[Federal Register Volume 62, Number 214 (Wednesday, November 5, 1997)]
[Notices]
[Pages 59932-59938]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-29296]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39285; File No. SR-NASD-97-26]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Granting Approval to Proposed Rule Change and
Notice of Filing and Order Granting Accelerated Approved to Amendment
No. 3 Relating to an Extension and Expansion of the Pilot for the
NASD's Rule Permitting Market Makers To Display Their Actual Quotation
Size
October 29, 1997.
I. Background
On April 11, 1997, 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
(``Exchange Act''),\1\ and Rule 19b-4 thereunder,\2\ to amend NASD Rule
4613(a)(1)(C) by (a) expanding from 50 to 150 the number of securities
in a pilot program for which market makers may quote their actual size
by reducing the minimum quotation size requirement for market makers in
certain securities listed on the Nasdaq Stock Market (``Nasdaq'') to
one normal unit of trading (``Actual Size Rule''), and (b) extending
the pilot through December 31, 1997.\3\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ November 18, 1996, the NASD filed with the Commission a
proposed rule change to implement the Actual Size Rule on a pilot
basis. (SR-NASD-96-43). Among other things, the filing and
subsequent amendments proposed to allow market makers to quote in
minimum sizes of 100 shares for a three-month pilot Program in the
50 Nasdaq securities subject to mandatory compliance with Exchange
Act Rule 11Ac1-4 (``Limit Order Display Rule'') on January 20, 1997.
The remaining securities were still subject to the existing minimum
quotation display requirements for proprietary quotes. The proposed
rule change was intended by the NASD to facilitate the display of
customer limit orders in accordance with the Limit Order Display
Rule. The Commission approved the pilot through April 18, 1997.
Securities Exchange Act Release 38512 (April 15, 1997) 62 FR 19373
(April 21, 1997) (SR-NASD-97-25).
On April 15, 1997, the Commission issued an order granting
accelerated approval to a NASD proposed rule change that extended
the pilot from April 18, 1997, to July 18, 1997. Securities Exchange
Act Release 38512 (April 15, 1997) 62 FR 19373 (April 21, 1997) (SR-
NASD-97-25).
On July 18, 1997, the Commission approved a rule change proposed
by the NASD to extend the pilot from July 18, 1997 to December 31,
1997. Securities Exchange Act Release No. 38851 (July 18, 1997) 62
FR 39565 (July 23, 1997) (SR-NASD-97-49). The Commission did so to
give it additional time to evaluate the economic studies and review
the public's comments on the NASD's June 3, 1997, study. In
addition, the Commission stated that it believed that extending the
pilot would benefit the markets by providing more experience with
the Actual Size Rule before a decision is made regarding approval.
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On July 10, 1997, the NASD filed Amendment No. 1 to the proposed
rule change proposing to extend the pilot through March 27, 1998 and
expand it to 150 stocks.\4\ On July 17, 1997, the NASD filed with the
Commission Amendment No. 2, to correct a technical deficiency in
Amendment No. 1.\5\ The proposal was noticed for comment on July 24,
1996.\6\
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\4\ See Letter from Robert E. Aber, Vice President and General
Counsel, the Nasdaq Stock Market, Inc., to Katherine England,
Assistant Director, Office of Market Supervision, Division of Market
Regulation, Commission, dated July 10, 1997.
\5\ See Letter from Robert E. Aber, Vice President and General
Counsel, the Nasdaq Stock Market, Inc., to Katherine England,
Assistant Director, Office of Market Supervision, Division of Market
Regulation, Commission, dated July 17, 1997.
\6\ Securities Exchange Act Release No. 38872 (July 24, 1997) 62
FR 40879 (July 30, 1997) (SR-NASD-97-26).
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On September 15, 1997, the NASD filed Amendment No. 3,\7\ proposing
to extend the pilot as previously noted and to expand the pilot by
adding a different group of 100 securities to those 50 currently
subject to the Actual Size Rule (``First 50'') than was proposed in
Amendment Nos. 1 and 2. The NASD believes that this second group of
securities will provide a better basis for comparison and economic
analysis comparing the Actual Size Rule's effect on pilot and non-pilot
Nasdaq securities. In addition, Nasdaq proposes to replace some of
securities in the initial 50 stock pilot that are no longer listed on
Nasdaq. Amendment No. 3 also proposed extending the pilot through March
27, 1998.
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\7\ See Letter from Robert E. Aber, Vice President and General
Counsel, the Nasdaq Stock Market, Inc., to Katherine England,
Assistant Director, Office of Market Supervision, Division of Market
Regulation, Commission, dated September 15, 1997.
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For the reasons discussed below, the Commission has determined to
approve the proposed rule change.
