[Federal Register Volume 63, Number 55 (Monday, March 23, 1998)]
[Notices]
[Pages 13894-13899]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-7372]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39760; File No. SR-NASD-98-21]
Self-Regulatory Organizations; Notice of Proposed Rule Change by
the National Association of Securities Dealer, Inc., Relating to an
Expansion of the NASD's Rule Permitting Market Makers To Display Their
Actual Quotation Size
March 16, 1998.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Exchange Act'' \1\ and Rule 19b-4 thereunder,\2\ notice is hereby
given that on March 5, 1998, the National Association of Securities
Dealers, Inc. (``NASD'' or ``Association''), through its wholly-owned
subsidiary, The Nasdaq Stock Market, Inc. (``Nasdaq''), filed with the
Securities and Exchange Commission (``Commission'' or ``SEC'') the
proposed rule change as described in Items I, II, and III below, which
Items have been prepared by Nasdaq. The Commission is publishing this
notice to solicit comments on the proposed rule change from interested
persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of
Substance of the Proposed Rule Change
The NASD proposes to amend NASD Rule 4613(a)(1)(C) to allow
permanently market makers to quote their actual size by reducing the
minimum quotation size requirement for market makers in all securities
listed on Nasdaq to one normal unit of trading (``Actual Size Rule'').
As discussed below, the Actual Size Rule presently applies to a group
of 150 Nasdaq securities on a pilot basis. The text of the proposed
rule change is as follows (additions are italicized; deletions are
bracketed).
* * * * *
NASD Rule 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 March
27, 1998, a] 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 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.
* * * * *
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
1. Summary of Proposal
Currently, quotations in most Nasdaq securities are required to be
displayed in a minimum size of 1,000 shares (200 or 500 shares for less
active stocks). The
[[Page 13895]]
requirement is different from that of any of the stock exchanges, which
require only the display of actual size of at least 100 shares. This
difference results from the requirements of the Small Order Execution
System (``SOES''), which was originally conceived and developed to
provide individual investors with a fast, efficient, and cost-effective
means of executing small orders in Nasdaq securities in a quote-based
dealer market.
On August 29, 1996, the SEC promulgated a new rule and adopted
amendments to other SEC rules that are designed to enhance the quality
of published quotations for securities and promote competition and
pricing efficiency in U.S. securities markets (these rules are
collectively referred to hereafter as the ``Order Handling Rules'').\3\
The Order Handling Rules have changed Nasdaq's market structure to a
more order-driven hybrid market, which include quotes from investors
(in the form of displayed limit orders), market makers, and Electronic
Communications Networks (``ECNs''). The implementation of these rules
has enhanced market quality and benefited investors significantly by
substantially reducing Nasdaq quoted spreads, without evidence of a
material reduction of liquidity or increased volatility. In connection
with these changes, Nasdaq implemented the Actual Size Rule pilot
program (originally including 50 Nasdaq stocks, but subsequently
expanded to 150 stocks) to allow market makers to display their actual,
freely-determined quotation size when not displaying a customer order.
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\3\ See Exchange Act Release No. 37619A (September 6, 1996) 61
FR 48290 (September 12, 1996) (``Order Handling Rules Adopting
Release'').
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Given the changes brought about by the Order Handling Rules, the
economic theory suggesting several long-term benefits of the Actual
Size Rule, and the empirical research indicating no adverse impact on
investors or the Nasdaq market, the NASD has concluded that artificial
minimum quotation sizes are no longer necessary and should be removed
for all Nasdaq stock. Specifically, the Actual Size Rule affords market
makers more flexibility to manage risk and quote prices that are more
favorable for small retail orders. In addition, requiring a minimum
commitment of market maker capital while allowing the display of
customer and ECN orders without a similar commitment could severely
impair the ability of market makers to set competive quotations. The
adoption of sixteenths could heighten the debilitating effect of the
quote size minimum, as could future reduction in Nasdaq's minimum quote
price invement if the minimum size increment is not equivalent reduced.
Moreover, rigorous empirical analysis of the original pilot program and
the pilot as expanded, including a study of the extreme market
conditions of October 27 and 28, 1997, demonstrate that the Actual Size
Rule has not materially affected Nasdaq market quality, as measured by
spread, volatility, quoted depth, and liquidity, and that investors
continue to have substantial access to a reasonable amount of market
maker capital in pilot stocks.
