[Federal Register Volume 65, Number 56 (Wednesday, March 22, 2000)]
[Notices]
[Pages 15401-15403]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-7067]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42536; File No. SR-NASD-99-75]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Approval to Proposed Rule Change Relating 
to ECN and ATS Participation in the ITS/CAES System

March 16, 2000.

I. Introduction

    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''), submitted to 
the Securities and Exchange Commission (``Commission''), pursuant to 
Section 19(b)(1) of the Securities Exchange Act of 1934 (``Exchange 
Act'' or ``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule 
change to permit Electronic Communication Networks (``ECNs'') and 
Alternative Trading Systems (``ATSs'') \3\ to register as market makers 
in listed securities using Nasdaq quotation and trading facilities.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ The term ECN is defined, with certain exceptions, as any 
electronic system that widely disseminates to third parties orders 
entered into the ECN by an exchange market maker or OTC market 
maker, and permits such orders to be executed against in whole or in 
part. See Exchange Act Rule 11Ac1-1(a)(8). The term ATS is defined 
more broadly as any organization, association, person, group of 
persons, or system: (1) That constitutes, maintains, or provides a 
market place or facilities for bringing together purchasers and 
sellers of securities or for otherwise performing with respect to 
securities the functions commonly performed by a stock exchange 
within the meaning of Exchange Act Rule 3b-16; and (2) that does 
not: (i) Set rules governing the conduct of subscribers other than 
the conduct of such subscribers' trading on such organization, 
association, person, group of persons, or system; or (ii) discipline 
subscribers other than by exclusion from trading. See Regulation 
ATS, Sec. 242.300(a). Essentially, an ECN is a type of ATS.
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    The proposed rule change was published for comment in the Federal 
Register on February 1, 2000.\4\ One comment was received on the 
proposal.\5\ This order approves the proposed rule change.
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    \4\ See Securities Exchange Act Release No. 42353 (January 20, 
2000), 65 FR 4857.
    \5\ See letter to Jonathan G. Katz, Secretary, Commission, from 
Sam Scott Miller, Orrick, Herrington & Sutcliffe, LLP, on behalf of 
MarketXT, dated March 3, 2000 (``MarketXT Letter'').
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II. Description

