[Federal Register Volume 60, Number 21 (Wednesday, February 1, 1995)]
[Notices]
[Pages 6327-6330]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-2388]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35275; File No. SR-NASD-94-68]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Granting Temporary Approval and Notice of Filing
and Order Granting Accelerated Approval of Amendment No. 2 of Proposed
Rule Change to Extend the Interim SOES Rules
January 25, 1995.
I. Introduction
On December 1, 1994, 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 March 27, 1995 certain of the prior changes to its Small
Order Execution System (``SOES'') that are scheduled to expire today.
The currently effective prohibition on short selling in SOES would not
be extended.
\1\15 U.S.C. Sec. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1994).
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Specifically, the NASD proposes to extend changes that: (1) Reduced
the maximum size order eligible for execution through SOES from 1,000
shares to 500 shares; (2) reduced the minimum exposure limit for
``unpreferenced'' SOES orders from five times the maximum order size to
two times the maximum order size, and eliminated the exposure limits
for ``preferenced orders''; and (3) implemented an automated function
for updating market maker quotations when the market maker's exposure
limit has been exhausted (collectively referred to hereinafter as the
``Amended Interim SOES Rules'').
In 1993, the Commission approved these changes to the SOES rules
(as well as a short selling prohibition) on a one-year pilot basis.\3\
Approval on a pilot basis was intended to permit the Commission to
reconsider the effects of the rules in light of experience with the
rules' operation in the marketplace.\4\ The NASD now seeks extension of
certain of these rules.
\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. 33377 (Dec. 23, 1993), 58
FR 69419 (Dec. 30, 1993).
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The NASD originally sought extension of the Amended Interim SOES
Rules through May 1, 1995. Notice of that proposed rule change appeared
in the Federal Register on December 16, 1994.\5\ The Commission
received comments from 58 commenters, with 12 supporting the proposal
and 46 opposing it. On January 23, 1995, the NASD amended its proposal
to request extension of the Amended Interim SOES Rules until March 27,
1995, rather than [[Page 6328]] until May 1, 1995.\6\ For the reasons
discussed below, this order approves the proposed rule change until
March 27, 1995.
\5\The NASD amended the proposed rule change twice since it was
originally filed with the Commission on December 1, 1994. The first
amendment was included in the Commission's original notice.
Securities Exchange Act Release No. 35077 (Dec. 9, 1994), 59 FR
65105 (Dec. 16, 1994).
\6\Letter from T. Grant Callery, Vice President & General
Counsel, NASD, to Mark Barracca, Branch Chief, SEC (Jan. 23, 1995).
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II. Description of the Proposed Rule Change
As noted above, the NASD has proposed to extend three of the four
Interim SOES Rules that became effective January 25, 1994. The proposal
does not include extending the short sale prohibition beyond January
25, 1995; thus, effective January 26, 1995, short sales in compliance
with the NASD's short sale rule applicable to the Nasdaq market as a
whole will be permitted in SOES.\7\ The following restrictions will be
effective until March 27, 1995:
\7\NASD Manual, Rules of Fair Practice, Sec. 48, CCH 2200H.
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(1) SOES Maximum Order Size: The maximum size order eligible for
SOES execution will be 500 shares for the highest tier of Nasdaq
National Market securities.\8\
\8\Market makers must continue to display a size of 1,000 shares
in their quotations for these securities, and to be firm for a
minimum of 1,000 shares at their published quotation, for any
negotiated transaction through SelectNet or over the telephone. See
NASD Manual, Schedules to the By-Laws, Schedule D, Part VI, Sec.
2(a)--(b), CCh 1819.
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(2) SOES Minimum Exposure Limit: The market maker's SOES minimum
exposure limit will be two times the maximum order size. The rule
change continues the application of the minimum exposure limit to
unpreferenced orders only, so that preferenced orders will not count
toward depletion of the minimum exposure limit.
(3) Automated Quotation Updates: The NASD proposes to continue
providing an automated quotation update function for marker makers
using SOES, at their election, on an issue-by-issue basis. If the
automated update function is not used, when a market maker depletes its
exposure limit in SOES, the market maker's quotation is closed to SOES
executions until the market maker updates its quote and reestablishes
its exposure limit. If used, the function updates a market maker's
quotation in any Nasdaq security when its exposure limit has been
exhausted, and reestablishes the original quotation size and exposure
limit, thereby preventing closed quotations. Market makers electing to
use the feature can set the fractional interval of the quotation update
for each security and set their exposure limit at the maximum order
size for that security that is, 500 shares for the highest tier of
Nasdaq National Market securities.