II. Proposed Rule Change
The NASD proposes to amend NASD Rule 4613(a)(1)(C) to allow market
makers to quote their actual size by reducing the minimum quotation
size requirement for market makers in certain securities listed on
Nasdaq to one normal unit of trading. As discussed below, the Actual
Size Rule presently applies to a group of 50 Nasdaq securities on a
pilot basis. The proposed rule change would expand the pilot group to
150 stocks and extend the pilot until March 27, 1998. The text of the
proposed rule change is as follows. (Additions are italicized;
deletions are bracketed.)
* * * * *
4613. Character of Quotations
(a) Two-Sided quotations
(1) No Change
(A)-(B) No Change
(C) As part of a pilot program implemented by the Nasdaq Stock
Market, during the period January 20, 1997 through at least [December
31, 1997] March 27, 1998, a registered market maker in a security
listed on the Nasdaq Stock Market that became subject to mandatory
compliance with SEC Rule 11Ac1-4 on January 20, 1997 or identified by
Nasdaq as being otherwise subject to the pilot program as expanded and
approved by the Commission, must display a quotation
[[Page 59933]]
size for at least one normal unit of trading (or a larger multiple
thereof) when it is not displaying a limit order in compliance with SEC
Rule 11Ac1-4, provided, however, that a registered market maker may
augment its displayed quotation size to display limit orders priced at
the market maker's quotation.
* * * * *
III. Comments \8\
The Commission received over 350 comment letters.\9\ A separate
summary of comments has been prepared and is available in the public
file. The relevant issues addressed by commenters are discussed in the
appropriate sections of this order.
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\8\ In order to give the public additional time to comment on
the economic analysis of the pilot that the NASD filed with the
Commission on June 3, 1997, the Commission extended the comment
period to July 3, 1997. Securities Exchange Act Release No. 38720
(June 5, 1997) 62 FR 38156 (June 11, 1997) (SR-NASD-97-26).
\9\ 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 several
academicians, individual investors, and professional associations.
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IV. Discussion
On August 29, 1996, the Commission promulgated a new rule, the
Limit Order Display Rule \10\ and adopted amendments to the Quote
Rule,\11\ which together are designed to enhance the quality of
published quotations for securities and promote competition and pricing
efficiency in U.S. securities markets (collectively, the ``Order
Execution Rules'').\12\ With respect to securities included on Nasdaq,
the Order Execution Rules were implemented according to a phased-in
implementation schedule: 50 Nasdaq securities became subject to the
rules on June 20, 1997 (``first 50''), 50 more securities became
subject to the rules on February 10, 1977 (``second 50''); and an
additional 50 securities became subject to the rules on February 24,
1997. The remaining Nasdaq securities were phased in on October 13,
1997.\13\
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\10\ 17 CFR 240.11Ac1-4.
\11\ 17 CFR 240.11Ac1-1.
\12\ See Securities Exchange Act Release No. 37619A (September
6, 1997) 61 FR 48290 (September 12, 1996) (``Order Execution Rules
Adopting Release'').
\13\ See, e.g., Securities Exchange Act Release No. 38490 (April
9, 1997); Securities Exchange Act Release No. 38870 (July 24, 1997).
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The SEC's Limit Order Display Rule requires the display of customer
limit orders, that: (1) Are priced better than a market maker's
quote,\14\ or (2) add to the size associated with a market maker's
quote when the market maker is at the best price in the market.\15\ By
virtue of the Limit Order Display Rule, investors now have the ability
to directly advertise their trading interest to the marketplace,
thereby allowing them to compete with market maker quotations and
affect the size of bid-ask spreads.\16\ The Order Execution Rules also
included amendments to the SEC's Quote Rule, the most significant of
which requires a market maker to display in its quote any better priced
orders that it places into an electronic communications network
(``ECN'') such as SelectNet or Instinet (``ECN Rule''). Alternatively,
instead of updating its quote to reflect better priced orders entered
into an ECN, a market maker may comply with the display requirements of
the ECN Rule through the ECN itself, provided the ECN: (1) Ensures that
the best priced orders entered by market makers into the ECN are
included in the public quotation; and (2) provides brokers and dealers
access to orders entered by market makers into the ECN, so that brokers
and dealers who do not subscribe to the ECN can trade with those orders
(``ECN Display Alternative'').
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\14\ For example, if a market maker's quote in stock ABCD is 10-
10\1/4\ (1000 x 1000) and the market maker receives a customer limit
order to buy 200 shares at 10\1/8\, the market maker must update its
quote to 10\1/8\-10\1/4\ (200 x 1000).
\15\ For example, if a market maker receives a customer limit
order to buy 200 shares of ABCD at 10 when its quote in ABCD is 10-
10\1/4\ (1000 x 1000) and the National Best Bid or Offer (``NBBO'')
for ABCD is 10-10\1/8\, the market maker must update its quote to
10-10\1/4\ (1200 x 1000).
