[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
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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