[Federal Register Volume 60, Number 194 (Friday, October 6, 1995)]
[Notices]
[Pages 52438-52440]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-24909]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36311; File No. SR-NASD-95-34]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Granting Temporary Approval of Proposed Rule
Change to Extend Certain SOES Rules Through January 31, 1996
I. Introduction
On August 11, 1995, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association'') filed with the Securities and
Exchange Commission (``SEC'' or ``Commission'') 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\ The NASD proposes to extend
through January 31, 1996 certain changes to its Small Order Execution
System (``SOES'') that were originally implemented in January 1994 for
a one-year pilot period (``January 1994 Amended SOES Rules'').\3\ These
rules subsequently were modified in January 1995 (``January 1995
Amended SOES Rules'') \4\ and further modified in March 1995 (``March
1995 Amended SOES Rules'').\5\ The March 1995 Amended SOES Rules are
scheduled to expire on October 2, 1995, and the NASD seeks to extend
these until January 31, 1996. Without further Commission action, the
SOES rules would revert to those in effect prior to January 1994.
\1\ 15 U.S.C. Sec. 78s(b)(1) (1988).
\2\ 17 CFR 240.19b-4 (1994).
\3\ Securities Exchange Act Release No. 33377 (Dec. 23, 1993),
58 FR 69419 (Dec. 30, 1993) (approving the Interim SOES Rules on a
one-year pilot basis effective January 7, 1994). See also Securities
Exchange Act Release No. 33424 (Jan. 5, 1994) (order denying stay
and granting interim stay through January 25, 1994) and Securities
Exchange Act Release No. 33635 (Feb. 17, 1994) (order denying
renewed application for stay).
\4\ Securities Exchange Act Release No. 35275 (Jan. 25, 1995),
60 FR 6327 (Feb. 1, 1995).
\5\ Securities Exchange Act Release No. 35535 (Mar. 27, 1995),
60 FR 16690 (Mar. 31, 1995).
The March 1995 Amended SOES Rules did not include the two
features found in the January 1994 Amended SOES Rules that:
(1) Reduced the maximum size order eligible for SOES execution
from 1,000 shares to 500 shares; and
(2) Prohibited short sale transactions through SOES.
The January 1995 Amended SOES Rules continued all of the January
1994 Amended SOES Rules, except for the short sale prohibition and,
as noted, the March 1995 Amended SOES Rules continued only the first
two January 1994 Amended SOES Rules.
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Notice of the proposed rule change appeared in the Federal Register
on August 31, 1995.\6\ Eleven comments were received in response to the
Commission release. For the reasons discussed below, this order
approves the proposed rule change until January 31, 1996.
\6\ Securities Exchange Act Release No. 36154 (Aug. 25, 1995),
60 FR 45502 (Aug. 31, 1995).
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II. Description of the Current and Prior Proposals
The NASD proposes to extend until January 31, 1996 the March 1995
Amended SOES Rules. Specifically, the NASD proposes to extend until
January 31, 1996 changes that:
(1) Reduce the minimum exposure limit for ``unpreferenced'' SOES
orders from five times the maximum order size to two times the maximum
order size, and eliminate the exposure limits for ``preferenced'' SOES
orders; and
(2) Maintain the availability of an automated function for updating
market maker quotations when the market maker's exposure limit has been
exhausted (market makers using this update function may establish an
exposure limit equal to the maximum order size for that security).
III. Comments
The current proposal attracted eleven comments, eight supporting
the proposal and three opposing it. The comments raised issues similar
to those raised in connection with previous amendments to the SOES
Rules.
Generally, commenters supporting the proposals have argued that the
various amendments to the SOES Rules have been necessary to limit the
exposure of market makers to multiple SOES executions, which benefits
retail investors by producing narrower spreads and more liquid markets.
Some commenters supporting the proposal also argued for additional
limits on market makers' SOES exposure, such as a reduction in the SOES
maximum order size to 500 shares.
Commenters opposed to the proposals have argued that the
statistical and market quality data cited by the NASD \7\ in support of
the various amendments to the SOES Rules are not sufficient to
[[Page 52439]]
support the NASD's position. They contend that the studies on which the
NASD relies fail to demonstrate any increase in market quality as a
result of the various amendments to the rules and that market makers
have ample opportunity to update their quotes in order to avoid
multiple SOES executions.
\7\ See infra notes 16-20 and accompanying text.
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IV. Discussion
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.\8\ In
evaluating a given proposal, the Commission examines the record before
it and relevant factors and information.\9\ The Commission believes
that approval of the proposal through January 31, 1996 meet the above
standards. Specifically, the Commission believes that the current
minimum exposure limit and automated quotation update feature are
appropriate while the NASD considers other methods for handling small
orders from retail customers.\10\
\8\ 25 U.S.C. 78s(b). The Commission's statutory role is limited
to evaluating the rules as proposed against the statutory standards.
