the 
Actual Size Rule on investors or the Nasdaq market, and after carefully 
considering all of the comment letters, the Commission has concluded 
that minimum quotation sizes are no longer necessary and should be 
removed for all Nasdaq stocks.
    The Commission therefore finds that the proposed rule change is 
consistent with the Exchange Act, including Sections 11A(a)(1)(C), 
15A(b)(6), and 15A(b)(11). Specifically, 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)(11) requires that the rules of a national securities 
association be designed to produce fair and informative quotations and 
to prevent fictitious or misleading quotations, among other things.
    As discussed above, the Commission believes that the Actual Size 
Rule should not have a material adverse impact on market spreads, 
volatility, depth, liquidity, or investor access. In addition, the 
Actual Size Rule should give market makers more flexibility to manage 
their risk. Removing the current minimum size requirements enables 
market makers to reflect size in their quotations based on market and 
business factors instead of a regulatory-imposed minimum. This should 
increase the information content of market makers' quotes. Finally, by 
removing the current regulatory size requirements, the Actual Size Rule 
removes a barrier to entry for making markets in Nasdaq securities. The 
Commission believes that the net long-term results of the Actual Size 
Rule should benefit market makers and investors without adversely 
affecting market quality.

V. Conclusion

    For the reasons discussed above, the Commission finds that the 
NASD's proposal is consistent with the Exchange Act (specifically, 
Sections 11A and 15A of the Exchange Act) and the rules and regulations 
thereunder applicable to a national securities association and has 
determined to approve the NASD's proposal to amend NASD Rule 
4613(a)(1)(C) permanently to allow Nasdaq market makers to quote their 
actual size by reducing the minimum quotation size requirement for 
Nasdaq market makers in all Nasdaq securities to one normal unit of 
trading.\153\
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    \153\ In approving this rule, the Commission has considered the 
proposed rule's impact on efficiency, competition, and capital 
formation. As discussed above, the proposed rule likely will produce 
more accurate and informative quotations, increase competition, and 
encourage market makers to maintain competitive prices.
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,\154\ that the proposed rule change, SR-NASD-98-21, be and 
hereby is approved.

    \154\ 15 U.S.C. 78s(b)(2).
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    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-19436 Filed 7-21-98; 8:45 am]
BILLING CODE 8010-01-M