[Federal Register Volume 62, Number 2 (Friday, January 3, 1997)]
[Notices]
[Pages 436-439]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-20]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38089; File No. SR-NASD-96-50]
Self-Regulatory Organizations; Notice of Proposed Rule Change by
the National Association of Securities Dealers, Inc. Relating to
Amendments to the NASD's Excess Spread Rule Applicable to Market Maker
Quotations
December 27, 1996.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on December
16, 1996, the National Association of Securities Dealers, Inc.
(``NASD'' or ``Association'') filed with the Securities and Exchange
Commission (``Commission'' or ``SEC'') the proposed rule change as
described in Items I, II, and III below, which Items have been prepared
by the NASD. The Commission is publishing this notice to solicit
comments on the proposed rule change from interested persons.
I. Self-Regulatory Organization's Statement of the Terms of
Substance of the Proposed Rule Change
The NASD proposes to amend NASD Rule 4613(d) on a one-year pilot
basis to provide that a registered market maker in a security listed on
The Nasdaq Stock Market, Inc. (``Nasdaq'') shall be precluded from
being a registered market maker in that issue for twenty (20) business
days if its average spread in the security over the course of any full
calendar month exceeds 150 percent of the average of all dealer spreads
in such issue for the month. The text of the proposed rule change is as
follows. (Additions are italicized; deletions are bracketed.)
* * * * *
NASD Rule 4613 Character of Quotations
(d) Reasonably Competitive Quotations [Excess Spreads]
A registered market maker in a security listed on The Nasdaq Stock
Market will be withdrawn as a registered market maker and precluded
from re-registering as a market maker in such issue for 20 business
days if its average spread in the security over the course of any full
calendar month exceeds 150 percent of the average of all dealer spreads
in such issue for the month.
(1) If a registered market maker has not satisfied the average
spread requirement set forth in this subparagraph (d) for a particular
Nasdaq security, its registration in such issue shall be withdrawn
commencing on the next business day following the business day on which
the market maker was sent notice of its failure to comply with the
requirement. A market maker may request reconsideration of the
withdrawal notification. Requests for reconsideration will be reviewed
by the Market Operations Review Committee, whose decisions are final
and binding on the members. A request for reconsideration shall not
operate as a stay of the withdrawal or toll the twenty business day
period noted in subparagraph (d) above.
(2) Grounds for requests for reconsideration shall be limited to
claims that Nasdaq's calculation of the market maker's average spread
for the month was in error.
(3) This subparagraph (d) shall be in effect until January 31,
1998.
[A market maker shall not enter quotations in The Nasdaq Stock Market
securities that exceed the parameters for maximum allowable spreads as
approved by the Association's Board of Governors and that may be
published from time to time by the Association. The maximum allowable
spreads for Nasdaq securities shall be 125 percent of the average of
the three (3) narrowest market maker spreads in each security (if there
are fewer than three (3) market makers in a security, the maximum
allowable spread will be 125% of the average spread); provided however,
that the maximum allowable spread shall never be less than \1/4\
point.]
* * * * *
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the NASD included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. The NASD has prepared summaries, set forth in Sections
(A), (B), and (C) below, of the most significant aspects of such
statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
NASD Rule 4613(d), which is commonly known as the NASD's ``excess
spread rule,'' presently provides that registered market makers in
Nasdaq securities shall not enter quotations that exceed the NASD's
parameter for maximum allowable spreads. Specifically, the rule
provides that the maximum allowable spread for any Nasdaq security is
125 percent of the
[[Page 437]]
average of the three narrowest market maker spreads in that issue
(``125 percent test''), provided, however, that the maximum allowable
spread shall never be less than \1/4\ of a point.\1\
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\1\ Unrelated to the excess spread rule, there is also a dealer
spread test that is part of the NASD's Primary Market Maker
(``PMM'') standards that are used to determine the eligibility of
market makers to an exemption from the NASD's short sale rule for
short sales effected during the course of bona fide market making
activity. Specifically, the market maker spread component of the PMM
standards provides that a market maker must maintain a spread no
greater than 102 percent of the average dealer spread.
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The excess spread rule was originally designed to bring a measure
of quality to the Nasdaq market by preventing firms from holding
themselves out as market makers without having a meaning quote in the
system. Despite the laudable regulatory objectives underlying the
excess spread rule, however, many market participants believe the rule
has produced a variety of unintended consequences that have undermined
the integrity of Nasdaq. Most notably, the SEC found in its 21(a)
Report on the NASD and The Nasdaq Stock Market that ``the
interdependence of quotes mandated by the rule may deter market makers
from narrowing their dealer spreads, because, once the spread is
tightened, the rule in some instances precludes a market maker from
widening the spread to earlier levels.'' \2\ As a result, the SEC found
that the excess spread rule creates an economic incentive for market
makers to discourage one another from narrowing their quotes, thereby
interfering with the ``free flow of prices in the market and imped[ing]
attempts by the market to reach the optimal competitive spread.'' \3\
Accordingly, the SEC has requested that the NASD ``modify the rule to
eliminate its undesirable effects, or to repeal it.'' \4\ In addition,
because of the constraints on quote movements created by the rule,
market participants claim that the excess spread rule has contributed
to locked and crossed markets during periods of market turbulence.
