[Federal Register Volume 63, Number 188 (Tuesday, September 29, 1998)]
[Notices]
[Pages 51978-51980]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-25918]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40455; File No. SR-NASD-98-01]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the National Association of Securities Dealers, Inc., and 
Notice of Filing and Order Granting Accelerated Approval to Amendment 
No. 4, Relating to the NASD's Rules Regarding Electronic Communications 
Networks, Locked and Crossed Markets, and a Member's Obligation to 
Provide Nasdaq with Certain Information

September 22, 1998.

I. Introduction

    On January 27, 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 (``SEC'' or ``Commission'') pursuant 
to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') 
\1\ a proposed rule change to amend the NASD's rules on locked and 
crossed markets and to propose a new rule to require NASD members to 
provide Nasdaq staff with certain information upon request. Nasdaq 
filed Amendment No. 1 to the proposal on June 8, 1998,\2\ Amendment No. 
2 on June 30, 1998,\3\ and Amendment No. 3 on July 16, 1998.\4\ The 
proposed rule change, as amended, was published for comment in the 
Federal Register on July 24, 1998.\5\ The Commission received three 
comment letters on the proposal. On August 26, 1998, in response to 
issues raised by commenters, Nasdaq filed Amendment No. 4 to the 
proposal.\6\ The Commission is publishing this notice and order to 
solicit comments on Amendment No. 4 and to approve the proposed rule 
change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ See letter from Robert E. Aber, Senior Vice President and 
General Counsel, The Nasdaq Stock Market, Inc. to Katherine A. 
England, Assistant Director, Division of Market Regulation 
(``Division''), SEC, dated June 5, 1998.
    \3\ See letter from Robert E. Aber, Senior Vice President and 
General Counsel, The Nasdaq Stock Market, Inc. to Katherine A. 
England, Assistant Director, Division, SEC, dated June 29, 1998.
    \4\ See letter from Robert E. Aber, Senior Vice President and 
General Counsel, The Nasdaq Stock Market, Inc. to Richard Strasser, 
Assistant Director, Division, SEC, dated July 15, 1998.
    \5\ See Securities Exchange Act Release No. 40227 (July 17, 
1998), 63 FR 39919 (July 24, 1998).
    \6\ See Letter from Robert E. Aber, Senior Vice President and 
General Counsel, The Nasdaq Stock Market, Inc. to Richard Strasser, 
Assistant Director, Division, SEC, dated August 25, 1998. Amendment 
No. 4 clarifies that ECNs are not required to register manually in 
each security with Nasdaq Market Operations.
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II. Background

    SEC Rule 11Ac1-1(c)(5) (``ECN Rule''),\7\ requires a Nasdaq market 
maker to reflect in its public quotes any superior prices for orders 
that the market maker privately places within an electronic 
communications network (``ECN''). A market maker will be deemed to have 
complied with the ECN Rule if the ECN in which the market maker has 
place a superior priced order displays the best ECN prices in Nasdaq's 
quote montage and provides broker-dealers that do not subscribe to the 
ECN's service access, through Nasdaq, to those publicly displayed 
prices. To accommodate this ``ECN Display Alternative,'' Nasdaq allowed 
ECNs to display their best prices from market makers and other ECN 
subscribers in the Nasdaq quote. It created a link to its SelectNet 
service to permit Nasdaq members to access those prices by sending 
orders to ECNs through SelectNet.
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    \7\ The ECN Rule is embodied in SEC Rule 11Ac1-1. 17 CFR 
240.11Ac1-1.
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    Based on its experience with the ECN Rule and operation of the 
SelectNet linkage, Nasdaq determined that it was necessary to revise 
certain NASD rules. For instance, certain ECN procedures regarding 
reserved quotation size appear to cause an increased incidence of 
locked and crossed markets, particularly at the market opening. 
Moreover, Nasdaq did not have an adequate mechanism in place to obtain 
important regulatory information from NASD members on a timely basis. 
Nasdaq, therefore, proposed to amend NASD Rules 4613(e) and 4623, as 
well as adopt new NASD Rule 4625, to address these issues.

