[Federal Register Volume 68, Number 175 (Wednesday, September 10, 2003)]
[Notices]
[Pages 53409-53411]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-22983]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-48434; File No. SR-NASD-2003-81]


Self-Regulatory Organizations; Order Granting Approval of 
Proposed Rule Change and Amendment No. 1 Thereto by National 
Association of Securities Dealers, Inc. Relating to Quote 
Decrementation in SuperMontage

September 3, 2003.

I. Introduction

    On May 12, 2003, 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 (``SEC'' or ``Commission''), pursuant to section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend NASD Rule 4710 and the 
decrementation of Quotes/Orders of order delivery Electronic 
Communication Networks (``Order Delivery ECNs'') in Nasdaq's National 
Market Execution System (``NNMS'' or ``SuperMontage''). On May 29, 
2003, Nasdaq filed Amendment No. 1 to the proposal.\3\ The proposed 
rule change, as amended, was published for notice and comment in the 
Federal Register on June 12, 2003.\4\ The Commission received one 
comment letter on the proposed rule change.\5\ This order approves the 
proposed rule change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Mary M. Dunbar, Vice President and Deputy 
General Counsel, Nasdaq, to Katherine A. England, Assistant 
Director, Division of Market Regulation (``Division''), Commission, 
dated May 29, 2003 (``Amendment No. 1''). In Amendment No. 1, Nasdaq 
replaced the proposed rule change in its entirety.
    \4\ See Securities Exchange Act Release No. 47993 (June 5, 
2003), 68 FR 35246 (June 12, 2003).
    \5\ See letter from Kim Bang, Bloomberg Tradebook, LLC, to 
Jonathan G. Katz, Secretary, Office of the Secretary, Commission, 
dated July 14, 2003 (``Bloomberg Letter'').
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II. Description of the Proposed Rule Change

    Nasdaq proposes to modify the SuperMontage decrementation process 
when an Order-Delivery ECN declines,\6\ partially-fills, or fails to 
respond to a non-directed order delivered to it within 30 seconds 
(``time-out'').\7\ Currently, SuperMontage rules provide that when an 
Order Delivery ECN declines, partially-fills, or times-out, without 
immediately transmitting a revised attributable Quote/Order at an 
inferior price, SuperMontage will zero out all of the ECN's Quotes/
Orders on the same side of the market at the price of the declined 
order (or better). Under this proposal, Order Delivery ECNs will not 
have all of their trading interest at the declined price level (or 
better) removed from the system. Instead, SuperMontage would only 
remove the total amount of each individual Quote/Order to which an 
order was delivered by SuperMontage.
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    \6\ An ECN's decline of a delivered order must comply with the 
Commission's Quote Rule, 17 CFR part 240. 11Ac1-1. NASD Regulation 
surveils for Quote Rule violations.
    \7\ See Securities Exchange Act Release No. 48196 (July 17, 
2003), 68 FR 43777 (July 24, 2003) (Notice of filing and immediate 
effectiveness of File No. NASD-2003-108 to temporarily increase the 
non-directed order maximum response time for Order-Delivery ECNs in 
Nasdaq's SuperMontage System.)
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    Nasdaq provided the following example of how the proposed 
modification to the decrementation process would operate for an ECN 
alone at the inside that elected to enter three separate bid Quotes/
Orders at the same price level in SuperMontage:

ECN Quote (1)--1,000 shares @ 20.00
ECN Order (2)--500 shares @ 20.00
ECN Order (3)--300 shares @ 20.00

