[Federal Register Volume 65, Number 21 (Tuesday, February 1, 2000)]
[Notices]
[Pages 4857-4859]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-2117]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42353; File No. SR-NASD-99-75]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to ECN/ATS Participation in the ITS/CAES System

January 20, 2000.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Exchange Act'' or ``Act''),\1\ notice is hereby given that on 
December 27, 1999, 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'') the proposed rule 
change as described in Items I, II, and III below, which Items have 
been prepared by Nasdaq. The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    Nasdaq is proposing to amend Rules 5210, 5220 and 6320 of the Rules 
of the NASD, to permit ECNs and ATSs to register as market makers in 
listed securities through Nasdaq-provided quotation and trading 
facilities. Below is the text of the proposed rule change. Proposed new 
language is in italics.
* * * * *
Rule 5210. Definitions
    (a) through (d)--No changes.
    (e) The term ``ITS/CAES Market Maker shall mean a member of the 
Association that is registered as a market maker with the Association 
for the purposes of participation in ITS through CAES with respect to 
one or more ITS securities in which he is then actively registered. The 
term ``ITS/CAES Market Maker'' shall also include a member of the 
Association that meets the definition of electronic communications of 
network (``ECN''), as defined in SEC Rule 11Ac-1-1(a)(8), or 
alternative trading system (``ATS''), subject to SEC Regulation ATS 
Rule 301(b), and has voluntarily chosen to register with Nasdaq and 
meets the terms of registration set forth in the Nasdaq-provided 
agreement linking ECNs and ATSs to the CAES system. Registration as an 
ITS/CAES Market Maker is mandatory for all registered CQS market makers 
in securities eligible for inclusion in the ITS/CAES linkage.
* * * * *
Rule 5220. ITS/CAES Registration
    In order to participate in ITS, a market maker or ECN/ATS must be 
registered with the Association as an ITS/CAES market maker in each 
security in which a market will be made in ITS. Such registration shall 
be conditioned on the ITS/CAES Market Maker's continuing compliance 
with the following requirements:
    (a)-(g) No change.
    (h) Election to participate in ITS/CAES through either automatic 
execution or order delivery. As a part of its contractual obligation 
required under subsection (i) below, Market Makers choosing order 
delivery status are required to satisfactorily demonstrate to Nasdaq 
the technical capacity to properly and timely respond to orders 
delivered through CAES.
    (i) With respect to order delivery ITS/CAES Market Makers, 
execution of an addendum to the ITS/CAES Market Maker application 
agreement at least two business days prior to the requested date of 
operation.
* * * * *
Rule 6320. Registration as a CQS Market Maker
    (a) No Change.
    (b) An Association member, including an operator of an ECN/ATS as 
defined in Rule 5210(e), seeking registration as a CQS market maker 
shall file an application with the Association. The application shall 
certify the member's good standing with the Association and shall 
demonstrate compliance with the net capital and other financial 
responsibility provisions of the Act. A member's registration as a CQS 
market maker shall become effective upon receipt by the member of 
notice of approval of registration by the Association.

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

    In its filing with the Commission, Nasdaq included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The self-regulatory organization has prepared summaries, 
set forth in Section 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

