[Federal Register Volume 69, Number 7 (Monday, January 12, 2004)]
[Notices]
[Pages 1769-1771]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-524]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49020; File No. SR-NASD-2003-143]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Approval to a Proposed Rule Change and 
Amendments Nos. 1, 2, and 3 Thereto to Establish a New ``Auto-Ex'' 
Order in Nasdaq's SuperMontage System

January 5, 2004.

I. Introduction

    On September 24, 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 (``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 establish an ``Auto-Ex'' order 
in Nasdaq's National Market Execution System (``NNMS'' or 
``SuperMontage''). Nasdaq filed Amendment Nos. 1 and 2 to the proposed 
rule change on October 3, 2003,\3\ and October 21, 2003,\4\ 
respectively. The proposed rule change, as amended, was published for 
comment in the Federal Register on October 28, 2003.\5\ The Commission 
received two comment letters on the proposal.\6\ In addition, Nasdaq 
submitted a response to comments.\7\ Nasdaq also submitted Amendment No 
3. to the proposed rule change on December 17, 2003.\8\ 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 to Katherine A. England, Assistant Director, 
Division of Market Regulation (``Division''), Commission, from Mary 
M. Dunbar, Vice President and Deputy General Counsel, Nasdaq, dated 
October 2, 2003 (``Amendment No. 1'').
    \4\ See letter to Katherine A. England, Assistant Director, 
Division, Commission, from John M. Yetter, Associate General 
Counsel, Nasdaq, dated October 21, 2003 (``Amendment No. 2'').
    \5\ See Securities Exchange Act Release No. 48675 (October 21, 
2003), 68 FR 61528 (``Notice'').
    \6\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Kim Bang, Bloomberg Tradebook LLC (``Bloomberg''), dated November 
20, 2003 (``Bloomberg Letter''), and Alex Goor, President, Inet ATS, 
Inc. (``Inet''), dated November 18, 2003 (``Inet Letter'').
    \7\ See letter to Jonathan G. Katz, Secretary, Commission, from 
Edward S. Knight, Executive Vice President, Nasdaq, dated December 
8, 2003 (``Nasdaq Letter'').
    \8\ See letter to Katherine A. England, Assistant Director, 
Division, Commission, from John M. Yetter, Associate General 
Counsel, Nasdaq, dated December 16, 2003 (``Amendment No. 3''). In 
Amendment No. 3, Nasdaq amended the proposed rule text to reflect 
the immediate effectiveness of SR-NASD-2003-150. See Securities 
Exchange Act Release No. 48798 (November 17, 2003) (Notice of Filing 
and Immediate Effectiveness of SR-NASD-2003-150). The Commission 
notes that this is a technical, non-substantive amendment and not 
subject to notice and comment.
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II. Description of the Proposed Rule Change

    Nasdaq proposes to establish an Auto-Ex order for use in 
SuperMontage. Auto-Ex orders may be either priced limit orders or 
market orders, and all market participants would be permitted to enter 
Auto-Ex orders. Auto-Ex orders would execute solely against the Quotes/
Orders of SuperMontage participants that participate in the system's 
automatic execution functionality and do not charge a separate quote-
access fee to participants accessing their Quotes/Orders through 
SuperMontage. Auto-Ex orders would access all available liquidity at 
multiple price levels, but under no circumstances would the order 
trade-through the Quote/Order of an Order-Delivery electronic 
communications network (``ECN'') or an automatic execution participant 
that charged an access fee to access liquidity at another price level. 
Thus, an Auto-Ex order would automatically be designated ``Immediate or 
Cancel,'' and the order (or any unexecuted portion thereof) would be 
cancelled whenever the best price available through SuperMontage solely 
reflects the Quote/Order of a market participant that is not eligible 
to receive the Auto-Ex order.
    Nasdaq intends to implement the Auto-Ex order as soon as possible 
following Commission approval, and will inform market participants of 
the exact implementation date via a Head Trader alert on http://www.nasdaqtrader.com.

