[Federal Register Volume 63, Number 168 (Monday, August 31, 1998)]
[Notices]
[Pages 46264-46267]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-23279]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40354; File No. SR-NASD-98-54]


Self-Regulatory Organizations; Notice of Filing and Immediate 
Effectiveness of Proposed Rule Change and Amendment No. 1 Thereto by 
the National Association of Securities Dealers, Inc. Relating to Public 
and Non-member Access to Nasdaq's SelectNet and SOES Systems through a 
Member Firm's Own System

August 24, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on July 30, 1998, the 
National Association of Securities Dealers, Inc. (``NASD'' or 
``Association'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') through its wholly owned subsidiaries, NASD 
Regulation, Inc. (``NASDR'') and The Nasdaq Stock Market, Inc. 
(``Nasdaq''), the proposed rule change as described in Items I, II, and 
III below, with Items have been prepared by the NASD. On August 21, 
1998, the NASD submitted to the Commission Amendment No. 1 to the 
proposed rule change.\2\ The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
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    \1\ U.S.C. 78s(b)(1).
    \2\ In Amendment No. 1, the Exchange made technical corrections 
to the proposed Notice to Members. See Letter from John Ramsay, Vice 
President and Deputy General Counsel, NASDR, to Richard Strasser, 
Assistant Director, Division of Market Regulation (``Division''), 
Commission, dated August 20, 1998 (``Amendment No. 1''). On August 
24, 1998, additional technical amendments were made to the Notice to 
Members to correct typographical errors. Telephone conversation 
between David A. Spotts, Office of General Counsel, NASDR, and 
Kenneth Rosen, Attorney, Division, Commission (August 24, 1998).
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The NASD is proposing to clarify in a Notice to Members the 
requirements for members to provide electronic access to Nasdaq's 
SelectNet service and its Small Order Execution System (``SOES'') to 
public customers and non-members through the member firm's own system.
    The text of the proposed Notice to Members is included in Appendix 
I.

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

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposal. The text of these 
statements may be examined at the places specified in Item IV below. 
The NASD has prepared summaries, set forth in sections A, B, and C 
below, of the most significant aspects of such statements.

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

    With the advent of enhanced software and telecommunications 
capabilities, NASD members are able to provide their customers with 
efficient electronic access to SelectNet and SOES. Several members have 
asked NASD staff about the requirements for allowing such access. NASD 
staff envisions that this access capability would operate much the same 
way that the New York Stock Exchange has allowed its members to offer 
access to NYSE's DOT system. NASD staff is publishing a Notice to 
Members, attached as Appendix I, to clarify the NASD's interpretation 
of its rules and its contract with members and outline issues that NASD 
members must be aware of in offering their customers electronic access 
to Nasdaq's execution services. This Notice to Members follows up on an 
interpretive letter that Nasdaq staff issued to a member in April 1998 
regarding non-member access to SelectNet.\3\ The Notice to Members 
provides details not contained in the interpretive letter and expands 
the discussion to address non-member access to SOES as well as 
SelectNet. Because the services differ, the NASD has discussed issues 
regarding each system separately.
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    \3\ Letter form Eugene A. Lopez, Vice President, Trading and 
Market Services, Nasdaq, to Lloyd H. Feller, Morgan, Lewis & 
Bockius, dated April 15, 1998.
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    The NASD believes that the proposed rule change is consistent with 
Section 15A(b)(6) of the Act,\4\ which requires, among other things, 
that the NASD's rules promote just and equitable principles of trade, 
facilitate securities transactions, and protect investors.
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    \4\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended.

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

    Written comments were neither solicited nor received.

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

    The foregoing rule change has become effective upon filing pursuant 
to Section 19(b)(3)(A) of the Act \5\ and Rule 19b-4(e)(1) \6\ 
thereunder in that it constitutes a stated policy, practice, or 
interpretation with respect to the meaning, administration, or 
enforcement of an existing rule of a self-regulatory organization.
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    \5\ 15 U.S.C. 78s(b)(3)(A).
    \6\ 17 CFR 240.19b-4(e)(1). In reviewing this proposal, the 
Commission has considered its impact on efficiency, competition, and 
capital formation. 15 U.S.C. 78c(f).
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    At any time within 60 days of the filing of the proposed rule 
change, the Commission may summarily abrogate such rule change if it 
appears to the Commission that such action is necessary or appropriate 
in the public interest, for the protection of investors, or otherwise 
in furtherance of the purposes of the Act.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference

[[Page 46265]]

Room. Copies of such filing will also be available for inspection and 
copying at the principal office of the NASD. All submissions should 
refer to File No. SR-NASD-98-54 and should be submitted by September 
21, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\7\
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    \7\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.

