[Federal Register Volume 66, Number 18 (Friday, January 26, 2001)]
[Notices]
[Pages 8020-8057]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-2381]



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Part III





Security and Exchange Commission





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Self-Regulatory Organizations; Order Approving Proposed Rule Changes by 
the National Association of Securities Dealers, Inc.; Notice

  Federal Register / Vol. 66 , No. 18 / Friday, January 26, 2001 / 
Notices  

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43863; File No. SR-NASD-99-53]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Changes by the National Association of Securities Dealers, Inc. and 
Amendment Nos. 1, 2, 3, 4, 5, 6, 7 and 8 Thereto and Notice of Filing 
and Order Granting Accelerated Approval of Amendment No. 9 Relating to 
the Establishment of the Nasdaq Order Display Facility and Order 
Collector Facility and Modifications of the Nasdaq Trading Platform

January 19, 2001.

Table of Contents

I. Introduction
II. Executive Summary
    A. Background of the Nasdaq System
    B. Overview of the SuperMontage Proposal
    1. Quote/Order Collection
    2. Display of Quotes/Orders
    3. Execution Services
    C. Summary of Conclusions
    1. Execution Procedures and Quote/Order Priority
    2. Inherent Conflicts of NASD Roles
III. Description of the Proposal
    A. Nasdaq Order Display Facility
    1. Enhanced Display of Trading Interest
    2. Size MMID and Summary Scan
    3. Reserve Size
    B. Order Collector Facility
    1. Entry of Quotes/Orders
    2. Order Execution and Delivery
    C. Non-Directed Orders
    1. Quote Decrementation of Non-Directed Orders
    2. Quote Refresh and Revised SOESed-Out-of-the Box Procedures
    D. Order Execution Algorithms
    E. Directed Orders
    F. Locked/Crossed Markets
    G. UTP Exchange Participation
    H. ECN Participation
    I. Odd-Lot Processing
    J. Nasdaq SmallCap
    K. System Roll Out
IV. Summary of Comments

V. Discussion

    A. Nasdaq Order Display Facility
    1. Non-Attributable Quotes and Other Factors
    2. Reserve Size
    B. Order Collector Facility
    1. Order Entry and Access
    2. Non-Marketable Limit Orders
    C. Quote Refresh and Revised SOESed-Out-of-the-Box Procedures
    D. Order Execution Algorithms
    1. Matching Against a Participant's Own Quote/Order at the BBO
    2. Preferenced Orders
    3. ECNs
    a. Order Execution Algorithms
    b. Time Restrictions on the Order Delivery Feature
    c. ECN's Automatic Execution Function
    4. UTP Exchange Priority
    5. Five-Second Interval Delay
    E. Directed Orders
    F. Locked/Crossed Markets
    G. UTP Exchange Participation as Automatic Execution 
Participants
    H. Odd-Lot Processing
    I. Issues Relating to Competition
    1. Centralization
    2. Other Issues Relating to Competition
    3. Nasdaq as an Exclusive Securities Information Processor
    4. Commission's Conclusion on Competition Issues
    J. Technology Issues
    K. Impact on Competition, Efficiency and Capital Formation
VI. Amendment No. 9
VII. Solicitation of Comments
VIII. Conclusion

I. Introduction

    On October 1, 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''), 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'' or ``Exchange Act''),\1\ and Rule 19b-4 thereunder,\2\ 
proposed rule changes to establish the Nasdaq Order Display Facility 
(``NODF'') and the Order Collector Facility (``OCF'') and to modify its 
primary trading platform, the Nasdaq National Market System (``NNMS''), 
collectively referred to as the SuperMontage proposal. On October 26 
and October 29, 1999, respectively, Nasdaq filed Amendment Nos. 1 and 2 
to the proposal.\3\ The SuperMontage proposal and Amendment Nos. 1 and 
2 were published for comment in the Federal Register on December 6, 
1999.\4\ On March 16, 2000, Nasdaq filed Amendment No. 3 to the 
proposal.\5\ On March 23, 2000, Nasdaq filed Amendment No. 4 to the 
proposal,\6\ which was published for comment in the Federal Register on 
March 30, 2000.\7\ On May 19, 2000, Nasdaq filed Amendment No. 5 to the 
proposal;\8\ on June 7, 2000, Nasdaq filed Amendment No. 6;\9\ and on 
August 8, 2000, Nasdaq filed Amendment No. 7.\10\ Amendment Nos. 5, 6 
and 7 were published for comment on August 15, 2000.\11\ On October 23, 
2000, the NASD filed Amendment No. 8,\12\ which was

[[Page 8021]]

published for comment on November 15, 2000.\13\ On January 9, 2001, the 
NASD filed Amendment No. 9.\14\ The Commission received 104 comments 
regarding the proposal.\15\ The Commission is approving the 
SuperMontage proposal, as amended, and is soliciting comments on 
Amendment No. 9 from interested persons.\16\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letters from Thomas P. Moran, Assistant General Counsel, 
Office of the General Counsel, Nasdaq, to Richard Strasser, 
Assistant Director, Division of Market Regulation (``Division''), 
Commission, dated October 26, 1999 (``Amendment No. 1''); and from 
John F. Malitzis, Assistant General Counsel, Office of the General 
Counsel, Nasdaq, to Richard Strasser, Assistant Director, Division, 
Commission, dated October 29, 1999 (``Amendment No. 2'').
    \4\ See Securities Exchange Act Release No. 42166 (November 22, 
1999), 64 FR 68125 (December 6, 1999) (``December 6, 1999 notice'').
    \5\ See letter from Richard G. Ketchum, President, NASD, to 
Belinda Blaine, Associate Director, Division, Commission, dated 
March 15, 2000 (``Amendment No. 3''). In Amendment No. 3, the NASD 
responded to comment letters and submitted substantive, clarifying, 
and technical amendments to the proposal. Other than the response to 
the comment letters, Amendment No. 3 was repeated in Amendment No. 
4, which was published for comment in the Federal Register.
    \6\ See letter from Richard G. Ketchum, President, NASD, to 
Belinda Blaine, Associate Director, Division, Commission, dated 
March 23, 2000 (``Amendment No. 4''). Among other things, in 
Amendment No. 4, the following aspects of the proposal were changed: 
(1) the order execution priorities of the system as they apply to 
electronic communications networks (``ECNs''), reserve size orders, 
and unlisted trading privilege exchanges (``UTP Exchanges''); (2) 
the five-second delay between price levels; and (3) the way odd-lots 
are processed.
    \7\ See Securities Exchange Act Release No. 42573 (March 23, 
2000), 65 FR 16981 (March 30, 2000).
    \8\ See letter from Richard G. Ketchum, President, NASD, to 
Belinda Blaine, Associate Director, Division, Commission, dated May 
16, 2000 (``Amendment No. 5''). Among other things, in Amendment No. 
5, the NASD responded to comment letters received by the Commission 
in response to Amendment No. 4, submitted technical amendments to 
the proposed rule language, and provided a description of how the 
proposal would be implemented.
    \9\ See letter from Richard G. Ketchum, President, NASD, to 
Belinda Blaine, Associate Director, Division, Commission, dated July 
6, 2000 (``Amendment No. 6''). Generally, in Amendment No. 6, the 
NASD stated that it intends to implement the SuperMontage only after 
the planned conversion to decimals takes place. It also confirmed 
that it will allow market participants ample opportunity to prepare 
and test their internal systems before the start-up of the 
SuperMontage. The NASD further amended the SuperMontage proposal to 
provide reciprocity for UTP Exchanges that provide automatic 
executions against their quotes/orders. Also, the NASD clarified the 
order routing process and quote update feature for UTP Exchanges 
that take order delivery.
    \10\ See letter from Richard G. Ketchum, President, NASD, to 
Annette Nazareth, Director, Division, Commission, dated August 7, 
2000 (``Amendment No. 7''). Among other things, in Amendment No. 7, 
the NASD responded to comment letters sent to the Commission by 
Bloomberg Tradebook, LLC and Instinet Corporation. As discussed 
below, the NASD amended the Order Execution Algorithm to provide 
that Nasdaq will rank orders from ECNs that charge a separate access 
fee on parity with orders from market makers and ECNs that do not 
charge a separate fee if the ECN notifies the NASD that the order 
offers price improvement that exceeds the access fee. Also, Nasdaq 
revised the directed order processing rules so that ECNs and market 
makers can elect to receive Liability Orders through the directed 
order process of the system.
    \11\ See Securities Exchange Act Release No. 43133 (August 10, 
2000), 65 FR 49842 (August 15, 2000).
    \12\ See letter from Richard G. Ketchum, President, Nasdaq, to 
Belinda Blaine, Associate Director, Division, Commission, dated 
October 20, 2000 (``Amendment No. 8''). Generally, in Amendment No. 
8, the NASD revised its Order Execution Algorithm to allow market 
participants that enter non-directed orders to interact with quotes/
orders in the SuperMontage based on price/time priority, price/size/
time priority, and price/time priority taking into account ECN 
access fees; created a new class of orders called preferenced 
orders; created a new data vendor data feed called NQDS Prime; 
clarified that SuperMontage will identify parties enering orders; 
modified the time priority feature to preserve time priority when 
quotes are increased in size; modified the response time frames for 
order-delivery ECNs and UTP Exchanges; modified the SuperMontage so 
that all non-directed orders entered by order-entry firms are 
designated as ``immediate or cancel'' orders; and revised the 
definition of agency orders for UTP Exchanges. Amendment No. 8 also 
contained a summary, Exhibit 3, that incorporated and reconciled the 
original rule proposal and the subsequent proposed amendments.
    \13\ See Securities Exchange Act Release No. 43514 (November 3, 
2000), 65 FR 69084 (November 15, 2000).
    \14\ See letter from Richard G. Ketchup, President, Nasdaq, to 
Robert L.D. Colby, Deputy Director, Division, Commission, dated 
January 8, 2001 (``Amendment No. 9''). In Amendment No. 9, the NASD 
withdrew Alternative A, regarding preferenced orders with no price 
restrictions, made a technical correction to its rule text to 
conform the definition of a preferenced order with the rule text 
describing the processing of such orders, and represented that 
Nasdaq will not use data received through the Order Audit Trail 
System (``OATS'') to gain an unfair competitive advantage over other 
market participants, including another self-regulatory organization 
(``SRO'') or broker/dealer (market maker or ECN).
    \15\ A summary of the comment letters received by the Commission 
is available for public inspection in the Commission's Public 
Reference Room.
    \16\ In addition, the Commission notes that the NASD withdrew a 
proposed rule change relating to an Integrated Order Delivery and 
Execution System (``IODES'') on March 16, 2000 (SR-NASD-98-17).
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II. Executive Summary

A. Background of the Nasdaq System

    The Nasdaq System originated 30 years ago for the purpose of 
collecting and displaying quotations posted by individual dealers in 
the over-the-counter market regulated by the NASD, which sponsored the 
system. Nasdaq's quotation management system currently collects and 
displays quotations of registered market makers and ECNs that are 
members of the NASD (collectively, ``Nasdaq Quoting Market 
Participants''). By agreement, Nasdaq also collects and displays 
quotations in Nasdaq securities from UTP Exchanges.\17\
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    \17\ As of the date of this Order, the Chicago Stock Exchange 
(``CHX'') is the only active UTP Exchange.
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    The existing quotation management system permits each Nasdaq 
Quoting Market Participant and UTP Exchange to enter a single quotation 
into the system at any one time. This single quotation may reflect the 
Nasdaq Quoting Market Participant's or UTP Exchange's proprietary 
trading interest or customer limit orders handled by that participant, 
or both.\18\ The quotations of Nasdaq Quoting Market Participants and 
UTP Exchanges are displayed on a quotation montage (arranged by price 
and time) that can be viewed on a Nasdaq screen, and are disseminated 
to vendors for further redistribution to broker-dealers and other 
subscribers.
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    \18\ NASD Rule 4613 requires a registered market maker to submit 
a two-sided quote (both bid and offer) that represents its 
proprietary trading interest and/or customer limit orders handled by 
the market maker. NASD Rule 4623 requires an ECN to submit the 
prices and sizes of orders at the highest buy price and lowest sell 
price entered into the ECN by market makers (and, in some cases, 
other subscribers). By agreement, UTP Exchanges must submit a two-
sided quote that represents their market's best quote.
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    Other Nasdaq systems facilitate a Nasdaq participant's ability to 
interact with the quotations of Nasdaq Quoting Market Participants and 
UTP Exchanges. In 1984, Nasdaq introduced the Small Order Execution 
System (``SOES''), which allows Nasdaq participants to execute small 
orders automatically against the quotation of a market maker at the 
best bid or offer (``BBO'').\19\ Nasdaq's SelectNet system, introduced 
in 1988, allows Nasdaq participants to route orders to a particular 
market maker or ECN.\20\ Although SelectNet is an order delivery 
service, rather than an execution service, a SelectNet order presented 
to a market maker or ECN at its displayed quotation obligates the 
market maker or ECN to execute the order at the price and size of its 
quote consistent with the Commission's Firm Quote Rule.\21\ The SOES 
and SelectNet systems currently are not integrated, so that it is 
possible for a market maker to receive a SelectNet order that it is 
obligated to execute and a SOES execution against the same quote, 
creating a double liability exposure.\22\
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    \19\ SOES was initially approved on a temporary basis in 
Securities Exchange Act Release No. 21567 (December 14, 1984), 50 FR 
1662 (December 27, 1984). It was granted permanent approval in 1985. 
See Securities Exchange Act Release No. 21743 (February 12, 1985), 
50 FR 7432 (February 22, 1985).
    \20\ See Securities Exchange Act Release No. 25263 (January 11, 
1988), 53 FR 1430 (January 19, 1988). See also Securities Exchange 
Act Release No. 25690 (May 11, 1988), 53 FR 17523 (May 17, 1988) 
(order granting permanent approval of SelectNet).
    \21\ See Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
    \22\ On January 14, 2000, the Commission approved an NASD rule 
change that allows Nasdaq to integrate the two systems to prevent 
most double liability situations. To date, the NASD has not 
implemented this change. See Securities Exchange Act Release No. 
42344 (January 14, 2000), 65 FR 3987 (January 14, 2000), 65 FR 3987 
(January 25, 2000) (``NNMS Order'').
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    Nasdaq's SOES and SelectNet systems supplement the separate order 
execution services offered by market makers, ECNs, and UTP Exchanges, 
but do not supplant those services. In fact, the large majority of 
orders are executed outside Nasdaq's order delivery and execution 
services through direct links--by telephone, dedicated line, or other 
means--among order entry firms, market makers, ECNs, and UTP Exchanges.
    In recent years, changes in technology and market structure have 
placed increasing demands on, and created new challenges for, Nasdaq's 
systems. For example, while Nasdaq's existing quotation management 
system displays the best bid and offer of a Nasdaq Quoting Market 
Participant or UTP Exchange, many market participants are interested in 
seeing more of a Nasdaq Quoting Market Participant's or UTP Exchange's 
trading interest outside its best bid and offer. In addition, the entry 
of ECNs and UTP Exchanges trading Nasdaq securities has increased 
competition among execution service providers, including Nasdaq.
    The changing competitive environment has been accompanied by 
changes in Nasdaq's structure and ownership. The NASD's ownership of 
Nasdaq was reduced to 60% on a fully diluted basis by a private 
placement sale of shares and warrants on June 28, 2000 and was further 
reduced to 40.6% by a second private placement just completed. The 
warrants are exercisable over a four year period beginning June 28, 
2002. Under the terms of the sale, the voting rights for NASD shares 
underlying warrants will shift to the warrant holders upon registration 
of Nasdaq as an exchange. Nasdaq filed an application for registration 
with the Commission on November 9, 2000.\23\
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    \23\ The Commission intends to give expeditious consideration to 
Nasdaq's application for registration and to similar applications 
from other markets, consistent with statutory requirements, in order 
to further competition and innovation among securities markets.
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    Subsequently, the NASD Board adopted a resolution stating its 
intent to divest itself of all remaining shares of Nasdaq not subject 
to outstanding warrants by June 30, 2002, subject to existing 
contractual and legal arrangements and to the reasonable judgment of 
NASD management that market conditions permit.\23\ The NASD also has 
undertaken that during any interim period it intends to vote its shares 
in Nasdaq on any matter in

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proportion to the votes of all other shareholders.
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    \24\ See letter from Joan C. Conley, Corporate Secretary, NASD, 
to Robert Colby, Deputy Director, Division, dated January 18, 2001.
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    The Commission has considered the SuperMontage proposal in the 
context of increased demand for information about trading interest, 
increasing competition among execution service providers, and changes 
in Nasdaq's ownership structure. The Exchange Act requires the 
Commission to approve the proposed rule changes if it finds that the 
changes are consistent with the requirements of the Exchange Act 
applicable to the NASD.
    In this context, including Nasdaq's demutualization, application 
for registration as an exchange, and impending full separation of the 
NASD and Nasdaq, and for the reasons discussed in this release, the 
Commission finds that the proposed rule changes are consistent with the 
requirements of the Exchange Act applicable to the NASD and therefore 
approves the proposed rule changes.

B. Overview of the SuperMontage Proposal

    The SuperMontage proposal is designed to modify Nasdaq's systems in 
three principal areas: (1) Quote/order collection; (2) quote/order 
display; and (3) execution services.
1. Quote/Order Collection
    SuperMontage will partially eliminate the distinction between 
quotes and orders and expand the ability of Nasdaq Quoting Market 
Participants and UTP Exchanges to represent quotes/orders in the Nasdaq 
market. It will permit, but not require, Nasdaq Quoting Market 
Participants and UTP Exchanges to enter multiple quotes/orders at the 
same price or at different prices.\25\ In addition, SuperMontage will 
allow Nasdaq Quoting Market Participants to enter quotes/orders on a 
non-attributable basis (i.e., anonymously), although market makers will 
be obligated to maintain a two-sided attributable quote/order 
consistent with Commission and NASD rules. UTP Exchanges will not be 
permitted to enter principal quotes on a non-attributable basis, but 
may enter agency quotes/orders on a non-attributable basis.
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    \25\ UTP Exchanges may only enter a single principal quote/
order. See Proposed NASD Rule 4710(f).
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    For Nasdaq Quoting Market Participants and UTP Exchanges that 
choose to enter multiple quotes/orders, SuperMontage will aggregate 
their best-priced attributable quotes/orders on each side of the market 
to create the Nasdaq Quoting Market Participant's or UTP Exchange's 
displayed quote, while maintaining the separate identity, price, and 
time of entry of each quote/order. Alternatively, a Nasdaq Quoting 
Market Participant or UTP Exchange may choose to maintain only its 
required quotation, and not enter additional quotes/orders.
2. Display of Quotes/Orders
    To the extent Nasdaq Quoting Market Participants and UTP Exchanges 
use the quote/order collection system to represent more quotes and 
orders than they currently are able to represent, SuperMontage will 
show more information than the current quotation montage. SuperMontage 
will display the additional information in two ways. First, the best-
priced non-attributable quotes/orders from all participants will be 
aggregated and displayed in the quotation montage as one buy and one 
sell price, each under the generic name ``SIZE'', along with the best-
priced attributable quotes/orders of each Nasdaq Quoting Market 
Participant and UTP Exchange. Second, and more significantly, 
SuperMontage will aggregate all quotes/orders (attributable and non-
attributable) at each price level, and display the three best prices 
with associated aggregate size on each side of the market through the 
NODF. This information will be distributed to market data vendors so 
that they can provide an equivalent display service to their customers. 
In addition, the NASD will make available to market data vendors 
individual attributable quotes/orders displayed in the three best price 
levels in the NODF.
    Thus, to the extent Nasdaq Quoting Market Participants and UTP 
Exchanges voluntarily enter their ``near the market'' quotes/orders, 
investors and market professionals will be able to see the aggregate of 
this interest at three price levels in widely available displays.
3. Execution Services
    SuperMontage will replace Nasdaq's current SOES and SelectNet 
services with two new processes: a directed order process and a non-
directed order process. Nasdaq participants that wish to use either of 
these processes to interact with the quotes/orders of Nasdaq Quoting 
Market Participants and UTP Exchanges may enter orders into the same 
order collection facility used by Nasdaq Quoting Market Participants 
and UTP Exchanges to enter quotes/orders.
    The directed order process will be functionally similar to the 
current SelectNet service in that it will allow a Nasdaq participant to 
direct an order to a particular Nasdaq Quoting Market Participant or 
UTP Exchange. As in SelectNet, a directed order can match a posted 
quote/order of the recipient (a Liability Order) or not match any 
quote/order of the recipient (a non-Liability Order).\26\ To avoid 
creating a risk of double liability, no Nasdaq Quoting Market 
Participant or UTP Exchange is required to receive directed Liability 
Orders through the OCF, but may elect to do so.
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    \26\ Non-liability orders are usually used to probe for 
undisplayed interest or to begin a negotiation.
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    The non-directed order process will be the default execution 
process for marketable orders entered by a Nasdaq participant into 
Nasdaq's order collection facility. A marketable order entered into the 
non-directed order process will be matched with the highest ranked 
quotes/orders of Nasdaq Quoting Market Participants and UTP Exchanges 
on the opposite side of the market, and either will be executed 
automatically or delivered (on a liability basis) to the matched Nasdaq 
Quoting Participants and UTP Exchanges, depending upon how such 
participants participate in the non-directed order process.\27\
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    \27\ Registered market makers must accept automatic executions 
(a sthey do currently under SOES). UTP Exchanges and ECNs may elect 
to accept automatic executions or delivery of the order.
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    The ranking of Nasdaq Quoting Market Participant and UTP Exchange 
quotes/orders in the non-directed order process will be established 
pursuant to one of three order execution algorithms: price/time 
priority, price/size/time priority, or price/time priority that account 
for ECN fees. The Nasdaq participant entering a non-directed order may 
select the algorithm used for executing its order, but the system will 
default to the price/time priority algorithm if none is selected. 
Within each algorithm, a non-directed order entered by a Nasdaq 
participant that is also a Nasdaq Quoting Market Participant will be 
matched first against its own quote/order on the other side of the 
market, provided that its quote/order is at the BBO. In addition, a 
Nasdaq participant entering a non-directed order will be permitted to 
``preference'' the order to a particular Nasdaq Quoting Market 
Participant or UTP Exchange, if that participant's quote/order is at 
the BBO.
    Nasdaq participants are not required to use either the directed or 
non-directed order processes to execute their orders but may choose, 
instead, systematically or on an order-by-order basis, to continue to 
use other methods such as telephone access or direct connections to 
market makers, ECNs,

[[Page 8023]]

and UTP Exchanges. Any Nasdaq member is free to offer a competing 
execution service, and may even use the Nasdaq service as one of its 
options.

C. Summary Conclusions

    The SuperMontage proposal generated significant controversy. 
Throughout a series of comment periods and revisions, commenters 
maintained that various aspects of the proposal were unfair or anti-
competitive, and that the proposal as a whole fell short of the 
standards that ought to be required of National Market System 
facilities.
    Many issues were resolved through the process of public comment and 
response. For example, under the original proposal Nasdaq Quoting 
Market Participants would have transmitted to Nasdaq multiple quotes/
orders at the same price or at different prices, and Nasdaq would have 
aggregated the best priced orders on either side of the market to 
produce the participant's required quotation, which would then be 
distributed by Nasdaq, in its capacity as an exclusive processor for 
the OTC market.
    In addition, Nasdaq would have distributed the aggregate amount of 
buying and selling interest at the three best price levels on either 
side of the market. Some commenters objected that the proposal in this 
form meant that Nasdaq alone would know the details of any quotes/
orders not incorporated into participant quotations, and that it would 
be unfair for Nasdaq to keep such information to itself. In response, 
Nasdaq agreed to disseminate the details of all attributable quotes/
orders in the three best price levels on either side of the market via 
a new information service, in addition to the aggregate amounts of 
interest at those prices. The result will be that all quote/order 
details will be generally available at the best price levels, except 
those quotes/orders that are submitted on an anonymous basis (non-
attributable quotes/orders). The Commission believes that this 
additional information will be valuable to competitors that may offer 
execution services complementary to, or in competition with, Nasdaq's 
SuperMontage services, and that Nasdaq's proposal appropriately 
resolves the issue. Several other issues have been dealt with in 
similar fashion. All of these are described at length in the Discussion 
section below.
    The remaining issues, which remain controversial, generally fall in 
two groups: (1) Disagreements about the appropriate priority and 
protections afforded to quotes/orders represented in SuperMontage under 
the applicable execution procedures, and (2) questions concerning the 
conflicts inherent in NASD's multiple roles as SRO and default 
regulator for the OTC market, and as the principal owner of Nasdaq, 
which will be the operator of SuperMontage. These issues have been 
carefully weighed by the Commission and are described individually and 
in detail in the Discussion section below. A more general description 
and overview of the Commission's analysis and reasoning follow:
1. Execution Procedures and Quote/Order Priority
    Following Amendment No. 7, the proposed execution procedures 
involved a single execution algorithm for non-directed orders (without 
any preferencing), and the directed order process. Preferencing through 
the non-directed order process had not yet been proposed. The single 
execution algorithm applicable to non-directed orders was based on 
price/time priority, but gave lower priority to quotes/orders of an ECN 
that charges a separate fee for accessing its quotes/orders, and last 
priority to the principal quotes of UTP Exchange specialists.\28\ Some 
ECNs and others objected to the treatment of quotes/orders involving 
payment of a separate fee, arguing among other things that many market 
participants preferred to deal with ECNs, even if they charged fees, 
because statistically the price improvement provided by certain ECNs 
exceeded the cost of their fees. Some also maintained that only 
displayed prices should be considered in assigning priority because any 
associated fees would be paid by brokers and not by customers. Still 
others argued that Nasdaq should not assign any priorities to quotes/
orders but should only provide a means to access displayed quotes and 
leave the choice of priorities to participants.
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    \28\ ECNs that charge fees were permitted to indicate on any 
individual quote/order that the quote/order would provide price 
improvement exceeding the applicable fee, and such quote/orders 
would be given parity with quotes/orders that did not require 
payment of a separate fee.
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    In response to these arguments and others, the NASD in Amendment 
No. 8 proposed to offer participants much greater control of the 
execution process by creating two additional execution algorithms using 
price/time and price/size/time priorities respectively, ignoring any 
separate fees, and by creating the ability to send preferenced orders 
to any Nasdaq Quoting Market Participant or UTP Exchange at the 
discretion of the entering firm. This response was satisfactory to some 
earlier commenters that had sought greater control of the execution 
process, but not to certain ECNs that had wanted the execution process 
to ignore access fees. Moreover, the new approach embodied in Amendment 
No. 8 brought new objections from some commenters that it would be a 
step backward in achieving price/time priority that would encourage 
price competition.
    The Commission believes that the competing interests of Nasdaq 
participants with respect to some of the issues of priority are 
essentially irreconcilable. For example, there is no way to 
simultaneously satisfy both those ECNs that want their orders executed 
and fees assessed when their orders have time priority at the displayed 
price, and other participants that want to avoid paying such fees when 
they can receive a better net price from other orders that do not have 
time priority. The Commission recognizes that there is merit to both 
sides of the discussion, but it believes that price priority ordinarily 
must take precedence over time priority. Because a quote that involves 
payment of a separate fee is, all other things equal, inferior to a 
quote at the same displayed price that does not involve payment of a 
fee, the Commission believes that it is reasonable to allow market 
participants to choose a method of execution that gives lower priority 
to quotes that require payment of a fee. It is true that price 
improvement may sometimes exceed the value of the required fee, but the 
fee is certain while price improvement is uncertain. The Commission 
believes that market participants are best able to exercise judgment in 
such cases.
    The Commission shares the view expressed by some commenters that 
price/time priority tends to encourage price competition. The 
Commission notes, however, that although price priority is generally 
followed in the Nasdaq market, there is at present virtually no time 
priority across market centers. The proposal, in its present form, 
provides for more time priority than currently exists in the market, 
and may to that extent encourage more price competition. Moreover, for 
the reasons outlined above, a displayed price does not always represent 
the actual price to a participant and, indeed, the actual price is 
often not the same for all participants that might execute against a 
particular quote.\29\ The Commission does not believe that it is 
appropriate to require strict time priority based on such prices.
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    \29\ Several ECNs have variable access fees that are differnt 
for subscribers and non-subscribers, and may depend on other 
factors, such as the volume of business.

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[[Page 8024]]

    For these reasons, the Commission finds that the combination of 
choices offered in the current proposal is both fair to participants 
and reasonably designed to promote competition.
2. Inherent Conflicts of NASD Roles
    Many commenters raised issues that relate in one way or another to 
the multiple roles that the NASD has as an SRO and, through Nasdaq, as 
an exclusive processor of market information and as an operator of 
trading facilities. The Commission notes that conflicting roles are 
inherent in the self-regulatory model. Indeed, the Act specifically 
recognizes that SROs will act not only as regulators, but also as 
operators of markets, and exclusive processors of information derived 
from those markets. The Act authorizes the Commission to oversee SRO 
functions to address the inherent conflicts, and to ensure, among other 
things, that SROs do not abuse their regulatory powers,\30\ and when 
acting as exclusive processors, make available market information in a 
non-discriminatory, fair, and reasonable fashion. Thus, the 
Commission's role is to reach a fair and appropriate balance of the 
conflicts inherent in the SRO structure, not to eliminate those 
conflicts.
---------------------------------------------------------------------------

    \30\ See discussion at Sectio V.I.2, infra, regarding 
limitations on the NASD's ability to use its regulatory authority to 
preference or prejudice another market or market participants.
---------------------------------------------------------------------------

    Prior to Amendment No. 8, many objections were raised that 
SuperMontage, as then proposed, would become a centralized, 
monopolistic execution system. The gist of these arguments was that 
because NASD is the default regulator for the OTC market,\31\ any 
market maker or ECN that wished to do business in Nasdaq securities 
must make its quotes available for execution through SuperMontage. 
Thus, SuperMontage would be, by the effect of NASD and Commission 
rules, the only execution system through which substantially all 
displayed trading interest could be reached. The only exception would 
have been any UTP Exchanges that chose not to participate in 
SuperMontage.
---------------------------------------------------------------------------

    \31\ Any broker-dealer that does business with the public and is 
not a member of a registered national seucrities exchange must be a 
member of the NASD. See 15 U.S.C. 78o(b)(8).
---------------------------------------------------------------------------

    In response to these concerns, the NASD has agreed to provide an 
alternative quotation and transaction reporting facility for NASD 
members, including alternative trading systems (``ATSs''), ECNs, and 
market makers. In effect, this facility makes participation in 
SuperMontage voluntary. This facility will permit NASD members to 
comply with their obligations under Commission and NASD rules 
(including Rule 11Ac1-1(c)(5) and Regulation ATS) without participating 
in the Nasdaq execution facility. The facility will identify through 
the central processor the identity of the NASD member that is the 
source of each quote.\32\ The facility also will provide a market 
neutral linkage to the Nasdaq and other marketplaces, but not an 
execution service. NASD represents that the facility will be available 
upon the implementation of SuperMontage by Nasdaq. The Commission 
believes that this undertaking by NASD, in conjunction with other terms 
applicable to the NASD's interaction with the SuperMontage,\33\ 
provides an appropriate balance of NASD's role as regulator of the OTC 
market and its role (through Nasdaq) as operator of an execution 
service in a competitive market.
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    \32\ See Rule 11Ac1-1(b)(1)(iii); 17 CFR 240.11Ac1-1(b)(1)(iii).
    \33\ See discussion at Sections V.I.2 and 3, infra.
---------------------------------------------------------------------------

    Some commenters also argued that automatic execution against market 
makers would give the SuperMontage an unfair advantage in attracting 
order flow, and make it difficult for others to offer competitive 
execution services. It appears that inherent in this argument is the 
view that Nasdaq should not be permitted to require its registered 
market makers to accept automatic executions, or that Nasdaq should not 
be permitted to operate a market itself, but should be restricted to 
providing connections among market makers and ECNs. Although the 
Commission is sensitive to the need to ensure that competition is fair, 
it cannot accept the view that Nasdaq should not be allowed to operate 
a market in which its registered market makers are required to accept 
automatic executions, particularly when participation in that market is 
voluntary. The Commission notes that compulsory automatic executions 
have been a feature of the Nasdaq market since at least 1988.\34\ The 
``SuperSOES'' proposal approved in January 2000 further expanded the 
scope of automatic execution against market maker quotes. The 
Commission therefore finds that the requirement that registered market 
makers in Nasdaq accept automatic executions against their published 
quotes is not a new feature of the SuperMontage and that it remains an 
appropriate feature of a system designed to provide economically 
efficient executions to investors within a fair and orderly market.
---------------------------------------------------------------------------

    \34\ SOES was initially developed in 1984, and market maker 
participation was made mandatory in 1988.
---------------------------------------------------------------------------

    Some commenters argued that Nasdaq's role as the exclusive 
processor of information for Nasdaq-listed securities will give 
SuperMontage an unfair advantage. On close examination, these 
criticisms pertained less to the operation of SuperMontage than to the 
requirement that market makers and ECNs quote through Nasdaq, as the 
sole consolidator of market data for Nasdaq securities. To address this 
issue, the NASD has agreed to provide an alternative quote and trade 
reporting mechanism, while Nasdaq has said that it is willing to confer 
with the other markets about establishing a separate central processor 
for information on Nasdaq securities under the UTP Plan.\35\ 
Nevertheless, the Commission believes that the current UTP plan must be 
revised to provide for a fair competitive environment in the future for 
all market centers trading in Nasdaq securities.\36\ The Commission 
believes that these undertakings, which are discussed in detail below, 
appropriately address the concerns about an advantage to Nasdaq arising 
from its role as the exclusive processor for Nasdaq securities.
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    \35\ See letter from Frank Zarb, Chairman and CEO, Nasdaq, to 
Senator Phil Gramm, dated October 24, 2000.
    \36\ The UTP Plan is the Joint Self-Regulatory Organization Plan 
Governing the Collection, Consolidation and Dissemination of 
Quotation and Transaction Information for Exchange-Listed Nasdaq/
National Market System Securities Traded on Exchanges on an Unlisted 
Trading Privileges Basis. See also, discussion at Section V.I.3, 
infra, regarding the need to revise the UTP Plan.
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    Finally, the Commission believes that Nasdaq, as well as the 
traditional exchanges, must have the flexibility to alter their 
existing services and to create new services in response to changes in 
the marketplace. Congress instructed the Commission to seek to 
``enhance competition and to allow economic forces, interacting with a 
fair regulatory field, to arrive at appropriate variation in practices 
and services.''\37\ The Commission believes that the SuperMontage 
proposal is consistent with these goals.
---------------------------------------------------------------------------

