[Federal Register Volume 63, Number 188 (Tuesday, September 29, 1998)]
[Notices]
[Pages 51978-51980]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-25918]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-40455; File No. SR-NASD-98-01]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change by the National Association of Securities Dealers, Inc., and
Notice of Filing and Order Granting Accelerated Approval to Amendment
No. 4, Relating to the NASD's Rules Regarding Electronic Communications
Networks, Locked and Crossed Markets, and a Member's Obligation to
Provide Nasdaq with Certain Information
September 22, 1998.
I. Introduction
On January 27, 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 (``SEC'' or ``Commission'') pursuant
to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'')
\1\ a proposed rule change to amend the NASD's rules on locked and
crossed markets and to propose a new rule to require NASD members to
provide Nasdaq staff with certain information upon request. Nasdaq
filed Amendment No. 1 to the proposal on June 8, 1998,\2\ Amendment No.
2 on June 30, 1998,\3\ and Amendment No. 3 on July 16, 1998.\4\ The
proposed rule change, as amended, was published for comment in the
Federal Register on July 24, 1998.\5\ The Commission received three
comment letters on the proposal. On August 26, 1998, in response to
issues raised by commenters, Nasdaq filed Amendment No. 4 to the
proposal.\6\ The Commission is publishing this notice and order to
solicit comments on Amendment No. 4 and to approve the proposed rule
change, as amended.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ See letter from Robert E. Aber, Senior Vice President and
General Counsel, The Nasdaq Stock Market, Inc. to Katherine A.
England, Assistant Director, Division of Market Regulation
(``Division''), SEC, dated June 5, 1998.
\3\ See letter from Robert E. Aber, Senior Vice President and
General Counsel, The Nasdaq Stock Market, Inc. to Katherine A.
England, Assistant Director, Division, SEC, dated June 29, 1998.
\4\ See letter from Robert E. Aber, Senior Vice President and
General Counsel, The Nasdaq Stock Market, Inc. to Richard Strasser,
Assistant Director, Division, SEC, dated July 15, 1998.
\5\ See Securities Exchange Act Release No. 40227 (July 17,
1998), 63 FR 39919 (July 24, 1998).
\6\ See Letter from Robert E. Aber, Senior Vice President and
General Counsel, The Nasdaq Stock Market, Inc. to Richard Strasser,
Assistant Director, Division, SEC, dated August 25, 1998. Amendment
No. 4 clarifies that ECNs are not required to register manually in
each security with Nasdaq Market Operations.
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II. Background
SEC Rule 11Ac1-1(c)(5) (``ECN Rule''),\7\ requires a Nasdaq market
maker to reflect in its public quotes any superior prices for orders
that the market maker privately places within an electronic
communications network (``ECN''). A market maker will be deemed to have
complied with the ECN Rule if the ECN in which the market maker has
place a superior priced order displays the best ECN prices in Nasdaq's
quote montage and provides broker-dealers that do not subscribe to the
ECN's service access, through Nasdaq, to those publicly displayed
prices. To accommodate this ``ECN Display Alternative,'' Nasdaq allowed
ECNs to display their best prices from market makers and other ECN
subscribers in the Nasdaq quote. It created a link to its SelectNet
service to permit Nasdaq members to access those prices by sending
orders to ECNs through SelectNet.
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\7\ The ECN Rule is embodied in SEC Rule 11Ac1-1. 17 CFR
240.11Ac1-1.
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Based on its experience with the ECN Rule and operation of the
SelectNet linkage, Nasdaq determined that it was necessary to revise
certain NASD rules. For instance, certain ECN procedures regarding
reserved quotation size appear to cause an increased incidence of
locked and crossed markets, particularly at the market opening.
Moreover, Nasdaq did not have an adequate mechanism in place to obtain
important regulatory information from NASD members on a timely basis.
Nasdaq, therefore, proposed to amend NASD Rules 4613(e) and 4623, as
well as adopt new NASD Rule 4625, to address these issues.
III. Description
Nasdaq proposes to amend NASD Rule 4613(e) to clarify that if, at
or after 9:25:00 a.m. Eastern Time, a market maker or ECN enters a
quotation that would lock or cross the market at the opening,\8\ that
market maker or ECN must act (such as by sending a SelectNet order to
take out the quotation that will be crossed or locked, or canceling its
own quotation) to avoid locking or crossing the market at the opening,
but in no case later than 30 seconds thereafter (i.e., 9:30:30 a.m.).