2. Background
a. SEC Order Handling Rules. With respect to securities listed on
Nasdaq, the Order Handling Rules were implemented according to a
phased-in implementation schedule: 50 Nasdaq securities became subject
to the rules on January 20, 1997 (``First Fifty''); fifty more became
subject to the rules on February 10, 1997 (``Second Fifty''), and an
additional fifty became subject to the rules on February 24, 1997. The
remaining Nasdaq securities were phased in pursuant to a specified time
table established by the Commission, with the last remaining securities
phased in on October 13, 1997.\4\
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\4\ See Exchange Act Release No. 38870 (July 24, 1997) 62 FR
40732 (July 30, 1997), corrected in 62 FR 45289.
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In particular, the SEC adopted Rule 11Ac1-4, (``Limit Order Display
Rule''), which requires the display of customer limit orders: (1) That
are priced better than a market maker's quote;\5\ or (2) that add to
the size associated with a market maker's quote when the market maker
is at the best price in the market.\6\ 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.\7\ The other rule changes adopted by the SEC involve
amendments to SEC's firm quote rule, Rule 11Ac1-1. The most significant
change requires market makers to display in their quote any better
priced orders that the market maker places into an electronic
communications network 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 communicated to Nasdaq for public dissemination; 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.
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\5\ For example, if a market maker's quote in stock ABCD is 10-
10\1/4\ (1,000 x 1,000) 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 1,000).
\6\ For example, if a market maker receives a limit order to buy
200 shares of ABCD at 10 when its quote in ABCD is 10-10\1/4\ (1,000
x 1,000) and the NBBO for ABCD is 10-10\1/8\, the market maker
must update its quote to 10-10\1/4\ (1,200 x 1,000).
\7\ There are seven exceptions to the Limit Order Display Rule:
customer limit orders that are (1) executed upon receipt; (2) placed
by customers who expressly request that they not be displayed; (3)
odd-lots; (4) block size orders (10,000 shares or $200,000), unless
the customer requests that the order be displayed; (5) delivered
immediately upon receipt to an exchange or association-sponsored
system, or an ECN that complies with Rule 11Ac1-1(c)(5)(ii) with
respect to that order; (6) delivered immediately upon receipt to
another exchange member or OTC market maker that complies with Rule
11Ac1-4 with respect to that order; or (7) all-or-none orders. See
17 CFR 240.11Ac-1-4(c).
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b. Actual Size Rule Pilot for First Fifty Stocks. In order to
facilitate implementation of the SEC's Order Handling Rules and reflect
the more order-driven nature of the Nasdaq market that was brought
about by implementation of these rules, on January 10, 1997, the
Commission approved a variety of amendments to NASD rules and Nasdaq's
SOES and SelectNet Service.\8\ In particular, one of the NASD rule
changes approved by the Commission provides that Nasdaq market makers
in the First Fifty stocks subject to the Commission's Limit Order
Display Rule are required to display a minimum quotation size of one
normal unit of trading when quoting solely for their own proprietary
account (i.e., the Actual Size Rule).\9\ For Nasdaq stocks outside of
the First Fifty, the minimum quotation size requirements remained the
same.\10\
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\8\ See Exchange Act Release No. 38156 (January 10, 1997) 62 FR
2415 (January 16, 1997) (order partially approving SR-NASD-96-43)
(``Actual Size Rule Approval Order'').
\9\ Thus, the Actual Size Rule does not affect 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
shares or more, it must display a quote size of at least 200 shares
absent an exemption from the Limit Order Display Rule.
\10\ In particular, NASD Rule 4613(a)(2) requires each market
maker in a Nasdaq issue other than those in the First Fifty to enter
and maintain two-sided quotations with a minimum size equal to or
greater than the applicable SOES tier size for the security (e.g.,
1,000 500, or 200 shares for Nasdaq National Market issues and 500
or 100 shares for Nasdaq SmallCap Market issues).
