[Federal Register Volume 59, Number 246 (Friday, December 23, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31658]
[[Page Unknown]]
[Federal Register: December 23, 1994]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35122; File No. SR-NASD-94-62]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change by National Association of Securities Dealers, Inc. Relating to
Limit Order Protection for Member to Member Limit Order Handling on
Nasdaq
December 20, 1994.
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 November
22, 1994, the National Association of Securities Dealers, Inc.
(``NASDA'' or ``Association'') filed with the Securities and Exchange
Commission (``SEC'' or ``Commission'') 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
Pursuant to the provisions of Section 19(b)(1) of the Act, the NASD
is filing a proposed rule change regarding the protection of limit
orders to expand the scope of limit order protection beyond that
presently afforded by member firms to their customers in the Nasdaq
Stock Market. Currently, the NASD's Interpretation to the Rules of Fair
Practice makes it a violation of just and equitable principles of trade
for a member firm to trade ahead of its own customer's limit orders.
The new proposal would extend this protection to the customer of a firm
that sends a limit order to another member for execution (so-called
member-to-member trades), with a proviso that until July 1, 1995, limit
order protection for member-to-member customer limit orders greater
than 1,000 shares in size will be protected at prices that are
superior, but not equal to the limit order price. Below is the text of
the proposed rule change. Proposed new language is italicized; language
to be deleted is bracketed.
Limit Order Protection Interpretation to Article III, Section 1 of the
NASD Rules of Fair Practice
To continue to ensure investor protection and enhance market
quality, the NASD Board of Governors is issuing an Interpretation to
the Rules of Fair Practice dealing with member firm treatment of
[their] customer limit orders in Nasdaq securities. This Interpretation
will require members acting as market makers to handle [their] customer
limit orders with all due care so that market makers do not ``trade
ahead'' of those limit orders. Thus, members acting as market makers
that handle customer limit orders, whether received from their own
customers or from another member, are prohibited from trading at prices
equal to or superior to that of the limit order without executing the
limit order provided that, prior to July 1, 1995, this prohibition
shall not apply to customer limit orders that a member firm receives
from another member firm and that are greater than 1,000 shares. Such
orders shall be protected from executions at prices that are superior
but not equal to that of the limit order. In the interests of investor
protection, the NASD is eliminating the so-called disclosure ``safe
harbor'' previously established for members that fully disclosed to
their customers the practice of trading ahead of a customer limit order
by a market-making firm.
Interpretation
Article III, Section 1 of the Rules of Fair Practice states that:
A member, in the conduct of his business, shall observe high
standards of commercial honor and just and equitable principles of
trade.
The Best Execution Interpretation states that: In any transaction
for or with a customer, a member and persons associated with a member
shall use reasonable diligence to ascertain the best inter-dealer
market for the subject security and buy or sell in such a market so
that the resultant price to the customer is as favorable as possible to
the customer under prevailing market conditions. Failure to exercise
such diligence shall constitute conduct inconsistent with just and
equitable principles of trade in violation of Article III, Section 1 of
the Rules of Fair Practice.
In accordance with Article VII, Section 1(a)(2) of the NASD By-
Laws, the following interpretation under Article III, Section 1 of the
Rules of Fair Practice has been approved by the Board:
A member firm that accepts and holds an unexecuted limit order from
a customer (whether its own customer or a customer of another member)
in a Nasdaq security and that continues to trade the subject security
for its own market-making account at prices that would satisfy the
customer's limit order, without executing that limit order under the
specific terms and conditions by which the order was accepted by the
firm, shall be deemed to have acted in a manner inconsistent with just
and equitable principles of trade, in violation of Article III, Section
1 of the Rules of Fair Practice, provided that, until July 1, 1995,
customer limit orders in excess of 1,000 shares received from another
member firm shall be protected from the market maker's executions at
prices that are superior but not equal to that of the limit order.
Nothing in this section, however, requires members to accept limit
orders from any customers[s].
By rescinding the safe harbor position and adopting this
Interpretation of the Rules of Fair Practice, the NASD Board wishes to
emphasize that members may not trade ahead of customer limit orders in
their market-making capacity even if the member had in the past fully
disclosed the practice to its customers prior to accepting limit
orders. The NASD believes that, pursuant to Article III, Section 1 of
the Rules of Fair Practice, members accepting and holding unexecuted
customer limit orders owe certain duties to their customers and the
customers of other member firms that may not be overcome or cured with
disclosure of trading practices that include trading ahead of the
customer's order. The terms and conditions under which customer limit
orders are accepted must be made clear to customers at the time the
order is accepted by the firm so that trading ahead in the firms'
market making capacity does not occur. For purposes of this
Interpretation, a member that controls or is controlled by another
member shall be considered a single entity so that if a customer's
limit order is accepted by one affiliate and forwarded to another
affiliate for execution, the firms are considered a single entity and
the market making unit may not trade ahead of that customer's limit
order.
