[Federal Register Volume 64, Number 194 (Thursday, October 7, 1999)]
[Notices]
[Pages 54704-54712]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-26154]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41967; File No. SR-NASD-98-85]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval to 
Amendment Nos. 2, 3, and 5 of the Proposed Rule Change by the National 
Association of Securities Dealers, Inc. To Establish the Nasdaq 
Application of the OptiMark System

September 30, 1999.

I. Introduction

    On November 13, 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\ and Rule 19b-4 thereunder,\2\ a proposed rule change to 
establish rules for a new facility called the Nasdaq Application of the 
OptiMark System (``Application''). The Application is an electronic 
trading system based on information processing technology provided by 
OptiMark Technologies, Inc., together with its wholly-owned subsidiary, 
OptiMark Services, Inc. (``OSI'').\3\ On December 11, 1998, Nasdaq 
filed Amendment No. 1 to the proposed rule change. The proposed rule 
change, as amended, was published for comment in the Federal Register 
on January 5, 1999.\4\ The Commission received four comment letters in 
response to the proposal.\5\ On July 16, 1999, the NASD filed Amendment 
No. 2 to the proposed rule change.\6\ On September 13, 1999, the NASD 
filed Amendments Nos. 3 and 4 to the proposed rule change.\7\ On 
September

[[Page 54705]]

24, 1999, the NASD withdrew Amendment No. 4 in its entirety and filed 
Amendment No. 5 to the proposed rule change.\8\ In Amendment No. 5, the 
NASD established trading parameters for the initial operations of the 
Application while its risk management tools are being refined, and 
requested that the Commission approve the Application on a pilot basis 
for a six-month period. The trading parameters include (1) a limitation 
on trading to 250 of the most actively traded Nasdaq securities, (2) a 
limitation on cycle frequency to one every five minutes, (3) a 
suspension of trading in the Application for 15 minutes if its volume 
equals or exceeds 12.5% of the average Nasdaq volume in the 250 
securities, and (4) a suspension of trading in the Application for the 
remainder of the trading day if its volume equals or exceeds 15% of the 
average Nasdaq volume in the 250 securities. This order approves the 
proposed rule change, as amended, until April 3, 2000.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ OptiMark Technologies, Inc. is a computer technology firm 
that has developed certain patented technology referred to as 
``OptiMarkTM.'' The Application is one of several 
different trading services based on this technology that may be 
available for other markets in the future. The Commission previously 
approved one such service for operation on the Pacific Exchange, 
Inc. See Securities Exchange Act Release No. 39086 (September 17, 
1997), 62 FR 50036 (September 24, 1997). While the OptiMark 
technology is virtually identical to that which was approved for the 
PCX Application, the proposed Nasdaq Application adapts and uses the 
OptiMark technology within the existing Nasdaq market structure.
    \4\ Securities Exchange Act Release No. 40835 (December 28, 
1998), 64 FR 549 (January 5, 1999).
    \5\ Letter from Jerry Putnam, President, Archipelago, L.L.C., to 
Jonathan G. Katz, Secretary, SEC, dated January 22, 1999 
(``Archipelago Letter''); letter from Ari Burstein, Assistant 
Counsel, Investment Company Institute, to Jonathan G. Katz, 
Secretary, SEC, dated January 26, 1999 (``ICI Letter''); letter from 
W. Dennis Ferguson, Chairman, Clearing Firms Committee, Securities 
Industry Association (``SIA''), to Jonathan G. Katz, Secretary, SEC, 
dated July 22, 1999; letter from W. Dennis Ferguson, Chairman, 
Clearing Firms Committee, SIA, to Richard Strasser, Assistant 
Director, Division of Market Regulation (``Division''), SEC, dated 
August 23, 1999.
    \6\ Letter from Eugene A. Lopez, Vice President, Trading and 
Market Services, Nasdaq, to Richard Strasser, Assistant Director, 
Division, SEC, dated July 16, 1999 (``Amendment No. 2''). In 
Amendment No. 2, the NASD amended proposed NASD Rule 4993(b) to 
provide that a Cycle will include Nasdaq Quote Montage Profiles 
reflecting all bid and offer quotes as reflected in the Nasdaq Quote 
Montage immediately prior to the commencement of the Cycle that 
could potentially be traded through by a Profile.
    \7\ Letter from Eugene A. Lopez, Vice President, Trading and 
Market Services, Nasdaq, to Richard Strasser, Assistant Director, 
Division, SEC, dated September 13, 1999 (``Amendment No. 3''). In 
Amendment No. 3, the NASD amended proposed NASD rules 4991 and 4992 
to clarify that only a Clearing Broker, as that term is defined in 
NASD Rule 6100(f), can establish the trading limits for users, 
including NASD members, that are not self-clearing. In addition, 
Amendment No. 3 clarifies that the terms ``Designated Broker'' is 
broader than ``Clearing Broker'' and includes correspondent brokers. 
Consequently, every user must be sponsored in the Application by a 
Designated Broker that is a Clearing Broker and that establishes the 
trading limits for its users and accepts responsibility for their 
trades. Some users also may be sponsored by an additional Designated 
Broker that is a correspondence broker. As noted in the text, 
Amendment No. 4 was withdrawn entirely by Amendment No. 5.
    \8\ Letter from Eugene A. Lopez, Vice President, Trading and 
Market Services, Nasdaq, to Richard Strasser, Assistant Director, 
Division of SEC, dated September 24, 1999 (``Amendment No. 5''). In 
addition to withdrawing Amendment No. 4 in its entirety, Amendment 
No. 5 adds a new paragraph (e) to Rule 4991 to define the term 
``Electronic Data Interchange'' (``EDI'') as a screen-based 
electronic communications facility that enables Designated Brokers 
to establish or modify trading or alert limits. Amendment No. 5 also 
adds a new Rule 4999 that establishes trading parameters for the 
initial operations of the Application. The parameters are described 
more fully in Section II.B Trading Parameters for Initial Operations 
below. Finally, as noted in the text, Amendment No. 5 requests that 
the Commission approve the Application on a pilot basis for a six-
month period.
---------------------------------------------------------------------------

II. Description of the Proposal

A. Summary of the Application and Purpose

    Nasdaq proposes to establish rules for a new facility called the 
Nasdaq Application of the OptiMark System.\9\ The Application is a 
computerized, screen-based trading service intended for use by both 
NASD members and non-members. For securities listed on The Nasdaq Stock 
Market,\10\ the Application would enable its users anonymously to 
represent their trading interest across a full spectrum of prices and 
sizes by entering Profiles (i.e., indications of trading interest) into 
the OptiMark System to be compared and matched with Profiles entered by 
other users.\11\ At specified times during the trading day (no more 
than once every five minutes during the proposed pilot period), the 
Application would conduct certain calculations against such expressions 
of interest to identify specific orders capable of execution. All such 
orders will be immediately executed and reported, except those that 
involve the matching of any Nasdaq Quote Montage Profile, as discussed 
further below.
---------------------------------------------------------------------------

