[Federal Register Volume 62, Number 11 (Thursday, January 16, 1997)]
[Notices]
[Pages 2415-2433]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-1107]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38156; File No. SR-NASD-96-43]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Granting Partial Approval and Notice of Filing and
Order Granting Accelerated Approval of Amendment No. 1 to Proposed Rule
Change Relating to Implementation of the Commission's Order Handling
Rules
January 10, 1997.
On November 18, 1996, the National Association of Securities
Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities
and Exchange Commission (``Commission'' or ``SEC'') a proposed rule
change pursuant to Section 19(b)(1) of the Securities Exchange Act of
1934 (``Act'') 1, and Rule 19b-4 thereunder.2 On January 9,
1997, the NASD submitted a letter amending the proposed rule
change.3 The proposed rule change adopts a new rule, and amends
existing NASD rules and The Nasdaq Stock Market's (``Nasdaq'') Small
Order Execution System (``SOES'') and SelectNet Service to enable the
NASD to implement on a timely basis the Commission's new limit order
display rule, Rule 11Ac1-4 under the Act 4 (``Display Rule'') and
amendments to Rule 11Ac1-1 under the Act 5 (``Quote Rule'').
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\1\ 15 U.S.C. Sec. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ Letter from Robert E. Aber, NASD to Robert L.D. Colby,
Commission, dated January 9, 1997. The amendment would (1) establish
a three month pilot for reduction of the market maker minimum
quotation size in the fifty Nasdaq securities subject to the first
phase-in of the Order Handling Rules; (2) state that a market
maker's obligation to maintain its displayed quotation size at or
above the applicable minimum quotation size does not apply when the
market maker's quote size has been decremented by the execution of
SOES orders, until that quotation size is decremented to zero; (3)
make the decrementing provision optional for market makers whose
quotation in a particular security is equal to or greater than the
SOES tier size for that security; and (4) permit market makers to
enter riskless principal orders, in addition to agency orders, into
the Small Order Execution System.
\4\ 17 CFR 240.11Ac1-4.
\5\ 17 CFR 240.11Ac1-1.
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Notice of the proposed rule change, together with the substance of
the proposal as initially filed, was provided by issuance of a
Commission release (Securities Exchange Act Release No. 38008, Dec. 2,
1996) and by publication in the Federal Register (61 FR 64550, Dec. 5,
1996). The Commission received over 350 comment letters on the
proposal.
I. Introduction and Background
A. The Commission's Order Handling Rules
On August 28, 1996, the Commission adopted the Display Rule, which
requires the display of customer limit orders priced better than a
market maker or specialist's quote, and adopted amendments to the Quote
Rule to enhance the quality of published quotations for securities, and
competition and pricing efficiency in U.S. securities markets.6
These rules (collectively, ``Order Handling Rules'') were designed to
address growing concerns about the handling of customer orders for
securities.
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\6\ See Securities Exchange Act Release No. 37619A (September 6,
1996), 61 FR 48290 (September 12, 1996) (``Adopting Release''). See
also Securities Exchange Act Release Nos. 38110 (January 2, 1997),
62 FR 1279 (January 9, 1997) (order revising the effective date of
the Order Execution Rules to January 13, 1997); and 38139 (January
8, 1997) (order revising the effective date of the Order Execution
Rules until January 20, 1997).
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Specifically, the Display Rule 7 requires the display of a
customer limit order priced better than a specialist's or over-the-
counter (``OTC'') market maker's quote or that adds to the size
associated with such quote if that quote is at the national best bid or
offer (``NBBO''). An OTC market maker who receives a customer limit
order meeting these parameters must immediately: (1) change its quote
and the size associated with its quote to reflect the limit order; (2)
execute the limit order; (3) deliver the limit order to an exchange-or
association-sponsored system that complies with the requirements of the
rule; (4) send the limit order to another market maker or specialist
who complies with the requirements of the rule; or (5) deliver a limit
order to an electronic communications network (``ECN'') that meets
certain requirements regarding the display of limit orders, as an
alternative to representing the limit order in its quote.8
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\7\ 17 CFR 240.11Ac1-4.
\8\ The Display Rule does not apply to limit orders placed by
customers requesting that they not be displayed, limit orders for
odd-lots, and limit orders that are all-or-none orders. The rules do
not require the display of limit orders of block size (10,000 shares
or $200,000) unless the customer requests that the order be
displayed.
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One amendment to the Quote Rule 9 requires an OTC market maker
to make publicly available any superior prices that a market maker
privately quotes through ECNs (``ECN Amendment''). A market maker may
comply with this amendment by changing its quote to display any such
superior prices privately quoted. Alternatively, a market maker can
deliver better priced orders to an ECN without changing its public
quote if that ECN: (i) ensures that the best prices market makers and
specialists have entered therein are communicated to the public
quotation system; and (ii) provides brokers and dealers equivalent
access to orders entered by market makers and specialists into the ECN,
so brokers and dealers that do not subscribe to the ECN can trade with
those orders (``ECN Display Alternative'').
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\9\ 17 CFR 240.11Ac1-1.
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The ECN amendment becomes effective on January 20, 1997 for
exchange traded securities and 50 of the 1000 most actively traded OTC
securities. These 50 securities have been identified by Nasdaq.10
The phase-in date for the next 100 securities is scheduled for February
7, 1997. On February 28, 1997, the additional 850 of the 1000 most
actively traded securities will be phased in. Finally, on March 28,
1997, the ECN amendment will apply to all remaining OTC securities.
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\10\ See Letter from S. William Broka, Senior Vice President,
Trading & Market Service, Nasdaq Stock Market, Inc., dated December
23, 1996.
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The Limit Order Display Rule also becomes effective on January 20,
1997 for all exchange traded securities and 50 OTC securities
identified by Nasdaq. Other Nasdaq securities will become
[[Page 2416]]
subject to the rule on a phased-in basis, with all Nasdaq securities
phased in by August 28, 1997.
B. Changes Required to NASD Rules and Systems
The Adopting Release recognized that the Order Handling Rules would
require the NASD, as well as national securities exchanges
(``exchanges''), to change certain systems and rules to facilitate
compliance with the Order Handling Rules by January 20, 1997.11
For example, the NASD's SOES system currently accepts limit orders. If
a limit order is not immediately executable, or non-marketable, (i.e.,
a limit order to buy priced below the offer price, or a limit order to
sell priced above the bid price), it is placed in the SOES limit order
file and subsequently executed if the best bid for a buy, or offer for
a sell order becomes equal to the limit price. Limit orders placed into
SOES are never publicly disseminated, included in the calculation of
the best bid or offer, or matched against incoming market orders. Thus,
an OTC market maker that places a customer limit order into the SOES
limit order facility would not comply with the Display Rule.
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\11\ See supra note 6.
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In addition, NASD Rule 4613 currently requires Nasdaq market makers
to display continuous two-sided quotations in Nasdaq National Market
(``NNM'') securities (approximately the top 4000 Nasdaq securities) in
sizes of 1,000, 500 or 200 shares, depending upon the price and trading
volume of the security. However, the Display Rule may require a market
maker to display in its quote a customer limit order that is smaller
than the mandatory quotation size imposed by NASD Rule 4613. This
creates the possibility that a market maker could be required to
publish a quote at a price and size that it is otherwise unwilling to
trade at for its own account. The changes to the NASD's systems and
rules approved today are intended to facilitate compliance with the
Order Handling Rules and are intended to more closely tailor a market
maker's obligations to the structure of the Nasdaq market anticipated
to result from implementation of the Order Handling Rules.
II. Proposed Rule Changes To Implement the Display Rule
A. Minimum Quotation Size Requirements
1. Quote Size When Displaying Customer Limit Orders
To facilitate the display of customer limit orders in accordance
with the Display Rule, the NASD proposes to amend NASD Rules 4613 and
6330 to provide that Nasdaq market makers and CQS market makers may
display a quotation size for one normal unit of trading (i.e., 100
shares) or a larger multiple thereof to reflect the actual size of a
customer limit order.12 Thus, if a market maker is bidding 20 for
1000 shares and offering 1000 shares at 20\1/4\ (20 bid--20\1/4\
offered, 1000 x 1000), and the market maker receives a customer limit
order to buy 100 shares at 20\1/8\, the market maker would be permitted
to update its quote to 20\1/8\-20\1/4\, 100 x 1000. Market makers would
not be responsible for executing any additional shares above the size
of the limit order. The NASD believes that this rule change will
promote market maker acceptance of limit orders priced inside quoted
markets, thereby furthering the investor protection and market
transparency objectives of the Order Handling Rules. Moreover, without
these rule changes, in instances where a customer limit order is
smaller than the applicable minimum quotation size requirement and a
market maker's quote is inferior to the limit order price, market
makers would be obligated to execute trades at prices superior to their
proprietary quotations. The NASD and Nasdaq maintain that subjecting
market makers to such an order execution requirement would be unfair
and create a disincentive for firms to function as market
makers.13
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\12\ As noted above, NASD Rule 4613 currently requires each
market maker in a Nasdaq issue to enter and maintain two-sided
quotations with a minimum size equal to or greater than the
applicable SOES tier size for the security (e.g., 1,000, 500, or 200
shares for NNM issues and 500 or 100 shares for Nasdaq SmallCap
Market issues). NASD Rule 6330 requires registered market makers in
exchange-listed securities to display a minimum quotation size of
200 or 500 shares in each reported security (as established and
published from time to time by the Association) depending on trading
characteristics of the security.
\13\ The Commission stated in the Adopting Release:
The Commission believes that SROs should consider amending such
rules and modifying certain systems to allow a specialist or market
maker to quote in sizes smaller than the minimum quotation size when
such quote represents a customer limit order. With these changes, a
specialist or market maker that displays a customer limit order in
its quote pursuant to the Display Rule would not be responsible for
executing as principal any additional shares at the limit price
where the size of the customer limit order is less than the minimum
quotation size set by the SRO.
Adopting Release, supra note, 61 FR at 48301 n.144.
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2. Quote Size When Displaying Proprietary Market Maker Quotes
The NASD stated in its filing that market makers should not be
subject to minimum quote size requirements greater than a normal unit
of trading in an environment in which Nasdaq market makers will compete
with customers to affect quotation prices. The NASD also stated that
the new order-driven nature of Nasdaq brought about by the Display Rule
will obviate the regulatory justification for minimum quote size
requirements because investors will have the capability to display
their own orders in the marketplace. The NASD stated that the inclusion
of limit orders and ECN orders in Nasdaq quotations should also ensure
that market liquidity and price continuity will not be harmed by the
elimination of minimum quotation size requirements. Therefore, it
proposed to amend NASD Rule 4613 to require market makers to quote in
minimum trading increments of 100 shares.
On January 9, 1997 the NASD filed an amendment to its filing that
proposes allowing market makers to quote in minimum sizes of 100 shares
for a three-month pilot program in the 50 Nasdaq stocks subject to the
first phase-in under the Order Handling Rules. The remaining securities
would still be subject to the existing minimum quotation display
requirements for proprietary quotes.
B. Operation of SOES
1. Current Operation of SOES
NASD Rule 4611(f) requires each market maker in an NNM security to
register as a SOES market maker in that security. SOES is voluntary for
market makers in Nasdaq SmallCap securities. The maximum SOES order
size for a NNM security is either 1,000, 500, or 200 shares, depending
on the price and volume of the security; the maximum order size for a
Nasdaq SmallCap Market security is 500 shares.14 SOES
automatically executes unpreferenced
[[Page 2417]]
orders in rotation against those market makers who are at the best
quoted bid or offer on Nasdaq at the time the order is entered. With
the agreement of the market maker, SOES orders also may be routed or
``preferenced'' to a particular market maker for execution at the
inside market, regardless of what price the preferenced market maker is
quoting. A SOES market maker is obligated to execute SOES orders up to
the minimum SOES exposure limit for that stock or such greater exposure
limit established by the market maker. The minimum exposure limit for a
particular stock is two times the applicable maximum SOES order size
(e.g., 2,000 shares for stocks in the 1,000 share tier size). If a
market maker's exposure limit is exhausted, it is temporarily suspended
from SOES, placed in a ``closed quote state,'' and permitted a five-
minute period to restore its exposure limit. If a market maker does not
restore its exposure limit within five minutes, it is automatically
withdrawn from the stock and cannot re-enter quotes in the issue for at
least twenty business days.
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\14\ A 1,000 share maximum order size applies to NNM securities
with an average daily non-block volume of 3,000 shares or more per
day, a bid price not exceeding $100 and with three or more market
makers. A 500 share maximum order size applies to NNM securities
with an average daily non-block volume of 1,000 shares or more per
day, a bid price not exceeding $150 and with two or more market
makers. A 200 share maximum order size applies to NNM securities
with an average daily non-block volume of less than 1,000 shares per
day, a bid price not exceeding $250 and with two or more market
makers. See NASD Notice to Members 88-43 (June 22, 1988).
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Thus, SOES is currently designed to execute orders against market
makers based on the tier size for a particular stock, without regard to
the quotation size displayed by a market maker. Because the minimum
quotation sizes for market makers are presently aligned with the
maximum SOES order sizes, it would not be possible to enter into SOES
an order greater in size than the market maker's quote.
2. Changes to SOES in Response to the Order Handling Rules
Because market maker quotes will at times reflect customer limit
orders under the Display Rule, the NASD proposed to modify SOES to
execute market orders only against market makers' displayed quotation
sizes.
a. Decrementation of displayed quotation sizes after SOES
executions.
To avoid instances where a market maker could automatically receive
multiple SOES executions because it displayed a customer's limit order
at a price superior to the market maker's proprietary quote or
increased its quote size because of the limit order, the NASD has
proposed to modify SOES to decrement 15 a market maker's displayed
quote size upon the execution of unpreferenced SOES orders. For
example, if a market maker's quote in security ABCD is 20-20\1/4\ (1000
x 1000), and it receives a customer limit order to buy 500 shares at
20\1/8\, it would update its quote to 20\1/8\-20\1/4\ (500 x 1000).
16 Thereafter, if the market maker received a SOES execution at
20\1/8\ for 500 shares, the size of its bid would be depleted to zero
and the market maker would have to re-enter a new quotation within five
minutes, or withdraw from the stock for 20 days. 17 The NASD
states that this change is intended to encourage market makers to
accept and display customer limit orders because they will not be
subject to mandatory SOES executions larger than the size of the limit
orders they display or at prices at which the market maker is not
willing to trade for its proprietary account. 18
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\15\ The term ``decrement'' is used here to mean to
automatically reduce the quote by the number of shares executed
against it.
\16\ The market maker could elect to quote a size of 1500 x
1000 if it wished to also represent its own proprietary trading
interest at the price established by the customer limit order.
\17\ If the market maker is using the auto-refresh feature,
described below, the update would be automatic.
\18\ The NASD and Nasdaq also propose that displayed quotations
not be decremented after the execution of an odd-lot order (i.e., an
order for less than 100 shares) and that the execution of a mixed
lot order (i.e., an order for greater than 100 shares but in an
increment other than 100 shares) will only decrement a market
maker's quotation by the number of shares represented by the number
of round lots contained in the mixed lot order.
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The NASD filed a letter amending the proposal to make decrementing
optional for market makers whose quotation in a particular security is
equal to or greater than the SOES tier size for that security. Thus,
market makers who are willing to commit greater capital will have the
option of accepting repeated orders at their quoted price and size on a
stock-by-stock basis.
In the NASD's proposal for a pilot program for the quotation
requirement, the non-pilot stocks would still be subject to the
decrementing proposal. Thus, market makers would be required to publish
a quote in non-pilot stocks in the required quote size, but this quote
could be decremented. Once the quote was decremented to zero, or the
market maker chose to manually change the price or size of the
proprietary quote, the market maker would be required to enter at least
the minimum quote size.
b. Split order execution. The NASD proposal would limit a market
maker's SOES exposure to its displayed quotation size, even if less
than the SOES maximum order size. In addition, SOES would be modified
to decrement market makers' displayed quotation sizes in response to
unpreferenced SOES executions. To ensure that a SOES order can be
executed in full in an environment in which SOES maximum order sizes
may be greater than a market maker's displayed quote, the NASD has
proposed changes to SOES that would allow one order to be executed
against multiple market makers. In addition, the NASD has proposed to
change SOES to reject ``all-or-none'' orders. 19
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\19\ An ``all or none'' order is a buy or sell order marked to
provide that no partial transaction is to be executed.