In light of the NASD's implementation of short sale prohibitions on
September 6, 1994,\9\ the NASD will terminate the prohibition against
short selling through SOES. Thus, beginning January 26, 1995, short
sales in compliance with the NASD's short sale rule will be permitted
through SOES.
\9\Securities Exchange Act Release No. 34277 (June 29, 1994), 59
FR 34885 (July 7, 1994) (approval of the NASD's short sale rule,
effective September 6, 1994).
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III. Comments
Commenters supporting and opposing the proposal stated reasons
similar to those put forth in response to the NASD's original proposal
to adopt the Interim SOES Rules.\10\ Commenters supporting the proposal
argue that the Amended Interim SOES Rules will limit the exposure of
market makers to multiple executions, which should produce narrower
spreads and more liquid markets. Those opposing extension of the rules
argue that market makers have ample opportunity to update their quotes
in order to avoid multiple SOES executions. They contend that two
studies submitted by proponents of the rules fail to show any increase
in market quality as a result of the rules. They also argue that the
SOES immediate automatic execution feature provides them the only
meaningful access to the Nasdaq market because, they allege, market
makers do not honor their quoted prices on the telephone or through
SelectNet. These commenters assert that they cannot obtain quote-based
trade executions except through SOES and that the Interim SOES Rules
have thereby restricted their access to Nasdaq and the ability of
certain customers to receive executions at quoted prices. These
commenters argue that the Interim SOES Rules thus produce unfair
discrimination and an inappropriate burden on competition.
\10\These comments addressed the proposal to extend the Interim
SOES Rules through May 1, 1995, as originally filed. As amended,
those rules would now expire March 27, 1995. See supra note 5.
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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.\11\ In
evaluating a given proposal, the Commission examines the record before
it and relevant factors and information.\12\ After balancing the
advantages and disadvantages of extension, the Commission believes that
limited extension of the Amended Interim SOES Rules through March 27,
1995 meets the above standards and is necessary and appropriate in the
public interest and for the protection of investors. As discussed in
more detail below, the Commission does not believe that, on the basis
of the information before it, an extension of the Amended Interim SOES
Rules beyond 60 days is justified under the applicable statutory
standard. Nevertheless, because much information has been made
available only recently, the Commission has determined that it is
appropriate to provide this brief phase-out period (until March 27,
1995), which will enable the market to make an orderly transition.\13\
\11\15 U.S.C. Sec. 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).
\12\In the 1975 Amendments, Congress directed the Commission to
use its authority under the Act, including its authority to approve
SRO rule changes, to foster the establishment of a national market
system and promote the goals of economically efficient securities
transactions, fair competition, and best execution. Congress granted
the Commission ``broad, discretionary powers'' and ``maximum
flexibility'' to develop a national market system and to carry out
these objectives. Furthermore, Congress gave the Commission ``the
power to classify markets, firms, and securities in any manner it
deems necessary or appropriate in the public interest or for the
protection of investors and to facilitate the development of
subsystems within the national market system.'' S. Rep. No. 75, 94th
Cong., 1st Sess., at 7 (1975).
\13\The Commission does not believe that further extension of
these restrictions without changes to benefit public investors would
be appropriate.
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Because the Interim SOES Rules were approved only for a pilot
period, the Commission noted in its approval order that it expected to
revisit the issues presented by the NASD's proposal.\14\ In
[[Page 6329]] approving the Interim SOES Rules, the Commission noted
its concern over the lack of reliable statistical analysis. The
Commission approved the rules, however, among other reasons, because of
the rules' limited duration and because of the agency's commitment to
monitor the rules' effects.\15\ The Commission stated that extension of
the Interim SOES Rules or other similar modifications upon expiration
of the Interim SOES Rules would ``require an independent consideration
under Section 19 of the Act.''\16\
\14\Both proponents of and opponents to the 1994 Interim SOES
Rules argued that imposing the rules would affect the Nasdaq market.