    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 (``i.e., 
listed securities) to market makers for execution. Through CAES, NASD 
order-entry firms and market makers can participate in the ``third 
market'' \6\ by entering market and limit orders in exchange-listed 
securities to be executed against other market makers quoting in those 
securities. CAES also serves as the NASD's interface with the 
Intermarket Trading System (``ITS''), which links the national 
securities exchanges.\7\
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    \6\ The third market refers to over-the-counter trading of 
exchange-listed securities.
    \7\ ITS is a communications 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'').
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    Traditional market makers actively make markets in a large number 
of New York Stock Exchange and American Stock Exchange listed stocks in 
the third market. While many NASD member firms act as third market 
makers today, Nasdaq believes that certain enhancements to CAES could 
provide additional benefits to all NASD members. The enhancements would 
allow CAES Market Makers to compete more effectively with all markets 
by providing the best possible executions for investors, thereby 
improving the national market system.
    Accordingly, Nasdaq proposes to allow ECNs and ATSs to choose to be 
ITS/CAES Market Makers by amending NASD Rules 5210(e), 5220 and 6320, 
to include ECNs and ATSs within the definition of ``ITS/CAES Market 
Maker'' and ``CQS Market Maker,'' and to require the execution of an 
ECN and ATS addendum to the ITS/CAES Market Maker application 
agreement. These changes would allow ECNs and ATSs to compete on an 
equal basis with other market makers, yet also require ECNs and ATSs to 
assume the additional obligations and restrictions imposed upon ITS/
CAES Market Makers by the ITS Plan and NASD rules. An ECN or 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 CAES on the same terms as other 
ITS/CAES Market Makers.\8\ 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.\9\ ECNs and ATSs would assume the added 
responsibility for implementing all technological and programming 
modifications to their internal systems to demonstrate compliance with 
these requirements.
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    \8\ With respect to the two-sided quotation obligation, ECN and 
ATS ITS/CAES Market Makers will be permitted to auto-quote in 100 
share lots away from the national best bid and offer (``NBBO'') to 
the extent that a particular ECN or ATS does not have a customer 
order to represent. If an ECN or ATS ITS/CAES Market Maker quotation 
is accessed because such quotation becomes the NBBO or is subject to 
another rule requiring its execution, the ECN or ATS ITS/CAES Market 
Maker will be required to assume a proprietary position in that 
security.
    \9\ NASD Rules 5240, 5262, 5263, and 5264, respectively.
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    In registering as ITS/CAES Market Makers, ECNs and ATSs 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. Nasdaq believes 
that, because of the CAES interface with ITS, the implementation on 
quote access fees would be infeasible within CAES and would not be 
consistent with the terms of the ITS Plan.
    In addition, as discussed above, the NASD intends to modify the 
operation of CAES to accommodate ECN and ATS participation. In the 
current CAES environment, all orders are executed against market makers 
through an automatic executive process. The system delivers a report of 
a completed execution at the market maker's quoted price and size when 
another CAES market maker or exchange chooses to access that market 
maker's quote. Because ECNs and ATSs are reluctant to participate 
within the current automatic execution environment, Nasdaq is working 
on modifications to CAES to facilitate order delivery interaction for 
any ITS/CAES Market Maker that chooses to operate in an order delivery 
mode (with an automated response to the delivered orders). The change 
would make it clear that all ITS/CAES Market Makers could receive the 
delivery of an order (as opposed to an execution report), and 
immediately accept or decline that delivery by automated

[[Page 15402]]

