United States General Accounting Office

GAO Report to Congressional Requesters

August 1998 SECURITIES MARKET

OPERATIONS

The Effects of SOES on

the Nasdaq Market

GAO/GGD-98-194

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-278412 

August 31, 1998

The Honorable Charles E. Schumer

House of Representatives

The Honorable Gary L. Ackerman

House of Representatives

The Honorable Sam Gejdenson

House of Representatives

This report responds to your request that we study the Small Order

Execution System (SOES) and its effects on the Nasdaq Stock Market.1 SOES

is a securities trading system that provides immediate automated

executions of trades in the Nasdaq Market. Our objectives were to

determine (1) the extent to which SOES is being used for its intended

purpose, (2) the effects of SOES on the marketplace, (3) the results of

attempts to limit trading on SOES or replace SOES, and (4) the effects of

recent market developments and proposals affecting SOES.

Background

How the Nasdaq Stock

Market Works

The Nasdaq Market is a market for securities traded “over-the-counter”

through a network of computers and telephones, rather than on a stock

exchange floor. Nasdaq is an electronic communications system in which

certain NASD member broker-dealers act as market makers by quoting

prices at which they are willing to buy (“bid quote”) or sell (“ask quote”)

securities for their own accounts or for their customers. For the securities

that are listed on the Nasdaq system, market makers enter into the system

their bid and ask quotes and the number of shares they are willing to buy

or sell (referred to as “depth” or “size”). Market makers are obligated to

trade at the depth that they are publicly displaying under Nasdaq’s firm

quote rule.2

 Market makers often choose, or under best execution

obligations are required, to provide executions at least as favorable as that

1

The Nasdaq Stock Market, Inc., is a wholly-owned subsidiary of the National Association of Securities

Dealers (NASD), a registered securities association. Nasdaq began operation in 1971 as the first

screen-based stock market for non-exchange listed securities.

2

The firm quote rule requires that a market maker execute a transaction at its displayed quotations for

at least a normal unit of trading, 100 shares, or for the actual size of the quotation if it is greater than

the normal unit.

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being displayed publicly by other participants, regardless of whether the

market maker itself is publicly displaying that price or depth.

The Nasdaq computer system brings together the bid, ask, and depth

quotations of the numerous market makers for all Nasdaq-listed securities

for display to Nasdaq member broker-dealers and other subscribers. The

Nasdaq workstation, through which all Nasdaq market makers and other

member broker-dealers can view the market, displays and continuously

updates bid and ask prices and the quote depth in a montage of quotes for

each listed security. The Nasdaq Market has thus been referred to as a

“dealer” market in which prices are set by the interaction of dealer quotes,

although, as discussed later, this has changed under SEC’s Order Handling

Rules to include the interaction of limit orders.3

In such a dealer market, market makers have the responsibility to provide

liquidity by being continuously willing to buy and sell the security or

securities in which they are making a market (or risking their capital), at

least at their publicly quoted prices. Liquidity is the ease with which the

market can accommodate large volumes of securities trading without

significant price changes. As a result, an individual who wants to buy or

sell a security at the quoted price would not have to wait until someone is

found who wishes to take the opposite side in the desired transaction. The

difference between the listed bid and ask prices is the “spread” that

market makers retain as compensation for their effort and risk.

Investors who want to buy or sell Nasdaq-listed securities place orders

with broker-dealers. The brokers have several ways to handle the orders.

If the broker makes a market in the stock, it may execute the order itself,

generally through its own internal automated execution system. If the

broker does not make a market in the stock, it may send the order to

market makers through Nasdaq’s automated order entry and delivery

system, called SelectNet. SelectNet orders may either be directed to a

specific market maker or broadcast generally to all market makers. In

conformance with SEC and NASD rules, market makers must execute

directed SelectNet orders, commonly referred to as “preferenced” orders,4

up to their displayed quotation size, if the orders are priced equal to their

quote, unless the market maker has just traded or moved its quote.

3

A limit order is a customer order to buy or sell a security at a specific price.

4

Preferenced orders are executed at the best quoted price, even though that price may not be that

market maker’s quoted price. However, market maker’s can designate the securities for which they are

willing to accept preferenced orders. Unpreferenced orders are routed on a rotational basis to the

SOES market makers quoting the best bid or ask prices and are executed at those prices.

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Directed orders that must be executed are commonly referred to as

“liability” orders. Other nonliability SelectNet orders can be accepted,

negotiated, or declined by one or more market makers. Brokers may enter

small orders of up to 1,000 shares for most stocks into SOES, where they

are automatically executed without negotiation. The broker may negotiate

large orders or those requiring special handling directly with one or more

market makers.

How SOES Works SOES is a system that allows small orders placed through it to be

automatically executed against Nasdaq market makers at the best bid or

ask prices displayed on the Nasdaq system. SOES trading has generally

represented less than 10 percent of total Nasdaq shares traded. SOES can be

used by NASD member firms that register as participating SOES order entry

firms. These firms may only enter orders that have been received from

their public customers. Some of these firms’ primary, if not exclusive,

business line is SOES trading. We call these firms SOES day trading firms. All

Nasdaq market makers in Nasdaq National Market securities (Nasdaq’s

largest stocks, accounting for over 90 percent of Nasdaq volume) must be

SOES market makers and receive SOES executions from SOES order entry

firms. Participation in SOES by market makers in Nasdaq’s smaller

securities (called Small Cap securities) is voluntary.

Market makers can also use SOES to execute their customer orders.

However, Nasdaq rules do not allow market makers to enter orders into

SOES for stocks for their proprietary trading (trading for their own

account).

Before January 1997, SOES rules generally required market makers to quote

a minimum of 1,000 shares to buy or sell (for some less actively traded

shares, the minimums may be 500 or 200 shares). Under a pilot program

begun in January 1997, called the actual size pilot, these regulatory

minimums were removed for 150 test stocks, and market makers were

allowed to enter quotations at any size in 100 share increments (and

multiples of 100). SEC approved the expansion of actual size rules to all

Nasdaq stocks on July 15, 1998, effective July 20, 1998.

Results in Brief NASD developed SOES to provide automatic access to the Nasdaq Market

and market makers for the securities orders of small, retail investors.

However, 1995 NASD data show that the primary users of SOES, accounting

for over 80 percent of SOES trading volume, are SOES day trading firms.

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These firms generally have provided access to SOES and proprietary

computer software to assist the trading of day traders. Day traders usually

(1) trade the maximum number of shares allowed on SOES, (2) trade

frequently during the day, and (3) rarely carry an inventory of securities

overnight. Market makers told us that many retail investors’ orders are

being filled by market makers using their own internal automated systems,

at prices that are to match the best Nasdaq prices. The day traders have

used a trading advantage provided by the automatic execution feature of

SOES, proprietary software the SOES day trading firms designed to benefit

from this feature, and Nasdaq rules that limited market maker access to

SOES, to profit at the expense of market makers and their customers. This

advantage has diminished over time because of market maker software

improvements and changes in trading rules.

Not surprisingly, market makers and SOES day trading firm officials

disagree about the effects of SOES day trading on the market. For example,

market makers told us that day traders are market professionals, who

should not have an advantage in the marketplace. They said that the day

traders not only profit at the expense of market makers, but also cause

losses for market maker customers, who may have to buy at higher prices

and sell at lower prices than they otherwise would. In contrast, SOES day

trading firm officials said that day trader activity has forced market

makers to monitor and update their quotes, or prices, and has ensured that

orders from individual investors are automatically executed at the best

prices. The various studies that have attempted to assess SOES effects on

the market have not effectively isolated the effects of SOES from those of

many other changes in the market, such as revised trading rules, that have

occurred during the same time SOES has been operating.

NASD has proposed various rule changes to reduce or eliminate the

advantage of SOES day traders. SEC approved some of the earlier rule

changes. However, a court decision in favor of a SOES day trader, as well as

two separate investigations by the Department of Justice and SEC of

market maker collusion to fix prices on the Nasdaq Market, which market

makers eventually settled without admitting or denying guilt, strengthened

the position of the SOES day trading firms and their day traders. SEC

officials told us that they had become more skeptical of NASD rule

proposals to change SOES, and that NASD had failed in two attempts to

eliminate SOES’ automatic execution feature in favor of systems that

attempted to limit the availability of automatic executions exclusively to

smaller investors and that routed orders to market makers for execution.

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Despite NASD’s lack of success in controlling SOES traders through rule

changes, the volume of SOES trading as a percentage of total Nasdaq share

volume has been declining, from almost 8 percent in January 1997 to less

than 5 percent in 1998. Some of the factors that may have influenced this

decline include changes in SEC and NASD rules, increased use of ECNs by

SOES day traders, and market makers’ use of their internal automated

trading systems. To make automatic trade executions more widely

available, Nasdaq has proposed an Integrated Order Delivery and

Execution System that would replace two existing systems, including SOES,

and provide an integrated order routing and execution system and a

voluntary limit order file, in which customer orders at specified prices

could be matched and executed. This system would allow market makers,

as well as SOES day traders, access to automatic execution of all trades.