\16\ There are eight exceptions to the immediate display
requirement of the Limit Order Display Rule: (1) Customer limit
orders executed upon receipt; (2) limit orders placed by customers
who request that they not be displayed; (3) limit orders for odd-
lots; (4) limit orders of block size (10,000 shares or $200,000);
(5) limit orders routed to a Nasdaq or exchange system for display;
(6) limit orders routed to a qualified electronic communications
network for display; (7) limit orders routed to another member for
display; and (8) limit orders that are all-or-none orders. See Rule
11Ac1-4(c).
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In order to facilitate implementation of the SEC's Order Execution
Rules and reflect the change in the Nasdaq market that was to be
brought about by the implementation of these rules, the Commission
approved, on January 10, 1997, a variety of amendments to NASD Rules
pertaining to Nasdaq's Small Order Execution System (``SOES'') and the
SelectNet Service (``SelectNet'').\17\ In particular, one of the NASD
Rule changes approved by the Commission provides on a temporary basis
that Nasdaq market makers in the first 50 securities subject to the
Commission's Limit Order Display Rule are only required to displayed a
minimum quotation size of one normal unit of trading when quoting
solely for their own proprietary account (i.e., the Actual Size
Rule).\18\ They can display a greater quotation size if they so choose
(or if required by the Limit Order Display Rule). For Nasdaq securities
outside of the first 50, the minimum quotation size requirements of
1,000, 500, or 200 shares remained the same.\19\
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\17\ See Actual Size Rule Approval Order.
\18\ Thus, the Actual Size Rule does not effect a market maker's
obligation to display the full size of a customer limit order. If a
market maker is required to display a customer limit order for 200
or more shares, it must display a quote size reflecting the size of
the customer's order, absent an exception from the Limit Order
Display Rule.
\19\ In particular, NASD Rule 4613(a)(2) requires each market
maker in a Nasdaq issue other than those in the first 50 to enter
and maintain two-sided quotations with a minimum size equal or
greater than the applicable SOES tier size for the security (e.g.,
1000, 500 or 200 shares for Nasdaq National Market issues and 500 or
100 shares for Nasdaq SmallCap Market issues (``Mandatory Quote Size
Requirement'').
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The NASD submitted the proposal for the Actual Size Rule because it
believed, and continues to believe, that the changes in Nasdaq brought
about by the Limit Order Display Rule obviates the regulatory
justification for minimum quote size requirements because investors now
have the capability to display their orders on Nasdaq. The NASD
originally imposed the Mandatory Quote Size Requirements to ensure an
acceptable level of market liquidity and depth in an environment where
Nasdaq market markers were the only market participants who could
affect quotation prices. Now that the Limit Order Display Rule permits
investors to enter orders as part of the quote, the NASD believes it is
appropriate to treat Nasdaq market makers in a manner equivalent to
exchange specialists and not subject them to minimum quote size
requirements when they are not representing customer orders. In sum,
with the successful implementation of the SEC's Order Execution Rules,
the NASD believes that Mandatory Quote Size Requirements impose
unnecessary regulatory burdens on market makers.
At the same time, the NASD does not believe that implementation of
the Actual Size Rule in an environment where limit orders are displayed
has or will compromise the quality of the Nasdaq market. First, the
NASD believes that display of customer limit orders enhances the depth,
liquidity, and stability of the market and contributes to narrower
quoted spreads, thereby mitigating the effects of the loss of displayed
trading interest, if any, by
[[Page 59934]]
market makers. Second, it also believes that removing artificial quote
size requirements may lead to narrower market spreads, thereby reducing
investors' transaction costs. Third, the NASD asserts that permitting
market makers to quote in size commensurate with their own freely-
determined trading interest will enhance the pricing efficiency of the
Nasdaq market and the independence and competitiveness of dealers
quotations. Fourth, the NASD suggests that removing quotation size
requirements will allowing greater quote size changes, thereby
increasing 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.
Indeed, in its order approving the Actual Size Rule on a pilot
basis, the Commission noted that it ``preliminary believes that the
proposal will not adversely affect market quality and liquidity'' \20\
and that it ``believes there are substantial reasons * * * to expect
that reducing market makers' proprietary quotation size requirements in
light of the shift to a more order-driven market would be beneficial to
investors.'' \21\ In addition, the Commission stated that, ``based on
its experience with the markets and discussions with market
participants, [it] believes that decreasing the required quote size
will not result in a reduction in liquidity that will hurt investors.
''\22\
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\20\ See Actual Size Approval Order, 62 FR at 2425.
\21\ Id. 62 FR at 2423.
\22\ Id. 62 FR at 2424.
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Nevertheless, in light of concerns raised by commentators opposed
to the Actual Size Rule regarding the potential adverse impacts of the
rule on market liquidity and volatility, the Commission originally
determined to approve the rule on a three-month pilot basis to afford
to the Commission and the NASD an opportunity to gain practical
experience with the rule and evaluate its effects. The factors
identified by the Commission to be considered in this evaluation
include, among others, the impact of reduced quotation sizes on
liquidity, volatility and quotation spreads.\23\
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\23\ See 62 FR 2415 at 2425.