III. Description

    Nasdaq proposes to amend NASD Rule 4613(e) to clarify that if, at 
or after 9:25:00 a.m. Eastern Time, a market maker or ECN enters a 
quotation that would lock or cross the market at the opening,\8\ that 
market maker or ECN must act (such as by sending a SelectNet order to 
take out the quotation that will be crossed or locked, or canceling its 
own quotation) to avoid locking or crossing the market at the opening, 
but in no case later than 30 seconds thereafter (i.e., 9:30:30 a.m.). 
The 9:25 a.m. benchmark will permit market makers and ECNs to determine 
which party entered a market-locking/crossing quotation, and thus which 
party is obligated to unlock or uncross the market at the opening. The 
9:30:30 provision establishes a deadline by when the market participant 
must resolve the locked or crossed market.
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    \8\ A locked market occurs when the quoted bid price is the same 
as the quoted ask price. A crossed market occurs when the quoted bid 
price is greater than the quoted ask price.
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    Nasdaq is also proposing to amend NASD Rule 4623 regarding ECNs. 
Under proposed NASD Rule 4623(c), if an ECN displays in Nasdaq an order 
having a reserved size and a market participant attempts to access that 
order by sending an order that is larger than the displayed size, the 
ECN would be required to execute the Nasdaq-delivered order: (1) Up to 
the size of the Nasdaq-delivered order, if the ECN order (including the 
reserved size and displayed portion) is the same size as or large than 
the Nasdaq-delivered order; or (2) up to the size of the ECN order 
(including the reserved size and displayed portion), if the Nasdaq-
delivered order is the same size as or larger than the ECN order 
(including the reserved size and displayed portion).\9\
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    \9\ Nasdaq also proposed to amend NASD Rule 4623(b)(4) to 
specify an ECN's obligation to register with Nasdaq Market 
Operations. As discussed below, this provision was further amended 
in Amendment No. 4.

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[[Page 51979]]

    Nasdaq is also proposing to adopt new NASD Rule 4625, which will 
authorize Nasdaq staff to request information in specific circumstances 
and will obligate members to comply with such requests. Specifically, 
under proposed new NASD Rule 4625, Nasdaq staff (i.e., Nasdaq 
MarketWatch or Market Operations staff) would be permitted to request 
from a member information directly related to an SEC or NASD rule that 
the Nasdaq department is responsible for administering, or other duties 
or responsibilities imposed on the Nasdaq department by the Plan of 
Allocation and Delegation of Function or otherwise delegated by the 
Association to the Nasdaq department. Failure to comply with a request 
for information under the proposed new rule in a timely, truthful and 
complete manner could be deemed to be conduct inconsistent with just 
and equitable principles of trade.

IV. Summary of Comments

    The Commission received three comment letters on the proposal. Two 
letters were from entities that operate ECNs, Bloomberg, L.P. (which 
owns Bloomberg Tradebook LLC) and Instinet Corporation, and one letter 
was from Morgan Stanley & Co. Inc., a large broker-dealer and Nasdaq 
market maker.\10\
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    \10\ See Letters to Jonathan G. Katz, Secretary, SEC, from Kevin 
M. Foley, Bloomberg L.P., dated August 14, 1998 (``Bloomberg 
Letter''); from Douglas Atkin, Chief Executive Officer, Instinet 
Corporation, dated August 17, 1998 (``Instinet Letter''); and from 
Jill W. Ostergaard, Counsel, Morgan Stanley & Co. Inc., dated August 
19, 1998 (``Morgan Stanley Letter'').
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ECN Registration

    Two commenters opposed Nasdaq's proposed amendment to NASD Rule 
4623(b)(4), discussing ECNs' obligation to register with Nasdaq Market 
Operations.\11\ The commenters interpreted the proposed amendment as 
requiring ECNs to register with Nasdaq Market Operations for each 
security as an ECN prior to entering prices and sizes in the SelectNet 
linkage on that security.\12\
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    \11\ See Bloomberg and Instinet Letters.
    \12\ As discussed below, Nasdaq filed Amendment No. 4 with the 
Commission to clarify that ECNs need not register separately for 
each security.
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Preventing Locked and Crossed Markets

    All commenters supported the proposed amendment to NASD Rule 
4613(e) to reduce the instances of locked and crossed markets at the 
opening. Additionally, one commenter believed the proposal to require 
ECNs to execute against reserve size will reduce the number of market 
maker and ECN quotations that lock or cross the market throughout the 
day and bring greater stability to the Nasdaq market.\13\ Two 
commenters were concerned, however, with the proposed requirement in 
NASD Rule 4623(c) that ECNs provide non-subscribers access to the 
reserve size to reduce intraday locking and crossing.\14\ One commenter 
was concerned that providing unlimited access to reserve size to 
broker-dealers that do not subscribe to the ECN's service creates a 
credit risk for the ECN.\15\ This commenter, therefore, suggested that 
non-subscriber access be limited to 10,000 shares to better balance the 
advantages of access with any counterparty risk an ECN might 
assume.\16\ In the alternative, this commenter suggested that the 
credit risk could be lessened by requiring the National Securities 
Clearing Corporation (``NSCC'') to take responsibility for a trade from 
the moment NSCC receives the executed trade. One commenter opposed this 
provision of the proposal because it was concerned that requiring ECNs 
to execute against reserve size creates a disparate standard for ECNs 
vis-a-vis dealers that are given large orders to ``work.'' \17\
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    \13\ See Morgan Stanley Letter.
    \14\ See Bloomberg and Instinet Letters.
    \15\ See Bloomberg Letter.
    \16\ Id.
    \17\ See Instinet Letter. But see Morgan Stanley Letter, which 
noted that the proposal does not go far enough in leveling the 
playing field between ECNs and market makers. This commenter noted 
that to provide unfettered competition among all market 
participants, market makers should be allowed to charge fees to 
market participants that access their quotations as ECNs are 
currently permitted to do.
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Obligation to Provide Information to Nasdaq Staff