    \37\ See S. Rep. No. 94-75, 94th Cong., 1st Sess. 7 (1975) at p. 
8. (``Senate Report'').
---------------------------------------------------------------------------

III. Description of the Proposal

    The SuperMontage proposal will enhance Nasdaq's quotation montage 
by adding a new display facility for trading interest, the NODF, and 
establishing a new system for collecting quotes/orders, the OCF. This 
proposal also will modify Nasdaq's primary trading platform, the

[[Page 8025]]

NNMS, as approved on January 14, 2000.\38\
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    \38\ See NNMS Order supra note 22.
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A. Nasdaq Order Display Facility

    Today, the Nasdaq screen, commonly referred to as the Nasdaq 
Workstation II (``NWII''), is split into two primary display 
components. The top portion of the NWII contains, among other things: 
(1) the Market Minder Window, which allows market participants to 
monitor price activity (inside bid/offer and last sale) of selected 
stocks; and (2) the Dynamic Quote Window, which shows for a particular 
stock the inside bid and offer, the last sale, change in price from 
previous close, daily high and low, volume, and the short sale arrow 
indicator. The bottom portion of the NWII contains the Nasdaq Quotation 
Montage. The Nasdaq Quotation Montage shows for a particular stock two 
columns (one for bids, one for offers), under which is listed the 
market maker identification (``MMID'') for each registered market 
maker, ECN, and UTP Exchange in the stock, and the corresponding quote 
(price and size). Nasdaq ranks the bids and offers along with the 
corresponding MMID in price/time priority. Accordingly, the market 
participant at the best bid who is first in time appears first in the 
montage, the market participant at the best bid (or the next best bid) 
who is next in time is ranked second, and so on.
    Market makers that choose to participate in Nasdaq are required to 
submit a two-sided principal quote,\39\ which may reflect customer 
limit orders held by the market maker. ECNs, to qualify under the Order 
Handling Rules, must submit the prices and sizes of orders at the 
highest buy price and lowest sell price entered into the ECN by market 
makers.\40\ UTP Exchanges that have an interface with Nasdaq are 
required under the UTP Plan to submit to Nasdaq a two-sided quote, 
which represents the exchange's best quote in the stock at issue.
---------------------------------------------------------------------------

    \39\ See NASD Rule 4613. While a market maker's quoted price and 
size is attributed to the market maker by the corresponding MMID, 
this may not represent the market maker's best price if the market 
maker has placed a better-priced order with an ECN that complies 
with the display alternative under SEC Rules 11Ac1-1(c)(5) and 
11Ac1-4. See 17 CFR 240.11Ac1-1(c)(5) and 17 CFR 240.11Ac1-4.
    \40\ See NASD Rule 4623. ECNs also may be required to submit the 
prices and sizes of orders at the highest buy price and lowest sell 
price entered into the ECN by all subscribers to comply with 
Regulation ATS.
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1. Enhanced Display of Trading Interest
    Under the proposal, Nasdaq will retain the bottom portion of the 
NWII, the Nasdaq Quotation Montage, which displays market maker, ECN 
and UTP Exchange attributable quotes ranked in price/time priority. 
Nasdaq proposes to add the NODF, which will be displayed in the top 
portion of the NWII. The NODF will display the three best price levels 
in Nasdaq on both the bid and offer side of the market. These displayed 
price levels will include, for the first time in the Nasdaq market, 
anonymous (or non-attributable) quotes/orders in addition to the 
attributable quotes/orders of market makers, ECNs, and UTP Exchanges. 
Each price level will be updated and will display the aggregate size of 
displayed trading interest (attributable and non-attributable, as 
explained below). In addition to displaying the aggregate size of 
displayed trading interest at the three best price levels, Nasdaq will 
create and make available a new vendor data feed called NQDS Prime. 
NQDS Prime will provide, on a real-time basis, all individual 
attributable quote/order information at the three best price levels 
displayed in the NODF.\41\
---------------------------------------------------------------------------

    \41\ See Amendment No. 8, supra note 12. The NASD has stated 
that if Nasdaq should display more than three price levels in the 
NODF, it will provide expanded price level information through NQDS 
Prime. Nasdaq will assess a separate, additional vendor data fee for 
quote/order information away from the inside. The NASD will seek 
approval for the fee from the Commission in a separate filing.
---------------------------------------------------------------------------

    Nasdaq Quoting Market Participants will be required to designate a 
quote/order as attributable or non-attributable \42\ and will be able 
to indicate a reserve size for the quote/order.\43\ If a quote/order is 
designated as attributable, the price and size of the quote/order will 
be displayed next to the Nasdaq Quoting Market Participant or UTP 
Exchange's MMID in the Nasdaq Quotation Montage if it is the Nasdaq 
Quoting Market Participant or UTP Exchange's best-priced attributable 
quote/order. Attributable quotes/orders will be displayed in the NODF 
as part of the aggregate trading interest when the price of the quote/
order is within the best three price levels (on either side of the 
market) in Nasdaq.
---------------------------------------------------------------------------

    \42\ According to the NASD, both attributable and non-
attributable quotes/orders are considered ``displayed orders'' 
because they are displayed in the Nasdaq system.
    \43\ UTP Exchanges will only be permitted to display principal 
quotes/orders on an attributable basis and agency quotes/orders on a 
non-attributable basis. See Proposed NASD Rule 4710(f). Further, UTP 
Exchanges will not be permitted to indicate a reserve size. See 
Proposed NASD Rule 4701(dd).
---------------------------------------------------------------------------

    If a quote/order is designated as non-attributable, it will be 
displayed in the NODF as part of the aggregate trading interest when it 
is within the best three price levels. That quote/order will not, 
however, be displayed in the Nasdaq Quotation Montage next to the 
Nasdaq Quoting Market Participant's or UTP Exchange's MMID but instead 
may be displayed in a special ``SIZE MMID,'' which is described in 
greater detail below, representing the aggregate size of the best 
priced non-attributable bids or offers. Pursuant to NASD Rule 4613, 
market makers will continue to be required to publish a two-sided quote 
that is attributed to their MMID in the Nasdaq Quotation Montage.
2. SIZE MMID and Summary Scan
    A SIZE MMID, representing the aggregate displayed size of the best-
priced non-attributable bids or offers, will be shown in the Nasdaq 
Quotation Montage along with the other MMIDs for the Nasdaq Quoting 
Market Participants and UTP Exchanges displaying attributable size. The 
bid side and the offer side of the market each will have one SIZE 
MMID.\44\
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    \44\ Nasdaq Level 1 Service provides the inside bid/offer 
quotations and identifies the market center at the best bid/best 
offer according to the Nasdaq UTP Plan. See NASD Rule 7010 and 
Nasdaq UTP Plan, Section VI, Paragraph C, Subparagraph 1. The 
National Quotation Data Service, or NQDS, provides individual market 
maker quotes, Level 1 Service, and last sale information. See id. 
According to the NASD, the SIZE MMID will be used in determining the 
best bid/best offer and corresponding market center for purposes of 
Level 1 and UTP.
---------------------------------------------------------------------------

    The SuperMontage also will include a ``Summary Scan'' function. The 
Summary Scan will be a query-only function that will provide a snapshot 
of the total displayed size (attributable and non-attributable) for all 
levels below the three price levels in the NODF. The Summary Scan will 
anonymously display the aggregate interest (attributable and non-
attributable) at each price level on both sides of the market, but will 
not be dynamically updated.
3. Reserve Size
    Nasdaq Quoting Market Participants will be able to use reserve 
size. According to the NASD, reserve size will work in virtually the 
same manner as approved in the NNMS Order.\45\ A

[[Page 8026]]

Nasdaq Quoting Market Participant will be required to display (either 
as attributable or non-attributable) 1,000 shares in order to use 
reserve size. Reserve size will replenish displayed size (attributable 
or non-attributable) by at least 1,000 shares once displayed size is 
decremented to zero. Reserve size, along with displayed (both 
attributable and non-attributable) size, will be accessible through 
Nasdaq's trading platform, the NNMS. Reserve size, however, will not be 
displayed in either the NODF or the Nasdaq Quotation Montage. As 
described further below in the Order Execution Algorithms section of 
this Order, reserve size generally will be accessed after all displayed 
size at a given price in the Nasdaq market is exhausted.\46\
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    \45\ See NNMS Order, supra note 22. Nasdaq also filed a proposal 
with the Commission that will permit the separate display of 
customer orders by market makers in Nasdaq through a market maker 
agency identification symbol. See Securities Exchange Act Release 
No. 41128 (March 2, 1999), 64 FR 12198 (March 11, 1999) (notice of 
filing of SR-NASD-99-09) (``Agency Quote Proposal''). The Commission 
subsequently extended the comment period for the Agency Quote 
Proposal. See Securities Exchange Act Release No. 41243 (April 1, 
1999), 64 FR 17428 (April 9, 1999). The Agency Quote Proposal 
currently is pending with the Commission. If the Commission approves 
the Agency Quote Proposal, a market maker's Agency Quote could also 
have reserve size.
    \46\ See Amendment No. 4, supra note 6. The displayed size of 
UTP principal quotes/orders will be executed after the reserve size 
of other participants has been accessed.
---------------------------------------------------------------------------

B. Order Collector Facility

    Nasdaq proposes to establish an OCF as part of the SuperMontage 
that will: (1) transmit to Nasdaq multiple quotes/orders at one price 
or quotes/orders at multiple price levels entered by Nasdaq Quoting 
Market Participants and UTP Exchanges; \47\ (2) accept orders to access 
quotes/orders displayed (as either attributable or non-attributable) in 
both the NODF and the Nasdaq Quotation Montage; and (3) unify Nasdaq's 
delivery of Liability Orders to Nasdaq Quoting Market Participants and 
UTP Exchanges,\48\ which should minimize the potential for dual 
liability.
---------------------------------------------------------------------------

    \47\ A UTP Exchange could only transmit a single bid quote/order 
or single offer quote/order for principal quotes/orders, but could 
send multiple quotes/orders for agency quotes/orders. See Proposed 
NASD Rule 4710(f).
    \48\ Under the proposed rule change, a Liability Order is an 
order that Nasdaq believes gives rise to liability under the Firm 
Quote Rule, Exchange Act Rule 11Ac1-1, for a Nasdaq Quoting Market 
Participant or UTP Exchange. See 17 CFR 240-11Ac1-1.
---------------------------------------------------------------------------

1. Entry of Quotes/Orders
    Nasdaq proposes to allow Nasdaq Quoting Market Participants and UTP 
Exchanges to transmit multiple quotes/orders and quotes/orders at 
multiple price levels (subject to restrictions on a UTP Exchange's 
ability to send multiple quotes/orders for principal quotes/orders), 
which the system will manage and display in the SuperMontage consistent 
with a quote/order's parameters. Nasdaq will time stamp each quote/
order upon receipt, and the time stamp will be used in determining the 
ranking of the quote/order for execution purposes. If a size increment 
is received from a Nasdaq Quoting Market Participant for an existing 
quote/order at a given price, the system will maintain the original 
time stamp for the original quantity and assign a separate time stamp 
for the augmentation, thus protecting the time priority of the 
originally-entered quantity. Subsequent decreases in size will be 
deducted from individually stamped components in reverse time priority. 
Once a displayed size is diminished to zero, however, the quote/order 
will no longer retain priority, although it may have a feature that 
automatically refreshes size.\49\
---------------------------------------------------------------------------

    \49\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    In addition, a Nasdaq Quoting Market Participant will designate a 
quote/order as either attributable or non-attributable, and could 
designate a reserve size.\50\ As noted above, for attributable quotes/
orders, the prices and sizes of a Nasdaq Quoting Market Participant's 
or UTP Exchange's best-priced attributable quotes/orders on both the 
bid and offer side will be aggregated and displayed in the Nasdaq 
Quotation Montage under the participant's MMID, and also will be 
included in aggregate trading interest displayed in the NODF if the 
quotes/orders fall within the three best price levels (on either side 
of the market) in Nasdaq. For non-attributable quotes/orders, Nasdaq 
will display the aggregate size of such quotes/orders in the NODF when 
the quotes/orders fall within the three best price levels (on either 
side of the market) in Nasdaq. In addition, the best-priced non-
attributable quotes/orders from all Nasdaq Quoting Market Participants 
and UTP Exchanges will be aggregated and displayed next to the SIZE 
MMID in the Nasdaq Quotation Montage.
---------------------------------------------------------------------------

    \50\ Under the proposal, UTP Exchanges cannot use the reserve 
size function, but may submit multiple non-attributable quotes 
representing agency interest.
---------------------------------------------------------------------------

    The proposal will not require Nasdaq Quoting Market Participants 
and UTP Exchanges to post multiple quotes/orders at multiple price 
levels. A market maker could continue to send only its best bid/best 
offer to Nasdaq, and an ECN could continue to send Nasdaq only its top 
of the book. In addition, UTP Exchanges may elect to provide only their 
best quotes for display in the Nasdaq Quoting Montage.\51\
---------------------------------------------------------------------------

    \51\ See Amendment No. 8, supra note.
---------------------------------------------------------------------------

2. Order Execution and Delivery
    Even under NNMS (i.e., the SOES and SelectNet integration), the 
SOES and SelectNet systems continue to operate on separate platforms, 
and from the end-user's perspective there are still two separate 
systems.\52\ In order to further integrate the systems and minimize the 
potential for market maker dual liability, Nasdaq proposes to route all 
Liability and non-Liability Orders in the Nasdaq system through the OCF 
portion of the SuperMontage.
---------------------------------------------------------------------------

    \52\ See NNMS Order, supra note 22.
---------------------------------------------------------------------------

    To access quotes/orders through the OCF, order entry firms, market 
makers, ECNs, and UTP Exchanges may enter either a directed or non-
directed (including preferenced) order into the OCF.\53\ The order can 
be up to 999,999 shares (there will be a separate odd-lot process), and 
must indicate whether it is a buy, sell, sell short, or sell short 
exempt order.\54\ The order must be a priced or market order. Non-
directed orders entered by order-entry firms will be designated as 
immediate or cancel orders. Orders entered by Nasdaq Quoting Market 
Participants or UTP Exchanges may be designated as immediate or 
cancel.\55\
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    \53\ See discussion in Section V.E., infra, for a description of 
the directed order process.
    \54\ Although Nasdaq eliminated the rule limiting the size of 
orders that may be entered into the NNMS, the system in the short 
term will only be able to deliver an execution up to 9,900 shares. 
However, if a market participant enters an order into the system 
that is eligible for automatic execution and exceeds the system size 
limit of 9,900, the OCF will break the order up into multiples of 
9,900 shares. See NMMS Order, supra note 22.
    \55\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    Nasdaq will affix the MMID of the sender to all delivered orders. 
Further, preferenced orders and non-directed orders that are executed 
against a market maker or other market participant that participates in 
the automatic execution functionality of the system will result in an 
execution report being sent to each party to the trade immediately upon 
execution that identifies all counterparties to the trade. This is true 
whether a non-directed order is executed against an attributable quote/
order or a non-attributable quote/order.\56\
---------------------------------------------------------------------------

    \56\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    The NASD represents that the SuperMontage improves the current 
SelectNet order cancellation process for ECNs and other participants 
that take order delivery. Today, a firm entering an order into 
SelectNet can cancel the order after 10 seconds regardless of the 
order's status--i.e., regardless of whether the market participant that 
received the order is attempting to execute the order. In SuperMontage, 
an order that is in delivery to an ECN or UTP Exchange cannot be 
canceled. Thus, if a market participant requests to cancel an order 
that has been delivered to an ECN or UTP Exchange, the system will hold 
the cancel request until the ECN or UTP Exchange has completed 
interacting with the delivered order (i.e., once the ECN or UTP 
Exchange

[[Page 8027]]

executes, partially executes, or declines the order) or fails to 
respond within the allowable time. For example, if an order is 
delivered to an ECN and the entering market participant requests to 
cancel, the system will hold the cancel request. If the ECN declines or 
partially executes the order, the cancel request will be honored, thus 
canceling the original order (or the unexecuted balance of the original 
order for partially-executed orders).\57\
---------------------------------------------------------------------------

    \57\ See Amendment No. 7, supra note 10.
---------------------------------------------------------------------------

C. Non-Directed Orders

    Under the proposal, a market participant will be able to 
immediately access the best prices in Nasdaq by entering a non-directed 
order into the OCF. A non-directed order is an order that the market 
participant does not route to a particular Nasdaq Quoting Market 
Participant or UTP Exchange, or a preferenced order (as further 
described below). A non-directed order must be a market order or a 
marketable limit order.\58\ Upon receipt of a non-directed order that 
is not a preferenced order, the OCF will ascertain the next Nasdaq 
Quoting Market Participant or UTP Exchange in the queue due to receive 
an order pursuant to one of three Order Execution Algorithms and 
deliver either an execution or a Liability Order, depending on how the 
Nasdaq Quoting Market Participant or UTP Exchange participates in 
Nasdaq.\59\ However, as described below in the Order Execution 
Algorithms section of this Order, a Nasdaq Quoting Market Participant's 
non-directed orders first will be matched against its own quotes/orders 
if the participant is at the Nasdaq BBO.
---------------------------------------------------------------------------

    \58\ Because non-directed orders entered by order-entry firms 
will be designated as ``immediate or cancel'' orders, if a 
marketable limit order becomes non-marketable after entry into the 
system, Nasdaq will return the order (or the unexecuted portion 
thereof) to the entering party. See Amendment No. 8, supra note 12.
    If an order is a sell short that is not exempt from NASD Rule 
3350 and the market moves from an up-bid to a down-bid after the 
order has been entered but before delivery or execution, the system 
will return the order to the participant who entered it. Sell-short 
exempt orders (i.e., those entered by primary market makers) may be 
entered into the system for execution.
    \59\ Under the proposal, market makers will continue to be 
required to take automatic executions via the NNMS; however, ECNs 
and UTP Exchanges will have the option to participate in either the 
system's automatic execution or order delivery functions.
---------------------------------------------------------------------------

    A new type of non-directed order called a ``preferenced order'' 
also can be entered into the non-directed order process, and will be 
considered a Liability Order. The market participant entering the 
preferenced order must designate the particular Nasdaq Quoting Market 
Participant or UTP Exchange against which the order is to be executed 
or delivered. When a preferenced order is next to be executed within 
the non-directed order queue it will be delivered to the designated 
party as an order or as an execution depending on how the party 
participates in Nasdaq. The SuperMontage will execute against (or 
deliver an order in an amount up to) both the displayed and reserve 
size of the preferenced Nasdaq Quoting Market Participant or UTP 
Exchange, but only if it is at the BBO. Any unexecuted portion will be 
returned to the entering market participant.\60\
---------------------------------------------------------------------------

    \60\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

1. Quote Decrementation of Non-Directed Orders
    For Nasdaq Quoting Market Participants and UTP Exchanges accepting 
automatic executions, the SuperMontage will deliver an execution up to 
the size displayed by the participant, then to other displayed orders 
at that price, and then to the participant's reserve size (if any).\61\ 
The SuperMontage will automatically decrement the aggregate quote in 
the NODF by the size of the delivered execution, and decrement the 
Nasdaq Quoting Market Participant's or UTP Exchange's quote/order in 
the Nasdaq Quotation Montage if the quote/order is attributable. 
Displayed (attributable or non-attributable) size will be replenished 
from reserve size for Nasdaq Quoting Market Participants accepting 
automatic executions if the participant's displayed size has been 
decremented to zero and the participant has reserve size. If an ECN 
accepts automatic executions and its attributable quotes/orders and 
reserve sizes are exhausted without the ECN updating or transmitting 
another attributable quote/order to Nasdaq, Nasdaq will zero out the 
side of the quote that is exhausted. If both sides of the ECN's quote 
are reduced to zero without the ECN updating or transmitting another 
attributable quote/order, the ECN will be placed into an excused 
withdrawal state until the ECN transmits a revised attributable quote/
order to Nasdaq. However, Nasdaq will continue to access any non-
attributable quotes/orders in NNMS while the ECN is in an excused 
withdrawal state.
---------------------------------------------------------------------------

    \61\ UTP Exchanges cannot use the reserve size feature.
---------------------------------------------------------------------------

    For Nasdaq Quoting Market Participants and UTP Exchanges not 
participating in automatic executions (i.e., order delivery ECNs and 
UTP Exchanges), Nasdaq will deliver a Liability Order. Nasdaq will 
automatically decrement the participant's quote by the size of the 
delivered order and the remaining quote, if not decremented to zero, 
will retain its priority in the queue.\62\
---------------------------------------------------------------------------

    \62\ For example, assume there are three market participants at 
the inside bid of $20 and ECN1, ranked first for execution purposes, 
is displaying 1,000 shares at $20 on the bid side of the market, 
with 5,000 in reserve. Further assume that five market sell orders 
are entered into the system for the following amounts: (1) 100 
shares; (2) 100 shares; (3) 100 shares; (4) 100 shares; (5) 700 
shares. These market sell orders will be processed as follows. The 
first 100-share order will be delivered to ECN1, reducing its 
displayed size to 900. The second, third and fourth orders also will 
be delivered to ECN1, further reducing its displayed size to 600. 
When the fifth order is delivered to ECN1, its displayed size will 
be reduced to zero and the remaining 100 shares will access the 
displayed size of the next market participant in the queue at $20. 
See Amendment No. 7, supra note 10. Nasdaq will not wait for an 
order to be processed before routing another order to an ECN. See 
Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    If an order delivery ECN or UTP Exchange declines or partially 
fills an order, or fails to respond in any manner within thirty seconds 
of order delivery, Nasdaq will immediately re-route the order (or 
unexecuted portion thereof) to the next Nasdaq Quoting Market 
Participant or UTP Exchange in the queue.\63\ In addition, in the case 
of an order delivery ECN that has declined or partially filled an order 
without immediately transmitting a revised quote/order or that has 
failed to respond within 30 seconds, Nasdaq will zero out the ECN's 
quotes/orders at that price level on that side of the market. In the 
case of an order delivery UTP Exchange that has declined or partially 
filled an order without immediately transmitting a revised quote/order 
or that has failed to respond within 30 seconds, Nasdaq will move the 
side of the UTP Exchange's quote/order, to which the declined or 
partially filled order was delivered, to the lowest bid or highest 
offer in Nasdaq for 100 shares.\64\
---------------------------------------------------------------------------

    \63\ See Amendment No. 8, supra note 12.
    \64\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    Nasdaq also will apply a shorter uniform turn-around standard of a 
maximum of 5 seconds to order delivery ECNs. The purpose is to 
establish a general standard (as opposed to an order-by-order standard) 
that measures whether an ECN is providing an automated response in a 
time period that ensures market quality. Thus, Nasdaq proposes to 
monitor an ECN's order turnaround time based on information received 
from the ECN's Nasdaq Service Display Platform (``SDP''). Nasdaq will 
use SDPs linked to each ECN to assign a time-stamp for when an order is 
delivered to the ECN. Nasdaq also will capture the time-stamp via the 
SDP of when the ECN sends a

[[Page 8028]]

response to the delivered order. Nasdaq will then calculate and 
monitor, on a real-time basis, the difference between the two time 
stamps and determine whether the ECN is meeting the 5 second maximum 
order-response standard. On an ongoing basis, Nasdaq will monitor ECN 
response times and provide each ECN with its own order responsiveness 
time statistics, which will not be made public. If an ECN regularly 
fails to meet the 5 second response time over a number of orders, 
Nasdaq will place that ECN's quote in a closed quote state. The closed 
quote state will be lifted when the ECN can certify that it can meet 
the 5 second response time requirement.\65\
---------------------------------------------------------------------------

    \65\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

2. Quote Refresh and Revised SOESed-Out-of-the-Box Procedures
    As noted previously, market makers are required to maintain a two-
sided, attributable principal quote in Nasdaq at all times. To assist 
with this requirement, market makers will be able to use the Quote 
Refresh (``QR'') function.\66\ QR allows a market maker to designate a 
refresh size (with a default refresh size of 1,000 shares) and price 
(e.g., a tick amount away from the price of its decremented quote) to 
which it wishes to refresh if its quoted size is decremented to zero. 
If a market maker is using QR but has an attributable quote/order in 
the system that is priced at or better than the quote that will be 
created by the QR, Nasdaq will display the better-priced or equally-
priced attributable quote/order that is already in the system, not the 
QR-produced quote. If a market maker is not using QR and the market 
maker has given Nasdaq multiple attributable quotes/orders, Nasdaq will 
display the market maker's next best-priced attributable quote/order 
when its best-priced attributable quote/order is decremented to zero.
---------------------------------------------------------------------------

    \66\ See NNMS Order, supra note 22.
---------------------------------------------------------------------------

    If a market maker's quote/order is decremented to zero and the 
market maker does not update its principal quote via QR, transmit a 
revised attributable quote/order to Nasdaq, or have another 
attributable quote/order in the system, Nasdaq will place the market 
maker's quote (both sides) in a closed state for three minutes. At the 
end of that time, if the market maker did not voluntarily update or 
withdraw its quote from the market, Nasdaq will refresh the market 
maker's quote/order to its normal unit of trading (generally 100 
shares) at the lowest bid and highest offer currently being displayed 
in that security and reopen the market maker's quote.\67\
---------------------------------------------------------------------------

    \67\ See discussion of current SOESed-out-of-the-Box procedure 
at Section V.C., infra and Proposed Amended NASD Rule 4613(a).
---------------------------------------------------------------------------

D. Order Execution Algorithms \68\
---------------------------------------------------------------------------

    \68\ The Order Execution Algorithm was substantially modified by 
Amendment Nos. 4, 6, 7, and 8 to the proposal. See supra notes 6, 9, 
10, and 12.
---------------------------------------------------------------------------

    The OCF will execute non-directed orders, other than preferenced 
orders, against Nasdaq Quoting Market Participant's and UTP Exchange's 
quotes/orders based on price/time priority unless the market 
participant chooses to override this default algorithm and select one 
of the alternative algorithms made available by the OCF. These 
alternative algorithms are: (1) price/size/time priority; and (2) 
price/time priority that accounts for ECN quote access fees.
    In the price/time algorithm, non-directed orders other than 
preferenced orders will be executed (within each price level) as 
follows: displayed quotes/orders of market makers, ECNs, and non-
attributable agency interest of UTP Exchanges, in time priority; (2) 
reserve size of market makers and ECNs, in time priority; and (3) 
principal quotes of UTP Exchanges, in time priority.\69\
---------------------------------------------------------------------------

    \69\ According to the NASD, similar to the Intermarket Trading 
System (``ITS''), the SuperMontage will generally attempt to probe 
and sweep the Nasdaq market before sending an order to another 
market center. See, e.g., Section 8(a)(v) of the ITS Plan.
---------------------------------------------------------------------------

    In the alternative order execution algorithm based on price/size/
time priority, non-directed orders other than preferenced orders will 
be processed (within each price level) as follows: (1) Displayed 
quotes/orders of market makers, ECNs, and non-attributable agency 
interest of UTP Exchanges, in size/time priority; (2) reserve size of 
market makers and ECNs, in size/time priority, with size priority based 
on the size of the related displayed quote/order; and (3) principal 
quotes of UTP Exchanges, in size/time priority.
    As a third choice, market participants will be able to indicate 
that their order should be executed in a manner that accounts for an 
ECN's separate quote access fee.\70\ Under this option, non-directed 
orders other than preferenced orders will be executed (within each 
price level) as follows: (1) Displayed quotes/orders of market makers, 
ECNs that do not charge a separate quote access fee, and non-
attributable agency interest of UTP Exchanges, as well as quotes/orders 
of ECNs that charge a separate quote access fee where the ECN indicates 
that the price improvement offered by the quote/order is equal to or 
exceeds the quote access fee, in time priority; (2) displayed quotes/
orders of ECNs that charge a separate quote access fee to non-
subscribers that do not indicate that the price improvement offered by 
the specific quote/order is equal to or exceeds the access fee, in time 
priority; \71\ (3) reserve size of market makers and ECNs that do not 
charge a separate quote access fee to non-subscribers, as well as 
reserve size of quotes/orders from ECNs that charge a separate quote 
access fee to non-subscribers where the ECN entering such quote/order 
has indicated that the price improvement offered by the specific quote/
order is equal to or exceeds the quote access fee, in time priority; 
(4) reserve size of ECNs that charge a separate quote access fee to 
non-subscribers that do not indicate that the price improvement offered 
by the specific quote/order is equal to or exceeds the quote access 
fee, in time priority; and (5) the principal interest of UTP Exchanges, 
in time priority.
---------------------------------------------------------------------------

    \70\ The algorithm is similar to the algorithm proposed in 
Amendment No. 7. See Amendment No. 7, supra note 10.
    \71\ In Amendment No. 6, supra note 9, the NASD represented that 
if, in a decimals environment, ECNs changed the manner in which they 
charge fees to reflect their fees in their published quote, these 
ECN quotes will be given the same priority for non-directed orders 
as market makers and non-attributable agency quotes of UTP 
Exchanges.
---------------------------------------------------------------------------

    Each of these algorithms will make an exception for non-directed, 
non-preferenced orders entered by a Nasdaq Quoting Market Participant 
when that Nasdaq Quoting Market Participant's quote/order is at the 
inside market. In that case, the SuperMontage will first attempt to 
match orders entered by the Nasdaq Quoting Market Participant against 
its own quote/order if the Nasdaq Quoting Market Participant is at the 
BBO. Finally, market participants may preference an order to a Nasdaq 
Quoting Market Participant or UTP Exchange at the BBO, as described 
above.
    In all three algorithms, there will be a five-second interval delay 
in certain instances before an order moves to the next price level. As 
a general rule, where an order might be partially filled at one price 
level but the remaining shares of the order will not be filled in full 
within the next two minimum trading increments (i.e., price ticks) 
away, there will be a five-second interval delay or pause before the 
order moves to the next price level. At any point after a delay, if the 
remainder of the order can be entirely filled within the next two price 
ticks away, there will be no further delays and the order will be 
filled completely. Thus, a large market order moving through many

[[Page 8029]]

price levels could pause for five seconds before every price move 
except for the last two.\72\
---------------------------------------------------------------------------

    \72\ Orders will be processed in time sequence. Thus, if an 
order is in interval delay because it meets the above parameters, 
orders that are behind the interval-delay order will be held in the 
queue.
---------------------------------------------------------------------------

    To reduce these interval delays, a market participant will be able 
to designate an individual order as a ``Sweep Order.'' A Sweep Order 
will trade through all interest (i.e., displayed and reserve interest) 
at the three price levels being displayed in the NODF at the time of 
entry, without pausing five seconds between each displayed price. If 
the order is not executed in full at the third price level, the order 
will pause for five seconds between each subsequent price level.\73\
---------------------------------------------------------------------------

    \73\ For example, assume that at 10:00:01 a.m., the inside 
market in Stock G is $104.55 to $104.60, and the following quotes/
orders are being displayed in the system on the bid side of the 
market: MMA $104.55--1,000 (total, including reserve), MMB $104.50--
2,000 (total, including reserve), ECN1 $104.45--9,000 (total, 
including reserve), MMC $104.45--10,000 (total, including reserve).
    At 10:00:02 a.m., Institution Q enters a 10,000 share market 
sell order (through a market maker), which is designated as a Sweep 
Order. Since the order will be filled in full by the interest that 
is at the three price levels being displayed in Nasdaq, Institution 
Q's order is filled in full with no time delay between prices. If at 
10:00:02 a.m., while the Sweep Order is executing against the 
quotes/orders in Nasdaq, an internal subscriber of ECN1 (an 
automatic execution ECN) wishes to execute against the $104.45 for 
9,000 shares being displayed in Nasdaq, before filling the 
subscriber's order, ECN1 could send a request to cancel the order to 
Nasdaq. If Nasdaq had already executed against the 9,000 shares, 
ECN1 would send a message to its customer declining the execution 
because the Sweep Order had filled the quote/order. If Nasdaq had 
not executed against the 9,000 shares, ECN1's request to cancel 
would be granted, the internal execution could occur, and the 
remainder of Institution Q's order would be executed against MMC. 
See Amendment No. 5, supra note 8.
---------------------------------------------------------------------------

E. Directed Orders

    A directed order is one that is routed by the market participant 
entering the order to a specific Nasdaq Quoting Market Participant or 
UTP Exchange. Unless the participant to which a directed order is being 
sent has agreed to accept directed orders that are Liability Orders, a 
directed order must be a non-Liability Order, and as such, must be 
designated as: (1) All-or-None (``AON'') with a size at least one unit 
of trading greater than the size of the attributable quote/order of the 
market participant to which the order is directed; or (2) a Minimum 
Acceptable Quantity order (``MAQ'') with a MAQ value of at least one 
unit of trading greater than the size of the attributable quote/order 
of the participant to which the order is directed. If a Nasdaq Quoting 
Market Participant or UTP Exchange is at the inside or is displaying 
(attributable or non-attributable) interest in the NODF and receives a 
directed non-Liability Order that it wants to fill, to avoid double 
execution, it may request to cancel its displayed quote/order in Nasdaq 
before it fills the non-Liability Order. Nasdaq will not decrement a 
quote/order upon the delivery of a directed non-Liability Order.
    Nasdaq Quoting Market Participants and UTP Exchanges also can elect 
to receive directed orders that are Liability Orders (i.e., orders that 
when delivered to market participants' quotes/orders impose an 
obligation to respond in a manner consistent with the Commission's Firm 
Quote Rule).\74\ If a market participant chooses to accept directed 
Liability Orders, Nasdaq will append an indicator to the Nasdaq Quoting 
Market Participant's or UTP Exchange's MMID, showing that the market 
participant is available to receive directed Liability Orders.
---------------------------------------------------------------------------

