[Federal Register Volume 67, Number 160 (Monday, August 19, 2002)]
[Notices]
[Pages 53826-53828]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-20977]



[[Page 53826]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46341; File No. SR-NASD-2002-76]


Self-Regulatory Organizations; Notice of Filing and Immediate 
Effectiveness of a Proposed Rule Change and Amendment Nos. 1 and 2 by 
the National Association of Securities Dealers, Inc. Relating to 
Interpretive Material 4613 and Computer Generated Quoting

August 12, 2002.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on June 13, 2002, the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association''), through its subsidiary, the Nasdaq Stock 
Market, Inc. (``Nasdaq''), filed with the Securities and Exchange 
Commission (``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by Nasdaq. 
On July 29, 2002, Nasdaq filed an amendment to the proposed rule 
change.\3\ On August 8, 2002, Nasdaq filed another amendment to the 
proposed rule change.\4\ As amended, the proposal is effective upon 
filing with the Commission, pursuant to section 19(b)(3)(A) of the 
Act,\5\ and Rule 19b-4(f)(1) thereunder.\6\ The Commission is 
publishing this notice to solicit comments on the proposed rule change, 
as amended, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Peter R. Geraghty, Associate Vice President 
and Associate General Counsel, Nasdaq, to Katherine England, 
Assistant Director, Division of Market Regulation (``Division''), 
Commission (``Amendment No. 1''). Amendment No. 1 clarifies that 
Nasdaq will summarily suspend a market maker's quoting activity if 
necessary to preserve capacity and to protect investors and the 
public interest. For example, Nasdaq will suspend a market maker's 
quoting activity if the performance of Nasdaq's market was in 
jeopardy and, after attempting to contact the market maker, the 
market maker failed to voluntarily suspend its computer generated 
quoting activity.
    \4\ See letter from Peter R. Geraghty, Associate Vice President 
and Associate General Counsel, Nasdaq, to Lisa Jones, Attorney, 
Division, Commission (``Amendment No. 2''). Amendment No. 2 
clarifies in the purpose section of the proposal that Nasdaq will 
give market makers advance notice should the standards for using 
computer generated quoting systems change. Amendment No. 2 also 
makes a technical amendment to the rule text of the proposal.
    \5\ 15 U.S.C. 78s(b)(3)(A).
    \6\ 17 CFR 240.19b-4(f)(1). For purposes of calculating the 60-
day abrogation period, the Commission considers the period to begin 
as of the date Nasdaq filed Amendment No. 1, July 29, 2002.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    Nasdaq proposes to amend NASD Interpretive Material 4613 (``IM-
4613'') to codify an interpretation concerning the extent to which IM-
4613 applies to computer generated quoting (``CGQ'') that is not 
designed to update a market maker's quote automatically to keep the 
market maker away from the inside market. Specifically, Nasdaq proposes 
to (1) define the term ``Computer Generated Quoting,'' (2) clarify that 
CGQ is generally prohibited, and (3) provide that market makers can 
engage in CGQ if such activity is consistent with the intent of IM-
4613. Nasdaq has also developed certain standards that a market maker 
must meet to engage in CGQ. According to Nasdaq, these standards are 
based on Nasdaq's experience with two market makers that recently began 
utilizing CGQ systems,\7\ and are designed to preserve the integrity of 
Nasdaq's systems and protect investors and the public interest. Below 
is the text of the proposed rule change. Proposed new language is in 
italics.
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    \7\ Nasdaq staff recently issued two letters indicating that the 
market makers could utilize CGQ systems that are consistent with IM-
4613. See letters from Edward S. Knight, Executive Vice President 
and General Counsel, Nasdaq, to Thomas Peterffy, Chairman, Timber 
Hill LLC, dated November 14, 2001; and to Richard J. McDonald, 
Compliance Director, Susquehanna Capital Group, dated April 23, 
2002.
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* * * * *