Nasdaq officials told us that this system, among other things, is intended to

eliminate the unintended double liability incurred by market makers as a

result of SOES day trading, without unduly benefiting market makers. This

double liability arises because market makers are required to execute

trades against their quotes through both SelectNet and SOES. However,

some features of the proposed system are controversial, and SEC has

received about 2,100 public comment letters on the system.

Scope and Methodology To determine the extent to which SOES was being used for its intended

purpose and how it has performed, we interviewed officials from NASD and

SEC and reviewed agency documents. We also interviewed selected market

participants about their use of SOES, including officials from seven market

making firms, five of which were among the largest Nasdaq trading firms;

three SOES day trading firms; one mutual fund; and two industry trade

associations, one representing market makers and the other SOES day

trading firms.

To determine past NASD attempts to limit SOES day trading, we reviewed

NASD proposed rule changes and SEC approval orders. We interviewed

current and former SEC officials to obtain information on the reasons for

which changes were or were not approved. We also reviewed pertinent SEC

reports, primarily its 21(a) report,5 public comment letters, and other

documents.

To determine the effects of SOES on the marketplace, we interviewed the

previously listed selected market participants. We also reviewed and

5

Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the

Nasdaq Market, U.S. Securities and Exchange Commission (August 8, 1996).

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analyzed the following six studies on the market effects of SOES: (1) The

Importance of Firm Quotes and Rapid Executions: Evidence From the

January 1994 SOES Rule Changes by Jeffrey Harris and Paul Schultz;

(2) SOES Trading and Market Volatility by Robert H. Battalio, Brian Hatch,

and Robert Jennings; (3) Day Trading on Nasdaq’s Automatic Small Order

Execution System (SOES): Adverse Selection and Spread by George

Benston and Robert Wood; (4) Nasdaq Market Reform: New Evidence

That Competition From the Public Lowers Trading Costs by Michael J.

Barclay, William G. Christie, Jeffrey Harris, Eugene Kandel, and Paul H.

Shultz; (5) Effects of the Removal of Minimum Sizes for Proprietary

Quotes in the Nasdaq Stock Market by the staff of NASD Economic

Research; and (6) SOES and the Nasdaq Stock Market by Nasdaq Economic

Research (Dean Furbush, D. Timothy McCormick, Kathleen L. Mitchel,

Lorraine M. Reilly, James P. Selway III, and Michael P. Watson). In

addition, we interviewed other academicians about SOES, as well as the

Chief Economist at NASD and officials from SEC’s Division of Market

Regulation. We also interviewed the selected market participants about

the various studies.

To determine the recent market developments and proposals affecting

SOES, we reviewed SEC and NASD rule changes since December 1996

concerning SOES and the latest NASD proposal to replace SOES.

6

 We

interviewed the selected market participants to obtain their views on the

proposed SOES replacement system and reviewed public comment letters.

We did our work in accordance with generally accepted government

auditing standards between October 1997 and July 1998 in Washington,

D.C.; Baltimore, MD; New York, NY, and vicinity; and Houston, TX.

NASD Established

SOES to Provide

Automatic Execution

of Small Retail

Orders, but It Has

Been Used Primarily

by Day Traders

NASD established SOES in 1984 as a means for market makers to provide

timely and efficient execution and processing of small retail orders. When

first established, SOES was a voluntary system for market makers that

allowed them to lower their processing costs by providing automatic

execution for these orders at the best available prices. After the 1987 stock

market crash, during which many market makers withdrew from SOES and

small investors had difficulty executing their orders, NASD made market

maker participation in SOES mandatory for Nasdaq National Market

securities. Since then, SOES day trading firms have developed trading

strategies to take advantage of the automatic execution feature of SOES,

and day traders have become the primary users of SOES. The day traders

6

Release No. 34-39718; File No. FN SR-NASD-98-17, March 4, 1998.

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trade frequently, usually trade the maximum number of shares allowed on

SOES, and rarely carry an inventory of securities from one day to the next.

SOES has provided the day traders and its other users access to market

makers during the periods of high trading volume that have occurred since

the 1987 market crash.

NASD Established SOES to

Provide Automatic

Execution of Small Retail

Orders

Nasdaq market makers recognized the need for increased automation of

the over-the-counter market when, during a surge of trading volume that

began in the fall of 1982, the handling of routine small orders became an

increasing burden for them. In November 1984, NASD submitted a proposed

rule change to SEC to reduce this burden. The submission announced that

NASD had developed a new, automated, small order execution system for

routing and executing limited sized orders in over-the-counter securities.

Its purpose was twofold: to improve the efficiency of these securities

transactions by allowing the orders of brokers’ small retail customers to

be sent electronically to Nasdaq market makers, and to receive automatic

executions at the best bid or ask price. The orders, initially of 500 shares

or less, were to be sent on a rotating basis to competing market makers,

who could participate on a voluntary basis. In general, such small orders

are considered to be of a size less likely to cause a movement in a stock’s

price or significantly reduce available liquidity. Member firms could

participate in SOES as either market makers or order entry firms. SOES was

approved by SEC in February 1985.

The automatic execution feature of SOES is consistent with the objectives

of the 1975 Securities Acts Amendments. These amendments set forth five

objectives for the securities markets to function in the public interest,

provide appropriate protection of investors, and maintain fair and orderly

markets. The objectives are (1) efficient execution of securities

transactions; (2) fair competition among market participants;

(3) widespread availability of quotation and trade information; (4) the

practicability of orders executed in the best market; and (5) the

opportunity, consistent with the foregoing provisions, for investors’ orders

to be executed without dealer participation. SOES provides for efficient

execution of investors’ orders at the best bid or ask price without

negotiating with a dealer.

Market Crisis Was Basis

for Making SOES

Participation Mandatory

From October 14 through 21, 1987, the U.S. stock markets experienced an

accelerated decline and record trading volumes. The Dow Jones Industrial

Average (DJIA) fell by over 30 percent—the largest decline since the market

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crash of October 1929. The Nasdaq composite index declined 27.2 percent

during October 1987, while Nasdaq trading volume reached the

unprecedented level of 288 million shares on October 21, 1987.

Market makers withdrew from voluntary SOES participation during the

decline, making it necessary for trades that would have been executed

automatically by SOES to be handled by contacting a market maker by

telephone. This added to the already high volume of telephone calls to

market makers, making them unusually difficult to contact. Consequently,

many investors could not contact market makers and obtain executions of

trades. The result was a severe reduction of liquidity in the Nasdaq market,

particularly for small retail investors.

Despite the withdrawals by some market makers, SOES remained open and

in operation throughout the October 1987 market crash and, according to

SEC, continued to provide an effective means for the execution of small

orders. However, the difficulty experienced by small investors in accessing

the market during the break caused NASD, with SEC encouragement, to

conclude that enhancements to SOES and Nasdaq were needed. In

March 1988, NASD proposed rule changes that SEC approved in June 1988.

The rule changes (1) prohibited a firm that withdraws, on an unexcused

basis, as a Nasdaq market maker in a security from reentering Nasdaq as a

market maker in that security for 20 business days; (2) made SOES

participation mandatory for all market makers in Nasdaq National Market

securities; (3) enabled NASD to establish different levels of maximum order

size limits of 200, 500, and 1,000 shares for SOES orders in national market

securities, depending on the trading characteristics of the different

securities; and (4) required a market maker to execute a minimum of 5

trades at a security’s maximum order size.

The various public commentators on the proposal to make SOES mandatory

were about equally divided between favoring and opposing the proposal.

Some commentators believed that mandatory SOES participation might

result in a widening of spreads by market makers to handle their increased

risk from the automatic SOES executions. However, neither the

commentators, NASD, nor SEC expected that SOES day trading firms would

develop and that day traders would become the primary users of SOES.

Primary Users of SOES Are

Day Traders

Shortly after market maker participation became mandatory, a few firms

realized that they could profit from using SOES. NASD data show that these

SOES day trading firms and their day traders became the primary users of

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SOES. NASD officials have stated that the characteristics of SOES day traders

are distinct from those of retail investors. They said that SOES day traders

trade at the maximum allowable SOES transaction size, and that their

trading volume is much higher than that of a typical retail investor. NASD

data show that SOES day traders are also usually position-neutral—having

neither a long (owning stock) nor a short (borrowing stock) position at the

end of the day. Nasdaq reported that, as of September 1995, day traders

accounted for about 83 percent of SOES share volume, 89 percent of the

dollar volume, and about 69 percent of all SOES trades.

SOES day trading firm officials told us that day traders have several

methods they use to buy and sell stocks. In addition to SOES, they may also

use electronic communication networks (ECN), such as Instinet, or other

Nasdaq order delivery systems such as SelectNet.7

 These officials said that

day traders used ECNs in an attempt to negotiate prices that would offer

them the highest profit when they closed out their positions. Until SEC

instituted new trading rules in 1997, as discussed later, the prices in ECNs

were not generally available to the investing public. Day traders accessed

these systems through the SOES day trading firms. These firms also

provided customized, proprietary software and various services, such as

facilities and training, to assist the day traders that constituted their

customers. The software systems included such features as real time

quotes, news information, custom tickers that display market maker

updates, charts of stock prices, and lists of the most active stocks.