    The two commenters that addressed the NASD's proposed new Rule 
4625, which would require NASD members to provide Nasdaq staff with 
regulatory information, generally supported the proposal.\18\ One 
commenter noted, however, that the proposal, by requiring ECNs and 
market makers to divulge sensitive client information to Nasdaq, could 
alter the working relationship among ECNs, market makers, and Nasdaq's 
MarketWatch.\19\ Another commenter, while supporting the proposed new 
rule, cautioned staff against setting unrealistic deadlines for 
receiving the requested information.\20\ This commenter proposed that 
Nasdaq apply a ``good faith'' test to any disciplinary action brought 
against an NASD member for not producing the requested information in a 
timely manner.
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    \18\ See Bloomberg and Morgan Stanley Letters.
    \19\ See Bloomberg Letter.
    \20\ See Morgan Stanley Letter.
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V. Discussion

    The Commission finds that the proposed rule change is consistent 
with the Act and the rules and regulations applicable to the NASD. In 
particular, the proposal is consistent with sections 15A(b)(6), 
15A(b)(11), and 11A(a)(1)(C) of the Act.
    Section 15A(b)(6) requires, among other things, that the rules of a 
registered national securities association be designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principals 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.\21\
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    \21\ 15 U.S.C. 78o-3(b)(6).
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    Section 15A(b)(11) requires that the NASD as a national securities 
association have rules that govern the form and content of quotations 
relating to securities in the Nasdaq market.\22\ Such rules must be 
designed to produce fair and informative quotations, prevent fictitious 
or misleading quotations, and promote orderly procedures for 
collecting, distributing, and publishing quotations. Sections 
11A(a)(1)(C) provides that it is in the public interest and appropriate 
for the protection of investors and the maintenance of fair and orderly 
markets to assure, among other things, the economically efficient 
executive of securities transactions and the availability to brokers, 
dealers, and investors of information with respect to quotations for 
and transactions in securities, and to assure fair competition among 
brokers and dealers.\23\
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    \22\ 15 U.S.C. 78o-3(b)(11).
    \23\ 15 U.S.C. 78k-1(a)(1)(C).
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    Specifically, both the requirement to avoid locking and crossing 
the market at the opening and to permit market participants to execute 
against reserve size are consistent with sections 15A(b)(6), 
15A(b)(11), and 11A(a)(1)(C). The Commission believes that these 
proposals will reduce the frequency of locked and crossed markets, 
which should provide more informative quotation information and 
contribute to the maintenance of a fair and orderly market. These 
improvements should benefit the markets and investors.

[[Page 51980]]