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As detailed below, the NASD has concluded that implementation of
the SEC's Order Execution Rules has significantly improve the quality
of the Nasdaq market by creating a market structure where customer
limit orders provide liquidity and effectively compete with market
maker quotations. In this type of environment, the NASD believes that
regulatory necessity for the Mandatory Quote Size Requirements no
longer exists. Nonetheless, the NASD determined to extend and broaden
the pilot to gain greater experience with voluntary quotation size. The
NASD is proposing the pilot be expanded to include an additional 100
securities and extended until March 27, 1998.
To evaluate that pilot, the NASD's Economic Research Department
conducted an economic analysis of the pilot's operation and of the
impact of the Commission's Order Handling Rules.\24\ The analyses thus
far indicates three general findings concerning implementation of the
SEC's Order Execution Rules and the Actual Size Rule: (1) The SEC's
Order Execution Rules have dramatically improved the quality of the
Nasdaq market, particularly with respect to the size of spreads: (2)
among those securities subject to the SEC's Order Execution Rules,
there is no appreciable difference in market quality between those
securities subject to the Actual Size Rule and those securities subject
to Mandatory Quote Size Requirements;\25\ and (3) implementation of the
Actual Size Rule has not resulted in any significant diminution of the
ability of investors to receive automated executions through SOES,
SelectNet, or proprietary systems operated by broker-dealers.
Accordingly, as is the case with 100-share minimum quotation size
requirements applicable to exchange specialists in order-driven
markets, the NASD believes that the Actual Size Rule has not harmed
investors or the quality of the Nasdaq market.
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\24\ On June 3, 1997, the NASD published an economic analysis
entitled ``Effects of the Removal of Minimum Sizes for Proprietary
Quotes in the Nasdaq Stock Market, Inc.'' (June Study). On September
10, 1997, the NASD published a related study entitled
``Implementation of the SEC Order Handling Rules'' (September
Study). Both studies are available to the public at Nasdaq's World
Wide Web sit at ``http://www.nasdaq.com''.
\25\ The first 50 securities includes Nasdaq's top ten issues by
dollar volume plus 40 issues chosen from Nasdaq's top 500 issues: 8
ranked between 11 and 100; 8 ranked between 101 and 200; 8 ranked
between 201 and 300; 8 ranked between 301 and 400; 8 ranked between
401 and 500. The second 50 securities include the ten Nasdaq stocks
and ranked between 11 and 20 by dollar volume plus 40 stocks chosen
from Nasdaq's top 500 stocks in the same manner explained above. The
ten largest Nasdaq stocks in the first 50 have no comparable peer
group among Nasdaq stocks and the next ten largest Nasdaq stocks
(i.e., Nasdaq stocks ranked 11-20 in size) included in the second 50
are also not comparable to the ``bottom 40'' of either the first 50
or second 50. The Nasdaq stocks ranked 1-20, therefore, have been
excluded from the analysis comparing the first 50 and the second 50.
Accordingly, the ``first forty'' stocks are those stocks that are
the ``bottom 40'' within the first 50 stocks and the ``second
forty'' stocks are those stocks that are the ``bottom 40'' within
the second 50 stocks.
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In the June Study, the NASD found that pilot and non-pilot stocks
experienced virtually the same improvements in market quality since the
implementation of the Order Handling Rules. Specifically, the NASD
found that investors in pilot stocks continued to have substantial and
reasonable access to market maker capital through both SOES and market
makers' proprietary automatic execution systems.\26\
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\26\ June Study at 2.
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A. Implementation of the SEC's Order Execution Rules Has Resulted in
Significant Benefits to Investors and Enhanced the Quality of the
Nasdaq Market
NASD Economic Research evaluated measures of market quality in four
main areas: spread, volatility, quoted depth, and liquidity. The Pilot
Stocks and the second tranche of 50 stocks to become subject to the
Order Handling Rules both include 40 stocks selected from the first
through fifth deciles of the 1,000 most active Nasdaq stocks.
Therefore, those from the Pilot Stocks (``First 40'') are reasonable
peers of those from the February 10 tranche (``Second 40'').\27\ The
NASD believes that, as shown below, the similar performance of the
First 40 and Second 40 indicates that the Actual Size Rule did not
impair the markets for these securities.
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\27\ The remaining 10 stocks in the first tranche were roughly
the top 10 stocks (``First 10''), and the remaining 10 from the
second tranche were roughly stocks 11 through 20 (``Second 10'').
Consistent with the Commission's request for a ``matched pairs
analysis,'' the First 10 and Second 10 are excluded from this
analysis, because these groups do not demonstrate similar trading
characteristics and hence cannot be properly compared. See Actual
Size Approval Order, 62 FR at 2425. Indeed, inclusion of the First
10 and Second 10 would likely produce skewed results. The market
quality improvements induced by the Order Handling Rules, however,
are apparent in both the First and Second 10.
