[Federal Register Volume 64, Number 61 (Wednesday, March 31, 1999)]
[Notices]
[Pages 15386-15388]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-7805]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-41208; File No. SR-NASD-98-59]
Self-Regulatory Organizations; Order Approving Rule Change by the
National Association of Securities Dealers, Inc. Relating to Trade
Reporting
March 24, 1999.
I. Introduction
On August 10, 1998, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association''), through its wholly owned subsidary,
the Nasdaq Stock Market, Inc. (``Nasdaq''), filed with the Securities
and Exchange Commission (``SEC'' or ``Commission''), pursuant to
Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') \1\
and Rule 19b-4 thereunder, \2\ a proposed rule change to amend the
trade reporting rules of the NASD to extend to market makers an
exception to the reporting of riskless transactions in Nasdaq National
Market, Nasdaq Smallcap, Nasdaq convertible debt, and non-Nasdaq OTC
equity securities. The proposed rule change was published for comment
in the Federal Register on September 4, 1998. \3\ This order approves
the proposal.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ Securities Exchange Act Release No. 40832 (August 28, 1998),
63 FR 47337.
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[[Page 15387]]
II. Description of the Proposal
The rules for reporting trades in Nasdaq securities have long
existed in their current form. The rules were broadly designed to
capture all trading activity by broker-dealers, both dealer to dealer
trades and traders with customers. These rules, and the trade reports
that result, serve several important purposes. They form the basis for
public dissemination of last sale transaction prices to the tape, thus
providing transparency of the Nasdaq market. They are also an integral
part of the audit trail used by the NASD in its regulatory efforts to
surveil and regulate firms' activities. Given the historical structure
of the dealer markets and the needs to provide a comprehensive view of
all trading. NASD trade reporting rules currently require the reporting
of all principal trades by market makers.
Non-market makers, however, generally do not report all principal
trades under current rules, to the extent the trades are defined as
``riskless''--that is, they involve a trade with another member,
usually a market maker, that is used to offset a trade with a customer.
Even though the non-market maker firm is involved in two separate
trades against its principal account, it reports one transaction to the
NASD.
In light of the growth and evolution of the structure of the Nasdaq
market, and in particular the recent implementation of the SEC Order
Handling Rules, \4\ the NASD is proposing to extend this riskless
principal exception to market makers as well. Thus, certain matching
principal trades involving a market maker would be explicitly included
within the riskless definition, and reported to the public tape only
once.
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\4\ See Securities Exchange Act Release No. 37619A (September 6,
1996), 61 FR 48290 (September 12, 1996).
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For example, under the SEC Order Handling Rules, market makers now
display certain customer limit orders in their public quotes. \5\ Those
orders are often filled by the market maker when that quote is accessed
by another market participant. \6\ Because market makers generally
trade exclusively from a principal account, they engage in two separate
principal trades: one with the other market participant, and then
another directly with the customer. Both of these trades are reported
by market makers under current rules. In effect, however, these two
trades can be viewed as one event--the execution of a customer order
upon the execution of an offsetting transaction obtained by the market
maker. Under the proposed rule change, these two trades would be
reported only once.
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\5\ 17 CFR 240.11Ac1-4(b).
\6\ In fact, NASD Rule IM-2110-2 (Limit Order Protection Rule)
requires market makers to execute customer limit orders (regardless
of whether the customer is theirs or that of another member) when
trading as principal at prices that would satisfy the customer's
limit order. See NASD Rule IM-2110-2; and Securities Exchange Act
Release No. 37619A (September 6, 1996), 61 FR 48290 (September 12,
1996).
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A riskless principal trade can also be viewed as one that involves
two orders, the execution of one being dependent upon the receipt or
execution of the other. For example, the execution of an institutional
customer order may be dependent upon finding the other side, in whole
or in part. To the extent that any of the order is offset with another
principal execution, that portion would be deemed riskless and should
be reported only once.
The effect of the proposed rule change can be illustrated in the
following examples. A market maker (MMI) holds a customer limit order
that is displayed in its quote to buy 1000 shares of ABCD at $10. MM2
sells 1000 shares to MMI at $10. MM2 reports the sale of 1000 shares,
as required under current rules. \7\MM1 then fills its customer order
for 1000 shares at the same price, exclusive of any mark-up or
commission. Under the proposal, the first trade would continue to be
reported (by the selling firm MM2 in this case, as required under
current rules), but the second leg between MM1 and the customer would
not be reported again, as it is deemed riskless. If the first execution
were through a Nasdaq facility that automatically generates a trade
report to the trade, such as SOES or SelectNet, no member would report
at all. Of course, members may still need to submit a ``clearing only''
entry into ACT to complete the transaction with the customer, but these
submissions are not reporting purposes. Thus, there will be no public
trade report for the second leg of the transaction.
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\7\ See, e.g., NASD Rule 4632(b), which requires the selling
market maker to report in a transaction between two market makers.
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In another example, an institutional customer presents a large
order to a market maker (MM1) to sell 100,000 shares of XYZZ, with
instructions to work the order, subject to a price limit. The market
maker may attempt to solicit interest from other parties to fill the
institutional order, in whole or in part. The market maker may find a
willing buyer, but for only 75,000 shares, at a price of $12 per share.