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The NASD submitted the proposal for the Actual Size Rule because it
believed,
[[Page 13896]]
and continues to believe, that the new and more order-driven nature of
Nasdaq brought about by the Limit Order Display Rule obviates the
regulatory justification for minimum quote size requirements. In
particular, while the NASD believed it was once desirable and
appropriate to impose the mandatory quote size requirements to ensure
an acceptable level of market liquidity and depth in an environment
where Nasdaq market makers were the only market participants who could
impact quotation prices, the Limit Order Display Rule now permits
investors to directly impact quoted prices. As a result, the NASD
believes that it is no longer necessary to subject market makers to
minimum quote size requirements when they are not representing customer
orders. In addition, economic theory indicates that permitting dealers
to quote in size commensurate with their true trading interest could
further narrow quoted spreads and enhance the pricing efficiency of the
Nasdaq marketplace.
Furthermore, Nasdaq believes that a disincentive for some market
makers would be removed, thus attracting additional liquidity and
pricing efficiency in the Nasdaq market. Indeed, the Commission noted
in its approval of the Actual Size Rule pilot that ``the 1,000 share
minimum quote size represents a barrier to entry for market making.
Lowering this barrier to entry could attract more market makers,
thereby increasing liquidity and competition across the market.'' \11\
This is especially important for smaller market making firms, which may
otherwise have difficulty competing on a price basis in an environment
with minimum quote size requirements.
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\11\ See Actual Size Rule Approval Order, supra, note 8, at
2425.
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In sum, with the successful implementation of the SEC's Order
Handling Rules, the NASD believes that mandatory quote size
requirements impose unnecessary regulatory burdens on market makers
that are not consistent with the Exchange Act.
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
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 market makers. Second, removing artificial quote
size requirements may lead to narrower market maker spreads, thereby
reducing investors' transaction costs. Third, 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,
removing quotation size requirements will facilitate 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, the Commission
noted that it ``preliminarily believes that the proposal will not
adversely affect market quality and liquidity'' \12\ 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.''
\13\ 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.'' \14\
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\12\ Id.
\13\ Id. at 2423.
\14\ Id. 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 determined to
approve the rule on a three-month pilot basis to afford the Commission,
the NASD and Nasdaq an opportunity to gain practical experience with
the rule and evaluate its effects.\15\ 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.\16\
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\15\ See Actual Size Rule Approval Order, supra note 8.
\16\ Specifically, the Commission stated that the NASD's study
should include an analysis of (1) The number of market makers in
each of the 50 securities, and any change in the number 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 by 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). The Commission also stated its expectation
that these factors should be contrasted over the time period
immediately preceding the pilot and after the beginning of the
pilot. In addition, the Commission stated that the NASD should
compare the First Fifty stocks (to which the Rule applied) with the
Second Fifty stocks (stocks subject to the SEC's Order Handling
Rules but not the Actual Size Rule).
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c. Findings of NASD Economic Research and Proposal to Expand Actual
Size Rule Pilot to 150 Stocks. On April 11, 1997, the NASD filed with
the Commission Filing No. SR-NASD-97-26 to extend and expand the Actual
Size Rule.\17\ Specifically, the NASD proposed to extend the pilot
until at least December 19, 1997, and to expand the number of stocks to
include the next 100 stocks subject to the Order Handling Rules. The
filing was subsequently amended to change the extension date from
December 19, 1997, to March 27, 1998, and to change the selection
methodology for the next group of 100 stocks to be subject to the
pilot, discussed further below.
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\17\ See Exchange Act Release No. 38513 (April 15, 1997) 62 FR
19369 (April 21, 1997) (``Notice of Proposal to Expand Actual Size
Rule to 150 Stocks'').
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This finding cited findings of research concerning the
implementation of the Order Handling Rules and the Actual Size Rule
pilot. Specifically, the NASD found that implementation of the Order
Handling Rules had significantly improved the quality of the Nasdaq
market by creating a market structure where customer limit orders
provide liquidity and compete effectively with market maker quotations.
In this type of environment, the NASD stated its belief that the
regulatory necessity for the mandatory quote size requirements no
longer exists. Accordingly, the NASD proposed to both extend and expand
the rule.