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For example, if the inside market for ABCD is 20-20\1/4\ and two
market makers are each at the inside bid for 500 shares, a SOES market
order to sell 1,000 shares of ABCD would be executed at 20, with both
market makers buying 500 shares. In addition, because all market maker
quotations at the inside could be depleted by the execution of a SOES
order, SOES is being modified to permit market orders to be filled at
multiple price levels. For example, if the inside market for ABCD is
20-20\1/4\ and Market Makers A and B are each at the inside bid for 100
shares, with Market Maker C bidding at 19\7/8\ for 800 shares, a SOES
market order to sell 1,000 shares of ABCD would be executed against all
three market makers. Market Makers A and B would each buy 100 shares at
20 and Market Maker C would buy 800 shares at 19\7/8\''. Finally, a
marketable limit order entered into SOES that exceeds the size of
market maker quotes at the limit price receives a partial fill. The
unfilled portion of the order is returned to the entering firm.
c. Displayed quotation sizes will constitute exposure limits. Under
the proposal, decrementing market maker quotes after unpreferenced SOES
executions will cause each market maker's displayed quotation size to
become its exposure limit. SOES will cease executing orders against a
market maker once its quote size has gone to zero. Therefore, the NASD
has proposed to amend the SOES rules to replace references to exposure
limits with references to a market maker's displayed size.
d. Prohibition against the entry of non-marketable limit orders
into SOES. SOES currently accepts both market orders and limit orders.
If a limit order is not immediately executable, or non-marketable,
(i.e., a limit order to buy priced below the offer price, or a limit
order to sell priced above the bid price) it is placed in the SOES
limit order file and subsequently executed if the limit price becomes
equal to the best bid or offer. Limit orders placed into SOES are never
publicly disseminated, included in the calculation of the best bid or
offer, or matched against incoming market orders. The NASD maintains
that the processing of such orders conflicts with the requirements of
the Display Rule and with the duty of best execution as articulated in
the Adopting
[[Page 2418]]
Release. 20 Therefore, the NASD has proposed that SOES no longer
accept non-marketable limit orders.
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\20\ See Adopting Release, supra note , 61 FR at 48324.
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e. Modifications to the SOES automated quotation update feature.
Currently, the ``auto-refresh'' feature of SOES updates both sides of a
market maker's quotation in parallel by a pre-determined amount after a
SOES execution. The NASD has proposed that, with regard to the fifty
stocks that would be included in the pilot, the Nasdaq Stock Market
would re-establish the market maker's quote, when it is exhausted, for
one normal unit of trading. For those securities not subject to the
pilot, the market maker's quote would be refreshed for the SOES tier
size. For both pilot stocks and all other securities the auto-refresh
feature would be modified to only update the side of a market maker's
quote that has been decremented. 21
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\21\ The NASD has also proposed to amend the auto-refresh
feature to allow a market maker to maintain its quote at the inside
market. With this auto-refresh feature, those market makers seeking
to buy or sell more stock than its displayed quotation could auto-
refresh at its same quotation price if the market maker entered a
quotation size equal to or greater than the maximum SOES order size.
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In its amendment, the NASD proposes to refresh all stocks for the
SOES tier size, because most stocks would remain subject to initial
quotation requirements at this size. The NASD would refresh stocks
subject to the pilot at the SOES tier size, because of difficulties
programming its system to provide different refresh sizes for
particular stocks.
f. Allowing SOES market makers to enter agency orders into SOES. A
SOES market maker currently is prohibited from entering agency orders
into SOES unless a locked or crossed market exists. This rule was
intended to prevent market makers from engaging in ``fair weather''
market making by executing unwanted orders against other market makers
through SOES. However, a market maker's disseminated quote may now
reflect a customer limit order displayed in accordance with the Display
Rule. The NASD has proposed to amend NASD Rule 4730 to permit a SOES
market maker to enter agency orders into SOES to ensure that a
customer's order has access to a better-priced customer limit order
displayed in a market maker's quote regardless of whether the
customer's broker dealer is a SOES market maker. Pursuant to the
amendment, market makers would be able to enter riskless principal
orders into SOES if these orders reflect customer agency orders.
22
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\22\ See supra note 3.
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g. Processing of marketable limit orders. SOES currently is
designed to execute marketable limit orders ahead of market orders
queued in SOES. Although a marketable limit order is functionally
equivalent to a market order when the limit price is equal or superior
to the inside market, 23 SOES currently provides preferential
treatment to marketable limit orders. To eliminate the disparate
treatment of substantively identical orders, the NASD proposed to amend
SOES to execute market and marketable limit orders on a time priority
basis.
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\23\ That is, a limit order to buy priced at or above the offer
and a limit order to sell priced at or below the bid.
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h. Market maker withdrawal from Nasdaq SmallCap Market securities.
Because SOES is voluntary for Nasdaq SmallCap Market securities, when a
market maker's exposure limit is exhausted in one of these securities,
the NASD does not deem the market maker to have voluntarily withdrawn
from the stock, because the market maker can continue to quote the
issue without participating in SOES. If market maker quotations are
decremented after SOES executions, however, it will now be possible for
a market maker in a SmallCap security to go into a ``closed quote''
state because its quotation size has been depleted. Accordingly, the
NASD proposal would amend NASD Rule 4730(b) to specify that a market
maker in a SmallCap security shall be deemed to have voluntarily
withdrawn from a stock if its quote size remains at zero at the close
of the trading day, thereby precluding the market maker from being a
market maker in the issue for twenty business days.
C. Proposed Rule Changes to Implement the ECN Amendment
The NASD also proposed to amend certain rules and characteristics
of the SOES and SelectNet systems to facilitate the development of a
means for ECNs to comply with the requirements of the ECN Display
Alternative. As noted above, the ECN Display Alternative relieves an
exchange specialist or OTC market maker of the requirement to publicly
quote any superior prices that it privately displays through an ECN if
that ECN: (1) Ensures that the best priced orders entered by market
makers and specialists into the ECN are communicated to an exchange or
Nasdaq for public dissemination; and (2) provides brokers and dealers
access to orders entered by exchange specialists and OTC market makers
into the ECN, so that brokers and dealers who do not subscribe to that
ECN can trade with those orders. This access must be equivalent to the
access that would have been available had the market makers or
specialists reflected these superior prices in their public
quotes.24
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\24\ See Adopting Release, supra note 6.
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The NASD has proposed to implement, on an interim basis, a linkage
to facilitate the operation of the ECN Display Alternative 25
based on existing Nasdaq system platforms, SOES and SelectNet
(``SelectNet Linkage''). The methodology for establishing the SelectNet
Linkage and the rule changes proposed by the NASD are described below.
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\25\ The NASD stated in the filing that they continue to examine
other means to develop a longer-term mechanism that would provide a
permanent means to establish an ECN Display Alternative that meets
every aspect of the Commission's rule. The NASD stated that it would
propose a permanent approach separately from the instant filing.
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1. Overview of the Operation of the SelectNet Linkage
The SelectNet Linkage is intended to provide a means for an ECN to
disseminate publicly the price and full size of the orders entered by
specialists and OTC market makers to the NASD and to provide access to
other broker-dealers to trade at those prices, equivalent to that
provided in the market where the prices are disseminated. The SelectNet
Linkage would disseminate ECN prices and sizes by utilizing the
methodology currently used for displaying Unlisted Trading Privileges
(``UTP'') exchange quotes,26 and would provide access to ECN
prices in the same manner that broker-dealers currently may preference
orders through SelectNet.
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\26\ Pursuant to 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 (``Nasdaq/NMS/UTP Plan''), Nasdaq acts as
the facilities manager for itself and the UTP Exchanges in
collecting, consolidating and disseminating quotes from Nasdaq
market makers and UTP exchange specialists that trade Nasdaq
securities pursuant to Section 12(f) of the Act. The prices quoted
by UTP exchange specialists appear on the Nasdaq montage with those
quoted by Nasdaq market makers. Currently, UTP exchange specialists
are not subject to SOES executions.
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The SelectNet Linkage would allow an ECN to enter its best-priced
orders into Nasdaq for display on the Nasdaq Workstation. To effect
transactions against these displayed prices, an NASD member that
subscribes to the Nasdaq Workstation II service would be permitted to
access the ECN prices by directing orders through SelectNet to the ECN.
New NASD Rule 4623 would
[[Page 2419]]
provide for display of and access to ECN prices and sizes and would
articulate the standards for ECN participation in the SelectNet
Linkage.
Proposed NASD Rule 4623 provides that an ECN that wishes to use the
SelectNet Linkage, or any future system Nasdaq develops to facilitate
compliance with the ECN Display Alternative, must: (1) Demonstrate to
the NASD that it meets the ECN definition found in the Quote Rule; (2)
be registered as an NASD member; (3) enter into and comply with the
terms of a Nasdaq Workstation Subscriber Agreement; (4) agree to
provide for Nasdaq's dissemination in the quotation data stream that it
makes available to quotation vendors, the prices and sizes of Nasdaq
market maker orders 27 at the highest buy price and the lowest
sell price for each Nasdaq security entered in and widely disseminated
by the ECN; and (5) provide an automated execution of priced orders
displayed through the linkage or, if the price is no longer available,
an automated rejection of any order routed to the ECN through the
Nasdaq-provided display alternative.
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\27\ The ECN Amendment does not require an ECN to provide non-
market maker interest in the data that would be provided under the
ECN Display Alternative. Nasdaq has been informed, however, by
several ECNs that have non-NASD member participants, e.g.,
institutional investors, that these ECNs will deliver to Nasdaq the
best prices for each security for which they permit orders to be
entered, whether those best prices are from a market maker subject
to the rule or an entity not subject to the rule. If the ECN so
chooses, it may send priced orders to Nasdaq from other entities
that are not Nasdaq market makers or exchange specialists. Nasdaq
will display such prices as it does other ECN-provided prices.
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a. Display of ECN prices. For quotation display purposes, ECNs
would deliver prices to Nasdaq reflecting customer orders in their
systems, and Nasdaq would display and disseminate rounded
prices.28 Nasdaq would furnish ECNs with market maker identifiers
(``MMIDs''). While ECNs would be assigned MMIDs, ECNs would not be
registered as market makers. With the exception of certain rules such
as the NASD's firm quote rule, the two-sided quote requirement,29
and the locked and crossed markets rule discussed below, ECNs would not
be subject to standard market maker requirements in the NASD's Rules.
Nasdaq would include the ECN prices and sizes in the Nasdaq Workstation
II quote montage with the ECN MMID and incorporate the ECN price in the
Nasdaq best price calculation. When the ECN is at the best bid or offer
in the market, its price would be included in the NBBO.
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\28\ ECNs often display priced orders that are quoted in finer
increments (e.g., \1/16\, \1/32\, \1/64\) than the minimum variation
for Nasdaq (currently \1/8\ for stocks over $10). Under the ECN
Amendment, Nasdaq would not be required to display the actual price
of the finer-incremented order; instead, it would round the order to
the nearest standard quote increment (rounding down for increments
on the better-priced bids and up for better-priced offers). The
Commission in the Adopting Release stated that Nasdaq should develop
a capability in its quote dissemination system to flag or specially
denote that an ECN priced order is rounded, but noted that this
capability does not currently exist. Nasdaq has stated that it is
developing a rounding indicator. See Letter from Alfred R. Berkeley,
President, NASD to Richard R. Lindsey, Director, Division of Market
Regulation, SEC, dated November 18, 1996, and letter from Richard R.
Lindsey to Alfred R. Berkeley, dated November 22, 1996 (regarding
display of rounded prices in public quotes).
\29\ The requirement for ECNs to display two-sided quotes is a
temporary requirement, contingent on Nasdaq's development of a
capability that permits ECNs to display a one-sided quote. Nasdaq
recognizes that ECNs often have orders only on one side of the
market. Currently, however, because Nasdaq's quote display system
was built to display market maker quotations and market makers are
required by rule to furnish both a bid and offer, Nasdaq's system
would be unable to recognize an ECN price unless that price were
also entered with a corresponding bid or offer. Accordingly, until
such time as Nasdaq builds a one-sided ECN priced order display
capability, ECNs must enter two-sided ``quotations.'' The NASD and
Nasdaq believe that the one-sided ECN order entry capability should
be available sometime in the first quarter of 1997.
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For example:
NBBO 20\1/8\-20\1/4\, 1000 x 1000
ABCD 19\7/8\-20\1/4\, 1000 x 1000
EFGH 20-20\1/2\, 1000 x 1000
ECNA 20\1/8\-20\1/4\, 1000 x 1000 (an ECN)
Following current practices for UTP exchanges, Nasdaq would not
include the ECN as a SOES market maker. Consequently, an ECN
participating in the SelectNet Linkage would not be subject to SOES
executions. The NASD stated in its filing that it would not subject
ECNs to SOES executions because the ECN would be exposed to the risk of
double executions and the consequent need to take a principal position,
which is inconsistent with the ECN's role of acting solely as agent on
behalf of its customers. The NASD stated that the risk of double
executions arises because, with electronic order entry capabilities,
once an order is displayed in multiple execution systems, such as SOES
and an ECN's own system, the same order can be accessed nearly
simultaneously by different counterparties.
b. Access to ECN prices. NASD members would be able to reach ECN
prices displayed in Nasdaq by directing orders through SelectNet, up to
the size displayed in the ECN quote. The ECN would have the ability to
accept orders at the displayed price, or accept orders at an improved
price if its actual price is at an increment better than that
displayed.30 The ECN would review its own file to determine
whether the priced order displayed in Nasdaq has already been executed
in the ECN's own system. The ECN could reject the order if the order
residing in its own system already has been executed by the time the
SelectNet order is delivered to the ECN. An ECN cannot decline an order
delivered through the SelectNet Linkage because it may find a better
order elsewhere. The Commission understands that ECNs that wish to
utilize the SelectNet Linkage will be required to provide virtually
immediate responses to members entering orders seeking to access
publicly displayed ECN orders.31 The Nasdaq Workstation Subscriber
Agreement would require prompt and non-discriminatory execution of
linkage orders by the ECN.
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\30\ See discussion below regarding the execution of SelectNet
orders at rounded ECN prices when such orders are priced at
increments finer than those permitted to be displayed in the
consolidated quote system.
\31\ An ECN is expected to respond on an automated basis to
orders delivered through the SelectNet Linkage much more rapidly
than a market maker that receives an order delivered through
SelectNet.
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In addition, as NASD members and subscribers to the Nasdaq
Workstation II service, ECNs would be subject to contractual
obligations to demonstrate that their systems are properly designed to
operate in high volume trading environments and that they have adequate
security and other operational procedures in place to maintain the
integrity of Nasdaq systems. ECNs that are not willing or are unable to
comply with such system requirements would not be permitted to
establish a SelectNet Linkage for ECN Display Alternative purposes.
2. Other Rule Changes Necessitated By Development of the SelectNet
Linkage
a. SelectNet changes. i. Current operation of SelectNet. SelectNet
is an automated order routing and execution system that allows a member
to direct buy or sell orders in Nasdaq securities to a single market
maker (preferenced orders) or broadcast orders to all market makers in
the security. Upon receiving a SelectNet order, a member can accept the
order, decline it (if consistent with its firm quote obligations), or
send a counter-offer to the originating member.
ii. Elimination of SelectNet Broadcast feature. The NASD has
proposed to eliminate the SelectNet Broadcast feature and allow only
the entry of a SelectNet order directed to a specific market maker or
ECN. The NASD offered several reasons for eliminating the Broadcast
feature in its rule filing. The NASD noted that with the Broadcast
feature, SelectNet falls within
[[Page 2420]]
the definition of an ECN 32 because it is an ``electronic system
that widely disseminates to third parties orders entered therein by an
exchange specialist or OTC market maker, and permits such orders to be
executed against in whole or in part.'' The NASD stated that it would
be unable to make the systems changes necessary to permit a market
maker to rely upon the ECN Display Alternative if it entered a priced
order into SelectNet. Consequently, market makers that entered priced
orders into SelectNet Broadcast would be required to change their
quotes in the Nasdaq Workstation display. The NASD also stated that the
SelectNet Broadcast feature is a very significant drain on Nasdaq
network capacity resources, and in the face of potentially heavy
additional system usage pursuant to the Order Handling Rules, network
resources are more appropriately devoted to establishing the ECN
linkage for directed orders.