    \74\ See Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
---------------------------------------------------------------------------

F. Locked/Crossed Markets

    A locked market occurs when a market participant's bid equals the 
lowest offer of another market participant. A crossed market occurs 
when a market participant's bid exceeds the lowest offer of another 
market participant. Under the NASD's proposal, if a Nasdaq Quoting 
Market Participant or UTP Exchange enters a quote/order that will lock 
or cross the market, the SuperMontage will not display the quote/order, 
but instead will reformat the quote/order as a marketable limit order 
and enter it into the SuperMontage as a non-directed order for 
execution.\75\ The reformatted order will be routed to the displayed 
quote/order (attributable or non-attributable) next in the queue that 
will be locked or crossed, and the order will be executed at the price 
of the displayed quote/order. Once the lock or cross is cleared, if the 
Nasdaq Quoting Market Participant's or UTP Exchange's quote/order that 
would have locked or crossed the market has not been completely filled, 
the SuperMontage will reformat the order again and display it 
(consistent with the parameters of the quote/order) as a quote/order on 
behalf of the entering Nasdaq Quoting Market Participant or UTP 
Exchange. It should be noted, however, that a market participant will 
receive a system warning (as it does today) if it attempts to send a 
quote/order that will lock or cross the market. To complete the order 
entry, the participant will be required to override the system warning. 
This override will help market participants avoid automatic executions 
resulting from inadvertent locking or crossing quotes/orders by not 
overriding the system warning.\76\
---------------------------------------------------------------------------

    \75\ See Proposed NASD Rule 4710(b)(3).
    \76\ See Amendment No. 7, supra note 10.
---------------------------------------------------------------------------

    If the market is locked or crossed at 9:30 a.m., Nasdaq will clear 
out the locked or crossed quotes by executing the oldest bid (offer) 
against the oldest offer (bid) which it is marketable against, at the 
price of the oldest quote/order. Nasdaq then will begin processing non-
directed orders that are in the queue.\77\
---------------------------------------------------------------------------

    \77\ According to the NASD, prior to the opening, Nasdaq will 
process ``trade-or-move'' messages in accordance with NASD Rule 
4613, as amended by File Nos. SR-NASD-99-23 and SR-NASD-00-18. See 
Securities Exchange Act Release Nos. 42400 (February 7, 2000), 65 FR 
7407 (February 14, 2000); and 42896 (June 2, 2000), 65 FR 36747 
(June 9, 2000).
---------------------------------------------------------------------------

G. UTP Exchange Participation

    Under the proposal, UTP Exchanges will be able to enter orders into 
the SuperMontage. Orders from UTP Exchanges that offer automatic 
execution reciprocity to Nasdaq will receive automatic execution 
against Nasdaq Quoting Market Participants that take automatic 
executions.\78\ Participating UTP Exchanges that do not offer automatic 
execution reciprocity to Nasdaq will have their orders delivered to the 
next Nasdaq Quoting Market Participant in the queue according to their 
choice of the Order Execution Algorithms.\79\ Otherwise, UTP Exchanges 
will be able to use the directed \80\ and non-directed order processes 
of SuperMontage in the same way as Nasdaq Quoting Market Participants. 
Also, UTP Exchanges will be able to enter multiple non-attributable 
quotes/orders representing agency interest. UTP Exchanges, however, 
will only be able to submit a single, two-sided attributable quote, and 
will not be able to use reserve size or QR.
---------------------------------------------------------------------------

    \78\ See Amendment Nos. 4 and 6, supra notes 6 and 9.
    \79\ See Amendment No. 6, supra note 9. As a result, market 
makers may have to develop separate systems to accept order delivery 
from UTP Exchanges.
    \80\ See Proposed NASD Rule 4710(f).
---------------------------------------------------------------------------

    As discussed above, pursuant to the Order Execution Algorithms, 
non-attributable agency interest of UTP Exchanges generally will be 
executed on parity with displayed quotes/orders (attributable and non-
attributable) of market makers and ECNs.\81\ The principal interest of 
UTP Exchanges will be last in priority under the Order

[[Page 8030]]

Execution Algorithms, and will be executed after the system does a 
complete sweep of the agency interest of UTP Exchanges and the 
displayed and reserve size of all Nasdaq Quoting Market Participants.
---------------------------------------------------------------------------

    \81\ See Amendment Nos. 4 and 8, supra notes 6 and 12.
---------------------------------------------------------------------------

H. ECN Participation

    As discussed above, ECNs that are NASD members will have the choice 
of participating in order delivery or automatic execution. Regardless 
of the method of participation, these ECNs will have full access to the 
SuperMontage for order entry and order delivery. Specifically, ECNs 
that are NASD members will be able to designate quotes/orders as 
attributable or non-attributable, and will be able to transmit multiple 
quotes/orders at the same price or at multiple prices. All ECNs will be 
able to use the SuperMontage's reserve size feature for quotes/orders. 
ECN participation in Nasdaq will continue to be governed by rule and 
private contract.

I. Odd-Lot Processing \82\
---------------------------------------------------------------------------

    \82\ The system's odd-lot processing function was substantially 
modified by Amendment No. 4 to the proposal. See Amendment No. 4, 
supra note 6.
---------------------------------------------------------------------------

    The SuperMontage will accept and execute orders for less than one 
normal unit of trading (i.e., odd-lot orders). The SuperMontage will 
provide a separate mechanism for processing and executing odd-lot 
orders including: (1) An ``odd-lot exposure limit'' for market makers; 
(2) an interval delay between odd-lot executions against the same 
market maker; and (3) an odd-lot order entry limitation of one order 
per second, per firm.
    Odd-lot orders will be processed in a round-robin fashion against 
market makers with an available exposure limit and will be executed at 
the BBO, even if the market makers are not at the inside. A market 
maker can set its exposure limit, on a security-by-security basis, from 
0 to 999,999 shares. The SuperMontage will not execute an odd-lot order 
against a market maker unless the market maker has a sufficient 
exposure limit to fill the odd-lot order. When a market maker's odd-lot 
exposure limit is reduced to zero, it will be taken out of the odd-lot 
rotation unless and until the market maker sets a new exposure limit. 
If no market maker has an odd-lot exposure limit, the SuperMontage will 
suspend the processing of odd-lots until an exposure limit is 
refreshed. Odd-lot executions will decrement the exposure limit (but 
not the quote/order sizes displayed in the Nasdaq Quotation Montage or 
NODF) by the size of the odd-lot order. To ensure continuity of price, 
if a mixed-lot is entered into the system, the odd-lot portion will be 
executed against the next market maker in the rotation at the round-lot 
portion price once the round-lot portion has been executed.
    The odd-lot processing mechanism also will provide a maximum five-
second interval delay between executions against the same market maker 
in the same security. A market maker will be able to adjust its 
interval-delay time down (i.e., down to 0-4 seconds), so that it may 
receive odd-lot executions more frequently than five seconds apart. 
Thus, after an odd-lot has been executed against a market maker with an 
available exposure limit, there will be at most a five-second interval 
delay before the market maker will be subject to another odd-lot 
execution. During the five-second (or less) interval delay, the market 
maker could adjust its odd-lot exposure limit up or down. Finally, the 
system will be programmed to accept odd-lot orders at a rate no faster 
than one order per second from any single participant.

J. Nasdaq SmallCap

    Nasdaq proposes to use the SuperMontage for all Nasdaq securities, 
including SmallCap securities. Nasdaq proposes to delete the current 
SOES rules excluding SmallCap securities from the NNMS.

K. System Roll Out \83\
---------------------------------------------------------------------------

    \83\ Nasdaq described its proposed system roll out in Amendment 
No. 5 to the proposal. See Amendment No. 5, supra note 8.
---------------------------------------------------------------------------

    Nasdaq intends to implement the SuperMontage as soon as practicable 
after decimal pricing is fully implemented in Nasdaq.\84\ Nasdaq plans 
to give market participants and vendors at least 90 days notification 
of changes in system specifications. At the time of such notification, 
market participants will be given new specifications in order to begin 
analyzing the system changes. Nasdaq has represented that its staff 
will work throughout this period with market participants to address 
any system and specification-related questions and issues.
---------------------------------------------------------------------------

    \84\ See Amendment No. 6, supra note 9.
---------------------------------------------------------------------------

    At least 60 days prior to system implementation, Nasdaq plans to 
give participants notice of specific testing dates and of the 
availability of a testing environment. In addition, at least 30 days 
prior to system implementation, Nasdaq plans to make available a 
testing environment in which firms may begin testing their software and 
hardware (if applicable). Finally, Nasdaq plans to hold at least two 
full-day, mock trading sessions on a weekend. This will allow market 
participants to train their personnel on the new system and to 
participate in a real-time trading environment.
    Nasdaq plans to phase-in Nasdaq securities similar to the way the 
SEC's Order Handling Rules were introduced. Specifically, Nasdaq 
intends to initially implement the system for a limited number of 
securities (e.g., 100) representing a cross-section of Nasdaq-listed 
stocks. On a regular basis thereafter, Nasdaq will add 100 new stocks 
until the system is implemented for all Nasdaq-listed securities. 
Nasdaq will select a cross section of stocks to be included in each 
group of 100 securities to be rolled out during a particular week.
    The purpose of the system roll out is to give Nasdaq and its 
members the opportunity to observe and gain experience with the new 
system, and to give Nasdaq the opportunity to make any adjustments to 
the system (subject to approval by the Commission), if necessary. 
Nasdaq intends to work closely with the Commission during the roll-out 
phase to ensure a smooth transition to the new system.

IV. Summary of Comments

    The Commission received 21 comment letters in response to the 
December 6, 1999 notice.\85\ Ten commenters supported \86\ and five 
commenters opposed \87\ the proposal to

[[Page 8031]]

establish the SuperMontage. Six commenters did not clearly state a 
position on the proposal.\88\ Of the commenters who supported the 
proposal, all expressed reservations regarding certain aspects of the 
proposal.\89\
---------------------------------------------------------------------------

    \85\ See December 6, 1999 notice, supra note 4, and Comment 
Summary for a complete description of these comments. The Commission 
notes that several commenters addressed the NNMS, which was pending 
at the time that the NASD submitted this proposed rule change. The 
Commission is not addressing these comments because the Commission 
has already approved the NNMS. See NNMS Order, supra note 22. The 
Commission also notes that several commenters raised issues with 
respect to the Agency Quote proposal currently pending before the 
Commission. The Commission will address those comments when it 
considers the Agency Quote proposal. If the Agency Quote proposal is 
not approved by the Commission, Nasdaq has represented that it will 
file conforming rule changes to eliminate references to Agency 
Quotes in its rule text. See Amendment No. 3, note 8, supra note 5. 
At least one commenter also questioned the application of the 
proposal with respect to the IODES proposal. Nasdaq, however, has 
withdrawn this proposal. See supra note 16. Other comments not 
directly related to the SuperMontage are also not addressed in this 
Order.
    \86\ See Electronic Traders Association Letter (``ETA'' Letter); 
Investment Company Institute Letter (``ICI'' Letter); Security 
Traders Association Letter (``STA'' Letter); Security Traders 
Association of New York, Inc. Letter (``STANY'' Letter); Merrill 
Lynch Letter; Chicago Stock Exchange Letter (``CHX'' Letter); Morgan 
Stanley Dean Witter Letter (``MSDW'' Letter); Goldman Sachs Letter; 
Nasdaq Institutional Advisory Council Letter (``ITAC'' Letter); and 
ITG Letter.
    \87\ See Bloomberg Letter; Automated Trading Desk Letter 
(``ATD'' Letter); Instinet Letter; Island Letter (Initially, Island 
did not explicitly approve of or oppose the proposed rule change. 
Island recommended that the Commission delay consideration of the 
proposed rule ``until such time as the Nasdaq market is restructured 
to ensure fair competition between Nasdaq and ECNs or until such 
time as the Commission has permitted ECNs such as Island to become 
registered national securities exchanges.'' However, in its comment 
letter responding to Amendment No. 4, Island expressed its 
opposition to the proposal); and NexTrade Letter.
    \88\ See BNY ESI & Co. Letter (``BNY'' Letter); Bancorp Letter; 
Heartland Letter (Heartland believed that the proposed rule change 
should not be approved until the SOES/SelectNet Integration is used 
and tested); American Century Investment Management Letter (``ACIM'' 
Letter); Salomon Smith Barney Letter; and Mount Pleasant Brokerage 
Services Letter (``MPBS'' Letter).
    \89\ See ETA Letter; ICI Letter; STA Letter; STANY Letter; 
Merrill Lynch Letter; MSDW Letter; ITAC Letter; CHX Letter; Goldman 
Sachs Letter; and ITG Letter.
---------------------------------------------------------------------------

    In response to the comment letters, the NASD and Nasdaq made 
several amendments to the proposal. These proposed changes were 
published for comment in the Federal Register on March 30, 2000 as 
Amendment No. 4.\90\ The Commission received 31 comment letters from a 
total of 27 commenters in response to Amendment No. 4.\91\ Of these 27 
commenters, 20 generally supported the proposal,\92\ while five opposed 
the proposal, including the proposed changes.\93\ Two commenters 
expressed neither support nor opposition to the proposal.\94\ Of those 
commenters who expressed support for the proposal, three expressed 
reservations about certain aspects of the proposal.\95\
---------------------------------------------------------------------------

    \90\ See Securities Exchange Act Release No. 42573, supra note.
    \91\ See Instinet Letter; ICI Letter; Bloomberg Letter; CHX 
Letter; Joseph J. Burrello, Principal and Manager of Nasdaq Trading, 
William Blair & Company, Larry Elmore, Partner and Manager of Equity 
Trading, J.C. Bradford & Co., Dennis A. Green, Senior Vice President 
and Manager of Nasdaq Trading, Legg Mason Wood Walker, Inc., Jack 
Hughes, First Vice President and Manager of Equity Trading, Janney 
Montgomery Scott, LLC, Robert Krohn, Managing Director of Nasdaq 
Trading, McDonald Investments, Inc., Greg Lemaster, Manager of 
Nasdaq Trading, Stifel, Nicolaus & Company, Inc., James R. Miller, 
Manager of Nasdaq Trading, Robert W. Baird & Company, Inc., Bobby 
Olsen, Vice President and Manager of Nasdaq Trading, Advest, Inc., 
Gerard Yurasits, Senior Nasdaq Trader, First Albany Corporation, 
Hedi H. Reynolds, Managing Director of Nasdaq Trading, Morgan, 
Keegan & Company, Inc., William Cahill, Managing Director of Nasdaq 
Trading, Robinson Humphrey Letter (``Traders'' Letter); Island 
Letter; Archipelago Letter; Granite Financial Letter; Security 
Investment Company Letters; Charles Schwab Letter (addressed to 
Senator Phil Gramm); Telemet Letter; Congressman Drier Letter; 
Congressman Pallone Letter; Congressman Dingell Letter; 
Congresswoman Morella Letter; Congressman Stupak Letter; 
Congresswoman Wilson Letter; Congressman Radanovich Letter; 
Congressman Towns Letter; Congressman McInnis Letter; Congressman 
Thomas Letter; Spears, Leeds & Kellogg Letter (addressed to Senator 
Phil Gramm); First Union Letter (addressed to Alfred R. Berkeley, 
President, the Nasdaq Stock Market); Seidel Letter (``Seidel'' 
Letter); Thurston, Springer, Miller, Herd & Titak Letter (``Titak'' 
Letter); Philadelphia Corporation for Investment Services Letter 
(``Philadelphia Corp.'' Letter)(address to Senator Arlen Spector); 
and Robert Bannon Letter (``Bannon'' Letter).
    The Commission notes that commenters did not limit their 
discussion to the topics addressed in Amendment No. 4. Rather, many 
commenters discussed the proposal in its entirety. These commenters 
are listed as responding to Amendment No. 4 because their letters 
were dated after Amendment No. 4 was published.
    \92\ See ICI Letter; CHX Letter; Traders Letter; Charles Schwab 
Letter; Congressman Drier Letter; Congressman Pallone Letter; 
Congresswoman Morella Letter; Congressman Stupak Letter; 
Congresswoman Wilson Letter; Congressman Towns Letter; Congressman 
McInnis Letter; Congressman Thomas Letter; Congressman Radanovich 
Letter; Titak Letter; Philadelphia Corp. Letter; Spears, Leeds & 
Kellogg Letter; First Union Letter; Security Investment Company 
Letters; Seidel Letter; and Bannon Letter.
    \93\ See Instinet Letter; Bloomberg Letter; Archipelago Letter; 
Granite Financial Letter; and Island Letter.
    \94\ See Congressman Dingell Letter; and Telemet Letter.
    \95\ See ICI Letter; Traders Letter; and Bannon Letter.
---------------------------------------------------------------------------

    In response to these comments, the NASD and Nasdaq made additional 
revisions to the proposal. The proposed changes were published in the 
Federal Register as Amendment Nos. 5, 6, and 7 on August 15, 2000.\96\ 
The Commission received 28 comment letters in response to these 
Amendments.\97\ Twelve expressed support for the proposal,\98\ while 13 
continued to oppose it.\99\ Three commenters supported the general 
concept of the SuperMontage, but expressed concerns about specific 
provisions contained in the proposal, or did not clearly state a 
position on the proposal.\100\
---------------------------------------------------------------------------

    \96\ See Securities Exchange Release No. 43133, supra note 11.
    \97\ The Commission notes that commenters did not limit their 
discussion to the topics addressed in Amendment Nos. 5, 6, and 7. 
Rather, many commenters discussed the proposal in its entirety. 
These commenters are listed as responding to Amendment Nos. 5, 6 and 
7 because their letters were dated after Amendment No. 7 was 
published.
    \98\ See Senator Schumer Letter; Congressman Ehrlich Letter; 
Congressman Shays Letter; Congressman Fossella Letter; Starbucks 
Coffee Letter (``Starbucks'' Letter)(addressed to Congresswoman 
Jennifer Dunn); STA Letter; Association of Publicly Traded Companies 
Letter (``APTC'' Letter); American Shareholder's Association Letter 
(``ASA'' Letter); Consumer Federation of America Letter (``CFA'' 
Letter); Wendell Garrett Letter (``Garrett'' Letter) (addressed to 
Congressman John Shadegg and Senator Jon Kyl); O'Connor Letter; and 
Jeffries Letter.
    \99\ See Philadelphia Stock Exchange Letter (``Phlx'' Letter); 
ACIM Letter; Instinet Letter; Bloomberg Letter; BRUT Letter; Harold 
Bradley Letter (``Bradley'' Letter); Archipelago Letter; NexTrade 
Letter; Seema Aurora Letter (``Aurora'' Letter); Island Letter; 
Renaissance Letter; Leon Letter; and Kupfer Letter.
    \100\ See T. Rowe Price Associates, Inc. Letter (``TRPC'' 
Letter); Gramm Letter; and Scudder Kemper Investments Letter 
(``Scudder Kemper'' Letter).
---------------------------------------------------------------------------

    In response to these comments, the NASD and Nasdaq made several 
additional changes to the proposed rule change. The proposed changes 
were published in the Federal Register as Amendment No. 8 on November 
15, 2000.\101\ The Commission received 24 comment letters in response 
to Amendment No. 8. One commenter expressed support for the 
proposal,\102\ while 6 continued to oppose it.\103\ Eight

[[Page 8032]]

commenters supported the general concept of the SuperMontage, but 
expressed concerns about specific provisions contained in the 
proposal.\104\ Nine commenters, while objecting to certain aspects of 
the proposal, did not clearly state a position on the proposal as a 
whole.\105\
---------------------------------------------------------------------------

    \101\ See Securities Exchange Act Release No. 43514, supra note 
13.
    \102\ See Bloomberg Letter.
    \103\ See Instinet Letter (Instinet also submitted a letter 
addressing changes to be made by Amendment No. 8 prior to the 
Commission's receipt of the Amendment. This letter has also been 
incorporated); Archipelago Letter; Letter from American Century 
Investment Management, Inc., Janus Capital Corporation, Neptune 
Capital Management LLC, State Farm Mutual Automobile Insurance 
Company, Alex Brown Investment Management, LP, Boston Company, 
Wachovia Bank, NA, State Street Research & Management Co., Banc One 
Investment Advisors Corporation, West Highland Capital, Inc., 
Fidelity Trust Company, GMG/Seneca Capital Management, Westchester 
Capital Management, Inc., Becker Capital Management, Inc., 
Greenville Capital Management, Inc., Friess Associates of Delaware, 
Inc., C.E. Unterberg, Tobin Advisors, LP, Kepmen Capital, Schroder 
Investment Management Ltd., Foreign & Colonial Management, Ltd., RAS 
Asset Management SGR, Scudder Investor Services, Inc., New York 
State Common Retirement Fund, Dreyfus Fund, Virginia Retirement 
System, Pennsylvania School Employee Retirement Systems, Harris 
Associates Securities, LP, Columbia Partners, LLC Investment 
Management, Caterpillar Investment Management, Ltd., Nicholas 
Applegate Capital Management, Inc., Symphony Asset Management, 
Monetta Financial Services, Inc., Buckingham Capital Management, 
Sedacca Capital Management, Inc., Robeco Group NV, Montag & 
Caldwell, Gemini Management Partners, LLC, Abu Dhabi Investment 
Authority, BT&T Asset Management AG, Jacobs Levy Equity Management, 
Inc., Newton Investment Management Ltd., Berliner Freiverkehrs 
(Aktien) AG, Compass Capital Ltd., SAC Capital, Standish, Ayer & 
Wood, Minnesota Power and Light Co., Frontier Capital Management, 
Sage Asset Management, LLC, Target Holdings Corporation, Lincoln 
Partners, Apex Capital, LLC, Twin Capital Management, Kanaly Trust 
Company, Rothschild Bank AG, Sanpaolo IMI Asset Management SGR, 
Banque Paribas Luxembourg, Golden Capital Management, Investment 
Adviser, Inc., R.H. Capital Associates, Quaker Capital Management, 
Eagle and Dominion Asset Management Ltd., Bank Invest, Morley Fund 
Management, Provident Investment Counsel, Gruber & McBaine Capital 
Management, Dupont Capital Management, Masters Capital Investments, 
LLC, Sawgrass Asset Management, LLC, Kaintuck Capital Management, 
LP, HighMark Capital Management, Inc., Atticus Holdings, LLC, Credit 
Agricole Indosuez Cheuvreux, Royce & Associates, Inc., OrbiMed 
Advisors LLC, Cordillera Asset Management, Inc., Fisher Investments, 
Inc., Ohio Valley Management, Inc., Loews Corporation, National City 
Investment Company, Zak Capital, Inc., Ocean Park Capital 
Management, LLC, Tattersall Advisory Group, Peninsula Capital 
Management, Westway Capital, LLC, Munder Capital Management, Kadem 
Capital, LLC, Phoenix Zweig Advisers, Fuller & Thaler Asset 
Management, Chicago Equity Partners, LLC, Amerindo Advisers, Ltd., 
Group Aesop Capital Partners, LLC, Wilen Management Corporation, 
Ballentine Capital Management, Inc., Summit Capital Management LLC, 
Sirach Capital Management LLC, Cadwell and Orkin, Wentworth, Hauser 
& Violich, Inc., Matrix Asset Advisors, Inc., George Weiss 
Associates (``Investment Companies Letter'')(addressed to Senator 
Phil Gramm); CFA Letter; Office of the Comptroller, State of New 
York (``NY'' Letter) (stating that SuperMontage could ideally 
increase information, but may provide unfair advantages to market 
makers); and Adriaanse Letter (``Adriaanse Letter'').
    \104\ See Security Investment Company Letter; ICI Letter; STA 
Letter; Pershing Trading Company, L.P. (``Pershing'' Letter); ACIM 
Letter; Cincinnati Stock Exchange (``CSE'' Letter); Scudder Kemper 
Letter; and Vanguard Letter.
    \105\ See Island Letter; BRUT Letter; Ryley Letter; CHX Letter; 
Suss Letter (``Suss Letter''); Silverman Letter (``Silverman 
Letter''); Erfort Letter (``Erfort Letter''); Birmingham Letter 
(``Birmingham Letter'') and aLV Letter (``aLV Letter'') (urging 
Commission to re-think passing the SuperMontage in its current 
form).
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V. Discussion

    After carefully considering the comments, the Commission finds, for 
the reasons discussed below, that the SuperMontage proposal is 
consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to the NASD. In particular, the 
Commission finds that the proposal is consistent with the requirements 
of Sections 15A(b)(6), (9), and (11), and 11A(a)(1)(C) of the Act.\106\ 
Section 15A(b)(6) \107\ 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. Section 15A(b)(9) requires 
that the rules of an association not impose any burden on competition 
that is not necessary or appropriate in furtherance of the purposes of 
the Act.\108\ Section 15A(b)(11) \109\ requires that the rules of an 
association be designed to produce fair and informative quotations, 
prevent fictitious or misleading quotations, and to promote orderly 
procedures for collecting, distributing, and publishing quotations. And 
finally, in Section 11A(a)(1)(C),\110\ Congress found 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) The 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.
---------------------------------------------------------------------------

    \106\ 15 U.S.C. 78o-3(b)(6), (9), and (11), and 15 U.S.C. 78k-
1(a)(1)(C).
    \107\ 15 U.S.C. 78o-3(b)(6).
    \108\ 15 U.S.C. 78o-3(b)(9).
    \109\ 15 U.S.C. 78o-3(b)(11).
    \110\ 15 U.S.C. 78k-1(a)(1)(C).
---------------------------------------------------------------------------

    As discussed more fully below, the Commission finds that the 
proposed changes are in the public interest and are designed to assure 
the economically efficient execution of securities transactions by 
increasing the availability of pre-trade information in Nasdaq 
securities, as well as the opportunity for the orders of market makers, 
public customers, and order entry firms to interact. Several commenters 
believed that the proposal will improve the Nasdaq market by either 
providing more information to investors, promoting greater efficiency 
in executions, or increasing overall market transparency.\111\ The ICI, 
for example, stated that ``creating a system that provides investors 
with greater access to priced orders and allows them to execute against 
those orders will greatly enhance the quality of the Nasdaq 
market.''\112\ MSDW stated that the ``ability to enter multiple 
proprietary/agency quotes/orders at multiple price levels will greatly 
assist market makers in managing their limit orders.''\113\ TRPA stated 
that ``the SuperMontage concept furthers the goals of unifying the 
markets and providing a means for orders to interact with one another, 
while allowing for continuing innovation.''\114\ The Commission agrees 
with these commenters that there is good reason to conclude that the 
SuperMontage, by providing for the enhanced display of trading interest 
in Nasdaq securities and by expanding the availability of automatic 
execution, will facilitate the price discovery process and promote 
quote competition among Nasdaq Quoting Market Participants and UTP 
Exchanges, thus helping to ensure the best execution of customer 
orders.
---------------------------------------------------------------------------

    \111\ See ETA Letter; Merrill Lynch Letter; Goldman Sachs 
Letter; MSDW Letter; STA Letter; STANY Letter; ITAC Letter; ICI 
Letter; Bannon Letter; Bancorp Letter; Charles Schwab Letter; 
Congressman Drier Letter; Congressman Pallone Letter; Congresswoman 
Morella Letter; Congressman Stupak Letter; Congresswoman Wilson 
Letter; Congressman Towns Letter; Congressman McInnis Letter; 
Congressman Thomas Letter; Spear, Leeds & Kellogg Letter; First 
Union Letter; Seidel Letter; Security Investment Company Letters; 
ITG Letter; APTC Letter; Jeffries Letter; Senator Schumer Letter; 
Congressman Radanovich Letter; Congressman Shays Letter; Congressman 
Fossella Letter; Titak Letter; ASA Letter; Starbucks Letter; 
Philadelphia Corp. Letter; Garrett Letter; NY Letter; and 
Congressman Ehrlich Letter.
    \112\ See ICI Letter.
    \113\ See MSDW Letter.
    \114\ See TRPA Letter.
---------------------------------------------------------------------------

    In addition, by introducing features to: (1) Assist market makers 
with the management of their quotes/orders; (2) reduce instances of 
double liability for market makers; and (3) encourage the entry of 
larger sized quotations and orders by market makers and ECNs, the 
proposal likely will add liquidity to the market and help assure the 
economically efficient execution of transactions in Nasdaq securities. 
The proposed changes thus should enhance the efficiency and increase 
the depth and liquidity of the market for Nasdaq securities, to the 
benefit of all investors.

A. Nasdaq Order Display Facility

    The NODF will increase the availability of information about 
quotations by displaying the three best price levels in Nasdaq on both 
the bid and offer side of the market to supplement the Nasdaq Quotation 
Montage. Each price level will be updated and will display aggregate 
trading interest at that price level.
    Several commenters stated this aspect of the proposal will result 
in more information to investors, promote greater efficiency in 
executions, promote liquidity, increase market transparency, and reduce 
market fragmentation.\115\ For example, several

[[Page 8033]]

commenters believed that the proposal will provide a better overall 
picture of the market's depth by enabling market participants to 
display (and accept) multiple levels of priced orders.\116\ In 
addition, one commenter believed that the enhanced display of trading 
interest will promote investor protection by decreasing trade-throughs 
(i.e., trades at prices worse than those available for a security) and 
giving market participants more options for meeting best execution, 
firm quote, and limit order display obligations.\117\ Another commenter 
stated that the proposal will help improve the current state of 
fragmented trading in Nasdaq securities, and offer an improved 
execution system over SOES and SelectNet.\118\ A third commenter 
believed that the NODF ``will offer an enhanced means for market 
participants to gauge trading interest at the Nasdaq inside market and 
prices near the inside market.'' \119\
---------------------------------------------------------------------------

    \115\ See ETA Letter; Merrill Lynch Letter; Goldman Sachs 
Letter; STA Letter; STANY Letter; ITAC Letter; ICI Letter; Bannon 
Letter; Bancorp Letter; MSDW Letter; Charles Schwab Letter; 
Congressman Drier Letter; Congressman Pallone Letter; Congresswoman 
Morella Letter; Congressman Stupak Letter; Congresswoman Wilson 
Letter; Congressman Towns Letter; Congressman McInnis Letter; 
Congressman Thomas Letter; Spears, Leeds & Kellogg Letter; First 
Union Letter; Seidel Letter; Security Investment Company Letters; 
ITG Letter; APTC Letter; Senator Schumer Letter; Congressman 
Radanovich Letter; Congressman Shays Letter; Congressman Fossella 
Letter; Titak Letter; ASA Letter; Starbucks Letter; Philadelphia 
Corp. Letter; Jeffries Letter; Garrett Letter; NY Letter; and 
Congressman Ehrlich Letter.
    \116\ See ITAC Letter; Congressman Fossella Letter; APTC Letter; 
and Charles Schwab Letter; see also Bannon Letter and Island Letter.
    \117\ See ITAC Letter.
    \118\ See Bannon Letter; see also Senator Schumer Letter.
    \119\ See MSDW Letter.
---------------------------------------------------------------------------

    Two commenters, however, questioned the need for the NODF.\120\ One 
of these commenters believed that fragmentation was no longer a problem 
in the Nasdaq market.\121\ Further, this commenter argued that if the 
NASD was concerned about the fragmentation and transparency of pre-
trade information, the NASD should allow market participants to display 
all of their bids and offers under their MMID.\122\ Another commenter 
argued that the NODF would create a false perception of liquidity in 
Nasdaq because orders below a market participant's top of book will not 
be attributed to the firm representing the order.\123\ This commenter 
believed, as a result, that liquidity will appear to reside in Nasdaq, 
rather than with the broker/dealer that represents the liquidity in 
Nasdaq.\124\
---------------------------------------------------------------------------

    \120\ See Bloomberg Letter and NexTrade Letter.
    \121\ See Bloomberg Letter.
    \122\ See Bloomberg Letter.
    \123\ See Archipelago Letter.
    \124\ See Archipelago Letter.
---------------------------------------------------------------------------

    One commenter also believed that the NODF was unnecessary because 
ECNs and market makers have created their own limit order books, and 
that the proposed NODF will not provide any additional capability to 
the market.\125\ Another commenter believed that the SuperMontage 
proposal did not provide complete transparency because of its anonymous 
display and reserve size features.\126\ This commenter urged the 
Commission to review this issue to ensure that large players do not 
receive an unfair trading advantage that is not available to small 
investors.\127\ Two commenters also suggested that the NODF should 
display the five best price levels in Nasdaq on both the bid and offer 
side of the market to allow investors to better gauge the market \128\ 
and to constrain volatility.\129\ Another commenter believed that 
Nasdaq should display information for individual market makers and ECNs 
up to three price levels.\130\
---------------------------------------------------------------------------

    \125\ See NexTrade Letter.
    \126\ See CFA Letter.
    \127\ See CFA Letter.
    \128\ See ICI Letter and ACIM Letter; see also ITAC Letter.
    \129\ See ACIM Letter.
    \130\ See Bloomberg Letter.
---------------------------------------------------------------------------

    The Commission finds that the NODF, as part of the SuperMontage, is 
consistent with Sections 15A(b)(6) and 15A(b)(11) of the Act \131\ in 
that, among other things, it is designed to facilitate transactions in 
securities and to produce fair and informative quotations. Further, the 
Commission finds that the order aggregation characteristics of the 
proposed rule change are consistent with Sections 11A(a)(1)(B) and 
11A(a)(1)(C) of the Act.\132\ In particular, in Section 11A(a)(1)(B), 
Congress found that new data processing and communications techniques 
create the opportunity for more efficient and effective market 
operations.\133\
---------------------------------------------------------------------------

    \131\ 15 U.S.C. 78o-3(b)(6), (b)(11).
    \132\ 15 U.S.C. 78k-1(a)(1)(B)-(a)(1)(C).
    \133\ 15 U.S.C. 78k-1(a)(1)(B).
---------------------------------------------------------------------------