1. Purpose
    Nasdaq operates a trading system known as the Computer Assisted 
Execution System (``CAES''), which allows NASD member firms to direct 
orders in Consolidated Quotation System (``CQS'') securities to Market 
Makers for execution. Through CAES, NASD order-entry firms and Market 
Makers can participate in the ``Third Market'' \2\ by entering market 
and limit orders in exchange-listed securities to be executed against 
other market makers quoting at the best bid or offer in those 
securities. CAES also serves as the NASD's interface with the 
Intermarket Trading System (``ITS'').\3\
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    \2\ Off-exchange trading of exchange-listed securities.
    \3\ ITS is a communication network designed to facilitate 
intermarket trading in exchange-listed securities by linking the 
NASD and the national securities exchanges. Operation of ITS is 
governed by a national market system plan known as the ``Plan for 
the Purpose of Creating and Operating an Intermarket Communications 
Linkage Pursuant to Section 11A(a)(3)(B) of the Securities Exchange 
Act of 1934'' (``ITS Plan''). Under the current ITS Plan, NASD 
members participating as ITS market makers must confine their market 
making to ``Rule 19c-3 securities'' (i.e., reported securities that 
were (1) not traded on a national securities exchange prior to April 
26, 1979, or (2) traded on such an exchange on April 26, 1979, but 
which ceased to be traded on an exchange for any period of time 
thereafter. By Commission action on December 9, 1999, this 
limitation will be removed effective February 14, 2000. See Exchange 
Act Release No. 42212 (December 9, 1999), 64 FR 70297 (December 16, 
1999).
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    The Third Market allows traditional market makers to actively make 
markets in a large number of New York Stock Exchange and American Stock 
Exchange listed stocks. While this market is currently utilized by many 
NASD member firms, Nasdaq believes that certain enhancements to CAES 
could provide more significant benefits to all NASD members. The 
enhancements

[[Page 4858]]