Appendix I--NASD Notice to Members 98-66

NASD Clarifies Acceptable Customer Access To SelectNet And SOES

Executive Summary
    In response to several inquiries from National Association of 
Securities Dealers, Inc. (NASD) members regarding their 
ability to provide electronic access to The Nasdaq Stock 
Market's (Nasdaq SelectNetSM to non-
member broker/dealers or customers, Nasdaq clarifies that, in the 
circumstances described below, members that are Nasdaq Workstation 
II subscribers may choose to provide an electronic 
transmission of a non-member's order through their own systems into 
SelectNet.
    In addition, members have also raised questions regarding the 
ability of a Small Order Execution SystemSM 
(SOESSM) order entry firm to provide public customers 
electronic access to Nasdaq's SOES system. This Notice clarifies that, 
in the circumstances described below, members that are SOES order entry 
firms may choose to provide an electronic interface for public customer 
orders through their own SOES order entry system.
    Questions regarding this Notice should be directed to Thomas Gira, 
Vice President, Market Regulation, NASD Regulation, Inc. (NASD 
RegulationSM), at (301) 590-6895 or Gene Lopez, Vice 
President, Trading and Market Services, Nasdaq, at (202) 728-6998.
Background--SelectNet And SOES
    Nasdaq provides a service known as SelectNet that permits NASD 
member firms to enter buy or sell orders in Nasdaq securities into the 
system, directing those orders to a single Market Maker (directed 
orders) or broadcasting the order to market participants (broadcast 
orders), SelectNet facilitates the communication of trading interest 
between members, the negotiation of orders with the possibility of 
price improvement, and the dissemination of last sale reports after 
execution of SelectNet orders. Trades executed through SelectNet are 
submitted for clearing as locked-in trades. SelectNet is available for 
execution of orders from 9 a.m. until 5:15 p.m., Eastern Time.
    Nasdaq allows Nasdaq Workstation II subscribers to enter SelectNet 
orders from a Nasdaq Workstation or through an electronic means known 
as an Application Programming Interface (API). As mentioned above, 
there are two types of SelectNet orders: (1) directed orders; or (2) 
broadcast orders. SelectNet orders may be directed to a particular 
market participant displaying a quotation in the Nasdaq quote montage 
or the SelectNet order may be generally broadcast to all participants. 
Orders entered into SelectNet have a minimum life of 10 seconds; in 
other words, they cannot be canceled by the order entry firm until 10 
seconds have elapsed. In the case of directed orders, the participant 
reviewing the order has up to three minutes to respond to the order, 
unless the party entering the order specified a longer time period. 
While directed orders generally have a lifespan of three minutes, 
directed orders sent to a participant at or up to the participant's 
quoted price and size impose liability on the recipient's part on 
receipt of the SelectNet order pursuant to the Securities and Exchange 
Commission's (SEC) firm quote rule, unless an exception to the rule 
applies.\1\ Traditionally, SelectNet has been used by members, Market 
Makers, and order entry firms alike, to access the quotations of other 
Market Makers and electronic communication networks (ECNs).
    Nasdaq also provides a service known as SOES that enables order 
entry firms and Market Makers to execute size-limited orders (agency 
and risk-less principal) in Nasdaq securities on behalf of public 
customers. SOES enables participants, among other things, to lock in 
their trades with designated clearance and settlement instructions, 
thereby providing an automated execution system to public customers.
    Only agency orders from public customers no larger than the maximum 
order size, as defined in NASD Rule 4710(g), may be entered by a SOES 
order entry firm into SOES for execution against a SOES Market Maker. 
Agency orders in excess of the maximum order size may not be divided 
into smaller parts for purposes of meeting the size requirements for 
SOES orders. The SOES rules currently contain a specific provision, 
NASD Rule 4720(c)(4), that requires SOES order entry firms to maintain 
the physical security of Nasdaq equipment located on the premises of 
the firm to prevent unauthorized entry of information into SOES. The 
NASD has, to date, interpreted this provision as barring firms from 
providing direct electronic entry to public customers.
Electronic Access To Nasdaq Systems
    With the advent of enhanced software and telecommunications 
capabilities, members are able to provide their customers with 
efficient electronic access to Nasdaq's execution services, SelectNet 
and SOES. This Notice clarifies the NASD's interpretation of its rules 
and its contract and outlines the issues that members must be aware of 
in offering their customers electronic access to Nasdaq's execution 
services. Because each service is different, we have provided two 
separate discussions for each execution service, SelectNet and SOES.
Customer Access To SelectNet
    Recently, several members have inquired about the permissibility 
under NASD rules and the Nasdaq Workstation II Subscriber Agreement 
(NWII Agreement) for a member to permit its customers to enter orders 
into the member's own electronic system and to re-transmit those orders 
directly and electronically, without the manual entry of such order by 
a person associated with the member, into the SelectNet system through 
an API arrangement. In other words, certain members that connect to 
Nasdaq through an API want to be able to build an electronic access 
link that the member provides to certain customers. The customer is 
then able to enter orders through this member-provided electronic entry 
point that flow through the member's network that electronically 
connects through the Nasdaq API to the Nasdaq SelectNet application. 
This Notice clarifies that such activity is permissible under NASD 
rules and the NWII Agreement, provided that the member undertakes 
measures to ensure that all relevant NASD rules and system protections 
are followed, as described below.
    1. Notice to Nasdaq Acknowledging Responsibility for Orders: 
Members providing a SelectNet electronic pass-through service to 
customers must provide a letter to Nasdaq that acknowledges that they 
are acting as agents for the non-member in submitting the order through 
their facilities and that they are responsible for the order sent 
through SelectNet. Any member providing this service must submit all 
such orders as an agent on behalf of the customer inputting the order. 
All orders submitted by customers into SelectNet will have the member's 
Market Participant Identifier