    The inside aggregated bid shows 1,800 shares @ 20.00.
    1. SuperMontage receives an 800 share market sell order.
    2. In response, SuperMontage sends an 800 share delivery to ECN 
Quote (1). Upon dispatch, SuperMontage immediately decrements 
ECN Quote (1) by the amount of the delivery (800 shares) 
leaving a display quote of 1,000 shares in ECN Quote (1) that 
remains available for execution.
    3. The ECN declines to execute the 800 share delivery to ECN Quote 
(1).
    4. The ECN's decline results only in the immediate removal of ECN 
Quote (1), i.e., the 800 shares originally decremented and the 
200 share remainder of ECN Quote (1). Orders (2) and 
(3) remain in the system and continue to be eligible for 
execution.
    The system reallocates the 800 shares from the incoming order in 
Step 1 against ECN orders (2) and (3), if not 
executed by a subsequent incoming order, before moving, if necessary, 
to the next best bid.\8\
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    \8\ Nasdaq clarified under the proposal a subsequent incoming 
order could potentially execute against an ECN's remaining orders 
prior to the return of a declined order to the system. Telephone 
conversation between Thomas P. Moran, Associate General Counsel, 
Office of the General Counsel, to Marc McKayle, Special Counsel, 
Division, Commission on August 27, 2003.
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    Thus, under the proposal, only individual Quotes/Orders would be 
removed in full by a decline, partial-fill, or a time-out when no 
revised attributable Quote/Order is immediately transmitted at an 
inferior price; not all trading interest at the declined price level or 
better. Other ECN Quotes/Orders at a particular price level that are 
not part of a SuperMontage delivery resulting in a decline, partial-
fill, or time-out would be retained in the system and remain available 
for execution, and are not traded through. Nasdaq represents that 
locked or crossed markets will not be created as a result of the 
proposed rule change.

III. Summary of Comments

    The Commission received one comment letter from Bloomberg 
Tradebook, LLC (``Bloomberg'') on the proposed rule change.\9\ 
Bloomberg neither explicitly supported nor opposed the proposed rule 
change, although it commented on decrementation generally, as well as 
on the proposed rule change. Bloomberg noted that conceptually, 
``(d)ecrementation is a design feature of SuperMontage that is intended 
to preserve the continuity of the market

[[Page 53410]]

and to prevent locked and crossed markets.'' However, Bloomberg also 
opined that the current decrementation procedures unfairly discriminate 
against Order Delivery ECNs, cuts squarely against an ECN's obligations 
under the Order Display Rule,\10\ are subject to being gamed by market 
participants, and implicate a broker-dealer's duty of best execution. 
In Bloomberg's view, ``[t]he problems decrementation has created * * * 
result from access fees ECNs are permitted to charge and the 
unwillingness of some market participants to pay those fees.'' 
Bloomberg believed that the Commission should address the access fee 
issue, and that all access fees, including fees charged by market 
centers, should be eliminated.
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    \9\ See Bloomberg Letter, supra note 5.
    \10\ 17 CFR 240.11Ac1-4.
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    Bloomberg also believed that Nasdaq's proposed amendment would not 
reduce the adverse impact of decrementation on Order Delivery ECNs 
since each ECN's Quote/Order would still be subject to decrementation. 
In addition, Bloomberg did not believe that Nasdaq's proposed amendment 
would provide any practical benefit since ECNs manage their own 
internal matching engines and aggregate multiple orders for 
representation as a single Quote/Order in SuperMontage. Further, 
Bloomberg believed that the decrementation process could still be gamed 
since firms seeking to knock an ECN out of the quote in SuperMontage 
would still be able to do so.
    In response to the Bloomberg Letter, Nasdaq stated that many of 
Bloomberg's comments extended beyond the narrow scope of the proposed 
rule change to modify SuperMontage's decrementation process to 
decrement only the ECN Quote/Order that an incoming order interacts 
with at a particular price level, as opposed to all of an ECN's 
available trading interest at a particular price level.\11\ In Nasdaq's 
view, Bloomberg's comments were directed at the decrementation process 
generally, its impact on ECNs and their customers, and its relationship 
to ECN access fees. In response, Nasdaq noted that the Commission 
approved the SuperMontage decrementation process, and that Nasdaq was 
merely proposing to modify the process. Nasdaq emphasized that its 
current decrementation process and its proposed modification to the 
process retain the key component that declining Quotes/Orders be 
removed from the system. Further, Nasdaq stated that the only issue 
presented by the filing is the method of such removal; the proposed 
rule change does not seek to change ECN access fee standards. 
Therefore, according to Nasdaq, Bloomberg's views on eliminating access 
fees would be more properly expressed in a petition for Commission 
rulemaking.
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    \11\ See letter from Thomas P. Moran, Office of General Counsel, 
to Jonathan G. Katz, Secretary, Office of the Secretary, Commission, 
dated July 30, 2003.
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    Nasdaq also offered general comments regarding the decrementation 
process. Nasdaq explained that decrementation was proposed as part of 
the original SuperMontage proposal to address locked and crossed 
markets that occurred in Nasdaq prior to SuperMontage. Nasdaq noted 
that access fee disputes could result in locked and crossed markets 
that would not only shut down Nasdaq's automatic execution 
functionality, but also many internal order-execution systems of Nasdaq 
market participants, until the locks or crosses were resolved. Nasdaq 
also stated that decrementation allows Nasdaq to fairly balance the 
needs and desires of a wide variety of users by accomodating ECNs, by 
allowing them to receive and decline orders (as opposed to receiving 
executions) while eliminating locked and crossed markets.
    With regard to Bloomberg's specific comments on the proposed rule 
change, Nasdaq emphasized its proposed modification to the 
decrementation process is an internal SuperMontage system change that 
imposes no new obligation on any market participant. Instead, the 
proposal is intended to make the current decrementation process more 
discerning and provide options to ECNs that voluntarily elect to change 
the way they represent their Quotes/Orders in SuperMontage. Nasdaq 
stated that the proposed rule change gives ECNs the option to mitigate 
decrementation by providing them, if they enter multiple Quotes/Orders, 
an increased opportunity for their individualized Quotes/Orders to 
interact with counterparties with which the ECN is willing to trade. 
Nasdaq stated it should not be precluded from altering its system to 
provide options to ECNs that choose to take the initiative to serve 
their customers better. According to Nasdaq, if an ECN chooses to enter 
individual representations of trading interest, Nasdaq's new processing 
would allow more of the ECN's customers to remain in the SuperMontage 
system longer, thereby increasing the potential interaction of those 
customers with orders from parties that will pay the ECN's access fee. 
Those ECNs that do not alter the way they represent their customers in 
SuperMontage would, in effect, continue to have their single quotes 
decremented in the same manner as the current SEC-approved process. 
According to Nasdaq, Bloomberg opposes a rule that forces them to do 
nothing, and will have no impact on them if they continue to do 
business as they do today.