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\32\ SEC Rule 11Ac1-1(a)(8).
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iii. Acceptance of orders at improved prices. The NASD has also
proposed a modification to SelectNet to permit an ECN or market maker
receiving an order through SelectNet at a specific price to execute
that order at a price reflecting price improvement without having to go
through the currently designed counter-offer mechanism. Currently, when
a market maker receives a SelectNet order, it can accept at the price
sent by the order entry firm; or it can counter with a different price
or size. As soon as the market maker puts in a different price,
however, the current system treats the new price as a counter-offer
message. Because ECNs are likely to hold orders at increments that
cannot currently be shown in Nasdaq, when an ECN attempts to accept an
order at a better price, e.g., \1/16\th better, the extant SelectNet
system would treat the new price as a counter-offer. Accordingly, to
comply with the ECN Amendment requirement that orders be executed at
their actual prices, Nasdaq will change SelectNet to prevent the
counter-offer mechanism from operating in such a situation and will
deliver to the order entry firm and the ECN an execution report at the
improved price.
b. SOES rule change. The NASD also has proposed an amendment to
NASD Rule 4730 to modify the SOES system to reject orders entered when
an ECN or UTP Exchange alone sets the price of the NBBO. Although UTP
exchanges and ECNs can establish the best price in Nasdaq, they are not
required to participate in SOES as market makers and therefore are not
accessible through SOES. Proposed Rule 4730(b)(10) provides that if
there are no SOES market makers at the best bid or offer that is being
disseminated by Nasdaq, orders entered into SOES will be returned to
the order entry firm to permit the order entry firm to direct the order
to the entity establishing the best price.
Because the ECN quote is incorporated in Nasdaq's inside price but
is not accessible through SOES under this approach, and SOES is
programmed to execute at the best price displayed, SOES, as currently
designed and operating, would execute orders against the next available
Nasdaq market maker at the inside price established by an ECN whether
that Nasdaq market maker is at the better ECN price or at an inferior
price. The NASD expressed concern that a person could ``game'' SOES by
entering an order into an ECN that drives the Nasdaq inside quote and
obtain multiple SOES automated executions at that price against Nasdaq
market makers even though they are not quoting the ECN price.
Therefore, the NASD has proposed to modify SOES to return
unexecuted SOES orders to the entering member when the inside quote
consists of a SOES-inaccessible price. Order entry firms that enter
orders into SOES during the period when there is no SOES market maker
at the inside market will be informed that the order has been rejected
and may choose to route that order into SelectNet to access the ECN
order driving the inside market or take other measures, such as routing
the order to a market maker that guarantees the best price.33 The
NASD stated that it believes that order entry firms could avoid
submitting orders to SOES during times that a SOES-inaccessible price
drives the inside by developing automated means to determine when an
ECN or UTP exchange is alone at the inside and delivering orders at
such times to an ECN through the SelectNet directed order
capability.34
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\33\ The NASD and Nasdaq have committed to continue to develop a
longer-term approach to the ECN Display Alternative that would
better integrate various electronic systems.
\34\ The NASD considered the alternative of modifying SOES to
ignore the ECN or UTP quote and execute SOES orders at the Nasdaq
market maker's inferior price. The NASD expressed concern that this
approach would raise best execution concerns because the customer's
order entered in SOES would be executed at a price inferior to the
best price displayed in Nasdaq's inside market.
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c. Locked and crossed markets rule amendments. The NASD has
proposed amendments to its locked and crossed markets rule, Rule
4613(e), to state that the locked and crossed markets rule applies to
any NASD member, when that member enters into an ECN a priced order
that is displayed in Nasdaq. The proposed amendment also states that
the locked and crossed markets rule would apply to ECNs when the ECN,
as an NASD member acting as agent, represents an institutional order or
other non-NASD member order the price of which would lock or cross the
best bid or offer in Nasdaq. Therefore, under the proposed locked and
crossed markets rule, NASD members using ECNs, and ECNs themselves for
non-member orders, must comply with Nasdaq's rule that before a market
is locked or crossed, the locking or crossing party must first make
reasonable efforts to execute the quote that would be locked.
The NASD believes that locked or crossed markets can cause investor
confusion because investors will not know the true price of the
security at the time when a locked or crossed quote is publicly
displayed. The NASD also notes that broker-dealers operating internal
order execution systems may be foreclosed from operating those systems
when the market for a particular security is locked or crossed.
The NASD and Nasdaq believe that an ECN should be prohibited from
entering an institutional order into Nasdaq until the ECN has made a
reasonable effort to reach the entity on the other side of the market
whose quote would be locked or crossed. It should be noted that if an
ECN locks or crosses the market, is alone at that price, and a SOES
order is entered against the ECN price that is causing the lock or
cross, SOES will be programmed to reject such orders, rather than
executing them against a Nasdaq market maker at a different price
level.
3. Modifications to Autoquote Policy
Currently, the NASD's Autoquote Policy--which prohibits computer
generated quotes--does not allow a market maker to autoquote to display
a customer limit order. Although the NASD has previously interpreted
the policy to permit a customer limit order to be displayed on an
automated basis, because of the requirements of the Display Rule and
the benefits to investors and the marketplace to be derived from the
Display Rule, the NASD has proposed an amendment to the Autoquote
Policy to clarify that it is permissible to autoquote to display a
customer limit order.
Another amendment to the Autoquote Policy proposed by the NASD
clarifies that ECNs may autoquote to maintain a continuous two-sided
quote for as long as Nasdaq requires ECNs to enter two-sided quotes
because of existing systems limitations. Once Nasdaq develops a
[[Page 2421]]
system capability that permits ECNs to display a one-sided quote, this
exception would lapse.
III. Comments
The Commission received 366 comment letters.35 A separate
summary of comments has been prepared and is available in the public
file. The specific issues addressed by commenters will be discussed in
the appropriate sections of this order.36
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\35\ The Commission received comment letters from numerous
broker-dealer firms, some of which are market makers, and others
that are order entry firms. The Commission received comment letters
from a large number of individuals who could be identified as SOES
traders. The Commission also received comment letters from one self-
described entrepreneur, several individual investors and academic
commenters. In addition, comment letters were received from several
professional associations. The Commission also received comment
letters from a member of Congress, Instinet, the American Stock
Exchange (``Amex'') and the Chicago Board Options Exchange
(``CBOE'').
\36\ Several commenters asked that the Commission extend the
comment period to allow additional comment. See letter from the
Honorable Ralph Hall to Arthur Levitt, Chairman, SEC, dated January
8, 1997. The Commission provided the full comment period required
under the statute and received over 350 comments. The Commission
also has considered numerous comments received after the close of
the comment period. In view of the importance of considering the
NASD's proposals before the effective date of the Order Handling
Rules, however, a longer comment period was not practicable.
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IV. Discussion
The standard by which the Commission must evaluate proposed rule
changes is set forth in Section 19(b) of the Act. The Commission must
approve a proposed NASD rule change if it finds that the proposal is
consistent with the requirements of the Act and the rules and
regulations thereunder that govern the NASD.37 In evaluating a
given proposal, the Commission examines the record before it and all
relevant factors and necessary information.38 After carefully
considering all of the comments, and based on the Commission's
experience and knowledge of current market practices and conditions,
the Commission believes the NASD's proposed rule changes are consistent
with the Act. As noted earlier, the Commission is not acting at this
time on the NASD's proposed change to the SelectNet broadcast feature.
---------------------------------------------------------------------------
\37\ 15 U.S.C. Sec. 78s(b). The Commission's statutory role is
limited to evaluating the rules as proposed against the statutory
standards, and does not require the SRO to prove its proposal is the
least burdensome solution to a problem.
\38\ In the Securities Acts Amendments of 1975 (``1975
Amendments''), Congress directed the Commission to use its authority
under the Act, including its authority to approve SRO rule changes,
to foster the establishment of a national market system and promote
the goals of economically efficient securities transactions, fair
competition, and best execution. Congress granted the Commission
``broad, discretionary powers'' and ``maximum flexibility'' to
develop a national market system and to carry out these objectives.
Furthermore, Congress gave the Commission ``the power to classify
markets, firms, and securities in any manner it deems necessary or
appropriate in the public interest or for the protection of
investors and to facilitate the development of subsystems within the
national market system.'' S.Rep. No. 75, 94th Cong., 1st. Sess., at
7 (1975).
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Section 15A of the Act, which incorporates by reference Section 11A
of the Act, establishes specific standards for NASD rules against which
the Commission must measure the NASD proposal.39 As discussed
below, the Commission has evaluated the NASD's proposed changes in
light of the standards and objectives set forth in Sections 15A and 11A
of the Act.
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\39\ See 15 U.S.C. Secs. 78k-1 and 78o-3.
---------------------------------------------------------------------------
In enacting the 1975 Amendments and establishing the objective of
achieving a national market system, Congress focused closely on the
concept of best execution. To this end, Section 11A provides, among
other things, that it is in the public interest and appropriate for the
protection of investors and the maintenance of fair and orderly markets
to assure economically efficient execution of securities transactions;
fair competition among market participants; the availability to
brokers, dealers and investors of information with respect to
quotations in securities; and the practicality of brokers executing
orders in the best market.40
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\40\ 15 U.S.C. Sec. 78k-1(a)(1).
---------------------------------------------------------------------------
Further, as discussed in the Adopting Release for the Order
Handling Rules, the 1975 Amendments contain an explicit statutory
mandate for the establishment of a national market system. Congress
considered mandating certain minimum components of the national market
system, but instead created a statutory scheme granting the Commission
broad authority to oversee the implementation, operation and regulation
of the national market system.41 In accordance with this mandate,
the Commission adopted the Order Handling Rules last year.
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\41\ S. Rep. No. 75, 94th Cong., 1st Sess. 8-9 (1975) (``Senate
Report'').
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The Commission believes that the rule changes proposed by the NASD
are consistent with the NASD's obligations under the Order Handling
Rules and with the regulatory framework for a national market system
established by Congress in the 1975 Amendments. Congress envisioned a
national market system supported by accurate and reliable public
quotation and transaction information, and the practicability of
brokers executing investors' orders in the best market.42 The
Commission expects that the NASD's rule changes will enhance
transparency and facilitate best execution of customer orders, thereby
contributing to the achievement of the full potential of the national
market system. Further, the NASD's rule changes will bring its systems
in compliance with the Order Handling Rules and ensure that its members
will be able to meet their obligations under the Order Handling Rules.
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\42\ Exchange Act Section 11A(a)(1)(C)(iii) & (iv), 15 U.S.C.
Sec. 78k-1(a)(1)(C)(iii) & (iv).
---------------------------------------------------------------------------
The Commission also believes that the proposal advances the
objectives of Section 11A of the Act.43 The Commission believes
that in furthering the objectives of the Order Handling Rules, the
proposed changes submitted by the NASD are designed to remove
impediments to the operation of a free and open market and a national
market system, enhance the protection of investors and the public
interest, and produce fair and informative quotations, consistent with
Sections 15A(b)(6) 44 and 15A(b)(11) 45 of the Act. In
addition, the Commission believes that the benefits of the proposal in
terms of making the systems and regulatory changes necessary to provide
for the enhanced opportunities for price improvement and greater
transparency of customer limit orders under the Commission's Order
Handling Rules outweigh any potential burden on competition or costs to
customers or broker-dealers affected adversely by the proposal. Thus,
the Commission believes that the proposal is consistent with Section
15A(b)(9) of the Act in that it does not impose a burden on competition
that is not necessary or appropriate in furtherance of the purposes of
the Act.46
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\43\ See 15 U.S.C. Sec. 78k-1.
\44\ Section 15A(b)(6) authorizes the NASD to adopt rules
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. Furthermore, the rules of the NASD must not be designed to
permit unfair discrimination between customers, issuers, brokers, or
dealers.
\45\ Section 15A(b)(11) authorizes the NASD to adopt rules
relating to quotations. Such rules must be designed to produce fair
and informative quotations, to prevent fictitious or misleading
quotations, and to promote orderly procedures for collecting,
distributing, and publishing quotations.
\46\ S.Rep. at 13-14. In weighing the competitive effects of an
SRO rule filing, the Commission must balance any perceived anti-
competitive effects against other statutory objectives. The statute
does not require the NASD to achieve its objective by selecting the
least anti-competitive alternative. See infra notes 86-87 and
accompanying text.
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[[Page 2422]]
The Commission has determined at this time to approve the NASD's
proposed rule change.47 The Commission believes that the rules
being approved today are consistent with the Act, in particular, with
Sections 11A(a),48 15A(b)(6),49 15A(b)(9) 50 and
15A(b)(11) 51 of the Act and Rules 11Ac1-1 and 11Ac1-4 thereunder.
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\47\ The Commission is not approving, however, the exception of
the proposed elimination of the SelectNet broadcast feature, which
the Commission is still considering. Furthermore, the Commission is
approving the elimination of the minimum quotation requirement only
for the NASD's pilot program for 50 stocks for a three-month period.
\48\ Section 11A(a)(1)(C) provides that it is in the public
interest among other things, to assure the economically efficient
execution of securities transactions and the availability to
brokers, dealers, and investors of information with respect to
quotations for and transactions in securities.
\49\ Section 15A(b)(6) requires that the rules of a 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.
\50\ Section 15A(b)(9) requires that rules of an Association not
impose any burden on competition not necessary or appropriate in
furtherance of the purposes of the Act.
\51\ Section 15A(b)(11) requires the NASD, among other things,
to formulate rules designed to produce fair and informative
quotations.
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Various commenters supported the proposed rule change, including
market makers, broker-dealers and associations representing broker-
dealers. Most of these commenters believed that the proposed rule
change would facilitate the implementation of the Order Handling Rules.
Many commenters opposed to the proposed rule change cited a concern for
decreased liquidity and increased volatility as a potential result of
approving the proposed rule change. Still other commenters, including
broker-dealers, individual investors and day traders, supported various
aspects of the proposed rule change while opposing others. The
Commission has determined, for the reasons discussed below, to
partially approve the proposal, and to approve Amendment No. 1 on an
accelerated basis.
Most of the favorable comments, as discussed below, supported the
NASD's efforts to implement the Order Handling Rules by providing
mechanisms for the display of customer limit orders and orders placed
in ECNs by market makers within the time frame set forth by the
Commission in the Adopting Release. In light of all the comment letters
received, the Commission believes that the proposal represents a
workable first step in the implementation of the Order Handling Rules.
In adopting the Order Handling Rules, the Commission firmly believed
that they would increase investor protection by ensuring that customer
limit orders were immediately displayed in the markets, thus narrowing
the quote and increasing quote competition and customer interaction,
and by providing investors information about and access to superior
prices that specialists and market makers displayed in ECNs. To provide
these benefits to the public as soon as possible, the Commission set an
accelerated implementation period that was brief in view of the
magnitude of the changes necessary to prepare for the Order Handling
Rules.
In responding to the established deadlines with the necessary
changes to its systems and rules, the NASD was subject to several
significant constraints. First, the NASD sought to create a linkage
with ECNs by modifying its existing systems because the schedule for
implementation of the rules precluded developing new systems or making
extensive revisions to its existing systems. Second, the redesign of
the NASD's SOES and SelectNet systems (``Legacy systems''), which the
NASD has proposed to replace with a newer NAqcess system, was limited
by these existing Legacy systems' age and inflexibility. Third, the
Nasdaq system has experienced rapid growth in trading and message
volume, and has struggled to maintain sufficient capacity for this
growth. The significant quote changes resulting from the Order Handling
Rules are expected to place serious additional demands on Nasdaq system
capacity. Because of these significant constraints and the need to
comply with the Order Handling Rules' effective dates, the NASD made a
number of compromises in adapting its systems and rules to the Order
Handling Rule requirements. These compromises underlie many of the
issues raised by commenters regarding the amendments. In a number of
instances, the NASD intends to revise its systems after the rules go
into effect, which will reduce some of the concerns raised by the
commenters.