    The Commission believes that the NODF has the potential to 
facilitate securities transactions by enhancing the display of trading 
interest. Currently, when Nasdaq receives a quote, it cannot discern 
whether that quote represents a single order or multiple orders at one 
price. Nasdaq Quoting Market Participants and UTP Exchanges can send 
Nasdaq only a single, two-sided quote. In contrast, under the proposal, 
Nasdaq Quoting Market Participants and UTP Exchanges generally will 
have the ability to transmit multiple orders at multiple price levels 
for display at their discretion.\134\ In addition, the NODF has two 
other features designed to enhance the display of trading interest--the 
size of displayed interest will be aggregated at the best three price 
levels on both sides of the market and the Summary Scan function will 
show the total displayed size (attributable and non-attributable) for 
all levels below the first three price levels. With the implementation 
of decimals, market participants will need to view and access greater 
depth. At a penny quotation increment, for example, a best offer of $20 
for 100 shares may be less meaningful than a second best offer at 
$20.01 for 1,000 shares. As discussed in more detail below, because the 
NODF is designed to enhance the display of trading interest among 
participants, it should facilitate trading in a decimals 
environment.\135\ While the Commission agrees with certain commenters 
that display of depth beyond three levels may be necessary once the 
markets move to decimals, the Commission understands that Nasdaq will 
consider expanding the number of levels as it further develops the 
system.
---------------------------------------------------------------------------

    \134\ UTP Exchanges will be permitted only to send a single bid 
and a single offer for principal orders/quotes, but may submit 
multiple agency quotes/orders. See Proposed NASD Rule 4710(f).
    \135\ As discussed in Section III.K, supra, the SuperMontage 
will not be implemented until after decimals in the Spring of 2001. 
In a recent study, SRI Consulting found that with smaller minimum 
pricing increments, liquidity may be dispersed as limit orders are 
spread over smaller price intervals. See SRI Consulting, Assessing 
the Impact on Message Traffic of Trading Equities and Option in 
Decimal Increments (Executive Summary at p. 31) (April 16, 1999). 
Therefore, market participants may want to see more price levels 
away from the BBO.
---------------------------------------------------------------------------

    With respect to concerns that Nasdaq should display even greater 
information, the Commission believes that Nasdaq's proposed NQDS Prime, 
which will provide on a real-time basis, all individual attributable 
quote and order information at the three best price levels displayed in 
the NODF,\136\ will help to address these concerns. NQDS Prime will 
enhance the display of trading interest and provide market participants 
greater information in making order-routing decisions. The Commission 
believes that this will provide investors with more options since 
market participants will be able to use this information to access 
liquidity through Nasdaq or non-Nasdaq systems (such as proprietary 
links).
---------------------------------------------------------------------------

    \136\ See Amendment No. 8, supra 12. At least one commenter 
supported the addition of NQDS Prime. See STA Letter.
---------------------------------------------------------------------------

1. Non-Attributable Quotes and Other Features
    Under the proposed rule change, a SIZE MMID, representing the 
aggregate size of the best-priced non-attributable bids or offers, will 
be displayed in the Nasdaq Quotation Montage along with the other MMIDs 
for the Nasdaq Quoting Market Participants and UTP Exchanges displaying 
attributable size.
    The Commission received several comment letters addressing this 
display feature in response to the December 6, 1999 notice.\137\ One 
commenter believed that there is a risk that non-attributable

[[Page 8034]]

proprietary orders will be susceptible to manipulation because a market 
maker could post a small bid under its own MMID and post a larger sell 
order anonymously.\138\ Another commenter argued that because Nasdaq 
Quoting Market Participants and UTP Exchanges can display quotes/orders 
anonymously under the proposed rule change, a ``moral hazard'' might be 
created.\139\ The commenter expressed concern that participants with 
weaker credit might ``hide behind unattributable quotations in times of 
market stress.'' \140\ Further, this commenter noted that because the 
solvency of a participant's counterparty may be unknown, investor 
confidence could be threatened.\141\ This commenter also opined that 
the anonymous display feature will deny viewers the opportunity to 
access secondary or tertiary quotations directly.\142\ In addition, one 
commenter believed that order entry firms could use the feature to 
access ECNs without paying an access fee.\143\
---------------------------------------------------------------------------

    \137\ See December 6, 1999 notice, supra note 4.
    \138\ See ATD Letter.
    \139\ See Bloomberg Letter.
    \140\ See Bloomberg Letter.
    \141\ See Bloomberg Letter.
    \142\ See Bloomberg Letter.
    \143\ See Bloomberg Letter.
---------------------------------------------------------------------------

    Another commenter pointed out that the NASD has not revealed how it 
proposes to provide participants with transaction reports.\144\ This 
commenter stated that the counterparty to a transaction should be 
disclosed at the time an order is executed, not at the end of the trade 
day.\145\ This commenter explained that disclosure of a counterparty's 
identity at the time of execution is critical in order for a market 
participant to monitor its intraday credit risk exposure.\146\
---------------------------------------------------------------------------

    \144\ See Island Letter.
    \145\ See Island Letter.
    \146\ See Island Letter.
---------------------------------------------------------------------------

    In response to some of the issues raised by commenters, the NASD 
has committed to assist market participants in their efforts to manage 
operational and credit risk.\147\ Nasdaq will affix the MMID of the 
sender to all directed orders, delivered non-directed orders, and 
delivered preferenced orders. Further, preferenced orders and non-
directed orders that are executed against a market maker or other 
market participant that participates in the automatic execution 
functionality of the system will result in an execution report 
immediately upon execution that identifies all of the parties to the 
trade. This is true if a non-directed order is executed against an 
attributable order or a non-attributable order.\148\
---------------------------------------------------------------------------

    \147\ See Amendment No. 8, supra note 12.
    \148\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    Two commenters believed that these features will allow ECNs to deny 
access to their quotes through SuperMontage to non-subscribing firms 
that do not pay their fees.\149\ One of these commenters believed that 
``[s]anctioning the denial of quote access through SuperMontage also 
conflicts with [b]est [e]xecution, as a firm who has been denied access 
may be unable to hit the inside bid or offer.'' \150\
---------------------------------------------------------------------------

    \149\ See STA Letter and Pershing Letter.
    \150\ See STA Letter.
---------------------------------------------------------------------------

    As an initial matter, the Commission notes that market makers 
currently can enter multiple quotes/orders by submitting a quote/order 
to Nasdaq and orders to multiple ECNs. Under the Commission's Order 
Handling Rules,\151\ a market maker can place a better-priced order 
with an ECN anonymously without updating its quote to reflect the 
better-priced order, as long as the ECN displays the order in the 
public market. Other market participants also may submit orders to ECNs 
and have their orders traded on an anonymous basis. As a result, market 
participants trading with ECN quotes currently are subject to a certain 
level of uncertainty regarding their ultimate counterparty. The 
SuperMontage proposal merely provides market makers with the ability to 
display multiple quotes in Nasdaq on an attributable and non-
attributable basis, which is consistent with the ability of market 
makers and other market participants to display orders on ECNs today.
---------------------------------------------------------------------------

    \151\ See 17 CFR 240.11Ac1-1(c)(5).
---------------------------------------------------------------------------

    The Commission believes that the use of non-attributable quotes 
(i.e., SIZE MMID) in the SuperMontage has the potential to promote the 
display of greater market interest and encourage greater transparency 
in the Nasdaq market. The ability to display non-attributed market 
interest may encourage certain market participants to submit larger 
quotes/orders, particularly institutions wishing to minimize the market 
impact of their orders. Furthermore, the Commission believes that the 
NASD has minimized the concerns raised by commenters regarding the 
identity of those with whom they are trading by affixing the MMID of 
the sender on delivered orders and identifying the counterparties in 
execution reports. Moreover, because only Nasdaq market makers, ECNs, 
and UTP Exchanges can enter non-attributable orders into the system, 
the range of participants that are responsible for non-attributable 
orders on their own behalf or for an anonymous customer is limited. All 
Nasdaq Quoting Market Participants have established clearing 
arrangements and credit standings monitored by the NASD and the 
National Securities Clearing Corporation (``NSCC''). UTP Exchanges have 
similar provisions to ensure financial responsibility. Moreover, the 
Commission fully expects that the NASD will monitor the use of these 
quotes/orders with a view towards preventing manipulation. Finally, as 
discussed further below, the Commission notes that market participants 
that wish to interact with a specific market participant still will be 
able to direct or preference orders to Nasdaq Quoting Market 
Participants and UTP Exchanges, including ECNs.
2. Reserve Size
    The proposed reserve size function will allow Nasdaq Quoting Market 
Participants to publicly display part of the full size of their order 
or interest, with the remainder held in reserve on a non-attributable 
basis.\152\ The reserve size function requires Nasdaq Quoting Market 
Participants to initially display a minimum of 1,000 shares, and to 
refresh the displayed size by a minimum of 1,000 shares each time the 
displayed size is decremented to zero. As originally described in the 
December 6, 1999 notice, reserve size would have been accessed based on 
time priority and status as a market maker, automatic execution ECN, or 
order delivery ECN.
---------------------------------------------------------------------------

    \152\ Market makers must display the full size of customer limit 
orders in some circumstances pursuant to the Commission's Order 
Handling Rules.
---------------------------------------------------------------------------

    Several commenters expressed support for the reserve size 
feature.\153\ One commenter felt that the reserve size feature would 
benefit investors,\154\ while another believed it would minimize the 
adverse market price impact associated with a larger-sized order.\155\ 
Another commenter, however, suggested that the reserve size feature 
should be altered to provide market participants with incentives to 
display large size attributable quotations.\156\
---------------------------------------------------------------------------

    \153\ See ITG Letter; ITAC Letter; and First Union Letter.
    \154\ See ITG Letter.
    \155\ See ITAC Letter.
    \156\ See Goldman Sachs Letter.
---------------------------------------------------------------------------

    In response to the commenter, in Amendment No. 4, the NASD added 
the ``size/time priority'' characteristic to the reserve size function 
to provide order execution priority for orders with the larger 
displayed size (after being refreshed out of reserve) over smaller 
displayed sizes (refreshed out of reserve size), with time priority 
being given to identically sized quotes.\157\ In addition, the NASD 
revised its original Order

[[Page 8035]]

Execution Algorithm so that it no longer distinguished between the 
reserve size of order delivery and automatic execution ECNs.\158\ 
Instead, the reserve size of market makers and ECNs that did not charge 
a separate access fee received priority over ECNs that charged a 
separate access fee.
---------------------------------------------------------------------------

    \157\ See Amendment No. 4, supra note 6.
    \158\ Id. Originally, the NASD proposed that non-directed orders 
be processed pursuant to one algorithm. In Amendment No. 8, the NASD 
proposed to offer market participants three algorithms from which to 
choose. See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    In response to the NASD's change in Amendment No. 4, one commenter 
questioned the Order Execution Algorithm's size/time prioritization of 
reserve size.\159\ The commenter expressed concern that the proposed 
algorithm would discourage market participants from displaying orders 
greater than 1,000 shares.\160\ Another commenter believed that size/
time priority was inconsistent with the basic premise of time priority 
and that the first quote accessed should maintain priority regardless 
of size.\161\
---------------------------------------------------------------------------

    \159\ See ICI Letter.
    \160\ See ICI Letter.
    \161\ See Traders Letter.
---------------------------------------------------------------------------

    In Amendment No. 7, the NASD again revised the reserve feature to 
give equal priority to quotes/orders of ECNs that charge separate 
access fees if they indicate that the price improvement exceeds the fee 
for that particular quote/order.\162\ In further response to the 
various concerns of commenters concerning the Order Execution 
Algorithm, Nasdaq amended the Order Execution Algorithm for non-
directed orders to allow market participants to take into account their 
objectives in executing their orders against the displayed and reserve 
size of Nasdaq Quoting Market Participants and UTP Exchanges.\163\ 
Nasdaq now permits market participants to select one of three Order 
Execution Algorithms: price/time priority; price/size/time priority; 
and price/time priority that accounts for ECN fees.
---------------------------------------------------------------------------

    \162\ See Amendment No. 7, supra note 10.
    \163\ See Amendment No. 8, supra.
---------------------------------------------------------------------------

    As an initial matter, the Commission notes that all Nasdaq Quoting 
Market Participants can use reserve size.\164\ As a result, the 
Commission believes that the reserve size feature should give market 
participants greater flexibility in handling large orders. In 
particular, the reserve size could prove useful to institutions that 
wish to minimize the market impact of their orders. Increased 
participation should, in turn, enhance the depth and liquidity of the 
market for Nasdaq securities, to the benefit of all market 
participants. In this regard, the Commission notes that ECNs have used 
reserve size features for years with considerable success.
---------------------------------------------------------------------------

    \164\ See Proposed NASD Rules 4710(b)(1)(B); 4710(b)(2); 
4701(y), and 4701(t).
---------------------------------------------------------------------------

    Two requirements should ensure that market participants continue to 
have an incentive to display their quotes/orders. First, market 
participants must display a minimum of 1,000 shares to use the reserve 
size feature. Second, all displayed quotations at the same price level 
in the SuperMontage generally will have priority up to their displayed 
size over all reserve size at the same price level. Third, market 
forces and competition may encourage Nasdaq Quoting Market Participants 
to display greater size if the price/size/time algorithm is widely 
used. In sum, the Commission concludes that Nasdaq's use of the reserve 
size feature is reasonable and could result in increased depth and 
liquidity in Nasdaq. The Commission, however, expects the NASD to 
monitor trading to ensure the proper use of the reserve size feature 
and compliance with the requirements applicable to the use of reserve 
size.

B. Order Collector Facility

    Under the proposal, the OCF will: (1) Transmit to Nasdaq multiple 
quotes/orders and quotes/orders at multiple price levels entered by 
Nasdaq Quoting Market Participants and UTP Exchanges;\165\ (2) accept 
orders to access quotes/orders displayed (as either attributable or 
non-attributable) in both the NODF and the Nasdaq Quotation Montage; 
and (3) unify Nasdaq's delivery of Liability Orders to Nasdaq Quoting 
Market Participants and UTP Exchanges, which should minimize the 
potential for dual liability. Upon receipt of an order seeking to 
access displayed quotes/orders, the OCF will determine whether to 
deliver an order or an execution based on the manner in which the 
market participant receiving the order participates in the Nasdaq 
market. For example, market makers will take automatic execution,\166\ 
and ECNs and UTP Exchanges will have the option of taking automatic 
execution or order delivery.\167\
---------------------------------------------------------------------------

    \165\ A UTP Exchange may transmit only a single bid or single 
offer for principal quotes/orders, but may send multiple agency 
quotes/orders. See Proposed NASD Rule 4710(f).
    \166\ See Proposed NASD Rule 4701(u).
    \167\ See Amendment 6, supra note 9.
---------------------------------------------------------------------------

    As discussed further below, the Commission believes that the 
proposed OCF is consistent with Sections 15A(b)(6)\168\ and 
11A(a)(1)(C)(i) of the Act,\169\ particularly with Congress' finding 
that it is in the public interest, and appropriate for the protection 
of investors and the maintenance of fair and orderly markets to assure 
the economically efficient execution of securities transactions. The 
OCF should provide market participants with greater flexibility to 
reflect their buying and selling interest at various price levels by 
allowing them to transmit multiple attributable quotes/orders at 
multiple price levels, as well as non-attributable quotes/orders that 
conceal the identity of the responsible participant until executed.
---------------------------------------------------------------------------

    \168\ 15 U.S.C. 78o-3(b)(6).
    \169\ 15 U.S.C. 78k-1(a)(1)(C)(i).
---------------------------------------------------------------------------

1. Order Entry and Access
    Under the proposal, order entry firms, market makers, ECNs, and UTP 
Exchanges will be able to access quotes/orders by submitting directed 
or non-directed orders up to 999,999 shares in the OCF.\170\ Large 
orders may be submitted as non-directed orders and receive automatic 
execution, subject to the possible application of a 5-second interval 
delay between successive price levels if the order is not categorized 
as a Sweep Order or cannot be filled completely at the inside price 
plus (or minus) two price ticks.
---------------------------------------------------------------------------

    \170\ Currently, Nasdaq can only handle orders up to 9,900 
shares. However, if a market participant enters an order for 
automatic execution that exceeds 9,900 shares, the OCF will break 
the order up into multiples of 9,900 shares and execute the orders.
---------------------------------------------------------------------------

    Five commenters expressed concern about access to the system.\171\ 
One of these commenters stated that the SuperMontage, as proposed, was 
too limited, and should permit all NASD members to enter non-
attributable limit orders in the system.\172\ One commenter 
specifically expressed concern that order entry firms would be excluded 
from receiving automatic executions for proprietary orders sent to the 
system.\173\
---------------------------------------------------------------------------

    \171\ See MPBS Letter; ITG Letter; ETA Letter; CHX Letter; and 
ATD Letter.
    \172\ See ITG Letter; See also MPBS Letter.
    \173 \ See ATD Letter.
---------------------------------------------------------------------------

    The Commission believes that the NASD has adequately addressed the 
commenters' concerns that access to the proposed system is too limited. 
First, the NASD has stated that order entry firms, as well as Nasdaq 
Quoting Market Participants and UTP Exchanges, may enter either 
directed or non-directed orders intended for execution into the OCF. 
Moreover, order entry firms sending proprietary orders to the system to 
access market maker quotes/orders will receive automatic execution of 
those orders. Second, the Commission believes that it is reasonable for 
Nasdaq to limit the ability to display quotes/orders to registered 
market makers, ECNs, and UTP Exchanges. These participants have certain 
obligations

[[Page 8036]]

under the Exchange Act, including those under the Order Handling Rules. 
Market makers in particular have unique obligations under NASD rules, 
such as the requirement to maintain continuous two-sided markets. ECNs 
offer efficient display and execution systems for limit orders. 
Limiting the ability to enter non-attributable limit orders into the 
system to market makers and ECNs encourages their participation in the 
Nasdaq market, which strengthens the Nasdaq market as a whole. 
Accordingly, the Commission concludes that the OCF is reasonably 
designed to provide order entry firms, as well as market makers, ECNs, 
and UTP Exchanges, with prompt access that is not unfairly 
discriminatory to the current inside market in Nasdaq securities.\174\ 
By facilitating the prompt and efficient execution of orders at the 
best available prices in Nasdaq, the OCF should strengthen the Nasdaq 
market, which will benefit market participants and investors.
---------------------------------------------------------------------------

    \174\ Several ECNs believe that the automatic execution feature 
of the OCF, among other things, is anti-competitive. These comments 
are discussed in Section V.I, infra.
---------------------------------------------------------------------------

2. Non-Marketable Limit Orders
    As originally proposed, marketable limit orders entered into the 
SuperMontage that became unmarketable prior to execution would have 
been held in the queue for 90 seconds to enable the order to retain 
time priority should it become marketable again. One commenter opined 
that this treatment of limit orders would violate the Commission's 
Order Handling Rules.\175\
---------------------------------------------------------------------------

    \175\ See Archipelago Letter (citing Exchange Act Rule 11Ac1-
1(b)(1)(i)).
---------------------------------------------------------------------------

    Under Amendment No. 8, non-directed orders entered by order-entry 
firms must be designated as immediate or cancel orders, while orders 
entered by Nasdaq Quoting Market Participants and UTP Exchanges may be 
designated as immediate or cancel. As a result, if an order-entry firm 
enters a marketable limit order that becomes unmarketable after entry 
into the system, Nasdaq will return the order (or the unexecuted 
portion thereof) to the entering party.\176\ If a Nasdaq Quoting Market 
Participant or UTP Exchange enters a marketable limit order that 
becomes unmarketable after entry and is not designated immediate or 
cancel, the system will reformat the order and display it as a quote/
order on behalf of the entering participant.
---------------------------------------------------------------------------

    \176\ See Amendment No. 8, supra note.
---------------------------------------------------------------------------

    The Commission believes that the NASD's amendment addresses 
concerns about the SuperMontage retaining undisplayed orders in the 
system. Further, the Commission notes that the NASD must comply with 
the Order Handling Rules and the dissemination of bids and offers.

C. Quote Refresh and Revised SOESed-Out-of-the-Box Procedures

    Under the proposed rule change, market makers can refresh size and 
price using the QR function if their quotes are decremented to zero. If 
a market maker uses QR, but has an attributable quote/order in the 
system that is priced at or better than the quote/order created by QR, 
Nasdaq will display the better-priced or equally-priced attributable 
quote/order in the system. If a market maker is not using QR and the 
market maker has given Nasdaq multiple attributable quotes/orders, 
Nasdaq will display the market maker's next best-priced attributable 
quote/order if its displayed quote/order has been decremented to zero. 
In addition, if a market maker's quote is closed for three minutes, and 
the market maker has failed to transmit a revised attributable quote/
order, the market maker's quote will be automatically reopened at the 
lowest bid and highest offer currently being displayed for a normal 
unit of trading.
    One commenter applauded the NASD's decision to reduce the time 
period that market makers have for updating their quotes from five to 
three minutes.\177\ This commenter and another commenter, however, 
believed that the 3-minute grace period during which a quote could be 
closed was too long.\178\ In addition, the commenter believed that the 
NASD's proposal to restore a quote after the three-minute grace period 
to the outside displayed quote/order was contrary to the NASD's policy 
on autoquotes reflected in NASD IM 4613.\179\ Another commenter opined 
that there could be a large number of market makers that are not in the 
market as their size is decremented to zero, particularly during times 
of significant market volatility.\180\
---------------------------------------------------------------------------

    \177\ See ETA Letter.
    \178\ See ETA Letter and MSDW Letter.
    \179\ See ETA Letter. The Commission notes that NASD IM 4613 
bans automated quote updates or tracking of inside quotations in 
Nasdaq subject to two exceptions. The Commission notes that the 
revised SOESed--Out-of-the-Box procedures are not related to the 
inside market.
    \180\ See Island Letter.
---------------------------------------------------------------------------

    The Commission believes that the QR function of the OCF, together 
with the reserve size refresh function, should help market makers 
maintain continuous, two-sided quotes and thereby facilitate market 
liquidity. In particular, the SuperMontage's automatic refreshing and 
reopening of the market maker's quote for a normal unit of trading 
(generally 100 shares) at the lowest bid and highest offer currently 
being displayed in that security should assist market makers in the 
management of their quotes and also ensure a market maker's continued 
participation in the market. Under the NASD's current rules, if a 
market maker fails to restore its quote in a security within five 
minutes after the quote is decremented to zero, then, subject to 
certain exceptions, that market maker is prohibited from re-entering 
its quote for 20 days. The current rule thus effectively eliminates the 
participation of market makers for 20 days (also known as being 
``SOESed-out-of-the-box''). In contrast, the revised procedures should 
help to ensure the presence of liquidity providers in the market.
    The Commission believes that Nasdaq has struck an appropriate 
balance by eliminating the SOESed-out-of-the-box penalty while adding 
features to assist market makers with their quote management, and by 
reducing the time that a quote may be in a closed state from five 
minutes to three minutes. The Commission fully expects, however, that 
the NASD will monitor the use of the system defaults by market makers 
to ensure that they do not become a surrogate for meaningful market 
making, and that the NASD will reevaluate the penalties against market 
makers for failure to properly maintain two-sided quotes if there is a 
decline in the overall quality of market making, particularly during 
market volatility.

D. Order Execution Algorithms

    The originally proposed Order Execution Algorithm, described in the 
December 6, 1999 notice, distinguished between market makers and ECNs 
that participated in the automatic execution functionality of the 
system and ECNs that participated in the order delivery functionality 
of the system. Market participants that received automatic executions 
would have been given priority in the Order Execution Algorithm.
    Six commenters criticized the NASD's proposed Order Execution 
Algorithm.\181\ Three of these commenters specifically opposed the 
Order Execution Algorithm's prioritization of automatic execution

[[Page 8037]]

participants (i.e., market makers and ECNs that accept automatic 
executions) over order delivery participants.\182\
---------------------------------------------------------------------------

    \181\ See Bloomberg Letter; ACIM Letter; Merrill Lynch Letter; 
Instinet Letter; NexTrade Letter; and CHX Letter. One commenter 
believed that by ranking customer orders by the status of the 
delivering broker, the Order Execution Algorithm impedes efficient 
order interaction. See ACIM Letter.
    \182\ See Instinet Letter; Bloomberg Letter; and NexTrade 
Letter. Instinet suggested that the inferior priority of order 
delivery participants will (1) impair the ability of participants to 
obtain best execution for their customers; and (2) improperly 
influence investors' choices of trading venues and inhibit the 
interaction of pools of liquidity.
---------------------------------------------------------------------------

    In response, the NASD amended the Order Execution Algorithm, 
eliminating the distinction between automatic execution participants 
and order delivery participants.\183\ In lieu of this distinction, the 
NASD proposed to give ECNs that do not charge a separate quote access 
fee priority over those that do.\184\ After receiving comments on this 
proposed change,\185\ the NASD again revised the Order Execution 
Algorithm.\186\
---------------------------------------------------------------------------

    \183\ See Amendment No. 4, supra note 6.
    \184\ For a discussion of how ECNs are treated under the Order 
Execution Algorithms, see Section V.D.3, infra. One commenter 
expressed support for the Order Execution Algorithm's basic 
foundation, execution of orders based on price/time priority, 
stating that this would encourage competition. See Bannon Letter.
    \185\ These comments are discussed in detail in Section V.D.3.a, 
infra.
    \186\ See Amendment No. 7, supra note 10.
---------------------------------------------------------------------------

    In Amendment No. 7, the NASD proposed that the Order Execution 
Algorithm would execute non-directed orders, based on time priority, 
against: (1) The displayed quotes/orders (attributable and non-
attributable) of market makers, ECNs that do not charge a separate 
quote access fee to non-subscribers, ECNs that charge a separate quote 
access fee to non-subscribers but indicate that the price improvement 
offered by their quote/order exceeds the separate quote access fee, and 
non-attributable quotes reflecting agency interest of a UTP Exchange; 
(2) displayed interest of ECNs that charge a separate quote access fee 
and do not indicate that the price improvement offered by their quote/
order exceeds the separate quote access fee; (3) reserve size of market 
makers, ECNs that do not charge a separate quote access fee, and ECNs 
that indicate that the price improvement for their quote/order is in 
excess of their quote access fee (in size/time priority); (4) reserve 
size of ECNs that charge a separate quote access fee and do not 
indicate that the price improvement offered by the specific quote/order 
exceeds the separate quote access fee (in size/time priority); and (5) 
principal quotes of UTP Exchanges.\187\
---------------------------------------------------------------------------

    \187\ See Amendment Nos. 4 and 7, supra notes 6 and 10. The 
SuperMontage would have initially executed non-directed orders of 
Nasdaq Quoting Market Participants against their own quotes/orders 
that are at the BBO.
---------------------------------------------------------------------------

    In response to these changes, certain commenters again expressed 
objections to the Order Execution Algorithm.\188\ Four commenters 
suggested that the Nasdaq system should be premised on strict price/
time priority.\189\ Another commenter suggested that the NASD replace 
the Order Execution Algorithm with a purely directed system, similar to 
SelectNet.\190\ One commenter believed that access fees should not 
affect the determination of the BBO.\191\
---------------------------------------------------------------------------

    \188\ See BRUT Letter; Instinet Letter; ACIM Letter; Bradley 
Letter; Archipelago Letter; Phlx Letter; Scudder Kemper Letter; CFA 
Letter; and Bloomberg Letter. These comments are discussed in detail 
in Section V.D.3, infra. 
    \189\ See ACIM Letter; Archipelago Letter; TRPA Letter; and 
Scudder Kemper Letter.
    \190\ See Archipelago Letter.
    \191\ See TRPA Letter.
---------------------------------------------------------------------------

    In response to these commenters, in Amendment No. 8,\192\ the NASD 
amended the proposal to give market participants that enter non-
directed orders several options as to how their orders will interact 
with quotes/orders in Nasdaq: price/time; price/size/time; price/time 
that accounts for ECN access fees; and preferencing at the best 
price.\193\ The SuperMontage will be programmed to default to the 
price/time priority algorithm for non-directed, non-preferenced orders. 
With all three algorithms for non-directed, non-preferenced orders, the 
system will make an exception for orders entered by a Nasdaq Quoting 
Market Participant when that Nasdaq Quoting Market Participant is at 
the inside market.\194\
---------------------------------------------------------------------------

    \192\ See Amendment No. 8, supra note .
    \193\ Market makers and ECNs will not lose time priority for 
updating trading interest to display greater size. Proposed NASD 
Rule 4707(a)(2).
    \194\ See Section V.D.2, infra, for a discussion of preferenced 
orders.
---------------------------------------------------------------------------

    One commenter supported the NASD's revision of the system's 
algorithms stating that generally ``market participants are better off 
when they can make informed choices.''\195\ Another commenter also 
supported the NASD's elimination of the per se treatment of ECN order 
access fees.\196\
---------------------------------------------------------------------------

    \195 \ See CHX Letter. See also, discussion at Section V.D.4 
regarding the commenter's concerns regarding the treatment of UTP 
Exchanges.
    \196\ See ICI Letter. This commenter also supported maintaining 
time priority when a market participant increases its displayed 
size. See also CFA Letter (supporting price/time default algorithm).
---------------------------------------------------------------------------

    However, three commenters stated that giving participants a choice 
of algorithms was an unacceptable compromise because participants still 
would be offered an algorithm that discriminated against ECN 
orders.\197\ Specifically, one commenter believed that it would be 
market makers, not investors, making this election, and that marker 
makers would put investors' orders entered on ECNs behind market makers 
to avoid interacting with ECNs.\198\ Another commenter believed that 
the default algorithm, in part, provided ``a level of institutional and 
regulatory legitimacy to ECN access fees, even though the vast majority 
of market participants consider those fees invalid and have never had 
the opportunity to debate or challenge them.''\199\ Two commenters also 
believed that investors' orders should be executed against first.\200\ 
In addition, four commenters generally supported executions based on 
strict price/time priority.\201\
---------------------------------------------------------------------------

    \197\ See CFA Letter; Investment Companies Letter; and NY 
Letter; see also Scudder Kemper Letter; Adriaanse Letter; and 
Silverman Letter.
    \198\ See Investment Companies Letter.
    \199\ See STA Letter; see also Pershing Letter.
    \200\ See Vanguard Letter and Instinet Letter.
    \201\ See Vanguard Letter; Security Investment Company Letters; 
ICI Letter; and NY Letter; see also Scudder Kemper Letter.
---------------------------------------------------------------------------

    Seven commenters also objected to the addition of the price/size/
time algorithm proposed in Amendment No. 8.\202\ Two of these 
commenters stated that granting size priority ahead of time priority 
would negate the incentive for price improvement.\203\ In addition, one 
of the commenters argued that the price/size/time algorithm would offer 
little, if any, benefit because, under the other two algorithms, 
participants would still have the ability to sweep through all orders 
at a given price level.\204\ Further, this commenter noted that 
participants could utilize directed orders to send an order to a 
participant displaying greater size.\205\ Another commenter believed 
that the price/size/time algorithm would handicap small retail traders 
that rely on limit orders to avoid the uncertain execution risk of 
market orders sold to wholesale trading interests.\206\ One commenter 
stated that the price/size/time algorithm was an unacceptable effort to 
attract larger orders.\207\
---------------------------------------------------------------------------

    \202\ See ICI Letter; ACIM Letter; Scudder Kemper Letter; Suss 
Letter; Birmingham Letter; Adriaanse Letter; and Vanguard Letter.
    \203\ See ICI Letter and Vanguard Letter. See also Adriaanse 
Letter.
    \204\ See ICI Letter; see also Vanguard Letter.
    \205\ See ICI Letter.
    \206\ See ACIM Letter.
    \207\ See Scudder Kemper Letter.
---------------------------------------------------------------------------

    As discussed in more detail below, the Commission finds that the 
Order Execution Algorithms are consistent with Section 15A(b)(6) of the 
Act \208\ because they do not unfairly discriminate against customers, 
issuers, brokers or dealers. The Commission also finds that the 
algorithms are consistent with Section 11A of the Act \209\ in that 
they promote the creation of a national

[[Page 8038]]

market system by helping to create the opportunity for more efficient 
and effective markets, maintain fair and orderly markets, and assure 
the economically efficient execution of securities transactions. 
Although none of the algorithms maintains pure price/time priority, 
they afford price/time priority to a wider range of orders than is 
currently available in Nasdaq.
---------------------------------------------------------------------------

    \208\ 15 U.S.C. 78o-3(b)(6).
    \209\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

    The Commission believes that the NASD's decision to retain the 
algorithm that executes/delivers orders on a price/time priority basis, 
taking into account ECN quote access fees, as one of the algorithms 
offered, is acceptable. The Commission does not believe that the 
proposed algorithm unfairly discriminates against ECNs, particularly in 
light of the fact that participants may choose either of two other 
algorithms that do not consider ECN fees.\210\ The choice rests with 
the participant entering an order. By offering three algorithms, 
participants may interact with the SuperMontage based on their 
preferences and priorities. For example, at least one ECN commenter 
argued prior to Amendment No. 8 that market participants frequently 
place greater importance on price improvement offered by ECNs than on 
the access fees they charge, and therefore, they prefer to interact 
with ECNs.\211\ Thus, presumably, these market participants would use 
the SuperMontage's default algorithm based on price/time priority to 
interact with ECNs that offer price improvement. For the same reason, 
the Commission believes that the default algorithm is acceptable. Those 
market participants that elect to take into account ECN fees may do so 
under the price/time algorithm that takes into account ECN fees.
---------------------------------------------------------------------------

    \210\ See discussion in Section V.D.3.a, infra.
    \211\ See Instinet Letter.
---------------------------------------------------------------------------