III. Summary of Comments and Nasdaq's Response

    As noted above, the Commission received two comment letters on the 
proposed rule change.\9\ Both commenters, Inet and Bloomberg, opposed 
the Commission's approval of the proposed rule change.
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    \9\ See supra note 6.
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    Inet and Bloomberg stated that the proposed rule change 
discriminates against ECNs by creating an order type that would bypass 
ECNs in favor of automatic execution participants. Both commenters 
questioned the primary rationale offered by Nasdaq in the Notice that 
the proposal would benefit market participants that seek speed and 
certainty of executions. For example, Inet noted that the Auto-Ex order 
would also bypass automatic execution participants that charged quote 
access fees, and questioned whether the true motivation of the proposal 
was to enhance speed of execution for market participants or provide 
for the systemic discrimination against ECNs in SuperMontage.\10\ Inet 
suggested that Nasdaq should establish criteria to differentiate 
between Order-Delivery ECNs that have consistently rapid order response 
times and those that have comparative slow order response times (on a 
regular or intermittent basis) by creating criteria under the proposal 
that would establish an acceptable ECN response time. Bloomberg also 
expressed doubts about Nasdaq's rationale because, in a race condition, 
a participant entering an order into SuperMontage may not have its 
order filled against an automatic execution participant if that 
participant's trading interest (bid or offer) was satisfied a split-
second before.
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    \10\ See also Bloomberg Letter. Bloomberg and Inet also noted 
that Nasdaq acknowledged that the average ECN response time is one 
second or less. See supra note 6.
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    In addition, both commenters stated that implementation of an Auto-
Ex order would undercut the principles of price/time priority in 
SuperMontage. Further, Inet stated that Nasdaq's

[[Page 1770]]

comparison of the proposed Auto-Ex order type with the ``Fill-or-
Return'' order on the Archipelago Exchange (``ArcaEx''), a trading 
facility of Pacific Exchange Equities, Inc. (``PCXE''), was inapposite. 
Inet asserted that unlike Nasdaq's proposed order type, the ArcaEx 
Fill-or-Return order distinguishes between providing executions on 
ArcaEx and routing to other market centers, not between ArcaEx market 
participants. According to Inet, Fill-or-Return orders execute in 
price/time priority against all contra-side orders available in ArcaEx, 
while the Auto-Ex order would ignore ECN orders represented in 
SuperMontage. Lastly, Bloomberg indicated that Nasdaq's assertion of 
the applicability of the Commission's rationale in the SuperSOES 
approval order was factually inaccurate and that the proposed rule 
change would marginalize ECNs and is anti-competitive.
    In its response letter, Nasdaq asserted that the proposed Auto-Ex 
order was not unfairly discriminatory or anticompetitive. Nasdaq 
believed that the proposal would provide Nasdaq market participants 
with greater flexibility in determining the terms and conditions under 
which orders routed to SuperMontage would interact with orders in 
SuperMontage. Specifically, Nasdaq stated that a market participant 
could opt to use an Auto-Ex order to: (1) Receive rapid executions, (2) 
avoid ECN access fees and Nasdaq's $0.001 per share routing fee to 
ECNs, and (3) avoid the duplicate routing of orders to ECNs through 
direct connections and SuperMontage.
    Nasdaq also emphasized that the Auto-Ex order was just one option 
available to market participants. According to Nasdaq, market 
participants that seek to achieve greater certainty that their orders 
will be executed in full, or that prefer to access all available 
liquidity though a single order, will not opt to use the Auto-Ex order. 
Moreover, when an ECN Quote/Order is the predominant source of 
liquidity at the inside in a particular stock, market participants 
would simply not use the Auto-Ex order. Moreover, Nasdaq noted that 
ECNs are provided further protection because Auto-Ex orders cannot 
trade-through the Quote/Order of a market participant that is not 
eligible to receive such an order.
    Nasdaq also responded to Inet's contention that its comparison of 
the Auto-Ex order to ArcaEx's Fill-or-Return order was inapposite. 
Nasdaq stated ArcaEx participants must accept automatic execution and 
do not have the option of a status comparable to Order-Delivery ECNs. 
Nasdaq asserted that ArcaEx's market structure effectively excludes 
ECNs from direct participation, puts ECNs last in line for ArcaEx 
liquidity, and allows market participants to use the Fill-or-Return 
order to avoid accessing ECN liquidity under any circumstances. Nasdaq 
also noted that ECNs--Bloomberg, Island, and Instinet--have similar 
order types. Thus, according to Nasdaq, its market participants should 
have the same flexibility.
    In response to Bloomberg's comment that Nasdaq's comparison of the 
Auto-Ex Order to SuperSOES was inaccurate, Nasdaq stated that SuperSOES 
order processing was virtually identical to Auto-Ex orders, because 
SuperSOES orders accessed liquidity available from automatic execution 
participants and were cancelled upon interacting with the quote of an 
order delivery participant. Nasdaq did note that SuperMontage differs 
from SuperSOES/SelectNet in that order delivery and automatic execution 
participants can be accessed by a single point of entry. However, 
Nasdaq reasoned that the SuperMontage unified point of entry for order 
delivery and automatic execution provided market participants with more 
options than were available during the operation of SuperSOES/SelectNet 
for accessing Order-Delivery ECNs, and in light of the enhanced 
accessibility of ECNs in SuperMontage, Nasdaq should not be foreclosed 
from providing a functionality that existed through SuperSOES/
SelectNet.
    Finally, Nasdaq responded to Inet's suggestion that it develop 
criteria for ECN response times. Nasdaq did not believe it was 
technically feasible to impose a response time standard that would 
ensure that executions of ECN-delivered orders would always be as fast 
as automatic executions. Nasdaq noted that the processing time for 
automatic executions is between .006 and .01 seconds. According to 
Nasdaq, although the average response time and average processing time 
for Order-Delivery ECNs is less than one second, particular orders may 
be much slower and the averages are invariably higher during the market 
open and market close. For example, Nasdaq stated that the average 
round-trip processing time for all order-delivery orders during the 
market close exceeded one second on the majority of trading days. 
Further, Nasdaq indicated that automatic execution participants, unlike 
ECNs, cannot simply back away from their Quotes/Orders because of 
trades preformed elsewhere or because it chooses not to do business 
with a contra-party. Thus, Nasdaq contended that the Auto-Ex order 
would simply provide market participants with a voluntary tool to use 
when they wish to ensure a rapid execution, rather than running the 
risk of a delay in a fast-moving market.