A. Changes to Minimum Quote Size Requirements
1. Comments
Commenters favoring this aspect of the proposal include market
makers, professional associations, institutions and Instinet. These
commenters generally agreed with the NASD that the Order Handling Rules
will transform Nasdaq into more of an order-driven market, and that
market makers should no longer be required to quote more than 100
shares because investor orders will be displayed to the market and
included in Nasdaq quotations. These commenters did not believe that
liquidity would be adversely affected by the amendment.
These commenters believe that the amendment will motivate market
makers to display a size commensurate with their interest whether as
principal or agent. They note that this will enhance price discovery,
as market makers will not be forced to a quotation size that is not
reflective of their actual trading interest, nor will market makers be
restricted in their ability to commit capital without also having an
opportunity to negotiate an appropriate clearing price.52 Making
the quotation requirement the lowest unit of trading, rather than an
artificial minimum decreed by regulation, also conforms to the
practices of other markets (e.g., the NYSE and Amex).53 Finally,
these commenters believe that the competitive environment that will
result from allowing market makers to quote in sizes equal to their own
freely determined trading interest will enhance pricing
efficiency.54
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\52\ Letter from Peter W. Jenkins, Chairman, and Holly A. Stark,
Vice Chairman, Security Traders Association Institutional Committee,
to Jonathan G. Katz, Secretary, SEC, dated December 24, 1996
(``STAIC Letter''); letter from William H. Sulya, Vice President-
Manager & Director, Nasdaq/OTC Department, A.G. Edwards & Sons,
Inc., to Jonathan G. Katz, Secretary, SEC, dated December 23, 1996
(``A.G. Edwards Letter''); letter from Taymond V. Wilmarth, Vice
President and Manager, Equity Trading, Stephens Inc., to Jonathan G.
Katz, Secretary, SEC, dated December 23, 1996 (``Stephens Letter'');
letter from Antonio Cecin, Managing Director, Equity Trading, Piper
Jaffray Inc., to Jonathan G. Katz, Secretary, SEC, dated December
24, 1996 (``Piper Jaffray Letter''); letter from Paul Schott
Stevens, Senior Vice President and General Counsel, Investment
Company Institute, to Jonathan G. Katz, Secretary, SEC, dated
December 26, 1996 (``ICI Letter''); letter from Robert J. McCann,
Managing Director, Co-Head, Global Equity Markets, Merrill Lynch, to
Jonathan G. Katz, Secretary, SEC, dated January 7, 1997 (``Merrill
Lynch Letter'').
\53\ Letter from Dennis Marino, Chairman, and John N. Tognino,
President, Security Traders Association, to Jonathan G. Katz,
Secretary, SEC, dated December 24, 1996 (``STA Letter''); letter
from Dennis Marino, President and Chief Executive Officer, Sherwood
Securities Corp., to Jonathan G. Katz, Secretary, SEC, dated
December 24, 1996 (``Sherwood Securities Letter''); letter from Bart
Green, Manager, OTC Trading, and Phil Schwab, Principal, Edward
Jones, to Jonathan G. Katz, Secretary, SEC, dated December 24, 1996
(``Edward Jones Letter''); Merrill Lynch Letter.
\54\ Letter from Robert Padala, President, The Security Traders
Association of New York, Inc., to Jonathan G. Katz, Secretary, SEC,
dated December 24, 1996 (``STANY Letter''); letter from Alan B.
Levenson, Esq. and Robert H. Rosenblum, Esq., Fulbright & Jaworski
L.L.P., on behalf of Herzog, Hein, and Geduld, Inc., to Jonathan G.
Katz, Secretary, SEC, dated December 26, 1996 (``Herzog, Heine,
Geduld Letter''); letter from the Denver Security Traders
Association, Inc., to Jonathan G. Katz, Secretary, SEC, dated
December 24, 1996 (``DSTA Letter''); letter from George K. Jennison,
Managing Director, Nasdaq Trading, Wheat First Butch Singer, to
Jonathan G. Katz, Secretary, SEC, dated December 31, 1996 (``Wheat
First Letter''); Merrill Lynch Letter.
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[[Page 2423]]
One supporting commenter noted that liquidity will not be reduced
because many firms provide automated execution at the quote for small
and medium sized customer orders and to other dealers in the market
through systems other than SOES.55 This commenter believes many
dealers will continue this practice for competitive reasons.
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\55\ Wheat First Letter.
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Commenters opposing the proposal include several order entry firms,
some academics, certain individual investors, the Amex and the CBOE.
Most of these commenters argued that the proposal would adversely
impact liquidity and create volatility. Several commenters were
concerned that with the 100-share minimum quotation size all SOES
market makers' quotations would easily be exhausted and result in a
closed quote state.56 The NASD rule, in the view of some, would
reduce the value of displayed market maker quotes, provide no incentive
to quote larger sizes and undermine the Quote Rule.57 A few order
entry firms asserted that the proposal effectively reduces market maker
risk by 90%.58 A number of commenters said that reducing the
minimum quote size would effectively eliminate investors' ability to
execute orders against market makers' quotes through SOES during
volatile trading conditions in individual stocks or market-wide, under
the theory that there would be no trading interest in the market from
customers or market makers during such times. These commenters argue
that this was the very reason that SOES was made mandatory after the
1987 Market Break.59 One commenter representing a group of SOES
users argued that the display of a limit order does not obviate the
need for market maker quotes and that the Commission, in the Adopting
Release, seemed to suggest that a need for market maker quotes would
continue. This commenter argued that the NASD's proposal is thus
inconsistent with the Adopting Release.60
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\56\ See Letters from Scott Dishner, to Jonathan G. Katz,
Secretary, SEC, dated December 16, 1996 (``Dishner Letter'');
Patrick G. Dolan, to Jonathan G. Katz, Secretary, SEC, dated
December 30, 1996 (``Dolan Letter''); Joseph Pellechia, to Jonathan
G. Katz, Secretary, SEC, dated December 23, 1996 (``Pellechia
Letter''); Ishtaj Rahman, to Jonathan G. Katz, Secretary, SEC, dated
December 19, 1996 (``Rahman Letter''); Joel Rebhun, to Jonathan G.
Katz, Secretary, SEC, dated December 17, 1996 (``J. Rebhun
Letter''); letter from Timothy Whelan, to Jonathan G. Katz,
Secretary, SEC, dated December 18, 1996 (``Whelan Letter'').
\57\ Letter from Bruce L. Miller, to Jonathan G. Katz,
Secretary, SEC, dated December 23, 1996 (``B. Miller Letter'');
letter from David K. Whitcomb, Professor of Finance, Graduate School
of Management, Rutgers University, to Dr. Richard Lindsey, Director,
Division of Market Regulation, SEC, dated November 21, 1996
(``Whitcomb Letter (11/21/96)''); letter from Ilian Petrov, to
Jonathan G. Katz, Secretary, SEC, dated December 16, 1996 (``Petrov
Letter''); letter from Sayan Bhattacharya, to Jonathan G. Katz,
Secretary, SEC, dated December 16, 1996 (``Bhattacharya Letter'');
letter from John Geisler, to Jonathan G. Katz, Secretary, SEC, dated
December 20, 1996 (``Geisler Letter''); letter from William Turner,
President, Turner Vision, to Jonathan G. Katz, Secretary, SEC, dated
December 26, 1996 (``Turner Vision Letter''); letter from Paul
Schultz, Associate Professor of Finance, College of Business, The
Ohio State University, to Richard Lindsey, Director, Division of
Market Regulation, SEC, dated December 13, 1996 (``Paul Schultz
Letter''); letter from Winston Meyer, to Jonathan G. Katz,
Secretary, SEC, dated December 20, 1996 (``Meyer Letter'').
\58\ Letter from Linda Lerner, General Counsel, All-Tech
Investment Group, Inc., to Jonathan G. Katz, Secretary, SEC, dated
November 22, 1996 (``All-Tech Letter (11/22/96)''); letter from
Marina Kaneti, to Jonathan G. Katz, Secretary, SEC, dated December
17, 1996 (``Kaneti Letter''); letter from Michael O'Reilly, to
Jonathan G. Katz, Secretary, SEC, dated December 16, 1996
(``O'Reilly Letter''); letter from Tolga Erman, to Jonathan G. Katz,
Secretary, SEC, undated (``Erman Letter''); letter from David
Sciortino, to Jonathan G. Katz, Secretary, SEC, December 19, 1996
(``Sciortino Letter''); letter from Frederick N. Balbi, President,
FNB Managment [sic] Inc., to Jonathan G. Katz, Secretary, SEC,
undated (``FNB Letter'').
\59\ See e.g., letter from Jason Goldstein, to Jonathan G. Katz,
Secretary, SEC, dated December 19, 1996 (``Jason Goldstein
Letter''); letter from Rob Lindauer, to Jonathan G. Katz, Secretary,
SEC, dated December 17, 1996 (``Lindauer Letter''); letter from
Bryan Hollander, to Jonathan G. Katz, Secretary, SEC, dated December
16, 1996 (``Hollander Letter''); letter from James R. Gibbs, Jr., to
Jonathan G. Katz, Secretary, SEC, dated December 15, 1996 (``Gibbs
Letter''); letter from Alexander Goor, to Jonathan G. Katz,
Secretary, SEC, dated December 18, 1996 (``Goor Letter'').
\60\ J. Lee Letter.
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Amex and CBOE expressed concern over the rule's impact on options
market makers' ability to trade at the quote.61 Several commenters
believed the requirement will hurt small order entry firms without
order routing arrangements.62
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\61\ The Amex also asked the Commission to clarify that the
Limit Order Protection Interpretation of the NASD (Manning II) still
requires market makers to fill customer limit orders at the quote
prior to or at the same time as trading for its dealer account. The
Commission notes that the present proposal has no effect on the
outstanding Limit Order Protection Interpretation of the NASD.
Letter from James F. Duffy, Executive Vice President and General
Counsel, American Stock Exchange, Inc., to Jonathan G. Katz,
Secretary, SEC, dated December 26, 1996 (``Amex Letter'').
\62\ Letter from Raymond L. Hope, Jr., to Jonathan G. Katz,
Secretary, SEC, dated December 21, 1996 (``Hope Letter''); Turner
Vision Letter; letter from David K. Whitcomb, Professor of Finance,
Graduate School of Management, Rutgers University, to Richard
Lindsey, Director, Division of Market Regulation, SEC, dated January
7, 1997 (``Whitcomb Letter (1/7/97)''). See also letter from Yusif
Simaan, Associate Professor of Finance, Fordham University, to
Richard Lindsey, Director, Division of Market Regulation, SEC, dated
December 9, 1996 (``Simaan Letter''); letter from John M. Lang,
President, I.Q. Management, Inc., to Jonathan G. Katz, dated
December 19, 1996 (``I.Q. Letter'').
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Many commenters, while opposed to the change in the minimum quote
size requirement for the market maker's proprietary quote, were not
opposed to the change in the minimum quote size for market makers
displaying a customer limit order.63
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\63\ Letter from Elizabeth Erwin, President, Momentum
Securities, Inc., to Jonathan G. Katz, Secretary, SEC, dated
December 23, 1996 (``Momentum Letter''); letter from James H. Lee et
al., to Jonathan G. Katz, Secretary, SEC, dated December 24, 1996
(``J. Lee Letter''); letter from Dongsoo Lee, to Jonathan G. Katz,
Secretary, SEC, dated December 16, 1996 (``Dongsoo Lee Letter'').
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Finally, a number of commenters opposed to the rule suggested an
alternative under which a market maker would separately display both
its own proprietary quote and any customer limit orders it
holds.64 They suggested that this could be accomplished either
through separate quotes with separate market maker identifiers or as a
separate field in the Nasdaq display.
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\64\ Whitcomb Letter (11/21/96); letter from Michael F. Frey,
President, A.J. Michaels & Co., Ltd., to Jonathan G. Katz,
Secretary, SEC, dated November 20, 1996 (``A.J. Michaels Letter'');
letter from Dennis Grossman, President, Grossman & Co., to Jonathan
G. Katz, Secretary, SEC, dated December 21, 1996 (``Grossman
Letter''); letter from Wesley Jordan, to Jonathan G. Katz,
Secretary, SEC, undated (``W. Jordan Letter''); letter from David
T.K. Lu, to Jonathan G. Katz, Secretary, SEC, undated (``Lu
Letter'').
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2. Commission Analysis
The Commission has determined to approve the amendment to reduce
quotation size requirements for market makers displaying customer limit
orders. The Commission believes there are substantial reasons, as
explained below, to expect that reducing market makers' proprietary
quotation size requirements in light of the shift to a more order-
driver market would be beneficial to investors. To gain practical
experience with the proposal, the Commission has determined to approve,
on a three-month pilot basis, the amendment reducing quotation size
requirements for market makers displaying proprietary quotes for the 50
securities first subject to the Limit Order Display Rule.65 During
this pilot program, the Commission, the NASD
[[Page 2424]]
and Nasdaq will evaluate the effect of reduced quotation sizes on the
market for these securities. As discussed below, factors to be
considered in this evaluation include, among others, the impact of
reduced quotation sizes on liquidity, volatility and quotation spreads.
The Commission believes that the quote size amendment is consistent
with the Sections 11A and 15 of the Act both for proprietary and limit
order quotes because, in the context of the implementation of the Order
Handling Rules, it is designed to encourage fair competition and
improved quotation prices, thus improving the quality of executions for
investors.
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\65\ These securities, selected by Nasdaq from the 500 most
actively traded securities, range in median daily dollar volume from
first to 478th, cover a range of industry sectors, and have an
average spread ranging from \1/8\ to over one dollar.
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The Commission believes that when an OTC market maker displays a
customer limit order, it is appropriate to relieve the market maker of
the obligation to quote a minimum size at the limit price. As noted by
the NASD and many commenters, if the limit order is smaller than the
minimum required quotation size, the quotation requirement would expose
the market maker to a principal execution at a price established by the
limit order, not by its own proprietary trading interest. In adopting
the Limit Order Display Rule, the Commission did not intend to increase
market makers' principal exposure and indeed expressly noted that the
SROs should consider amending their rules as necessary to allow market
makers displaying customer limit orders to quote in smaller size
increments.66
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\66\ Adopting Release, supra note 6, at n. 144.
---------------------------------------------------------------------------
The Commission is also approving, on a limited basis, the NASD's
reduction of minimum quotation sizes for proprietary market maker
quotes. The Commission recognizes the concerns of many of the opposing
commenters regarding the provision's potential impact on liquidity and
volatility. The Commission, based on its experience with the markets
and discussions with market participants, believes that decreasing the
required quote size will not result in a reduction in liquidity that
will hurt investors. As discussed in its release adopting the Order
Handling Rules, the Commission expects the public display of market
makers' ECN orders and customer orders to add significant depth and
stability to the market in OTC stocks. Indeed, the display of customer
limit orders provides an unprecedented opportunity in the Nasdaq market
for customer interest to interact without the intervention of a dealer.
In this regard, the Commission also anticipates that many market makers
will choose to display larger quotes as a competitive matter. For these
reasons, the Commission also does not believe that the amendments will
result in smaller quotes that will prevent investors from obtaining
executions in market crises. The Commission also notes that brokers
often use other means, such as directing orders to market makers
through SelectNet, routing orders on a pre-agreed basis through the
NASD's ACES systems, or using private order routing systems, to obtain
automated executions for retail investors at sizes larger than market
makers' published quotations.