    \9\ See Proposed NASD Rule 4991(a).
    \10\ Although during the pilot period the Application would be 
limited to 250 of the most actively traded Nasdaq securities, Nasdaq 
anticipates that ultimately the Application would be available for 
all securities listed on Nasdaq, including securities listed on the 
Nasdaq SmallCap market. The Application would not be available for 
securities not listed on Nasdaq, such as those that may be quoted in 
the OTC Bulletin Board.
    \11\ For a description of a Profile, see Section II.B below.
---------------------------------------------------------------------------

    Nasdaq represents that integrating OptiMark's technology into 
Nasdaq will continue Nasdaq's effort to improve opportunities for 
investors to receive the best available prices in the marketplace and 
reduce trading costs. It states that the proposed Application would (1) 
match all trading interest on a level playing field, (2) provide an 
alternative method for institutional investors to transact with minimal 
market impact and to obtain price improvement, (3) benefit market 
makers by providing an additional option to manage inventory risk 
through fast and efficient executions, and (4) benefit issuers through 
enhanced liquidity and flexibility for their shareholders.

B. Description of the Operation of the Application

    The NASD is establishing the Application as a facility of Nasdaq, 
and the NASD accordingly has represented that it will control the 
operation of, and be fully responsible for, the Application, including 
its regulation and oversight.\12\ NASD members and their customers will 
trade on the Application in the manner described below.
---------------------------------------------------------------------------

    \12\ Letter from Eugene A. Lopez, Vice President, Trading and 
Market Services, Nasdaq, to Richard Strasser, Assistant Director, 
Division, SEC, dated June 3, 1999 (``June 3 Letter'').
---------------------------------------------------------------------------

Access to the Application
    The Application is available to any NASD member that is a Clearing 
Broker, as that term is defined in NASD Rule 6100(f), that chooses to 
become a user and complies with all applicable rules. A user is a 
subscriber who has entered into an agreement with OSI to access the 
Application. In addition, both NASD members that are not Clearing 
Brokers and non-members may become users, provided they are authorized 
in advance by one or more Designated Brokers that are Clearing Brokers 
(``Designated Broker/Clearing Brokers'').\13\ These non-self-clearing 
users can be authorized by one or more Designated Brokers in accordance 
with a Designated Broker Consent Agreement. The Designated Broker 
Consent Agreement, between the Designated Broker and OSI or OptiMark 
OTC Services, Inc., provides the Designated Broker's authorization for 
Profiles of a user to be routed, executed, and reported in the 
Designated Broker's name. These agreements include any applicable 
credit limits imposed by the Designated Broker/Clearing Broker. A 
user's credit limits, as they may be established from time to time by a 
Designated Broker/Clearing Broker, will be programmed into the OptiMark 
System.\14\ The Designated Broker will be alerted as its potential 
exposure to the users it authorizes to participate in the Application, 
individually or in the aggregate, approaches the established credit 
limits (``Alarm Threshold'') or reaches the limit at which the 
Designated Broker will no longer permit a customer to submit Profiles 
``Trading Limit''). A Designated Broker is responsible for all of its 
users' orders and resulting transactions.
---------------------------------------------------------------------------

    \13\ The term ``Designated Broker'' is defined in proposed NASD 
Rule 4991(c) as ``an NASD member who has been designated by a User 
to execute, clear, and settle transactions resulting from the 
Application.'' Proposed Rule 4991(c) further provides that 
``[p]articipation as a Designated Broker shall be conditioned upon 
the Designated Broker's membership in, or maintenance of an 
effective clearing arrangement with a member of, a clearing agency 
registered pursuant to the Act,'' and that ``[o]nly Designated 
Brokers that are members of a registered clearing agency 
(`Designated Broker/Clearing Broker') are permitted to establish 
trading limits for Users.''
    \14\ In Amendment No. 5, the NASD added paragraph (e) to 
proposed rule 4991 to provide for an ``Electronic Data Interchange'' 
(``EDI''), which is defined as ``a screen-based electronic 
communications facility with an appropriate audit trail that enables 
Designated Brokers to establish or modify trading or alert limits 
for the purposes of Profile validation by (1) submitting such 
trading instructions on-line and (2) receiving notifications on-line 
when their instructions have been received and when they have been 
implemented.'' No more than 10 Eligible Securities can be traded in 
the Application until the EDI is implemented.
---------------------------------------------------------------------------

    The Application would allow NASD members to access the new trading 
facility through the Nasdaq Workstation and the Nasdaq network that 
connects those Workstations. Nasdaq will provide a user interface that 
permits NASD members that are subscribers to the Nasdaq Workstation 
Service and have signed appropriate User Agreements to transmit 
Profiles from their Workstations to the OptiMark Matching

[[Page 54706]]

Module,\15\ which will conduct Cycles \16\ on a periodic basis.\17\
---------------------------------------------------------------------------

    \15\ See proposed NASD Rule 4991(g).
    \16\ For a description of a Cycle, see Section II.B below.
    \17\ The primary site of the Application, which will house the 
computer software and hardware complex that conducts the central 
processing of Profiles, is located in the Nasdaq data center in 
Trumbull, Connecticut. Nasdaq will be the facilities manager for the 
OptiMark System with respect to the Nasdaq Application. Letter from 
Eugene A. Lopez, Vice President, Trading and Market Services, 
Nasdaq, to Richard Strasser, Assistant Director, Division, SEC, 
dated April 28, 1999.
---------------------------------------------------------------------------

    The Application also would allow access through other networks and 
access devices, as long as such access is properly authorized. Non-
member users sponsored by NASD members (subject to the applicable 
agreements referenced above), as well as any NASD member, could access 
the Application through OptiMark-provided network(s), which may provide 
access through third parties.
Entry of Profiles and Incorporation of the Nasdaq Quote Montage
    Users would access the Application by submitting customized 
expressions of trading interest called Profiles. Profiles reflect an 
investor's willingness to trade at a variety of prices and sizes, 
including the level of satisfaction, on a sliding scale, of trading at 
a given price and size. For example, an investor may be 100% satisfied 
to buy 100,000 shares of XYZ Company at a price up to $1.00 above the 
current market price, but only 50% satisfied to buy that number of 
shares at a price $1.50 above it, and not satisfied at all to pay more 
than $2.00 above it. The satisfaction levels are expressed as a number 
between zero and one for each coordinate on a price/size grid.
    These user-defined Profiles, which are represented by graphical 
user interface software, are not disclosed to other users or market 
participants, including any Designated Broker through whom a user is 
authorized to submit Profiles and obtain executions. The Profiles are 
received and logged in by the OptiMark Matching Module. The Application 
is programmed to obtain the optimal outcome of matching buyers and 
sellers at the best prices possible.
    In addition to Profiles submitted directly by Users, the Nasdaq 
Application will include certain system-generated Profiles known as the 
``Nasdaq Quote Montage Profiles,'' which reflect the bid and offer 
quotes from Nasdaq Market Makers, electronic communications networks 
(``ECNs''), and UTP Exchange Plan Specialists as displayed in the 
Nasdaq Quote Montage at the time a matching Cycle begins. Immediately 
prior to commencement of a Cycle, the system will view the Nasdaq Quote 
Montage and create Nasdaq Quote Montage Profiles for each quote that 
could potentially be traded through by a Profile.\18\ In this way, the 
expressions of interests of all users, as well as publicly displayed 
quotes that potentially could be matched with such expressions of 
interest, would be reflected in the Application.
---------------------------------------------------------------------------