IV. Discussion

    The Commission has carefully reviewed the proposed rule change, the 
Bloomberg Letter, and Nasdaq's response and finds that the proposed 
rule change, as amended, is consistent with the requirements of the Act 
and the rules and regulations thereunder applicable to a national 
securities association.\12\ In particular, the Commission finds that 
the proposed rule change, as amended, is consistent with section 
15A.\13\ Specifically, the Commission finds that the proposed rule 
change is consistent with section 15A(b)(6) of the Act because it is 
designed 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.\14\ The Commission also finds that the proposed rule change 
is consistent with section 15A(b)(11) because it is designed to produce 
fair and informative quotations, to prevent fictitious or misleading 
quotations, and to promote orderly procedures for collecting, 
distributing, and publishing quotations.\15\
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    \12\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
    \13\ 15 U.S.C. 78o-3.
    \14\ 15 U.S.C. 78o-3(b)(6).
    \15\ 15 U.S.C. 78o-3(b)(11).
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    While the Commission appreciates and considered Bloomberg's 
comments regarding decrementation generally, whether decrementation is 
consistent with the Act was decided on January 19, 2001, when the 
Commission approved decrementation in SuperMontage.\16\ The ability of 
SuperMontage to decrement Quotes/Orders of Order Delivery ECNs is not 
at issue in the proposed rule change.\17\ Instead, what is at issue is

[[Page 53411]]