The 9:25 a.m. benchmark will permit market makers and ECNs to determine
which party entered a market-locking/crossing quotation, and thus which
party is obligated to unlock or uncross the market at the opening. The
9:30:30 provision establishes a deadline by when the market participant
must resolve the locked or crossed market.
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\8\ A locked market occurs when the quoted bid price is the same
as the quoted ask price. A crossed market occurs when the quoted bid
price is greater than the quoted ask price.
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Nasdaq is also proposing to amend NASD Rule 4623 regarding ECNs.
Under proposed NASD Rule 4623(c), if an ECN displays in Nasdaq an order
having a reserved size and a market participant attempts to access that
order by sending an order that is larger than the displayed size, the
ECN would be required to execute the Nasdaq-delivered order: (1) Up to
the size of the Nasdaq-delivered order, if the ECN order (including the
reserved size and displayed portion) is the same size as or large than
the Nasdaq-delivered order; or (2) up to the size of the ECN order
(including the reserved size and displayed portion), if the Nasdaq-
delivered order is the same size as or larger than the ECN order
(including the reserved size and displayed portion).\9\
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\9\ Nasdaq also proposed to amend NASD Rule 4623(b)(4) to
specify an ECN's obligation to register with Nasdaq Market
Operations. As discussed below, this provision was further amended
in Amendment No. 4.
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[[Page 51979]]
Nasdaq is also proposing to adopt new NASD Rule 4625, which will
authorize Nasdaq staff to request information in specific circumstances
and will obligate members to comply with such requests. Specifically,
under proposed new NASD Rule 4625, Nasdaq staff (i.e., Nasdaq
MarketWatch or Market Operations staff) would be permitted to request
from a member information directly related to an SEC or NASD rule that
the Nasdaq department is responsible for administering, or other duties
or responsibilities imposed on the Nasdaq department by the Plan of
Allocation and Delegation of Function or otherwise delegated by the
Association to the Nasdaq department. Failure to comply with a request
for information under the proposed new rule in a timely, truthful and
complete manner could be deemed to be conduct inconsistent with just
and equitable principles of trade.
IV. Summary of Comments
The Commission received three comment letters on the proposal. Two
letters were from entities that operate ECNs, Bloomberg, L.P. (which
owns Bloomberg Tradebook LLC) and Instinet Corporation, and one letter
was from Morgan Stanley & Co. Inc., a large broker-dealer and Nasdaq
market maker.\10\
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\10\ See Letters to Jonathan G. Katz, Secretary, SEC, from Kevin
M. Foley, Bloomberg L.P., dated August 14, 1998 (``Bloomberg
Letter''); from Douglas Atkin, Chief Executive Officer, Instinet
Corporation, dated August 17, 1998 (``Instinet Letter''); and from
Jill W. Ostergaard, Counsel, Morgan Stanley & Co. Inc., dated August
19, 1998 (``Morgan Stanley Letter'').
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ECN Registration
Two commenters opposed Nasdaq's proposed amendment to NASD Rule
4623(b)(4), discussing ECNs' obligation to register with Nasdaq Market
Operations.\11\ The commenters interpreted the proposed amendment as
requiring ECNs to register with Nasdaq Market Operations for each
security as an ECN prior to entering prices and sizes in the SelectNet
linkage on that security.\12\
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\11\ See Bloomberg and Instinet Letters.
\12\ As discussed below, Nasdaq filed Amendment No. 4 with the
Commission to clarify that ECNs need not register separately for
each security.
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Preventing Locked and Crossed Markets
All commenters supported the proposed amendment to NASD Rule
4613(e) to reduce the instances of locked and crossed markets at the
opening. Additionally, one commenter believed the proposal to require
ECNs to execute against reserve size will reduce the number of market
maker and ECN quotations that lock or cross the market throughout the
day and bring greater stability to the Nasdaq market.\13\ Two
commenters were concerned, however, with the proposed requirement in
NASD Rule 4623(c) that ECNs provide non-subscribers access to the
reserve size to reduce intraday locking and crossing.\14\ One commenter
was concerned that providing unlimited access to reserve size to
broker-dealers that do not subscribe to the ECN's service creates a
credit risk for the ECN.\15\ This commenter, therefore, suggested that
non-subscriber access be limited to 10,000 shares to better balance the
advantages of access with any counterparty risk an ECN might
assume.\16\ In the alternative, this commenter suggested that the
credit risk could be lessened by requiring the National Securities
Clearing Corporation (``NSCC'') to take responsibility for a trade from
the moment NSCC receives the executed trade. One commenter opposed this
provision of the proposal because it was concerned that requiring ECNs
to execute against reserve size creates a disparate standard for ECNs
vis-a-vis dealers that are given large orders to ``work.'' \17\
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\13\ See Morgan Stanley Letter.