The Commission recognizes that with the shift to a more order
driven market, the role of market makers in providing liquidity changes
substantially. Currently, Nasdaq market makers are the principal source
of liquidity for investors seeking immediacy (i.e., seeking to buy or
sell at the best currently available market price). In contrast, on
exchanges, where the specialist market maker typically displays most
customer orders, those orders provide the principal source of
liquidity. With the display of ECN orders and retail and institutional
customer limit orders in the Nasdaq market, Nasdaq market makers may
frequently find themselves in a similar situation, with customer orders
providing the primary source of liquidity and market makers providing
liquidity during temporary imbalances in supply and demand.
The Commission believes that it is appropriate to consider whether,
in a market displaying customer orders in competition with market maker
quotes, there is justification for requiring market makers to quote at
a mandatory size. Neither the Act nor the Commission's rules require a
quote size larger than 100 shares. Historically, because customer
trading interest was not displayed in the Nasdaq market, the NASD
determined that it was appropriate that market makers display at least
a minimum size in their quotes that would be representative of their
trading interest in that security. In contrast, the exchanges have not
imposed such a requirement on their own order-driven markets, where
specialist market makers are permitted to quote sizes as small as one
round lot (100 shares) when they are not representing customer orders.
The Commission recognizes, of course, that exchange specialists, in
consideration for their central role in a particular security on the
exchange, are subject to various trading requirements which are
intended to ensure the maintenance of stable and liquid markets.67
However, a substantial factor contributing to market depth on the
exchanges is the peer allocation review process on many of the
exchanges, under which specialists are rated on their performance in
maintaining stable and liquid markets, and risk forfeiting their stock
allocations should their performance lag. The Commission notes that on
Nasdaq, not only will customer orders provide liquidity, but multiple
market makers compete in various securities. Consequently, even though
market makers do not risk losing a stock allocation to another market
maker by regulation, they nevertheless risk losing business in the
stock to another market maker, an ECN, or a customer order if they are
not quoting competitive prices and significant size at those prices. In
other words, given a choice between two market makers quoting different
sizes at the same price, all else equal, a customer would be more
likely to approach the market maker quoting the larger size.68
Accordingly, at this time the Commission believes that there may be
substantial reason to expect that various competitive pressures would
encourage market makers to maintain deep markets.
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\67\ For example, New York Stock Exchange Rule 104.10 requires a
specialist to maintain, as far as reasonably practicable, a fair and
orderly market, as measured by price continuity and depth, and
minimization of the effects of any temporary disparity between
supply and demand. See Division of Market Regulation, SEC, The
October 1987 Market Break Report, (February 1988) p.4-2.
\68\ While, as pointed out by commenters, a significant share of
retail order flow in the Nasdaq market is internalized or otherwise
subject to predetermined order routing arrangements, the Commission
nevertheless believes that market maker quotes should serve an
important function in attracting trading interest, especially in an
order driven environment where there is less incentive and
flexibility for market makers to avoid displaying actual trading
interest.
---------------------------------------------------------------------------
The economic impact on the market of reducing the minimum market
maker quote size from 1000 shares to 100 shares raises several issues.
The Commission recognizes that the 1000-share quote minimum applicable
to many Nasdaq stocks has been viewed as a means of providing liquidity
to orders seeking the quoted price. However, the Commission
preliminarily believes that a number of factors may well prevent a
significant loss of liquidity in moving to 100-share quote minimums.
First, the presence of limit orders mitigates the loss of displayed
trading interest by market makers. The Commission believes that the
increased representation of customer limit orders is likely to add
depth to the markets. As customer limit orders that are priced better
than existing market maker quotes are displayed in the public quote,
greater flexibility in market maker quotation size may increase trading
[[Page 2425]]
interest from market professionals at the inside quotation, thereby
adding to market depth. As noted by one commenter, revising minimum
quote size will increase the information content of market maker quotes
by facilitating different quote sizes from dealers who have a
substantial interest in the stock at a particular time and those who do
not.69 This same commenter notes, and the Commission agrees, that
for the most liquid Nasdaq securities, ``the ability to interact with
live bids and offers that represent real orders, where size is revealed
at all price levels (depth of book) is the most fair for all market
participants.'' 70
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\69\ STAIC Letter.
\70\ STAIC Letter.
---------------------------------------------------------------------------
Second, the 1000 share minimum quote size represents a barrier to
entry for market making. Lowering this barrier to entry could attract
more market makers, thereby increasing liquidity and competition across
the market. Similarly, with large minimum quotes, smaller firms cannot
effectively compete on a price basis for stocks with a high per-share
price. For example, if security ABCD is trading at $85 per share, the
market maker would be exposed at its quote for executions at a minimum
of $85,000 when subject to a minimum quote size of 1000. If the minimum
quote size is only 100 shares, the market maker's minimum capital
exposure at its quote would be reduced to $8500. The Commission
believes that a lower minimum quotation size will likely attract
smaller firms into the market, increasing both price competition and
liquidity.
Moreover, a significant motivation for the Commission's approval,
on a limited basis, of the reduction of minimum quotation sizes for
market maker quotes is the belief that greater quotation flexibility is
likely to lead to narrowing of the spread. Reducing the quotation size
requirement reduces the risk that market makers must take, and should
encourage them to quote more aggressive prices.71 Thus, the
Commission believes even if there were a decline in quoted depth in
certain securities, many investors in those securities may well receive
better executions with narrower spreads.
---------------------------------------------------------------------------
\71\ See All-Tech Letter (11/22/96); Kaneti Letter; Petrov
Letter. See supra note 58. Even opponents of change recognize that
reducing the mandatory size for quotations reduces market maker
risk.
---------------------------------------------------------------------------
Even if the spread is not narrowed, reducing the required quotation
size could encourage continued and even increased market maker
participation at the inside market other prices to the extent that the
minimum quotation size requirement poses a barrier to entry. Thus, this
change could help maintain or increase liquidity in the stock. This
could be particularly significant if the display of customer limit
orders reduces the profitability of market making in OTC securities, a
possibility predicted by the Commission in the Adopting Release.72
The reduction in risk resulting from reducing the required quotation
size and the concomitant reduced exposure to automated executions
should help preserve market maker participation that might otherwise be
eroded by the display of limit orders and a larger market maker quote
size. As noted below, the Commission has requested that the NASD study
include information on the spreads and number of market makers of the
50 stocks that are the subject of the pilot program.73
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\72\ Adopting Release, supra note 6.
\73\ The Commission is aware of several articles associating
smaller quote sizes with narrower spreads. See Bacidore, The Impact
of Decimalization on Market Quality: An Empirical Investigation of
the Toronto Stock Exchange (Revised: July 1996); Harris, Minimum
Price Variations, Discrete Bid-Ask Spreads, and Quotation Sizes,
Review of Financial Studies 7 (1994); Copeland, T. and Galai D.,
Information Effects of the Bid-Ask Spread, 38 Journal of Finance
(1983). Although cognizant of distinctions in the relevant markets
involved in these studies that make comparisons with the Nasdaq
market nondefinitive, the Commission believes that these studies
provide additional support for the proposed pilot program.
---------------------------------------------------------------------------
Although the Commission preliminarily believes that the proposal
will not adversely affect market quality and liquidity, the Commission
believes that it is appropriate to take steps to further assess the
effect on the markets. Therefore, the Commission is approving a
lowering of the minimum quote size in a limited number of securities at
this time to assess this provision's impact on a select group of Nasdaq
securities. Thus, the Commission has determined that it is appropriate
to allow the NASD to implement its proposed rule change reducing
minimum quotation sizes for market makers' proprietary orders for the
50 stocks included in the first phase of the Limit Order Display Rule
for a three-month period.74 The Commission believes that these
securities, all of which are among the 500 most actively traded Nasdaq
securities, provide the most appropriate basis on which to assess the
potential for any negative impact suggested by opposing commenters. The
three-month pilot will give the Commission, the NASD and Nasdaq time to
assess the impact of the change on the market, before considering the
rule change on a broader or permanent basis. The Commission is
approving this pilot program to begin at the same time as the first
phase of the Order Handling Rules because the Commission believes that
it is important for the markets and the Commission, in its oversight
role over these markets, to be able to evaluate the combined impact of
the NASD's proposed changes to Nasdaq and the Order Handling Rules in a
limited group of securities.
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\74\ The Commission notes that at the conclusion of the three-
month pilot, the market makers must quote the previously required
size unless the Commission approves the change on an extended or
permanent basis.
---------------------------------------------------------------------------
The Commission requests that the NASD and Nasdaq conduct a study
during this pilot to gauge the effect of the reduction in minimum quote
size on the market for these 50 stocks. The Commission notes that these
50 stocks were chosen to provide a broad cross section of the most
liquid Nasdaq securities. The number of market makers in these stocks
presently ranges from a low of three to a high of 49. The inside spread
ranges from \1/8\ to $1 and the price ranges from approximately $9 to
$141 with an average price of $44.50. The current 1000 share minimum
for these stocks therefore represents, on average, approximately
$44,000 per trade, a substantial amount in the retail context.
Specifically, the NASD study should include an analysis of: (1) The
number of market makers in each of the 50 securities, and any change in
the number over time; (2) the average aggregate dealer and inside
spread by stock over time; (3) the average spread for each market maker
by stock; (4) the average depth by market maker (including limit
orders), and any change in the depth over time; (5) the fraction of
volume executed by a market maker who is at the inside quote by stock;
and (6) a measure of volume required to move the price of each security
one increment (to determine the overall liquidity and volatility in the
market for each stock). The Commission expects that these factors be
contrasted over the time period immediately preceding the pilot and
after the beginning of the pilot. Further, the Commission notes that
beginning three weeks after the commencement of the pilot on 50 stocks,
market makers will be required to display customer limit orders in 100
additional stocks pursuant to Rule 11Ac1-4. These 100 stocks will not
be part of the pilot that the Commission is approving today, and
therefore provide an opportunity for direct comparison with the stocks
in the pilot. Thus, the Commission requests that the NASD and Nasdaq
include in the study a matched pairs analysis of the 50 stocks in the
pilot with 50 stocks in the second phase-in. This analysis should
[[Page 2426]]
encompass the six factors enumerated above. The Commission will
consider the results of the study in determining whether to extend or
expand the pilot.
Some commenters suggested that the Commission establish a system of
dual quotes so that market makers could separately display limit orders
and proprietary trading interest. 75 The Act does not require an
exchange or association to separately display these two types of
trading interest. These changes also could require extensive systems
changes on the part of Nasdaq, and could absorb substantial additional
Nasdaq systems capacity at a time when Nasdaq capacity may potentially
be under strain. The Commission also does not believe that the NASD is
statutorily required to move toward a central limit order book or
``black box'' system, as favored by some commenters. 76 It should
be noted that the Commission was recently urged to adopt such
approaches as alternatives to its Order Handling proposals. The
Commission determined that at present it is in the best interest of
investors, and consistent with the Act, to require the display of
customer limit orders through the quotations communicated by market
makers to the consolidated quotation stream, directly or through market
or ECN systems. 77
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\75\ See supra note 64.
\76\ Whitcomb Letter (11/21/96); All-Tech Letter (11/22/96).
\77\ Adopting Release, supra note 6. The Commission also does
not believe that the liquidity available to options market makers,
like other investors, will be reduced by the Amendments. Nor do the
amendments approved today alter the access of options market makers
to Nasdaq systems such as SOES or SelectNet.
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B. Changes to SOES in Response to the Order Handling Rules
Many commenters addressed the NASD's proposed changes to SOES in
response to the Order Handling Rules. Specific areas of concern are
discussed below.
1. Decrementation of Displayed Quotation Sizes After SOES
Executions
a. Comments. As noted above, the rule change provides that a market
maker's displayed size will be decremented after each unpreferenced
SOES execution. Market makers generally, and the DSTA and STA,
expressed support for the amendment. Several other market makers, while
supportive of the provision, argued that a market maker should have the
option to set a higher exposure limit than just its displayed quote
size. 78 One market maker and the SIA argued that there is no
reason to distinguish between preferenced and unpreferenced orders in
decrementing the quote, and that a market maker's quote should be
decremented upon execution of preferenced orders as well as non-
preferenced orders. 79
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\78\ Letter from Edward J. Johnsen, Vice President and Counsel,
Morgan Stanley & Co. Incorporated, to Jonathan G. Katz, Secretary,
SEC, dated December 20, 1996 (``Morgan Stanley Letter''); Stephens
Letter; Piper Jaffray Letter
\79\ Letter from Bernard L. Madoff, Chairman, Trading Committee,
Securities Industry Association, to Jonathan G. Katz, Secretary, SEC
dated December 26, 1996 (``SIA Letter''); letter from Lon Gorman,
Chief Executive Office, and Leonard Mayer, President, Mayer &
Schweitzer, Inc., to Jonathan G. Katz, Secretary, SEC, dated
December 27, 1996 (``Mayer & Schweitzer Letter'').
---------------------------------------------------------------------------
Academics, order entry firms and SOES traders opposed the amendment
to make the displayed quotation size a firm's exposure limit. Several
commenters argued that the proposed reduction of minimum quotation
sizes to 100 shares, together with the proposal to establish a market
maker's displayed quotation size as its exposure limit, would
effectively eliminate SOES. 80 One order entry firm expressed
concern that it is not clear what maximum order size limits order entry
firms will be held to in the future. In addition, several SOES traders
suggested that if this amendment is adopted, the NASD interpretation
limiting order entry firms to one 1000-share trade per security every
five minutes (``five minute rule'') should be eliminated. 81
---------------------------------------------------------------------------
\80\ All-Tech Letter (11/22/96); Whitcomb Letter (11/21/96);
Simaan Letter; Momentum Letter; letter from Mark K. Sydenstricker,
Vice President and Chief Financial Officer, The Exchange House,
Inc., to Jonathan G. Katz, Secretary, SEC, dated December 20, 1996
(``Exchange House Letter'').
\81\ See e.g., letter from Adam Raichel, to Jonathan G. Katz,
Secretary, SEC, dated December 19, 1996 (``Raichel Letter''); letter
from Michael Gleeson, to Jonathan G. Katz, SEC, dated December 19,
1996 (``Gleeson Letter''); letter from Paul R. Rudd, to Jonathan G.
Katz, Secretary, SEC, dated December 18, 1996 (``P. Rudd Letter'');
letter from Chris Boran, to Jonathan G. Katz, Secretary, SEC,
undated (``Boran Letter''); letter from Arthur E. Herrmann, to
Jonathan G. Katz, Secretary, SEC, dated December 10, 1996
(``Herrmann Letter''); letter from Feral Talib, to Jonathan G. Katz,
SEC, undated (``Talib Letter'').
---------------------------------------------------------------------------
Several SOES traders argued that in light of the decrementing
provision, the 15-second quote update period following an execution is
too long and should be reduced or eliminated. 82 In addition, some
of these commenters argued that the five minutes during which a market
maker goes into a ``closed quote'' status following decrementation to
zero is too long. 83
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\82\ Letter from Gil Shapiro, to Jonathan G. Katz, Secretary,
SEC, dated December 17, 1996 (``Shapiro Letter''); letter from
Joshua Pohl, to Jonathan G. Katz, Secretary, SEC, dated December 16,
1996 (``Pohl Letter''); Joseph Walsh, to Jonathan G. Katz,
Secretary, SEC, dated December 17, 1996 (``Walsh Letter''); Raichel
Letter; letter from Nancy Tom, to Jonathan G. Katz, Secretary, SEC,
dated December 24, 1996 (``Tom Letter''); letter from Charles Rhyee,
to Jonathan G. Katz, Secretary, SEC, dated December 20, 1996
(``Rhyee Letter''); Whelan Letter.
\83\ Letter from Matthew Kansler, to Jonathan G. Katz,
Secretary, SEC, dated December 20, 1996 (``Kansler Letter''); letter
from John Parente, to Jonathan G. Katz, Secretary, SEC, dated
December 19, 1996 (``Parente Letter''); letter from Alexis
Theofilactidis, to Jonathan G. Katz, Secretary, SEC, dated December
20, 1996 (``Theofilactidis Letter''); letter from Marcie D. Rebhun,
to Jonathan G. Katz, Secretary, SEC, dated December 15, 1996 (``M.