whether the modification to the decrementation process, wherein 
SuperMontage can decrement only the single ECN Quote/Order that 
declines to trade with an order sent to it by the system, is consistent 
with the Act.\18\ The Commission finds that it is.
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    \16\ See Securities Exchange Act Release No. 43863 (January 19, 
2001), 66 FR 8020 (January 26, 2003)(``Original SuperMontage 
Approval Order'').
    \17\ Id. See also Domestic Securities, Inc. v. Securities and 
Exchange Commission, 333 F.3d 239 (DC Cir. 2003). The Court found, 
in pertinent part, that the Original SuperMontage Approval Order 
marked the consummation of the Commission's decisionmaking process 
concerning the system rules, including decrementation, and the rules 
finally determined the rights and obligations of the market and of 
each market participant who traded on the system.
    \18\ While the Commission acknowledges that ECN access fees 
maintain a significant tangential relationship to the SuperMontage 
decrementation process, the abolition of ECN fees is not at issue in 
this proposed rule change. Nasdaq recently submitted File No. NASD-
2003-128 relating to ECN fees.
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    The Commission notes that the amendment is essentially identical to 
the process as originally approved,\19\ except that an ECN's Quotes/
Orders would be removed from the system on an individual basis. 
Bloomberg stated that the proposal would not have any practical effect 
because it is the practice of ECNs to aggregate orders within the quote 
sent to SuperMontage. The Commission believes that Nasdaq has 
adequately responded to Bloomberg's comments. Nasdaq has correctly 
represented that the proposed rule change provides a new option for 
Order Delivery ECNs. The Commission recognizes that many proposed rule 
changes relating to a self-regulatory organization's trading system 
will require the affected market participants to either reprogram their 
internal trading systems or alter their business practices to ensure 
system compatibility and compliance. In that regard, this proposed rule 
change is not unique. The proposed rule change may allow ECNs that opt 
to change their method of quote management and submit individual orders 
to SuperMontage to mitigate the impact of access fee disputes on their 
ability to trade with participants with which no dispute exists. 
However, ECNs may also choose to continue aggregating multiple orders 
for representation, and decrementation, as a single Quote/Order in 
SuperMontage. Thus, while ECNs that do not reconfigure their trading 
systems or revise their quote management practices would not benefit 
from this proposed rule change, ECNs that choose to make the necessary 
operational and technological adjustments may benefit.
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    \19\ See Original SuperMontage Approval Order, supra note 15.
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    The Commission believes that Nasdaq's approach reasonably balances 
the interests of accommodating Order Delivery ECNs and providing an 
efficient trading system. Nasdaq represents that SuperMontage 
decrementation has eliminated the ECN access fee-related locked or 
crossed markets which caused the shutdown of Nasdaq's automatic 
execution functionality, and many internal order-execution systems, 
until the lock or cross was resolved. The Commission continues to 
believe that the SuperMontage decrementation process should help to 
reduce instances of locked and crossed markets and the problems 
associated with locked and crossed markets, while accommodating ECNs 
with an alternative to automatic execution.\20\ The Commission also 
continues to believe that the reduction of locked and crossed markets 
in the Nasdaq market should improve market quality and enhance the 
production of fair and orderly quotations.\21\ In the Commission's 
view, the NASD's proposal is reasonably designed to maintain the 
integrity of Nasdaq quotes by reducing the incidence of locking and 
crossing quotations displayed in Nasdaq. The proposal will continue to 
reduce locked and crossed markets because a declined order, if 
necessary, would decrement each ECN's individual Quote/Order. The 
Commission believes that the proposal, by retaining ECNs' trading 
interest that is not decremented by the incoming order in the system, 
could enhance SuperMontage liquidity and transparency, and provide ECN 
customers with an increased opportunity to have their orders executed 
by market participants that are willing to pay the ECN access fee.
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    \20\ The Commission has concluded previously that continued 
locking and crossing of markets can negatively impact market 
quality. Id. See also Division of Market Regulation, The October 
1987 Market Break 9-6 (February 1988) (Stating that the continued 
existence of locked and crossed markets indicates that the 
quotations for a security are suspect and may not provide an 
accurate reflection of the market for a security).
    \21\ Id.
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V. Conclusion

    For the foregoing reasons, the Commission finds that the proposal, 
as amended, is consistent with the requirements of the Act and rules 
and regulations thereunder.
    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\22\ that the proposed rule change (SR-NASD-2003-81), as amended, 
is approved.\23\
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    \22\ 15 U.S.C. 78s(b)(2).
    \23\ The proposed rule change will become effective within 60 
days of the date of this Order. Telephone conversation between 
Thomas P. Moran, Associate General Counsel, Office of the General 
Counsel, to Marc McKayle, Special Counsel, Division, Commission on 
September 3, 2003.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\24\
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    \24\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-22983 Filed 9-9-03; 8:45 am]
BILLING CODE 8010-01-P