[[Page 46266]]

(MPID) attached to them, and the member (Market Maker or ECN) receiving 
the order through SelectNet will know only that another member has 
attempted to access its Nasdaq-published price.
    Further, the member should provide a system description of its 
facility that allows non-members access to SelectNet. Such a system 
description must provide details on the manner in which orders are 
received and re-transmitted, including the security and capacity of the 
member's system, the manner in which the member's system connects to 
Nasdaq's service, and any internal system protocols designed to fulfill 
a member's ``know your customer'' obligations and other regulatory 
obligations.
    The letter and system description should be submitted to: Market 
Regulation, NASD Regulation, Inc., 9513 Key West Ave., Rockville, MD 
20850.
    2. Compliance With NASD Rules: Any member that chooses to offer 
this service to a customer must ensure that orders submitted through 
this member-provided service comply with SEC and NASD rules. For 
example, the member must ensure that rules related to the Short-Sale 
Rule, including the Affirmative Determination Rule, are complied with. 
Similarly, the member must ensure that any obligations regarding limit 
order protection and display and the ECN Rule are met. In particular, 
if customers use this mechanism to broadcast SelectNet orders, a Market 
Maker allowing customers to do so must be cognizant that SelectNet 
broadcast is an ECN that is not linked to Nasdaq's quote montage, and 
accordingly requires the Market Maker to reflect such price in its 
quote.
    3. Internal System Controls Regarding a Member's Procedures for 
Supervision of Submission of Orders: Members that provide non-members 
with SelectNet access should have in place adequate written procedures 
and controls that permit the member to effectively monitor and 
supervise the entry of electronic orders. Among the items that should 
be addressed in such written controls and procedures are: (1) the entry 
of unauthorized orders; (2) orders that exceed or attempt to exceed 
credit and other parameters, such as order size, that the member has 
established for a particular customer; (3) activity by a customer that 
could be considered manipulative or an attempt to improperly affect the 
price of the security or related products; and (4) violations of the 
affirmative determination and Short-Sale Rules. Whenever possible, 
these controls should be automated and system driven.
    A member providing SelectNet access to non-members should have a 
signed agreement with the non-member customer that outlines the 
responsibilities of the member and the customer with respect to the use 
of this means of access.
    4. Acknowledgment of Responsibility for Orders: Any members that 
provides its customers with access to SelectNet should understand that 
the member remains responsible for honoring all executions that may 
occur. Consequently, any member that chooses to provide such service 
must make appropriate determinations under NASD rules prior to 
providing the service that the customer is capable of using the means 
of access being provided by the firm. In particular, the ``know your 
customer rule'' embedded in the NASD Conduct Rules requires that the 
member providing customer electronic access to SelectNet assess the 
ability of the customer to use such access. Further, a member's 
customer agreement that permits the customer to access SelectNet should 
inform the customer that he or she is subject to potential prosecution 
under the federal securities laws for illegal activity and that the 
NASD will monitor all such trading activity so as to detect any such 