The market maker may determine to fill the entire customer order for
100,000 shares at $12 per share at that time (exclusive of any
markdown, commission equivalent, or other fee), by trading the 25,000
share balance out of inventory. Here, there will still be two separate
trade reports under the proposal because only a portion of the customer
execution is deemed riskless. The size of the trade reports, however,
will be adjusted to exclude the riskless portion. Specifically, instead
of MM1 reporting these as a market maker sell transaction of 75,000
shares and then a market maker buy from the customer for 100,000
shares, these trades would be reported under the proposal as a market
maker sell transaction of 75,000 shares and then a market maker buy
from the customer of only 25,000 shares.\8\
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\8\ It should be noted that in this particular example, the
market maker with the order is responsible for reporting both legs
of the transaction. If the customer were buying stock in the same
example, and the market maker first buys 75,000 shares from another
market maker, the 75,000 share trade would be reported by the
selling market maker under current NASD rules (i.e., seller reports
in a trade between two market makers). The market maker with the
customer order would still report the 25,000 share trade.
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In another variation of the previous example, MM1, while holding
the institutional customer order and working it on their behalf, may
obtain several executions to satisfy the order by selling to other
market participants at varying prices throughout the trading day. In
this example, assume that the entire order is filled with these
individual executions. Because MM1 is the seller in these executions,
it has the trade reporting responsibility and will continue to report
under current rules each individual component trade with other market
participants as they occur. Under the proposal, however, MM1 would not
report the transaction with the customer, as the executions used to
satisfy the order already have been reported to the tape. The
transactions, however, may be confirmed to the customer at an average
price of the component executions, to the extent permissible under Rule
10b-10 of the Act.\9\
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\9\ See, e.g., SEC no-action letter from Catherine McGuire, SEC,
to Eugene Lopez, the Nasdaq Stock Market, dated May 6, 1997
(permitting the issuance of a single confirmation at any average
price and with multiple capacities for a single customer order
effected with multiple executions).
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In addition, the NASD is clarifying the riskless principal trade
reporting provision to ensure its consistent application to any order
received by a member, regardless of the person or entity that it was
received from. Specifically, while the current rule refers to orders
received from a ``customer,'' the proposed rule simply refers to ``an
order.'' Thus, a transaction is considered riskless regardless of
[[Page 15388]]
whether the market maker is holding an order from a customer, another
member, the customer of another member, or any other entity, including
non-member broker-dealers. Furthermore, the text of the rule is being
amended to more clearly provide that such trades are reported exclusive
of any mark-up, mark-down, commission, or other fee.
III. Discussion
The Commission finds that the proposed rule change is consistent
with Section 15A of the Act \10\ and the rules and regulations
thereunder. In particular, the Commission believes that the proposal is
consistent with the Section 15A(b)(6) \11\ requirements that the rules
of an exchange be designed to prevent fraudulent and manipulative acts
and practices, to promote just and equitable principles of trade, 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.\12\
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\10\ 15 U.S.C. 78o-3.
\11\ U.S.C. 78o-3(b)(6).
\12\ In approving the proposed rule change, the Commission has
considered the proposed rule's impact on efficiency, competition,
and capital formation. 15 U.S.C. 78c(f).
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The Commission agrees with the NASD that, for reporting purposes,
it is appropriate to treat riskless principal trades as one trade. As
the NASD noted, with the implementation of the SEC Order Handling
rules, which generally require that a broker-dealer publish its
customer's limit orders,\13\ the number of riskless principal
transactions executed by NASD member firms has increased. Reducing the
number of transactions required to be reported should result in a
corresponding reduction in transaction fees.
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\13\ 17 CFR 240.11Ac1-4(b).
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Moreover, current NASD rules for reporting principal transactions
allow members that are not acting as market makers to report a riskless
principal transaction as one transaction. In the past, the Commission
has been concerned that a market maker making a continuous two-sided
market might have difficulty identifying when a riskless principal
transaction was effected. Accordingly, the principal trade reporting
rule required members effecting riskless principal trades as a market
maker to report both sides of the trade in an effort to avoid the
possibility that compliance problems and interpretive difficulties
would arise. Due to advances in the NASD's technology, however, the
Commission believes that it is now appropriate for the NASD to allow a
member acting as market maker to report riskless principal transactions
as one transaction. The NASD has recently begun implementing its Order
Audit Trail System \14\ (``OATS''), which, among other things, requires
market makers to record and report certain information with respect to
each order, including the origin of the order (i.e., in-house,
customer, or another member). The implementation of OATS should assist
the NASD in determining whether a trade is properly reported as a
riskless principal transaction. For these reasons, the Commission
believes that extending the riskless principal exception for trade
reporting to market makers so that they can report certain matching
principal trades only one is reasonable and consistent with the
Act.\15\
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\14\ OATS will be implemented in several phases. At this time,
OATS reporting requirements have only been implemented for
electronic orders received by ECNs and market makers in the
securities in which they make a market. See Securities Exchange Act
Release No. 39729 (March 6, 1998), 63 FR 12559 (March 13, 1998)
(order approving File No. SR-NASD-97-56).
\15\ The Commission notes that a riskless principal transaction
is defined as a transaction where a member, after having received an
order to buy a security, purchases the security as principal at the
same price to satisfy the order to buy or, after having received an
order to sell, sells the security as principal at the same price to
satisfy the order to sell, excluding the mark-up or mark-down,
commission-equivalent, or other fee. The Commission expects that the
NASD will issue an interpretation giving examples of how mark-ups
and other fees will be excluded for purposes of determining whether
a trade is at the same price.
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IV. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2Sec. of the
Act,\16\ that the proposed rule change (SR-NASD-98-59) is approved.
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\16\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\17\
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\17\ For the Commission, he
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-7805 Filed 3-30-99; 8:45 am]
BILLING CODE 8010-01-M