In particular, the research conducted by the NASD's Economic
Research Department in early 1997 indicated three general findings
concerning implementation of the Order Handling Rules and the Actual
Size Rule: (1) The Order Handling Rules have dramatically improved the
quality of the Nasdaq market, particularly with respect to the
narrowing of quoted spreads; (2) among those securities subject to the
Order Handling Rules, there is no appreciable difference in market
quality between those stocks subject to the Actual Size Rule and those
stocks subject to mandatory quote size requirements; \18\
[[Page 13897]]
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. The specific findings of this analysis were published
in the original notice of filing SR-NASD-97-26.\19\
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\18\ The First Fifty stocks include 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 401 and 300; 8 ranked between 401 and 500. The ``second
fifty'' stocks include the ten Nasdaq stocks ranked between 11 and
20 by dollar volume plus 40 stocks chosen from Nasdaq's top 500
stocks in the same manner explained above. Because the ten largest
Nasdaq stocks have no comparable peer group among Nasdaq stocks and
the next ten largest Nasdaq stocks included in the Second Fifty
(i.e., Nasdaq stocks ranked 11-20 in size) are not comparable to the
``bottom 40'' of either the First Fifty or Second Fifty, those
stocks have been excluded from the analysis comparing the First
Fifty and the Second Fifty. Accordingly, the ``first forty'' stocks
are the ``bottom 40'' stocks within the First Fifty stocks and the
``second forty'' stocks are the ``bottom 40'' stocks within the
``second forty'' stocks.
\19\ See Notice of Proposal to Expand Actual Size Rule to 150
Stocks, at note 15.
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On June 3, 1997, the NASD supplemented its proposal to extend and
expand the Actual Size Rule by submitting to the SEC a study entitled
``Effects of the Removal of Minimum Sizes for Proprietary Quotes in The
Nasdaq Stock Market, Inc.'' (``June 1997 Study''). The June 1997 Study,
which provides greater detail of the NASD's analysis, became a part of
the NASD filing with the Commission and was made available to the
public through Nasdaq's web site. The June 1997 Study presented a
thorough empirical analysis that produced no evidence that the
implementation of the Actual Size Rule had affected the market quality
of pilot stocks. This study analyzed standard measures of market
quality, including spread, volatility, and depth. In addition, the
study reflected an examination of the ability of investors to access
market maker capital through SOES and proprietary autoexecution systems
and calculated the normalized effective depth, a measure of market
liquidity. The study revealed that for stocks subject to the Actual
Size Rule, investors continued to have reasonable and substantial
access to market maker capital through automatic execution systems.
To provide the public with an opportunity to review and comment on
the June 1997 Study, the Commission extended the comment period on
Filing No. SR-NASD-97-26 until July 3, 1997.\20\ On July 17, 1997, the
NASD amended the filing at the Commission's request to extend the pilot
until March 27, 1998, to provide the Commission with additional time to
evaluate economic studies on the proposal and to review comments on the
June 1997 Study.\21\
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\20\ See Exchange Act Release No. 38720 (June 5, 1997) 62 FR
31856 (June 11, 1997).
\21\ See Exchange Act Release No. 38872 (July 24, 1997) 62 FR
40879 (July 30, 1997).
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Notwithstanding the results of the June 1997 Study, commenters
expressed concerns on the proposal to expand the Actual Size Rule. In
particular, it was noted that the pilot had been limited to only 50
Nasdaq securities. Further, these securities generally represent the
most liquid Nasdaq stocks. In addition, the proposed expansion of the
Actual Size Rule would apply to the 100 stocks that were next to be
phased in under the Order Handling Rules. These stocks were also drawn
from the most liquid Nasdaq stocks. Thus, it was argued, even an
expanded pilot would still be skewed toward larger, more active issues.
In response to these concerns expressed by SEC staff and
commenters,\22\ the NASD amended the proposed rule change on September
15, 1997, to change the selection methodology for the next group of
securities to be subject to the pilot to provide an enhanced sample
more representative of the entire Nasdaq market.\23\ Specifically, the
remaining Nasdaq National Market issues were divided into deciles based
on average daily dollar volume, and 110 stocks were chosen by randomly
selecting approximately the same number from each decile.\24\ Thus, as
expanded, the pilot would provide the Commission, NASD, and market
participants with additional data across a range of securities, thereby
allowing a more enhanced evaluation of the effects of the rule.