    \18\ See Amendment No. 2, note 6 above.
---------------------------------------------------------------------------

    When a user enters a Profile into the Application, either through 
the Nasdaq network or another network capable of sending Profiles to 
the Application, the user can choose to restrict the ability of that 
Profile to match with a Nasdaq Quote Montage Profile. If the user 
chooses to limit the ability of its Profile to match with a Nasdaq 
Quote Montage Profile, the user's Profile will contain an added 
condition that is expected to limit the user's chances of finding 
matches from the contra side of the market. As discussed below, the 
system's matching algorithm will not allow any matches at a price 
inferior to that of another coordinate with Standing. The NASD 
represents that because each coordinate from a Nasdaq Quote Montage 
Profile has Standing, it is afforded full price protection.\19\
---------------------------------------------------------------------------

    \19\ Letter from Eugene A. Lopez, Vice President, Trading and 
Market Services, Nasdaq, to Richard Strasser, Assistant Director, 
Division, SEC, dated March 19, 1999 (``March 19 Letter'').
---------------------------------------------------------------------------

Central Processing Cycles--OptiMark's Matching Algorithm
    At one or more times throughout the trading day, all Profiles 
(including the Nasdaq Quote Montage Profiles) will be centrally 
processed by the OptiMark Matching Module operated by OSI to obtain the 
optimal matches among users. The maximum frequency with which these 
``Cycles'' may take place will be every five minutes,\20\ with no Cycle 
taking place prior to 9:45 a.m. EST or after 3:45 p.m. EST. The exact 
frequency of Cycles for any given Nasdaq security will be determined by 
Nasdaq, in consultation with OptiMark, based on the general 
characteristics of the security, the robustness of the associated 
Profile flow over a period, and the current level of interest expressed 
by users.
---------------------------------------------------------------------------

    \20\ The five-minute Cycle frequency is applicable for the six-
month period of initial operations for which the Commission is 
approving the proposed rule change. Proposed Rule 4999(b).
---------------------------------------------------------------------------

    The OptiMark Matching Module employs a sophisticated computer 
algorithm that measures and ranks all relevant mutual satisfaction 
outcomes by matching individual coordinates from intersecting buy 
Profiles with those of sell Profiles for a particular stock. These 
intersecting Profiles are matched in accordance with the following 
eligibility restrictions and priority principles.
    1. Eligibility Restrictions--At commencement of a Cycle, each 
individual coordinate with a non-zero satisfaction value from all buy 
and sell Profiles received by the OptiMark Matching Module in a given 
eligible security would be grouped into the Buy Profile Data Base or 
the Sell Profile Data Base, respectively. Each individual coordinate, 
no matter how small or large,\21\ from either Profile Data Base would 
be eligible to be matched with one or more coordinates from the other 
Profile Data Base and would result in one or more orders,\22\ provided 
that neither of two parameters are violated.
---------------------------------------------------------------------------

    \21\ The minimum trading increment would be 100 shares.
    \22\ The proposal defines the term ``Order[s]'' to mean one or 
more order[s] generated from a Cycle at specific prices and sizes at 
which immediate execution may occur. To be capable of execution, 
orders in eligible securities must be in round lots equal to or 
greater than 1,000 shares, except for Orders resulting from 
processing the Nasdaq Quote Montage Profiles, which may be in any 
round lot size. Orders must be in price increments conforming to the 
requirements of Nasdaq trading system rules and system requirements 
applicable to all orders executed in Nasdaq. Such Orders shall 
include the following information: (1) The stock ticker symbol; (2) 
a designation as ``buy,'' ``sell long,'' ``sell short,'' or ``sell 
short exempt''; and (3) such other information as may be required by 
Nasdaq. See proposed NASD Rule 4991(h).
---------------------------------------------------------------------------

    Under the first parameter, no buy and sell coordinates could be 
matched in violation of any applicable user instructions for the 
respective Profiles, including: (a) The maximum quantity associated 
with the Profile; or (b) any boundary conditions restricting the 
aggregate number of shares that may be bought or sold at a particular 
price or size range.
    Under the second parameter, no buy and sell coordinates could be 
matched at a price inferior to that of another coordinate with Standing 
that is eligible for matching.\23\
---------------------------------------------------------------------------

    \23\ A coordinate has Standing if: (a) It has a satisfaction 
value of 1, and (b) all coordinates having the same price and a 
smaller size, down to and including the minimum trading increment 
(100 shares), are included in the associated Profile at a 
satisfaction value of 1. Also, each coordinate from a Nasdaq Quote 
Montaged Profile would have Standing. Conversely, no coordinate' 
from a Profile containing any boundary conditions restricting the 
aggregate number of shares that may be bought or sold at a 
particular size range shall have Standing. For example, no 
coordinate from a Profile submitted by a User on an ``all-or-none'' 
basis would have Standing.
---------------------------------------------------------------------------

    2. Priority Principles--The methods for considering potential 
matches between buy and sell coordinates in the Profile Data Bases 
would vary, depending on whether both coordinates

[[Page 54707]]

represent satisfaction values of 1 or less than 1. As a result, there 
are two separate stages of a Cycle, the Aggregation Stage and the 
Accumulation Stage, which are discussed below.
    Aggregation Stage. The OptiMark Matching Module initially would 
process eligible buy and sell coordinates in the Profile Data Bases, 
each with the full satisfaction value of 1 only. At this stage of 
calculation (``Aggregation Stage''), smaller-sized coordinates may be 
aggregated to build sufficient size to be matched with larger-sized 
coordinates to generate Orders in accordance with the following rules 
of priority, subject to the applicable eligibility restrictions:
    (A) Price aggressiveness. A coordinate with a more aggressive price 
(i.e, a higher price for a buy coordinate and a lower price for a sell 
coordinate) would have priority over coordinates with less aggressive 
prices.
    (B) Standing. Among the coordinates with the same price, a 
coordinate with Standing would have priority over all other coordinates 
without Standing.
    (C) Time of entry. Among the coordinates with the same price and 
Standing, the time of the entry of the associated Profile would 
determine relative priority, with earlier submissions having priority. 
All Profiles submitted by users would be appropriately time-stamped 
with a unique serial number when received by the OptiMark Matching 
Module. Because each Nasdaq Quote Montage Profile would be generated 
from the most current quotation prevailing at the time of commencement 
of a Cycle, the effective time of entry of a Nasdaq Quote Montage 
Profile would be later than that of any other Profile submitted by a 
user.
    D. Size. Among the coordinates with the same price, Standing and 
time of entry, priority would be determined by size, with larger sizes 
having higher priority.
    Such sorting enables the system to construct a single buy 
coordinate list and a single sell coordinate list, where the top 
coordinate on each list has priority over the rest. Once the priority 
buy and sell coordinates are established, the system will select the 
coordinate with the earlier time of entry at the top of either list as 
the ``aggregation attractor'' and then will seek to aggregate one or 
more coordinates from the contra list (in strict order or priority on 
that list) against the aggregation attractor to match its size and 
price. The matches against the aggregation attractor must comply with 
all applicable eligibility restrictions. If the matches against the 
aggregation attractor are successful (i.e., matches consistent with 
eligibility restrictions), the Cycle will result in the generation of 
Orders. The system will then go on to select the next aggregation 
attractor, and the process will continue. If the matches against the 
aggregation attractor are unsuccessful, the next aggregation attractor 
will be selected (skipping over the failed one), and the process will 
continue as before. The Aggregation Stage will terminate when no 
further aggregation are possible.\24\
---------------------------------------------------------------------------