\14\ See Bloomberg and Instinet Letters.
\15\ See Bloomberg Letter.
\16\ Id.
\17\ See Instinet Letter. But see Morgan Stanley Letter, which
noted that the proposal does not go far enough in leveling the
playing field between ECNs and market makers. This commenter noted
that to provide unfettered competition among all market
participants, market makers should be allowed to charge fees to
market participants that access their quotations as ECNs are
currently permitted to do.
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Obligation to Provide Information to Nasdaq Staff
The two commenters that addressed the NASD's proposed new Rule
4625, which would require NASD members to provide Nasdaq staff with
regulatory information, generally supported the proposal.\18\ One
commenter noted, however, that the proposal, by requiring ECNs and
market makers to divulge sensitive client information to Nasdaq, could
alter the working relationship among ECNs, market makers, and Nasdaq's
MarketWatch.\19\ Another commenter, while supporting the proposed new
rule, cautioned staff against setting unrealistic deadlines for
receiving the requested information.\20\ This commenter proposed that
Nasdaq apply a ``good faith'' test to any disciplinary action brought
against an NASD member for not producing the requested information in a
timely manner.
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\18\ See Bloomberg and Morgan Stanley Letters.
\19\ See Bloomberg Letter.
\20\ See Morgan Stanley Letter.
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V. Discussion
The Commission finds that the proposed rule change is consistent
with the Act and the rules and regulations applicable to the NASD. In
particular, the proposal is consistent with sections 15A(b)(6),
15A(b)(11), and 11A(a)(1)(C) of the Act.
Section 15A(b)(6) requires, among other things, that the rules of a
registered national securities association be designed to prevent
fraudulent and manipulative acts and practices, to promote just and
equitable principals 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.\21\
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\21\ 15 U.S.C. 78o-3(b)(6).
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Section 15A(b)(11) requires that the NASD as a national securities
association have rules that govern the form and content of quotations
relating to securities in the Nasdaq market.\22\ Such rules must be
designed to produce fair and informative quotations, prevent fictitious
or misleading quotations, and promote orderly procedures for
collecting, distributing, and publishing quotations. Sections
11A(a)(1)(C) provides that it is in the public interest and appropriate
for the protection of investors and the maintenance of fair and orderly
markets to assure, among other things, the economically efficient
executive of securities transactions and the availability to brokers,
dealers, and investors of information with respect to quotations for
and transactions in securities, and to assure fair competition among
brokers and dealers.\23\
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\22\ 15 U.S.C. 78o-3(b)(11).
\23\ 15 U.S.C. 78k-1(a)(1)(C).
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Specifically, both the requirement to avoid locking and crossing
the market at the opening and to permit market participants to execute
against reserve size are consistent with sections 15A(b)(6),
15A(b)(11), and 11A(a)(1)(C). The Commission believes that these
proposals will reduce the frequency of locked and crossed markets,
which should provide more informative quotation information and
contribute to the maintenance of a fair and orderly market. These
improvements should benefit the markets and investors.
[[Page 51980]]
The Commission believes, as do two commenters, that continued
locking and crossing of the market can negatively impact market
quality.\24\ As the Commission has previously stated, market makers and
ECNs are required to use reasonable means to avoid locking and crossing
the market.\25\ Consequently, Nasdaq market makers and ECNs must use
``reasonable means'' to take out the quote that their quote, if
immediately posted, would lock or cross. NASD has interpreted
``reasonable means'' to include referencing a SelectNet order to the
firms at the bid or offer.\26\ Experience has shown, however, that ECNs
increasingly are remaining at the inside quote after executing an
incoming order at the displayed size even when the incoming order
exceeds the displayed ECN order size. As a result, the incidence of
locked and crossed markets has increased.
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\24\ See Instinet and Morgan Stanley Letters.
\25\ See Letter to Joseph R. Hardiman, President, NASD, from
Richard R. Lindsey, Director, Division, SEC, dated November 22, 1996
(noting that, in the OTC market, a Nasdaq market maker holding a
limit order that is marketable against another market maker's or
ECN's quote may send a SelectNet message to the market maker or ECN
displaying the existing quote. However, after using reasonable
efforts to execute against the existing quote, the market maker
should display the limit order even if it locks the market).