IV. Discussion

    After careful consideration of the proposed rule change, the 
comment letters, and Nasdaq's response, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities association \11\ and, in particular, the requirements of 
Section 15A of the Act \12\ and the rules and regulations thereunder. 
Specifically, the Commission believes that the proposed rule change is 
consistent with Section 15A(b)(6) of the Act,\13\ which, among other 
things, requires that NASD's rules be 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.
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    \11\ In approving this proposed rule change, the Commission 
notes that it has considered its impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \12\ 15 U.S.C. 78o-3.
    \13\ 15 U.S.C. 78o-3(b)(6).
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    The Commission notes that Inet and Bloomberg believed that the 
proposed Auto-Ex order unfairly discriminates against Order-Delivery 
ECNs or is anti-competitive. The Commission acknowledges that the Auto-
Ex order will treat Order-Delivery ECNs and automatic execution 
participants that charge a fee differently than automatic execution 
participants that do not charge a fee. However, the Commission believes 
that the proposal accommodates the various needs and interests of 
market participants in SuperMontage by taking into account the needs 
and business models of ECNs, while providing Nasdaq market participants 
with an optional order type that may enhance the ability of market 
participants to control costs associated with executing an order, such 
as avoiding the Nasdaq ECN order routing fee and allowing such 
participants to route orders directly to ECNs.
    The Commission notes Order-Delivery ECNs would continue to be able 
to participate in SuperMontage. The Auto-Ex order would only execute at 
the Nasdaq best bid or offer and would not

[[Page 1771]]