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\22\ See e.g., letter from David K. Whitcomb, Professor of
Finance, Rutgers University, to Jonathan Katz, Secretary, SEC, dated
July 3, 1997.
\23\ See letter from Robert E. Aber, Vice President and General
Counsel, to Katherine A. England, Assistant Director, Market
Regulation, dated September 15, 1997.
\24\ 110 stocks were chosen to make up for four of the original
stocks that were delisted, and as reserves in case any others delist
in the interim. This ensured that a total of 150 stocks were
available under an expanded Actual Size Rule.
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d. SEC Approval to Expand Actual Size Rule Pilot to 150 Stocks. On
October 29, 1997, the Commission approved the NASD proposal to expand
the Actual Size Rule pilot to include 150 stocks, as amended to provide
for a sample more representative of the entire Nasdaq market.\25\ The
pilot also was extended until at least March 27, 1998. In approving the
proposal, the Commission stated its belief that the data preliminarily
indicates that the pilot has not resulted in any degradation to Nasdaq
market quality, and that 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 Handling Rules.\26\
Nonetheless, the Commission decided that it would be appropriate to
gather further data using the more representative sample of Nasdaq
stocks before reaching a final decision as to whether or not to extend
the Actual Size Rule to the entire Nasdaq market.
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\25\ See Exchange Act Release No. 39285 (October 29, 1997) 62 FR
59932 (November 5, 1997) (``Actual Size Rule Expansion Approval
Order'').
\26\ Actual Size Rule Expansion Approval Order, at 59936.
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The Commission requested that the NASD continue to evaluate the
effects of the Actual Size Rule and identified several areas of
analysis to be covered.\27\ The Commission also requested that the NASD
compare data among deciles, focusing attention on active versus
inactive stocks. In response, the NASD conducted an additional study of
the effects of the Actual Size Rule, as expanded (``January 1998
Study'')
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\27\ In particular: (1) The number and composition of the market
makers in each stock; (2) the average aggregate dealer and inside
spread; (3) the average spread of each market maker by stock; (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.
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3. January 1998 Study
Summary results of the January 1998 Study are described below. The
complete study is attached as Exhibit 2 to this filing and will be
available through Nasdaq's web site.
a. Methodology of January 1998 Study. To assess the effect of the
expansion of the pilot, this study compared measures of market quality
for a group of stocks that joined the pilot (the ``Next 103'') to a
control group of peer stocks (the ``Non-ASR 3,207'') that remained
subject to mandatory minimum quote sizes.\28\ Similar to the June 1997
Study, a thorough analysis reveals the Actual Size Rule has had no
material effect on Nasdaq market quality.
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\28\ The study reviews data for 18 trading days between October
13 and November 7 (October 27 and 28 are excluded and analyzed
separately) and compares it to 20 trading days between November 10
and December 9.
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Importantly, it should be noted that the January 1998 Study may be
viewed as a more straightforward analysis of the Actual Size Rule. This
is because in the June 1997 Study, the analysis was complicated by the
fact that, with respect to the First 40 stocks presented therein, the
Order Handling Rules were implemented at the same time as the Actual
Size Rule. Thus, the pre-Actual Size Rule implementation period of
review for those stocks did not reflect the impact of the Order
Handling Rules. In contrast, in the January 1998 Study,
[[Page 13898]]
the pre-Actual Size Rule implementation period of review did reflect
the Order Handling Rules, which were fully phased in by October 13,
1997. In other words, the January 1998 Study assessed only one
significant policy change for the subject securities, that being the
implementation of the Actual Size Rule. Furthermore, as indicated above
in Section A.3., the NASD amended Filing No. SR-97-26 to change the
sample design to a more representative cross section of Nasdaq
securities.
b. Actual Size Rule Has No Material Effect on Nasdaq Market
Quality. Several measures of market quality were analyzed in the
January 1998 Study: spread, volatility, depth, and liquidity. Each of
these measures are discussed below.
i. Spread Measures. The quoted dollar spread \29\ of the Next 103
fell 3.8% post implementation, while the quoted spread for the control
group Non-ASR 3,207 similarly fell 4.8%. Multivariate regression
analysis, which is used to control for stock-specific changes in
volume, price, and interday volatility, shows that this differential is
immaterial. Thus, there is no statistically significant evidence of a
differential change in quoted spreads associated with implementation of
the Actual Size Rule.