    \24\ March 19 Letter, note 19 above.
---------------------------------------------------------------------------

    Accumulation Stage. Upon completion of the Aggregation Stage, the 
OptiMark Matching Module would consider potential matches between 
eligible buy coordinates and sell coordinates in the Profile Data Bases 
where one or both parties have a satisfaction value of less than 1 but 
greater than 0. At this stage of calculation (``Accumulation Stage''), 
only those buy and sell coordinates with the same associated price and 
size would be matched to generate Orders in accordance with the 
following rules of priority, subject to the applicable eligibility 
restrictions:
    (A) Mutual satisfaction. A potential match with a higher mutual 
satisfaction value (the product of the two satisfaction values) would 
take precedence over other potential matches with lower mutual 
satisfaction values.
    (B) Time of entry (based on the earlier Profile). Among the 
potential matches with the same mutual satisfaction, the match with the 
earlier time of entry, as determined initially by the effective time of 
entry assigned to the earlier of the buy and sell Profiles involved 
(the ``earlier Profile''), would have priority over other potential 
matches.
    (C) Size. Among the potential matches with the same mutual 
satisfaction and time of entry for the earlier Profile, priority would 
be given to the one with a larger size.
    (D) Time of entry (based on the later Profile). Among the potential 
matches with the same mutual satisfaction, time of entry (for the 
earlier Profile), and size, the match with the earlier time of entry, 
as determined this time by the effective time of entry assigned to the 
later of the buy and sell Profiles involved (the ``later Profile''), 
would have priority over other potential matches.
    (E) Price assignment. In regard to all remaining ties between 
potential matches, which would consist solely of the coordinates for a 
single pair of buy and sell Profiles from two users that may be matched 
with the same mutual satisfaction, time of entry and size, but at 
different prices, priority would be given to the match at a price more 
favorable to the use whose Profile has the earlier time of entry. For 
example, among the last potential matches remaining at the price of 10 
and at 10\1/8\, if the sell Profile is the earlier Profile, then the 
match would take place at the price of 10\1/8\. Two or more Profiles 
that are entered into the system representing the same number of shares 
may result in executions at differing prices depending on the other 
information and conditions entered into the system.
Generation of Orders Resulting From OptiMark Cycles
    Any Orders generated from a Cycle at specific prices and sizes that 
involve the matching of any two user-submitted Profiles, in whole or in 
part, will be immediately executed. The trade between the matched users 
will be transmitted automatically through Nasdaq's Automated 
Confirmation Transaction Service (``ACT'') for trade reporting and 
clearing purposes (discussed more fully below).
    Orders generated from a Cycle at specific prices and sizes that 
involve the matching of any Nasdaq Quote Montage Profile, in whole or 
in part, will be immediately delivered to the relevant participant 
through Nasdaq's existing delivery and execution systems, which will be 
adapted for this purpose. Currently, this means Nasdaq's Small Order 
Execution System (``SOES'') and its SelectNet Service. To facilitate 
the delivery and execution of any Orders resulting from the Nasdaq 
Quote Montage Profiles, Nasdaq intends to employ these evolving trading 
systems in the form that they exist at the time the Application begins 
operations. Any Order transmitted through these means to the 
participant's quote will be executed, unless the quote has been 
executed or canceled, in whole or in part, prior to delivery from the 
Application. If the quotation against which the contra Profile was 
matched has been executed or canceled, in whole or in part, prior to 
delivery from the Application, the Orders generated by the Application 
that correspond to the executed or canceled quotation shall be canceled 
without imposing any liability against the displayed quotation. In the 
case of any Orders delivered from the Application to any UTP Plan 
Exchange Specialist, those executed by the Exchange shall considered 
executed and reported on such Exchange.\25\
---------------------------------------------------------------------------

    \25\ See proposed NASD Rule 4994(a), Order Execution, Reporting, 
and Clearing.

---------------------------------------------------------------------------

[[Page 54708]]

Clearance and Settlement
    As indicated above, transactions that result from matches through 
the Application will be cleared using Nasdaq's post-execution service, 
ACT. Accordingly, final locked-in trades will be forwarded to the 
National Securities Clearing Corporation (``NSCC'') in the ordinary 
course, and will clear and settle regular way through NSCC as would any 
other Nasdaq transaction. All users will receive a report of any 
execution resulting from processing the Profiles submitted by them 
(including any execution resulting against a displayed quotation) as 
soon as possible after the execution takes place. Users that are not 
self-clearing will have the option of re-allocating for clearing 
purposes all or a portion of any execution to another broker by the end 
of the trading day. A Designated Broker generally will be notified 
promptly after the close of the trading day to the extent it has been 
allocated for clearing purposes any transaction resulting from a 
Profile submitted by a user sponsored by that Designated Broker.\26\
---------------------------------------------------------------------------

    \26\ In the comparison, clearance and settlement process, the 
specific identify of the counterparties to a particular trade will 
be temporarily masked until 4:30 p.m. of the trade day.
---------------------------------------------------------------------------