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\2\ See Appendix to Report Pursuant to Section 21(a) of the
Securities Exchange Act of 1934 Regarding the NASD and The Nasdaq
Stock Market (``21(a) Report''), SEC, August 8, 1996, at p. 98.
\3\ Id. at p. 99.
\4\ Id.
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Accordingly, Nasdaq and the NASD are submitting this rule proposal
to help to ameliorate adverse consequences the current excess spread
rule could potentially have on the competitiveness and independence of
quotations displayed on the Nasdaq market. In formulating this proposal
Nasdaq and the NASD felt that it was important to strike a reasonable
balance between the need to eliminate any constraints that the excess
spread rule places on firms to adjust their quotations and the need to
avoid fostering a market environment where registered market makers can
maintain inordinately wide spreads and still receive the benefits of
being a market maker (e.g., affirmative determination exemption and
preferential margin treatment). Nasdaq and the NASD also believe it is
critical to transform the excess spread rule into a performance
standard used to determine market maker eligibility, instead of a
strict regulatory requirement applicable to every quote update in a
Nasdaq security, violations of which are punishable by disciplinary
action.
With these considerations in mind, Nasdaq and the NASD discussed a
variety of proposals to amend the excess spread rule. Ultimately, as
discussed below, Nasdaq and the NASD reached a determination to
eliminate the current ``125 percent test'' and instead substitute a new
minimal market maker performance requirement that would help to ensure
that all registered market makers are providing some threshold level of
market making support in their issues. Specifically, under the
proposal, a registered market maker would be required to maintain an
average spread over the course of any full calendar month equal to or
less than 150 percent of the average of all market makers in the issue
over the course of the month (``150 percent test''). If a market maker
failed to satisfy this standard with respect to a particular issue, it
would be forced to withdraw from that issue for at least 20 business
days.
Even though the proposed minimal market maker performance standard
would have adverse ramifications for those market makers who quote
inordinately wide spreads, Nasdaq and the NASD believe the proposal is
responsive to the SEC's request that the NASD eliminate the undesirable
effects of the excess spread rule. Specifically, because the proposed
``150 percent test'' is based on the average of all market makers in an
issue and not just the three market makers quoting the narrowest
spreads and because of the magnitude of increase to 150 percent, Nasdaq
and the NASD do not believe that the interdependence of market maker
quote movements noted by the SEC in its 21(a) Report will occur with
this standard. Moreover, Nasdaq and the NASD believe market makers will
not feel constrained to narrow or widen their spreads under the
proposal because the ``150 percent test'' would evaluate a market
maker's quotation behavior over the course of a full calendar month,
rather than each time a market maker updates its quote, as is presently
the case.
Nasdaq and the NASD also believe it is important to eliminate the
current excess spread rule because of the order-driven nature of the
Nasdaq market that will be brought about by implementation of the SEC's
new limit order display rule on January 10, 1997.\5\ In particular,
because spreads in Nasdaq securities likely will narrow because of the
display of customer limit orders, the average of the three narrowest
market maker spreads will be commensurately narrowed. As a result, the
interdependence of market maker quotations highlighted by the SEC in
its 21(a) Report will be exacerbated and some market makers may even
choose to withdraw from making markets, thus dampening liquidity on
Nasdaq and reducing competition among market makers. Conversely, under
the current excess spread rule, market makers may have an economic
incentive to not accept customer limit orders or only accept those
limit orders priced at the inside bid or offer so as to not narrow the
maximum allowance spread parameters. Such a development would be
completely contradictory to the important investor protection
objectives underlying adoption of the SEC's limit order display rule.
Because neither result is acceptable, Nasdaq and the NASD believe that
the current excess spread rule should be eliminated.
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\5\ SEC Rule 11Ac1-4 requires the display of customer limit
orders that are priced better than a market maker's quote or that
add to the size associated with a market maker's quote when the
market maker is at the best price in the market. See Securities
Exchange Act Release 37619A (September 6, 1996), 61 FR 48290
(September 12, 1996) (``Order Handling Rule Adopting Release'').