    The Commission also concludes that the NASD's algorithm based on 
price/size/time priority is consistent with the statute. This algorithm 
will assist participants in quickly assessing liquidity in a dynamic 
trading environment, while rewarding liquidity providers, particularly 
in a decimals environment where liquidity may be spread over a greater 
number of trading increments. The Commission acknowledges concerns 
raised by commenters that the choice of algorithms lessens the 
importance of time priority, and thus may provide less incentive to 
aggressively enter better-priced quotes. However, as stated above, the 
three algorithms proposed by the NASD afford greater price/time 
priority than currently exists in the market.
    The Commission notes that today most orders in Nasdaq securities 
are executed directly between Nasdaq participants, not using Nasdaq 
systems. No price/time priority rules apply to this trading, other than 
a market maker's duty to protect its customer limit orders before 
trading as principal. While price priority is generally honored as a 
market principle in executing orders outside of Nasdaq's systems, time 
priority is not accorded to quotes in this trading. Even after 
SuperMontage is implemented, many orders probably will be executed 
outside of SuperMontage free from time priorities.
    The Commission does not believe that entering orders into the 
SuperMontage should be mandated. Therefore, requiring time priority 
within SuperMontage runs the risk of reducing market participants' 
willingness to enter orders into SuperMontage, undermining its 
effectiveness. For this reason, the Commission believes that providing 
the choice of a price/size/time priority algorithm is a statutorily-
permissible balance between encouraging liquidity, accommodating the 
preferences of market participants, and maintaining time priority. 
Furthermore, while this algorithm may reduce the incentive to be the 
first with the better price, it may encourage a Nasdaq Quoting Market 
Participant to display greater size. By providing this choice of 
algorithms, SuperMontage will allow broker/dealers to manage their 
orders in SuperMontage to obtain the best execution as they would in 
the dealer market where time priority does not apply, while still 
increasing order interaction within SuperMontage. The Commission also 
believes that the choice of algorithms could promote greater 
competition and innovation among market centers and market 
participants.
1. Matching Against a Participant's Own Quote/Order at the BBO
    All three Order Execution Algorithms first match orders entered by 
a Nasdaq Quoting Market Participant against its own quote/order on the 
other side of the market if the Nasdaq Quoting Market Participant is at 
the BBO. Several commenters expressed support for this internalization 
feature of the Order Execution Algorithm. \212\ The commenters believed 
that matching a market participant's order against the market 
participant's quote/order if the market participant is at the BBO will 
enable market participants to better manage their order flow while at 
the same time providing customers with best execution.\213\ Without the 
internalization feature, one commenter wrote, ``the [proposed Nasdaq] 
system begins to look like a central limit order book [``CLOB''],'' 
which the commenter opposed.\214\
---------------------------------------------------------------------------

    \212\ See STA Letter; MSDW Letter; and STANY Letter.
    \213\ See STA Letter; MSDW Letter; and STANY Letter.
    \214\ See STANY Letter.
---------------------------------------------------------------------------

    Five commenters, however, questioned or opposed the proposal's 
internal matching provision.\215\ One of these commenters opined that 
the internalization of orders could impede access to liquidity and 
price discovery for market participants, especially if a significant 
amount of a particular security's daily volume is internalized.\216\ 
Two commenters stated that market makers receiving directed orders 
should be under an affirmative obligation to seek price 
improvement.\217\ One of the two commenters also stated that the 
internalization function provided a disincentive for market makers to 
price improve.\218\ This commenter suggested that the internalization 
function, combined with the inferior priority of ECNs that charge 
separate access fees, would reduce market maker incentives to better 
the national BBO.\219\ Another commenter expressed strong opposition to 
the internalization function of the SuperMontage, arguing that it was 
an example of the proposal's bias towards market maker interests.\220\
---------------------------------------------------------------------------

    \215\ See ICI Letter; Instinet Letter; CFA Letter; Bloomberg 
Letter; and ACIM Letter.
    \216\ See ICI Letter; see also Scudder Kemper Letter.
    \217\ See ACIM Letter; and CFA Letter.
    \218\ See ACIM Letter; see also Scudder Kemper Letter.
    \219\ See ACIM Letter; see also Bradley Letter.
    \220\ See Instinet Letter; see also Bloomberg Letter and Bradley 
Letter.
---------------------------------------------------------------------------

    The Commission recognizes that, today, trading interest in the 
Nasdaq market is largely divided among different market centers. It is 
primarily a dealer market, in which multiple market makers compete for 
order flow based on a variety of factors, including internalization and 
payment for order flow arrangements.\221\ Under these arrangements, 
orders are routed to a particular market maker that has an opportunity 
to execute the orders as principal without facing significant 
competition from investors or other

[[Page 8039]]

dealers who may wish to interact with the directed order flow. Thus, 
presently, market makers internalize order flow without ever providing 
access to any other market participants publicly displaying their 
quotes/orders.\222\ It is unlikely that market makers will enter 
customer market orders into SuperMontage rather than simply 
internalizing them directly. Still, the internal matching function 
attempts to encourage market makers to enter these orders into 
SuperMontage where superior quotes would have some chance of 
interacting with them. The Commission believes that the SuperMontage's 
internalization feature is a reasonable attempt to encourage Nasdaq 
Quoting Market Participants to include their customer orders in a 
system that will provide greater transparency and accessibility to 
other participants, and could lead to a more transparent and seamless 
integration of internalizing market makers with the rest of the 
marketplace.
---------------------------------------------------------------------------

    \221\ See Securities Exchange Act Release No. 42450 (February 
23, 2000), 65 FR 10577 (February 28, 2000). In September 1999, for 
example, there was an average of 11.4 market makers per Nasdaq 
issue. NASD, http://www.marketdata.nasdaq.com> (visited December 11, 
1999). There was an average of 47.5 market makers in the top 1% of 
issues by daily dollar trading volume, 24.0 market makers in the 
next 9% of issues, and 4.9 market makers in the bottom 10% of 
issues. Id.
    \222\ According to the NASD, only 26% of the share volume and 
36% of trades in Nasdaq are executed using SOES or SelectNet. See e-
mail to William Atkinson, Office of Economic Analysis, Commission, 
from Michael Edleson, Senior Vice President, Chief Economist, NASD, 
dated August 18, 2000.
---------------------------------------------------------------------------

    The Commission reiterates, however, that its approval of this 
aspect of the proposal is based on the structure of the existing dealer 
market and the voluntary nature of the SuperMontage. The Commission 
also reiterates its long-standing position that, while a broker does 
not necessarily violate its duty of best execution by internalizing its 
agency orders, the duty also is not necessarily satisfied by routing 
orders to a market center that merely guarantees an execution at the 
national BBO without taking into account the possibility of price 
improvement.\223\
---------------------------------------------------------------------------

    \223\ See Securities Exchange Act Release No. 42450 at notes 48 
and 49 and accompanying text, supra note 221; see also Securities 
Exchange Act Release No. 35751 (May 22, 1995), 60 FR 27997 (May 26, 
1995) (``Manning II'') (prohibiting market makers from trading ahead 
of their customer limit orders in Nasdaq securities).
---------------------------------------------------------------------------

2. Preferenced Orders
    Prior to Amendment No. 8, one commenter recommended bringing back 
preferencing, arguing that it would separate quotation collection and 
accessing technologies, because ``market participants would be able to 
respond to quotations in the market place without placing their orders 
in the SuperMontage ECN order book. Accordingly, participation in the 
SuperMontage could then more appropriately be said to be voluntary.'' 
\224\
---------------------------------------------------------------------------

    \224\ See Bloomberg Letter.
---------------------------------------------------------------------------

    In response to the commenter, the NASD amended the proposal to 
include a new class of order called a preferenced order.\225\ The NASD 
proposed two possible approaches to preferenced orders: preferenced 
orders with no price restrictions (Alternative A) and preferenced 
orders only at the best price (Alternative B).
---------------------------------------------------------------------------

    \225\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    Two commenters supported Alternative A, because it would provide 
flexibility.\226\ Another commenter, who did not specifically support 
Alternative A, opposed the adoption of Alternative B because it would 
constitute a first step in transforming the SuperMontage into a 
CLOB.\227\ However, other commenters disagreed, claiming, for example, 
that allowing market makers to preference orders away from the BBO 
would give them the ability to trade with each other and ignore better-
priced quotes/orders offered by other participants.\228\ The NASD 
responded by withdrawing Alternative A.\229\
---------------------------------------------------------------------------

    \226\ See CHX Letter and STA Letter.
    \227\ See Bloomberg Letter.
    \228\ See Instinet Letter; ACIM Letter; CSE Letter; Scudder 
Kemper Letter; and NY Letter.
    \229\ See Amendment No. 9, supra note 14.
---------------------------------------------------------------------------

    Under the current proposal, a market participant entering a 
preferenced order must designate by MMID the Nasdaq Quoting Market 
Participant or UTP Exchange against which the order is to be executed 
or delivered. The preferenced order will be entered into the non-
directed order process, and will be considered a Liability Order. 
Preferenced orders will be processed in the same queue as non-directed 
orders. Additionally, like non-directed orders, a preferenced order 
will be delivered as an order to an ECN or UTP Exchange that does not 
participate in the automatic execution functionality of the system, or 
will be delivered as an execution against market makers as well as ECNs 
or UTP Exchanges that choose to accept automatic executions.
    When a preferenced order is next to be executed within the non-
directed order queue, the preferenced order will be executed (or 
delivered for execution) against the preferenced Nasdaq Quoting Market 
Participant or UTP Exchange to which the order is being directed only 
if the Nasdaq Quoting Market Participant or UTP exchange is at the BBO 
up to the displayed and reserve size. If the preferenced Nasdaq Quoting 
Market Participant or UTP Exchange is not at the BBO when the 
preferenced order is next to be executed or delivered, the preferenced 
order will be returned to the entering participant. Thus, under this 
approach, preferenced orders only will be executed at the BBO, and only 
if the preferenced Nasdaq Quoting Market Participant or UTP Exchange is 
quoting at the BBO at the time of execution or delivery.
    Several commenters objected to the addition of preferenced 
orders.\230\ Two commenters believed that market makers will use 
preferenced orders to avoid order routing priorities (such as price/
time) in Nasdaq.\231\ Two commenters believed that because preferenced 
orders will allow market participants to trade around price-setting 
orders, broker/dealers will be able to enter into payment for order 
flow agreements more easily.\232\ Another commenter also argued that 
because preferenced orders will diminish price/time priority, fewer 
investors will enter limit orders into the SuperMontage, thus 
decreasing liquidity in the system.\233\
---------------------------------------------------------------------------

    \230\ See Instinet Letter; NY Letter; CFA Letter; ICI Letter; 
Investment Companies Letter; ACIM Letter; Birmingham Letter; 
Adriaanse Letter; and Vanguard Letter.
    \231\ See Instinet Letter; NY Letter; see also Investment 
Companies Letter; Adriaanse Letter; and Vanguard Letter.
    \232\ See CFA Letter and ICI Letter.
    \233\ See Vanguard Letter.
---------------------------------------------------------------------------

    The Commission notes, first, that the preferencing feature allows 
any market participant to designate those market participants with whom 
it wishes to transact on a Liability Order basis,\234\ while ensuring 
that its customers receive executions at the BBO. Second, preferenced 
orders allow ECNs, UTP Exchanges, and market makers to accept Liability 
Orders designated for them without incurring double liability since 
these orders will be processed in the non-directed order queue. This 
may encourage market participants to display larger size quotations and 
thereby increase liquidity in the market. Third, the Commission notes 
that this is just one of the delivery options available to market 
participants and that market participants also may send directed 
orders, non-directed non-preferenced orders, and orders outside the 
SuperMontage (via private links) using, in part, data from NQDS Prime.
---------------------------------------------------------------------------

    \234\ The Commission notes that a Nasdaq Quoting Market 
Participant or UTP Exchange may elect not to take a directed order 
on a Liability Order basis. See Proposed NASD Rule 4710(c).
---------------------------------------------------------------------------

    The Commission also notes that preferenced orders will not 
duplicate the features offered by directed orders. These orders differ 
significantly. Directed orders will always be delivered for a response 
(e.g., accept or decline), as opposed to an automatic execution, and 
directed orders will not decrement a quote. Preferenced orders, on the 
other hand, will be Liability Orders processed

[[Page 8040]]

in time sequence (like non-directed orders), will be delivered to the 
quote/order, or will be automatically executed against the quote/order 
of a market participant, and will decrement the size of a quote/order. 
Based on these differences, the Commission believes that directed 
orders and preferenced orders will provide participants with distinct 
features from which they may choose, depending on their needs.
    It is highly unlikely that orders subject to payment for order flow 
will be preferenced through SuperMontage rather than routed directly to 
market makers. Still, those orders that are preferenced will not freely 
interact with limit orders and quotes in SuperMontage, and so will not 
encourage aggressive quoting in SuperMontage, as noted by commenters. 
But, here again, SuperMontage will be a voluntary system operating in a 
market with no general time priority. Orders that might be preferenced 
within SuperMontage could also be routed directly to market makers and 
ECNs outside of SuperMontage. Nasdaq evidently determined that 
preferenced orders otherwise would simply be executed outside of 
SuperMontage, and chose to accommodate them within SuperMontage.
    The proposal now requires the recipient of the preferenced order to 
be quoting at the BBO, which encourages Nasdaq Quoting Market 
Participants or UTP Exchanges to at least quote as well as the best 
quote to receive these orders. Thus, the requirement encourages better 
quotes from these participants.
    In all, while the Commission recognizes that preferenced orders do 
not create as strong incentives to quote aggressively in SuperMontage 
as would strict time priority, there is substantial doubt whether these 
orders would be entered in SuperMontage at all without the preferencing 
feature. And, by preferencing these orders through SuperMontage, order 
entry firms can provide special handling to difficult orders while 
encouraging recipients to maintain competitive quotes. The Commission's 
approval of this aspect of the Order Execution Algorithms is predicated 
on the context of the existing dealer market.
3. ECNs
a. Order Execution Algorithms
    In Amendment No. 4, the NASD amended the original Order Execution 
Algorithm to give market makers \235\ and ECNs that do not charge 
separate quote access fees priority over ECNs that charge separate 
access fees.\236\ The NASD stated that this prioritization was 
consistent with the practice of many market participants to route their 
orders to market makers that do not charge a fee before routing to ECNs 
that do, in order to ensure that they incur the lowest possible trading 
costs consistent with best execution principles.\237\
---------------------------------------------------------------------------

    \235\ Market makers are prohibited from charging access fees 
under the Firm Quote Rule. See Exchange Act Rule 11Ac1-1.
    \236\ The NASD's original proposal gave priority to participants 
that accepted automatic execution over those that accepted order 
delivery. In response to commenters, in Amendment Nos. 3 and 4, the 
NASD amended the Order Execution Algorithm. One commenter stated 
that the amended Order Execution Algorithm offered ``some 
improvement,'' but it was still discriminatory because UTP Exchanges 
would be executed behind market makers. See Bloomberg Letter.
    \237\ See Amendment No. 4, supra note 6.
---------------------------------------------------------------------------

    Six commenters addressed this change to the proposal.\238\ Two 
commenters agreed with the NASD that it is appropriate to give the 
orders of ECNs that do not charge fees priority over those that do 
because the ECNs that charge fees provide an inferior execution 
price.\239\ One of these commenters stated that, ``by definition, ECNs 
that are charging access fees should lose their standing as their order 
is effectively an inferior price.''\240\ An earlier commenter on the 
original proposal also suggested that any access fees charged by ECNs 
should be reflected in their displayed quote so that other market 
participants could make informed order routing and best execution 
decisions.\241\
---------------------------------------------------------------------------

    \238\ See CHX Letter; Bannon Letter; Instinet Letter; 
Archipelago Letter; Bloomberg Letter; and Island Letter.
    \239\ See CHX Letter and Bannon Letter.
    \240\ See Bannon Letter.
    \241\ See ITG Letter.
---------------------------------------------------------------------------

    Four commenters, however, objected to the priority rules and 
disagreed with the NASD's rationale.\242\ Instinet, for example, argued 
that ECNs frequently offer a better price than market makers at the 
national BBO, even after access fees have been deducted from the 
execution price.\243\ Instinet believed that the Order Execution 
Algorithm would result in an anti-competitive trading environment 
because it was based on the false assumption that ECNs that charge fees 
provide inferior executions, and because the Nasdaq system has no 
mechanism to identify an ECN's true price. Instinet also stated that 
market participants appear to place greater importance on price 
improvement opportunities than on ECN access fees. In addition, 
Instinet asserted that the amended Order Execution Algorithm failed to 
take into account the general negative impact on best execution and the 
diminished opportunities for price improvement that would result from 
giving ECNs that charge order access fees inferior priority. Similarly, 
Island argued that it was inconsistent for the NASD to claim, on one 
hand, that ``the de minimus access fee that ECNs typically charge 
warrants consideration under the principles of best execution,'' while 
on the other hand refusing to acknowledge the price improvement, 
however small, that ECNs generate for investors by providing a rounding 
indicator of ECN quotations that better the inside market.\244\
---------------------------------------------------------------------------

    \242\ See Instinet Letter; Bloomberg Letter; Archipelago Letter; 
and Island Letter.
    \243\ See Instinet Letter.
    \244\ See Island Letter.
---------------------------------------------------------------------------

    In response, the NASD revised the Order Execution Algorithm to 
allow an ECN to offset the price improvement for the particular quote/
order against the access fee for purposes of determining price 
priority. Where price improvement exceeds the fee charged to non-
subscribers, the ECN quote would be on parity with the quotes/orders of 
market makers, ECNs that do not charge a separate fee, and the non-
attributable agency quotes/orders of UTP Exchanges.\245\ The NASD also 
represented that if, in the decimals environment, ECNs change the 
manner in which they charge fees and develop the capability to reflect 
access fees in their published quotes, the NASD would give these ECNs 
the same priority for non-directed orders as market maker quotes/orders 
and non-attributable agency quotes/orders of UTP Exchanges.\246\ 
Further, the NASD committed to re-examine the Order Execution Algorithm 
if, after decimals are implemented, Nasdaq quotation increments are 
finer than one penny. Should this occur, the NASD would determine 
whether it is prudent and feasible to rank orders based on quotation 
increments of less than one penny.\247\
---------------------------------------------------------------------------

    \245\ See Amendment No. 7, supra note 10.
    \246\ See Amendment No. 6, supra note 9.
    \247\ Id.
---------------------------------------------------------------------------

    Several commenters expressed objections to Amendment No. 7 as it 
pertained to ECN fees.\248\ Specifically, one commenter stated that the 
algorithm was based on the assumption that access fees affect a 
dealer's decision to hit a bid or take an offer.\249\ This commenter 
pointed out that dealer bids often ``remain at a specific price while a 
market maker sells stock at the same price in the ECNs, accepting their 
fee. The dealers have the opportunity to trade net but choose the 
liquidity and

[[Page 8041]]

anonymity of the ECNs instead in exchange for the fee.'' \250\
---------------------------------------------------------------------------

    \248\ See Instinet Letter, ACIM Letter, BRUT Letter; Scudder 
Kemper Letter; Bradley Letter; Archipelago Letter; CFA Letter; and 
Bloomberg Letter.
    \249\ See Scudder Kemper Letter.
    \250\ See Scudder Kemper Letter.
---------------------------------------------------------------------------

    Various commenters suggested that the Order Execution Algorithm was 
unfairly discriminatory. For instance, one commenter stated that the 
revised algorithm was discriminatory since the only fees included were 
ECN fees.\251\ The commenter believed that the need for this treatment 
was unsubstantiated.\252\ Another commenter objected to the manner in 
which the NASD proposed to determine whether an ECN offered price 
improvement net of its access fee, and therefore could be treated on 
par with market makers.\253\ This commenter stated that the proposed 
algorithm will use an ECN's net price when the ECN's gross price is 
equivalent to, and the net price is inferior to, other orders displayed 
in Nasdaq, but will use an ECN's gross price when the gross price is 
equivalent to, and the net price is superior to, all other orders in 
Nasdaq.\254\
---------------------------------------------------------------------------

    \251\ See Bloomberg Letter.
    \252\ See Bloomberg Letter.
    \253\ See Archipelago Letter.
    \254\ See Archipelago Letter (see examples provided in footnote 
11).
---------------------------------------------------------------------------

    Two commenters suggested that the proposed amendment would 
negatively affect price competition and result in wider spreads. In 
particular, the commenters noted that market makers would have no 
incentive to provide price improvement at the national BBO.\255\ One 
commenter stated that ECNs should be given top priority if their 
orders, when factoring in price improvement, represent the best bid or 
offer, and that all limit orders should be processed in strict price/
time priority without regard to ECN access fees.\256\ Another commenter 
also objected to providing ECNs with execution parity only when their 
price improvement exceeds their fee.\257\
---------------------------------------------------------------------------

    \255\ See Instinet Letter and ACIM Letter.
    \256\ See Instinet Letter.
    \257\ See BRUT Letter.
---------------------------------------------------------------------------

    One commenter suggested that the proposal would ``unwind the SEC's 
order-handling rules by pushing a significant majority of ECNs to the 
back of Nasdaq's priority queues despite a record of publishing the 
market's best prices with far greater frequency than Nasdaq market 
makers.'' \258\ Another commenter stated that the proposal to have ECNs 
report price improvement within their quote is ``unrealistic'' in a 
``dynamic order environment.'' \259\ This commenter also believed that 
if Nasdaq ``is to become a for-profit central execution center, it is 
inappropriate for Nasdaq to impose any methodology of prioritization 
within the system on factors other than displayed price.'' \260\
---------------------------------------------------------------------------

    \258\ See ACIM Letter.
    \259\ See BRUT Letter.
    \260\ See BRUT Letter.
---------------------------------------------------------------------------

    One commenter also questioned the NASD's rationale for the need of 
the algorithm.\261\ The commenter opined that firms, not investors, pay 
the access fees charged by ECNs and, therefore, it is not true that 
individuals who execute a particular trade on an ECN that charges an 
access fee automatically receive a clearly inferior price.\262\ In 
addition, the commenter believed that, as a result of rounding, even in 
a decimals environment, investors may be denied access to a better 
price.\263\
---------------------------------------------------------------------------

    \261\ See CFA Letter.
    \262\ See CFA Letter.
    \263\ See CFA Letter.
---------------------------------------------------------------------------

    In addition, four commenters believed that the algorithm unfairly 
penalized order delivery ECNs that enter an order at one quantity and 
then increase size to add an additional quantity to reflect one or more 
customer limit orders.\264\ Specifically, two of these commenters 
believed that ECNs were treated unfairly under the algorithm if they 
either reduced the order size or placed or changed an order on the 
other side of the market for the security.\265\ The commenters believed 
that, under the current algorithm, the changes would take away a market 
maker's or ECN's established time priority.\266\
---------------------------------------------------------------------------

    \264\ See Bloomberg Letter; Instinet Letter; Scudder Kemper 
Letter; and TRPA Letter.
    \265\ See Bloomberg Letter and Instinet Letter.
    \266\ See Bloomberg Letter and Instinet Letter.
---------------------------------------------------------------------------

    In response to commenters, the NASD amended the Order Execution 
Algorithm to provide three alternative Order Execution Algorithms for 
accessing quotes/orders in the SuperMontage. These alternatives are 
based on price/time priority, price/time priority considering quote 
access fees, and price/size/time priority. Further, the NASD amended 
the proposal to give parity to ECNs that charge quote access fees when 
the price improvement on a particular quote/order at least equals the 
fee under the price/time priority option that takes ECN fees into 
account. In addition, the NASD responded to commenters by protecting 
the time priority of Nasdaq Quoting Market Participants that change 
their displayed trading interest by increasing displayed size.\267\ As 
amended, the system will maintain the original time stamp for the 
original quantity and assign a separate time stamp for the 
augmentation, thus protecting the time priority of the originally 
entered quantity. Subsequent non-execution decreases in size will be 
deducted from individually stamped components in reverse time priority 
(i.e., the last entered size component will be exhausted first).
---------------------------------------------------------------------------

    \267\ See Amendment No. 8, supra note 12. Under the prior 
proposal, if a market participant chose to give Nasdaq a quote 
instead of order detail, the market participant would have lost time 
priority to its quote when it added to size. At least one commenter 
supported this change. See STA Letter.
---------------------------------------------------------------------------

    One commenter complained that the revised Order Execution 
Algorithms fail to provide a real choice, since market makers will 
``inevitably choose the algorithm that allows them to avoid interacting 
with investor orders on ECNs as ECNs charge access fees.'' \268\ 
Another commenter questioned the NASD's justification for taking into 
account ECN fees under the theory of ``best execution.'' \269\ This 
commenter believed that the Commission's approval of this theory 
``suggests that brokers must now consider market access fees charged to 
brokers in connection with their order routing decisions[,]'' including 
payment for order flow.\270\ Further, this commenter noted that the 
algorithm fails to ``give greater priority to ECN orders that offer 
`net' price improvement (after taking into account access fees) over 
other orders displayed at the same price.  * * * and fails to 
distinguish between ECNs that charge different access fees.'' \271\ 
Five commenters also believed that the algorithms fail to protect the 
standing of investor orders displayed on Nasdaq through ECNs.\272\
---------------------------------------------------------------------------

    \268\ See Instinet Letter; see also CFA Letter and NY Letter.
    \269\ See Island Letter.
    \270\ See Island Letter.
    \271\ See Island Letter; see also CFA Letter.
    \272\ See Instinet Letter; Suss Letter; Birmingham Letter; and 
Adriaanse Letter; and CFA Letter.
---------------------------------------------------------------------------

    The Commission concludes that the Order Execution Algorithms and 
time priority protection for size increases are consistent with Section 
15A(b)(6) of the Act \273\ in that they remove impediments to and 
perfect the mechanism of a free and open market. These alternatives 
will give market participants greater flexibility in determining how 
their orders will be executed based on individual preferences and 
priorities and should provide broker/dealers with greater opportunities 
to take into account known fees and possible price improvement in 
choosing how to obtain the best execution for an order. If ECNs in fact 
offer better prices than the quote, even after taking into account 
their fees, then order entry firms may choose the algorithm that 
ignores ECN fees, or preference them directly. If ECN fees predominate 
over their price improvement, order entry firms likely will choose the 
algorithm that takes ECN fees into account. This is especially

[[Page 8042]]

true given that the orders most likely to be routed through 
SuperMontage will be on behalf of the market makers themselves or 
institutional or sophisticated traders that can well judge whether ECN 
price improvement is likely to exceed ECN fees. In addition, the 
Commission believes that the alternative Order Execution Algorithms 
will provide an incentive for Nasdaq Quoting Market Participants and 
UTP Exchanges to display greater size and to provide price improvement 
to attract greater order flow under each of the possible execution 
alternatives.
---------------------------------------------------------------------------

    \273\ 15 U.S.C. 78o(b)(6).
---------------------------------------------------------------------------

    With respect to the price/time algorithm that takes ECN fees into 
account, the Commission finds that it is reasonable for Nasdaq to give 
priority to the interest of market makers and ECNs that do not charge 
fees over the interest of ECNs that charge separate access fees because 
the quotes/orders of non-charging market makers and ECNs are equivalent 
at the displayed price. The quote/order of an ECN that charges a 
separate fee, on the other hand, typically is not comparable to the 
quote/order of a market maker or a non-charging ECN because it may 
actually result in an inferior execution price after the fee is added. 
In other words, when a broker-dealer accesses a market maker quote, the 
broker-dealer knows that it will pay exactly the amount displayed 
because market makers do not charge fees in addition to their 
quotes.\274\ If a broker-dealer accesses a quote/order of an ECN that 
charges a separate fee, however, the broker-dealer may be charged a fee 
of up to 1.5 cents per share in addition to the quoted price, which may 
be passed along to its customer. This per-share fee may add 
significantly to the costs of trading with that ECN. The price/time 
algorithm that takes ECN access fees into account is a reasonable 
attempt to allow market participants to access the quote of an entity 
that does not charge fees before directing their orders to an ECN that 
charges fees.\275\
---------------------------------------------------------------------------

    \274\ 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. See Securities Exchange Act 
Release No. 42536 (March 16, 2000), 65 FR 15401 (March 22, 2000).
    \275\ While, today, ECN fees are small in relation to the 
existing quotation increment of \1/16\, with the coming of decimal 
pricing the significance of ECN fees in comparison to the minimum 
quotation increment could become much greater.
---------------------------------------------------------------------------

    The Commission notes, however, that today some ECNs allow finer 
quoting increments than Nasdaq and therefore, on occasion, may offer 
internal prices that are better than the prices displayed in Nasdaq, 
notwithstanding their fee.\276\ However, until such time as 
SuperMontage uses quoting increments that are small enough to reflect 
all potential ECN fees and price improvement alternatives, it is not 
possible to reflect the actual net price in the quote. Thus, it is 
necessary for a market participant to consider probabilities in 
evaluating an ECN's quote. If the ECN charges a fee, that fee is a 
certainty in each trade to be weighed against a possibility of 
offsetting price improvement. It is reasonable for the NASD to take the 
certainty, but not the possibility, into account by providing an 
algorithm that reflects ECN fees.
---------------------------------------------------------------------------

    \276\ Currently, ECN public quotes are rounded away to the next 
\1/16\th price when the ECN's best internal price is at a fraction 
smaller than \1/16\th (the current minimum Nasdaq quote increment).
---------------------------------------------------------------------------

    Furthermore, within that algorithm, the NASD also recognizes that 
it is possible for an ECN's real price to be at least as good as the 
price displayed in Nasdaq even after its fee has been subtracted, if 
the price improvement offered by the ECN's internal price (as opposed 
to its rounded displayed price on Nasdaq) is equal to or greater than 
its fee. As described above, the NASD has amended the algorithm to 
allow a fee charging ECN to indicate that the price improvement equals 
or exceeds the fee for a particular quote/order. Those quotes/orders 
will be given the same priority as the quotes/orders of market makers 
and ECNs that do not charge separate quote access fees. As a result of 
this change, the Commission believes that the price/time algorithm that 
accounts for ECN fees does not discriminate unfairly against any Nasdaq 
market participant.\277\ The algorithm treats quotes/orders that are 
comparable equally; only those quotes/orders that have a separate fee 
that exceeds the price improvement will have lower priority within the 
system (with the exception of UTP Exchange principal quotes, which are 
discussed below).
---------------------------------------------------------------------------

    \277\ Even if the SuperMontage were to include an identifier 
flagging ECN price improvement, as some commenters suggest, the 
amount of that price improvement would remain unknown, and could in 
fact be trivial, whereas the fee charged is known to a participant.
---------------------------------------------------------------------------

    In addition, the NASD has committed to work with ECNs to develop 
the capability to reflect access fees in their published quotes. If 
fees are reflected in the quote, they will be ranked equally with those 
quotes/orders without fees based on price. For example, if ECN1 
represents a quote/order to buy at $20.00, and charges a fee of $.01 
per share, it would enter a bid of $19.99, which would be ranked in 
time priority with other bids of $19.99 entered by market makers, ECNs 
that do not charge a separate fee, and agency interest of UTP 
Exchanges.
    The Commission notes that while quotes/orders generally will be 
comparable if fees are displayed in the quote, an ECN quote, on 
occasion, still may not reflect the true ECN price because the quote 
will have to be rounded if the fee combined with the quote is not at a 
whole penny increment.\278\ However, the NASD has represented that it 
will re-examine the algorithm if, after decimals are implemented, 
quotations are in increments smaller than one penny. Should this occur, 
the NASD will determine whether it is prudent and feasible to rank 
orders based on quotation increments of less than one penny.\279\
---------------------------------------------------------------------------

    \278\ In a decimals environment, Nasdaq's minimum quoting 
increment may be a penny.
    \279\ The Commission notes that quoting in subpennies raises 
other issues, such as capacity and trading issues, not related to 
the SuperMontage. These issues will need to be addressed marketwide. 
See Securities Exchange Act Release No. 42914 (June 8, 2000), 65 FR 
38010 (June 19, 2000) (ordering the implementation of decimal 
pricing). In the Commission's order requiring the implementation of 
decimals, the Commission called for a study regarding the impact of 
decimal pricing on systems capacity, liquidity, and trading 
behavior, including an analysis of whether there should be a uniform 
minimum increment for a security.
---------------------------------------------------------------------------

    For these reasons, the Commission finds that the price/time 
algorithm taking ECN fees into account is consistent with Section 
15A(b)(6) of the Act,\280\ which requires that the rules of the 
association not be designed to permit unfair discrimination between 
brokers or dealers. For the same reasons, the Commission believes that 
it is appropriate for the reserve size of non-charging ECNs to have 
priority over the reserve size of ECNs that charge a separate fee.
---------------------------------------------------------------------------

    \280\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

b. Time Restrictions on the Order Delivery Feature
    Under the original proposal, if a quote/order was routed to an 
order delivery ECN and the ECN failed to respond within five seconds of 
order delivery,\281\ Nasdaq would immediately route the quote/order to 
the next Nasdaq Quoting Market Participant or UTP Exchange in the 
queue.
---------------------------------------------------------------------------

    \281\ Nasdaq subsequently clarified that it will add two seconds 
for ``processing time,'' and therefore, the time to respond would 
actually be seven seconds. See letter from Richard G. Ketchum, 
President, NASD, to Annette Nazareth, Director, Division, 
Commission, dated July 18, 2000.
---------------------------------------------------------------------------

    Two commenters argued that this aspect of the proposal would expose 
ECNs to significant financial risk because, in the event of Nasdaq 
system problems, ECNs might not be able to

[[Page 8043]]

confirm the execution of a trade before Nasdaq automatically re-routed 
the order to the next Nasdaq Quoting Market Participant in the queue, 
and in turn would be required to assume the risk of filling a 
customer's trade.\282\ One commenter recommended that the NASD give 
ECNs at least ten seconds to respond to incoming orders.\283\ Another 
commenter opined that the NASD should not be able to ``[d]eclare itself 
non-liable for errors and losses caused by Nasdaq technology failures * 
* * that can shift business risk to market participants. * * *'' \284\ 
To avoid punishing ECNs when the failure is Nasdaq's, one commenter 
proposed canceling orders if it is clear from the ECN's response that 
the time elapsed between the ECN's actual receipt and response exceeds 
a mandated minimum.\285\
---------------------------------------------------------------------------