SOES Provided a Trading

Advantage for Day Traders

SOES day traders have had a trading advantage in the Nasdaq market over

market makers and their customers because day traders can execute

trades faster. Day traders execute trades immediately, through SOES, that

market makers, with similar orders, would have to manually enter and

possibly negotiate through SelectNet. Day traders’ software systems have

enabled them to take advantage of their immediate, automatic access to

SOES by entering as many trades as they wanted, quickly cancel orders or

enter multiple orders with an individual keystroke, and be notified about

securities that reached predetermined prices. Conversely, market makers

have not been able to use the day traders’ techniques on SOES because

7

ECNs are generally privately operated screen-based electronic trading systems that allow participants

to enter priced orders that then are widely disseminated to third parties. Participants may include

retail investors; mutual funds, pension funds, and other institutional investors; broker-dealers; and

market makers. The sponsors of these systems are currently regulated by SEC as broker-dealers, even

though the systems may operate differently from the activities of traditional broker-dealers. Instinet is

a private trading system that is linked as an ECN to Nasdaq. SOES day trading firms, and their day

traders, have access to Selectnet and Instinet because the firms, as NASD members, are allowed

access to ECNs through their Nasdaq workstations.

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Nasdaq rules until recently restricted market makers from entering SOES

orders on behalf of their customers for stocks in which they make a

market. In addition, market makers still cannot use SOES for their

proprietary trades. The ability to execute trades faster than market makers

has allowed SOES day traders to profit from short term price movements in

stocks.

In addition, market makers told us that SOES day traders have an advantage

over them because the day traders can get executions through SOES faster

than the market makers can update their quotes. Specifically, market

makers told us that the day traders initially used their advantage to profit

at the expense of market makers that did not closely monitor their stocks.

The SOES day trading firms provided day traders with software to monitor

and identify market maker quotes that were “stale”—that is, as the prices

of securities moved up and down, the market maker’s quote may have

been out of line with other market maker quotes for a short period of time.

For example, one market maker who was not closely monitoring a

particular stock may have left his bid and ask prices (the prices at which

he is willing to buy or sell stock respectively) at $19.75 and $20, at the

same time that other market makers moved their bid and ask quotes,

because of some news on the stock, to $20.25 and $20.50. By taking

advantage of their software that allowed them to identify this discrepancy,

SOES traders could profit from the opportunity presented because they

could automatically buy at $20 and then sell at $20.25. However, these

opportunities became less frequent as market makers began to automate

their quote monitoring.

At the time of our review, day traders generally used software provided by

the SOES day trading firms to monitor a handful of stocks that had

numerous intraday price movements, or to monitor many actively traded

stocks, looking for trends to develop in order to buy in “up-trending”

markets and sell in “down-trending” markets. They tried to buy stocks

when they anticipated that prices would be increasing, selling later at

higher prices; or similarly, selling stocks when they anticipated prices

would fall and buying back later at lower prices—in either case profiting

on the price momentum. According to market makers, one way day

traders do this is to identify when institutional traders are buying or selling

large amounts of a particular stock, and then buy or sell ahead of them.

For example, assume an institutional trader wanted to buy 10,000 shares

of a particular stock. If 10 market makers are each quoting prices for 1,000

shares, the trader’s broker begins to purchase all the available shares at

the quoted price through SelectNet. However, after purchasing 1,000

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shares from each of two market makers, the broker finds that SOES day

traders have purchased the rest of the shares through SOES, using the

advantage provided by the automatic execution feature of SOES and their

software that allows them to execute many orders at the same time. The

SOES traders then sell the 8,000 shares to the broker at a higher price to the

broker. According to market makers, this happens hundreds of times a day

and causes institutional traders, as well as retail investors, to have to buy

at higher prices and sell at lower prices because they do not have the same

speed of access to the market as SOES day traders.

Market makers told us that they have established their own internal

automated trading systems, which they use to fill retail investors’ orders,

and made software improvements in order to minimize their exposure to

day traders. As a result of the improvements and changes in the trading

rules, which we discuss later, the trading advantage that SOES day trading

firms have had over market makers and their customers has decreased.

SOES Has Provided Access

to Market Makers During

Periods of High Trading

Volume

Although regulators have had only two opportunities to observe SOES

performance under periods of high trading volume, their analyses have

shown that SOES provided investors placing small orders continued access

to market makers throughout those periods. Only two periods of

exceptionally high trading volume and volatility have occurred since

June 1988 when SOES became mandatory—in October 1989 and

October 1997.

On October 13 and 16, 1989, the securities markets experienced unusual

price volatility and trading volume. On the 13th, the DJIA experienced a

decline of 190 points—the second largest single-day point decline to that

time. On the next trading day, the 16th, the DJIA closed up 88 points, the

fourth largest point gain to that time.8 SEC reported that market maker

withdrawal from SOES participation during this period was significantly

lower than in October 1987. SEC attributed this to the rule changes adopted

the previous June, which made SOES participation mandatory and

penalized withdrawals with a 20-day ban before reentry. SEC also found

that SOES operated well and succeeded in handling its share of the third

highest volume to that time on the Nasdaq Market. SEC concluded that, in

part because SOES was able to handle the increased retail order flow, the

Nasdaq Market operated much more effectively than in October 1987.

8

The percentage decline, 6.9 percent, was only the 20th largest from 1900 through 1989, and the

following day’s percentage gain, 3.4 percent, was not among the top 20 largest gains during those

years.

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On October 27, 1997, the DJIA fell 550 points, 7.2 percent, the largest 1-day

point drop in its history. The Nasdaq composite index fell by 7 percent,

and trading volume was 906.4 million shares, well above the 1997 average

daily volume of about 647.4 million shares. The next day, October 28, 1997,

after trading resumed, the market rallied, and the Nasdaq index gained

back much of what had been lost the previous day. That day, Nasdaq

recorded trading volume of 1.3 billion shares—its first ever billion share

day.

NASD’s study of trading on October 27 and 28, 1997, found that SOES

continued to provide investors efficient access to market makers on both

days. SOES accounted for 6.9 percent of total Nasdaq share volume on

Monday the 27th, which was similar to its use on previous days. The

number of SOES orders entered on the 27th was about 114,000, which was

well above the daily average for the previous week of about 83,000 orders.

On Tuesday the 28th, SOES trading accounted for 6.4 percent of total

Nasdaq share volume. On the 28th, the nearly 172,000 orders entered into

SOES were more than twice the number entered on the average day. An

NASD official told us that, while the SOES proportion of total Nasdaq volume

did not rise, additional retail investor trading volume could have been

executed through market makers’ internal automated systems. Market

makers established such in-house trading systems during the years

between the 1989 and 1997 market breaks.

SEC has not completed its analysis of trading on October 27-28, 1997.

However, SEC officials told us that they found no problems with small

retail investors accessing the market during this 2-day period. According

to the officials, SOES maintained its share of total trading over the period,

which generally indicates that it allowed small orders to execute

automatically against market maker quotes.

The volume of SOES trading has increased significantly since SOES began.

According to NASD data, when SOES was introduced the system accounted

for about 4,500 trades per day. In 1995, SOES accounted for over 40,000

trades a day, and by mid-October 1997, it accounted for about 83,000

trades a day. SOES share of the total Nasdaq market before 1995 was

generally between 1 and 4 percent of total share volume. In 1995, SOES

share of total volume increased to over 6 percent and remained at that

level until, as discussed later, it declined after SEC and NASD rules’ changes

and increased use of ECNs.

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Opinions Varied

About the Effects of

SOES Day Traders on

the Market

Opinions varied about the effect of SOES trading on the Nasdaq Market.

Market makers and SOES day trading firms disagreed about their respective

roles in the market. They also disagreed about the effects of SOES day

trading on spreads, liquidity, and volatility. Various studies did not help to

resolve these disagreements because they did not clearly and precisely

isolate the effects of SOES day trading from those of many other changes in

the market, such as revised trading rules, that have occurred since SOES

has been operating. Further, some market participants alleged that the

nature of SOES day trading has allowed SOES to be used for price

manipulation. Although regulators said they have found no indication that

SOES has been put to such a use, they continue to examine for such issues.

Market Makers and SOES

Day Trading Firms

Disagreed About Their

Roles in the Market

Market makers told us that they viewed day traders as sophisticated

professional traders who are detrimental to the market because they profit

at market makers’ and others’ expense. They said that SOES day trading not

only has cost them money, but also has resulted in their institutional

customers, such as pension funds and mutual funds, having to pay higher

prices for securities because the day traders have an advantage in the

market as described previously.