trade-through the price of a market participant that does not accept 
automatic execution or charges a quote access fee. Thus, ECNs that 
provide depth and liquidity at or near the inside market would continue 
to receive executions. In addition, the use of Auto-Ex orders would be 
voluntary and there may be many instances where this order type would 
not be appropriate. For example, as stated by Nasdaq, use of an Auto-Ex 
order may be inappropriate where an ECN's Quote/Order is the 
predominant source of liquidity at the inside market for a particular 
stock or when a market participant seeks to access all available 
liquidity though SuperMontage.\14\ In the latter example, a market 
participant may elect to use a regular non-directed order, rather than 
the Auto-Ex order. Therefore, the Commission believes that the Auto-Ex 
order is reasonably designed to accommodate the participation of ECNs 
and other market participants in SuperMontage, to give market 
participants greater flexibility in determining how their orders will 
be executed, and to provide greater opportunities to control execution 
and routing costs.
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    \14\ See Nasdaq Letter, supra note 7.
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    Inet and Bloomberg commented that the Auto-Ex order ``undercuts'' 
the principle of price/time priority in SuperMontage. However, the 
Commission notes that SuperMontage has never been a trading environment 
characterized by strict price/time priority. For example, SuperMontage 
has order execution algorithms based on price/size/time and price/time 
taking into account ECN fees, which may be used on an order-by-order 
basis, as well as Preferenced Orders, which execute solely against the 
Quote/Order of a recipient identified by the participant entering the 
order at the best bid or offer regardless of the recipient's time 
priority within the price level, and Directed Orders, which can be 
directed to a particular market participant at any price. The 
Commission notes that the Auto-Ex order, while not identical, has 
functional similarities to these current Nasdaq features, including the 
order execution algorithm based on price/time priority that takes 
access fees into account and Preferenced Orders.
    Inet also commented that the Auto-Ex order was not like the ArcaEx 
Fill-or-Return order. The Commission recognizes that distinctions may 
be drawn between the Auto-Ex order and the ArcaEx Fill-or-Return order. 
Nonetheless, the Commission believes that the Auto-Ex order provides 
functionality and flexibility for market participants that is similar 
to the ArcaEx Fill-or-Return order. In particular, the Auto-Ex order, 
like the Fill-or-Return order, permits a market participant to 
determine whether its order will be routed away to an alternate market. 
Thus, while the Auto-Ex order is not identical to the Fill-or-Return 
order, both orders give the market participant some ability to control 
where its order is routed.
    The Commission also believes that the proposed Auto-Ex order may 
provide greater speed and certainty of execution. The Commission 
recognizes that an Order-Delivery ECN may determine to reject an order 
to avoid dual liability or because a fee dispute exists with a contra-
party. If an order is rejected and returned to SuperMontage, market 
conditions, especially during a fast market, may change and the order 
may receive an inferior execution. Thus, the Commission believes that 
an Auto-Ex order may help to assure the quality of execution in certain 
market conditions. The Commission also notes that market participants 
that have access fee disputes with ECNs could use the Auto-Ex order to 
avoid ECNs that will reject their orders. In such an instance, the 
Commission believes that the use of an Auto-Ex order may benefit the 
Order-Delivery ECN and the market participant with which the fee 
dispute exists as the respective interest of the parties could 
potentially interact with contra-parties with which no fee dispute 
exists.
    Notwithstanding the foregoing, the Commission emphasizes that 
broker-dealers must evaluate whether the use of the Auto-Ex order type 
is consistent with their best execution obligations. As the Commission 
has previously stated, the customer's instructions and expectations 
should determine the order handling procedures that a broker-dealer 
employs and whether the execution of an order is the best under the 
circumstances. Without specific instructions from a customer, however, 
a broker-dealer should periodically assess the quality of competing 
markets to ensure that its order flow is directed to markets providing 
the most advantageous terms for the customer's order.\15\ Currently, 
market participants have the choice, in part, of using Nasdaq's 
facility to access liquidity or private linkages outside of 
SuperMontage to access liquidity. As a result, broker-dealers must be 
able to identify the best available terms among multiple competing 
marketplaces and be able to access those marketplaces.\16\ An inability 
to reach quotations and execute among market centers can compromise a 
broker-dealer's ability to satisfy its duty of best execution. For 
example, it could be inconsistent with a broker-dealer's duty of best-
execution to use Auto-Ex orders if such use regularly leads to a 
failure to obtain the best available price for customers' orders. Thus, 
while the Commission has permitted Nasdaq to develop a market structure 
that gives its market participants operational flexibility, the 
Commission emphasizes that market participants must utilize 
SuperMontage functions in a manner that is consistent with their best 
execution obligations.
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    \15\ See Market 2000: An Examination of Current Equity Market 
Developments, Division, Commission, (January 1994), Study V at 4.
    \16\ See Securities Exchange Act Release No. 43863 (January 19, 
2001), 66 FR 8020 (January 26, 2001) (Order approving SR-NASD-99-
53).
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V. Conclusion

    For the foregoing reasons, the Commission finds that the proposal 
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,\17\ that the proposed rule change and Amendment Nos. 1, 2, and 3 
thereto (File No. SR-NASD-2003-143) are approved.
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    \17\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\18\
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    \18\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. 04-524 Filed 1-9-04; 8:45 am]
BILLING CODE 8010-01-P