improper activity. Further, the member should inform the customer that 
if the NASD detects improper activity through the customer's use of 
SelectNet, the member's link to Nasdaq may be terminated if at any 
time, activity harmful to the integrity of The Nasdaq Stock market or 
its systems is detected.
    5. Nasdaq's Liability: In allowing members to provide their 
customers access to SelectNet, Nasdaq--pursuant to its NWII Agreement--
assumes no liability for any order entered into the member's system, or 
through the API, into Nasdaq's system.
    6. Nasdaq's Right to Terminate: In the event that the member's use 
of the API to allow the entry of SelectNet orders by non-members 
threatens the integrity of Nasdaq's systems, Nasdaq continues to 
reserve the right under the NWII Agreement to unilaterally and 
immediately terminate the member's access.
    7. Right to Examine: The member acknowledges that, as a self-
regulatory organization (SRO) responsible for examining the activity of 
a member, NASD Regulation may examine the member's books, records, and 
facilities to determine whether a violation of NASD rules and/or 
federal securities laws, rules, and regulations may have occurred. Such 
examination may include an examination of the electronic system itself, 
as well as the member's records regarding its customers and their 
activity.
    8. Clearing Responsibility: The member providing the electronic 
connection must be a member of a clearing agency registered with the 
SAE through which system-compared trades may be settled; or the member 
must have a correspondent clearing arrangement with a member that can 
do so. The member providing access must accept and settle each trade 
executed through this connection or, if settlement is to be made 
through another clearing member, the clearing member must guarantee the 
acceptance and settlement of such trades.
    9. Fees for Execution of SelectNet Orders: All orders entered by 
customers into SelectNet are subject to the same fee schedule that 
Nasdaq has established for the entry of orders by members. For example, 
Nasdaq currently charges a member $1 for each execution of a SelectNet 
order. As long as that fee is in place, Nasdaq will bill the member 
entering the customer pass-through order that amount for an execution 
that the customer receives. Similarly, if a customer using a member's 
pass-through service enters a broadcast order that is executed, Nasdaq 
will bill the member $2.50 for the execution. Under the SEC's Order 
Handling Rules, the SEC has permitted ECNs the right to charge members 
that use SelectNet to access the ECN's priced orders displayed in 
Nasdaq. Members should be aware that if they provide customers with 
SelectNet access and a customer accesses the order of an ECN that 
charges for such access, the ECN will bill the member for such access.
    10. System Setup: Members providing an electronic pass-through of 
SelectNet orders must use the Nasdaq API between the member's system 
and Nasdaq's system. Members may use service bureaus to develop and 
operate the electronic access capability. All such API connections must 
be set up on an eight presentation device to one service delivery 
platform ratio. If a member chooses to use a service bureau to develop 
the service, the member is nonetheless responsible for ensuring that 
all NASD rules and NWII Agreement requirements are complied with. No 
service bureau is permitted to operate a service on behalf of a member 
unless the service bureau has entered into an agreement with Nasdaq.
Public Customer Access To SOES
    Members have inquired about the permissibility under NASD rules for 
an NASAD SOES order entry firm to permit public customers to enter SOES 
agency orders into the member's electronic