means.\10\ A decline would be permissible only if it were consistent 
with the Commission's and the NASD's firm quote rules.
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    \10\ 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 
Commission 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. In comparing 
the proposed CAES order delivery system with the ITS configuration, 
Nasdaq anticipates that CAES order delivery market makers will be 
capable of responding to CAES and ITS orders in approximately 2-5 
seconds.\11\
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    \11\ 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 obligation to respond to an ITS commitment comes 
from the Commission Firm Quote Rule. 17 CFR 240.11Ac1-1.
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III. 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 the Association, and, in particular, with the 
requirements of Section 15A(b)(6).\12\ 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 the rules are not 
designed to permit unfair discrimination between customers, issuers, 
brokers, or dealers.
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    \12\ 15 U.S.C. 780-3(b)(6).
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    In addition, the Commission believes that the proposed rule change 
is consistent with the provisions of Sections 11A(a)(1)(C), 
11A(a)(1)(D), and 11A(a)(2) of the Exchange 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 fair 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 securities 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 the best execution of such orders. Section 11A(a)(2) 
directs the Commission to facilitate the establishment of a national 
market system for qualified securities. Overall, the Commission 
believes that the proposed rule promotes the objectives of these 
sections of the Exchange Act by encouraging participation in the 
national market system for listed securities and providing fair access 
for all NASD members, ultimately benefiting investors and the public 
interest.
    Because ITS remains the primary link between the registered 
exchanges and Nasdaq for listed securities, ECN and ATS access to ITS 
is an important Commission goal. Specifically, the Commission seeks to 
make information non prices, volume, and quotes for securities in all 
markets available to all investors, so that buyers and sellers of 
securities, wherever located, can make informed investment decisions 
and not pay more than the lowest price at which someone is willing to 
sell, and not sell for less than the highest price a buyer is prepared 
to offer. The Commission notes, however, that information alone is not 
enough. There must be an avenue for accessing markets disseminating 
market information. Integrating ECNs and ATSs into ITS provides access 
from other ITS/CAES Market Makers and other markets to the quotes 
displayed by the ECNs and ATSs.\13\
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    \13\ ECNs also are accessible through becoming a subscriber to 
the system, and by telephone.
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    The number of ECNs and ATSs has increased significantly over the 
past several years, as has their share of the market in Nasdaq 
securities. This increased competition has benefited the marketplace in 
many ways--among other things, it has encouraged the existing exchanges 
to improve their services, and has given institutional investors 
additional venues in which to trade. In addition, ECNs have helped to 
contribute to narrower spreads to the benefit of investors, including 
retail investors, who have enjoyed significant cost savings when 
trading Nasdaq securities. While these benefits have accrued to Nasdaq 
securities, ECNs have not traded in great measures in securities listed 
on traditional exchanges.
    Linking ECNs and ATSs to ITS by permitting them to register as ITS/
CAES Market Makers will improve investors' ability to obtain best 
execution of their orders in listed stocks. Furthermore, the Commission 
believes that ECN and ATS participation in CAES should have a positive 
impact upon the third market, as well as trading in listed securities 
overall, by adding new competitive quoting vehicles, thereby 
contributing to a more dynamic and competitive market.
    The Commission believes it is appropriate to require ECNs and ATSs 
that register as ITS/CAES Market Makers to fulfill the same intermarket 
obligations as are required of traditional market makers. The 
Commission expects the NASD to ensure that ECN and ATS ITS/CAES Market 
Makers (as well as non-ECN and non-ATS ITS/CAES Market Makers) carry 
our necessary technical and programming modifications to their internal 
systems to demonstrate an ability to comply with these obligations.
    ECNs and ATSs that register as ITS/CAES Market Makers will be 
required to post and maintain two-sided quotations, as well as be firm 
for the price and size of those quotations, as required in the ITS 
Plan. In addition, ECN and ATS ITS/CAES Market Makers will be permitted 
to autoquote in 100 share lots away from the NBBO when they do not have 
a customer order to represent. The Commission finds it consistent with 
the Exchange Act to require ECNs and ATSs that participate in ITS/CAES 
to display two-sided quotes at all times and to be firm for their 
displayed quotes, including those quotes that do not represent 
customers orders. In the Commission's view, it is reasonable to permit 
an ECN or ATS ITS/CAES Market Maker to autoquote in 100 share lots away 
from the NBBO when it does not have a customer order to represent 
because ECNs and ATSs typically do not take proprietary positions. An 
ECN or ATS ITS/CAES Market Maker, however, will be required to be firm 
for its displayed quote, in accordance with Commission and NASD firm 
quote rules for any orders that seek to trade with that quote. ECNs and 
ATSs could reduce the likelihood of an execution at that quote by 
quoting away from the best market price. Although ECNs and ATSs do not 
generally assume proprietary positions in the securities they trade, 
the Commission believes it is appropriate to require them to comply

[[Page 15403]]