    \282\ See Instinet Letter and Bloomberg Letter.
    \283\ See Instinet Letter.
    \284\ See ACIM Letter.
    \285\ See Bloomberg Letter.
---------------------------------------------------------------------------

    In response to these comments, the NASD altered its approach to 
monitoring order-delivery ECN responsiveness. First, in Amendment No. 
8, Nasdaq established a 30-second (as opposed to 7-second) maximum time 
period for an ECN to respond to any given order.\286\ That is, if an 
ECN fails to respond within 30 seconds of the time a particular order 
is dispatched from the Nasdaq system to the ECN, Nasdaq will withdraw 
the order and ``zero out'' the affected side of the unresponsive ECN's 
quote until the ECN transmits a revised attributable quote/order.
---------------------------------------------------------------------------

    \286\ See Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    Second, the NASD proposed a shorter uniform turn-around time of a 
maximum of 5 seconds. The purpose is to establish a general standard 
(as opposed to an order-by-order standard) that measures whether an ECN 
is providing an automated response in a time period that ensures market 
quality. If an ECN regularly fails to meet the five-second response 
time over a period of orders, Nasdaq will place that ECN's quote in a 
closed-quote state. The closed-quote state will be lifted when the ECN 
can certify that it can meet the five-second response time requirement.
    One commenter believed that the 30-second maximum response time was 
reasonable and balances the competing interests of avoiding dual 
liability and providing an efficient trading system.\287\ However, one 
commenter objected to the 30-second response time.\288\ This commenter 
believed that 30 seconds was too long in today's volatile, fast-paced 
market. Another commenter, however, expressed significant reservations 
about the 5-second response time standard for ECNs.\289\ The commenter 
questioned how a determination would be made that an ECN ``regularly'' 
failed to meet the 5-second response time over a period of orders. The 
commenter recommended that a neutral body, such as the Commission, make 
this determination using objective criteria.
---------------------------------------------------------------------------

    \287\ See CHX Letter.
    \288\ See STA Letter.
    \289\ See Instinet Letter.
---------------------------------------------------------------------------

    The Commission believes that the NASD has responded reasonably to 
the concerns of the commenters that systems delays may expose them to 
an unacceptable degree of risk by incorporating several suggestions 
made by commenters, such as increasing the ECN response time and 
incorporating a second 5-second measurement based on an ECN's actual 
receipt time. While the Commission understands the concerns raised by 
one commenter regarding the 5-second response time measurement, the 
Commission notes that ECNs are required to provide an immediate 
automated response to SelectNet messages, and, in Nasdaq's experience, 
ECNs generally respond in far less than 5 seconds to orders presented 
to their quotes.\290\ Therefore, the Commission believes that this is a 
reasonable time in which to expect ECNs to respond to orders on a 
regular basis. In addition, an earlier ECN commenter on the proposal, 
prior to Amendment No. 8, stated that a 5-second response time for 
order delivery ECNs should be more than adequate under normal 
circumstances.\291\ Further, the Commission believes that a certain 
level of discretion in determining whether an ECN regularly meets this 
standard is necessary to maintain a flexible standard that can 
accommodate delays that may result from a variety of circumstances. 
Also, the Commission notes that Nasdaq will lift the closed-quote state 
of an ECN failing this standard when the ECN (not Nasdaq) certifies 
that it can meet the 5-second standard.
---------------------------------------------------------------------------

    \290\ See Securities Exchange Act Release No. 42847 (May 26, 
2000), 65 FR 35690 (June 5, 2000) (noticing a proposed rule change 
by the NASD to include UTP Exchanges in the NNMS).
    \291\ See Island Letter.
---------------------------------------------------------------------------

    The Commission believes that the 5-second parameter should ensure 
that overall response times remain prompt, while still accommodating 
order delivery ECNs on individual orders with a 30-second response 
time. The Commission believes that the provisions made by the NASD to 
permit ECNs to control the risk of errors are reasonable and ECNs 
should be able to protect themselves adequately under normal operating 
conditions. The Commission expects, however, that during the 
implementation period the NASD will carefully monitor its systems to 
determine whether the 30-second and 5-second response times should be 
modified.
c. ECN's Automatic Execution Function
    Under the proposal, ECNs will have the option to receive automatic 
executions or to receive delivered orders to which they will respond. 
Regardless of the method of participation, ECNs will have full access 
to the SuperMontage for order entry and order delivery. The 
SuperMontage also will have a ``request a cancel'' feature.\292\ For 
example, under this proposal, if an internal subscriber of an ECN that 
accepts automatic executions wants to access an order in the ECN that 
also is being displayed in Nasdaq, the ECN could request a cancel 
before effecting the internal match. If the request is declined because 
the order already is executed in Nasdaq, the ECN could decline its 
internal customer's order to avoid dual liability.\293\ Alternatively, 
the ECN could choose to take only order delivery.
---------------------------------------------------------------------------

    \292\ In SuperMontage, an order that has exited the Nasdaq 
system and is en route to an ECN or UTP Exchange cannot be canceled. 
Thus, if a market participant requests to cancel an order, the 
system will hold the cancel request until the ECN or UTP Exchange 
completes interacting with the delivered order (i.e., the ECN or UTP 
Exchange executes, partially executes, or declines the order) or 
fails to respond within the allowable time.
    \293\ See Amendment No. 5, supra note 8.
---------------------------------------------------------------------------

    Three commenters believed that ECNs should be required to 
participate in the automatic execution functionality instead of having 
an option to participate as order delivery ECNs.\294\ Two of these 
commenters believed that the ``request a cancel'' functionality would 
minimize the potential of double executions against ECNs, and eliminate 
any valid reason for such a distinction between market makers and 
ECNs.\295\ One of these commenters believed that ECNs, with certain 
modifications, could operate within their current business models in an 
automatic execution environment.\296\ The commenter believed that 
automatic executions are essential to ensure that market participants 
meet their firm quote rule obligations.\297\ The commenter also 
suggested that if certain market participants accepted order delivery

[[Page 8044]]

while market makers were required to participate with automatic 
executions, market makers would have to develop dual systems.\298\
---------------------------------------------------------------------------

    \294\ See Merrill Lynch Letter; MSDW Letter; and Goldman Sachs.
    \295\ See Goldman Sachs Letter; and MSDW Letter.
    \296\ See Merrill Lynch Letter.
    \297\ See Merrill Lynch Letter.
    \298\ See Merrill Lynch Letter.
---------------------------------------------------------------------------

    Two commenters opined that automatic execution ECNs could be 
exposed to dual liability if Nasdaq execution messages arrived after 
matches were executed within the ECN.\299\ Another commenter stated 
that the ``request a cancel'' function would cause significant 
execution delays thereby undermining the competitiveness of ECNs by 
eliminating one of the principal benefits offered by agency brokers--
speed of execution.\300\
---------------------------------------------------------------------------

    \299\ See NexTrade Letter and Bloomberg Letter; see also 
Instinet Letter.
    \300\ See Instinet Letter.
---------------------------------------------------------------------------

    The Commission agrees with the NASD's position that it is necessary 
to accommodate the different trading models of all participants in the 
SuperMontage. In order to accommodate ECNs, the NASD has chosen to 
provide them an alternative to automatic execution: order delivery. The 
Commission believes that given the different business models of ECNs, 
it is not inconsistent with the statute to provide them with this 
alternative to automatic execution.
    With regard to the commenters' concerns that ECNs may be subject to 
dual liability under automated execution, the Commission notes that 
ECNs may limit their risk of dual liability by not accepting automatic 
executions. Further, even if ECNs choose to accept automatic 
executions, their risk of dual liability may be limited by the 
``request a cancel'' function and their ability to receive directed 
orders.\301\ As a result, the Commission believes that ECNs have 
sufficient alternatives for limiting their exposure to dual liability.
---------------------------------------------------------------------------

    \301\ See Amendment Nos. 7 and 8, supra notes 10 and 12.
---------------------------------------------------------------------------

4. UTP Exchange Priority
    In response to commenters, the NASD amended the proposal to allow 
UTP Exchanges to receive automatic executions for their orders as long 
as they provide reciprocal automatic executions for orders sent to them 
from Nasdaq. Further, the NASD amended the proposal to allow UTP 
Exchanges to display agency interest on a non-attributable basis and 
have that interest receive parity with quotes/orders of Nasdaq Quoting 
Market Participants.\302\ However, under the amended Order Execution 
Algorithms, the principal interest of UTP Exchanges will still be lower 
in priority than the quote/orders of Nasdaq Quoting Market 
Participants.
---------------------------------------------------------------------------

    \302\ See Amendment No. 4, supra note 6.
---------------------------------------------------------------------------

    One commenter argued that it would be unfair and ``grossly 
anticompetitive to give the principal interest of the UTP Exchange last 
priority at a given price level.'' \303\ Another commenter stated that 
the SuperMontage will ``severely curtail the ability of other market 
centers to trade Nasdaq-listed securities.'' \304\ Two commenters 
believed that the SuperMontage imposes burdens on competition by not 
permitting attributable UTP agency orders and by placing UTP principal 
orders last in the queue.\305\ One of these commenters also questioned 
the treatment of orders from UTP Exchanges that elect to receive orders 
rather than executions and the applicability of the Firm Quote Rule to 
such orders.\306\
---------------------------------------------------------------------------

    \303\ See Archipelago Letter. See also CHX Letter; CSE Letter; 
and Section V.G., infra.
    \304\ See Phlx Letter.
    \305\ See CSE Letter and Phlx Letter.
    \306\ See Phlx Letter.
---------------------------------------------------------------------------

    Two commenters objected to the proposal's requirement that UTP 
Exchanges may only submit non-attributable orders, and thus depriving 
them of credit for the liquidity provided to Nasdaq.\307\ One of these 
commenters also noted that the execution of non-attributable UTP 
Exchange orders in SuperMontage will deny UTP Exchanges revenue from 
the sale of quotation and last sale data generated by these 
orders.\308\
---------------------------------------------------------------------------

    \307\ See CSE Letter and Phlx Letter.
    \308\ See CSE Letter.
---------------------------------------------------------------------------

    Two commenters argued that UTP Exchanges must be treated on par 
with NASD members regardless of whether such Exchanges submit agency or 
proprietary orders.\309\ One of these commenters believed that the 
algorithms, as proposed in Amendment No. 8, will place UTP Exchanges' 
proprietary quotes below inferior ECN quotes.\310\ The other commenter 
called the NASD's proposal to give the proprietary quotes of UTP 
Exchanges the lowest priority in the algorithms ``a bold attempt to 
protect Nasdaq market makers from competition,'' and that this 
treatment is not consistent with the fair competition requirement of 
the Act.\311\ Lastly, these two commenters argued that all participants 
in the SuperMontage must be treated equally in order for Nasdaq to 
fulfill its dual responsibilities as a securities market and as an 
exclusive SIP.\312\
---------------------------------------------------------------------------

    \309\ See CHX Letter and CSE Letter.
    \310\ See CHX Letter.
    \311\ See CSE Letter.
    \312\ See CHX Letter and CSE Letter.
---------------------------------------------------------------------------

    The Commission believes that it is reasonable to rank principal 
quotes/orders of UTP Exchanges after the quotes/orders of Nasdaq 
Quoting Market Participants in the SuperMontage's execution algorithms 
because UTP Exchanges compete with Nasdaq for order flow. Under the 
current UTP Plan, Nasdaq serves as the processor for quotes and trade 
reports in Nasdaq securities, and in this capacity UTP data is given 
equal treatment. However, neither the UTP Plan nor Nasdaq's SIP role 
requires Nasdaq to imbed competing exchanges in its trading system. 
Moreover, it is reasonable for Nasdaq to first conduct a complete sweep 
of Nasdaq Quoting Market Participants' interest before matching an 
order against the principal interest of another competing exchange. 
This practice is consistent with the practice of certain exchanges, 
which first probe their own markets before directing an order to 
another exchange. Indeed, the Intermarket Trading System (``ITS'') Plan 
requires such a probe.\313\ The Commission notes that the SuperMontage 
has provided that a UTP Exchange's non-attributable agency interest 
will receive priority on parity with market makers and ECNs. The 
Commission believes that the superior execution priority of non-
attributable UTP Exchange agency interest over attributable UTP 
Exchange principal interest helps to protect agency orders and to 
increase order interaction in the markets.\314\
---------------------------------------------------------------------------

    \313\ See Section 8(a)(v) of the ITS Plan.
    \314\ The Commission notes that the NASD is currently 
negotiating with at least one UTP Exchange. The Commission expects 
that the UTP Plan will be amended, if needed, to reflect changes 
provided for in this proposal.
---------------------------------------------------------------------------

    The Commission recognizes the concern raised by commenters that, 
because UTP agency orders are not attributed to the UTP Exchange, the 
liquidity contributed by the UTP Exchange will not be displayed and 
acknowledged. However, the Commission believes that the SuperMontage 
should not be required to promote and provide attribution for the 
agency orders of another market that have been included in the 
SuperMontage for execution purposes. If, however, Nasdaq as an 
exclusive processor is publishing depth of book for the SuperMontage, 
it would need to disseminate similar depth of book that another UTP 
Plan participant wished to display. The Commission believes that it is 
sufficient that agency orders of other markets receive parity with 
quotes/orders of market makers and ECNs. Further, with respect to the 
commenter's other concern regarding the applicability of the Firm Quote 
Rule to orders received from UTP Exchanges,

[[Page 8045]]

the Commission notes that NASD Rule 4710(b) requires market makers to 
accept and execute non-directed orders against their quotes.
    With respect to concerns raised by another commenter regarding 
revenue appropriation from the sale of quotation and last sale data 
generated by agency orders from UTP Exchanges and executed within the 
SuperMontage, the Commission notes that the UTP Plan outlines the 
responsibilities of UTP Plan participants, but does not provide a 
comprehensive or exclusive set of terms that govern the interaction of 
the markets. Because the UTP Plan only covers distribution and other 
basic terms, it is not uncommon for the NASD and UTP Plan Participants 
to negotiate terms for dealing with each other. Therefore, the 
Commission expects that these issues will be resolved among the 
participants of the UTP Plan. For instance, the NASD negotiated the 
terms of SuperMontage participation with the UTP Plan's only active 
participant, the CHX.\315\
---------------------------------------------------------------------------

    \315\ See Amendment No. 4, supra note 6.
---------------------------------------------------------------------------

5. Five-Second Interval Delay
    As originally proposed, after all interest was exhausted at a price 
level, the SuperMontage would have imposed a limited 5-second interval 
delay before moving to the next price level. Two commenters questioned 
whether the proposed 5-second delay would reduce volatility in the 
markets as intended.\316\ In addition, four commenters believed that 
the 5-second interval delay either was too long or too short, depending 
on activity in the stock.\317\ Two commenters also opposed the 5-second 
interval delay as unnecessary and inconsistent with the interest of 
investors.\318\ Specifically, one commenter believed that the delay 
would permit market makers, ECNs, and UTP Exchanges to decline to fill 
a non-Liability Order before moving their quotes to an inferior 
price.\319\ This commenter believed that the ability of a market 
participant to consider whether to decline or accept an execution at a 
published quote would interfere with the need of investors and traders 
for certainty and could result in executions at inferior prices.\320\
---------------------------------------------------------------------------

    \316\ See ETA Letter and ICI Letter.
    \317\ See STA Letter; STANY Letter; Salomon Smith Barney Letter; 
and Merrill Lynch Letter.
    \318\ See ETA Letter and STANY Letter; see also ACIM Letter.
    \319\ See ETA Letter.
    \320\ See ETA Letter.
---------------------------------------------------------------------------

    In response to these comment letters, the NASD revised its 
process.\321\ The SuperMontage, subject to the exception for orders 
designated as Sweep Orders, will limit the 5-second interval delay to 
situations where an order is partially filled at the inside price and 
the remaining shares of the order cannot be filled within the next two 
trading ticks. In this situation, there will be an interval delay or 
pause before the order moves to the next price level away from the 
original price level. If, at any point, the remainder of the order can 
be filled within the next two trading ticks, the order will be executed 
immediately. If an order is in interval-delay because it meets the 
above parameters, orders that are behind the ``interval-delay order'' 
will not jump the queue. In addition, a market participant may set a 
parameter on individual orders so that these orders will trade through 
all interest (i.e., displayed and reserve interest) at the three price 
levels being displayed in the NODF at the time of entry, without 
pausing 5 seconds in between each displayed price (i.e., a Sweep 
Order).
---------------------------------------------------------------------------

    \321\ See Amendment No. 4, supra note 6.
---------------------------------------------------------------------------

    One commenter supported the limited 5-second interval delay between 
price levels, and the proposed Sweep Order parameter.\322\ However, the 
commenter was still uncertain if the NASD's modifications to the 
process went far enough to address concerns about SuperMontage-imposed 
trading delays.\323\
---------------------------------------------------------------------------

    \322\ See ICI Letter.
    \323\ See ICI Letter.
---------------------------------------------------------------------------

    The Commission finds that the limited 5-second interval delay is 
consistent with Sections 15A(b)(6) and 11A of the Act\324\ in that it 
is designed to facilitate transactions in securities and maintain a 
fair and orderly market. The 5-second interval delay is designed to 
provide Nasdaq Quoting Market Participants and UTP Exchanges with 
adequate time to update their quotes, without unduly delaying 
executions. The Commission believes that the 5-second interval delay 
could assist market makers in fulfilling their obligation to maintain 
continuous two-sided quotes, and, in turn, could promote quote 
competition among all market participants. The Commission notes that 
during the 5-second delay it will be possible for market makers and 
other market participants, who are not at the inside quote, to change 
their quotes to the inside because of market interest. Such competition 
should, in turn, enhance the quality of the Nasdaq market by improving 
the price discovery process for Nasdaq securities. The Commission also 
believes that the delay could help stabilize the market during periods 
of volatility by allowing Nasdaq Quoting Market Participants and UTP 
Exchanges the opportunity to monitor and assess their quotes in a 
reasonable manner in response to changing market conditions.\325\
---------------------------------------------------------------------------

    \324\ 15 U.S.C. 78o-3(b)(6) and 15 U.S.C. 78k-1.
    \325\ Although one commenter was concerned that the five-second 
interval delay would allow a market participant to decline an 
execution at its published quote, the Commission notes that market 
makers will still be subject to automatic execution and therefore, 
will not be able to decline orders sent to their quotes. See ETA 
Letter.
---------------------------------------------------------------------------

    The Commission believes that the two exceptions to the 5-second 
interval delay between price levels (for orders that can be filled at 
the initial price level and within the next two price ticks away and 
orders designated as Sweep Orders) provide a reasonable compromise 
between the need for fast executions and the need to provide market 
participants adequate time to manage their capital risk by monitoring 
and updating their quotes. Finally, the Commission expects that NASD 
will monitor market performance in the SuperMontage as it relates to 
the five-second interval delay, particularly the potential for queuing, 
and consider modifying that time period, if modification is necessary.

E. Directed Orders

    As proposed in the original notice, directed orders would have 
allowed Nasdaq market participants to deliver a non-Liability 
Order\326\ to a Nasdaq Quoting Market Participant or UTP Exchange only 
if the order was designated as AON or MAQ for a size that is at least 
one normal unit of trading (e.g., 100 shares) greater than the 
displayed amount of the quote/order to which the order is directed.
---------------------------------------------------------------------------

    \326\ A non-Liability Order is an order that when delivered 
imposes no obligation to respond under the Firm Quote Rule. See 
Proposed NASD Rule 4701(q).
---------------------------------------------------------------------------

    One commenter believed that directed orders away from the BBO 
should be treated as Liability Orders.\327\ Another commenter expressed 
concern that if a recipient accepts a directed order for execution, a 
trade-through could occur if that order is executed at a price outside 
of the displayed price.\328\ This commenter recommended adding a 
``clean-up'' feature for directed orders pursuant to which a directed 
order could be executed only if the order satisfied the interest 
displayed on the proposed system at better prices (with no five-second 
delay if within two price levels from the inside quote if the order 
goes through several price levels).\329\ Two commenters also 
recommended developing a workable trade-through rule, in conjunction 
with the Order

[[Page 8046]]

Execution Algorithm, to provide incentives for the entry and protection 
of better-priced quotes displayed in the system.\330\ Two other 
commenters argued that the order routing process as proposed would not 
allow customers to preference them.\331\ They stated that the non-
directed order process offered no capability for preferencing, and the 
directed order process offered an ineffective way of preferencing 
because all directed orders must be designated as non-Liability 
Orders.\332\
---------------------------------------------------------------------------

    \327\ See Heartland Letter.
    \328\ See MSDW Letter.
    \329\ See MSDW Letter.
    \330\ See ITAC Letter and CSE Letter.
    \331\ See Instinet Letter; and Bloomberg Letter.
    \332\ See Instinet Letter; and Bloomberg Letter.
---------------------------------------------------------------------------

    In response to these comments, the NASD revised the proposal to 
allow Nasdaq Quoting Market Participants and UTP Exchanges to elect to 
receive Liability Orders through the directed order process.\333\ Under 
the proposed change, a Nasdaq Quoting Market Participant or UTP 
Exchange can choose to receive a directed order against its quote that 
is also a Liability Order. A market participant also can choose to 
accept directed orders against its quotes only as non-Liability 
Orders.\334\ Thus, for example, a market maker can choose to receive 
both non-directed and directed Liability Orders, or it can choose to 
receive only non-directed orders on a liability basis. The NASD and 
Nasdaq have indicated that ECNs that opt to receive directed Liability 
Orders will avoid dual liability because they will retain the ability 
to fill, partially execute, or decline a directed or non-directed 
Liability Order.\335\
---------------------------------------------------------------------------

    \333\ See Amendment No. 7, supra note 10.
    \334\ See Amendment No. 7, supra note 10.
    \335\ See Amendment No. 7, supra note 10.
---------------------------------------------------------------------------

    One commenter believed that the NASD's change provided a partial 
solution, but expressed concern that it will subject market makers to 
double liability if market makers elect to receive directed Liability 
Orders.\336\ Another commenter believed that allowing directed orders 
would permit trade-throughs to occur.\337\ One commenter stated that 
directed orders would limit the ability of institutional traders to 
effectively participate in the SuperMontage.\338\
---------------------------------------------------------------------------

    \336\ See Bloomberg Letter.
    \337\ See CSE Letter.
    \338\ See Scudder Kemper Letter.
---------------------------------------------------------------------------

    The Commission believes that these proposed rules are in accordance 
with Section 15A(b)(6) of the Act\339\ because they are designed to 
facilitate transactions in securities, remove impediments to and 
perfect the mechanism of a free and open market and national market 
system. While the Commission recognizes the concern raised by one 
commenter regarding the potential double liability of market makers, 
the Commission also recognizes that market makers are not required to 
receive directed Liability Orders. If a market maker does not elect to 
receive directed Liability Orders, the market maker will not be exposed 
to double liability.\340\ Reducing the potential for dual liability may 
encourage market makers to display larger sized quotations, thereby 
providing greater liquidity to the market for Nasdaq securities. 
Further, the ``request a cancel'' feature limits the exposure of Nasdaq 
Quoting Market Participants and UTP Exchanges by allowing participants 
to fill directed non-Liability Orders without being exposed to a dual 
execution. At the same time, ECNs and others that choose to use the 
directed order process to take Liability Orders may do so.
---------------------------------------------------------------------------

    \339\ 15 U.S.C. 78o-3(b)(6).
    \340\ The Commission notes that market participants will still 
be able to preference market makers on a Liability Order basis. 
Under this option, market makers will not be exposed to double 
liability because preferenced orders are processed in the non-
directed order queue.
---------------------------------------------------------------------------

    The Commission emphasizes, however, that while directed orders are 
not necessarily inconsistent with the achievement of best execution, a 
market participant must periodically assess the quality of competing 
markets to assure that order flow is directed to markets providing the 
most advantageous terms for its customers' orders. Thus, a participant 
may not simply employ default order routing to a broker-dealer 
affiliate or particular NASD member without undertaking such an 
evaluation on an ongoing basis.\341\
---------------------------------------------------------------------------

    \341\ See Securities Exchange Act Release No. 37619A (September 
6, 1996), 61 FR 48290 (September 12, 1996) (order approving the 
Order Handling Rules).
---------------------------------------------------------------------------

F. Locked/Crossed Markets

    Generally, under Nasdaq's proposal, if a Nasdaq Quoting Market 
Participant or UTP Exchange enters an order that will lock or cross the 
market, the OCF will not display the order as a quote/order, but 
instead the order will be treated as a marketable limit order and 
entered into the OCF as a non-directed order for execution. If the 
market is locked or crossed at the opening, the system will clear the 
locked or crossed quotes by executing the oldest bid (offer) against 
the oldest marketable offer (bid) at the price of the oldest quote/
order.
    One commenter believed that locked or crossed markets at the 
opening should be resolved in price/time and not time/price 
priority.\342\ Another commenter stated that the potential for locked 
or crossed markets will continue to exist if ECNs opt to take order 
delivery for Liability Orders.\343\ The commenter believed that the 
problem would be alleviated if ECNs were required to receive automatic 
executions.\344\ However, as described in greater detail previously, 
the NASD believes that it is necessary to accommodate the needs of ECNs 
by providing them with an alternative to automatic execution.
---------------------------------------------------------------------------

    \342\ See ACIM Letter.
    \343\ See MSDW Letter.
    \344\ See MSDW Letter.
---------------------------------------------------------------------------

    In addition to the issues raised above, one commenter questioned 
the manner in which the NASD proposed to resolve locks and crosses on 
the opening of the market.\345\ This commenter stated that, as 
proposed, the system will permit participants to enter non-firm quotes 
up until the opening and then execute the oldest bids against the 
oldest offers at the open.\346\ This commenter opined that in this 
system market participants will have no incentive to find the correct 
price for a stock before the opening.\347\
---------------------------------------------------------------------------

    \345\ See Island Letter.
    \346\ See Island Letter.
    \347\ See Island Letter.
---------------------------------------------------------------------------

    Another commenter raised the concern that SuperMontage will subject 
ECNs to an unacceptable risk of automatic execution by converting ECN 
quotes into orders when they lock or cross the market.\348\ This 
commenter explained that ECNs are not capable of receiving automatic 
executions because they do not take proprietary positions and 
therefore, cannot accept the risk of multiple executions against their 
quotes.\349\
---------------------------------------------------------------------------

    \348\ See Instinet Letter.
    \349\ See Instinet Letter.
---------------------------------------------------------------------------

    The NASD responded by explaining that when a market participant 
enters a locking or crossing quote into the system, it will receive a 
system warning, as it does today.\350\ In order to complete the quote 
entry, the participant is required to override the system warning. 
After overriding the warning, the quote results in an order being 
generated that accesses the quote that will be locked or crossed. 
Therefore, the NASD stated, ECNs can avoid automatic executions for 
their own quotes by not overriding the system warning.\351\
---------------------------------------------------------------------------

    \350\ See Amendment No. 7, supra note 10.
    \351\ See Amendment No. 7, supra note 10.
---------------------------------------------------------------------------

    The NASD added that ECNs are not at risk if another participant 
enters a quote/order that locks or crosses an existing ECN quote. If 
that occurs, the system again will issue a warning to the party 
attempting to lock or cross the market. If that party overrides the 
system warning, the system will then convert the locking or crossing 
quote

[[Page 8047]]

and process it as a non-directed order. It will not deliver an 
automatic execution to an ECN that chooses to accept only order 
delivery against its quote. In either case, there is little or no risk 
to an order delivery participant of an unwanted automatic 
execution.\352\
---------------------------------------------------------------------------

    \352\ See Amendment No. 7, supra note 10.
---------------------------------------------------------------------------

    The Commission finds that the proposal's provision to address 
locked and crossed markets is consistent with the Act because it is 
designed to reduce the frequency of locked and crossed markets, which 
should help to provide reliable quotation information, facilitate price 
discovery, and contribute to the maintenance of a fair and orderly 
market. The proposal also should facilitate more efficient openings. 
The proposal seeks to eliminate locked and crossed markets by matching 
marketable orders against one another, after providing notice that an 
execution will occur. The Commission believes this approach is 
reasonable. As the Commission has concluded previously, continued 
locking and crossing of the market can negatively impact market 
quality.\353\ By helping to reduce the frequency of locked and crossed 
markets, the Commission believes that the proposal should improve 
market quality and enhance the production of fair and orderly 
quotations.
---------------------------------------------------------------------------

    \353\ See Securities Exchange Act Release No. 40455 (September 
22, 1998), 63 FR 51978 (September 29, 1998) (order approving File 
No. SR-NASD-98-01).
---------------------------------------------------------------------------

    While the Commission understands the commenter's concern that the 
proposal will not completely eliminate crossed and locked markets 
because ECNs will be given the option of taking order delivery for 
Liability Orders rather than automatic executions, the ECNs still will 
be required to execute the locking order immediately, and Nasdaq will 
decrement the ECNs' quote upon delivery of the order. Thus, the lock or 
cross should be removed quickly. In addition, as stated previously, the 
Commission believes the NASD's position that, despite this negative 
aspect, it is necessary to accommodate the ECNs by providing them with 
an alternative to automatic execution is consistent with the Act.