Opponents argued that the rules would heighten volatility and widen
spreads. E.g., Letters to Jonathan G. Katz, Secretary, SEC, from
Michael Frey, President, A.J. Michaels & Co., at 7 (May 11, 1993);
Douglas P. Ralston, President, Shearman, Ralston Inc., at 1 and 6
(May 10, 1993); and Harvey L. Pitt, counsel for Dina Securities,
Inc., at 15 (June 11, 1993). The NASD and its supporters, on the
other hand, argued that placing certain restrictions on the use of
SOES, for example, lowering the maximum order size, would act to
decrease volatility and narrow spreads. Securities Exchange Act
Release No. 32143 (Apr. 14, 1993), 58 FR 21484 (Apr. 21, 1993)
(notice of the NASD's proposed Interim SOES Rules, File No. SR-NASD-
93-16). The Commission's December 1993 SOES order describes in some
detail the order size reduction, the minimum order exposure limit
reductions, and the automated quotation update feature that the NASD
proposes to extend. See Securities Exchange Act Release No. 33377
(Dec. 23, 1993), 58 FR 69419 (Dec. 30, 1993). That order also
discusses the NASD's rationale for these changes to the SOES rules
and the Commission's rationale for approving them for a one-year
period.
\15\Securities Exchange Act Release No. 33377 (Dec. 23, 1993),
58 FR 69419 (Dec. 30, 1993).
\16\Securities Exchange Act Release No. 33377 (Dec. 23, 1993),
58 FR 69419 (Dec. 30, 1993) (footnote omitted). The Commission's
order further stated that ``[t]he NASD should consider whether
additional criteria for evaluating the effectiveness of the
modifications are appropriate, and should include in its assessment
of the modifications all factors that it deems relevant in
evaluating the effects of the modifications [and] . . . [i]f an
assessment is not feasible, the NASD should provide a reasoned
explanation supporting that determination.'' Id.
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In connection with its extension request, the NASD submitted an
econometric study conducted by the NASD's Economic Research
Department\17\ and commissioned a consulting economist to provide an
assessment of the effect of the Interim SOES Rules.\18\ In summary, the
NASD's Economic Research Department found that since implementation of
the Interim SOES Rules: (a) Spreads in Nasdaq securities have declined;
and (b) volatility of Nasdaq securities appears to be unchanged, except
for brief, market-wide period of volatility in March and April 1994.
The commissioned study reported that while percentage quoted spreads
increased a statistically insignificant amount, percentage quoted
spreads, adjusted for other determining factors, declined by a
statistically significant, but economically insignificant, amount. From
this data, the author concluded that the Interim SOES Rules did not
harm market quality.
\17\Securities Exchange Act Release No. 35080 (Dec. 9, 1994), 59
FR 65109 (Dec. 16, 1994). The NASD's Economic Research Department
examined Nasdaq bid-ask spreads in specific stocks and price
volatility on two sample days each month from November 1993 (three
months prior to the effective date of the rules) through August
1994.
\18\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)). This analysis compared sample days in
the three months prior to and three months after the effective date
of the Interim SOES Rules.
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An evaluation of the empirical data submitted by the NASD does not
persuasively demonstrate that the quality of the market improved
subsequent to the adoption of the Interim Rules. The evidence in both
studies shows that spreads declined, but the results were only
marginally significant, and the size of the reduction is too small to
be important. Nevertheless, the Commission believes that these studies
demonstrate that the Interim Rules have operated for one year with no
apparent significant negative implications for overall market quality.
The absence of negative implications for market quality must be
considered in conjunction with other effects of the Interim SOES Rules
on the investing public. Commenters opposed to the Interim SOES Rules
argue that the restrictions impose a burden on the ability of some
customers to obtain execution of transactions in size in the Nasdaq
market. They contend that, to the extent that the Interim Rules
restrict their access to SOES, their ability to obtain executions is
limited because they cannot effectively trade over the telephone and
through SelectNet. In support of these arguments, they refer to a large
number of complaints alleging that market makers have refused to fill
trades now ineligible for SOES execution at their quoted prices. In
addition, they have provided anecdotal information that certain SOES
order entry firms have suffered serious drops in daily trading volume
since approval of the Interim Rules. The Commission takes such
allegations seriously, and is reviewing them as part of its obligation
to oversee the securities markets.