See S. Rep. No. 75, 94th Cong., 1st. Sess., at 13 (1975).
\9\ In the Securities Acts Amendments of 1975, 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).
\10\ See letter from Joan C. Conley, Secretary, NASD, to Mark
Barracca, Branch Chief, Division of Market Regulation, SEC (Sept.
22, 1995) (submission of File No. SR-NASD-95-42, the NASD's NAqcess
proposal which is designed to replace SOES).
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The Commission believes that a sufficient basis exists for
approving the NASD's proposal to continue the current operation of
SOES. The system provided and continues to provide retail investors
enhanced opportunity to obtain execution of orders in size up to 1,000
shares and, accordingly, has improved access to the Nasdaq market.
In addition, the March 1995 Amended SOES Rules resulted in an
increase in the SOES minimum exposure limit from 1,000 shares to 2,000
shares. Moreover, the March 1995 Amended SOES Rules continued the
methodology for calculating a market maker's outstanding exposure limit
that excluded orders executed pursuant to a preferencing arrangement.
Under the SOES Rules prior to the January 1994 Amended SOES Rules, both
preferenced and unpreferenced orders were considered when calculating a
market maker's remaining exposure limit. Thus, in relative terms, the
2,000 share exposure limit potentially provides greater liquidity under
certain conditions compared to the pre-January 1994 Amended SOES Rules'
5,000 share minimum exposure limit.
The Commission continues to believe that the current operation of
SOES has eliminated the economically significant restrictions imposed
on order entry firms by the January 1994 Amended SOES Rules. The
Commission believes that while the proposal does not restore the pre-
January 1994 Amended SOES Rules minimum exposure limit, it provides
customers fair access to the Nasdaq market and reasonable assurance of
timely executions. In this regard, the maximum order size equals the
size requirement prescribed under the Firm Quote Rule and NASD rules
governing the character of market maker quotations.\11\ Moreover,
market maker's minimum exposure limit for unpreferenced orders is
double its minimum size requirement prescribed under these rules.\12\
\11\ NASD Manual, Schedules to the By-Laws, Schedule D, Part V,
Sec. 2(a), (CCH) para. 1819.
\12\ 17 CFR 240.11Ac1-1(c). Nonetheless, the Commission is
concerned about the potential for delayed and/or inferior
executions. In this regard, the Commission expects the NASD to
monitor the extent to which exposure limits are exhausted, the
extent to which the automated quotation update feature is used, and
the effects these two aspects have on liquidity. Moreover, the
Commission expects the NASD to consider the possibility of
enhancements to eliminate the potential for delayed and/or inferior
executions. The Commission expects the NASD to report back to the
Commission on these issues by December 1, 1995.
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The Commission also believes that extending the automated update
function is consistent with the Firm Quote Rule.\13\ The update
function provides market makers the opportunity to update their
quotations automatically after executions through SOES; \14\ under the
Commission's Firm Quote Rule, market makers are entitled to update
their quotations following an execution and prior to accepting a second
order at their published quotes.\15\
\13\ The SOES automated update function is also consistent with
the NASD's autoquote policy which generally prohibits autoquote
systems, but allows automatic updating of quotations ``when the
update is in response to an execution in the security by the firm.''
NASD Manual, Schedules to the By-Laws, Schedule D, Part V, Sec. 2
(CCH para. 1819).
\14\ The NASD has indicated that 21 percent of market makers in
Nasdaq National Market securities use the automated quotation update
feature for 38 percent of all market making positions in Nasdaq
National Market securities. Letter from Richard Ketchum, Executive
Vice President and Chief Operating Officer, NASD, to Jonathan G.
Katz, Secretary, SEC (Mar. 22, 1995).
\15\ The Firm Quote Rule requires market makers to execute
orders at prices at least as favorable as their quoted prices. The
Rule also allows market makers a reasonable period of time to update
their quotations following an execution, allows market makers to
reject an order if they have communicated a quotation update to
their exchange or association, and provides for a size limitation on
liability at given quote. 17 CFR 240.11Ac1-1(c)(2). See also,
Securities Exchange Act Release No. 14415 (Jan. 26, 1978), 43 FR
4342 (Feb. 1, 1978).
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In connection with its proposal, the NASD submitted data it
believes supports extending the current minimum exposure limit and the
automated quotation update feature.\16\ In addition, in connection with
the Commission's consideration of the NASD's proposal, the Commission
requested that the NASD provide any industry-wide or firm-specific data
that market maker firms have provided the NASD concerning the effect
SOES has had on profitability or the market making function.\17\
According to the NASD, since the restoration in March 1995 of the
maximum order size of 1,000 shares, the volume of trading through SOES
has increased both in absolute terms and relative to overall Nasdaq
volume. As a result, the NASD believes, some market makers have
withdrawn from making a market in certain Nasdaq securities. The NASD
argues that failure to extend the March 1995 Amended SOES Rules would
exacerbate this withdrawal.