SOES day trading firm officials told us that day traders are small, individual

investors trading for their own accounts. They said that day trading has

benefited the market by forcing market makers to monitor and update

their quotes and by increasing price competition. They said that, by taking

advantage of “stale” market maker quotes, SOES day traders have forced

market makers to improve their quote monitoring and revise their quotes

immediately as the market changes, thereby improving the efficiency with

which prices are determined. Further, they said that using SOES is the least

expensive way for day traders to execute trades. For example, the

maximum charge to execute a trade through SOES is $.50 for market

makers and $.50 for order entry firms, whereas the charge to execute a

trade through other trading systems can be as much as $15.

Disagreements About

SOES Effects on Spreads

Market makers have indicated that SOES day trading has caused widened

spreads, but SOES day trading firms disagreed. Since SOES was made

mandatory, market makers stated their cost of doing business has

increased as a result of SOES day trading, which has caused them to

increase their spreads.9

 Market makers reported that they were initially

9

Market makers earn their income off the spread between their buying and selling prices for stocks.

Market makers have said that, to the extent that their costs rise, they raise their prices and widen their

spreads.

Page 13 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
B-278412 

unable to adequately monitor all the stocks in which they made a market,

which increased the probability of stale quotes and thus the likelihood that

they could lose money to SOES day traders. Additionally, they reported that

the automatic execution feature had enabled SOES day traders to execute

their orders before market makers could execute their customers’ orders.

Market makers have said that day traders’ strategies have increased their

costs of doing business, and that in order to cover these costs, they have

widened their spreads. SOES day trading firm officials, however, said that

day trader SOES activity causes market makers to monitor and update their

quotes, benefiting everyone in the market. They also said that they often

quote better prices than market makers when they do the trades to close

out their positions, which results in a narrowing of spreads.

Studies that examined SOES effects on spreads have focused on whether

SOES day trading actually widens spreads. The studies recognized that

many factors, such as rule changes, affected spreads. However, during the

periods covered by the studies, they were unable to isolate the effects of

SOES from these other factors. One study found that the 1997 rule changes

implemented in the Nasdaq Market had caused spreads to narrow while

SOES day trading was occurring.10 However, this study did not focus on

measuring the effects of SOES. Another study found that adverse selection11

 attributed to SOES day trading had contributed to wider spreads.12

Specifically, this study reported that market makers were, in essence,

being forced to trade with SOES traders, who may have been better

informed than other traders about which way prices would move. This

may put market makers at a disadvantage and cause them to suffer an

opportunity loss. Because market makers have an obligation to both buy

and sell stock, they may be buying at higher prices when they need to buy,

and selling at lower prices when they need to sell, because of SOES traders’

activities. Their opportunity loss is the difference between the prices at

which they actually bought and sold and those at which they could have

bought and sold without the temporary price effects of the SOES activity.

The study attempted to measure the market makers’ losses caused by this

10Michael J. Barclay, William G. Christie, Jeffrey H. Harris, Eugene Kandel and Paul H. Schultz, Nasdaq

Market Reform: New Evidence that Competition from the Public Lowers Trading Costs, Working Paper

97-10, July 1, 1997.

11Adverse selection is a term taken from the field of insurance analysis. It describes a tendency for

poorer risks to seek or continue coverage to a greater extent than do better risks. Adverse selection

leads to higher costs for insurers and to attempts by insurers to put restrictions on policies. In

securities markets, the parallel is that some participants are better informed than others. Market

makers prefer to negotiate prices as a way of determining how well informed traders are and to reduce

adverse selection costs.

12George Benston and Robert A. Wood, Day Trading on Nasdaq’s Automatic Small Order Execution

System (SOES): Adverse Selection and Spread, Unpublished, 1997.

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B-278412 

adverse selection, and concluded that market makers increased their

spreads to offset these losses. Measuring adverse selection is always very

difficult because it relies on measuring differences in information that are

not observable. As a result, it is not clear that the study accurately

measured the opportunity losses resulting from adverse selection. In

addition, the study did not isolate or control for the influences of other

factors that could have affected prices, such as rule changes. Because the

study did not control for these other factors, the study may not have

accurately measured the effects of adverse selection.

Disagreements About

SOES Effects on Liquidity

Market makers said that they have reduced the number of stocks in which

they make markets, in part because of SOES. They said that they did this

because their costs increased due to SOES day trader activity. The more

stocks they covered, the more likely they were to have stale quotes, which

in turn attracted SOES day traders. They said that the reduction has

resulted in less liquidity in the market because they are putting up less

capital in total than formerly, and because they are offering to buy or sell

smaller amounts of the stocks in which they make a market. Furthermore,

they stated that the cost of liquidity may have risen because their retail

and institutional customers cannot purchase as much of a stock at a given

price as they could before SOES.

SOES day trading firms said that, for the most part, day trading has not

caused a reduction in liquidity. They stated that, because they are

purchasing and selling securities at the market maker’s spread, and doing

so frequently, they are not only providing the market maker with increased

profits, but are also putting their capital at risk, thereby providing liquidity

to the market. Market participants have also said that other market making

firms have started making markets in those stocks that had experienced

an initial reduction of market maker activity, thereby continuing to

provide liquidity to the market.

Some studies concluded that SOES day trading had caused market makers

to make markets in fewer stocks. For instance, NASD looked at the stocks

whose number of market makers had declined since SOES was made

mandatory, and found that the stocks with higher levels of SOES activity

were the ones with the largest decline in market maker participation.13

While acknowledging that SOES day trading has affected market maker

activity in some stocks, the approaches taken by the studies did not often

13Nasdaq Economic Research (Dean Furbush, D. Timothy McCormick, Kathleen L. Mitchel, Lorraine M.

Reilly, James P. Selway III, and Michael P. Watson), “SOES and the Nasdaq Stock Market,”

Unpublished, November 29, 1995.

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B-278412 

take into account other factors, such as rule changes, profitability, or

market conditions, that may contribute to fewer market makers in stocks.

Additionally, it was difficult to determine from the studies whether market

makers would continue to make markets in fewer stocks in the long run.

Disagreements About

SOES Effects on Volatility

Market makers and other market participants said that SOES day trading

has caused increased volatility in the market. They stated that the trading

strategies of SOES day traders, such as the momentum based strategy of

buying in “up trending” markets and selling in “down trending” markets,

has led to increased volatility. Conversely, SOES day trading firms said that

volatility has been the result of market forces, not SOES trading.

Some of the studies examining volatility showed that SOES day trading and

volatility were correlated. However, the studies did not clearly establish

whether SOES day trading caused volatility or whether other market factors

caused volatility, which then attracted SOES day trading. Some studies

found that significant SOES trading occurred on days with large price

changes in stocks, and concluded that SOES day trading causes volatility.

One study, which assessed the behavior of quotes where clusters of

maximum-sized SOES trades occurred, found that price volatility and SOES

activity were correlated. Another study, which attempted to determine

whether increased volatility had attracted SOES trading or whether SOES

trading caused volatility, found a correlation between instances of high

volatility and periods in which a large portion of trades were SOES trades.

The study concluded that large volumes of SOES trading caused increased

volatility in the short run, but contributed to lower volatility in the long

run.14 Other studies also indicated that SOES day trading actually

concentrated the price discovery process by moving prices to their

equilibrium faster than would have happened in the absence of such

trading.

Some Market Participants

Said That, by Its Nature,

Day Trading Has Resulted

in Price Manipulation

Some market participants said that, by its nature, day trading has resulted

in the manipulation of some stocks’ prices. These participants stated that,

although SOES may not be the cause of price manipulation, the nature of

day trading, especially momentum-based trading, can assist those who

want to manipulate stock prices. For example, they said that stock

manipulators can momentarily quote prices for stocks that trigger SOES

momentum trading by putting prices into an ECN, and then cancelling the

14Robert H.Battalio, Brian Hatch, and Robert Jennings, “SOES Trading and Market Volatility,” Journal

of Financial and Quantitative Analysis, Vol. 32, No. 2 (June 1997).

Page 16 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
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quote before a trade occurs. They have pointed to specific stocks that have

incurred certain “spikes” in their prices over short periods of time

concurrent with periods of large volumes of SOES day trading. They have

further stated that no logical reason existed for the rapid increases in the

prices of the stocks other than the likelihood that the stock prices were

being manipulated.

Both NASD and SEC officials that we talked to said that they have

investigated the allegations of price manipulation and have not found that

SOES was being used for such purposes, but that their investigations are

continuing. NASD officials said that, in most of the cases evaluated thus far,

the increase in SOES volume was attributable to investors’ natural reactions

to news and other information in the marketplace that would affect price

levels. They further stated that, while SOES volume and price volatility were

correlated in certain stocks, the correlation does not support allegations

that the stocks were manipulated through SOES. We plan to review this

issue in more detail during future work.