    The Designated Broker that agreed to sponsor a user in the 
Application is fully responsible for the clearance and settlement of 
that user's trades. Nasdaq and the operator of the OptiMark Matching 
Module are not responsible for either the user or another Designated 
Broker failing to pay for or to deliver the securities traded through 
this facility. Further, the NASD, Nasdaq and any other subsidiary or 
affiliate, and the operator of the OptiMark Matching Module are not 
deemed parties to or participants in, as principal or as agent, any 
trade that may occur through the Application. In proposed NASD Rule 
4998(a), the Association states that neither Nasdaq, the NASD, nor any 
affiliate, operator, licensor, or administrator of the OptiMark 
Matching Module may be held responsible for any damages arising from 
the use of the Application. In addition, proposed NASD Rule 4998(b) 
states that neither Nasdaq, the NASD, nor any affiliate, operator, 
licensor, or administrator of the Application makes any express or 
implied warranties with respect to any results that a user or 
Designated Broker using the Application may expect. Paragraph (b) of 
the proposed NASD Rule 4994 states that responsibility for clearance 
and settlement remains with the Designated Broker. The User Agreements 
that each party must sign prior to entering a Profile into the 
Application likewise make clear that the responsibility for clearance 
and settlement lies with the Designated Broker, and that the Designated 
Broker must evaluate the ability of users to settle trades when it 
authorizes a user to submit Profiles under its sponsorship.
    Finally, trades executed through the Application will not be 
subject to NASD Rule 11890, regarding clearly erroneous trades. The 
Application will require parties entering Profiles to agree that, once 
matched, their Profiles cannot be deemed to be erroneously entered. 
Consequently, Nasdaq is amending Rule 11890 to make clear that the Rule 
cannot be used by any Application user as a means to break a trade 
resulting from an OptiMark match.
Trade Reporting, Short Sales, and Halts
    As with other execution services provided by Nasdaq, a public trade 
report will be immediately disseminated by Nasdaq for any executions 
resulting from the Application. These trade reports will be reported on 
behalf of the sell side party to the trade. The report for any 
resulting transaction will not be distinguished on the public tape from 
any other trade reported through Nasdaq. SEC Transaction Fees (Section 
31 Fees) \27\ apply and will be charged against the seller(s).
---------------------------------------------------------------------------

    \27\ 15 U.S.C. 78ee.
---------------------------------------------------------------------------

    With respect to the Nasdaq's short sale rule, Rule 3350, which 
applies to Nasdaq National Market securities, the OptiMark Matching 
Module will be programmed to capture the bid price direction at the 
commencement of every Cycle, as well as the short sale status of every 
Profile entered (i.e., whether it is marked short, and whether or not 
it is exempt). It will exclude any Profile that could result in a match 
and execution of any transaction in a Nasdaq National Market security 
that would be prohibited by the short sale rule.
    Nasdaq will suspend within the Application any activity in any 
security that is subject to a trading halt or suspension pursuant to 
Commission or rules, Nasdaq Market Emergency Rules, or if deemed 
necessary for the protection of investors or to preserve system 
capacity and integrity.
Recordkeeping, Surveillance, and Inspection
    The NASD will maintain, or cause to be maintained, all of the 
records relating to the Application that are maintained for other 
facilities of Nasdaq, including a detailed audit trail of each 
transaction resulting from the Application.\28\ OptiMark will maintain 
all records that are required by the Nasdaq to fulfill its regulatory 
responsibilities and will provide such records upon request to the 
Nasdaq or the Commission.\29\ Information regarding all profiles 
submitted to the Application, whether executed or not, is subject to 
review by the Commission and NASD Regulation, and may be used for the 
purpose of ensuring that any activity conducted through the Application 
is consistent with the federal securities laws and NASD rules. Thus, 
although the Profiles entered into the facility may be anonymous with 
respect to other users and the operators of the system itself, 
regulatory authorities would have full access to all information 
entered.
---------------------------------------------------------------------------

    \28\ As a facility of Nasdaq, the Nasdaq Application is subject 
to SEC review, examination and inspection like any of Nasdaq's other 
trading services, such as SelectNet or SOES.
    \29\ Letter from Eugene A. Lopez, Vice President, Trading and 
market Services, Nasdaq, to Robert L.D. Colby, Deputy Director, 
Division, SEC, dated may 24, 1999; June 3 Letter, note 12 above.
---------------------------------------------------------------------------

    NASD Regulation, Inc. (``NASDR'') has determined that a Profile 
should be considered an order with respect to the NASD's Order Audit 
Trail System, NASD Rules 6950-6957 (``OATS'').\30\ When a customer or 
another member firm gives an order to a member firm that, in turn, is 
entered into the Application as a Profile, the member firm must comply 
with the requirements of OATS. A member firm would be required to 
record and report the receipt of the order, along with any subsequent 
routing, cancellation, and modification of the order. In addition, when 
the order is routed to the Application, the route would be required to 
be reported to OATS in the same manner as orders routed to any other 
Nasdaq execution facility.\31\
---------------------------------------------------------------------------

    \30\ Letters from Thomas R. Gira, Vice President, Market 
Regulation, NASDR, to Richard C. Strasser, Assistant Director, 
Division, SEC, dated July 8 and July 28, 1999.
    \31\ The OATS requirements also would apply when a member firm 
enters a proprietary non-market-making order into the Application 
for execution. The OATS requirements would not apply when a non-
member user submits a Profile directly to the Application pursuant 
to a Designated Broker Consent Agreement. Id.
---------------------------------------------------------------------------

    The operations of all components of the Application will be 
monitored on an ongoing basis under Nasdaq's inspection, surveillance, 
and compliance programs. All information regarding activity in the 
Application will be maintained and provided to the NASD on a regular 
and continuous basis for normal surveillance purposes. In addition, the 
NASD will monitor OptiMark personnel who perform services for the 
Application to make sure that their activity is consistent with the 
NASD's responsibilities as a self-regulatory organization.

[[Page 54709]]

    As a party that has agreed to participate in the operation of the 
Application as a facility of Nasdaq, OptiMark is required to assist the 
NASD in any way deemed necessary by the NASD in carrying out the NASD's 
regulatory responsibilities with respect to the Application. OptiMark 
personnel will perform administrative and computer services and will 
not be permitted to trade through the Application. In addition, 
OptiMark personnel will not be permitted to advise others with respect 
to trading any particular security or securities, other than to carry 
out such functions as may be prescribed by the NASD for OptiMark 
personnel who are members of a Nasdaq service desk team. OptiMark will 
take reasonable steps to ensure that no OptiMark employee who provides 
services to the Application is subject to a statutory disqualification, 
as defined in Section 3(a)(39) of the Act.\32\ OptiMark also will 
establish adequate safeguards and procedures to facilitate the 
confidentiality of trading information of Application users. Finally, 
all of the operations of OptiMark that are related to the operation of 
the Application as a facility of Nasdaq, including those portions 
developed by OptiMark, are subject to Commission oversight, 
examination, and inspection.\33\
---------------------------------------------------------------------------

    \32\ 15 U.S.C. 78c(a)(39).
    \33\ Letter from Eugene A. Lopez, Vice President, Trading and 
Market Services, Nasdaq, to Richard Strasser, Assistant Director, 
Division, SEC, dated April 28, 1999.
---------------------------------------------------------------------------

