[Federal Register Volume 62, Number 2 (Friday, January 3, 1997)]
[Notices]
[Pages 436-439]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-20]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38089; File No. SR-NASD-96-50]


Self-Regulatory Organizations; Notice of Proposed Rule Change by 
the National Association of Securities Dealers, Inc. Relating to 
Amendments to the NASD's Excess Spread Rule Applicable to Market Maker 
Quotations

December 27, 1996.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on December 
16, 1996, the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by the NASD. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The NASD proposes to amend NASD Rule 4613(d) on a one-year pilot 
basis to provide that a registered market maker in a security listed on 
The Nasdaq Stock Market, Inc. (``Nasdaq'') shall be precluded from 
being a registered market maker in that issue for twenty (20) business 
days if its average spread in the security over the course of any full 
calendar month exceeds 150 percent of the average of all dealer spreads 
in such issue for the month. The text of the proposed rule change is as 
follows. (Additions are italicized; deletions are bracketed.)
* * * * *
NASD Rule 4613  Character of Quotations
    (d) Reasonably Competitive Quotations [Excess Spreads]
    A registered market maker in a security listed on The Nasdaq Stock 
Market will be withdrawn as a registered market maker and precluded 
from re-registering as a market maker in such issue for 20 business 
days if its average spread in the security over the course of any full 
calendar month exceeds 150 percent of the average of all dealer spreads 
in such issue for the month.
    (1) If a registered market maker has not satisfied the average 
spread requirement set forth in this subparagraph (d) for a particular 
Nasdaq security, its registration in such issue shall be withdrawn 
commencing on the next business day following the business day on which 
the market maker was sent notice of its failure to comply with the 
requirement. A market maker may request reconsideration of the 
withdrawal notification. Requests for reconsideration will be reviewed 
by the Market Operations Review Committee, whose decisions are final 
and binding on the members. A request for reconsideration shall not 
operate as a stay of the withdrawal or toll the twenty business day 
period noted in subparagraph (d) above.
    (2) Grounds for requests for reconsideration shall be limited to 
claims that Nasdaq's calculation of the market maker's average spread 
for the month was in error.
    (3) This subparagraph (d) shall be in effect until January 31, 
1998.

[A market maker shall not enter quotations in The Nasdaq Stock Market 
securities that exceed the parameters for maximum allowable spreads as 
approved by the Association's Board of Governors and that may be 
published from time to time by the Association. The maximum allowable 
spreads for Nasdaq securities shall be 125 percent of the average of 
the three (3) narrowest market maker spreads in each security (if there 
are fewer than three (3) market makers in a security, the maximum 
allowable spread will be 125% of the average spread); provided however, 
that the maximum allowable spread shall never be less than \1/4\ 
point.]
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in Sections 
(A), (B), and (C) below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    NASD Rule 4613(d), which is commonly known as the NASD's ``excess 
spread rule,'' presently provides that registered market makers in 
Nasdaq securities shall not enter quotations that exceed the NASD's 
parameter for maximum allowable spreads. Specifically, the rule 
provides that the maximum allowable spread for any Nasdaq security is 
125 percent of the

[[Page 437]]