IM-4613--Autoquote Policy

    (a) General Prohibition--The Association has extended a policy 
banning the automated update of quotations by market makers in Nasdaq. 
Except as provided below, this policy prohibits systems known as 
``autoquote'' systems from effecting automated quote updates or 
tracking of inside quotations in Nasdaq. This ban is necessary to 
offset the negative impact on the capacity and operation of Nasdaq of 
certain autoquote techniques that track changes to the inside quotation 
in Nasdaq and automatically react by generating another quote to keep 
the market maker's quote away from the best market.
    (b) Exceptions to the General Prohibition--Automated updating of 
quotations is permitted when: (1) The update is in response to an 
execution in the security by that firm (such as execution of an order 
that partially fills a market maker's quotation size), and is in 
compliance with Rule 4613(b)(2); (2) it requires a physical entry (such 
as a manual entry to the market maker's internal system which then 
automatically forwards the update to Nasdaq); (3) the update is to 
reflect the receipt, execution, or cancellation of a customer limit 
order; or (4) an electronic communications network as defined in SEC 
Rule 11Ac1-1(a)(8) is required to maintain a two-sided quotation in 
Nasdaq for the purpose of meeting Nasdaq system design requirements.
    (c) Computer Generated Quoting--
    (1) Definition--``Computer Generated Quoting'' means the practice 
of effecting, without a physical entry, a quote update that is not 
designed to keep a market maker's quote away from the Nasdaq and/or 
national best bid/best offer, but does not include the activity set 
forth in subparagraph (b) of this interpretive material.
    (2) Prohibition--The prohibitions against autoquoting contained in 
paragraph(a) of this interpretative material, shall also apply to the 
practice of Computer Generated Quoting, unless the market maker meets 
the conditions in subparagraph (c)(3) of this interpretive material.
    (3) Exception--A market maker may engage in the practice of 
Computer Generated Quoting if the market maker: Prior to engaging in 
such activity provides Nasdaq a description of its Computer Generated 
Quoting system; requests and obtains written interpretive relief from 
Nasdaq staff stating that the market maker's Computer Generated Quoting 
system is permissible under Interpretive Material 4613; and complies 
with terms that are set forth in the interpretive relief. In 
establishing terms of the interpretive relief, Nasdaq shall consider 
the applicant's impact on Nasdaq's capacity, in conjunction with the 
overall impact on Nasdaq's capacity of existing Computer Generated 
Quoting systems authorized by Nasdaq, as well as the protection of 
investors and the public interest. If a market maker that engages in 
Computer Generated Quoting fails to comply with the terms set forth in 
the interpretive relief, Nasdaq may summarily modify or revoke the 
interpretive relief and/or summarily suspend such quoting activity if 
necessary to preserve capacity and to protect investors and the public 
interest.
* * * * *

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

    In its filing with the Commission, Nasdaq included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements

[[Page 53827]]

may be examined at the places specified in Item IV below. Nasdaq has 
prepared summaries, set forth in Sections A, B, and C below, of the 
most significant aspects of such statements.