System Capacity and Integrity
    The Application will be operated by Nasdaq, which will adhere 
closely to all of the principles applied by the Commission in reviewing 
automation at markets operated by the self-regulatory 
organizations.\34\ Nasdaq has reviewed the proposed system and believes 
that it will provide sufficient capacity to handle the volume of data 
reasonably anticipated for the Application. Further, Nasdaq has 
reviewed the system's security measures that will be in place and 
carefully considered all aspects of the system to ensure that it has 
been designed to prevent unauthorized access to the Application. 
Because the primary site of the system will be operated from Nasdaq's 
own data processing facility, Nasdaq believes that it will be able to 
maintain the security of the operations and to monitor closely and 
maintain the reliability of the system and its software.\35\
---------------------------------------------------------------------------

    \34\ See note 50 below.
    \35\ March 19 Letter, note 19 above.
---------------------------------------------------------------------------

Fees for the Application
    The NASD will submit a fee filing pursuant to Section 19(b) of the 
Act \36\ to address the execution charges that will be assessed. The 
NASD plans to assess a fee for every execution that occurs as a result 
of a match; OSI will not separately assess a fee.\37\ A market 
participant whose quote in Nasdaq is accessed through the Application 
will not pay any fee.\38\
---------------------------------------------------------------------------

    \36\ 15 U.S.C. 78s(b).
    \37\ March 19 Letter, note 19 above.
    \38\ Amendment No. 3, note 7 above.
---------------------------------------------------------------------------

Trading Parameters for Initial Operations
    In Amendment No. 5, the NASD added proposed NASD Rule 4999 to 
establish trading parameters for operation of the Application during 
the proposed pilot period.\39\ Under proposed Rule 4999(a), the number 
of Eligible Securities is limited to a maximum of 250 issues 
specifically approved by Nasdaq. These securities were selected 
primarily on the basis of their historical volume and index trading 
activities and are among the top tier of Nasdaq's most actively-traded 
and well-capitalized issues. The proposal authorizes the NASD to amend 
the list of securities by filing a proposed rule change with the 
Commission pursuant to Section 19(b)(3)(A) of the Act. In addition, 
only 10 of the initial 250 Eligible Securities may be traded through 
the Application until an appropriate EDI facility is implemented.\40\
---------------------------------------------------------------------------

    \39\ As discussed further below, the NASD is proposing trading 
parameters in response to comments raised by the public and the SEC 
staff.
    \40\ See note 14 above for a description of the EDI facility.
---------------------------------------------------------------------------

    Proposed Rule 4999(b) limits the maximum frequency of Cycles to one 
every five minutes, except that no Cycle may take place at any time 
during a trading day when Nasdaq has suspended all trading activities 
through the Application pursuant to proposed NASD Rule 4999(c). Under 
proposed NASD Rule 4999(c), all trading activities in the Application 
will be suspended immediately for the remainder of the trading day if 
the cumulative total daily volume of transactions resulting from all 
Cycles that are executed and reported through Nasdaq systems since the 
opening of regular trading hours on that day (``Application Volume'') 
equals or exceeds 15% of the ``Volume Trigger.'' The term ``Volume 
Trigger'' is defined in proposed NASD Rule 4999(d) as the share-volume 
equivalent (based on a weighted average dollar price) of the average 
daily aggregated dollar volume of all transactions, including those 
resulting from all Cycles, that are executed and reported through 
Nasdaq systems in the current approved list of 250 Eligible Securities 
for the preceding 30 consecutive trading days. In addition, if the 
Application Volume equals or exceeds 12.5% of the Volume Trigger, all 
trading through the Application will be suspended immediately 
thereafter for 15 minutes. Trading will resume upon expiration of the 
15-minute halt and will continue until the regularly scheduled close of 
the Nasdaq Application; provided, however, that trading will be shut 
down for the day, as described above, if Application Volume equals or 
exceeds 15% of the Volume Trigger.

III. Comment Summary and NASD Response

    The Commission received four letters in response to its request for 
comments on the proposed rule change.\41\ The ICI Letter strongly 
supported approval, asserting that the Application would increase 
liquidity, reduce trading costs, and increase the efficiency of the 
Nasdaq market. The Archipelago Letter, however, expressed concern that 
the Application should not be approved unless it was properly 
integrated into the marketplace. In particular, the Archipelago Letter 
was concerned that (1) the proposal did not include a fee schedule, (2) 
the proposal did not require the Application to access customer limit 
orders priced below a market maker's or ECN's best quote and therefore 
could generate a substantial number of executions that traded through 
investor orders, and (3) the maximum frequency of Cycles (every 90 
seconds) was too short a period given that the Application would be 
exempt from many requirements that govern the operation of continuous 
markets.
---------------------------------------------------------------------------

    \41\ See note 5 above.
---------------------------------------------------------------------------

    In its response to the Archipelago Letter,\42\ Nasdaq stated that 
its practice was not to include fee schedules in system approval 
filings and that it planned to make a separate fee filing at a 
subsequent time. With respect to the possibility that customers' orders 
not equal to the best quote could be traded through, Nasdaq noted that 
such orders would not be publicly displayed and that no inter-linked 
market has a requirement that precludes a trade-through in such 
circumstances. Finally, Nasdaq noted that, during the proposed pilot 
period, Cycles would be limited to no more than one every five minutes.
---------------------------------------------------------------------------

    \42\ Amendment No. 3, note 7 above.
---------------------------------------------------------------------------

    The Clearing Firm Committee of the SIA (``Committee'') submitted 
two

[[Page 54710]]

comment letters,\43\ each of which expressed concern that the 
Application presented unique risks for clearing firms who acted as 
Designated Brokers and introduced significant risk into the clearance 
and settlement system. The Committee believed that these risks should 
be addressed before the Commission approved the proposed rule change. 
Specifically, the Committee was concerned that the Application did not 
provide clearing brokers with a sufficient capability to monitor the 
intra-day positions of the users that they sponsor in the Application 
because their trades would not be disclosed to the clearing brokers 
until the end of the trading day. The Committee noted that the 
counterparty, concentrated positions, and liquidity of an issue all 
were important factors to be considered in risk management. The 
Committee believed that real-time monitoring of positions was not as 
critical in the market for exchange-listed securities because the depth 
and liquidity of that market would allow a Clearing Broker to trade out 
of a position if necessary due to the failure of a correspondent or 
user. It asserted that, in the over-the-counter market, many issues 
were thinly traded and would leave the Clearing Brokers with an 
unacceptable level of risk.
---------------------------------------------------------------------------

    \43\ See note 5 above.
---------------------------------------------------------------------------

    The Committee also was concerned about the unwieldy methods for 
communicating changes in Trading Limits and Alarm Thresholds to the 
Application. The Committee contrasted the Application with the risk 
management tools currently provided to Clearing Brokers in ACT, which 
allows them to set credit limits for their correspondents, to monitor 
the trading of correspondents on an intra-day basis, and to block 
reporting to ACT when a correspondent reaches its trading limits. The 
Committee believed that automated risk management tools should be a 
prerequisite to approval of the Application. In particular, it asserted 
that the Application should provide enhancements that allowed Clearing 
Brokers to monitor risk effectively on an intra-day basis and that 
placed control of credit limits with the Clearing Brokers. If such 
enhancements were not provided, the Committee expressed concern that 
responsible firms would restrict access to the Application by 
establishing conservative credit limits, but that other Clearing 
Brokers with less sophisticated risk management systems might act less 
responsibly. These less responsible firms might be susceptible to 
failure, thereby causing a domino effect throughout the industry.\44\
---------------------------------------------------------------------------