Rebhun Letter'').
---------------------------------------------------------------------------
b. Commission analysis. The NASD has proposed to replace its
current mandatory quote size and SOES exposure limits with voluntary
quote size, decremented as executions occur against this quote size. As
a result, the maximum exposure at the quote will be reduced from twice
the SOES tier size to the displayed quote size. The NASD redesigned the
SOES exposure limits to reflect the introduction of customer limit
orders required by the Order Handling Rules. Decrementing the quote
will ensure that quotes reflecting limit orders are withdrawn once the
limit order is fully executed, consistent with display of customer
limit orders. The NASD applied decrementing to market maker proprietary
quotes as well as customer limit orders in part because of the
inability of the system to differentiate between market maker limit
order and proprietary quotes. In addition, the NASD believes that
reducing the quotation to reflect SOES executions more accurately
reflects the nature of the market maker quote when limit orders are
required to be displayed.
The Commission believes that allowing both proprietary and customer
quote sizes to be reduced to reflect executions may encourage more
competitive market maker quotes because, as discussed previously,
market makers can control more precisely the extent of their exposure
in SOES at the quoted price. This in turn may improve customer
execution prices and increase investor participation in the market. In
addition, market makers may be encouraged to continue or increase their
market making role, mitigating the competitive pressure resulting from
the display of ECN prices and customer limit orders.
In addition, the Commission believes that the display of customer
limit orders should result in an increase in the displayed quotation
size, offsetting at least in part the reduced exposure limits for
market maker quotes. The Commission believes that these potential
benefits from quotes more representative of market makers' actual
trading interest and the display of limit orders offsets the potential
for reduced execution size against the quote in
[[Page 2427]]
SOES. Therefore, the Commission believes that the decrementing of quote
size is consistent with the Act, in particular 11A.
In response to commenters who recommended that market makers have
an option of setting a higher exposure limit, the NASD has amended the
proposal to make the decrementing provision optional for quotes
displaying size equal to or more than the SOES tier size for the
security. \84\ The Commission agrees that this modification is
consistent with the Act. The Commission believes that allowing market
makers that quote in substantial size to opt out of decrementing will
encourage the display of greater quote size and allow market makers to
maintain quotes that add depth to the markets.
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\84\ See supra note 3.
---------------------------------------------------------------------------
The Commission notes that the NASD did not propose in the current
filing any amendments to the 15-second period following an execution
during which a marker maker may update its quote, or the five-minute
``closed quote'' provision. These provisions thus are not under review
at this time. Similarly, amendment of the five minute rule is not part
of the current proposal, and thus not under review at this time. \85\
However, the Commission believes that these time periods are not
inappropriately long in the context of the instant SOES revisions. The
Commission also believes that dropping a market maker with a zero quote
to the bottom of the display screen helps reduce confusion and makes
clear which market makers are ``in the market.''
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\85\ The Commission notes that the NASD has proposed substantial
revisions to small order execution in its NAqcess proposal.
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Finally, the Commission believes that it is consistent with the Act
to modify the quotation requirements for unpreferenced orders only. The
Commission recognizes that many firms have arrangements with
correspondents by which they agree to execute order flow at the
prevailing quote. These preferencing arrangements are wholly voluntary,
and can be subject to conditions if so desired by the market maker. The
Commission has considered such arrangements in the past, \86\ and has
not found them to be violative of the investor protection goals of the
statute. For firms executing high volumes of trades pursuant to such
arrangements, mandatory decrementing pursuant to such activity would
require the market maker to repeatedly update its quote in response to
orders executed at its quote. The Commission does not believe this
outcome is compelled by the statute. In any event, the NASD's current
proposal does not include an optional decrementing provision for
preferenced order flow, and thus this issue is not currently before the
Commission.
---------------------------------------------------------------------------
\86\ See Securities Exchange Act Release No. 29810 (October 10,
1991), 56 FR 52098 (October 17, 1991) (order approving SR-NASD-91-18
and SR-NASD-91-26, amendments to SOES).
---------------------------------------------------------------------------
2. Split Order Execution
a. Comments.Order entry firms and SOES traders argued against
allowing SOES executions at split prices. These commenters stated that
order entry firms and their customers would experience added expense
and delay because their orders could be subject to multiple executions
against multiple parties. 87 Several commenters stated that a SOES
order of 1000 shares could be split up into as many as 10 trades and
executed against 10 separate market makers at a price inferior to the
best displayed quote at the time the order was sent. 88 Several
commenters also objected to the elimination of ``all or none'' orders
from SOES. 89
---------------------------------------------------------------------------
\87\ Letter from Kelly Jordan, to Jonathan G. Katz, Secretary,
SEC, dated December 18, 1996 (``K. Jordan Letter''); letter from
Michael P. Doyle, to Jonathan G. Katz, Secretary, SEC, dated
December 18, 1996 (``Doyle Letter''); letter from Brian Schartz, to
Jonathan G. Katz, Secretary, SEC, undated (``Schartz Letter'');
letter from Drew Sohn, to Jonathan G. Katz, Secretary, SEC, dated
December 17, 1996 (``Sohn Letter''); Bhattacharya Letter, All-Tech
Letter (11/22/96); letter from Paul Nadan, to Jonathan G. Katz,
Secretary, SEC, dated December 18, 1996 (``P. Nadan Letter'');
letter from Steve Dworkin, to Jonathan G. Katz, Secretary, SEC,
undated (``Dworkin Letter''); Petrov Letter, W. Jordan Letter;
letter from Nicola Victory, to Jonathan G. Katz, Secretary, SEC,
dated December 16, 1996 (``Victory Letter''); letter from Cornel
Catrina, to Jonathan G. Katz, Secretary, SEC, dated December 16,
1996 (``Catrina Letter'').
\88\ Whitcomb Letter (11/21/96); Simaan Letter.
\89\ Letter from Ed Chui, to Jonathan G. Katz, Secretary, SEC,
dated December 19, 1996 (``Chui Letter''); letter from Tracy Clarke,
to Jonathan G. Katz, Secretary, SEC, undated (``Clarke Letter'');
letter from Robert Beers and Stephen Wilk, to Jonathan G. Katz,
Secretary, SEC, dated December 26, 1996 (``Beers & Wilk Letter'');
letter from Michael T. Studer, President, Castle Securities Corp.,
to Secretary, SEC, dated December 24, 1996 (``Castle Letter'');
letter from Russell A. Grigsby, President, Cornerstone Securities
Corporation, to Jonathan G. Katz, Secretary, SEC, dated December 20,
1996 (``Cornerstone Letter''); FNB Letter.
---------------------------------------------------------------------------
b. Commission analysis. The Commission is approving the proposed
amendment because it is a necessary adjunct to eliminating required
quote sizes for market makers, and allowing display of customer limit
orders of less than the SOES order size. As discussed previously, the
Commission does not believe that in a market displaying limit orders
the Act compels a market maker to trade at a size greater than the
minimum trading unit, thus assuming greater risk than it would
otherwise. Although split order executions can result in somewhat
greater execution costs for an order entry firm, these split executions
accurately reflect trading interest in the market at that time. In
addition, the amendment is necessary to ensure the smooth functioning
of SOES in an environment where market makers must regularly update
their quotes to reflect customer limit orders and assess their own
desire to assume market risk. Finally, if a customer wants to assure
that it does not receive split executions, it may enter orders at the
size of the best displayed quotes, or request that its order not be
executed through SOES.
The NASD has proposed to prohibit entry of all-or-none orders in
SOES because it believes that most users of all-or-none market orders
do not expect execution of all-or-none orders at multiple prices. The
amendment to the SOES system to allow split executions, combined with
the proposed elimination of minimum quote size, could result in SOES
orders being executed at more than one price. In addition, revising the
SOES system to provide all-or-none executions in the context of the
modified SOES system would require substantial Nasdaq resources. The
Commission believes that the NASD's decision to not provide for all-or-
none orders in the revised SOES system reduces the possibility of
investor confusion regarding the execution prices that could result
and, thus, is consistent with the directive in Section 15A(b)(6) that
the NASD's rules be designed to facilitate the maintenance of fair and
orderly markets.
3. Prohibition Against the Entry of Non-Marketable Limit Orders into
SOES
a. Comments.Several market makers expressed support for prohibiting
entry of non-marketable limit orders into SOES while several order
entry firms and a SOES trader argued against it. These latter
commenters generally argued that the NASD should not prohibit the entry
of non-marketable limit orders into SOES and therefore should not
eliminate the SOES limit order file. 90 One commenter said that
the concept is not adequately described. 91
---------------------------------------------------------------------------
\90\ Letter from Warren E. Spehar and Michael J. Schunk,
Managing Partners, First Westchester Securities, to Jonathan G.
Katz, Secretary, SEC, dated December 18, 1996 (``First Westchester
Letter''); letter from Seth Hurwitz, to Jonathan G. Katz, Secretary,
SEC, dated December 18, 1996 (``Hurwitz Letter''); FNB Letter.
\91\ Grossman Letter.
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b. Commission analysis. The Commission believes the prohibition is
consistent with the Act because, as noted by the NASD, limit orders
held in
[[Page 2428]]
the SOES limit order file are not displayed in the public quote, thus
making the file inconsistent with the Limit Order Display Rule.
Further, because of its inherent limitations, the limit order file also
was infrequently used, undermining its potential usefulness. Thus, the
Commission agrees that it is appropriate to eliminate the file to
assure compliance with the Order Handling Rules.92
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\92\ The Commission notes that the NASD's NAqcess proposal,
which would create a publicly displayed limit order book, is still
under consideration. See Securities Exchange Act Release No. 37302
(June 11, 1996), 61 FR 31574 (June 20, 1996).
---------------------------------------------------------------------------
4. Modifications to the SOES Automated Quotation Update Feature
a. Comments. Several market makers supported the proposal to allow
auto-refreshing of the market maker's quote.93 One market maker
commented that automation facilitates the efficient operation of the
multiple market making system and fosters efficiency and liquidity.
Without this modification, according to this commenter, market making
would become prohibitively expensive for many firms.94 Another
market maker argued that if a market maker could have one side of its
quote refreshed at an inferior price without also adjusting the other
side of its quote, then the NASD also should modify Rule 4613(d), the
NASD excess spread parameters rule.95 Several commenters were
concerned about the NASD's proposal to refresh market maker quotes for
100 shares instead of tier size.96
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\93\ DSTA Letter; Edward Jones Letter; Herzog, Heine, Geduld
Letter.
\94\ Edward Jones Letter.
\95\ Morgan Stanley Letter.
\96\ Castle Letter; Gleeson Letter; letter from Wayne Hong, to
Jonathan G. Katz, Secretary, SEC, dated December 20, 1996 (``Hong
Letter''); letter from James B. Carpenter, to Jonathan G. Katz,
Secretary, SEC, undated (``Carpenter Letter''); letter from Tai
Truong, to Jonathan G. Katz, Secretary, SEC, dated December 15, 1996
(``Truong Letter''); letter from Daniel Balber, to Jonathan G. Katz,
Secretary, SEC, undated (``Balber Letter''); letter from John
Cassimatis, to Jonathan G. Katz, Secretary, SEC, dated December 16,
1996 (``Cassimatis Letter'').
---------------------------------------------------------------------------
b. Commission analysis. The Commission is approving the
modification because it believes an automatic quote update feature,
which is currently available in SOES, is consistent with the Act. As
originally proposed, the auto-refresh capability will update the quote
for only the required minimum quote size. In the NASD's amendment
establishing the pilot, however, for programming reasons the NASD
proposed to auto-refresh the quotation up to the SOES order size for
all securities, including the 50 pilot stocks. The market maker would
be allowed to reduce the size in these 50 pilot stocks if it wished to
quote at a smaller size. The Commission believes that auto-refresh will
be a helpful tool for market making in this new environment, and is
consistent with the Act.
5. Allowing SOES Market Makers to Enter Agency Orders into SOES
a. Comments. Several market makers expressed support for the
proposal to allow SOES market makers to enter customer orders into
SOES.97 The SIA and several market makers argued that market
makers should be allowed to enter riskless principal orders into SOES
as well as agency orders, as these orders are the economic equivalent
of agency orders.98 Several market makers argued that market
makers should also be permitted to enter proprietary orders into
SOES.99
---------------------------------------------------------------------------
\97\ See e.g., Herzog, Heine, Geduld Letter; Edward Jones
Letter.
\98\ SIA Letter; letter from Peter C. Cohan, Managing Director,
Pershing to Jonathan G. Katz, Secretary, SEC, dated January 2, 1997
(``Pershing Letter''); Mayer & Schweitzer Letter.
\99\ Letter from Dan B. Franks, Senior Vice President, Equity
Trading, Scott & Stringfellow, Inc., to Jonathan G. Katz, Secretary,
SEC, dated December 23, 1996 (``Scott & Stringfellow Letter'');
letter from Leslie Seff, Fidelity Capital Markets, to Jonathan G.
Katz, dated December 23, 1996 (``Fidelity Capital Letter'').
---------------------------------------------------------------------------
Several SOES traders opposed the proposal.100 One SOES trader
suggested that verification procedures were needed to assure that
orders entered by market makers were legitimate agency orders.101
---------------------------------------------------------------------------
\100\ Gleeson Letter; letter from Stephen Kovacs, to Jonathan G.
Katz, Secretary, SEC, dated December 20, 1996 (``Kovacs Letter'');
Grossman Letter.
\101\ Letter from Hendrickson, to Jonathan G. Katz, Secretary,
SEC, dated December 18, 1996 (``Hendrickson Letter'').
---------------------------------------------------------------------------
b. Commission analysis. In the Adopting Release for the Order
Handling Rules, the Commission suggested that the NASD consider
revising SOES to allow market makers to enter customer orders into SOES
in particular to execute against displayed customer limit
orders.102 The Commission was concerned that firms operating
internal automated execution systems could execute substantial customer
orders based on individual limit orders establishing a best bid or
offer price. The Commission suggested that while under best execution
principles the firm would be expected to match the displayed quote up
to its size, the firm should be provided a mechanism to instead execute
the customer limit order directly against the superior displayed quote.
The NASD proposal is consistent with this suggestion. The NASD has not
permitted market makers to enter orders into SOES for their own
account, because to date the NASD has concluded that automated
execution by one market maker against another would expose market
makers to excessive risk and thus would discourage market making.
Therefore, the proposal is limited to market maker riskless principal
orders reflecting agency orders held by the market maker. The NASD
intends to monitor for compliance with this condition as part of its
regular examination program for market makers.
---------------------------------------------------------------------------
\102\ Adopting Release, supra note .
---------------------------------------------------------------------------
The Commission believes it is consistent with the Act to eliminate
differentiating between agency orders entered in SOES by market makers
or order entry forms. Accordingly, the Commission is approving the
amendment. Furthermore, the Commission notes that riskless principal
orders entered by market makers on behalf of customer orders will be
accorded like treatment under the rule. The Commission agrees with the
NASD that the amendment will help to ensure that all customer orders
receive the benefit of interaction with other interest in the market
and enhanced price improvement opportunities.
6. Processing of Marketable Limit Orders
a. Comments. Only one commenter addressed the issue of eliminating
the priority accorded marketable limit orders over market orders in
SOES, expressing support for the proposal.103
---------------------------------------------------------------------------
\103\ Herzog, Heine, Geduld Letter.
---------------------------------------------------------------------------
b. Commission analysis The Commission believes the amendment is
consistent with the Act, and therefore approves this modification. This
amendment will eliminate an unwarranted advantage to investors placing
marketable limit orders over those placing market orders. This result
recognizes the functional equivalency of these two types of orders.
7. Market Maker Withdrawal from Nasdaq SmallCap Market Securities
a. Comments. Only one commenter addressed this issue; this market
maker believed the provision should be modified such that a market
maker would be deemed to have voluntarily withdrawn from the market if
its quote remained at zero at the opening of the following trading
day.104
---------------------------------------------------------------------------
\104\ Herzog, Heine, Geduld Letter.