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\29\ Quoted dollar spread is the difference between the inside
ask and inside bid. Individual dollar spreads are weighted by the
amount of time each spread was in effect for the day, i.e., the
spread's duration.
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The effective spread \30\ (for trades of all sizes) of the Next 103
fell 2.6% post implementation, while the effective spread for the
control group Non-ASR 3,207 fell 5.7%. Multivariate regression analysis
shows that, consistent with the effect on quoted dollar spreads,
effective spreads have not changed materially for either group. Thus,
there is no statistically significant evidence of a differential change
in effective spreads associated with implementation of the Actual Size
Rule.
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\30\ Effective spread is a trade-based measures defined as twice
the absolute difference between the trade price and the bid-ask
midpoint (``BAM''). Thus, effective spread accounts for trades
executed at prices inside the spread.
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ii. Volatility. Volatility \31\ decreased slightly between the pre-
and post-implementation periods for both the Next 103 and the Non-ASR
3,207. For the Next 103, mean volatility fell 5.8%, while volatility
for the Non-ASR 3,207 fell 3.4%. Again, based on multivariate
regression analysis, the differential cannot be attributed to
implementation of the Actual Size Rule.
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\31\ Intraday volatility is measured using the standard
deviation of the logarithm of the BAM.
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iii. Depth. Mean aggregate depth \32\ provided by market makers at
the inside market dropped by 5.2% for the Next 103, and 5.8% for the
Non-ASR 3,207. When ECNs are included, aggregate depth fell by 2.0% for
the Next 103 and 2.7% for the Non-ASR 3.207. Again, based on
Multivariate regression analysis, these differentials are not
statistically significant. Thus, implementation of the Actual Size Rule
is not associated with a change in aggregate quote depth.
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\32\ Quoted depth is the size of a market maker quote, or the
number of shares at the quote that a market maker is required to
transact under the Firm Quote Rule. Aggregated quoted depth is the
sum of the quoted depths of all market makers quoting at the
prevailing inside market.
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Furthermore, neither (1) the mean number of market makers, nor (2)
the mean number of market makers at the inside changed significantly
for either stock group after implementation.
iv. Liquidity. While liquidity is an important market quality
concept, it is difficult to measure empirically. One such measure of
liquidity is ``effective depth,'' and a refinement called ``normalized
effective depth'' that makes the measure more robust across varying
stock prices. These measures integrate the spread, or price, and depth
components of the liquidity concept using trading activity in place of
quoted depth. These measures are described fully in the study, which
indicate that there was no statistically significant association
between effective depth and the Actual Size Rule.
c. Actual Size Rule Does Not Impair Ability of SOES to Provide
Access to Market Maker Capital. An analysis of measures of market maker
accessibility via Nasdaq's SOES system or proprietary systems shows
that the implementation of the Actual Size Rule has not impacted the
operation of these systems. Specifically, 98.5% of SOES orders in Next
103 stocks were fully executed after these stocks became subject to the
Actual Size Rule. Indeed, the average size of a SOES trade in Next 103
stocks fell only 18 shares after the expansion of the pilot program.
Clearly, the effect of the Actual Size Rule on the ability of investors
to achieve executions via SOES has been minimal.
The extreme market conditions of October 27 and 28, 1997 provided
another test of the effect of the Actual Size Rule on the Nasdaq
marketplace. This study includes a comparison of both the market
quality and SOES accessibility of a group of the original pilot stocks
(the First 36) to a group of peer stocks subject to minimum quote size
requirements (the Second 36). There is no significant evidence that the
Actual Size Rule impacted either market quality or SOES accessibility
during these periods of market stress.
4. Conclusion and Proposal To Expand the Actual Size Rule to All Nasdaq
Stocks on a Permanent Basis
The implementation of the Order Handling Rules, which have moved
Nasdaq toward a more order-driven market by integrating customer and
ECN limit orders into the marketplace, called into question the
propriety of requiring market makers to post a minimum depth for
proprietary quotes. No other equity market requires such a minimum.