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1. Spreads \28\
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\28\ See also Summary of Comments, Section B.6.
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The NASD looked at mean spreads for the First and Second 40 and
found that mean spreads declined by about $0.12 for both the First 40
and the Second 40, or by about 33%. For the First 40, the mean spread
declined from $0.41 to $0.28, and for the Second 40 the mean spread
declined from $0.36 to $0.24. The results in the NASD's study indicate
an equivalent spread effect across the two groups. These results
provide no statistically significant evidence of a differential change
in quoted spreads between the First 40 and Second 40. Therefore, the
NASD believes there is no effect on quoted spreads associated with
removal of the 1,000-Share Quote Size Rule.
[[Page 59935]]
2. Volatility \29\
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\29\ See also Summary of Comments, Section B.5.
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The NASD looked at the volatility of the First and Second 40 and
found that volatility slightly increased following the imposition of
the Order Handling Rules for both the First 40 and the Second 40. For
the First 40, average volatility rose from 1.16% to 1.25%, an increase
of 7.6%. For the Second 40, volatility rose from 0.98% to 1.24%. It
also found that the increase in volatility does not, however, appear to
be attributable to the Order Handling Rules, because volatility also
increased for other stocks in the top 500 that had not become subject
to the Order Handling Rules during the sample period.
On the surface, the results indicate a general increase in
volatility, in particular for the Second 40 stock group. In order to
correct for stock-specific characteristics such as price, volume, and
interday volatility, the NASD used a multivariate regression analysis.
The multivariate regression results show that the differential increase
in volatility for the Second 40 can be attributed to volume, price, and
interday volatility.\30\ In the presence of these factors, the
differential volatility effect on the Second 40 is statistically
insignificant. The NASD found that these results demonstrate that there
is no statistically significant evidence of a differential change in
intraday volatility between the First 40 and Second 40.
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\30\ June Study at 31.
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3. Quoted Depth Measures
The NASD examined the impact of the Actual Size Rule on quoted
depth. First the NASD studied the percentage change in number of market
makers and the percentage change in number of market makers at the
market maker inside market. After performing a regression analysis, it
found no statistically significant difference between the First 40 and
the Second 40.\31\ For both measures, the marginal impact of the
removal of the 1,000-Share Quote Size Rule is negligible. The NASD also
studied the distribution of the sizes of all dealer quote updates. It
found that quote updates for 100 and 1,000 share stocks were similar
for the First 40 and the Second 40.\32\
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\31\ June Study at 35 and Table B.5 of Appendix B.
\32\ June Study at 34.
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Based on this evidence, the NASD concluded that the changes in
quoting behavior induced by the implementation of the Order Handling
Rules have been qualitatively similar for both the First 40 and Second
40.
4. Liquidity \33\
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\33\ See also Summary of Comments, Section B.4.
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The NASD looked at effective depth in order to measure liquidity.
Similar to the sections on spread, volatility, and quoted depth
measures above, the change in normalized effective depth \34\ after
implementation of the Order Handling Rules was calculated for the First
40 and Second 40. Effective depth is calculated for each Bid-Ask
Midpoint (``BAM'') movement category, and mean values across all stocks
and days in the sample for each category were calculated. The NASD
applied multivariate regression analysis and found that there is no
statistically significant association between the removal of the 1,000-
Share Quote Size Rule and any change in normalized effective depth.
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\34\ Normalized effective depth is defined as the dollar volume
required to move the BAM one percentage point, calculated for BAM
moves of the following percentage movements; all movements, 0.5%,
1%, 1.5%, 2%, 2.5%, and 3%.
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After accounting for changes in stock price, trading volume, and
interday volatility, the NASD found no evidence of a statistically
significant association between the removal of the regulatory minimum
size for proprietary quotes and a change in liquidity.
B. Implementation of the Actual Size Rule Has Not Resulted in any
Diminution in the Ability of Investors To Receive Automated Executions
Through SOES, SelectNet, or Other Proprietary Systems Operated by
Broker Dealers \35\
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\35\ See also Summary of Comments, Section B.9.
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For some market participants, Nasdaq's SOES system is the primary
means they use to obtain executions. Use of the SOES system has
increased over the past few years. SOES executions accounted for 8.3%
of all Nasdaq share volume in 1996, up from 5.6% in 1995 and 3.0% in
1993. Much of the SOES activity is derived from day traders. The
majority of SOES orders are for 1,000 shares, the maximum tier size for
stocks.
As detailed above, the SOES system was changed on January 20 to
execute orders based on market maker quoted size. The NASD examined
SOES activity to determine if the removal of the 1,000-Share Quote Size
Rule diminished the ability of the SOES system to provide executions.