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While Nasdaq and the NASD believe the proposed ``150 percent test''
will help to ensure that market makers maintain at least a minimal
level of commitment to their issues, Nasdaq and the NASD, nevertheless,
believe it would be prudent to not impose the ``150 percent test'' on a
permanent basis until there is a substantial basis to conclude that the
``150 percent test'' has not contributed to or fostered the same
unintended consequences created by the current excess spread rule
(e.g., the interdependence of market maker quote movements and the
exacerbation of locked and crossed market situations). Accordingly,
Nasdaq and the NASD propose that the ``150 percent test'' be
implemented on a one-year pilot basis until January 31, 1998. During
the pilot period, Nasdaq and the NASD will analyze market maker
quotation behavior to determine whether the rule
[[Page 438]]
has met its dual objectives of removing constraints on market maker
quotation movements and ensuring some minimal level of commitment by
market makers to their issues. Throughout the pilot period, Nasdaq and
the NASD also will proactively explore whether there are other
alternative means to achieve these objectives without reliance on a
quotation-based evaluation criteria.
In addition, because a market maker would be precluded from
functioning as a registered market maker in a particular Nasdaq
security for twenty business days if it failed to meet the ``150
percent test'', the proposal also amends NASD Rule 4613(d) to afford
market makers the opportunity to request reconsiderations of their
withdrawal notices. Requests for reconsideration will be reviewed by
the Market Operations Review Committee, whose decisions will be final
and binding on the members. Because Nasdaq and the NASD believe that
such reconsiderations should be exclusively limited to an evaluation as
to whether the ``150 percent test'' was indeed satisfied, the proposed
rule change provides that the grounds for reconsideration shall be
limited to claims that Nasdaq's calculation of the market maker's
average spread for the month was in error.
The NASD believes that the proposed rule change is consistent with
Sections 15A(b)(6), 15A(b)(9), 15A(b) (11) and 11A(a)(1)(C) of the Act.
Among other things, 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. Section 15A(b)(9) provides
that the rules of the Association may not impose any burden on
competition not necessary or appropriate in furtherance of the purposes
of the Act. Section 15A(b)(11) empowers the NASD to adopt rules
governing the form and content of quotations relating to securities in
the Nasdaq market. Such rules must be designed to produce fair and
informative quotations, prevent fictious and misleading quotations, and
promote orderly procedures for collecting and distributing quotations.
Section 11A(a)(1)(C) provides that it is in the public interest to,
among other things, 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. Specifically, because Nasdaq and the NASD
believe the proposed ``150 percent test'' will help to ameliorate
adverse consequences the current excess spread could potentially have
on the competitiveness and independence of quotations displayed on the
Nasdaq market, Nasdaq and the NASD believe the proposed rule change
will promote the integrity of quotations on the Nasdaq market and
enhance competition among market makers, thereby contributing to
greater market liquidity, improved price discovery, and the best
execution of customer orders. At the same time, while Nasdaq and the
NASD believe the proposed ``150 percent test'' will remove a constraint
on market maker quote movements, Nasdaq and the NASD also believe that
the proposal will help to ensure that all registered market makers are
providing some threshold level of market making support in their
issues. Nasdaq and the NASD also believe that use of the ``150 percent
test'' will avoid fostering a market environment where registered
market makers can maintain inordinately wide spreads and still receive
the benefits of being a market maker. Accordingly, the NASD and Nasdaq
believe the proposed rule change is consistent with all of the above-
cited Sections of the Act and the rules thereunder.
B. Self-Regulatory Organization's Statement on Burden on Competition
The NASD believes that the proposed rule change will not result in
any burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Act.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
Comments were neither solicited nor received.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
The NASD and Nasdaq request that the Commission find good cause to
accelerate the effectiveness of the proposed rule change pursuant to
Section 19(b)(2) of the Act by January 10, 1997. As noted above in the
text accompanying footnote 5, Nasdaq and the NASD believe that serious
market consequences could potentially result from retention of the
current excess spread rule in a market environment where customer limit
orders are required to be displayed. Accordingly, since implementation
of the SEC's new limit order display rule is scheduled to commence on
January 10, 1997, Nasdaq and the NASD believe good cause exists to
accelerate approval of the proposed rule change on or prior to January
10, 1997. In addition, in a separate rule filing, SR-NASD-96-43, Nasdaq
and the NASD proposed to modify the SOES Automated Quotation Update
Feature so that only one side of a market maker's quote would be
updated when its quote size has been decremented to zero through SOES
executions. By updating the bid or the offer, but not both, the NASD
and Nasdaq believe the auto-refresh feature will not exacerbate or
contribute to locked or crossed markets, as has been the case with the
current update feature during turbulent market conditions. Accordingly,
Nasdaq and the NASD believe that the instant rule filing and SR-NASD-
96-43 should be approved in tandem and, therefore, that good cause
exists to accelerate approval of the instant rule filing if such
acceleration is necessary to ensure that both filings are approved at
the same time.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing. 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 the proposed rule change that are filed with
the Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for inspection and copying in the
Commission's Public Reference Room. Copies of such filing will also be
available for inspection and copying at the principal office of the
NASD. All submissions should refer to file number SR-NASD-96-50 and
should be submitted by January 24, 1997.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\6\
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\6\ 17 CFR 200.30-3(a)(12).
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[[Page 439]]
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-20 Filed 1-2-97; 8:45 am]
BILLING CODE 8010-01-M