The NASD believes that the Actual Size Rule will have a positive
impact on market quality. First, removing artificial quote size
requirements may lead to narrower market maker spreads, thereby
reducing investors' transaction costs. This could result because market
makers would be afforded more flexibility to manage risk and quote
prices that are more favorable for small retail orders. Second,
permitting market makers to quote in size commensurate with their own
freely-determined trading interest should enhance the pricing
efficiency of the Nasdaq marketplace and the independence and
competitiveness of dealer quotations. Third, removing quotation size
requirements will facilitate greater quote size variability, which
would increase 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. In
addition, removal of minimum quote size requirements may also eliminate
a barrier to entry into the market for smaller market making firms,
thus attracting more firms into the market, increasing both price
competition and liquidity, thereby benefiting investors.
Furthermore, requiring a minimum commitment of market maker capital
while allowing customer and ECN orders entry without a similar
commitment could severely impair the ability of market makers to set
competitive quotations. The adoption of quotation increments of
sixteenths could have heightened the debilitating effect of the quote
size minimum, as could future reductions in Nasdaq's minimum quote
price increment if the minimum size increment is not equivalently
reduced.
Finally, while economic theory suggests there may be several long
term benefits derived from the removal of minimum quotation size,
empirical research indicates that removal of the
[[Page 13899]]
regulatory minimum has not had any adverse impact on investors or the
Nasdaq market. In the absence of a compelling reason to the contrary,
economic theory clearly indicates that the imposition of a potentially
damaging regulatory constraints, such as the minimum quote size, on the
market is inadvisable. This position is consistent with Section 15A of
the Exchange Act, which prohibits the NASD from imposing ``any burden
on competition not necessary or appropriate'' in furtherance of the
purposes of the Exchange Act. This Section, among others within the
Exchange Act, codifies a Congressional intent that the U.S. securities
markets be free from competitive restraints to the furthest extent
possible consistent with the other goals of the Exchange Act.\33\
Accordingly, the NASD believes that these minimums should be removed
via the implementation of the Actual Size Rule for all Nasdaq
securities on a permanent basis.
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\33\ See Senate Comm. on Banking, Housing & Urban Affairs,
Report to Accompany S.249, S.Rep. No. 94-75, 94th Cong., 1st Sess.
7, 13, reprinted in 1975 U.S. Code Cong. & Admin. News 179.
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5. Statutory Basis
For the reasons noted above, the NASD believes the proposed rule
change is consistent with Sections 11A(a)(1)(C), 15A(b)(6), 15A(b)(9),
and 15A(b)(11) of the Exchange Act. Section 11A(a)(1)(C) provides that
it is in the public interest to, among other things, assure the
economically efficient execution of securities transactions and the
availability to brokers, dealers, and investors of information with
respect to quotations for and transactions in securities. Section
15A(b)(6) requires that the rules of a national securities association
be designed to prevent fraudulent and manipulative acts and practices,
to promote just and equitable principles of trade, to foster
cooperation and coordination with persons engaged in regulating,
clearing, settling, processing information with respect to, and
facilitating transactions in securities, to remove impediments to and
perfect the mechanism of a free and open market and a national market
system and, in general, to protect investors and the public interest.
Section 15A(b)(9) requires that rules of an Association not impose any
burden on competition not necessary or appropriate to furtherance of
the purposes of the Exchange Act. Section 15A(b)(11) requires the NASD,
as a registered securities association, among other things, to
formulate rules designed to produce fair and informative quotations.
B. Self-Regulatory Organization's Statement on Burden on Competition
The NASD believes that the proposed rule change will not result in
any burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Exchange Act.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
Comments were neither solicited nor received.
III. Date of Effectiveness of the Proposed Rule Change and Timing
for Commission Action
Within 35 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission
designate up to 90 days of such date if it 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, including whether the proposed rule
change is consistent with the Exchange Act. Persons making written
submissions should file six copies thereof with the Secretary,
Securities and Exchange Commission, 450 Fifth Street, N.W., 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. 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 No. SR-NASD-98-21 and should
be submitted by April 13, 1998.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\34\
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\34\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-7372 Filed 3-20-98; 8:45 am]
BILLING CODE 8010-01-M