\16\ Letter from Richard G. Ketchum, Executive Vice President
and Chief Operating Officer, NASD, to Brandon Becker, Director,
Division of Market Regulation, SEC (Aug. 1, 1995).
\17\ Letter to Richard G. Ketchum, Executive Vice President and
Chief Operating Officer, NASD, from Brandon Becker, Director,
Division of Market Regulation, SEC (Aug. 25, 1995). As of the
issuance of this order, the NASD has not provided any data in
response to this request.
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The Commission is not convinced, however, that the data submitted
by the NASD demonstrates a casual relationship between the change in
the operation of SOES as a result of the March 1995 Interim SOES Rules
and the decline in the number of market makers in the selected
securities. Rather, the Commission believes the NASD's data
demonstrates, at best, a correlation between the two. The NASD did not
control for other factors that may have affected the number of market
makers in the securities covered by their study (e.g., decreased
spreads; increased volatility; seasonality; and increased capital
requirements associated with increased prices). Such factors could
potentially explain the decline in the number of market makers
independent of SOES activity. In addition, the NASD
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selected securities with the largest decline in the number of market
makers. From an economic and statistical basis, this introduces severe
statistical problems and a bias toward those securities with the
largest number of market makers. This selection, under any
circumstance, would find the largest absolute changes in the number of
market makers.
In further support of its proposal, the NASD continues to rely on
studies previously submitted to the Commission in support of the
amendments to SOES.\18\ In its order approving both the January 1995
and March 1995 Amended SOES Rules, however, the Commission expressed
its belief that this data submitted by the NASD demonstrated neither
significant improvement to nor serious deterioration in the quality of
the Nasdaq market subsequent to the adoption of the January 1994
Amended SOES Rules.\19\ The information submitted since does not alter
the Commission's original assessment. The Commission, therefore,
continues to believe that the data submitted by the NASD demonstrates
neither a significant improvement to nor serious deterioration in the
quality of the Nasdaq market subsequent to the adoption of the January
1994 Amended SOES Rules.\20\ Moreover, the Commission believes this is
true whether the amended SOES rules are viewed collectively or
individually. Thus, the Commission's evaluation of the data submitted
by the NASD does not change its determination to approve the proposal
to extend the March 1995 Amended SOES Rules through January 31, 1996.
\18\ Securities Exchange Act Release No. 35080 (Dec. 9, 1994),
59 FR 65109 (Dec. 16, 1994) and letter from John F. Olson, Counsel
for the NASD, Gibson, Dunn & Crutcher, to Jonathan Katz, Secretary,
SEC (Dec. 30, 1994) (submitting in connection with File No. SR-NASD-
94-68 analysis entitled The Association Between the Interim SOES
Rules and Nasdaq Market Quality prepared by Dean Furbush, Ph.D.,
Economists Incorporated (Dec. 30, 1994)).
\19\ Securities Exchange Act Release No. 35275 (Jan. 25, 1995),
60 FR 6327 (Feb. 1, 1995).
\20\ Nonetheless, the Commission continues to be interested in
data and studies demonstrating the effect, if any, of the SOES rule
changes on the Nasdaq market.
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V. Conclusion
As indicated above, the Commission has determined to approve the
October 1995 Amended SOES Rules through January 31, 1996. In light of
the balance of factors described above and the limited duration of the
current proposal, the Commission believes extension of the reduction in
the minimum exposure limit, the limitation of the exposure limit to
unpreferenced orders, and the addition of an automatic quotation update
feature is consistent with the Act.
The Commission, in the exercise of the authority delegated to it by
Congress, and in light of its experience regulating securities markets
and market participants, has determined that approval of these
temporary changes to the SOES Rules until January 31, 1996 is
consistent with maintaining investor protection and fair and orderly
markets, and that these goals, on balance, outweigh possible anti-
competitive effects on order entry firms and their customers.
Accordingly, the Commission finds that the rule change is
consistent with the Act and the rules and regulations thereunder
applicable to the NASD and, in particular, Sections 15A(b)(6),
15A(b)(9), and 15A(b)(11). In addition, the Commission finds that the
rule change is consistent with the Congressional objectives for the
equity markets, set out in Section 11A, 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.
It is Therefore Ordered, pursuant to Section 19(b)(2) of the Act,
that the instant rule change SR-NASD-95-34 be, and hereby is, approved,
effective October 3, 1995 through January 31, 1996.
By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 95-24909 Filed 10-5-95; 8:45 am]
BILLING CODE 8010-01-M