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

    Nasdaq believes that the underlying purpose of IM-4613 is to 
preserve the integrity of Nasdaq's systems by prohibiting automated 
quoting activity that does not contribute to the depth and liquidity of 
the market. However, the language of IM-4613 arguably can be read to 
prohibit market makers from using any automated means to update their 
quotes, with a few narrow exceptions,\8\ even if such systems would 
contribute to the liquidity of the market. The confusion created by 
this conflict caused several market makers to request interpretive 
advice on the applicability of IM-4613 to certain quoting activity.
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    \8\ The current rule contains certain exceptions, including when 
the update of quotes is the result of an execution, or the quote, 
while generated automatically, is entered manually. See NASD IM 
4613(b).
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    Specifically, two Nasdaq market makers inquired as to whether the 
rule applies to situations where a market maker generates quote updates 
through automated means that do not track away from the inside 
market.\9\ These market makers engage in trading strategies where their 
quoted prices are based on several factors, such as the last sale, 
bids, offers and sizes, where available, on stocks, futures and 
options, and certain statistically derived relationships among these 
instruments. Another market maker recently requested an interpretation 
so that it may submit quotes automatically based on the best prices 
contained in an affiliated electronic communications network.\10\
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    \9\ See infra note 10.
    \10\ Id.
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    Nasdaq believes these types of CGQ systems, if carefully monitored, 
can be utilized without raising the concerns that IM-4613 addresses. In 
the requests received to date, the market makers do not employ 
techniques that track changes to the inside market to keep the market 
maker's prevailing quote away from the inside market, and the systems 
are designed to result in the market maker regularly participating at 
or near the best bid and offer. As such, while these systems could 
produce quote update rates similar to those that track away from the 
inside market, the CQG systems, in contrast, will contribute to the 
liquidity of the market.
    However, Nasdaq's overall system capacity is not limitless, and 
Nasdaq has an overarching obligation to protect investors and the 
public interest. Therefore, Nasdaq cannot permit these systems to be 
utilized without certain controls, and has taken the position that CGQ 
is permitted under IM-4613 if the activity will not adversely impact 
the overall functioning of the Nasdaq market.\11\ This requirement is 
in addition to the requirement that the system does not produce quotes 
to track away from the inside market, and must be designed to result in 
the market maker regularly participating at or near the inside market. 
Prior to issuing the interpretations, Nasdaq carefully analyzed its 
system capacity demand models, and developed quotation capacity 
standards that would permit market makers to utilize CGQ systems, but 
also maintain enough excess capacity so that Nasdaq can meet its peak 
demand.
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    \11\ Nasdaq staff issued interpretive letters to the two market 
makers whose CGQ systems generate quotes based on the relationship 
between the price of the stock and other instruments. Nasdaq will 
issue a letter to another market maker, and re-issue letters to the 
first two market makers, contemporaneous with the filing of this 
proposed rule change. At such time, all three letters will contain 
uniform quote update limits, which are discussed later. The letters 
are posted on NASD Regulation's Web site at http://www.nasdr.com.
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    These standards will be applied to all market makers utilizing CGQ 
systems, and Nasdaq will consider such things as quote updates per 
second, both at the individual security level and firm wide level, and 
are calibrated to ensure that Nasdaq retains excess capacity during 
times of peak demand.\12\ Market makers also will be required to phase 
in their CGQ activity in consultation with Nasdaq staff, and comply 
with the autoquoting restrictions contained in the Nasdaq UTP Plan.\13\ 
In addition, market makers must be able to demonstrate compliance with 
these standards,\14\ and suspend their CGQ activity quickly upon 
request from Nasdaq.
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    \12\ Pursuant to the three interpretive letters issued 
simultaneously with the filing of this proposed rule change, Nasdaq 
proposes that the market makers will be subject to the following 
quote update limitations:
     From 9:30 a.m. to 9:35 a.m. Eastern Time and from 3:55 
p.m. to 4 p.m. Eastern Time, a market maker utilizing a CGQ system 
shall not exceed the following parameters: 30 quotes per second in 
aggregate for all securities, measured over each 15 second interval; 
and a maximum of 3 quotes per second for each security; and
     From 9:35:01 a.m. to 3:54:59 p.m. Eastern Time, a 
market maker utilizing a CGQ system shall not exceed the following 
parameters: 50 quotes per second in aggregate for all securities, 
measured over each 15 second interval; and a maximum of 3 quote per 
second for each security.
    \13\ See Nasdaq UTP Plan, Amendment 12.
    \14\ To demonstrate compliance with the standards, a market 
maker's system must measure quote update rates and supply such data 
to Nasdaq upon request.
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    Nasdaq believes CGQ systems can enhance market quality by 
contributing liquidity, but it will not allow the use of CGQ systems to 
compromise the overall high level of performance and reliability of the 
Nasdaq market. Therefore, on an ongoing basis, Nasdaq will monitor 
closely overall quoting activity and its system capacity, and adjust 
the standards if necessary to ensure that Nasdaq can meet capacity 
demands.\15\ In addition, Nasdaq will monitor closely each individual 
market maker's quoting activity, and, if Nasdaq determines a market 
maker is not complying with the terms of the interpretive relief, 
Nasdaq may summarily modify or revoke the interpretive relief and/or 
summarily suspend the quoting activity of such market maker if 
necessary to preserve capacity and to protect investors and the public 
interest.\16\ In addition, Nasdaq may refer the matter for disciplinary 
action.
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    \15\ Nasdaq notes that Nasdaq technology staff constantly 
monitors capacity levels to ensure that Nasdaq systems operate 
effectively. Nasdaq systems capacity is designed to meet peak usage 
requirements, which normally occur at the opening of the market, the 
closing, or at other times during the day due to scheduled events. 
In addition, peak usage can be caused by unexpected events, such as 
a merger announcement. As Nasdaq staff have gained experience with 
the two market makers utilizing the CGQ systems, it has modified the 
standards several times, and it is possible these standards would be 
modified again as staff gain additional experience with more market 
makers. In developing current and future CGQ standards, Nasdaq will 
look first to ensuring the overall integrity of its systems and to 
protect investors and the public interest. Nasdaq will notify market 
makers permitted to utilize CGQ systems in advance if the standards 
for using such systems change. See Amendment No. 2, supra note 4.
    \16\ See Amendment No. 1, supra note 3.
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    To summarize, the proposed rule change clarifies that IM-4613 
applies to systems that, without physical entry, submit quote updates 
that are not designed to keep a market maker's quote away from the 
inside. Nasdaq believes that defining the term ``Computer Generated 
Quoting'' and specifically stating that such systems are prohibited 
accomplish this. As discussed above, the general prohibition is 
necessary to maintain the integrity of Nasdaq's systems, and the 
exception is the codification of the existing interpretation designed 
to permit market makers to utilize CGQ systems consistent with Nasdaq's 
obligations to preserve the integrity of its systems and to protect 
investors and the public interest.