---------------------------------------------------------------------------
b. Commission analysis. The Commission believes this amendment is
consistent with the Act, and therefore
[[Page 2429]]
approves this modification. The Commission does not believe that
requiring a market maker to reenter a quote in a SmallCap security by
the close of trading for the day presents a significant hardship to
market makers in a security. Furthermore, establishing an outer time
frame by which a market maker must reenter its quote makes it clear to
the market which market makers in a security are willing to continue
---------------------------------------------------------------------------
market making in the security.
C. Implementing the SelectNet Linkage
As noted above, the NASD proposed to change certain rules and
aspects of the SOES and SelectNet systems to implement the SelectNet
Linkage, which is intended to facilitate the operation of the ECN
Display Alternative based on existing Nasdaq system platforms, SOES and
SelectNet. The nature of this linkage was constrained by the needs of
the ECNs and the limitations on the Nasdaq computer systems discussed
previously.
1. Display of ECN Prices
a. Comments. Several market makers and the SIA supported the
proposal for the display of ECN prices and characterized it as a
``reasonable interim approach.'' 105 Those favoring the proposal
praised the consolidated market maker/ECN quote as increasing market
transparency.
---------------------------------------------------------------------------
\105\ Herzog, Heine, Geduld Letter; Mayer & Schweitzer Letter;
SIA Letter; Pershing Letter.
---------------------------------------------------------------------------
Comments criticizing the proposal were submitted by Instinet,
individual investors, academics, order entry firms and SOES traders.
The majority of critical comments concerned the rounding indicator.
Many commenters objected to the determination of the NASD not to
disseminate the actual prices displayed by ECNs if those prices are in
increments finer than the NASD's minimum quotation increments.106
Some commenters argued that the failure to display the actual price or
an indicator that a price was rounded would make it impossible for
brokers to find the best price for retail customers.107 These
commenters requested either that rounding not be approved without the
indicator, or encouraged the NASD and Nasdaq to implement the rounding
indicator as soon as possible, and move to finer increments or decimal
pricing as soon
as feasible.108 One commenter, noting that ECNs with rounded
prices will not have display priority over market makers at an
inferior, displayed price, but instead will be treated as if their
rounded price were their actual price and entered according to time
priority, questioned whether any technological reason existed for this
approach.109 One order entry firm suggested that rounding without
an indicator permits an ECN to ``hide its market'' which is
inconsistent with the Order Handling Rules.110 This firm also
suggested that once the rounding indicator is available, market makers
should be allowed to quote with the indicator. Finally, several order
entry firms suggested that rounding permits the market maker to trade
at the superior price with the ECN, give its customer a fill at the
posted quote, and keep the ``hidden'' fraction.111
---------------------------------------------------------------------------
\106\ A.J. Michaels Letter; All-Tech (12/23/96); Grossman
Letter; Hope Letter; I.Q. Letter; Hurwitz Letter; Simaan Letter;
Whitcomb Letter (11/21/96).
\107\ All-Tech Letter (12/23/96), Whitcomb Letter (11/21/96);
Simaan Letter; letter from Seth Modlin, to Jonathan G. Katz,
Secretary, SEC, dated December 19, 1996 (``Modlin Letter'').
\108\ A.J. Michaels Letter; All-Tech Letter (12/23/96); Simaan
Letter; Whitcomb Letter (11/21/96). See also Hope Letter; I.Q.
Letter; Hurwitz Letter.
\109\ Whitcomb Letter (12/10/96). See also Instinet Letter.
\110\ All-Tech Letter (12/23/96).
\111\ A.J. Michaels Letter; First Westchester Letter.
---------------------------------------------------------------------------
b. Commission analysis. While recognizing and sharing concern about
the lack of a rounding indicator, the Commission believes that this
amendment represents a significant step forward in the public display
of prices entered into ECNs. For the first time, a consolidated montage
displaying both quotes of market makers and ECN prices will enable
investors and market professionals alike to view in one place all the
trading interest in a particular security in the market. In addition to
providing improved transparency, the proposed Nasdaq linkage will
enable investors to access prices that previously were available only
to subscribers to an ECN. Thus, investors will have access to better
prices and the goal of best execution for all customers will be
advanced.
The Commission has determined the NASD's proposal to develop the
SelectNet linkage is consistent with Act and, thus, is approving the
proposal. The Commission believes the SelectNet linkage furthers the
Section 11A objective of achieving more efficient and effective market
operations, fair competition among brokers and dealers, and the
economically efficient execution of investor orders in the best market.
Specifically, the development of the SelectNet linkage will facilitate
the display of customer limit orders, thereby advancing the national
market system goal of the public availability of quotation information,
as well as fair competition, market efficiency, and best execution. The
enhanced transparency of these orders also increases the likelihood
that limit orders will be executed because contra-side market
participants will have a more accurate picture of trading interest in a
given security.
In adopting the Order Handling Rules, the Commission recognized
that ECNs may display orders in increments smaller than the minimum
quotation increments used in the public trading markets. The Order
Handling Rules sought to publicize the ECN prices in the existing
public quotation systems, but in doing so did not require the SROs to
alter their existing trading increment. Rather, the Commission allowed
market makers' and specialists' quotes in ECNs at finer increments to
be displayed in the SROs markets at prices rounded to the SROs'
quotation increment, with a rounding indicator.112 The NASD and
other SROs have indicated that, as a technical matter, display of a
rounding indicator is not possible by the implementation date of the
rules.
---------------------------------------------------------------------------
\112\ Adopting Release, supra note .
---------------------------------------------------------------------------
Many commenters stated that the lack of a rounding indicator will
make it difficult to determine if an improved price is available from
an ECN. The NASD and Nasdaq have acknowledged this difficulty and have
committed to resolving this problem by implementing a rounding
indicator as soon as possible. The Commission believes the NASD and
Nasdaq are acting in good faith and have granted the SROs no-action
relief concerning the lack of a rounding indicator until July 31,
1997.113 The Commission believes that there is much to be gained
by going forward with the SelectNet linkage without the indicator,
pending Nasdaq's development of an appropriate format for such a
notation. The Commission notes that, consistent with the Order Handling
Rules, when an order is sent through SelectNet to an ECN and a market
maker or specialist has entered an order at a better price, which is
rounded for display in Nasdaq, the order sent through SelectNet will
receive the better price available in the ECN. Moreover, broker-dealers
will be able to enter orders through the SelectNet linkage priced at
finer increments than the rounded quotes. Broker-dealers and their
customer can use such orders to define the prices at which they are
willing to trade.
---------------------------------------------------------------------------
\113\ See supra note .
---------------------------------------------------------------------------
2. Access to ECN Prices
a. Comments.
Some commenters criticized the lack of an electronic linkage
between the ECNs and SOES, and argued that it should be possible for
SOES orders to be
[[Page 2430]]
electronically routed to an ECN.114 Several commenters noted that
the lack of the linkage could eliminate the market maker's risk of
exposure to executions at the ECN price.115 Furthermore,
commenters argued that without automated execution through the linkage,
ECNs would be able to favor their own customers in executions.116
Other commenters expressed concern that because a SOES/SelectNet
linkage was not required, the execution of small orders entered into
SOES, but rejected on the basis of a superior ECN quote, will be
delayed while they are manually rerouted to SelectNet.117 In
contrast, Instinet argued that the proposal's requirement that ECNs
automate SelectNet response functions is costly and excessively
burdensome. Instinet further maintained that ECNs should be given
flexibility to evaluate the credit worthiness of non-ECN subscribers.
---------------------------------------------------------------------------
\114\ Morgan Stanley Letter; Instinet Letter; Exchange House
Letter; Grossman Letter; Lu Letter.
\115\ See e.g., Grossman Letter; Hurwitz Letter.
\116\ See e.g., Cornerstone Letter; All-Tech Letter (12/23/96).
\117\ All-Tech Letter (11/22/96); Pompeo Letter; Beers & Wilk
Letter; Edward Jones Letter.
---------------------------------------------------------------------------
b. Commission analysis. As discussed above, some commenters
criticized the lack of an automated execution between SOES and the
ECNs. The Commission, in the Adopting Release, stated that ECNs must
provide broker-dealers who use SOES with equivalent automated access to
the best priced market maker orders in the ECN for NNM and SmallCap
securities.118 This could be accomplished either through an
electronic linkage to SOES or by other means agreed upon with the
NASD.119 The Commission recognizes that the SelectNet Linkage does
not include an electronic linkage to SOES. The SelectNet linkage was
developed to accommodate the ECNs, at least on an interim basis, to
receive an order rather than an automated execution such as provided by
SOES. The ECNs by definition provide automated executions of orders
internally. Linking to an external automated execution system would
create the risk of two simultaneous executions against the same order,
thereby forcing the ECN operator to trade as principal without an order
on the other side. Because the Commission expressed strong support for
an effective ECN display alternative as an element of the Order
Handling Rules,120 the NASD determined to create the SelectNet
linkage as an interim measure to implement the ECN display alternative
by the implementation date of the rules. Because of the age and
inflexibility of the SOES and SelectNet systems, the NASD was unable to
link its SOES system to the SelectNet system by the effective date of
the rules, in order to allow SOES orders to be routed to the ECN via
SelectNet when the ECN displayed a superior price. The NASD has
indicated that the existing linkage is in its view an interim measure,
and that it intends to link these functions in the future. The NASD
also intends to include in its proposed ECN addendum to the Nasdaq
Workstation subscriber agreement requirements that the ECN respond
promptly to a SelectNet linkage order.
---------------------------------------------------------------------------
\118\ Adopting Release, supra note . The Commission also
discussed the provision of telephonic access to ECN prices.
\119\ Id.
\120\ Adopting Release, supra note .
---------------------------------------------------------------------------
In response to Instinet's comment opposing the requirement of
automated responses from ECNs, the Commission believes that this
requirement is necessary to assure the smooth functioning of the
SelectNet linkage. The Commission believes that, because the SelectNet
linkage does not provide automated executions, any significant delay in
response to a SelectNet order from the ECN will unreasonably prolong
execution time for the customer. However, the Commission believes that
the NASD requirements for ECNs will result in execution response times
of a matter of seconds, so that use of the linkage will be virtually
immediate.
The Commission takes very seriously the concern expressed that ECNs
could potentially favor their own customers. The Commission is
satisfied, however, that adequate safeguards are in place to prevent
ECNs from discriminating between customers in a manner inconsistent
with the Order Handling Rules. First, ECNs will be required to execute
an ECN addendum to the Nasdaq Workstation subscriber agreement
providing that they cannot prefer their own customers in executions or
discriminate against linkage orders. Second, the subscriber agreement
requires prompt responses to linkage orders. Finally, the Quote Rule
only excepts a broker-dealer from honoring its quote if it is effecting
a transaction or is in the process of updating its quote. If an ECN
cannot demonstrate that one of these exceptions applies, it will be
liable for a violation of its Quote Rule obligations as well as the
NASD ECN subscriber agreement.
In response to Instinet's concern about the need for time to
examine the credit worthiness of customers, the Commission notes that a
key condition of performing as a display alternative under the Order
Handling Rules is that the ECN provide access to its prices to broker-
dealers equivalent to that provided by market makers and specialists.
Market makers and specialists must be firm at their quotes for orders
from at a minimum all brokers and dealers. The ECN must satisfy the
same standard. The Commission staff has interpreted the Quote Rule to
allow a narrow exception so that the market maker may take into account
the substantial likelihood that a counterparty may not perform in
determining whether to trade with the counterparty at its
quote.121 The SelectNet linkage and the NASD ECN addendum would
not preclude an ECN from declining an order from a counterparty if it
had a substantial basis for believing the counterparty would not
perform; indeed, an ECN could program its system to reject linkage
orders from particular counterparties if the ECN can satisfy this
narrow exception from the Quote Rule. Rejection of linkage orders for
generalized credit concerns would not constitute providing equivalent
access as required to qualify as an ECN display alternative.
---------------------------------------------------------------------------
\121\ The Commission staff interpreted the Quote Rule as
permitting a market maker from refraining from trading at its
displayed quote if it had a substantial basis for believing that the
counterparty to the transaction will not be able to honor the trade.
Letter from Richard Lindsey, Director, Division of Market
Regulation, SEC, to Richard Grasso, Chairman and CEO, NYSE, dated
November 22, 1996, p. 17.
---------------------------------------------------------------------------
3. Implementation of the ECN Linkage
a. Comments. Instinet argued that the Workstation Subscriber
Agreement required by the rule should not contain substantive
conditions not imposed on other users Nasdaq workstation users.
Instinet also objected to the characterization of the linkage by the
NASD and Nasdaq as ``interim,'' and expressed its opposition to further
modifications that may make the linkage resemble a consolidated limit
order file. Instinet requested that the SEC monitor negotiations
regarding further modification between the ECNs and the NASD.
b. Commission analysis. In its November interpretive letter,
122 the Commission staff recognized that the SROs should have the
ability to establish reasonable conditions on ECNs linking with the SRO
pursuant to the ECN display alternative. The Commission believes that
the NASD's Workstation Subscriber Agreement addendum is an appropriate
vehicle for establishing reasonable conditions for ECNs linking with
Nasdaq. Regarding
[[Page 2431]]
Instinet's concerns about the NASD's further modifications to the
interim approach, the Commission believes it is premature to consider
the nature of potential revisions at this time. The Commission believes
that it is important to enhance the SelectNet linkage to connect the
market order executions systems with the ECN linkages; however, the
design of these future enhancements has not been determined and is not
before the Commission in the present filing. Any future changes would
be filed by the NASD and Nasdaq as a rule filing with the Commission
and published for comment. The Commission will fully consider the
issues presented by, and comments on, such a filing at that time. The
Commission intends to monitor future negotiations between the ECNs and
the NASD regarding the design of this linkage.
---------------------------------------------------------------------------
\122\ See letter from Richard R. Lindsey, Director, Division of
Market Regulation, SEC, to Richard Grasso, Chairman and CEO, NYSE,
dated November 22, 1996.
---------------------------------------------------------------------------
4. Eliminating SelectNet Broadcast Feature
a. Comments. Several market makers, the STA and the DSTA favor the
elimination of the SelectNet broadcast feature. 123 Several
commenters expressed support for the elimination of the counter-offer
function.124
---------------------------------------------------------------------------
\123\ A.G. Edwards Letter; letters from Daryl Andersen (Nasdaq
Equity Trading), Joseph G. Geelan (Vice President, Institutional
Trading), Jeff Peterson (Vice President, Senior Trader), Daniel L.
Henn (Vice President, Nasdaq Equity Trading), Dede Yurecko (Vice
President, Senior Trader), Art Kearney (Executive Vice President,
Director of Capital Markets), Beth McCann (Vice President,
Institutional Trading), John G. Kinnard & Co., to Secretary, SEC,
dated December 24, 1996 (``Kinnard Letters''); DSTA Letter, Edward
Jones Letter; Mayer & Schweitzer Letter; STA Letter; STAIC Letter;
STANY Letter.
\124\ Edward Jones Letter.
---------------------------------------------------------------------------
Many commenters, including academics, order entry firms and SOES
traders, objected to eliminating the SelectNet broadcast feature.
125 Several commenters argued that eliminating the SelectNet
broadcast feature effectively eliminated the ability of SelectNet to
function as an electronic stock market.126 These commenters argued
that the proposal turns SelectNet into ``nothing more than a message
routing system.'' 127
---------------------------------------------------------------------------
\125\ See e.g., All-Tech Letter (12/23/96); Boran Letter; Frame
Letter; Grossman Letter; letter from Gerard Hunter, to Jonathan G.
Katz, Secretary, SEC, dated December 19, 1996 (``G. Hunter
Letter''); FNB Letter, W. Jordan; Cornerstone Letter.
\126\ Whitcomb Letter (11/21/96); Simaan Letter.
\127\ Simaan Letter, Whitcomb Letter (11/21/96); letter from
Jerry Putnum, Terra Nova Trading, LLC, to Jonathan G. Katz,
Secretary, SEC, dated December 9, 1996 (``Terra Nova Letter'').