    \44\ The Committee also believed that the NASD's reliance on the 
legal agreements required of users and Designated Brokers who 
participate in the Application represented an attempt to conduct 
improper rulemaking.
---------------------------------------------------------------------------

    The NASD responded to the Clearing Committee's concerns in two 
letters.\45\ First, it emphasized that only Designated Brokers that are 
Clearing Brokers will be allowed to establish Trading Limits and Alarm 
Thresholds for non-self-clearing users of the Application. Second, the 
NASD noted that both users that are not members of the NASD and NASD 
members that are not self-clearing must be sponsored by a Designated 
Broker that is a Clearing Brokers before they can participate in the 
Application. Third, the NASD emphasized that the Trading Limits 
established by a Clearing Brokers establish a ``hard ceiling'' for user 
Profiles. The Application would reject any Profile that created a 
potential for a user's trading to exceed its Trading Limit. Finally, 
the NASD stated that it was committed to enhancing the Application in 
the future and that it had begun to examine changes to the Application 
that would more closely integrated ACT risk management with the 
Application. In the meantime, however, as discussed above, the NASD has 
proposed to limit the Application to 250 of the largest Nasdaq stocks, 
to cap the maximum daily volume that may be done through the 
Application, and to provide an electronic means for delivering and 
receiving confirmation of intra-day credit adjustments.
---------------------------------------------------------------------------

    \45\ Letter from Richard Ketchum, President, NASD, and Phillip 
J. Riese, CEO, OptiMark Technologies, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated September 3, 1999; letter from Eugene 
A. Lopez, Vice President, Trading and Market Services, Nasdaq, to 
Richard Strasser, Assistant Director, Division, SEC, dated July 26, 
1999.
---------------------------------------------------------------------------

IV. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities association, 
particularly the requirements of Section 15A(b).\46\ The NASD's 
proposal to establish rules to implement the Application is consistent 
with the requirements of Section 15A(b)(6) that the rules of an 
association be designed to remove impediments to and perfect the 
mechanism of a free and open market and a national market system, while 
protecting investors and the public interest. In addition, NASD's 
proposal is consistent with the requirements of Section 15A(b)(6) that 
an association's rules be designed to prevent fraudulent and 
manipulative acts and practices, and to promote just and equitable 
principles of trade, and not be designed to permit unfair 
discrimination between customers, issuers, and broker-dealers.\47\
---------------------------------------------------------------------------

    \46\ 15 U.S.C. 78o-3(b).
    \47\ In approving the proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    The Commission also finds that the proposed rule change is 
consistent with Section 11A of the Act.\48\ The Commission believes 
that the proposed Application would further the purposes of Section 11A 
and the development of a national market system by promoting 
economically efficient execution of securities transactions, fair 
competition among markets, the best execution of customer orders, and 
an opportunity for orders to be executed without the participation of a 
dealer.
---------------------------------------------------------------------------

    \48\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

    The Commission previously approved a proposed rule change by the 
Pacific Exchange, Inc. (``PCX''), to establish the PCX Application of 
the OptiMark System, which permits trading through the OptiMark system 
of equity securities listed or traded on the PCX.\49\ Approval of the 
Nasdaq Application of the OptiMark System will extend to investors the 
opportunity to take advantage of the OptiMark trading program for 
securities quoted on Nasdaq. The Application provides a new and 
potentially more efficient way to match and execute trading interest in 
securities. The Application could be particularly useful in meeting the 
demands of sophisticated portfolio managers and other market 
professional implementing complex trading strategies. These market 
participants often desire to minimize the market effect of their 
transactions through expression of varied trading interests on a 
confidential basis. The Application will give these investors a means 
for carrying out their investment strategies, often without the 
participation of a dealer. At the same time, the Application will allow 
retail customers, through member users, to interact with institutional 
trading interests. As discussed above, retail trading interest may 
enter the Application through a broker-dealer directly or through the 
Nasdaq Quote Montage Profiles.
---------------------------------------------------------------------------

    \49\ Securities Exchange Act Release No. 39086 (September 17, 
1997), 62 FR 50036 (September 24, 1997).
---------------------------------------------------------------------------

    The Commission believes that the Application, as a facility of 
Nasdaq, is designed to operate in a manner that is consistent with the 
regulatory purposes

[[Page 54711]]

of the Act. The NASD will control the operation of the Application and 
will be fully responsible for all activity that takes place through the 
Application, including its regulation and oversight. As part of its 
obligations under the Act and pursuant to its own rules, the NASD will 
conduct all necessary surveillance of the operation of and trading 
through the Application. The NASD also has represented that the 
Application will have a full audit trail capability, adequate computer 
capacity to handle and process user Profiles and order flow, and 
adequate computer security and procedures to ensure the safety and 
confidentiality of user transmissions.\50\ Finally, OptiMark, as a 
party that has agreed to operate portions of a facility of a self-
regulatory organization, is required to cooperate with the NASD in 
meeting its regulatory responsibilities and will be subject to 
Commission oversight and examination.
---------------------------------------------------------------------------

    \50\ As with any other facility of a self-regulatory 
organization, the Commission expects to conduct a full EDP review of 
the Application and its operations. See e.g., the Commission's 
Automation Review Policy guidelines, Securities Exchange Act Release 
No. 27445 (Nov. 16, 1989), 54 FR 48703 (Nov. 24, 1989); Securities 
Exchange Act Release No. 29185 (May 9, 1991), 56 FR 22490 (May 15, 
1991).
---------------------------------------------------------------------------

    Access to OptiMark will be limited to NASD members that are 
Clearing Brokers, as well as non-self-clearing NASD members and non-
members who will have access to the Application only through a 
Designated Broker/Clearing Broker.\51\ With respect to these users, 
before submitting Profiles to the Application, the Designated Broker/
Clearing Broker will be required to authorize their access to the 
Application and accept responsibility for their transactions. The 
Designated Broker Agreement will impose credit limits on the user's 
trading through the Application, and these credit limits will be 
programmed into the OptiMark Matching Module. The Designated Broker 
will be alerted as its potential exposure to its customers, 
individually or in the aggregate, approaches the established credit 
limits. The Application will not allow any user to enter a Profile that 
could result in a transaction that exceeded the user's credit limit. 
This ``hard ceiling'' on a user's trading means that a Designated 
Broker/Clearing Broker will always know the maximum amount of exposure 
that it could have in the Application.
---------------------------------------------------------------------------