Attempts to Limit

SOES Day Trading or

Replace SOES

After NASD and Nasdaq market makers became concerned about day

traders use of SOES, NASD proposed various SOES rule changes to limit the

activity of the day traders. SEC approved these rule changes, but SOES day

traders contested one of these changes in federal court. The court’s

decision and the outcomes of two federal investigations of the

competitiveness of the Nasdaq Market served to bolster the case for

automated trade execution in that market. SEC did not act on two later

NASD attempts to replace SOES with other systems that did not feature

immediate automatic execution of small orders because of (1) technical

concerns about the systems’ operations, (2) market participant opposition,

and (3) lack of provisions for the execution of small orders without

market maker intervention. A chronology of SOES and SOES-related events

can be found in appendix I.

NASD Changed Its Rules to

Limit SOES Day Trading

Not long after SOES became mandatory, market makers complained to NASD

that SOES day trading firms were using SOES to execute orders for day

traders, which was not its purpose. In response, NASD proposed several

rule changes to limit SOES day trading activity. These changes are

summarized below and discussed in more detail in appendix I.

• An August 1988 rule change prohibited SOES users from “order

splitting”—that is, dividing orders they received that were larger than the

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SOES maximum order size into smaller parts so that they could be entered

into SOES.

• A December 1988 rule change prohibited entering orders into SOES on

behalf of a professional trading account (PTA). A PTA was defined to

include any account in which five or more day trades had been executed

through SOES during any trading day or where a professional trading

pattern in SOES was demonstrated. The rule defined “day trade” or “day

trading” to mean the execution of offsetting trades in the same security for

generally the same size during the same trading day.

• An October 1991 rule change set criteria for NASD to designate a trading

account a PTA. The criteria included excessive frequency of short-term

trading, excessive frequency of short-sale transactions, existence of

discretion, and direct or physical access to SOES execution capability.15 The

rule change expanded the definition of a “day trade” by eliminating the

restriction that both sides of a trade must be executed through SOES to be

considered a day trade.

• A second October 1991 rule change allowed market makers a 15-second

delay to update a quotation before being obliged to execute a second

similar order in the same security through SOES. This rule change also

allowed market makers to decline preferencing by SOES order entry firms.16

• The December 1993 rule changes, which are known as “Interim SOES

Rules,” further attempted to restrict day traders’ use of SOES.

17 Approved

on a 1-year pilot basis, the rule changes (1) reduced the maximum size

order eligible for SOES execution from 1,000 shares to 500 shares,

(2) reduced the minimum exposure limit from 5 times to 2 times the

maximum order size, (3) allowed market makers to voluntarily use a new

Nasdaq system feature that automatically updates quotations once the

market makers’ exposure limit has been exhausted, and (4) prohibited

short-sale transactions through SOES.

SEC approved all these rule changes. As a former SEC official told us, SEC’s

sympathy toward the market makers’ position was understandable in view

of the fact that SEC encouraged NASD, following the 1987 market crash, to

make SOES participation mandatory for market makers. SEC officials told us

that SEC approved NASD’s rule filings until SEC’s investigation of NASD

showed NASD’s abusive behavior toward day traders and the illegal pricing

15A short sale is the sale of a security that is not owned by the seller to take advantage of an

anticipated decline in the price of the security.

16SOES allows preferencing of orders in which the orders are designated to be sent to a particular

market maker.

17The rules were considered interim in anticipation of NASD’s designing a system to replace SOES.

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B-278412 

convention among Nasdaq market makers that SEC reported in its 21(a)

report.

Other Events Further

Bolstered SOES Day

Trading

While NASD and SEC were attempting to limit the activities of SOES day

traders, a series of events occurred during the period 1993 through 1996

that helped further legitimize and bolster the position of SOES day traders

in the market. A lawsuit filed against SEC by SOES day traders contesting its

approval of the PTA definition, a Department of Justice investigation of the

practices of certain Nasdaq market makers and Nasdaq’s market structure,

and SEC’s own investigation of NASD and the Nasdaq Market—together

caused SEC to become more skeptical of Nasdaq market makers’ views and

increased SEC scrutiny of NASD rule proposals affecting SOES.

Court Decision Favored Day

Traders

In 1991, shortly after SEC’s approval of NASD’s rule expanding the definition

of a PTA, William Timpinaro, a SOES trader, and others filed a petition with

the U.S. Court of Appeals for the District of Columbia Circuit. The lawsuit

sought the court’s review of SEC’s rule approval decision.18

In August 1993, the court remanded the case to SEC to provide further

support for its assertions that failure to restrict professional traders from

SOES would cause market makers to cease making markets or widen

spreads. In addition, the court found the definition of a PTA

unconstitutionally vague and subject, in part, to open interpretation, and

therefore asked SEC to address the vagueness of the definition.

In response to the decision, NASD withdrew the PTA rules. According to SEC

officials, the Timpinaro case showed that SEC decisions on SOES rule

changes were likely to be litigated, which caused SEC to be more cautious

about the actions it considered to resolve problems surrounding SOES.

Antitrust Investigation Found

Market Makers’ Conduct

Anticompetitive

In October 1994, the Department of Justice’s (DOJ) Antitrust Division

started a broad review of Nasdaq’s market structure. DOJ started its review

following (1) reports in the media about an academic study on spreads on

the Nasdaq Market and related market maker behavior19 and (2) a class

18Timpinaro v. SEC, 2 F.3d 453 (D.C. Cir. 1993).

19The study was actually published in December 1994. William G. Christie and Paul H. Schultz, “Why

Do Nasdaq Market Makers Avoid Odd-Eighth Quotes?” Journal of Finance, 49 (Dec. 1994), pp.

1813-1840.

Page 19 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
B-278412 

action antitrust complaint filed by Nasdaq investors against various

Nasdaq market makers.20

DOJ’s review resulted in a July 17, 1996, civil action. DOJ alleged that the

market makers adhered to and enforced a pricing convention that was

designed to and did deter price competition among the market makers in

their trading of stocks with the public. It also stated that the illegal pricing

convention resulted in investors incurring higher transactions costs than if

the market makers had not acted to restrain competition.

On that same day, the defendants and DOJ filed a proposed order to settle

the complaint and resolve the allegations. The order sought to eliminate

the anticompetitive conduct and establish procedures to ensure that such

conduct did not recur. Specifically, the market makers were to refrain

from adhering to the pricing convention regarding their actions to fix,

raise, lower, or maintain prices or quotes for Nasdaq securities. The order

also required each defendant firm to adopt an antitrust compliance

program and designate an antitrust compliance officer. The officer is

required to monitor and tape record certain telephone conversations

between stock traders and report any instances of noncompliance with the

order to DOJ. Although approved by the District Court, the settlement has

been stayed pending appeal. On August 6, 1998, the appeals court affirmed

the district court’s approval of the settlement.

SEC’s Investigation Revealed

Market Maker Abuses

In August 1996, SEC settled its investigation with NASD. In the 21(a) report

on the investigation, SEC found that Nasdaq market makers adhered to a

pricing convention that often increased transaction costs paid by

customers. The pricing convention particularly affected small orders, such

as those transacted over SOES. SEC also found failure to honor price

quotations and trade reporting violations among Nasdaq market makers.

NASD was also found lax in prosecuting rule violations by market makers,

while it focused enforcement efforts on the activities of SOES day trading

firms.

According to SEC officials, the investigation caused SEC to change its views

regarding SOES. As noted in SEC’s report, the evidence of the pricing

convention and other anticompetitive behavior of market makers provided

SEC ample reason to doubt that SOES traders were to blame for the width of

the spreads in the Nasdaq Market. In settling the matter, NASD consented to

20In December 1997, the parties reached a proposed settlement, which the court has yet to approve.

The 30 market makers involved agreed to pay a total settlement of $1.01 billion.

Page 20 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
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SEC’s findings and sanctions and agreed to undertake actions to eliminate

any pricing conventions and detect and punish anticompetitive behavior.

Attempts to Replace SOES

Have Failed to Win SEC

Approval

NASD has twice tried to replace SOES with alternative systems. In

March 1994, NASD proposed a system called N*Prove. N*Prove was designed to

replace SOES, and its immediate automatic trade executions, with a system

that would give market makers 15 seconds to decline an incoming order

before the order would be executed. N*Prove included a limit order file that

provided the opportunity for some customer orders to interact with each

other without market maker intervention. SEC was concerned that such a

system could result in a queuing of orders, insufficient opportunities for

customer interaction without the intervention of a market maker, and

inadequate enforcement of NASD’s firm quote rule. NASD withdrew the

N*Prove proposal without formal action by SEC.

Late in 1995, NASD proposed to replace SOES with NAqcess. Like N*Prove,

NAqcess was to be an order delivery system and provided a limit order file,

but it was modified to resolve problems posed by N*Prove. NAqcess would

provide for automatic execution of a customer’s order after it was

displayed for 20 seconds, and if the market maker did not decline the

order. To lessen the queuing problem associated with N*Prove, NAqcess

would have routed orders to market makers with the best quotes in

priority order, at 1-second intervals. Orders declined would be

re-presented to available market makers.