The Board also wishes to emphasize that all members accepting
customer limit orders owe those customers duties of ``best execution''
regardless of whether the orders are executed through the member's
market making capacity or sent to another member for execution. As set
out above, the best execution Interpretation requires members to use
reasonable diligence to ascertain the best inter-dealer market for the
security and buy or sell in such a market so that the price to the
customer is as favorable as possible under prevailing market
conditions. The NASD emphasizes that order entry firms should continue
to routinely monitor the handling of their customers' limit orders
regarding the quality of the execution received.
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
The purpose of the proposed rule change is to expand the scope of
the current Interpretation from protecting only limit orders received
from a market maker's own customers to protecting limit orders that a
market maker receives from other member firms for execution, the so-
called ``member-to-member'' limit orders. The background and rationale
for adoption of this proposed rule change are discussed below.
I. Background
A. The Existing Interpretation. In July 1994, a limit order
protection rule became effective for NASD members accepting limit
orders in Nasdaq securities.\1\ Under the existing Limit order
Interpretation to the Rules of Fair Practice, a member firm cannot
accept and hold its customer's limit order in a Nasdaq security and
continue to trade that security for its own account at prices that
would satisfy the customer's limit order without filling that order at
the limit order price or a price more favorable to the customer. The
rule renders trading ahead of the customer's order a violation of just
and equitable principles of trade. When the NASD initially proposed the
limit order rule, it solicited comment from members on the advisability
of implementing restrictions on trading ahead for all customer limit
orders, including those passed from one member firm to another for
execution.\2\ The vast majority of members commented that limit order
protection for a firm's own customer was appropriate and beneficial to
the market, but several cautioned against the potential adverse impact
that could result from application of the rule to member-to-member
orders. In recognition of the concerns raised, the Board deferred
broader application of the rule and commissioned a special Limit Order
Task Force to review the issue. The Task Force devoted considerable
attention to discussions of the impact such additional rulemaking would
have upon the financial viability of the competing dealer system and
the potential adverse impacts upon the quality and efficiency of that
market structure. Accordingly, the Task Force recommended limit order
protection for member-to-member trades that would make it a violation
to trade ahead of customer limit orders when the market makers traded
at a price superior to the limit order price. The NASD Board thereafter
carefully considered the Task Force's recommendation and determined
that for member-to-member trades, the membership should consider
whether limit order protection should be extended beyond the Task Force
recommendation to include protection for customer orders of 1,000
shares or less from member trading at the limit order price and prices
superior to that price. The NASD solicited comment on this proposal.
---------------------------------------------------------------------------
\1\See Notice to Members 94-58 and Securities Exchange Act
Release No. 34279 (June 29, 1994
\2\See Notice to Members 93-49 (July 23, 1993).
---------------------------------------------------------------------------
B. Comments Regarding NASD Notice To Members 94-79).
The NASD received 33 letters in response to its proposal to deal
with member-to-member limit orders. Twelve member firms supported the
proposal as outlined in NTM 94-79.\3\ Two members opposed the proposal
adopted by the Board, but suggested that the Board adopt the Limit
Order Task Force recommendation.\4\ Seventeen commenters opposed the
proposal for various reasons outlined below.\5\ One person expressed no
opinion, except that more study should be done.\6\ Among the
supporters, the commenters generally stated that the proposal would
have a positive effect on investor perception of Nasdaq. In particular,
two comment letters strongly recommended the expansion of limit order
protection to all customer orders regardless of size. For example,
Charles Schwab noted that limit order protection should be extended to
all orders, regardless of size, and noted that it has already extended
limit order protection to all orders that its market making unit, Mayer
& Schweitzer, receives, regardless of order origin. According to the
Schwab letter, if a limit order protection rule were to be uniformly
applied, there would be increased trade volume, quicker executions, and
tighter spreads. Schwab also stated the belief that expansion of limit
order protection is consistent with just and equitable principles of
trade and should promote investor confidence in the Nasdaq market. In
addition, Lehman Brothers was equally strong in recommending that the
Board's proposal in NTM 94-79 should extend the benefits of limit order
protection to all customers without any order size limitations. Lehman
noted that the proposal should not have a ``significant overall impact
on market makers,'' nor should it have an effect on a market maker's
willingness to commit capital. Lehman also noted that a broadened rule
would be easier to comply with, and ultimately, would provide strong
investor protection benefits.