G. UTP Exchange Participation as Automatic Execution Participants

    One commenter supported UTP Exchange participation in the 
SuperMontage and stated that the proposal represented a ``positive step 
in integrating the Nasdaq and UTP Exchange markets.'' \354\ This 
commenter, however, stated that as a purely legal matter, the proposal 
could not be implemented without an amendment to the UTP Plan because 
certain features of the proposal change the obligations of Nasdaq under 
the UTP Plan.\355\
---------------------------------------------------------------------------

    \354\ See CHX Letter.
    \355\ See CHX Letter. The Commission notes that the NASD is 
currently working on amendments to the UTP Plan.
---------------------------------------------------------------------------

    In the original proposal, UTP Exchanges had the option of receiving 
orders either for delivery or automatic execution, but they were only 
permitted to send orders to the SuperMontage for order delivery. Some 
commenters disapproved of this approach. Specifically, they argued that 
incoming UTP Exchange orders should be subject to automatic execution, 
so that market makers could avoid having duplicate systems solely to 
service UTP Exchanges.\356\ While one commenter acknowledged the 
rationale behind the proposal's exclusion of UTP Exchanges from 
automatic execution, it argued that their inclusion was ``in the best 
interests of all market participants,'' and that such inclusion would 
be equitable if UTP Exchanges provided reciprocal automatic execution 
capability to incoming market maker orders.\357\ The Chicago Stock 
Exchange also objected to the inability of UTP Exchanges to participate 
in automatic executions and the prioritization of UTP Exchanges in the 
Order Execution Algorithm.\358\
---------------------------------------------------------------------------

    \356\ See STA Letter; STANY Letter; and Merrill Lynch Letter.
    \357\ See STANY Letter.
    \358\ See CHX Letter; see also Archipelago Letter.
---------------------------------------------------------------------------

    Another commenter acknowledged that it would be difficult for the 
NASD to surveil, and if necessary, discipline UTP Exchange members for 
``backing away'' from their quotes, and suggested that potential 
solutions should be considered.\359\ In addition to the duplicate 
systems issues, the commenter cited a potential loss of liquidity that 
would result if UTP Exchanges and ECNs did not participate in automatic 
executions.\360\
---------------------------------------------------------------------------

    \359\ See Merrill Lynch Letter.
    \360\ See Merrill Lynch Letter.
---------------------------------------------------------------------------

    In response to concerns about UTP Exchange participation as 
originally filed, the NASD amended the proposal to give UTP Exchanges 
the option to receive automatic executions in the SuperMontage, 
provided that they give Nasdaq reciprocity.\361\ In addition, UTP 
Exchanges will still have the option of accepting order delivery rather 
than automatic execution.\362\
---------------------------------------------------------------------------

    \361\ See Amendment Nos. 4 and 6, supra notes 6 and 9.
    \362\ See Amendment No. 6, supra note 9.
---------------------------------------------------------------------------

    One commenter objected to what it considered to be the 
unnecessarily disparate treatment for order-delivery UTP Exchanges and 
order-delivery ECNs that attempt to access other participants.\363\ The 
commenter noted that order-delivery ECNs will have the ability to 
automatically execute against other participants, but order-delivery 
UTP Exchanges will not.\364\ The commenter believed that this was done 
to put order-delivery UTP Exchanges at a competitive disadvantage.\365\ 
Another commenter also disagreed with the NASD's proposal to provide a 
UTP Exchange automatic executions against Nasdaq's market only if the 
UTP Exchange is similarly willing to provide automated execution 
against its quotes.\366\ The commenter believed that it was possible to 
promote inter-exchange competition without requiring UTP Exchanges to 
become part of Nasdaq's limit order book.
---------------------------------------------------------------------------

    \363\ See CHX Letter.
    \364\ See CHX Letter.
    \365\ See CHX Letter. CHX noted that it is currently exploring 
with Nasdaq the possibility of allowing automatic execution UTP 
Exchanges to have the ability to revert to order-delivery if Nasdaq 
has systems delays.
    \366\ See CSE Letter.
---------------------------------------------------------------------------

    The Commission believes that the NASD's treatment of UTP Exchanges 
is consistent with the Act. While the Commission believes that it is 
reasonable for the NASD to attempt to accommodate the various needs of 
its members, the Commission does not believe that NASD must make the 
same accommodations for competing markets. The Commission believes that 
Nasdaq should be able to provide access to a competing exchange that is 
equivalent to the access the competing exchange provides for Nasdaq 
members.\367\ In addition, the Commission notes that the SuperMontage 
is voluntary and that UTP Exchanges may elect to post their quotes/
orders in the NASD's display alternative.\368\
---------------------------------------------------------------------------

    \367\ The Commission notes that Nasdaq is exploring other ways 
to accommodate UTP Exchanges. The Commission expects that some of 
the issues raised by UTP Exchanges will be further addressed in 
those discussions.
    \368\ See discussion at Section V.I.3, Nasdaq as an Exclusive 
Securities Information Processor.
---------------------------------------------------------------------------

H. Odd-Lot Processing

    Certain commenters criticized the original proposal for handling 
limit orders, saying that it would be ``cumbersome'' and create the 
opportunity for ``gaming the system'' \369\ by breaking large orders 
into odd-lots so that those orders would not affect the published 
quote.\370\ Four commenters also expressed concern that dealers without 
a current interest in a security

[[Page 8048]]

would be forced into executions under the proposed odd-lot processing 
method.\371\ At least one commenter opined that the proposed odd-lot 
processing would impose unnecessary administrative and operational 
burdens on firms,\372\ and several commenters raised issues regarding 
decrementing a market maker's bids and offers.\373\
---------------------------------------------------------------------------

    \369\ See STA Letter; STANY Letter; Salomon Smith Barney Letter; 
ITAC Letter; and MSDW Letter; see also Merrill Lynch Letter.
    \370\ See STA Letter; STANY Letter; Salomon Smith Barney Letter; 
and MSDW Letter.
    \371\ See Salomon Smith Barney Letter; STA Letter; STANY Letter; 
and MSDW Letter.
    \372\ See Merrill Lynch Letter.
    \373\ See Salomon Smith Barney Letter; MSDW Letter; Merrill 
Lynch Letter; STA Letter; and STANY Letter.
---------------------------------------------------------------------------

    In response to these comments, the NASD revised its proposed odd-
lot execution process.\374\ Under the current proposal, the 
SuperMontage will include a separate mechanism for processing and 
executing odd-lot orders at the inside price that will provide: (1) An 
``odd-lot exposure limit'' for market makers; (2) a market maker 
interval delay between odd-lot executions against the same market 
maker; and (3) an odd-lot order entry parameter of one order per 
second, per firm. Odd-lot orders will be processed in a round-robin 
fashion against a market maker with an available exposure limit, even 
if the market maker is not at the inside.\375\ One commenter argued 
that ECNs should be permitted to interact with odd-lot orders.\376\
---------------------------------------------------------------------------

    \374\ See Amendment No. 4, supra note 6.
    \375\ Id.
    \376\ See Island Letter.
---------------------------------------------------------------------------

    The Commission believes that the proposed rule change allows for 
greater market maker participation in executing odd-lot orders. The 
Commission also believes that allowing all market makers registered in 
a security to participate in executing these orders should strengthen 
the Nasdaq market and benefit market participants by permitting the 
prompt, efficient execution of odd-lot orders.\377\ Market makers may 
elect to execute odd-lot orders at the inside price even when the 
market maker is not at the inside bid/offer, thereby adding to the 
depth and liquidity of the market. The Commission notes that 
historically only market makers have participated in the odd-lot 
process because ECNs do not take proprietary positions. If an ECN were 
to participate in the revised odd-lot process, it would have to take 
proprietary positions from time to time because it would be required to 
execute at the inside quote.\378\ The Commission believes that the 
proposed odd-lot system is consistent with the Act based on the current 
roles of market makers and ECNs, but believes that Nasdaq should 
explore including ECNs in the odd-lot execution process if ECNs can 
demonstrate that they can provide equivalent treatment to these orders 
as market makers.
---------------------------------------------------------------------------

    \377\ Currently, odd-lots are automatically executed only 
against market makers who are at the inside bid/offer.
    \378\ The Commission notes that any system operated by, or on 
behalf of, an OTC market maker or exchange market maker that 
executes customer orders primarily against the account of such 
market maker as principal is excluded from the definition of an ECN. 
See 17 CFR 240.11Ac1-1(a)(8)(ii). An OTC market maker is defined as 
any dealer who holds itself out as being willing to buy from and 
sell to its customers, or otherwise, a covered security for its own 
account on a regular or continuous basis otherwise than on an 
exchange in amounts of less than block size. See 17 CFR 240.11Ac1-
1(a)(13).
---------------------------------------------------------------------------

I. Issues Relating to Competition

1. Centralization
    Many commenters believed that the proposal will improve the Nasdaq 
market by providing more information to investors, promoting greater 
efficiency in executions, or increasing overall market 
transparency.\379\ One commenter believed that the SuperMontage is 
greatly needed and ``that it will eventually make the market more 
efficient and competitive, all to the benefit of the investor.''\380\ 
Another commenter stated that the SuperMontage will improve the Nasdaq 
market and integrate ``market makers, ECNs and UTP Exchanges in a more 
unified, competitive manner.''\381\ One commenter also believed that 
the SuperMontage will ``continue a natural competition between 
securities markets.''\382\ Another commenter stated that the 
SuperMontage was ``an inclusive model built with the connectivity to 
link all market participants, including electronic communications 
networks into the market center. However, it in no way imposes new 
obligations or burdens, or diminishes the opportunity for market 
participants to interact with one another through other means.''\383\ 
In addition, one commenter, after Amendment No. 8, stated that the 
``SuperMontage has been transformed from a revolution in fundamental 
market structure to an incremental evolution in market technology 
characterized by a marketplace that preserves investor choice and 
competition.''\384\
---------------------------------------------------------------------------

    \379\ See ETA Letter; Merrill Lynch Letter; Goldman Sachs 
Letter; MSDW Letter; STA Letter; STANY Letter; ITAC Letter; ICI 
Letter; Bannon Letter; Bancorp Letter; Charles Schwab Letter; 
Congressman Dreier Letter; Congressman Pallone Letter; Congresswoman 
Morella Letter; Congressman Stupak Letter; Congresswoman Wilson 
Letter; Congressman Towns Letter; Congressman McInnis Letter; 
Congressman Thomas Letter; Spear, Leeds & Kellogg Letter; First 
Union Letter; ITG Letter; Jeffries Letter; Congressman Ehrlich 
Letter; Congressman Radanovich Letter; Congressman Shays Letter; 
Titak Letter; ASA Letter; APTC Letter; Philadelphia Corp. Letter; 
Garrett Letter; and Senator Schumer Letter.
    \380\ See STA Letter.
    \381\ See MSDW Letter.
    \382\ See APTC Letter.
    \383\ See Congressman Radanovich Letter.
    \384\ See Bloomberg Letter.
---------------------------------------------------------------------------

    Fourteen commenters, however, were concerned that the proposal will 
have a negative impact on competition.\385\ Most of these commenters 
argued that the proposal was anti-competitive because, in their view, 
it will implement a monopolistic, centralized execution system that 
will compel participation by NASD regulated broker-dealers, and in turn 
stifle ECN innovation and diminish market competition. Several 
commenters also expressed concern that the automatic execution feature 
of the SuperMontage will have a negative impact on competition by 
forcing order flow into the SuperMontage.\386\ Specifically, Instinet 
stated that, because of the NASD's status as a regulator, the NODF will 
effectively become a mandatory display facility for investors' orders 
to the exclusion of more efficient, better-priced pools of 
liquidity.\387\ Instinet believed that Nasdaq's affiliation with NASD 
Regulation will create the perception among Nasdaq Quoting Market 
Participants that customer orders routed to the SuperMontage will be 
insulated from best execution challenges.\388\ Instinet thus asserted 
that liquidity provided by other facilities could evaporate, and that 
investor order display and execution options will diminish.\389\ 
Instinet also argued that Nasdaq will have a regulatory advantage over 
ECNs because of its ability to subsidize market operations from the 
revenues that Nasdaq earns from the sale of market data.\390\
---------------------------------------------------------------------------

    \385\ See ETA Letter; Island Letter; Instinet Letter; Bancorp 
Letter; Archipelago Letter; Granite Financial Letter; ATD Letter; 
ACIM Letter; BRUT Letter; Phlx Letter; Leon Letter; Aurora Letter; 
Renaissance Letter; CSE Letter; and NexTrade Letter. In its comment 
letter, Island specifically questioned whether ECNs could compete in 
a regulatory environment structured to favor Nasdaq.
    \386\ See ETA Letter; Island Letter; Bloomberg Letter; Instinet 
Letter; Leon Letter; and NexTrade Letter.
    \387\ See Instinet Letter; see also Leon Letter.
    \388\ See Instinet Letter.
    \389\ See Instinet Letter; see also NexTrade Letter.
    \390\ See Instinet Letter.
---------------------------------------------------------------------------

    Phlx believed that the SuperMontage will result in an 
``unacceptable concentration of market power in the NASD at the expense 
of the regional exchanges * * * . Under the SuperMontage proposal, 
Nasdaq will function as its own ITS. * * * [without providing] for any 
representation.''\391\
---------------------------------------------------------------------------

    \391\ See Phlx Letter.

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

[[Page 8049]]

    In response, the NASD stated that, while the proposal creates a 
central means for accessing liquidity in Nasdaq and other market 
centers, it in no way establishes the SuperMontage as the sole means 
for providing or accessing liquidity. NASD members, individual 
investors, and members of other exchanges will be free to route their 
orders to any market center they choose. Moreover, ECN subscribers will 
be free to use the execution services offered by the ECNs to access 
liquidity within the ECNs. The NASD emphasized that nothing in the 
proposal prohibits ECNs and other market participants from establishing 
links or order-routing arrangements.\392\ The NASD maintained that 
providing a means for accessing liquidity and trading interest is an 
essential and core function of a market. The NASD pointed out that it 
already provides both quotation and execution services. Nasdaq has 
operated SOES since 1984, and SelectNet since 1988, both of which are 
integrated with Nasdaq's quotation system. The NASD believes that 
eliminating this capability would be a step backward for the market and 
investors, and would be contrary to Sections 11A and 15A of the 
Exchange Act as it will foster inefficiencies in the execution of 
securities, minimize opportunities to obtain best execution, limit 
market linkages, result in disorderly markets, and ultimately harm 
investors.\393\
---------------------------------------------------------------------------

    \392\ See Amendment No. 5, supra note 8.
    \393\ See Amendment No. 7, supra note 10.
---------------------------------------------------------------------------

    The Commission believes that the SuperMontage does not impose any 
burden on competition that is not necessary or appropriate in 
furtherance of the Act. The Commission has long held the view that 
competition and innovation are essential to the health of the 
securities markets. Indeed, competition is one of the hallmarks of the 
national market system. The SuperMontage is a reasonable effort by the 
NASD to enhance the quality of the Nasdaq market by providing more 
information to investors, promoting greater efficiency in executions, 
and increasing overall market transparency. Although the SuperMontage 
may provide a new means for accessing liquidity in Nasdaq stocks, the 
SuperMontage will not be the sole means for providing or accessing 
liquidity. Under the proposal, broker-dealers may continue to seek 
alternative order routing and execution services that provide value to 
their customers through price, speed, and technology. Broker-dealers 
wishing to interact with institutional orders below the top of the 
book, for example, may continue to use ECNs.\394\ Those that wish to 
continue to maintain anonymity through clearance and settlement may 
continue to use ECNs. In addition, market participants wishing to 
execute orders without the participation of a dealer may continue to do 
so under the proposal. NQDS Prime will provide all individual 
attributable quote/order information at the three best price levels 
displayed in the SuperMontage. With this information, market 
participants will have the choice of using Nasdaq's facility to access 
liquidity or private linkages outside of the SuperMontage to access 
liquidity. Moreover, participation in the SuperMontage is voluntary. A 
market participant, such as an ECN, may elect not to display, or 
provide access to, its quotes/orders through Nasdaq and instead display 
and provide access to its quotes/orders on other markets, such as the 
Chicago Stock Exchange, the Cincinnati Stock Exchange, and possibly in 
the future, the Pacific Exchange (``PCX''). In addition, the NASD has 
agreed to create an alternative quote reporting mechanism that will 
allow an ECN, ATS, or market maker to maintain its quotes in an NASD 
facility without being a participant in Nasdaq, and therefore the 
SuperMontage.\395\
---------------------------------------------------------------------------

    \394\ While market participants also may interact with quotes/
orders below the top of the book in the SuperMontage, the Commission 
notes that directed orders will have to be for a size greater than 
the quoted size unless the Nasdaq Quoting Market Participant or UTP 
Exchange is willing to accept a directed Liability Order. As a 
result, the Commission believes that market participants will 
continue to have the same incentive to access ECNs for quotes/orders 
below the top of the book as they do today. In addition, customer 
orders routed to the SuperMontage will not ``be insulated from best 
execution challenges'' merely because the orders are routed to an 
SRO's market. Indeed, the Commission has noted in this release 
several instances where best execution may not be achieved within 
SuperMontage. See e.g., discussions at V.D.2. and V.E.
    \395\ See Section V.I.3, NASD as an Exclusive Securities 
Information Processor, infra.
---------------------------------------------------------------------------

    At the heart of the commenters' competition arguments is the view 
that automatic execution against market makers gives the SuperMontage 
an unfair advantage in drawing order flow and makes it difficult for 
others to build competing links to market makers. The Commission finds 
that the automatic execution feature offered by the SuperMontage is a 
reasonable way for Nasdaq to improve market efficiency. Since at least 
1988, automatic execution has been a vital element of Nasdaq's dealer 
market. The NASD's automatic execution system, SOES, was initially 
developed in 1984 to provide an efficient facility for order entry 
firms to execute retail customer orders of limited size in Nasdaq 
securities.\396\ SOES offered an alternative for those firms to the 
traditional telephone contact and negotiation with market makers by 
providing automatic execution of customer orders against Nasdaq market 
makers at the best available market price.
---------------------------------------------------------------------------

    \396\ See Securities Exchange Act Release No. 21433 (October 29, 
1984), 49 FR 44042 (November 1, 1984).
---------------------------------------------------------------------------

    Initially, participation in SOES was voluntary. During the October 
1987 market break, however, the Nasdaq market experienced significant 
operational problems.\397\ Sharp downward volatility and record volume 
resulted in delayed transaction reports and a large number of locked 
and crossed markets. The unusual market conditions created a situation 
in which it was impossible for market makers to ensure that their 
quotes, against which trades were continuing to be executed in SOES, 
accurately reflected the rapidly changing market. Because participation 
in SOES at that time was voluntary, a majority of market makers 
responded by withdrawing from SOES.\398\ Trades that normally would 
have been handled through SOES then had to be executed by contacting 
market makers by telephone. This necessarily increased the already 
extraordinary workload of market makers and contributed to a large 
number of unfilled orders, as well as complaints that market makers 
were not accessible.
---------------------------------------------------------------------------

    \397\ See Division of Market Regulation, The October 1987 Market 
Break 9-3 to 9-15 (February 1988) (``1987 Market Break Report'').
    \398\ As described more fully in the 1987 Market Break Report, 
the number of market making positions declined more than 83 percent 
between October 19 and October 22, 1987. Id. at 9-14.
---------------------------------------------------------------------------

    In response to those problems, the NASD adopted a number of rules 
to facilitate the execution of retail customer orders in SOES and to 
ensure market maker participation in the system (``1988 SOES 
modifications''), including making SOES participation mandatory for all 
market makers in Nasdaq securities.\399\ These changes were intended, 
among other things, to ensure that order entry firms could obtain 
automatic executions for their customers in volatile markets. Upon 
approval, the Commission stated its belief that the 1988 SOES 
modifications would enhance market liquidity, improve the accuracy of 
Nasdaq's pricing systems, promote the timeliness of trade reporting, 
and help alleviate locked and crossed markets.\400\
---------------------------------------------------------------------------

    \399\ See Securities Exchange Act Release No. 25791 (June 9, 
1988), 53 FR 22594 (June 16, 1988).
    \400\ Id.
---------------------------------------------------------------------------

    In 1999, the NASD recognized that, while SOES and SelectNet 
provided

[[Page 8050]]

valuable services to market participants, the operation of two separate 
and independent execution systems resulted in frequent dual liability 
for market makers. In response to this problem, the NASD proposed to 
integrate SOES and SelectNet, and re-establish SelectNet as a non-
Liability Order delivery and execution system for Nasdaq National 
Market System securities and recast SOES as the NNMS. The Commission 
approved the integration on January 25, 2000.\401\ Pursuant to the NNMS 
Order, the maximum order size now eligible for automatic execution in 
Nasdaq National Market System securities is 9,900 shares. Further, the 
NNMS Order permitted market makers to enter both proprietary and agency 
orders into NNMS, and receive executions.
---------------------------------------------------------------------------

    \401\ See NNMS Order, supra note 22.
---------------------------------------------------------------------------

    The Commission continues to believe that automatic execution 
provides many benefits to a marketplace, particularly speed and 
certainty of executions. As the NASD pointed out, certainty of 
execution is important to all investors, particularly in fast moving 
markets. The automatic execution feature of the SuperMontage should 
promote investor confidence by increasing the likelihood that orders of 
moderate size from large and small investors alike will be filled 
almost instantaneously. The SuperMontage's automatic execution feature 
also should improve the accuracy of Nasdaq's pricing systems, promote 
the timeliness of trade reporting, and help alleviate locked and 
crossed markets. Further, the Commission notes that the SuperMontage 
does not dramatically modify the automatic execution feature in NNMS, 
which was approved by the Commission after being published for comment.
    In a comment letter prior to Amendment No. 8, Bloomberg suggested 
an alternative, hybrid approach to automatic execution, in which Nasdaq 
could send order messages that converted into executions within a 
fraction of a second if market makers failed to respond.\402\ Bloomberg 
stated that such a hybrid approach, which is both technologically 
feasible and affordable, would promote the use of automatic execution 
facilities among market professionals and enhance market 
efficiency.\403\
---------------------------------------------------------------------------

    \402\ See Bloomberg Letter.
    \403\ See Bloomberg Letter.
---------------------------------------------------------------------------

    In response, the NASD stated that Bloomberg's approach could harm 
investors, particularly small investors, because there no longer would 
be a method of providing automatic execution to small orders. Further, 
the NASD stated that if all market participants receive only orders (as 
opposed to executions), which they may reject in full or fill 
partially, investors' orders would be ``bounced'' from one market 
participant to another. Thus, this approach could result in orders that 
are entered later in time being filled before orders that are entered 
earlier in time, depending on how and when the market participant 
receiving the order responds to the order.\404\
---------------------------------------------------------------------------

    \404\ See Amendment No. 5, supra note 8.
---------------------------------------------------------------------------

    The NASD also noted that, under Bloomberg's alternative, instances 
of backing away could increase, particularly because it could 
exacerbate the dual liability problem that many market makers face 
today. Automatic execution, in comparison, reduces the potential that a 
market participant may back away from its quote.
    Finally, the NASD argued that automatic execution significantly 
reduces the potential for locked and crossed markets. The NASD stated 
that its proposal will reduce instances of locked/crossed markets 
because a substantial number of market participant quotes will be 
subject to automatic execution. The NASD questioned whether Bloomberg's 
proposal would be equally effective in addressing locked/crossed 
markets, especially because the system presumably would not move stale 
quotes out of the way to resolve a locked/crossed market. Rather, under 
Bloomberg's proposal, the system would continue to deliver orders and 
default to executions against a stale quote. The quote would have to be 
manually removed before the lock/cross could be resolved.\405\
---------------------------------------------------------------------------

    \405\ See Amendment No. 5, supra note 8.
---------------------------------------------------------------------------

    The Commission does not believe that Bloomberg's suggested hybrid 
approach would necessarily be as effective as the approach proposed by 
Nasdaq. A hybrid order delivery system would require the NASD to 
constantly monitor dealer executions to prevent instances of backing 
away outside of the system. It also would be less effective in 
addressing locked and crossed markets. In addition, the Commission 
notes that the NASD has represented that order delivery messages use 
significantly more message capacity than order execution messages. 
Thus, an increased reliance on automatic executions could reduce 
network traffic and increase speed and reliability of the entire Nasdaq 
market.\406\ As discussed further below, the NASD has represented that 
a system based on an automatic execution platform can be expanded 
rapidly to handle any increased volume of message traffic.\407\
---------------------------------------------------------------------------

    \406\ See NNMS Order, supra note 22.
    \407\ See Amendment Nos. 3 and 4, supra notes 5 and 6.
---------------------------------------------------------------------------

    Finally, Instinet and Bloomberg argued that the order display and 
order routing facilities of the SuperMontage should not be linked to 
the order matching facility of the SuperMontage. Instead, Instinet and 
Bloomberg believed that Nasdaq's order display and routing facilities, 
which the NASD proposes to continue operating under the SuperMontage, 
should be separate from its proposed order matching facility.\408\
---------------------------------------------------------------------------

    \408\ As Instinet stated, ``[t]he NASD's proposal unnecessarily 
ties together two distinct services provided by Nasdaq--establishing 
a mandatory linkage between (i) Nasdaq's facilities for displaying 
and making quotes accessible under the Commission's order display 
rules (i.e., the Order Handling Rules and Regulation ATS) and (ii) 
Nasdaq's new ECN-like facility for automatically matching individual 
quotes and orders.'' See Instinet Letter (emphasis in original).
---------------------------------------------------------------------------

    In the Commission's view, however, the SuperMontage not only builds 
on the order execution foundation laid by SOES and NNMS, but represents 
another step in the ongoing technological evolution of the U.S and 
global securities markets. This past year, for example, the Commission 
approved the first completely electronic options exchange, the 
International Stock Exchange.\409\ The Commission also just approved a 
proposed rule change by the New York Stock Exchange to implement NYSe 
Direct+, which would provide automatic executions for certain limit 
orders of a specified size.\410\ PCX also recently proposed to 
incorporate automatic execution into its trading platforms and create 
an electronic book for its equities business by operating the 
Archipelago Exchange as a facility of the PCX.\411\
---------------------------------------------------------------------------

    \409\ See Securities Exchange Act Release No. 42455 (February 
24, 2000), 65 FR 11401 (March 2, 2000).
    \410\ See Securities Exchange Act Release No. 43767 (December 
22, 2000), 66 FR 834 (January 4, 2001).
    \411\ See Securities Exchange Act Release No. 43608 (November 
21, 2000), 65 FR 78822 (December 15, 2000) (noticing proposed rule 
change (SR-PCX-00-25) that the Archipelago ECN become a facility of 
PCX).
---------------------------------------------------------------------------

    These market developments are consistent with--and indeed, were 
foreshadowed by Congress in--Section 11A of the Exchange Act. In 
Section 11A, Congress recognized that technology would drive 
competition among the securities markets, stating that ``[n]ew data 
processing and communications techniques create the opportunity for 
more efficient and effective market operations.'' \412\ The Commission 
believes that

[[Page 8051]]

SuperMontage proposal is consistent with Section 11A in that it 
incorporates new technological features to provide investors with the 
opportunity to receive economically efficient execution of their 
securities transactions and to promote fair and orderly markets.\413\ 
It is not only essential that investors have the ability to see the 
depth of the supply and demand in a security, but also that they have 
the ability to access the depth of the supply. The SuperMontage will 
provide a new means of accessing that liquidity.
---------------------------------------------------------------------------

    \412\ 15 U.S.C. 78k-1.
    \413\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

2. Other Issues Relating to Competition
    Several commenters expressed concerns about the NASD's dual role as 
an operator of a market (i.e., Nasdaq) and as a self-regulator.\414\ 
Specifically, one commenter believed that the NASD will use its 
regulatory powers to ``nourish the private ECN'' and thereby restrain 
competition,\415\ while another commenter believed that Nasdaq's 
regulatory privileges will inhibit competition and force market 
participants to accept what Nasdaq offers.\416\ Other commenters viewed 
the proposal as an inappropriate attempt by the NASD to compete with 
its own members' trading systems, particularly ECNs, using the revenues 
generated by those participants to finance the SuperMontage.\417\ Two 
commenters believed that the SuperMontage would receive financial 
subsidies from Nasdaq's market information revenues.\418\ Three 
commenters believed that the NASD has an inherent conflict of interest 
with respect to the competing interests of market makers and order 
entry firms.\419\ Another commenter believed that Nasdaq's interests 
will diverge from its market participants as it begins to compete with 
market makers and ECNs for executions.\420\ One commenter urged the 
Commission to supervise the NASD's ``competitive stance'' so that ``no 
unfair advantage over market participants is created or even 
perceived.''\421\ Another commenter recommended that the NASD ``divest 
itself of its residual interest in Nasdaq'' to reduce anti-competitive 
conflicts.\422\ Finally, several commenters opined that the NASD's 
conflicts of interest might become more pronounced with Nasdaq's 
announced intention to demutualize.\423\
---------------------------------------------------------------------------

    \414\ See ETA Letter; NexTrade Letter; Instinet Letter; Bancorp 
Letter; STA Letter; Bloomberg Letter; Island Letter; BRUT Letter; 
Phlx Letter; Renaissance Letter; ACIM Letter; Erfort Letter; and 
Archipelago Letter (stating that the SuperMontage will ``pose 
insurmountable conflicts''); see also Scudder Kemper Letter.
    \415\ See Bloomberg Letter; see also Renaissance Letter and 
Archipelago Letter.
    \416\ See BRUT Letter.
    \417\ See Island Letter; Instinet Letter; and NexTrade Letter; 
see also Scudder Kemper Letter.
    \418\ See NY Letter and Instinet Letter.
    \419\ See ETA Letter; Archipelago Letter; and Instinet Letter.
    \420\ See BRUT Letter.
    \421\ See STA Letter.
    \422\ See Archipelago Letter.
    \423\ See ETA Letter; Instinet Letter; Island Letter; and 
Bancorp Letter. In contrast, Archipelago believed that the conflicts 
will diminish if Nasdaq were entirely independent of the NASD.
---------------------------------------------------------------------------

    Another commenter questioned whether Nasdaq will use market data 
compiled by the NASD Automated Confirmation of Transactions (``ACT'') 
facility and OATS.\424\ This commenter argued that because ECN 
competitors of the SuperMontage will not have access to this data, 
Nasdaq should not have access to the data and should be required to 
compete on equal ground with other trading systems.\425\ To permit 
Nasdaq to use this information, the commenter argued, would allow 
Nasdaq to use its affiliation with NASD to unfairly compete for 
customer orders.\426\
---------------------------------------------------------------------------

    \424\ See Archipelago Letter; see also Renaissance Letter.
    \425\ See Archipelago Letter.
    \426\ See Archipelago Letter. See Commission discussion at 
Section V.I.3.
---------------------------------------------------------------------------

    Three commenters also expressed concern about the potential fees 
the NASD might charge for access to the SuperMontage.\427\ One 
commenter stated that the NASD would have no incentive to control costs 
associated with the SuperMontage because it would be a monopoly.\428\ 
This commenter noted that currently it costs twice as much to execute a 
trade through SelectNet as it does on the Island ECN.\429\ The 
commenter attributed the difference in cost to the fact that Island has 
competitors while SelectNet has a unique relationship with the 
NASD.\430\ The commenter opined that the fees associated with the 
SuperMontage will exceed those for SelectNet as a result of the 
monopoly created.\431\
---------------------------------------------------------------------------

    \427\ See STANY Letter; ACIM Letter; and ITG Letter. ITG 
requested clarification regarding the fees for the NODF and OCF.
    \428\ See Renaissance Letter.
    \429\ See Renaissance Letter.
    \430\ See Renaissance Letter.
    \431\ See Renaissance Letter. As discussed above, the Commission 
notes that the SuperMontage will not be the sole means for providing 
or accessing liquidity. Broker-dealers may continue to pursue other 
alternative order routing and execution services that provide value 
to their customers. As a result, the Commission believes that 
competitive pressures may limit the fees associated with the 
SuperMontage. See discussion at V.I.1.
---------------------------------------------------------------------------

    The Commission recognizes the concerns of the commenters, but notes 
that many of these conflicts are inherent in the self-regulatory model. 
Indeed, the Act specifically contemplates that SROs not only will act 
as regulators, but also will operate markets.\432\ For instance, the 
Act authorizes the Commission to oversee SRO functions to address the 
inherent conflicts of the self-regulatory model, and to attempt to 
ensure that an SRO does not secure advantages as a commercial entity by 
virtue of its regulatory authority. Among other things, the Commission 
must find that the rules of the NASD provide for fair representation of 
its members, appropriate discipline for violations of the Act, and a 
fair procedure for disciplining members.\433\ The NASD is required to 
file proposed rule changes with the Commission when it establishes 
fees, and these fees must be reasonable and equitably allocated among 
members, issuers, and other persons using any facility or system of the 
SRO in accordance with Section 15A(a)(5) of the Act.\434\ Further, NASD 
trading rules, such as the SuperMontage proposal, are subject to the 
Commission's rule review process. This process provides the opportunity 
for interested parties and the public to voice their comments and 
concerns about proposed rules to the Commission. Moreover, the 
Commission, through inspections, vigilantly monitors all SROs, 
including the NASD, for objective compliance and enforcement of their 
rules. Thus, through oversight, inspection, and provisions designed to 
ensure due process, the Act has provided, and the Commission 
implements, significant safeguards that serve to address the conflicts 
inherent in the self-regulatory model and that protect the legitimate 
interests of SRO members.
---------------------------------------------------------------------------

    \432\ Section 3(a)(26) of the Act defines an SRO as ``[a]ny 
national securities exchange, registered securities association, or 
registered clearing agency * * *.'' See 15 U.S.C. 78c(a)(26). 
Section 3(a)(1) of the Act defines an exchange as ``[a]ny 
organization, association, or group of persons * * * which 
constitutes, maintains, or provides a market place or facilities for 
bringing together purchasers and sellers of securities * * *.'' See 
15 U.S.C. 78c(a)(1).
    \433\ See 15 U.S.C. 78o-3(b)(4), (7), and (8).
    \434\ 15 U.S.C. 78o-3(a)(5). See also 15 U.S.C. 78o-3(b)(9) and 
(11), and 15 U.S.C. 78k-1(a)(1)(C). The Commission notes that the 
NASD will file a separate proposal to establish fees for the 
SuperMontage. The NASD has committed to the creation of a 
SuperMontage fee structure that does not discriminate between Nasdaq 
market participants that interact with the system on an order-
delivery versus an automatic execution basis. The NASD has also 
committed to avoiding systemic biases including biases that result 
from differential fees or incentives between quotes and orders, 
whether they are directed, non-directed, or preferenced. See 
Amendment No. 8, supra not 12.
---------------------------------------------------------------------------

    It would be inconsistent with the NASD's self-regulatory 
responsibility for

[[Page 8052]]

the NASD to use its regulatory power to advance Nasdaq's market 
interests to the detriment of its members, and the Commission intends 
to be vigilant to prevent this. As a result, the NASD will not be able 
to use its regulatory authority to act in any manner in preference to, 
or prejudice of, Nasdaq or any other stock market, marketplace, or 
market participant \435\ generally or specifically because of that 
entity's relationship to the SuperMontage or Nasdaq.\436\ For example, 
the NASD has no rule that would require the use of the SuperMontage for 
execution of orders; and such rules or interpretive positions clearly 
would be inappropriate.\437\ Further, the operation of the SuperMontage 
by an affiliate of the NASD does not validate its use to satisfy best 
execution obligations, or replace the required regular and rigorous 
review by broker-dealers of execution quality available from different 
markets. Broker-dealers will continue to have the responsibility to 
make an independent determination of how to obtain best execution of 
their customers' orders.
---------------------------------------------------------------------------

    \435\ This would not preclude the NASD from contracting with 
Nasdaq for services.
    \436\ Moreover, the NASD should not share its regulatory data 
with Nasdaq for business purposes. When Nasdaq registers as a 
national securities exchange, it will have its own regulatory 
responsibilities as an SRO separate and apart from the NASD. Market 
participants will choose whether to be members of Nasdaq or the 
NASD. In reviewing for-profit exchanges, including Nasdaq's 
proposal, the Commission is considering ways to minimize the 
potential heightened conflict of interests. See also, discussion at 
Section V.I.3, NASD as an Exclusive Securities Information 
Processor.
    \437\ For example, the fact that SOES was available in the past 
did not mean that broker-dealers were forced to use it to execute 
customer orders, nor did it free a broker-dealer from its duty to 
consider price improvement opportunities.
---------------------------------------------------------------------------

    In addition, the Commission believes that NQDS Prime should help 
eliminate any informational advantage accruing to the SuperMontage. 
Further, Nasdaq has asserted that it will not use information about the 
source and scope of a reserve size quote to influence reserve size 
execution priority within SuperMontage, or provide optimized reserve 
size executions based on information residing solely in the 
SuperMontage.\438\
---------------------------------------------------------------------------

    \438\ See Amendment No. 8, supra note.
---------------------------------------------------------------------------

    Finally, the Commission notes that, under Regulation ATS, ECNs may 
choose whether to register as national securities exchanges and become 
their own SRO, or to register as broker-dealers and comply with the 
requirements of another SRO.\439\ Today's regulatory structure is 
designed to provide all market centers with structural flexibility in 
order to enhance competition between market centers, while promoting 
market fairness, efficiency, and transparency.
---------------------------------------------------------------------------

    \439\ See Securities Exchange Act Release No. 40760 (December 8, 
1998), 63 FR 70844 (December 22, 1998). To date, two ECNs have 
applied to register as exchanges. As noted in note #411, supra, PCX 
has proposed that Archipelago become a facility of the Exchange.
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3. Nasdaq as an Exclusive Securities Information Processor
    Prior to Amendment No. 8, several commenters asserted that the 
Nasdaq as an exclusive securities information processor (``SIP'') can 
compel the submission of quotations to Nasdaq.\440\ As such, commenters 
believed that the NASD could compel the submission of orders through 
the SuperMontage.\441\ Also, two commenters stated that Nasdaq's 
proposed treatment of UTP Exchanges' principal interest is inconsistent 
with its role as the exclusive SIP, and will discourage competition 
with competing exchanges.\442\
---------------------------------------------------------------------------

    \440\ See Bloomberg Letter; Scudder Kemper Letter; Instinet 
Letter; and Archipelago Letter.
    \441\ See Bloomberg Letter; Scudder Kemper Letter; Instinet 
Letter; and Archipelago Letter.
    \442\ See Archipelago Letter and CSE Letter.
---------------------------------------------------------------------------