SEC received more than 1,000 comment letters, and NAqcess was never

approved. SEC officials told us that many commentators, including

institutional investors, opposed NAqcess. Day traders opposed NAqcess

because it would have eliminated the SOES immediate automated execution

feature and given market makers the opportunity to decline trades. The

commentators noted the anticompetitive behavior and backing-away

violations of market makers revealed by SEC’s 21(a) investigation. SEC

officials said that SEC asked NASD to address the commentators’ concerns.

They said NASD could not resolve the concerns and withdrew the proposal.

Recent Market

Developments and

Proposals Affecting

SOES

In January 1997, NASD implemented SEC’s order handling rules and began

an actual size pilot program. On July 15, 1998, SEC approved a rule allowing

market makers to quote actual size for all stocks. Also, in June 1997, NASD

implemented a rule change that decreased the minimum quotation

increment allowed from 1/8th to 1/16th of a dollar. Analyses by NASD and

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others show that these changes have decreased spreads and have been

associated with a reduction in SOES’ share of Nasdaq trading volume. In

March 1998, NASD proposed replacing SOES with a new system that would

make automatic trade executions more widely available to market

participants and that would limit the unintended double execution liability

incurred by market makers. While most market participants agree with

this proposal, some of its provisions are controversial.

New Rules Have Lessened

SOES Activity

SEC’s order handling rules became effective first for actively traded, then

later for all, Nasdaq securities. The order handling rules required Nasdaq

market makers to display customer limit orders and to disseminate the

best prices placed by market makers in ECNs, which previously were not

included in the Nasdaq Market. SEC intended these rules to make the

Nasdaq Market a more competitive, customer order-driven market and

thus reduce bid-ask spreads.

A follow-up NASD study showed that spreads for the first 150 stocks that

became subject to the rules narrowed by about 33 percent.21 Another study

found that, for the first 100 stocks phased in between January 20, 1997,

and February 10, 1997, spreads narrowed by over 35 percent.22 The study

also showed that the proportion of share volume traded through SOES fell

by 6 percentage points for the first 50 stocks subject to the rule changes.

As spreads become narrower, the ability of SOES day traders to earn a

profit on a trade of a given size, such as 1,000 shares, may be lessened.

Starting in January 1997, NASD also implemented an actual size pilot

program. This program allowed market makers to display quotes in

minimum sizes of 100 shares for 50 stocks, then later for another 100

stocks. NASD indicated that allowing actual size quotes in conjunction with

the requirement to display limit orders would narrow spreads. NASD’s

initial, June 1997, study showed a reduction in the average spread of about

33 percent when the same stocks were compared before and after the pilot

began. However, the reduction in spreads was about the same for both

pilot and nonpilot stocks, indicating that the pilot had no significant effect

on spreads. A second study of 103 stocks brought into the pilot in

November 1997 also showed the same result. As discussed previously, on

21NASD Economic Research Department, Effects of the Removal of Minimum Sizes for Proprietary

Quotes in The Nasdaq Stock Market, Inc., Unpublished, June 4, 1997.

22Michael J. Barclay, William G. Christie, Jeffrey H. Harris, Eugene Kandel, and Paul H. Schultz, The

Costs of Trading Nasdaq Issues: The Impact of Limit Orders and ECN Quotes, The Charles A. Dice

Center for Research in Financial Economics, Fisher College of Business, The Ohio State University

(July 1, 1997).

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July 15, 1998, SEC approved a rule to permanently allow market makers to

display actual size quotations for all Nasdaq securities.

Data in the NASD studies indicated that actual size quotations reduced SOES

market share of Nasdaq volume. Data in the first study showed that SOES

market share declined by only about 2.9 percent for nonpilot stocks, but

declined by about 17.3 percent for pilot stocks. Data in the second study

showed SOES market share to have declined by 19.5 percent for nonpilot

stocks and 26.7 percent for pilot stocks. However, NASD further analyzed

these data to control for differences in price, volume, and interday

volatility, and concluded that actual size quotations had little effect on

SOES market share.

In May 1997, SEC approved a NASD proposed rule, which became

operational early in June. The rule decreased the minimum quotation

increment from 1/8th to 1/16th of a dollar for securities with a bid price

greater than or equal to $10. The change was intended, among other

things, to provide investors with a greater opportunity to receive better

prices when they buy or sell stocks. NASD’s preliminary analysis showed

that the decrease in the quotation increment resulted in a decrease in the

quoted spread for stocks subject to SEC’s order handling rules.

Before these changes were made, in January 1997, SOES trading accounted

for 12.9 percent of the total dollar volume of Nasdaq trading and

7.7 percent of total share volume. About 1 year later, in February 1998,

SOES trading accounted for 6.8 percent of total dollar volume and

4.6 percent of total share volume. According to a NASD official, part of this

reduction could also be attributed to increased use of ECNs; market

makers’ internal automated trading systems; and software improvements

for SelectNet, Nasdaq’s automated order entry and delivery system.

Officials of SOES day trading firms told us that they have developed ECNs to

allow their day traders, and other investors, more direct access to the

market than that provided by SOES.

Proposed System Would

Make Automatic Execution

Available to All Traders

In March 1998, SEC published for comment a NASD proposal to establish a

new Integrated Order Delivery and Execution System. The system would

replace SOES and SelectNet and would provide an integrated order routing

and execution system and a voluntary limit order file. The proposed

system would provide investors and traders, including market makers,

immediate and automatic executions for their orders in strict time priority

(on a first-come, first-served basis). As proposed, with the approval of the

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actual size rule, the new system permits market participants to enter

orders up to 999,999 shares.

The proposed system would allow market makers to turn the system off

momentarily to prevent having trades executed against them while they

are handling telephone orders. Orders of greater than 1,000, but less than

5,000, shares are to be presented to market makers or ECNs for 17 seconds,

with the options of accepting, declining, or doing nothing. If nothing is

done, the order will default to an execution at the displayed quote amount.

Orders of 5,000 shares or more are to be presented to market makers for

review for 32 seconds and then, if not acted on, will also default to an

execution. Market makers and ECNs would only have to honor one

execution at the quoted size and then, depending on the order size, would

have 17 or 32 seconds to update quotes. The proposed system, with the

approval of the actual size rule, would allow proprietary orders of any

NASD member, both market makers and non-market makers, to be entered.

SEC has received about 2,100 comment letters on this proposal. The

commentators generally have favored adoption of the new system.

However, commentators representing SOES day trading firms and day

traders have opposed the feature that allowed market makers to shut off

the system while taking telephone orders. They also opposed the 17- and

32-second delays in which market makers could choose to decline orders

of more than 1,000 and 5,000 shares, respectively. They said that the

shutoff feature and time delays were inconsistent with NASD’s Firm Quote

Rule. Other commentators, representing investment bankers and

broker-dealers, opposed the system’s limit order file. They said that the

limit order file, which would allow orders to be executed without market

maker intervention, would provide NASD an unfair advantage over its

member firms that also provide limit order services.23 Finally, some large

market makers and Nasdaq-listed companies favored adoption of the

system without any changes.

As published, the system proposal does not contain any analytical

justification of the share sizes at which the time delays would become

operational. Time delays allow market makers to delay the execution of

trades, which reduces market efficiency. However, time delays may be

appropriate to protect market makers from unlimited automatic trade

executions at a given price. If time delays are appropriate, the actual

experience of market makers regarding share sizes that are typically

negotiated may provide a basis for determining the share size limits. For

23The limit order file would result in Nasdaq’s competing with market makers to execute these orders.

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example, the six market makers we interviewed about their operations

told us that they had in-house automated execution systems. One market

maker said that 95 percent of its trades are executed using its internal

automated system. Another said that its customers can obtain automatic

executions through its internal automated system for orders of up to 2,000

shares.

Conclusions The use of SOES primarily by day traders was an unintended consequence

of mandatory market maker participation in SOES. Small retail trades,

which were expected to be done through SOES, instead are being done to a

large extent through market makers’ internal automated systems

developed after SOES day traders became active. These systems have

provided market makers’ small retail customers the same kind of

immediate, automatic trade executions available through SOES, even during

periods of unusually high trading volume and volatility such as occurred

during October 1989 and October 1997. However, they are not mandatory,

and no major market disruptions on the order of October 1987 have

occurred during this period to test whether market makers’ internal

systems would continue to provide immediate, automatic executions

during such a crisis.

Despite its unintended consequence, SOES has benefited the market by

providing efficient execution of securities transactions at the best bid and

ask prices and allowing investor orders to be executed without manual

market maker intervention. These results are consistent with national

market system goals. In addition, the SOES automatic execution feature

provides market discipline for market makers and ensures access to the

market for small investors in times of market stress. We did not come to

any definitive conclusions about SOES day trading’s effects on spreads,

liquidity, or price volatility in the Nasdaq Market because the various

studies and our discussions with market makers and SOES day trading firm

officials could not separate the effects of SOES trading from those of other

market changes.