As indicated above, the Commission has determined to approve the
Amended Interim Rules through March 27, 1995. In light of the balance
of factors described above, the Commission does not believe that
further extension of this proposal would be appropriate.\19\ The short
extension the Commission has determined to approve will permit the
market to make an orderly transition to operation in a changed
environment. The Commission believes that such a measure is appropriate
in the public interest. Moreover, the Commission notes that the Amended
Interim Rules, unlike the rules currently in effect, will permit the
entry of short sale orders. The Commission believes this will
ameliorate during the phase-out period the burdens associated with the
Interim SOES Rules by expanding the types of orders that are eligible
for automatic execution.
\19\Of course, a different proposal that modified the Amended
Interim Rules to provide additional public benefits would require an
independent Commission determination.
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The Commission notes that subsequent to approval of the Interim
SOES Rules in December 1993, the NASD submitted a proposal to replace
SOES with the Nasdaq Primary Retail Order View and Execution System
(``NPROVE''). As currently proposed, NPROVE would
differ from SOES in two general ways:
NPROVE would provide a facility for automated
routing and execution of small orders, allowing market makers a 15
second opportunity to decline an order (if consistent with the Firm
Quote Rule, permitting a brief period for quote updates). SOES
generally provides immediate execution of orders against an assigned
market maker at the best bid or offer and thereafter notifies the
affected market maker; and
NPROVE would provide an opportunity for public
limit orders to interact with other limit orders and incoming market
orders, and for execution of market orders at prices superior to the
best market maker quotes. SOES provides limited opportunity for such
interaction.
In light of comments received as recently as January 9, 1995
concerning NPROVE, as well as other developments in the Nasdaq
market,\20\ the Commission believes that the NASD's NPROVE
proposal warrants further assessment. Among other matters, commenters
have raised concerns about the NASD's ability to monitor sufficiently
market maker compliance with the Firm Quote Rule and the potential for
significant order queues to develop. Before further Commission action
on NPROVE, the Commission believes that the NASD should address
such issues, including the potential for queuing during periods of
market stress, whether there are restrictions on access to the system
inconsistent with the purposes of the Act, and whether there are
adequate mechanisms to ensure effective oversight of market makers'
compliance with the Firm Quote Rule.
\20\As has been widely disclosed, the Commission is conducting
an inquiry into certain practices in the Nasdaq market and the
Antitrust Division of the Department of Justice recently has made
public an inquiry into whether Nasdaq market makers are violating
federal antitrust laws. Although not tied directly to the
Commission's consideration of the instant proposal, the Commission
expects that these inquiries may provide valuable information that
will affect future reform efforts and ultimately improve the quality
of the Nasdaq market. In addition, the NASD has formed a committee
headed by former U.S. Senator Warren Rudman to review the
effectiveness of the operation and surveillance of Nasdaq and the
governance of the NASD and Nasdaq.
[[Page 6330]]
V. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendment No. 2. 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 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. Sec. 552, will be available for inspection and
copying in the Commission's Public Reference Room. Copies of such
filing will also be available for inspection and copying at the
principal office of the NASD. All submissions should refer to the file
number SR-NASD-94-68 and should be submitted by February 22, 1995.
VI. Conclusion
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 a temporary extension of
the Amended Interim SOES Rules will provide an orderly phase-out period
and is consistent with maintaining investor protection and fair and
orderly markets, and that these goals, on balance, outweigh any
temporary anti-competitive effects on order entry firms and their
customers.
For the reasons discussed in this order, pursuant to Section
19(b)(2) of the Act,\21\ the Commission finds good cause for approving
the proposed rule change, as amended, prior to the 30th day after
publication of Amendment No. 2 in the Federal Register. The proposed
amendment shortens the date that the Amended Interim SOES Rules would
expire from May 1, 1995 to March 27, 1995, and will facilitate
maintenance of fair and orderly markets. Prior to Amendment No. 2, the
proposed rule change was published in the Federal Register for the full
statutory period.
\21\15 U.S.C. Sec. 78s(b)(2).
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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-94-68 be, and hereby is, approved,
effective January 26, 1995, extending the Interim SOES Rules, exclusive
of the short sale prohibition, through March 27, 1995.
By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 95-2388 Filed 1-31-95; 8:45 am]
BILLING CODE 8010-01-M