---------------------------------------------------------------------------
\3\See letters from: (1) Santa Barbara Securities, Inc.; (2)
Southwest Securities; (3) Wilshire Capital Management; (4) Freeman
Welwood & Co., Inc.; (5) The Advest Group, Inc.; (6) R.A. Mackie &
Co., LP; (7) Mericor Financial Services; (8) Absolute Investments;
(9) Charles Schwab; (10) Lehman Brothers; (11) Merrill Lynch; and
(12) A.G. Edwards & Sons, Inc. Merrill and A.G. Edwards qualified
their support for the proposal, essentially agreeing with the
details of the proposal, but urged that staff examine several
additional issues that could arise with the adoption of the rule as
proposed.
\4\Letters from: (1) Sherwood Securities Group; and (2) Security
Traders Association.
\5\Two comment letters from the same organization, Herzog Heine
Geduld, were received which accounts for the discrepancy in the
number totals. A number of the negative letters made reference to
the Herzog/Shearman & Sterline Letters. Five of the negative comment
letters are form letters form traders within two firms, one of
which, Southwest Securities, submitted a comment letter supporting
the Board's proposal.
\6\Letter from Andrew Peck Associates, Inc.
---------------------------------------------------------------------------
The firms opposed to any limit order action on member-to-member
trades believed that the proposal would adversely affect the dealer
market structure. In particular, many of those opposed to the concepts
contained in NTM 94-79 concurred in the formulation of the issues as
set forth in the Shearman & Sterling letter on behalf of Herzog Heine
Geduld. Specifically, that letter stated that the proposal posed the
following problems:
(1) The costs of handling limit orders would be cross-subsidized by
other market participants;
(2) Illiquid stocks could be adversely affected;
(3) Increased concentration among market making firms could occur,
favoring vertically integrated firms;
(4) The resulting concentration could lead to reduced competition;
(5) The proposal could harm liquidity, market maker profits, and
spreads; and
(6) The proposal could allow for undetectable ``smurfing'' (the
breaking up of larger orders to fit within the 1,000 share limit order
protection).
C. SEC Action. Shortly after the Board's publication of its
original proposal, on September 29, 1994, the Securities and Exchange
Commission proposed a new rule, Rule 15c5-1,\7\ that would prohibit a
market maker in Nasdaq National Market Securities from trading for its
own account, directly or indirectly, at a price at which the market
maker could execute a customer limit order it is holding, without
executing the customer's limit order at the limit price or a price more
favorable to the customer, under the specific terms and conditions by
which the order is accepted by the market maker. Although the rule as
proposed would apply only to Nasdaq National Market securities, the SEC
solicitated comment on the feasibility of extending the limit order
protection to other securities, including SmallCap and OTC Bulletin
Board securities. The Commission also solicited comment on the terms
and conditions provisions in its rule, which would allow the parties to
a trade to set special conditions to order handling parties to allow a
market maker to employ the appropriate strategy in filling a larger
sized order without being subjected to the requirements of the proposed
rule. In particular, the Commission solicited comment on whether the
rule should specifically distinguish orders by measurable
characteristics, such as number of shares or dollar amount.
---------------------------------------------------------------------------
\7\Securities Exchange Act Release No. 34753 (September 29,
1994); 59 FR 50866 (October 6, 1994).
---------------------------------------------------------------------------
II. Expanded Limit Order Protection
After carefully weighing the ramifications of its actions on the
liquidity in the Nasdaq Stock Market and after reviewing the comments
it received on this proposal, the NASD determined that it should
further expand limit order protection for all customer orders. The NASD
has determined that all customer limit orders for Nasdaq securities--
whether originating within the firm or at another member firm--should
be protected from trading ahead by the market maker holding the order.
Thus, under the NASD's new Limit Order Interpretation to the Rules of
Fair Practice Article III, Section 1, a member firm cannot accept and
hold a customer's limit order in a Nasdaq security and continue to
trade that security for its own account at prices that would satisfy
the customer's limit order without filling that order at the limit
order price or a price more favorable to the customer. Such ``trading
ahead'' activity would be a violation of just and equitable principles
of trade. Of course, the expansion of the Interpretation continues to
permit a member to establish with its customers specific terms and
conditions with regard to the acceptance of limit orders, provided that
the member makes those terms and conditions clear to the customer at
the time the order is accepted by the firm so that trading ahead in the
firm's market making capacity does not occur. Similarly, the
Interpretation continues in place the understanding that nothing in the
Interpretation would obligate a market maker to accept limit orders
from any or all customers or member firms. However, in recognition that
the expansion of the Interpretation represents a significant change in
the operation of a dealer market, the new Interpretation contains a
phase-in period to expire on July 1, 1995, during which time, the NASD
will permit member firms to handle member-to-member limit orders that
are larger than 1,000 shares in size differently. Such orders during
this phase-in period must be protected when the member firm accepting
the order trades for its own account at prices that are superior to the
limit order but not equal to the limit order price. The NASD believes
that this measured implementation of the Interpretation is wholly
prudent given the nature of the adjustment being made by certain firms
in their order handling procedures and the potential need for
reassessment of the existing revenue structure. During this period, the
NASD will evaluate carefully any adverse impact the new Interpretation
may be having on market maker participation or market quality.