    \51\ NASD members will be required to maintain information and 
records concerning non-member access for which they are responsible. 
The NASD has represented to the Commission that it would require its 
members to make such non-member user information available to the 
NASD upon request, so that the NASD can fulfill its duties regarding 
surveillance. Telephone conversation between Eugene A. Lopez, Vice 
President, Trading and Market Services, Nasdaq, and Daniel M. Gray, 
Special Counsel, Division, SEC, on June 29, 1999.
---------------------------------------------------------------------------

    The Application does not at this point provide a clearing broker 
with the opportunity to monitor its intra-day exposure to its users or 
permit a Clearing Broker to input its Trading Limits and Alarm 
Thresholds directly into the Application. The Application therefore 
does not provide some of the risk management tools that currently are 
available to Clearing Brokers through ACT for trading in Nasdaq 
securities. The Commission believes, however, that the Application 
provides reasonable risk management tools for its initial operations 
during the six-month pilot period. These tools include the hard ceiling 
on a user's trading, the addition of an EDI for communication of 
Trading Limits and Alarm Thresholds, and the trading parameters that 
will restrict the scope of the initial operations of the Application. 
The limitation of Eligible Securities to 250 of the most actively-
traded securities on Nasdaq provides greater assurance that the depth 
and liquidity of the market should help to ensure that a Clearing 
Broker may trade out of a position quickly if necessary. The limitation 
on frequency of Cycles to one every five minutes will provide a 
Clearing Broker with a greater opportunity to modify its credit limits 
in response to notices that a user is approaching its credit limit. The 
addition of the EDI will enhance the ability of clearing brokers to 
modify credit limits quickly and accurately. Finally, the absolute 
limitation on trading volume in the Application to 15% of total Nasdaq 
volume in the 250 Eligible Securities helps to ensure that the 
Application will not become a primary facility of the Nasdaq market 
while the Application's risk management tools are being refined during 
the six-month pilot period.\52\ The NASD has agreed to work on these 
enhancements and to submit them to the Commission before the six-month 
pilot period expires.
---------------------------------------------------------------------------

    \52\ The SIA Clearing Committee expressed the view that the 
NASD's reliance on contractual requirements included in the User and 
Designated Broker Agreements was not appropriate because such 
agreements had not been subject to public comment. The Commission 
disagrees and notes that the relevant provisions of these agreements 
were described in the notice of the proposed rule change that was 
published for public comment.
---------------------------------------------------------------------------

    Although it is approving the Application for a six-month pilot 
period, the Commission stresses the need for Clearing Brokers to 
recognize the different nature of the risk management tools provided by 
the Application and those provided by ACT for trading through other 
Nasdaq facilities. It is of paramount importance that Clearing Brokers 
set appropriate user credit limits in advance of trading through the 
Application. Unlike in ACT, where Clearing Brokers have an opportunity 
to monitor their intra-day exposure to correspondents and to refuse to 
accept responsibility for certain large trades after they have been 
executed,\53\ in the Application, Clearing Brokers must set credit 
limits based on a recognition that they will not have this opportunity 
to decline a transaction. To help monitor the credit limits set by 
clearing brokers in the Application, Nasdaq will provide reports, upon 
request, to the Commission and NSCC showing each participating Clearing 
Broker's total allocated trading limits for its customer base.
---------------------------------------------------------------------------

    \53\ The ACT risk management functions are set forth in NASD 
Rule 6150.
---------------------------------------------------------------------------

    The Commission believes that the NASD is adopting reasonable 
requirements for the clearance and settlement of transactions resulting 
from the Application. All such transactions will be reported through 
ACT, forwarded to NSCC in the ordinary course, and clear and settle 
regular way as would any other Nasdaq transaction. The Commission also 
believes that the proposal is designed in a manner that will allow the 
NASD to meet its obligations with respect to the recordkeeping and 
reporting of transactions resulting from the Application. As with other 
execution services provided by Nasdaq, a public trade report will be 
immediately disseminated by Nasdaq for any executions resulting from a 
Cycle in the Application. The report for such transactions will not be 
distinguished on the public tape from any other trade reported through 
Nasdaq. Although such transaction reports may occur in rapid sequence, 
the individual transaction reports will still be displayed in the order 
of execution of the transactions.
    In addition, all transactions resulting from the Application will 
comply with the applicable SEC and NASD rules, including the NASD's 
short sale rule, Rule 3550.
    In sum, the Commission historically has encouraged markets to 
integrate new data communications and trade execution mechanisms into 
their markets in furtherance of the development of the national market 
system. The Application is likely to promote competition among market 
centers because it has the potential to attract new market participants 
and to increase order flow to Nasdaq. By

[[Page 54712]]

attracting order flow, the Application may provide a new and enhanced 
source of liquidity for investors. Finally, existing market interest on 
Nasdaq will be adequately integrated into the Application through the 
Nasdaq Quote Montage Profiles, which will create the opportunity for 
trading interest expressed through user Profiles to interact with 
publicly displayed quotes.
    The Commission finds that good cause exists to approve Amendment 
Nos. 2, 3, and 5 to the proposed rule change prior to the 30th day 
after the date of publication of filing thereof in the Federal 
Register. Amendment No. 2 expands the range of publicly displayed bid 
and offer quotes that will be included in a Cycle as Nasdaq Quote 
Montage Profiles and that will thereby interact with user Profiles. As 
the NASD notes, this change will make the Application more consistent 
with the PCX Application of the OptiMark System that previously was 
approved by the Commission. Amendment No. 3 merely clarifies that all 
users must be either self-clearing or sponsored by a Designated Broker 
that is a Clearing Broker, and that only Designated Brokers that are 
Clearing Brokers can establish the trading limits for users. Finally, 
Amendment No. 5 provides for an EDI to enhance the ability of 
Designated Brokers to modify Trading Limits or Alarm Thresholds, and 
establishes several trading parameters for the initial operations of 
the Application during the six-month pilot period; these trading 
parameters limit the scope of the Application during the pilot. The 
Commission therefore finds good cause to accelerate approval of 
Amendment Nos. 2, 3, and 5.

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment Nos. 2, 3, and 5, including whether they 
are consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Copies of 
the submission, all subsequent amendments, all written statements with 
respect to the proposed rule change that are filed with the Commission, 
and all written communications relating to the proposed rule change 
between the Commission and any person, other than those that may be 
withheld from the public in accordance with the provisions of 5 U.S.C. 
552, will be available for inspection and copying in the Commission's 
Public Reference Room. Copies of such filing also will be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to File No. SR-NASD-98-85 and should be 
submitted by October 28, 1999.

VI. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\54\ that the proposed rule change (SR-NASD-98-85) is approved on a 
pilot basis until April 3, 2000.\55\

    \54\ 15 U.S.C. 78s(b)(2).
    \55\ Approval of the pilot should not be interpreted as 
indicating that the Commission is predisposed to approving the 
proposal permanently.
---------------------------------------------------------------------------

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\56\
---------------------------------------------------------------------------

    \56\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Jonathan G. Katz,
Secretary.
[FR Doc. 99-26154 Filed 10-6-99; 8:45 am]
BILLING CODE 8010-01-M