[[Page 53828]]

Statutory Basis
    Nasdaq believes that the proposal is consistent with section 
15A(b)(6) of the Act.\17\ Section 15A(b)(6) requires, among other 
things, that the rules of a registered national securities association 
be designed to prevent fraudulent and manipulative acts and practices, 
to promote just and equitable principles of trade, to foster 
cooperation and coordination with persons engaged in regulating, 
clearing, settling, processing information with respect to, and 
facilitating transactions in securities, to remove impediments to and 
perfect the mechanism of a free and open market and a national market 
system, and, in general, to protect investors and the public interest; 
and are not designed to permit unfair discrimination between customers, 
issuers, brokers, or dealers. Nasdaq believes that permitting market 
makers to use these systems should have several benefits. Market makers 
will be able to utilize existing computer models, or develop new 
models, to automatically generate and update their quotes, which should 
enhance the price discovery process and allow members to increase the 
number of stocks in which they are registered as market makers.
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    \17\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    Nasdaq does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Nasdaq has neither solicited nor received written comments on the 
proposed rule change.

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

    The foregoing proposed rule change has become effective upon filing 
pursuant to section 19(b)(3)(A) of the Act \18\ and Rule 19b-4(f)(1) 
\19\ thereunder because the proposal is a stated policy, practice or 
interpretation with respect to the meaning, administration, or 
enforcement of an existing rule. At any time within 60 days of the 
filing of the proposed rule change, the Commission may summarily 
abrogate such rule change if it appears to the Commission that such 
action is necessary or appropriate in the public interest, for the 
protection of investors, or otherwise in furtherance of the purposes of 
the Act.
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    \18\ 15 U.S.C. 78s(b)(3)(A).
    \19\ 17 CFR 240. 19b-4(f)(1).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to File No. SR-NASD-2002-76 and 
should be submitted by September 9, 2002.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-20977 Filed 8-16-02; 8:45 am]
BILLING CODE 8010-01-P