would allow CAES market makers to compete more effectively with any and 
all markets operating today by providing the best possible executions 
for investors, therein contributing to a greater national market 
system.
    Over the past three years, NASD members acting as ECNs in The 
Nasdaq Stock Market have provided increasingly more significant 
benefits to investors in Nasdaq securities. ECNs have helped to 
contribute to narrower spreads and have enhanced the ability for 
investors to control the prices at which they obtain executions. While 
these benefits have accrued to Nasdaq securities, ECNs have not traded 
in great measure in securities listed on traditional exchanges.
    The reason for this is, in part, that NASD Rules currently do not 
clearly provide that ECNs can register as CQS and CAES market makers. 
In addition, CAES functionality currently permits only automatic 
executions in accessing the market maker's quotation. ECNs, which, to 
date, have functioned only within order delivery systems (i.e., 
SelectNet for Nasdaq securities), have been reluctant to participate in 
CAES due to this system feature.
    Nasdaq is now proposing to modify the CAES rules and system to 
allow ECN/ATSs to register as market makers in listed securities 
through CAES. Nasdaq believes that ECN/ATS participation in CAES would 
have a positive impact upon this market by significantly increasing 
order flow, thereby contributing to a more active and liquid market to 
the benefit of all CAES users, and, ultimately, to investors. 
Furthermore, Nasdaq is unable to discern any reason why ECN/ATSs should 
be denied the opportunity to participate in the Third Market on an 
equal basis with other NASD members who choose to register as ITS/CAES 
Market Makers.
    Accordingly, Nasdaq proposes to allow ECN/ATSs to choose to be 
deemed ITS/CAES Market Makers by amending NASD Rules 5210(e), 5220 and 
6320, thereby including ECN/ATSs within the definition of ``ITS/CAES 
Market Maker'' and ``CQS Market Maker,'' and requiring the execution of 
an ECN/ATS addendum to the ITS/CAES Market Maker application agreement. 
These changes would allow any ECN/ATS to compete on an equal basis with 
other Market Makers, yet also require such ECN/ATS to assume the 
additional obligations and restrictions imposed upon ITS/CAES Market 
Makers by the ITS Plan and NASD rules. An ECN/ATS that chooses to 
exercise this option of registration, consequently, would be required 
to post two-sided quotations, be firm for the price and size of those 
quotations, and participate in the CAES execution service on the same 
footing as other non-ECN/ATS ITS/CAES market makers.\4\ This selection 
would also impose the additional compliance duties traditionally 
required of market makers participating in ITS/CAES, including, for 
example, the rules concerning pre-opening application, trade through, 
locked and crossed markets, and block transactions.\5\ ECN/ATSs would 
assume the added responsibility for implementing any and all 
technological and programming modifications to their internal systems 
to demonstrate compliance with such requirements.
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    \4\ With respect to the two-sided quotation obligation, ECN/ATS 
CAES Market Makers will be permitted to auto-quote in 100 share lots 
away from the national best bid and offer to the extent that a 
particular ECN or ATS does not have a customer order to represent. 
If an ECN/ATS CAES Market Maker quotation is accessed because such 
quotation becomes the national best bid or offer or is subject to 
another rule requiring its execution, the ECN/ATS CAES Market Maker 
will be required to assume a proprietary position in that security.
    \5\ NASD Rules 5240, 5262, 5263, and 5264, respectively.
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    In registering ECN/ATSs as ITS/CAES Market Makers, ECN/ATS CAES 
Market Makers will be required to operate on terms that are the same as 
traditional CAES Market Makers. In particular, within the ITS/CAES 
market, there will be an absolute prohibition against quote access 
fees. Because ECN/ATSs would be registered as market makers, the 
Commission's interpretation of its firm quote rule which prohibits 
quote access fees by market makers would apply to ECN/ATS market makers 
as it does with traditional ITS/CAES market makers.\6\ This prohibition 
will eliminate the inequitable position that currently exists within 
the Nasdaq market in which ECN/ATSs, unlike market makers, are 
permitted to charge quote access fees.\7\ Furthermore, Nasdaq believes 
that, due to the CAES interface with ITS, the implementation of quote 
access fees would be entirely infeasible within CAES and would 
negatively affect the terms of the ITS plan.
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    \6\ Specifically, the Commission has stated in response to a 
request for ``no action relief'' that SEC Rule 11Ac1-1(c)(2) (``SEC 
Firm Quote Rule'') does not permit a market maker posting a quote to 
impose a fee on market participants that customarily trade with the 
market maker at its quote without a markup. See letter from Robert 
L.D. Colby, Deputy Director, SEC Division of Market Regulation, to 
M. Joseph Messina, Vice President, M.H. Meyerson & Co., Inc., dated 
May 5, 1998. ECN/ATSs, though not classified within the Nasdaq 
market as market makers (NASD Rule 4623), will be classified as 
market makers within the ITS/CAES market.
    \7\ See, e.g., letter from Richard R. Lindsey, Director, SEC 
Division of Market Regulation, to Charles R. Hood, Senior Vice 
President and General Counsel, Instinet Corporation, dated January 
17, 1997, granting ``no action relief'' for ECNs that impose quote 
access fees upon non-customer broker-dealers.
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    In addition, as discussed above, modifications must be made to the 
operation of the CAES system itself to technologically accommodate ECN/
ATS participation. In the current CAES environment, all orders are 
executed against market makers through an automatic execution process. 
That is, the system delivers a report of a completed execution at the 
market maker's quoted price and size when another CAES market 
participant or ITS Exchange chooses to access that market maker's 
quote. In an effort to conform to the stated necessity of ECN/ATSs 
wherein they would be unable to participate within the current 
automatic execution environment, Nasdaq would modify CAES to facilitate 
order delivery interaction for any ITS/CAES Market Maker that chooses 
to operate in an order delivery mode as long as the firm automates its 
response to the delivered orders. The change would make it clear that 
either an ECN/ATS or non-ECN/ATS Market Maker could receive the 
delivery of an order (as opposed to an execution report), and 
immediately accept or decline that delivery by automated means.\8\ A 
decline would be permissible only if it were consistent with the SEC's 
and NASD's firm quote rules.
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    \8\ If order delivery is selected, the ITS/CAES market maker 
(ECN or non-ECN) would be required to demonstrate to Nasdaq its 
ability to conform to system specifications which would mandate an 
automated and immediate acceptance or rejection, consistent with SEC 
and NASD firm quote obligations.
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    Nasdaq contends that this modification will allow market makers to 
operate effectively and rapidly in fast moving markets. Indeed, in 
comparing the proposed CAES order delivery system with the ITS 
configuration, Nasdaq anticipates CAES order delivery market makers to 
be capable of responding to CAES and ITS orders in approximately 2-5 
seconds.\9\
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    \9\ The ITS Plan does not have any requirement related to 
response times. In fact, in ITS, when one participant forwards a 
commitment to another, the commitment has a life of one minute or 
two minutes. The responding market is not required by system or rule 
to respond to that message, except in so far s the firm quote rule 
requires a response.
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    Further, Nasdaq believes the CAES order delivery system to be 
entirely consistent with the ITS Plan, in that the ITS/CAES market will 
continue to require automated responses to all ITS commitments sent by 
other exchange participants to the Third Market. In fact, the only 
variation between the current and proposed CAES interface to ITS is 
that, in certain situations, the automated