    The Commission believes, as do two commenters, that continued 
locking and crossing of the market can negatively impact market 
quality.\24\ As the Commission has previously stated, market makers and 
ECNs are required to use reasonable means to avoid locking and crossing 
the market.\25\ Consequently, Nasdaq market makers and ECNs must use 
``reasonable means'' to take out the quote that their quote, if 
immediately posted, would lock or cross. NASD has interpreted 
``reasonable means'' to include referencing a SelectNet order to the 
firms at the bid or offer.\26\ Experience has shown, however, that ECNs 
increasingly are remaining at the inside quote after executing an 
incoming order at the displayed size even when the incoming order 
exceeds the displayed ECN order size. As a result, the incidence of 
locked and crossed markets has increased.
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    \24\ See Instinet and Morgan Stanley Letters.
    \25\ See Letter to Joseph R. Hardiman, President, NASD, from 
Richard R. Lindsey, Director, Division, SEC, dated November 22, 1996 
(noting that, in the OTC market, a Nasdaq market maker holding a 
limit order that is marketable against another market maker's or 
ECN's quote may send a SelectNet message to the market maker or ECN 
displaying the existing quote. However, after using reasonable 
efforts to execute against the existing quote, the market maker 
should display the limit order even if it locks the market).
    \26\See NASD Notice to Members 97-49.
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    The Commission believes that the proposal to require ECN orders 
having reserve size to interact with incoming orders from SelectNet 
will help reduce the frequency of locked and crossed markets on Nasdaq 
and, as a result, improve market quality. Moreover, the Commission 
believes that requiring an ECN to accept a SelectNet order for larger 
than the ECN's displayed size balances the interest to reduce the 
frequency of locked and crossed markets with market participants' 
desire to display only portion of a large order.
    One commenter expressed concern that the proposal increases an 
ECN's counterparty risk by allowing non-participant broker-dealers 
(with whom the ECN has no contractual relationship) to access the ECN's 
reserve size.\27\ The Commission notes, however, that the risk is no 
greater than that involved in any other broker-to-broker transaction. 
Moreover, the SEC's broker-dealer capital requirements as well as 
NSCC's novation of executed trades should greatly reduce the risk of 
non-performance that ECNs may face. Moreover, since the SEC implemented 
its Order Handling Rules, non-subscriber broker-dealer non-performance 
resulting from permitting non-subscriber access in those instances.
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    \27\See Bloomberg Letter.
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    The Commission believes that the proposed provision applying the 
restrictions against locking or crossing the market at the opening 
should help to clarify NASD members' responsibilities, including 
setting a deadline for required action. As a result, the proposed 
provision should promote a more orderly opening in Nasdaq securities.
    The Commission believes that the proposal to adopt NASD Rule 4625, 
regarding a member's obligation to supply Nasdaq MarketWatch and Market 
Operations staff with certain information upon request, is consistent 
with the NASD's regulatory responsibilities under section 15A of the 
Act. The Commission believes that to properly fulfill its obligation to 
administer NASD and SEC rules, as well as other applicable 
requirements, Nasdaq staff must be able to obtain information regarding 
matters such as locked and crossed markets, trade reports, trading 
activity, and erroneous transactions on a timely basis from market 
participants.
    In response to two commenters who were concerned with the proposal 
requiring ECNs to register independently for each security, Nasdaq 
filed Amendment No. 4 to the proposal.\28\ This amendment clarifies 
that ECNs are required to register with Nasdaq Market Operations prior 
to being included in Nasdaq as an ECN but are not required to register 
manually in each security. According to the NASD, in practice, once an 
ECN registers with Nasdaq Market Operations, Nasdaq systems allow the 
ECN to enter quotations in all Nasdaq securities. The Commission 
believes that this amendment addresses the commenters' concerns that 
the rule change, as originally proposed, would unnecessarily burden 
ECNs by requiring them to register on a per-security basis.
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    \28\ In Amendment No. 4, Nasdaq is withdrawing the previously 
proposed amendment to NASD Rule 4623(b)(4) and is proposing to 
replace it with the following (new language is italicized; deletions 
are bracketed):
    (4) agree to provide for Nasdaq's dissemination in the quotation 
data made available to quotation vendors the prices and sizes of 
Nasdaq market maker orders (and other entities, if the (electronic 
communications network) ECN so chooses) at the highest buy price and 
the lowest sell price for each Nasdaq security entered in and widely 
disseminated by the (electronic communications network) ECN, and 
prior to entering such prices and sizes, register with Nasdaq Market 
Operations as an ECN.
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    The Commission believes that Amendment No. 4 should be approved on 
an accelerated basis because it does not impose any requirements in 
addition to those originally proposed and published for comment. In 
fact, Amendment No. 4 revised the NASD's proposal so that the ECN 
registration requirement is consistent with the current practice that 
once an ECN registers with Nasdaq Market Operations Nasdaq systems 
allow the ECN to enter quotations in all Nasdaq securities.
    For the foregoing reasons, the Commission finds that the proposed 
rule change, as amended, is consistent with the Act and the rules and 
regulations thereunder applicable to the NASD,\29\ and, in particular, 
with sections 15A(b)(6), 15A(b)(11), and 11A(a)(1)(C) of the Act. In 
addition, the Commission finds good cause for approving Amendment No. 4 
to the proposal prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register.
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    \29\ In approving this proposal, the Commission has considered 
its impact on efficiency, competition, and capital formation. 15 
U.S.C. 78c(f).
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VI. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2),\30\ that the 
proposed rule change (SR-NASD-98-01) be, and hereby is, approved.

    \30\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\31\
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    \31\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-25918 Filed 9-28-98; 8:45 am]
BILLING CODE 8010-01-M