---------------------------------------------------------------------------
It was argued that eliminating the SelectNet broadcast feature,
together with eliminating the SOES limit order file, meant that public
orders could be entered into the market only if a market maker or ECN
chose to accept that order in its sole discretion. 128 Another
order entry firm echoed this comment and stated that order entry firms
will now have no means of displaying orders between the spread.
129 Several order entry firms stated that the elimination of the
broadcast function forces order entry firms to subscribe to an ECN.
130
---------------------------------------------------------------------------
\128\ See e.g. First Westchester Letter; Cornerstone Letter.
\129\ Cornerstone Letter.
\130\ First Westchester Letter; Grossman Letter.
---------------------------------------------------------------------------
b. Commission analysis. The Commission is not taking action on the
SelectNet broadcast feature at this time, pursuant to an NASD consent
to an extension of time for consideration of this portion of its
proposal. The NASD said that a major basis for its proposal to
eliminate the SelectNet broadcast feature was concern that the Nasdaq
system had inadequate capacity to continue all current functions once
the Order Handling Rules went into effect. The NASD indicated that the
SelectNet broadcast feature uses substantial systems capacity. The
Commission intends to monitor the impact on Nasdaq systems capacity and
quote traffic of the phase-in of the Order Handling Rules before
reaching a determination regarding elimination of the SelectNet
broadcast feature.
5. Rejection of SOES Orders When ECN or UTP Exchange Is at the Inside
Quote
a. Comments. Market makers generally were in favor of the proposal
to reject SOES orders when no Nasdaq market maker was quoting at the
inside quote. They believe it is appropriate for the order to be
returned to the entering firm when an exchange or ECN is driving the
inside. Order entry firms and SOES traders generally opposed the
proposal. One order entry firm argued that it would be possible for an
order to be sent to an ECN through the SelectNet Linkage, rejected by
the ECN, returned to the broker who then enters the order into SOES,
which then rejects the order because in the interim, an ECN established
a better price.131 Another stated that the proposal would render
SOES unusable for most large issues for many periods if market makers
use the display alternative.132 Several commenters believed this
aspect of the proposal creates a risk that some market makers would
improperly use ECNs to avoid being subject to SOES executions. 133
Another order entry firm claimed that the proposal undermines
competition and legitimizes collusive behavior.134 One order entry
firm argued that the rule change moves the market from an environment
where a customer cannot hope to obtain best execution to an environment
where the customer must obtain best execution or no execution at
all.135 This commenter stated that the customer preferring speed
and certainty of execution over price improvement is disadvantaged.
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\131\ All-Tech Letter (11/22/96). See also Beers & Wilk Letter;
letter from Geoffrey Dubey, to Jonathan G. Katz, Secretary, SEC,
dated December 20, 1996 (``Dubey Letter''); Edward Jones Letter, Lu
Letter; letter from Michael McLoughlin, to Jonathan G. Katz,
Secretary, SEC, dated December 16, 1996 (``McLoughlin Letter'');
letter from Dario Pompeo, to Jonathan G. Katz, Secretary, SEC, dated
December 18, 1996 (``Pompeo Letter'') (discussing the delay involved
with this aspect of the proposal).
\132\ Exchange House Letter.
\133\ Cornerstone Letter; Morgan Stanley Letter.
\134\ First Westchester Letter.
\135\ All-Tech Letter (11/22/96).
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b. Commission analysis. The Commission is approving the amendment
to effect this change as consistent with the Act and the rules
thereunder, particularly the Order Handling Rules. As discussed below,
the NASD was unable to link the SOES system with the SelectNet linkage
by the implementation date for the Order Handling Rules. Therefore,
when an ECN or a UTP exchange is alone at the best quote, the SOES
system must either reject orders, execute them against Nasdaq market
makers at the ECN or UTP exchange quote, or execute them at the Nasdaq
market makers' best quote even though that quote is inferior to the
NBBO. The Commission agrees with the NASD's analysis that to hold the
market maker to a SOES execution at a price that is being driven by the
ECN or exchange would be competitively unfair, and to execute SOES
orders at the market maker's own quote would result in customer
executions at a price that is inferior to the NBBO, generally violating
best execution duties of broker-dealers entering the orders.
The Commission recognizes that the shutdown of SOES when better ECN
or UTP exchange quotes are displayed in the NBBO will reduce the
ability to execute customer orders immediately on an automated basis.
At the same time, it will contribute to competitive quotations by
encouraging customer orders to be routed to the ECN or UTP exchange
displaying the best quote. Market makers that want to attract SOES
order flow in these securities will be encouraged to publish a Nasdaq
quote equal to or better than that displayed by the ECN or UTP
exchange. This competition could improve market quotation quality and
produce better prices for investors.
The proposed amendment is intended to address a problem arising
from the
[[Page 2432]]
lack of an interconnectivity between the SOES system and the SelectNet
linkage. As discussed previously, the NASD was unable to complete the
programming for the SelectNet linkage and the necessary changes to the
SOES rules, and also link the separate SelectNet and SOES systems, both
of which are aging Legacy systems. As discussed previously, the NASD
has indicated that it plans to develop a revised system that will
connect its market order execution system with its linkage to ECNs.
When this system is developed, it should be possible to route market
orders directly to the best market maker or ECN quote prevailing at
that time.
In the meantime, the Commission believes that order entry firms
should be able to reprogram their systems to scan the quote line and
direct their order either into SOES or the SelectNet link, depending on
where the best quote is at the time of the order's entry. In this
manner, order entry firms can improve the efficiency of order routing
and reduce the number of rejections received in the SOES system. The
Commission notes that many SOES users are already frequent SelectNet
users for orders not eligible for SOES.
The Commission also notes that during the initial stages of
implementation of the Order Handling Rules when the rounding indicator
is not available, SOES orders will be rejected only when ECN prices are
a full quotation increment better than the best bid or offer. When a
price is displayed in an ECN at a superior price at a smaller
increment, such as 20 1/16, and rounded to a price reflecting a
standard trading increment, such as 20 1/8, SOES executions will not
stop if the best market maker quote is also at 20 1/8. This should
substantially reduce the number of SOES rejections resulting from
superior ECN prices, because ECN prices often are superior to Nasdaq by
only a smaller quotation increment.
The Commission acknowledges that this provision creates a risk that
market makers could enter orders into ECNs to avoid being subject to
SOES executions. The Commission preliminarily believes that such
activity would raise concerns under a broker-dealer's obligation to
observe SRO just and equitable principles of trade. 136 The
Commission encourages the NASD to monitor such activity carefully and
to consider disciplinary action where warranted.
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\136\ NASD Rule 2110.
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6. Summary and Effect on SOES Users
A number of commenters argued that the NASD was using the proposed
changes as a whole to limit the ability of customers of order entry
firms to trade efficiently through SOES. In particular, these
commenters argue that the reduction in market makers' minimum quote
size to 100 shares, the potential that SOES orders would receive split
executions, the inability to enter all-or-none orders, and the
inability to enter SOES orders when one or more ECNs are alone at the
inside quote would limit their ability to execute orders rapidly and at
low cost over SOES.
As discussed above, the Commission has reviewed each of these
proposed revisions individually and has determined each of them to be
consistent with the purposes of the Act. Furthermore, the Commission
does not believe that these revisions, taken together, necessarily
adversely affect the ability of customers of order entry firms to trade
through SOES. As noted above, far from commenters' predictions of a
market of uniform 100-share quotes, the Commission believes that the
display of ECN orders and customer limit orders in the market should
increase liquidity and narrow spreads in Nasdaq securities. In such an
environment, customers entering orders through SOES would be expected
to benefit from the better prices in the market. To the extent a SOES
order would be subject to multiple executions, any improved prices
could in fact offset the increased transactions costs attributable to
split executions. Finally, as discussed above, the Commission believes
that order entry firms should be able to program their systems to
reroute SOES orders through SelectNet when SOES is disabled because one
or more ECNs are alone at the inside price.
Therefore, while it is true that the NASD's proposed revisions will
require changes in how orders are executed through SOES, the Commission
does not believe that the revisions, individually or in the aggregate,
impose unfair competitive burdens on SOES order entry firms or their
customers, nor do they unfairly discriminate against investors who
actively trade on the SOES system or the broker-dealers which service
these investors.
After considering the comments, the Commission believes that at
this time the NASD's proposed amendment is necessary to promptly
effectuate the Order Handling Rules given the abbreviated time frames
and the limitations on the NASD's system. The Commission also believes
that the ultimate benefits of the availability to the customer of
superior quotes resulting from display of ECN prices outweigh the
inefficiencies resulting from rejections of SOES orders when ECNs are
at better prices.
7. Locked and Crossed Markets Rule Amendments
a. Comments. Several market makers, the STA and the STANY commented
in favor of applying the locked and crossed markets rule to market
makers and other NASD members entering orders into ECNs, and to ECNs
that are displaying orders in Nasdaq for non-NASD members. 137 The
STANY supports the application of the locked and crossed markets rule
to ECNs, because of the market confusion and inefficiency that results
from locked and crossed quotes in Nasdaq. A few commenters offered
suggestions to modify the rule, 138 including a requirement that a
locking or crossing market maker should be required to notify the NASD,
which notifies the potentially locked or crossed market maker, before
entering the quote. 139 Another market maker supported the
amendment as a first step, and suggested that the NASD should have
authority to halt trading in locked and crossed markets, as do the
exchanges. 140
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\137\ DSTA Letter; Herzog, Heine, Geduld Letter; letter from
David Kuang, to Jonathan G. Katz, Secretary, SEC, dated December 19,
1996 (``Kuang Letter''); Mayer & Schweitzer Letter; STA Letter;
STANY Letter.
\138\ STA Letter; Herzog, Heine, Geduld Letter; Morgan Stanley
Letter.
\139\ Morgan Stanley Letter.
\140\ Herzog, Heine, Geduld Letter.
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Instinet argued that an ECN does not trade as principal and does
not have the ability to make ``reasonable efforts'' to avoid a locked
or crossed market. Two commenters questioned the meaning of the
exception for ``extraordinary circumstances.'' 141 Another order
entry firm stated that the rule is unclear. 142
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\141\ Amex Letter; Cornerstone Letter.
\142\ Grossman Letter.
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Amex and CBOE argued that applying the locked and crossed markets
rule, Rule 4613(e), to ECNs, would inhibit the ability of options
specialists and market makers to hedge in an ECN. Amex stated that it
is impractical to require an options market maker to first ``clear the
Street'' of all Nasdaq market maker quotes that it might cross when
entering a hedging order into an ECN. It argued that the effects of the
proposed application of the locked and crossed markets rule to ECNs and
their users during volatile markets are uncertain and may cause a
disruption in the ECN trading of Nasdaq stocks and may further disrupt
trading in their options.
b. Commission analysis. The NASD has proposed the amendment to the
locked and crossed markets rule to
[[Page 2433]]
reduce the potential for a very significant and disruptive incidence of
locked and crossed markets arising from ECN prices. The NASD argues
that locked and crossed quotes interfere with the operation of the
Nasdaq market by obscuring the true bid and offer prices at the time,
and also may impact the use of firm, automated order execution systems.
The NASD thus believes that NASD members, including ECNs, should
attempt to trade with a market maker quote before locking or crossing
that quote. The Commission believes that it is consistent with the
purposes of the Act to maintain Nasdaq quotations that are informative
and reliable. The Commission further believes that 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 by ECNs. The Commission urges the NASD to consider other means
of reducing the incidence of locked and crossed quotes such as
efficient means of executing against market maker quotes before
entering a locking or crossing order.
The Commission notes that the term ``extraordinary circumstance''
is existing language in the locked and crossed markets rule. It would
encourage any market participants unclear about the meaning of this
language to seek interpretive guidance from the NASD.
8. Modifications to Autoquote Policy
a. Comments. Several commenters expressed support for the
modification to the autoquote policy to permit computer generated
display of limit orders, responses to executions and ECN prices.
143 One order entry firm argued that autoquoting should not be
available in response to a partial fill.144 One academic argued
that the temporary requirement permitting ECNs to autoquote to post
two-sided quotes (until technical modifications can permit one-sided
quotes) forces ECNs to post ``phantom'' quotes, further debasing the
meaning of quotes in the Nasdaq market.145
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\143\ Herzog, Heine, Geduld Letter; Kuang Letter.
\144\ All-Tech Letter (12/23/96).
\145\ Whitcomb Letter (11/21/96).
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b. Commission analysis. The Commission has determined that the
NASD's proposal is consistent with the Act and, therefore, is approving
the amendment. The proposed amendments are narrow exceptions to the
autoquote policy designed to help effectuate the Order Handling Rules.
In the Adopting Release, the Commission urged the NASD to reconsider
its general ban on computer generated quotes to allow members to use
computer generated quotes that add value to the market.146 The
Commission understands that the NASD continues to consider this policy
generally, while proposing these specific modifications to facilitate
the Order Handling Rules.
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\146\ Adopting Release, supra note.
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The Commission also notes that the NASD's method of adapting its
existing quotation system to accept quotes from ECNs, by permitting
ECNs to autoquote to maintain two-sided quotes is only a temporary
solution until the NASD can modify its system to accept one-sided
quotes from ECNs.
V. Amendment No. 1
The Commission finds good cause for approving Amendment No. 1 prior
to the thirtieth day after the date of publication of notice thereof in
the Federal Register. Commission approval of the request made in
Amendment No. 1 to grant temporary approval, on a three-month pilot
basis, to the minimum quotation size requirements will allow market
participants and the Commission to assess the effects of these changes.
In addition, the Order Handling Rules will become effective on January
20, 1997. To facilitate the implementation of these rules, the NASD
must make changes to its current rules that will affect manner of
operation of its systems. The Commission believes that industry
participants must be provided sufficient time to acclimate to these
changes. Therefore, the Commission believes that granting accelerated
approval to Amendment No. 1 is appropriate and consistent with Section
15A and Section 19(b)(2) of the Act.147
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\147\ 15 U.S.C. Secs. 78o-3, 78s(b)(2).
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Interested persons are invited to submit written data, views and
arguments concerning Amendment No. 1 to the proposed rule change.
Persons making written submissions should file six copies thereof with
the Secretary, Securities and Exchange Commission, 450 Fifth Street,
N.W., Washington, D.C. 20549. Copies of the submission, all subsequent
amendments, all written statements with respect to Amendment No. 1 that
are filed with the Commission, and all written communications relating
to Amendment No. 1 between the Commission and any persons, other than
those that may be withheld from the public in accordance with the
provisions of 5 U.S.C. Sec. 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-96-43 and should be submitted by February 6, 1997.
VI. Conclusion
For all of the aforementioned reasons, 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. Specifically, the Commission believes the
proposed rule change is consistent with Section 15A(b)(6) of the Act
148 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, in general, to protect investors and the
public interest.149 In addition, the Commission believes the
proposed rule change is consistent with Section 15A(b)(9) 150 and
Section 15A(b)(11) 151 of the Act because it does not impose any
burden on competition not necessary or appropriate in furtherance of
the purposes of the Act and because it is designed to produce fair and
informative quotations.
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\148\ 15 U.S.C. Sec. 78o-3(b)(6).
\149\ In making this finding, the Commission notes that the
proposal should promote efficiency and competition in the securities
markets. 15 U.S.C. Sec. 78c(f).
\150\ 15 U.S.C. Sec. 78o-3(b)(9).
\151\ 15 U.S.C. Sec. 78o-3(b)(11).
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It is Therefore Ordered, pursuant to Section 19(b)(2) of the
Act,152 that the proposed rule change (SR-NASD-96-43) is partially
approved, including Amendment No. 1 on an accelerated basis. The
Commission is not approving at this time the NASD's elimination of the
SelectNet broadcast feature and the elimination of minimum market maker
quotation size for securities other than those covered by Amendment No.
1. The pilot program established by Amendment No. 1 expires on April
18, 1997.
\152\ 15 U.S.C. Sec. 78s(b)(2).
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By the Commission.
Dated: January 10, 1997.
Margaret H. McFarland
Deputy Secretary.
[FR Doc. 97-1107 Filed 1-13-97; 1:58 pm]
BILLING CODE 8010-01-P