The NASD believes that the expansion of its own Rule will enhance
investor confidence in the Nasdaq Stock Market by providing customers
with the opportunity to improve the quality of executions of their
orders. When a customer limit order is given priority over a market
maker's own trading activity, it is likely that the customer's order
will be executed more quickly and efficiently than before. Price
discovery may also be improved in that limit orders may contribute to
the tightening of spreads between the bid and ask prices of a security.
Expansion of limit order protection to so-called member-to-member
limit orders eliminates any adverse effect on customer protection that
may have arisen depending on whether the customer's broker was also a
market maker in a particular security. The NASD carefully considered
the potential negative effects on the Nasdaq market (loss of market
liquidity, concentration of market making firms and lack of sponsorship
for smaller capitalized companies) that could occur with the expansion
of limit order protection. The NASD has determined that in the long
term, any such negative effects should be outweighed by the increased
benefits to customers receiving the expanded protection and
accordingly, there should be an increase in investor confidence and
participation in the Nasdaq Stock Market. In this connection, the NASD
notes that Nasdaq market makers are free to negotiate additional
compensation from order routing firms to the extent that such
compensation is economically and competitively justified.
However, because a requirement that market makers yield priority to
the execution of customer interest could have a short-term, temporary
effect on the market maker' ability to offer liquidity at the limit
order price, the NASD has proposed in its rule to delay the complete
effectiveness of the rule for six months. Therefore, until July 1,
1995, market makers would be allowed to trade at the same price as the
limit order price for orders over 1,000 shares. Accordingly, the NASD
has determined that it is appropriate to propose limit order protection
standards which appropriately differentiate between small-sized and
large-sized customer limit orders for the first six months that the
rule is in effect. For small limit orders (1,000 shares or less), the
NASD proposes to implement the same limit order protection that is
currently in place for a market maker's own customers--that a market
maker may not trade ahead for its own account at a price that would
satisfy the limit order price. For larger-sized orders, however, the
NASD believes it is appropriate to impose a different standard. When a
member accepts and holds a customer limit order greater than 1,000
shares from another member firm, the dealer's obligation to fill that
limit order would be triggered when the market maker trades at a price
that is superior to the limit order price.
Thus, during the next six months, if the inside market in a Nasdaq
issue were 20--20\1/4\ and the market maker accepted a customer buy
order from another broker/dealer priced at 20 for 2,000 shares, when
the firm buys at any price superior to 20 (that is, purchases at a
price lower than a buy limit order, in this example, purchasing at
19\7/8\ or 19\15/16\, it would be required to sell to the customer at
20 or better. Using the same example, if the customer limit order were
for 500 shares at 20, the rule would prohibit members from trading
ahead at 20 without filling the customer order at 20. Accordingly, the
proposal would require protection for orders greater than 1,000 shares
when the dealer trades at a superior price, and protection for orders
of 1,000 shares or less when the dealer trades at the limit order price
or a price more favorable to the customer.
Consequently, the NASD believes that the proposed rule change is
consistent with Section 15A(b)(6) in that these proposed changes are
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, to facilitate
transactions in these securities, to remove impediments to and to
perfect the mechanism of free and open market and a national market
system, and in general to protect investors and the public interest.
(B) Self-Regulatory Organization's Statement on Burden on Competition
The NASD does not believe that the proposed rule change will result
in any burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Act, as amended, The NASD has looked
carefully at the suggestions by some commentators that smaller and non-
integrated firms will be unable to compete with large integrated firms
under the new requirement, but can find no substantive support for the
position advanced. First, the proposed Interpretation does not
eliminate the ability of any firm to compete with respect to service,
cost, investment recommendations or other executive parameters. For
example, the NASD notes that at least one firm has already announced a
new price improvement mechanism for Nasdaq securities. Accordingly,
while the NASD will monitor carefully for an adverse competitive
effects of the Interpretation, the NASD believes that any speculation
on potential adverse effects is far outweighed by the enhanced
execution opportunities that will be provided to public investors.
(C) Self-Regulatory Organization's Statement on Comments on the
Proposed Rule Change Received from Members, Participants, or Others
Written comments were neither solicited nor received.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
Within 35 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if its finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which the NASD consents, the Commission will:
(A) By order approve such proposed rule change, or
(B) Institute proceedings to determine whether the proposed rule
change should be disapproved.
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 the file number in the caption
above and should be submitted by January 13, 1995.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\8\
---------------------------------------------------------------------------
\8\17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-31658 Filed 12-22-94; 8:45 am]
BILLING CODE 8010-01-M