[[Page 4859]]

response to the ITS commitment will incorporate an automated response 
by the CAES participant to CAES, followed, in succession, by an 
automated response from CAES to ITS. This fully automated response 
procedure, as with all others contained in this proposal, will be in 
compliance with every aspect of the ITS Plan.
2. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
the provisions of Sections 11A(a)(1)(C), 11A(a)(1)(D), 11A(a)(2) and 
15A(b)(c) of the Act. Section 11A(a)(1)(C) provides that it is in the 
public interest and appropriate for the protection of investors and the 
maintenance of air and orderly markets to assure: (1) Economically 
efficient execution of securities transactions; (2) fair competition 
among brokers and dealers; (3) the availability to brokers, dealers and 
investors of information with respect to quotations and transactions in 
securities; (4) the practicability of brokers executing investors' 
orders in the best market; and (5) an opportunity for investors' orders 
to be executed without the participation of a dealer. Section 
11A(a)(1)(D) states that the linking of all markets for qualified 
securitis through communications and data processing facilities will 
foster efficiency, enhance competition, increase the information 
available to brokers, dealers and investors, facilitate the offsetting 
of investor's orders and contribute to best execution of such order. 
Section 11A(a)(2) directs the Commission to facilitate the 
establishment of a national market system for qualified securities. 
Section 15A(b)(6) requires that the rules of a registered national 
securities association be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system, and, in general, to 
protect investors and the public interest; and are not designed to 
permit unfair discrimination between customers, issuers, brokers, or 
dealers.
    Nasdaq believes that the proposed rule specifically promotes the 
objectives of these sections of the Act by encouraging participation in 
the National Market System for listed securities and providing fair and 
unburdened access for all NASD members, to the ultimate benefit of 
member firms and public customers alike.

B. Self-Regulatory Organization's Statement on Burden on Competition

    Nasdaq 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

    No written comments were either solicited or received.

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

    Within 35 days of the publication of this notice in the Federal 
Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) by order approve the proposed rule change, or
    (B) institute proceedings to determine where the proposed rule 
change should be disapproved.

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. In particular, commenters are 
invited to address whether ATSs (in addition to ECNs) should be 
included in the proposal. The Commission also notes that the proposed 
rule change will have an effect on the operation of the ITS pre-opening 
application. Generally, under ITS rules, an exchange specialist is 
required to accept those pre-opening responses sent to the exchange by 
market makers from other participant markets prior to the opening of 
their markets for trading in the security. If, however, one or more 
market makers from other participant markets have already opened 
trading in a security, the exchange specialist is not required to (but 
may in his discretion) accept preopening responses from that other 
participant market for the purpose of including them in the opening 
transaction.\10\ Because a pre-opening response from the ITS/CAES Third 
Market is sent in aggregate form--that is, pre-opening third market buy 
and sell interest from all third market makers is sent as one response, 
it is possible that an ECN/ATS CAES Market Maker trading a security 
before the opening will trigger the exception to the requirement that 
the exchange specialist accept a pre-opening response from the third 
market. The Commission requests that interested persons provide written 
comment on this aspect of the proposal.
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    \10\ The same procedure applies for re-openings following 
trading halts. See Exhibit A of the ITS Plan, ``Pre-Opening 
Application Rule,'' Sec. (b)(iii)(B).
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    Persons making written submissions should file six copies thereof 
with the Secretary, Securities and Exchange Commission, 450 Fifth 
Street, N.W., Washington, D.C. 20549-0609. 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 at the Commission's Public 
Reference Room, located at the above address. 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-
99-75 and should be submitted by February 22, 2000.
    For the Commission, by the Division of Market Regulation, pursuant 
to delegated authority.\11\
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    \11\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-2117 Filed 1-31-00; 8:45 am]
BILLING CODE 8010-01-M