\26\See NASD Notice to Members 97-49.
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The Commission believes that the proposal to require ECN orders
having reserve size to interact with incoming orders from SelectNet
will help reduce the frequency of locked and crossed markets on Nasdaq
and, as a result, improve market quality. Moreover, the Commission
believes that requiring an ECN to accept a SelectNet order for larger
than the ECN's displayed size balances the interest to reduce the
frequency of locked and crossed markets with market participants'
desire to display only portion of a large order.
One commenter expressed concern that the proposal increases an
ECN's counterparty risk by allowing non-participant broker-dealers
(with whom the ECN has no contractual relationship) to access the ECN's
reserve size.\27\ The Commission notes, however, that the risk is no
greater than that involved in any other broker-to-broker transaction.
Moreover, the SEC's broker-dealer capital requirements as well as
NSCC's novation of executed trades should greatly reduce the risk of
non-performance that ECNs may face. Moreover, since the SEC implemented
its Order Handling Rules, non-subscriber broker-dealer non-performance
resulting from permitting non-subscriber access in those instances.
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\27\See Bloomberg Letter.
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The Commission believes that the proposed provision applying the
restrictions against locking or crossing the market at the opening
should help to clarify NASD members' responsibilities, including
setting a deadline for required action. As a result, the proposed
provision should promote a more orderly opening in Nasdaq securities.
The Commission believes that the proposal to adopt NASD Rule 4625,
regarding a member's obligation to supply Nasdaq MarketWatch and Market
Operations staff with certain information upon request, is consistent
with the NASD's regulatory responsibilities under section 15A of the
Act. The Commission believes that to properly fulfill its obligation to
administer NASD and SEC rules, as well as other applicable
requirements, Nasdaq staff must be able to obtain information regarding
matters such as locked and crossed markets, trade reports, trading
activity, and erroneous transactions on a timely basis from market
participants.
In response to two commenters who were concerned with the proposal
requiring ECNs to register independently for each security, Nasdaq
filed Amendment No. 4 to the proposal.\28\ This amendment clarifies
that ECNs are required to register with Nasdaq Market Operations prior
to being included in Nasdaq as an ECN but are not required to register
manually in each security. According to the NASD, in practice, once an
ECN registers with Nasdaq Market Operations, Nasdaq systems allow the
ECN to enter quotations in all Nasdaq securities. The Commission
believes that this amendment addresses the commenters' concerns that
the rule change, as originally proposed, would unnecessarily burden
ECNs by requiring them to register on a per-security basis.
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\28\ In Amendment No. 4, Nasdaq is withdrawing the previously
proposed amendment to NASD Rule 4623(b)(4) and is proposing to
replace it with the following (new language is italicized; deletions
are bracketed):
(4) agree to provide for Nasdaq's dissemination in the quotation
data made available to quotation vendors the prices and sizes of
Nasdaq market maker orders (and other entities, if the (electronic
communications network) ECN so chooses) at the highest buy price and
the lowest sell price for each Nasdaq security entered in and widely
disseminated by the (electronic communications network) ECN, and
prior to entering such prices and sizes, register with Nasdaq Market
Operations as an ECN.
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The Commission believes that Amendment No. 4 should be approved on
an accelerated basis because it does not impose any requirements in
addition to those originally proposed and published for comment. In
fact, Amendment No. 4 revised the NASD's proposal so that the ECN
registration requirement is consistent with the current practice that
once an ECN registers with Nasdaq Market Operations Nasdaq systems
allow the ECN to enter quotations in all Nasdaq securities.
For the foregoing reasons, the Commission finds that the proposed
rule change, as amended, is consistent with the Act and the rules and
regulations thereunder applicable to the NASD,\29\ and, in particular,
with sections 15A(b)(6), 15A(b)(11), and 11A(a)(1)(C) of the Act. In
addition, the Commission finds good cause for approving Amendment No. 4
to the proposal prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
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\29\ In approving this proposal, the Commission has considered
its impact on efficiency, competition, and capital formation. 15
U.S.C. 78c(f).
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VI. Conclusion
It is therefore ordered, pursuant to section 19(b)(2),\30\ that the
proposed rule change (SR-NASD-98-01) be, and hereby is, approved.
\30\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\31\
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\31\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-25918 Filed 9-28-98; 8:45 am]
BILLING CODE 8010-01-M