First, the NASD examined whether the incidence of ECNs alone at the
inside market was different for the First 40 and Second 40 stocks. When
an ECN is alone at the inside, SOES is unavailable. The NASD found that
ECNs were alone at the inside market only 9.2% of the time after
implementation of the Order Handling Rules for the First 40 stocks, and
only 9.4% of the time for the Second 40.\36\ Second, the NASD examined
how often all market makers at the inside market were quoting a size of
100. The NASD found that this occurred only 1.6% of the time in the
First 40 stocks and only 0.8% of the time in the Second 40.
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\36\ The NASD also found that between August 11 and 29, 1997,
SOES access was restricted to 100 shares only 1.2% of the time. That
is, only 1.2% of the trading day was it the case that there was no
market maker at the inside quoting an amount greater than 100
shares. September Study at 4.
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Both measures provide evidence from which the NASD concluded that
times during which SOES is unavailable are uncommon and that the degree
of any degradation of the effectiveness of SOES due to the Actual Size
Rule is statistically insignificant. Moreover, the NASD concluded that
only certain measures of SOES performance (e.g., multiple price SOES
executions, average SOES trade size) have experienced any marginal
change between the First 40 and the Second 40.\37\ To the extent a
marginal difference exists, the NASD found it to be slight and
therefore concluded that the removal of the 1,000-Share Quote Size Rule
has had no meaningful effect on the SOES system's ability to provide
reasonable access to executions.
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\37\ See June Study at 42-46. For example, for the First 40,
average SOES trade size fell by 15.0% and by 6.0% for the Second 40.
It is important to note, however, that given that the mean price of
stocks in the First 40 was roughly $35, the average SOES trade size
of 753 shares represents a trade of approximately $26,000. Compared
to most retail activity, the average SOES trade in the First 40
continues to be quite large. Given that the average SOES trade size
is still large and that SOES continues to account for a substantial
proportion of Nasdaq dollar volume, it is unlikely that the decrease
in average trade size of SOES executions has negatively impacted the
ability of the SOES system to provide executions for retail-size
orders.
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C. Response to Electronic Traders Association (``ETA'') Study \38\
The ETA is an association representing SOES order entry firms whose
customers use SOES for day trading. The ETA conducted its own study of
the Actual Size Rule. Its study found that SOES orders in pilot stocks
are less likely to be executed than for non-pilot stocks; that the mean
time between entry and execution of a SOES order is longer for pilot
than for non-pilot stocks; and that the mean price concession is larger
for pilot stocks than for non-pilot stocks.
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\38\ See also Summary of Comments, Section B. 10.
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The NASD examined the ETA study and found it seriously flawed. The
NASD noted that the ETA study is based on a small sample of data from
three of
[[Page 59936]]
the 425 firms that enter orders through SOES; the ETA does not
distinguish between SOES orders that were actively canceled by the
order entry firm and those that were returned to the order entry firm;
and the ETA report does not account for considerable differences in the
average trading characteristics (e.g., price, volume) between pilot and
non-pilot stocks. The NASD found that the ETA study provides ``no basis
to conclude that the Actual Size Rule has adversely affected the
ability of the SOES system to provide investors with reasonable access
to market maker capital.'' \39\
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\39\ September study at 3.
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D. The Pilot Justifies an Expansion and Extension of the Actual Size
Rule
While some market participants may maintain that the Actual Size
Rule should be abandoned because it has not had a demonstrably positive
market impact, the NASD believes, in light of the pilot experience and
its economic research, that the Rule should be retained. The NASD
believes it eliminates an unnecessary regulatory requirement and,
moreover, it has not had any adverse market impacts. In particular,
with respect to the first 50 securities, the NASD believes that
competitive forces in the marketplace, be they the result of displaying
customer limit orders, ECN quote display, or market maker competition
for order flow, have driven the Nasdaq market to perform at least as
well, if not better, than if the artificial 1,000 share minimum
quotation size requirement was in place.\40\ As a result, given the
conclusion that the market performs the same with or without the Actual
Size Rule, the NASD believes it is far preferable for the protection of
investors and the efficiency of the capital formation process to
promote a regulatory environment for Nasdaq that achieves its results
through aggressive competition rather than artificial regulatory fiat.
In sum, in light of the performance of the first 50 securities, the
NASD believes there is no regulatory basis to justify the retention of
artificial quotation size requirements for Nasdaq market makers.
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\40\ Some market participants have asserted that the lack of
difference in performance between the First 40 and the Second 40 is
attributable to the operation of several features of SOES.
Specifically, these market participants claim that the SOES Auto-
Refresh Feature, which refreshes a market maker quote to the
applicable SOES tier size once its quote has been completely
decremented, along with the ``No Decrementation'' and ``Supplemental
Size'' features of SOES, artificially increase the number of 1000-
share quotes in the first 50 securities. The ``No Decrementation''
feature of SOES allows a market maker to provide that its quote
shall not be decremented after the execution of SOES orders. To use
this feature, a market maker's quote size must be equal to the
applicable SOES tier size. The ``Supplemental Size'' feature of SOES
allows a market maker to establish a ``supplemental size'' that is
used to automatically replenish a market maker's quote once it has
been completely decremented. When a market maker's quote is
replenished from the supplemental size, it is replenished to 1000
shares. In order to use this feature, a market maker must initially
enter a quote size equal to or greater than the applicable SOES tier
size. The NASD notes that market maker's use of each of these system
features is completely voluntary and they are available for all
Nasdaq securities. Accordingly, the NASD believes it would be
inaccurate to assert that these SOES features have obfuscated the
impact of the Actual Size Rule. Id. 62 FR at 19371.