[[Page 46267]]

system that provides an electronic SOES interface. Such facilities 
allow the public customer to enter orders into a member-provided 
electronic entry device, which flows through the member's network into 
the member's own computer system and then, without manual intervention, 
into SOES. This Notice clarifies that such activity is permissible 
under the NASD rules, provided that the member undertakes measures to 
ensure that all relevant NASD rules and system protections are 
followed, as described below.
    1. Compliance With NASD Rules, Including SOES Rules (NASD Rules 
4710-4770): Any member that chooses to offer SOES access to a public 
customer must ensure that orders submitted through this member-provided 
service comply with SEC and NASD rules, including the SOES rules and 
its interpretations.\2\ For example, the member must ensure that agency 
orders for public customers are within the maximum order size as 
required by NASD Rule 4730(c)(3). In addition, agency orders involving 
a single investment decision in excess of the maximum order size may 
not be divided into smaller parts for purposes of meeting the size 
requirements for orders entered into SOES. Thus, any trades entered 
within any five-minute period in accounts controlled by an associated 
person or customer will be presumed to be based on a single investment 
decision.
    Furthermore, members must ensure that rules related to the Short-
Sale Rule, including the Affirmative Determination Rule, are complied 
with. Finally, members must also be able to continue to meet their 
obligations to comply with the SEC's Confirmation Rule, Rule 10b-10.
    2. Internal System Controls Regarding a Member's Procedures for 
Supervision of Submission of SOES Orders: NASD SOES order entry firms 
that provide public customers with SOES access should have in place at 
the time they offer such access to public customers adequate written 
procedures and controls that permit the member to effectively monitor 
and supervise the entry of electronic orders.
    Among the items that should be addressed in such written controls 
and procedures are controls to monitor for: (1) the entry of 
unauthorized orders; (2) orders that exceed or attempt to exceed credit 
or SOES order size and other parameters that the member has established 
for a particular public customer; (3) activity by a public customer 
that could be considered manipulative or an attempt to improperly 
affect the price of the security or related products; (4) violations of 
the Affirmative Determination and Short-Sale Rules. Wherever possible, 
such controls should be automated and system driven.
    In addition, the firm's procedures must provide for the 
identification of locations where the firm makes SOES order entry 
devices available to its public customers and provides ongoing 
technical support and maintenance. If such site does not qualify as a 
branch office or office of supervisory jurisdiction (OSJ) of the member 
under NASD rules, a member must still supervise such activity by 
providing for periodic visits to such locations to ensure that certain 
restrictions on activities are in place and that the site is not 
conducting a securities business at such locations. For guidance on 
what constitutes a branch office or OSJ in member off-site locations, 
please see the interpretive letter dated March 17, 1998, and listed 
under NASD Rule 3010 on the NASD Regulation Web Site (www.nasdr.com--
from the Home Page, click on ``Members Check Here,'' then click on 
``Interpretive Letters'').
    3. Acknowledgment of Responsibility for Orders: Any member that 
provides its public customers with access to SOES should understand 
that the member is responsible for honoring all executions that may 
occur. Consequently, any member that chooses to provide such service 
must make appropriate determinations under NASD rules, including the 
SOES rules, prior to providing the service to a particular public 
customer that the public customer is capable of using the means of 
access being provided by the firm. In particular, the ``know your 
customer rule'' embedded in the NASD Conduct Rules requires that the 
member providing customer electronic access to SOES assess the ability 
of the customer to use such access.
    4. Right to Examine: The member acknowledges that, as an SRO 
responsible for examining the activity of a member, NASD Regulation may 
examine the member's books, records, and facilities to determine 
whether a violation of NASD rules and/or the federal securities laws, 
rules, and regulations may have occurred. Such examination may include 
an examination of the electronic system itself, as well as the member's 
records regarding its public customers and their activity.
    5. Fees for Execution of SOES Orders: All orders entered by public 
customers into SOES are subject to the same fee schedule that Nasdaq 
has established for the entry of orders by members. For example, Nasdaq 
currently charges 50 cents per order executed by the member entering a 
SOES order for a public customer. As long as that fee is in place, 
Nasdaq will bill the member entering the public customer pass-through 
order that amount for an execution that the public customer receives.

Endnotes

    1  SEC Rule 11Ac1-1(c).
    2  NASD Notice to Members 88-61.

[FR Doc. 98-23279 Filed 8-28-98; 8:45 am]
BILLING CODE 8010-01-M