SOES day traders’ ability to access Nasdaq quotes and trade faster through

SOES than market makers and their customers could trade through other

systems has provided them an advantage that they have used to profit at

the expense of market makers and their customers. Allowing one market

segment such a continuing advantage over others is contrary to the goal of

fair competition among market participants. However, the day traders’

advantage from their use of SOES has become less of a factor in the market

Page 25 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
B-278412 

over time, as market makers have improved systems to address the effects

of automated trading and regulators have adjusted market rules. SOES day

trading may be further affected by (1) the 1997 order handling rules that

have provided all market participants, including day traders, more direct

access to the best available prices through ECNs than is available through

SOES, and (2) the 1998 actual size rule that reduces market maker exposure

to day traders if the market makers choose to reduce their quotation sizes.

Nasdaq, SEC, and affected market participants have been unable to agree

on a new system to replace SOES that would retain the benefits of

automatic execution. The latest Nasdaq proposal to replace SOES and

SelectNet with an integrated system is intended to do both. However, it

could establish delays for the execution of some trades that may hinder

market efficiency. Such delays could also disrupt the market discipline

provided by the immediate, automatic execution of retail orders.

Determining a share size at which time delays may be appropriate for

market makers could be done by analyzing their experience regarding

share sizes that are typically negotiated, and by better documenting the

size of orders most often submitted by retail investors.

Recommendations We recommend that the Chairman, SEC, ensure that any trading system

approved to replace the current Nasdaq trading systems be designed to

correct the trading advantage available to SOES day traders and provide for

the immediate, automatic execution of investors’ small orders at the best

possible prices. We also recommend that the Chairman, SEC, require

Nasdaq to provide adequate data analysis to support aspects of the system

that may affect market efficiency and discipline. For example, such

analysis should be used to determine the appropriate share size at which

time delays would be allowed in the proposed Integrated Order Delivery

and Execution System.

Agency Comments

and Our Evaluation

NASD and SEC provided written comments on a draft of this report. (See

apps. II and III.) Both NASD and SEC recognized that the issues the report

addresses are complex and that the parties involved have a vested interest

and often widely divergent views on how SOES should operate. NASD

commented that the report provides a balanced and accurate description

of the issues. While SEC generally agreed with the report’s conclusions and

recommendations, it took exception to our conclusion that SOES day

traders currently enjoy an advantage over other market participants,

which SEC referred to as an “unfair advantage.” We continue to believe that

Page 26 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
B-278412 

SOES day trader’s ability to access Nasdaq quotes and trade faster through

SOES than market makers and their customers could trade through other

systems has provided day traders an advantage that they have used to

profit at the expense of market makers and their customers. We also found

that while this advantage exists, it has diminished over time and become

less of a factor in the market as market makers have improved systems to

address the effects of automated trading and regulators have adjusted

market rules.

Separately, we made technical corrections to the draft as suggested by

both agencies.

We will provide copies of this report to the Chairman and Ranking

Minority Members of the House Commerce Committee, SEC, NASD, and

other interested committees and organizations. Copies will be made

available to others on request.

Major contributors to this report are listed in appendix IV. Please call me

on (202) 512-8678 if you or your staff have any questions about the report.

Richard J. Hillman

Associate Director, Financial Institutions

 and Markets Issues

Page 27 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Contents

Letter 1

Appendix I 

Chronology of SOES

and SOES-Related

Events

30

Appendix II 

Comments From

NASD

38

Appendix III 

Comments From the

Securities and

Exchange

Commission

39

Appendix IV 

Major Contributors to

This Report

41

Abbreviations

DJIA Dow Jones Industrial Average

DOJ Department of Justice

ECN Electronic Communication Network

NASD National Association of Securities Dealers

PTA Professional Trading Account

SEC Securities and Exchange Commission

SOES Small Order Execution System

Page 28 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Page 29 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix I 

Chronology of SOES and SOES-Related

Events

February 1985 SEC approves proposed NASD rule change for implementation of SOES. NASD

created SOES to provide an economical and efficient system to route and

execute small retail agency orders, initially 500 shares, of Nasdaq

securities. Use of SOES by NASD members was to be voluntary.

June 1988 SEC approves NASD proposed rule change to make SOES participation

mandatory for all market makers in Nasdaq national market securities.

The change was intended to ensure investors access to the Nasdaq market

after investors experienced problems in attempting to access the market

during the high volume trading of the week of October 19, 1987. (We found

that market makers had withdrawn from SOES and from making markets.24

) The change was expected to facilitate the automatic execution of

customers’ small orders without the need for telephone contact between

order entry and executing firms. The proposal established maximum order

size limits of 200, 500, and 1,000 shares, depending on the trading

characteristics of different securities.

August 1988 SOES rules are amended so that agency orders no larger than the maximum

order size received from public customers may be entered by a SOES order

entry firm and orders in excess of the maximum size may not be divided

into smaller parts to meet the size requirements (“order splitting”). The

change was made in response to market maker complaints of rapid-fire

executions against their quotes by SOES day traders.

December 1988 SEC approves NASD SOES rules changes to prohibit members from entering

SOES orders on behalf of Professional Trading Accounts (PTA). A PTA was

defined to include any account in which five or more day trades had been

executed through SOES during any trading day or where a professional

trading pattern in SOES is demonstrated. The rule defined “day trade” or

“day trading” to mean the execution of offsetting trades in the same

security for generally the same size during the same trading day.

Professional day traders were using SOES automatic executions to take

advantage of slight disparities in market maker quotes arising from market

makers’ being slow to update quotes in response to market news. SEC

favored the rule change because it was concerned that the SOES

participation requirements, combined with the presence of professional

day traders in the market, posed risks that would cause market makers to

24Financial Markets: Preliminary Observations on the October 1987 Crash (GAO/GGD-88-38, Jan. 26,

1988).

Page 30 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix I 

Chronology of SOES and SOES-Related

Events

eliminate their market maker positions in stocks, thereby reducing

liquidity in the market.

August 1990 SEC approves SOES rules change to prohibit market makers from entering

agency orders into SOES in securities in which they make markets. This

change was intended to prevent market makers from executing customer

orders they have received against their competitors, using SOES.

November 1990 SEC approves SOES rules change to provide SOES capability for entering and

storing limit orders.

October 1991 SEC approves SOES rules change to allow market makers to (1) use a

15-second delay to update quotes after receiving a SOES execution and

(2) indicate order entry firms from which they will accept preferenced

orders.

SEC approves SOES rules change to expand the definition of a PTA by

eliminating a requirement that both sides of a trade must be executed

through SOES for it to be considered a day trade. The change set forth

criteria for NASD to designate a trading account a PTA, including excessive

frequency of short-term trading, excessive frequency of short-sale

transactions, existence of discretion, and direct or physical access to SOES

execution capability. The rule change also expanded the definition of a

“day trade” by eliminating the requirement that both sides of a trade must

be executed through SOES for it to be considered a day trade. NASD believed

these changes were necessary to curtail professional day traders’ use of

SOES to “pick off” market makers with quote discrepancies. NASD regarded

the day trading as an abuse of SOES, for which the system was not created.

NASD and certain members thought that SOES day trading exacerbated

market volatility, created wider spreads, and resulted in a loss of liquidity

for individual and institutional investor orders. SEC expressed concern that

the presence of day traders could result in a widespread reduction in

market making and have a significant negative impact on market liquidity.

William Timpinaro et al. file a petition for review of the SEC approval

orders with the U.S. Court of Appeals for the District of Columbia District.

Page 31 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix I 

Chronology of SOES and SOES-Related

Events

April 1993 SEC responds to questions submitted to it by the Court of Appeals

concerning the interrelationship of the Firm Quote Rule with the PTA and

15-Second Rules.

November 1993 The Court of Appeals remands the PTA Rules back to SEC for it to provide

further explanations of the professional trader rule and to consider

whether the rules were unacceptably vague.

December 1993 NASD withdraws the PTA rules because they did not prove effective in

limiting the use of SOES, thus eliminating restrictions enacted by those

rules and the associated definitions of day trading and day traders.

SEC approves rule change, called “Interim SOES Rules,” to allow a 1-year

pilot that provided for (1) a reduction in the SOES maximum order size

from 1,000 to 500 shares, (2) a reduction in the exposure limit from 5 times

to 2 times the maximum order size, (3) an automated function to update

market makers quotations once the exposure limit is exhausted, and

(4) prohibition of short sales through SOES. The changes were expected to

reduce the effects that active trading through SOES had on market maker

risk and SOES participation. NASD stated that it proposed these rules to take

the place of the withdrawn PTA rules in an attempt to “limit the types of

transactions that may be executed through SOES and thereby limit the use

of SOES by those who use it in a manner inconsistent with the intended use

of SOES.” SEC believed that SOES day trading imposed increased risks and

costs on Nasdaq market makers, which caused them to widen spreads and

might cause them to withdraw from making markets. SEC further reasoned

that these costs outweighed any momentary increases in liquidity and

marginal increases in price discovery that day trading contributed to the

market. Since December 1993, items (1) and (3) of the Interim Rules have

been periodically extended pending the time when a system to replace

SOES is adopted. Item (2) was extended through January 1997 when the

exposure limit went down one times the maximum order size. Item

(4) was extended until February 1995.