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The NASD is proposing to expand the pilot to 150 stocks in order to
provide a better sample of stocks to use in studying the effects of the
Actual Size Rule upon the Nasdaq Market. Further, to address criticism
by several commentators that the group of stocks making up the pilot
(both currently and as the NASD initially proposed to expand it) is not
an ideal sample of Nasdaq stocks upon which to base a decision on the
future of the Actual Size Rule, the NASD altered the group of 100
stocks it is proposing to add to the current pilot.
The NASD has selected stocks that are representative of the entire
Nasdaq market by sampling across dollar volume categories. Within
dollar volume categories, it sought variation across SOES tier sizes of
1,000 and 500 shares. The NASD then randomly chose 100 stocks.\41\
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\41\ Ten additional stocks were chosen to make up for delistings
within the first 50 stocks in the pilot and as reserves in case
other pilot stocks delist. Only domestic common stocks were chosen.
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V. Conclusion
The Commission approved the Actual Size Rule on a pilot basis so
that the effects of the rule could be assessed. In doing so, the
Commission stated that it believed that a reduction in the quotation
size requirement could reduce the risks that market makers must take,
produce accurate and informative quotations, and encourage market
makers to maintain competitive prices even in the changing market
conditions resulting from the Order Execution Rules.
As discussed above, the NASD has produced an extensive economic
analysis of the pilot, and several commentators have provided their own
economic analysis as well. These economic analyses have proved useful
in assessing the pilot Program's impact on the Nasdaq market. Although
the economic studies arrive at conflicting results on the value of the
Actual Size Rule, the Commission preliminarily believes that the data
indicates that the pilot has not resulted in harm to the Nasdaq market.
Indeed, as discussed above, the Actual Size Rule appears to be a
reasonable means to provide market making obligations that reflect the
new market dynamics produced by the Order Execution Rules.
Nevertheless, as several commenters noted, the pilot Program was
limited to 50 out of over 5,000 securities. Moreover, the Commission
had decided that it would be appropriate to gather further data before
reaching a final decision as to whether or not to extend the Actual
Size Rule to the entire Nasdaq market. The Commission notes that there
has been some disagreement as to how to interpret the data the NASD and
others have published concerning the pilot Program. This is due in part
to the limited nature of the pilot Program and the need for commenters
to extrapolate data concerning these 50 securities to the entire Nasdaq
market. These problems can be reduced if the pilot is expanded as
proposed. An extension and expansion of the pilot will provide the
Commission, the NASD, and market participants with additional data and
time to study the Order Execution Rules' effects on the Nasdaq market.
Based upon the expanded pilot, the Commission will be in a better
position to evaluate the impact of the Actual Size Rule upon the Nasdaq
market.
The NASD initially proposed to expand the pilot Program by adding
the 100 securities that were next to be phased-in under the Order
Execution Rules earlier this year. Although the first 50 securities
were chosen to provide a broad cross section of the most liquid Nasdaq
securities,\42\ the NASD filed Amendment No. 3 to select an additional
110 securities \43\ from an enhanced sample more representative of the
entire Nasdaq market. This was done in response to a number of the
comment letters which suggested that the First 50 securities were not
representative of the Nasdaq Market. Specifically, it was suggested
that, because all 30 of the largest Nasdaq stocks were subject to the
100 share minimum, it was impossible to gauge the Actual Size Rule's
effect on large Nasdaq stocks, since there were no sufficiently large
non-pilot stocks with which to compare.
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\42\ Actual Size Approval Order, 62 FR 2415.
\43\ As discussed above, ten additional stocks were chosen to
replace those pilot stocks that have already delisted or that may
delist in the future. The proposal still calls for the pilot to
expand from 50 to 150 stocks.
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These additional 100 securities were chosen from those domestic
Nasdaq National Market (``NNM'') stocks with a
[[Page 59937]]
SOES tier size of either 1,000 or 500 shares that were not included in
the First 50. These stocks were ranked by average (mean) daily dollar
volume over the first seven months of 1997, and then divided into
deciles, each containing approximately the same number of stocks.
Eleven stocks were chosen at random from each decile, for a total of
110 stocks. Ten extra stocks were chosen to make up for four stocks of
the First 50 that no longer trade on Nasdaq, and as reserves should any
delist in the interim. This ensures that a total of 150 stocks will be
ultimately subject to the Actual Size Rule is approved. The chosen
stocks will be identified in a fax or Notice to Members published after
SEC approval of the proposed rule change.