with the same ITS requirements as other market makers if they voluntary 
choose to register as an ITS/CAES Market Makers.
    The Commission notes that ECN and ATS ITS/CAES Market Makers will 
also be required to follow the NASD's rules, as well as the terms of 
the ITS Plan, concerning the pre-opening application, trade throughs, 
locked and crossed markets, and block transactions.\14\ These market 
integrity provisions provide for continuity of transaction among the 
various market centers.
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    \14\ A trade through occurs when a transaction is effected at a 
price below the best prevailing bid, or above the best prevailing 
offer. The NASD's rules and the ITS Plan require price protection 
among the various markets by ensuring that the best national bids 
and offers are provided opportunities to trade with other markets 
effecting trades outside the best national quote. The NASD's rules 
and the ITS Plan also contain a block trade policy that provides 
special rights to any market displaying the best national bid or 
offer when block-size transactions are occurring in another market.
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    The Commission also believes it is appropriate to prohibit ECNs and 
ATSs that choose to register as ITS/CAES Market Makers from charging 
quote access fees for trades effected through CAES. Market Makers are 
prohibited under NASD rules from charging access fees when trading 
through CAES. Moreover, trades in ITS between markets are not subject 
to market fees, even though these markets charge fees to their members 
for executing trades on that market.\15\
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    \15\ The Commission received one comment letter from an ECN 
regarding the proposed rule change. See MarketXT Letter. MarketXT 
believes that ECNs should be permitted to charge fees in the ITS/
CAES market because Nasdaq has proposed a rule change that would 
permit market makers to charge an access fee for agency quotes in 
the Nasdaq market. See Securities Exchange Act Release No. 41343 
(April 28, 1999), 64 FR 24430 (May 6, 1999) (File No. SR-NASD-99-
16). ECN fees have been permitted in the Nasdaq market since ECNs 
were first linked to that market in 1997. The Commission has stated 
that it is considering options to reduce or eliminate ECN fees in 
the Nasdaq market. The Commission does not believe that investors' 
interests are best served by permitting ECN fees in the ITS market, 
where fees are not permitted among existing participants.
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    The Commission also believes it is not inconsistent with the 
Exchange Act to allow the CAES functionality to operate in order 
delivery mode, as opposed to automatic execution mode, in accessing an 
ITS/CAES Market Maker's quote. ECNs, which, to date, have functioned 
only within order delivery systems (e.g., SelectNet for Nasdaq 
securities), have been reluctant to participate in CAES due to the 
automatic execution feature. The proposed rule change will allow all 
ITS/CAES Market Makers, including ECNs and ATSs that choose to register 
as such, to operate in CAES in either order delivery mode or automatic 
execution mode. The Commission believes that requiring ITS/CAES Market 
Makers that choose to operate in order delivery mode to have an 
automated response to an incoming order should ensure that transactions 
done through CAES, as well as those done through the ITS/CAES 
interface, are executed efficiently. The ability of an ITS/CAES Market 
Maker to select the mode of operation in which it receives orders of 
ITS commitments addresses the ECNs' concerns over exposure to double 
executions.\16\ Specifically, allowing an ITS/CAES Market Maker to 
operate in order delivery mode will permit it to suspend acceptance of 
orders when it is in the process of updating its quote, providing such 
action is in compliance with the Commission's and NASD's firm quote 
rules.
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    \16\ Double execution could occur if an ECN displays a customer 
order to buy and an order to sell comes in through ITS, while 
another order to sell comes into the ECN at the same time. Automatic 
execution would force the ECN to honor both sell orders.
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    Finally, the Commission believes that the proposed rule change is 
not inconsistent with the terms of the ITS Plan. Specifically, under 
the proposed rule change, ITS/CAES Market Makers will continue to be 
required to provide automated responses to all ITS commitments sent by 
other exchange participants to the third market. The Commission notes 
that, although the proposed rule change may affect the operation of the 
ITS pre-opening application,\17\ no amendment to the ITS Plan is 
technically required. Specifically, the ITS Plan defines ``ITS/CAES 
Market Maker'' as an ``NASD member that is registered as a market maker 
with the NASD * * * with respect to one or more specified ITS/CAES 
securities.'' Thus, the NASD's proposed definition of ``ITS/CAES Market 
Maker'' does not conflict with or violate the ITS Plan. Furthermore, 
nothing in the ITS Plan requires that ITS/CAES Market Maker 
automatically execute commitments received through ITS.
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    \17\ 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 pre-opening responses 
from the other participant market for the purpose of including them 
in the opening transaction. Because a pre-opening response from the 
ITS/CAES 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 and ATS ITS/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 same procedure 
applies of re-openings following trading halts. See Exhibit A of the 
ITS Plan, ``Pre-Opening Application rule,'' Sec. (b)(iii)(B).
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\18\ that the proposed rule change (SR-NASD-99-75) is approved.
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    \18\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-7067 Filed 3-21-00; 8:45 am]
BILLING CODE 8010-01-M