March 1994 NASD files with SEC a proposal for a system called N*Prove. N*Prove was

designed to replace the SOES immediate automatic execution system with

an order delivery system that would have given Nasdaq market makers 15

seconds to decline incoming small orders, rather than have the orders

automatically executed against them. The N*Prove proposal also included a

Page 32 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix I 

Chronology of SOES and SOES-Related

Events

limit order file that would have provided the opportunity for some

customer orders to interact with each other. N*Prove was to route orders to

market makers on a rotating basis, depending on their priority ranking in

the Nasdaq quote montage.

October 1994 DOJ Antitrust Division announces that it is undertaking a broad review of a

number of aspects of Nasdaq’s market structure.

December 1994 NASD responds to an SEC staff request to provide an assessment of the

potential for order queues to develop under a system proposed to replace

SOES, called N*Prove. N*Prove would route orders, on a rotating and priority

basis, to individual Nasdaq market makers for automated execution,

unless the market maker declined the order.

February 1995 SEC approves extension of the Interim SOES Rules through March 27, 1995,

except that the prohibition on short sales was not extended because of the

acceptance of a broader Nasdaq short-sale rule.

March 1995 SEC approves extension of Interim SOES Rules through October 2, 1995,

except that the change in the maximum order from 1,000 to 500 shares was

not extended because the available data demonstrated no significant

improvement or detriment at either share amount.

October 1995 SEC approves extension of Interim SOES Rules through January 31, 1996.

December 1995 SEC publishes, to solicit comments, a proposed NASD rule change that

would replace SOES with NAqcess. NAqcess would provide for automatic

execution of customers’ orders after they are displayed for 20 seconds and

the market maker does not decline the order. Orders could only be

declined if another order was just executed and the market maker is

updating quotations. NAqcess also provided for a limit order file against

which order would be automatically executed. According to SEC officials,

SEC received over 1,000 comment letters, and NASD withdrew the NAqcess

proposal.

February 1996 SEC approves extension of Interim SOES Rules through July 31, 1996.

Page 33 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix I 

Chronology of SOES and SOES-Related

Events

July 1996 SEC approves extension of Interim SOES Rules through July 31, 1997.

DOJ files a civil action complaint re: United States v. Alex Brown & Sons, et

al. (S.D.N.Y.) pursuant to Section 4 of the Sherman Act, as amended, 15

U.S.C. section 4 seeking equitable and other relief to prevent and restrain

violations. DOJ alleged that the defendants and others adhered to and

enforced a “quoting convention” that was designed to, and did, deter price

competition.

Defendants of United States v. Alex Brown & Sons, et al. and DOJ file a

proposed Stipulation and Order to resolve the allegations of the DOJ

complaint. The order would eliminate the anticompetitive conduct and

establish procedures to ensure that such conduct did not recur.

August 1996 SEC completes its investigation of the Nasdaq Market. In the investigation

report, the 21(a) report, SEC found that Nasdaq Market makers adhered to

a pricing convention that often increased transaction costs paid by

customers. The pricing convention particularly affected small orders, such

as those transacted over SOES, which are executed at the best available bid

and ask prices. SEC also found that NASD had harassed SOES day trading

firms. Further, it found that NASD had been lax in its enforcement of

extensive trade reporting and failure to honor quotation (backing away)

violations by Nasdaq market makers. In its settlement, NASD agreed to take

actions to eliminate any pricing conventions and detect and punish

anticompetitive behavior.

January 1997 SEC approves extension of Interim SOES Rules through July 31, 1997.

SEC approves SOES rule change that would establish a 5-second grace

period between SOES executions in locked and crossed markets. A locked

market occurs when one market maker’s quoted bid price for a security

equals another market maker’s ask price. A crossed market occurs when

one market maker’s quoted bid price is greater than another market

maker’s ask price. The change was intended to continue to provide

incentive to market makers to update quotes and enhance market makers’

ability to react to SOES transactions in locked and crossed markets.

SEC’s order handling rules become effective for actively traded, then all,

Nasdaq securities. The order handling rules required Nasdaq market

makers to display customer limit orders and to disseminate the best prices

Page 34 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix I 

Chronology of SOES and SOES-Related

Events

placed by market makers in ECNs. A follow-up NASD study showed that

spreads had narrowed by 33 percent. Another study by economists

Barclay, Christie, Harris, Kandel, and Schultz found that, for the affected

stocks, spreads narrowed by over 35 percent, and the proportion of share

volume traded through SOES fell by 6 percentage points, as a result of the

rule changes.

SOES rule changes become effective with the order handling rules. Notable

among the changes are (1) a market maker’s displayed quotation size is to

constitute the minimum exposure limit that the market maker is obligated

to execute and (2) market makers are allowed to enter all customer orders

into SOES, including those for stocks in which they make a market.

NASD implements an actual size pilot program that allowed market makers

to display quotes in minimum sizes of 100 shares for 50 stocks (then later

another 100 stocks) being phased in under the order handling rules. NASD

stated that allowing actual size quotes in conjunction with the requirement

to display limit orders would narrow spreads.

April 1997 The federal district court granted the Stipulation and Order filed in United

States v. Alex Brown & Sons et al., 963 F. Supp. 235 (S.D.N.Y. 1997).

May 1997 SEC approves a NASD rule change to decrease the minimum quotation

increment for securities with a bid price greater than or equal to $10 that

are listed and traded on the Nasdaq Stock Market to 1/16th of $1.00. The

change was intended to enhance the transparency of the Nasdaq Market,

provide investors with a greater opportunity to receive better execution

prices, facilitate greater quote competition, promote the price discovery

process, contribute to narrower spreads, and enhance the capital

formation process. NASD’s preliminary analysis showed that the decrease in

the quotation increment resulted in a decrease in quoted spread for stocks

subject to SEC’s order handling rules.

December 1997 SEC approves a NASD rule change regarding (1)excused withdrawals of

market makers from participation as market makers in Nasdaq national

market securities and (2)reinstatements of market makers who fail to

reenter quotes after their quote sizes have been decremented through SOES

trading. The rule change listed specific factors for which market makers

can be excused or reinstated.

Page 35 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix I 

Chronology of SOES and SOES-Related

Events

SEC approves a NASD rule change to indicate that, once SOES executes an

unpreferenced market order or marketable limit order against a SOES

market maker, that market maker is not required to execute another

unpreferenced SOES order at the same bid or offer in the same security

until 17 seconds have elapsed, absent a quotation update by the market

maker within such 17-second period. The additional 2 seconds were added

to the 15-second delay to allow time for market makers to receive reports

of SOES executions.

March 1998 SEC publishes, for public comment, a proposed NASD rule change to

establish a new Integrated Order Delivery and Execution System. The

system would replace existing SOES and SelectNet systems and provide an

integrated order routing and execution system featuring:

1. Automatic trade executions for all.

The system is expected to provide investors and traders immediate and

automatic executions in strict time priority. It would provide a limit order

file through which both limit orders and market maker quotes would be

subject to automatic execution. However, it would allow market makers to

turn the system off momentarily to prevent themselves from getting hit

while handling telephone orders.

2. No size limits and no ephemeral quotes.

The system would allow orders of up to 999,999 shares to be entered, with

a minimum life of 10 seconds.

3. No multiple executions.

A market maker would have to honor only one execution at its quoted

price and would have 17 seconds to update its quote. For trades of more

than 1,000 shares the market maker would have the option of declining the

trade if a trade had already been executed at the quote or if the market

maker was updating its quote.

NASD submits proposed rule change to permanently allow market makers

to quote actual size by reducing the minimum quotation size requirement

for market makers in all securities listed on Nasdaq to one normal unit of

trading (at least 100 shares or multiples thereof). NASD staff study of test

period found that the actual size rule had no effect on market quality or

Page 36 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix I 

Chronology of SOES and SOES-Related

Events

SOES access. One commentator opposed to the rule change disputed NASD’s

finding, contending that the actual size rule resulted in substantial

reduction in market depth and liquidity, especially during times of market

stress.

July 1998 SEC approves a NASD proposed rule change to allow market makers to

quote permanently in actual size by reducing the minimum quotation size

requirement for all Nasdaq securities to one normal unit of trading of 100

shares and multiples of 100. In its study of the effects of the actual size

rule, NASD stated that artificial minimums were no longer necessary and

that the rule allows market makers to better manage risks with no harm to

market quality or SOES access.

Page 37 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix II 

Comments From NASD

Page 38 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix III 

Comments From the Securities and

Exchange Commission

Page 39 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix III 

Comments From the Securities and

Exchange Commission

Page 40 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
Appendix IV 

Major Contributors to This Report

General Government

Division

Michael A. Burnett, Assistant Director

Tamara E. Cross, Evaluator-in-Charge

David P. Tarosky, Senior Evaluator

Mitchell B. Rachlis, Senior Economist

Office of the General

Counsel

Rosemary Healy, Senior Attorney

(233540) Page 41 GAO/GGD-98-194 The Effects of SOES on the Nasdaq Market
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