The Commission believes that the proposed amendment is consistent
with the Exchange Act because it will provide for a more representative
group of securities under an expanded Actual Size Rule pilot. The next
100 stocks include securities with significantly different trading
volumes, so the NASD will be better able to assess the impact of the
Actual Size Rule on the full panoply of Nasdaq stocks. This will
further the evaluation of the Actual Size Rule and will assist the SEC
in its determination as to whether to expand the pilot ultimately to
all Nasdaq securities or to end it. In addition, Amendment No. 3
responds to the commentators who expressed concern that an expansion of
the pilot to 150 stocks would capture stocks that account for a large
majority of Nasdaq trading volume and SOES activity, and thus act as a
de facto implementation of the Actual Size Rule. Regardless of the
validity of this concern, the modified additional 100 stocks no longer
contain only the next 100 most active stocks.
The Commission requests that the NASD continue to evaluate the
effects of the reduction in the minimum quotation size for those Nasdaq
stocks included in the pilot. Specifically, the NASD should continue
its analysis of. (1) The number and composition of the market makers in
each of the 50 securities, and any change 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 per 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). Finally, the
NASD should compare data for each decile of securities, focusing
particular attention on relatively active versus inactive securities
that are among the lower tier of NNM securities, by daily dollar
trading volume.
VI. 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, NW., Washington, DC 20549.
Copies of the submission, all subsequent amendments, all written
statements with respect to Amendment No. 3 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-97-26 and should be submitted by November 26, 1997.
VII. Commission's Findings and Order Granting Accelerated Approval of
Amendment No. 3 to the Proposed Rule Change
For the reasons discussed above, the Commission finds that the
NASD's proposal is consistent with the Exchange Act and the rules and
regulations thereunder applicable to a national securities association
and has determined to approve the expansion of the pilot to 150 Nasdaq
securities and to extend the pilot through March 27, 1998.\44\
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\44\ The Commission also has determined to approve the
replacement of those securities in the pilot that are no longer
listed on Nasdaq with others from the list of securities provided by
the NASD.
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The Commission also is approving Amendment No. 3 on an accelerated
basis. In Amendment No. 3, the NASD has addressed criticism by several
commentators who believe that the current pilot is not well designed to
study effects of the Actual Size Rule. These commentators believe that
the 50 stock pilot is not sufficiently representative of the entire
Nasdaq Market and cannot form the basis for an adequate economic study.
In particular, the commenters stated that most of the 20 largest Nasdaq
stocks are subject to Actual Size Rule and that very few small stocks
are subject to rule, and thus it is impossible to gauge the rule's
effect on the largest and smallest stocks without similar groups of
nonpilot stocks to use in comparison.
The Commission finds that the 150 stock pilot the NASD is now
proposing is a reasonable sampling of the Nasdaq market, calculated to
allow the NASD and others to study the effects of the Actual Size Rule.
The Commission also believes that approving Amendment No. 3 to the
proposed rule change will provide it with additional data for use in
determining whether to expand the Actual Size Rule to cover the entire
Nasdaq market or to take another course of action. The Commission finds
good cause in approving the extension element of Amendment No. 3 to the
proposed rule change on an accelerated basis in order to give the NASD
sufficient time to collect data on the expanded pilot, analyze that
data, and publish a report on its findings. By allowing the NASD to
begin its analysis quickly so that it may publish its findings
promptly, commentators will have more time to examine the study and the
Commission will be in a better position to make a determination on the
future of the Actual Size Rule in a timely manner. An additional three
months is designed to provide the Commission and the public time to
fully consider the results of the NASD's economic study and is merely a
technical change to prevent a rushed study and comment period. The
Commission therefore finds good cause for approving the proposed rule
change prior to the thirtieth day after the date of publication of
notice of filing thereof.
Accordingly, the Commission believes that the proposed rule change
(SR-NASD-97-26) is consistent with Sections 15A(b)(6) and (b)(9) of the
Exchange Act \45\ and
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\45\ In approving this rule, the Commission notes that it has
considered the proposed rule's impact on efficiency, competition,
and capital formation. The proposed rule likely will produce more
accurate and informative quotations and encourage market makers to
maintain competitive prices. It will also provide the Commission
with additional data, enabling it to evaluate better the impact of
the Actual Size Rule on the Nasdaq market and market participants.
Since the Commission believes that the data discussed above
indicates that the pilot has not resulted in harm to the Nasdaq
market thus far, the net effect of approving the proposed rule
change will be positive. 15 U.S.C. 78c(f).
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Exchange Act,\46\ that the proposed rule change, SR-NASD-97-26, be and
hereby is approved through March 28, 1998.
\46\ 15 U.S.C. 78s(b)(2).
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[[Page 59938]]
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\47\
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\47\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 97-29296 Filed 11-4-97; 8:45 am]
BILLING CODE 8010-01-M