    Several commenters questioned whether the SuperMontage would impact 
Nasdaq in its capacity as an exclusive SIP.\443\ Archipelago stated 
that Nasdaq could use its status as an exclusive SIP to gain 
competitive advantages not available to ECNs. Specifically, Archipelago 
maintained that Nasdaq, as an exclusive SIP and the operator of the 
SuperMontage, could access the ACT and OATS systems to analyze the 
trading activity of competitive systems and the order routing practices 
of all market participants to garner competitive advantages. 
Archipelago stressed that Nasdaq, as a market operator, should not be 
allowed to compete unfairly for order flow through its role as an 
exclusive SIP. Both Archipelago and Instinet suggested that the 
SuperMontage would contravene the congressional intent that Nasdaq, as 
an exclusive information processor, act in a ``manner which is 
absolutely neutral with respect to all market centers, all market 
makers, and all private firms.'' \444\ Instinet suggested that the 
proposal, as amended, would allow Nasdaq to use its regulatory 
advantages and status as an exclusive SIP to lock in its competitive 
position in the marketplace. Archipelago suggested that Nasdaq would 
not operate in a manner that is absolutely neutral with respect to 
market centers because ECNs and UTP Exchanges would be disadvantaged by 
the SuperMontage's Order Execution Algorithm.
---------------------------------------------------------------------------

    \443\ Under Section 3(a)(22)(B) of the Act, the term ``exclusive 
processor'' is defined as a ``securities information processor * * * 
which, directly or indirectly, engages on an exclusive basis on 
behalf of any national securities exchange or registered securities 
association * * * in collecting, processing, or preparing for 
distribution or publication any information with respect to (i) 
transactions or quotations on or effected or made by means of any 
facility of such exchange or (ii) quotations distributed or 
published by means of any electronic system operated or controlled 
by such association.'' 15 U.S.C. 78c(22).
    \444\ Archipelago Letter and Instinet Letter. Also see Gramm 
Letter; Scudder Kemper Letter; ACIM Letter; and BRUT Letter.
---------------------------------------------------------------------------

    To address concerns about mandatory participation in Nasdaq, in 
publishing Amendment No. 8 for comment, the Commission noted that the 
NASD agreed to provide an alternative quotation and transaction 
reporting facility for NASD members.\445\ In response to Amendment No. 
8, several commenters expressed concern that Nasdaq's regulatory and 
competitive advantages were not adequately addressed.\446\ In 
particular, commenters indicated that Nasdaq's operation of the 
SuperMontage and status as an exclusive SIP presented a conflict of 
interest.\447\ Commenters questioned whether Nasdaq could be a truly 
voluntary facility as long as it retained its status as an exclusive 
SIP.\448\ Commenters suggested that a meaningful display alternative to 
Nasdaq for OTC securities would have to exist prior to the 
SuperMontage's implementation in order to truly make the SuperMontage 
voluntary.\449\ Commenters also asserted that the Nasdaq, as an 
exclusive SIP, is mandated by Congress to operate in a manner that is 
``absolutely neutral with respect to all market centers.'' \450\
---------------------------------------------------------------------------

    \445\ See Amendment No. 8, supra note 12.
    \446\ See Instinet Letter; Brut Letter; NY Letter; Investment 
Companies Letter; ACIM Letter; Archipelago Letter; Scudder Kemper 
Letter; and CHX Letter.
    \447\ See Instinet Letter; Brut Letter; Archipelago Letter; and 
NY Letter.
    \448\ See Instinet Letter; Brut Letter; and NY Letter.
    \449\ See Instinet Letter and Brut Letter.
    \450\ See Instinet Letter and Brut Letter (citing S. Rep. No. 
94-75, at 11-12 (1975); see also ACIM Letter; Scudder Kemper Letter; 
Archipelago Letter; and CSE Letter.
---------------------------------------------------------------------------

    One commenter questioned whether SIP neutrality was possible since 
``[o]nce Nasdaq enters the execution business, it itself becomes a 
market center. * * *'' \451\ One commenter stated that the only way 
Nasdaq could fulfill the dual roles of a securities market and 
exclusive SIP would be to treat NASD members and UTP Exchanges 
equally.\452\ Another

[[Page 8053]]

commenter stated that the SuperMontage should be approved only within 
the context of a broader program of reform of Nasdaq's role in OTC 
market structure that leaves Nasdaq to compete on the merits of its 
technology and vision with no regulatory advantages.\453\ Some 
commenters suggested that if Nasdaq was not required to divest itself 
of its SIP status, irreparable harm could be done to the competitive 
landscape for Nasdaq traded securities.\454\
---------------------------------------------------------------------------

    \451\ See Brut Letter.
    \452\ See CHX Letter.
    \453\ See Brut Letter.
    \454\ See Instinet Letter and Brut Letter.
---------------------------------------------------------------------------

    One commenter expressed concern that if Nasdaq becomes a registered 
exchange, stocks traded on Nasdaq would be excluded from the NASD 
display alternative.\455\ Instinet stated that a neutral and viable 
alternative facility for all Nasdaq stocks with sufficient 
technological resources should be available prior to approval of the 
SuperMontage. Instinet also believed that Nasdaq's role as SIP for 
Nasdaq-listed securities should be discontinued \456\ and the SIP for 
Nasdaq securities should not be affiliated with any market center. 
Instinet said that ownership, governance, and market data revenue of 
such a SIP should be broadly shared among market centers or vested 
through a competitive bidding process. Instinet also stated that all 
market centers should have direct access to the SIP's facilities and 
that its order routing and execution functions should not privilege any 
market center's individual liquidity pool over another's.
---------------------------------------------------------------------------

    \455\ See Instinet Letter. The Commission notes that the NASD 
has committed to provide an alternative quotation and transaction 
reporting facility for its members who transact business in the 
residual over-the-counter (``OTC'') market. The term residual OTC 
market ``refers to transactions by NASD members otherwise than on an 
exchange or Nasdaq, in securities listed on an exchange or Nasdaq, 
but not reported elsewhere. See letter from Robert Glauber, Chief 
Executive Officer and President, NASD, to Arthur Levitt, Chairman, 
Commission, dated December 13, 2000.
    \456\ See also Archipelago Letter.
---------------------------------------------------------------------------

    In the early 1970's, the Commission took the initial steps toward 
creating a central market system in which investors would have access 
to information from all markets. Congress adopted this fundamental 
policy determination when it enacted the Securities Acts Amendments of 
1975 (``1975 Amendments'').\457\ To implement the national market 
system, the Commission has required the SROs to act jointly pursuant to 
various national market system plans in disseminating consolidated 
market information. These plans govern all aspects of the arrangements 
for disseminating market information. Among other things, they require 
the individual SROs to funnel market information to a central 
processor, which then consolidates the information into a single stream 
for dissemination to the public. In this way, the public is assured of 
access to a highly reliable source of information that is fully 
consolidated from all the various market centers that trade a 
particular security.
---------------------------------------------------------------------------

    \457\ Pub. L. 94-29, 89 Stat. 97 (1975).
---------------------------------------------------------------------------

    Currently, Nasdaq is registered with the Commission as an exclusive 
SIP under Section 11A(b) of the Act.\458\ Nasdaq functions as an 
exclusive processor in two separate but closely related activities. 
First, it is responsible for the collection of quotation and 
transaction information for the OTC market in Nasdaq-listed securities 
pursuant to NASD rules. And, second, it is the processor for the UTP 
Plan.
---------------------------------------------------------------------------

    \458\ See 15 U.S.C. 78k-1(b).
---------------------------------------------------------------------------

    The UTP Plan was jointly developed and negotiated by its 
participants, the American Stock Exchange (``AMEX''), CHX, NASD, PCX, 
and the Phlx.\459\ The UTP Plan provides for an Operating Committee 
composed of one representative for each participant. The 
responsibilities of the Operating Committee include oversight of the 
consolidation and dissemination of quotation information and 
transaction reports, evaluating the processor, and determining cost 
allocation and revenue sharing. The Operating Committee, by majority 
vote of the full participants, also may terminate the processor, for 
cause, if it determines that the processor has failed to perform its 
functions in a reasonably acceptable manner, or that its reimbursable 
expenses have become excessive and are not justified on a cost 
basis.\460\
---------------------------------------------------------------------------

    \459\ AMEX has withdrawn from the UTP Plan. The Boston Stock 
Exchange (``BSE'') is a limited participant. A ``limited 
participant'' is a national securities exchange whose participation 
in the Nasdaq/UTP Plan is restricted to reporting market 
information. Recently, CSE became a full participant in the UTP 
Plan.
    \460\ The UTP Plan terminates in March, 2001. See discussion 
below regarding the need to re-evaluate the plan in light of market 
changes.
---------------------------------------------------------------------------

    Under NASD Rules, Nasdaq, acting on behalf of the NASD, collects 
and prepares for distribution information concerning quotations and 
transactions in the OTC market for Nasdaq-listed securities, including 
Nasdaq National Market System Securities and Nasdaq Small Cap 
securities. Under the UTP Plan, information concerning quotations and 
transactions in participant exchange markets for Nasdaq National Market 
System securities, but not for Nasdaq Small Cap securities, is 
collected and consolidated by Nasdaq with the information collected by 
Nasdaq on behalf of NASD. Amendments to the NASD's rules (including 
changes in market information fees relating to all Nasdaq System 
securities) are subject to Commission review under Section 19(b) of the 
Exchange Act.\461\ Amendments to the Nasdaq/UTP Plan are subject to 
Commission review under Rule 11Aa3-2.\462\ Participants may withdraw 
from the UTP Plan with thirty days' prior written notice.
---------------------------------------------------------------------------

    \461\ Exchange Act Rule 11Aa3-2 establishes the procedures that 
govern amendments to each of the Plans. In addition, Section 19(b) 
of the Act, and Rule 19b-4 thereunder, govern proposed rule changes 
by the NASD that relate to the Nasdaq System. In general, all 
amendments to the Plans and NASD rules must be filed with the 
Commission, published for public comment, and approved by the 
Commission.
    \462\ See 17 CFR 11Aa3-2.
---------------------------------------------------------------------------

    The Commission appreciates concerns about Nasdaq's status as an 
exclusive SIP, because at the heart of the commenters' exclusive SIP 
argument is the concern that Nasdaq's role as an exclusive SIP compels 
SuperMontage participation. To address concerns that Nasdaq has an 
advantage as the mandatory collector of quotes and trade data for over-
the-counter market participants, and thus, that the SuperMontage would 
be involuntary, the NASD has committed to provide NASD members with the 
ability to opt-out of the SuperMontage by providing an alternative 
quotation and transaction reporting facility for NASD members. This 
would allow NASD members to publish quotes and effect transactions in 
the over-the-counter market, but not to participate in the OCF function 
of the SuperMontage.\463\ The facility would be designed to allow NASD 
members to meet their obligations under the SEC's Order Handling Rules 
and Regulation ATS, as well as any transaction reporting obligations 
imposed by NASD rules. The NASD intends its display alternative, which 
would be operational contemporaneously with the SuperMontage, to 
provide a market-neutral electronic linkage to the Nasdaq, as well as 
other marketplaces. Thus, Nasdaq's functions as the mandatory over-the-
counter data collector will be disentangled from its roles as a self-
regulator and market operator.
---------------------------------------------------------------------------

    \463\ See letter from Robert Glauber, Chief Executive Officer 
and President, NASD, to Arthur Levitt, Chairman, Commission, dated 
December 13, 2000.
---------------------------------------------------------------------------

    The Commission believes that the NASD display alternative should 
help assuage concerns about Nasdaq's competitive advantages, and 
further distinguish its status as a trading market and the collector of 
over-the-counter quotes and trades. The Commission, therefore, is 
conditioning its approval of

[[Page 8054]]

the SuperMontage on the following, which must be implemented prior to 
or at the same time as the SuperMontage: (1) that the NASD will offer a 
quote and trade reporting alternative that satisfies the Order Handling 
Rules, Regulation ATS, and other regulatory requirements for ATSs, 
ECNs, and market makers; (2) that NASD quotes disseminated through the 
exclusive SIP will identify the ATS, ECN, or market maker source of the 
quote; and (3) that participation in SuperMontage will be entirely 
voluntary, because NASD quotes will be included in the Nasdaq quotation 
management system while Nasdaq is the exclusive SIP, but only for 
display purposes, and the NASD will provide access to its quotes on a 
market-neutral basis.
    The commenters' other concerns about Nasdaq's role as central 
processor are, in fact, criticisms generally of the current structure 
for providing consolidated data. They also blur the distinction between 
the roles of Nasdaq as SIP for Nasdaq's own market, and Nasdaq's role 
as exclusive processor for all markets trading Nasdaq-listed 
securities. The operation of SuperMontage's trading system does not 
depend on Nasdaq's exclusive processor function; rather, UTP Exchanges 
need not participate in any aspect of Nasdaq other than its 
consolidation of quotes and trade information. As noted previously, 
this consolidation function grew out of Nasdaq's origination of this 
market. It is subject to renegotiation of the markets trading Nasdaq 
securities, and as mentioned previously, Nasdaq has indicated that it 
is willing to confer with all relevant parties about establishing an 
independent exclusive SIP that is jointly owned by the exchanges that 
trade Nasdaq securities.\464\
---------------------------------------------------------------------------

    \464\ See letter from Frank Zarb, Chairman and CEO, Nasdaq, to 
Senator Phil Gramm, dated October 24, 2000. The UTP Plan outlines 
the responsibilities of UTP Plan participants but does not provide a 
comprehensive or exclusive set of terms that govern the interaction 
of the markets. Because the UTP Plan only covers distribution and 
other basic terms, it is not uncommon for the NASD and UTP Plan 
Participants to negotiate terms for dealing with each other separate 
from the UTP Plan. For instance, the NASD negotiated the terms of 
participation in the OCF function of SuperMontage with the UTP 
Plan's only active participant, the CHX. See Amendment No. 4, supra 
note 6. In addition, Nasdaq discussed with Archipelago its 
participation in the OCF function as a UTP Exchange in light of the 
proposal for Archipelago to become a facility of the PCX.
---------------------------------------------------------------------------

    As a separate policy matter, and in light of commenters' concerns, 
the Commission believes that it is now appropriate for the NASD and the 
UTP Exchanges to re-evaluate the UTP Plan.\465\ The Commission notes 
that the SuperMontage is being implemented in conjunction with several 
other market initiatives, such as Nasdaq becoming an exchange,\466\ and 
further, that more exchanges may begin trading Nasdaq securities in the 
near future. In light of the foregoing and the fact that the UTP Plan 
will be coming up for renewal and consideration by the Commission 
within the next few months, the Commission believes that it is 
appropriate to discuss its concerns regarding the UTP Plan in the 
context of this Order to initiate a dialog among the UTP Plan 
participants.
---------------------------------------------------------------------------

    \465\ The Commission notes that its discussion of possible 
changes to the UTP Plan should not be interpreted as necessary pre-
conditions to the implementation of the SuperMontage.
    \466\ See Form 1 submitted on November 9, 2000.
---------------------------------------------------------------------------

    Accordingly, the Commission intends to require as a condition for 
extending the existing plan beyond the March, 2001 termination date, 
that there be good faith negotiations among the plan participants on a 
revised plan for Nasdaq securities that provides for either (i) a fully 
viable alternative exclusive SIP for all Nasdaq securities, or (ii) a 
fully viable alternative non-exclusive SIP in the event that the plan 
does not provide for an exclusive SIP. If the revised plan provides for 
an exclusive consolidating SIP, a function currently performed by 
Nasdaq, the Commission believes that, in order to avoid conflicts of 
interest, there should be a presumption that a plan participant, and in 
particular Nasdaq, should not operate such exclusive consolidating SIP. 
The presumption may be overcome if: (i) The plan processor is chosen on 
the basis of bona fide competitive bidding and the participant submits 
the successful bid; and (ii) any decision to award a contract to a plan 
participant, and any ensuing review or renewal of such contract, is 
made without that plan participant's direct or indirect voting 
participation. If a plan participant is chosen to operate such 
exclusive SIP, the Commission believes there should be a further 
presumption that the participant-operated exclusive SIP shall operate 
completely separate from any order matching facility operated by that 
participant and that any order matching facility operated by that 
participant must interact with the plan-operated exclusive SIP on the 
same terms and conditions as any other market center trading Nasdaq 
listed securities. Further, the Commission will expect the NASD to 
provide direct or indirect access to the alternative SIP, whether 
exclusive or non-exclusive, by any of its members that qualifies, and 
to disseminate transaction information and individually identified 
quotation information for these members through the SIP.
    The Commission believes that the revised plan should be open to all 
SROs and that the plan should share governance of all matters subject 
to the plan equitably among the SRO participants. The plan should 
provide for sharing of market data revenues among SRO participants. The 
Commission also believes the Plan should provide a role for 
participation in decision making to non-SROs that have direct or 
indirect access to the alternative SIP provided by NASD.
    If negotiations among plan participants do not produce a revised 
plan within six months from the date of this order,\467\ the Commission 
intends promptly to amend the plan directly in a manner consistent with 
the foregoing.
---------------------------------------------------------------------------

    \467\ The Commission will consider allowing an additional 3 
months for negotiation if it is requested by the participants for 
good cause.
---------------------------------------------------------------------------

    The Commission also recognizes that the NASD, in its regulatory 
capacity, can obtain sensitive market data that could benefit Nasdaq's 
market operation if used for competitive purposes. Thus, the Commission 
has received assurances from Nasdaq that it will not use OATS data to 
gain an unfair competitive advantage over other market 
participants.\468\ The Commission will maintain vigilant oversight of 
this matter. In addition, in response to the concern that Nasdaq could 
accrue an unfair informational advantage through the SuperMontage, the 
filing was amended to provide, on a real-time basis, all individual 
attributable quote and order information at the three best price levels 
displayed in the NODF through NQDS Prime, and to identify the sender of 
all directed orders, delivered non-directed orders, and delivered 
preferenced orders.\469\ The Commission believes that these provisions 
help to address commenter concerns, and demonstrate the NASD's intent 
not to impose any burden on competition not necessary or appropriate in 
furtherance of the purposes of the Act.\470\
---------------------------------------------------------------------------

    \468\ See Amendment No. 9, supra note 14.
    \469\ See Amendment No. 8, supra note 12.
    \470\ 15 U.S.C. 78o-3(b)(9).
---------------------------------------------------------------------------

    Notwithstanding the above, the Commission recognizes that the 
ongoing evolution of the securities industry requires that traditional 
interaction of market participants be reevaluated, and may necessitate 
fundamental structural change. In that regard, the Commission is 
reviewing SIP and market information

[[Page 8055]]

arrangement issues in a context separate from the SuperMontage, and has 
initiated a Market Data Advisory Committee under the Federal Advisory 
Committee Act. The Commission will continue to consider market data 
issues, including through its Advisory Committee on Market Data. The 
Commission may adopt alternative market data approaches that supersede 
the need for the UTP Plan discussed previously.
4. Commission's Conclusion on Competition Issues
    The Commission believes that Nasdaq and traditional exchanges must 
have the flexibility to rethink their structures to permit appropriate 
responses to the rapidly changing marketplace. Congress instructed the 
Commission to seek to ``enhance competition and to allow economic 
forces, interacting with a fair regulatory field, to arrive at 
appropriate variation in practices and services.'' \471\ The Commission 
finds that the SuperMontage is consistent with these goals in that it 
is reasonably designed to promote price discovery, best execution, 
liquidity, and market innovation, while continuing to preserve 
competition among market centers.
---------------------------------------------------------------------------

    \471\ See Senate Report at p. 8, supra note 37.
---------------------------------------------------------------------------

    In addition, the Commission finds that the SuperMontage does not 
unfairly discriminate among brokers and dealers. First, the Commission 
notes that the proposal was amended to eliminate distinctions between 
automatic execution participants and order delivery participants with 
regard to order execution priority. Second, the proposal always has 
provided ECNs with the opportunity to participate either as automatic 
execution ECNs or order delivery ECNs.\472\ Third, the NASD amended the 
proposal to allow ECNs, market makers, and UTP Exchanges to accept 
Liability Orders through the directed order process. Further, the NASD 
amended the proposal to have the execution algorithm default to a 
price/time priority algorithm and allow executions based on priorities 
other than access fees. By providing ECNs with the option of automatic 
execution or order delivery, by amending the directed order process, by 
revising the Order Execution Algorithms, and by giving ECNs that accept 
automatic executions the ability to request a cancellation in order to 
avoid dual liability, the Commission believes that the NASD has made 
reasonable efforts to ensure that ECNs will have the ability to 
participate fairly in the SuperMontage.\473\
---------------------------------------------------------------------------

    \472\ Amendment No. 6 to the proposal makes clear that UTP 
Exchanges have a similar option. See note 9, supra.
    \473\ The Commission also notes that like today, all ECNs (even 
if they are order delivery participants in the system) will be able 
to automatically execute against market maker quotes. In addition, 
order delivery ECNs will continue to receive messages that include 
the identity of the market participant hitting their quote. See 
Amendment No. 8, supra note 12.
---------------------------------------------------------------------------

    The Commission again notes that mandatory market maker 
participation in automatic execution is not new. Mandatory market maker 
participation in automatic executions has been a characteristic of the 
Nasdaq market since the 1988 SOES modifications. The Commission 
believes that many of the same principles that served as a catalyst for 
the 1988 SOES modifications currently exist, including speed and 
certainty of executions at the best displayed price, market liquidity 
and depth, investor protection in fast moving or volatile markets, and 
the maintenance of investor confidence. These continue to be reasons 
for automatic executions in the Nasdaq market today.
    In the Commission's view, Nasdaq has the right to seek a more 
efficient model of doing business. Nasdaq, like other markets and 
market participants, must be permitted to innovate and adjust to the 
dynamic nature of today's securities industry. The Commission believes 
that the NASD has developed a reasonable system architecture for the 
SuperMontage that attempts to strengthen its market while accommodating 
the business operations and interests of all Nasdaq Quoting Market 
Participants, and without unfairly discriminating against UTP 
exchanges. The Commission finds that the proposal is consistent with 
Section 15A(b)(9) of the Act in that it does not impose any burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Act.\474\ In short, the Commission concludes that the 
SuperMontage represents a market innovation that is likely to 
strengthen the Nasdaq market while leaving room for further market 
initiatives by competing markets and Nasdaq market participants.
---------------------------------------------------------------------------

    \474\ 15 U.S.C. 78o-3(b)(9).
---------------------------------------------------------------------------

J. Technology Issues

    Many aspects of the proposal will require significant technological 
changes to the present system architecture, particularly the NODF and 
the OCF. Several commenters expressed concern about the NASD's 
technological capability to implement the proposal, particularly in 
light of Nasdaq's past system delays and outages, the increased message 
traffic that could be created by the proposal, and other changes, such 
as decimalization.\475\ Commenters called for Nasdaq to improve its 
technology and capacity prior to implementing the present changes; to 
provide assurances that the systems can accommodate any foreseeable 
market conditions; and to correct any present deficiencies before 
embarking on the implementation of the SuperMontage.\476\ In addition, 
one commenter believed that all systems specifications should be made 
available for public inspection and comment.\477\ Finally, one 
commenter expressed the concern that because proposed NASD Rule 4705(g) 
relieves Nasdaq of all liability for losses stemming from use of the 
SuperMontage, Nasdaq has no incentive to prevent outages.\478\ Given 
this, the commenter recommended that there be rigid oversight over 
Nasdaq's system performance.\479\
---------------------------------------------------------------------------

    \475\ See ITAC Letter; ETA Letter; Bancorp Letter; Bloomberg 
Letter; STA Letter; STANY Letter; NexTrade Letter; Salomon Smith 
Barney Letter; Instinet Letter; and MSDW Letter; see also CHX 
Letter; Renaissance Letter; and ACIM Letter.
    \476\ See ETA Letter; Bancorp Letter; STANY Letter; STA Letter; 
Salomon Smith Barney Letter; Instinet Letter; and NexTrade Letter.
    \477\ See Bloomberg Letter.
    \478\ See Archipelago Letter.
    \479\ See Archipelago Letter.
---------------------------------------------------------------------------

    In response, the NASD stated that, like the commenters, it 
seriously considered the impact of the increase in trading volume from 
the new system, and the corresponding stress that such an increase 
could place on Nasdaq's computer systems.\480\ The NASD explained that 
the NODF has been designed, and will be constructed, around a state-of-
the-art ``scaleable'' architecture that Nasdaq can easily expand to 
meet future demands on the system. Specifically, the NASD represented 
that the new architecture for the NODF does not have the limitations 
associated with the underlying systems for SOES and SelectNet. The NODF 
architecture has been developed to provide for full horizontal 
scalability. This means that Nasdaq will be able to run multiple 
replications of the NODF/NNMS system, called ``Security Processors.'' 
Each Security Processor will contain the entire NODF/NNMS functionality 
to support the quotes, executions, and orders for a given subset of 
Nasdaq securities. The Security Processors will not communicate with 
one another in

[[Page 8056]]

the processing of quotes, executions, or orders. In addition, the NASD 
noted that Security Processors could be added, as necessary, to allow 
the system to expand and increase in capacity as volume grows. The NASD 
stated that the scaleable Security Processor approach should eliminate 
several different problems that market participants currently 
encounter, including (1) delays for current users; (2) delays in 
updating quotes to reflect an execution; and (3) performance problems 
associated with SelectNet. For the same reasons, the NASD is confident 
that the NODF will be able to meet all capacity requirements for 
decimal pricing in the U.S. securities markets.\481\
---------------------------------------------------------------------------

    \480\ Nasdaq also noted that while market participants may give 
Nasdaq multiple levels of orders for display in the system, they are 
not required to do so. Market participants may opt to give Nasdaq 
only their top of file--as they do today--as long as they comply 
with the Commission's Order Handling Rules.
    \481\ See Amendment No. 5, supra note 8.
---------------------------------------------------------------------------

    Further, according to the NASD, the proposed system will not be 
affected by any announced capacity constraints on Nasdaq's systems 
because the NODF is based on a different architecture, as described 
above. Therefore, the capacity constraints Nasdaq experiences with its 
current architecture will not affect the development or operation of 
the NODF architecture.
    In Amendment No. 5, the NASD further stated that construction of 
the proposed system has not diverted resources from its continuing 
decimalization efforts. The NASD emphasized that it has not and will 
not, in any way, divert technology resources from its decimalization 
efforts. The NASD represented that the system development team consists 
of personnel that are exclusively dedicated to the proposed system and 
are completely separate from other Nasdaq software teams. In addition, 
the NASD stated that it uses outside consultants to augment internal 
staff where needed.
    Specifically, according to the NASD, the SuperMontage is being 
built using the Tandem System. On the other hand, Nasdaq is modifying 
its existing Unisys-based quotation platform to accommodate decimal 
pricing, and that project is staffed with a dedicated Unisys-based 
development team.\482\ The NASD asserted that personnel resources for 
decimals will take complete priority over other Nasdaq projects, 
including the SuperMontage.\483\
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    \482\ The NASD represented that there are 30 programmers who are 
dedicated to Nasdaq's efforts to achieve decimals. Nasdaq explained 
that these resources will not be used or otherwise diverted from its 
efforts to achieve trading in a decimal environment, nor will other 
resources related to achieving decimalization--such as quality 
assurance and testing personnel--be used at the expense of 
completing decimalization efforts.
    \483\ The NASD also explained that the SuperMontage uses 
dedicated Tandem computing resources for development and integration 
testing while sharing the actual production testing facilities with 
other Tandem-based applications. The decimalization of other Tandem 
legacy applications, such as SOES, SelectNet, and ACT, use different 
resources.
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    Further, the NASD's international development efforts have been 
out-sourced to separate and distinct teams, with only two individuals 
coming from existing NASD staff--neither of whom were involved in any 
related Nasdaq market systems. All systems development for the 
international markets is being performed by a joint venture company and 
has no impact on domestic Nasdaq development or resources.\484\ 
Finally, in response to the concerns of some commenters, Nasdaq will 
attempt to roll out the system on a measured basis.\485\
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    \484\ All NASD and NASD Regulation activities have been out-
sourced to Electronic Data Systems, which relieves the Nasdaq team 
of any billing or administrative technology burdens. Systems 
development for the American Stock Exchange is managed by a fully 
independent team that is now out-sourced to SIAC.
    \485\ On a temporary basis, it will be possible to operate the 
NODF side-by-side with the NNMS and SmallCap SOES systems, and for a 
security to trade on either the NODF or the NNMS/SmallCap SOES, but 
not both simultaneously. In Amendment No. 5, the NASD described the 
roll out of the system in greater detail. See Section III.K, supra.
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    After considering the above representations, the Commission 
believes that the NASD has provided the appropriate assurance that 
Nasdaq has a plan to address the technological concerns and objections 
raised about the SuperMontage. The Commission notes the importance of 
the reliability of systems capability and capacity to investors, market 
intermediaries, and the markets as a whole. The Commission expects the 
NASD and Nasdaq to continually evaluate and monitor the development of 
the SuperMontage and to implement any additional technological changes 
as necessary before fully implementing the system. The Commission also 
expects the NASD to demonstrate that the development and capabilities 
of the system satisfy the Commission's Automation Review Policy \486\ 
before implementing the proposed system. In particular, the Commission 
expects the NASD to provide to the Commission staff documentation 
called for in ARP II relating to systems change notifications, 
including, but not limited to: (1) Capacity estimates; (2) test plans 
and schedules; (3) contingency protocols; (4) vulnerability 
assessments; and (5) production schedules (e.g., project management and 
task schedules). The Commission expects the NASD to provide this 
information as it is developed and prior to testing, as appropriate, 
and to update periodically this information, including a description of 
all test results.
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    \486\ See Securities Exchange Act Release Nos. 27445 (November 
16, 1989), 54 FR 48703 (November 24, 1989) and 29185 (May 9, 1991), 
56 FR 22490 (May 15, 1991) (``ARP II'').
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    Finally, the Commission notes that the NASD has provided assurance 
that technological resources will not be diverted from Nasdaq's 
decimalization efforts to any other Nasdaq initiative, including the 
current proposal. In any case, the Commission notes that the NASD has 
committed to delaying implementation of the proposed system until after 
the full implementation of decimal pricing.\487\
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    \487\ See Amendment No. 6, supra note 9.
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K. Impact on Competition, Efficiency and Capital Formation

    Section 3(f) of the Act requires that the Commission consider 
whether the NASD's proposal will promote efficiency, competition, and 
capital formation.\488\ As discussed above, the Commission has 
carefully considered the merits of the issues raised by each of the 
commenters, and has concluded that the design of SuperMontage, in 
conjunction with the conditions imposed by the Commission, attempts to 
accommodate all Nasdaq market participants and does not prohibit the 
development of other trading systems or market innovation. The 
Commission believes that the SuperMontage is a reasonable effort by the 
NASD to enhance the quality of the Nasdaq market by providing more 
information to investors, promoting greater efficiency in executions, 
and increasing overall market transparency. While the SuperMontage will 
provide a central means for accessing liquidity in Nasdaq stocks, it 
does not represent an exclusive means, nor does it prevent broker-
dealers from seeking alternative order routing and execution services. 
In addition, the Commission believes that the proposal should promote 
competition and capital formation by providing market makers and ECNs 
with several quote and order management options (e.g., unattributable 
quotes and reserve size), and by providing ECNs and UTP Exchanges the 
ability to participate in the SuperMontage as either automatic 
execution participants or order delivery participants.\489\
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    \488\ 15 U.S.C. 78c(f).
    \489\ 15 U.S.C. 78c(f).
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VI. Amendment No. 9

    In Amendment No. 9, the NASD selected how preferenced orders would 
be processed. Under the Amendment, preferenced orders will be executed 
only if the preferenced Nasdaq Quoting Market Participant or UTP 
Exchange is

[[Page 8057]]

at the BBO. This limitation ensures that customers will always receive 
executions at the BBO and should assist broker-dealers in fulfilling 
their best execution obligations. The Commission notes that those 
market participants wishing to access a Nasdaq Quoting Market 
Participant or UTP Exchange outside of the BBO may submit directed 
orders through the system or submit orders outside of Nasdaq (via 
private links or through ECNs).
    The Commission finds that Amendment No. 9 is consistent with 
Section 15A(b)(6) of the Act,\490\ which requires that the rules of an 
association be designed to promote just and equitable principles of 
trade and to remove impediments to and perfect the mechanism of a free 
and open market and a national market system. The Commission also finds 
good cause to approve Amendment No. 9 to the proposed rule change prior 
to the thirtieth day after the date of publication of notice of filing 
of the amendment in the Federal Register. Specifically, Amendment No. 9 
merely withdraws one alternative to the processing of preferenced 
orders, which was noticed in Amendment No. 8, and makes a technical 
correction to the definition of preferenced orders to make the 
definition conform with the description of how preferenced orders are 
processed against displayed quote/orders and reserve size, as well as 
represent that Nasdaq will not use OATS data to gain an unfair 
competitive advantage over other market participants. The Commission 
notes that in Amendment No. 8 the NASD specifically sought comment on 
two possible alternatives for processing preferenced orders with the 
clear intention of withdrawing one of the alternatives. Further, the 
Commission notes that the description in Amendment No. 8 made clear 
that preferenced orders would be processed against displayed quote/
orders and reserve size. Accordingly, the Commission believes that 
there is good cause, consistent with Sections 15A(b)(6) and 19(b) of 
the Act \491\ to approve Amendment No. 9 to the proposal on an 
accelerated basis.
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    \490\ 15 U.S.C. 78o-3(b)(6).
    \491\ 15 U.S.C. 78o-3(b)(6) and 78s(b).
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VII. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 9, including whether Amendment No. 9 
is 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 at the Commission's 
Public Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the Exchange. All 
submissions should refer to File No. SR-NASD-99-53 and should be 
submitted by February 16, 2001.

VIII. Conclusion

    For the reasons discussed above, the Commission finds that the 
SuperMontage proposal, as amended, is consistent with the requirements 
of the Act (specifically, Sections 3, 11A, and 15A of the Act) and the 
rules and regulations thereunder applicable to a national securities 
association.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\492\ that the SuperMontage proposal (SR-NASD-99-53), as amended, 
be and hereby is approved.
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    \492\ 15 U.S.C. 78s(b)(2).

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-2381 Filed 1-25-01; 8:45 am]
BILLING CODE 8010-01-P