average of the three narrowest market maker spreads in that issue 
(``125 percent test''), provided, however, that the maximum allowable 
spread shall never be less than \1/4\ of a point.\1\
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    \1\ Unrelated to the excess spread rule, there is also a dealer 
spread test that is part of the NASD's Primary Market Maker 
(``PMM'') standards that are used to determine the eligibility of 
market makers to an exemption from the NASD's short sale rule for 
short sales effected during the course of bona fide market making 
activity. Specifically, the market maker spread component of the PMM 
standards provides that a market maker must maintain a spread no 
greater than 102 percent of the average dealer spread.
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    The excess spread rule was originally designed to bring a measure 
of quality to the Nasdaq market by preventing firms from holding 
themselves out as market makers without having a meaning quote in the 
system. Despite the laudable regulatory objectives underlying the 
excess spread rule, however, many market participants believe the rule 
has produced a variety of unintended consequences that have undermined 
the integrity of Nasdaq. Most notably, the SEC found in its 21(a) 
Report on the NASD and The Nasdaq Stock Market that ``the 
interdependence of quotes mandated by the rule may deter market makers 
from narrowing their dealer spreads, because, once the spread is 
tightened, the rule in some instances precludes a market maker from 
widening the spread to earlier levels.'' \2\ As a result, the SEC found 
that the excess spread rule creates an economic incentive for market 
makers to discourage one another from narrowing their quotes, thereby 
interfering with the ``free flow of prices in the market and imped[ing] 
attempts by the market to reach the optimal competitive spread.'' \3\ 
Accordingly, the SEC has requested that the NASD ``modify the rule to 
eliminate its undesirable effects, or to repeal it.'' \4\ In addition, 
because of the constraints on quote movements created by the rule, 
market participants claim that the excess spread rule has contributed 
to locked and crossed markets during periods of market turbulence.
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    \2\ See Appendix to Report Pursuant to Section 21(a) of the 
Securities Exchange Act of 1934 Regarding the NASD and The Nasdaq 
Stock Market (``21(a) Report''), SEC, August 8, 1996, at p. 98.
    \3\ Id. at p. 99.
    \4\ Id.
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    Accordingly, Nasdaq and the NASD are submitting this rule proposal 
to help to ameliorate adverse consequences the current excess spread 
rule could potentially have on the competitiveness and independence of 
quotations displayed on the Nasdaq market. In formulating this proposal 
Nasdaq and the NASD felt that it was important to strike a reasonable 
balance between the need to eliminate any constraints that the excess 
spread rule places on firms to adjust their quotations and the need to 
avoid fostering a market environment where registered market makers can 
maintain inordinately wide spreads and still receive the benefits of 
being a market maker (e.g., affirmative determination exemption and 
preferential margin treatment). Nasdaq and the NASD also believe it is 
critical to transform the excess spread rule into a performance 
standard used to determine market maker eligibility, instead of a 
strict regulatory requirement applicable to every quote update in a 
Nasdaq security, violations of which are punishable by disciplinary 
action.
    With these considerations in mind, Nasdaq and the NASD discussed a 
variety of proposals to amend the excess spread rule. Ultimately, as 
discussed below, Nasdaq and the NASD reached a determination to 
eliminate the current ``125 percent test'' and instead substitute a new 
minimal market maker performance requirement that would help to ensure 
that all registered market makers are providing some threshold level of 
market making support in their issues. Specifically, under the 
proposal, a registered market maker would be required to maintain an 
average spread over the course of any full calendar month equal to or 
less than 150 percent of the average of all market makers in the issue 
over the course of the month (``150 percent test''). If a market maker 
failed to satisfy this standard with respect to a particular issue, it 
would be forced to withdraw from that issue for at least 20 business 
days.
    Even though the proposed minimal market maker performance standard 
would have adverse ramifications for those market makers who quote 
inordinately wide spreads, Nasdaq and the NASD believe the proposal is 
responsive to the SEC's request that the NASD eliminate the undesirable 
effects of the excess spread rule. Specifically, because the proposed 
``150 percent test'' is based on the average of all market makers in an 
issue and not just the three market makers quoting the narrowest 
spreads and because of the magnitude of increase to 150 percent, Nasdaq 
and the NASD do not believe that the interdependence of market maker 
quote movements noted by the SEC in its 21(a) Report will occur with 
this standard. Moreover, Nasdaq and the NASD believe market makers will 
not feel constrained to narrow or widen their spreads under the 
proposal because the ``150 percent test'' would evaluate a market 
maker's quotation behavior over the course of a full calendar month, 
rather than each time a market maker updates its quote, as is presently 
the case.
    Nasdaq and the NASD also believe it is important to eliminate the 
current excess spread rule because of the order-driven nature of the 
Nasdaq market that will be brought about by implementation of the SEC's 
new limit order display rule on January 10, 1997.\5\ In particular, 
because spreads in Nasdaq securities likely will narrow because of the 
display of customer limit orders, the average of the three narrowest 
market maker spreads will be commensurately narrowed. As a result, the 
interdependence of market maker quotations highlighted by the SEC in 
its 21(a) Report will be exacerbated and some market makers may even 
choose to withdraw from making markets, thus dampening liquidity on 
Nasdaq and reducing competition among market makers. Conversely, under 
the current excess spread rule, market makers may have an economic 
incentive to not accept customer limit orders or only accept those 
limit orders priced at the inside bid or offer so as to not narrow the 
maximum allowance spread parameters. Such a development would be 
completely contradictory to the important investor protection 
objectives underlying adoption of the SEC's limit order display rule. 
Because neither result is acceptable, Nasdaq and the NASD believe that 
the current excess spread rule should be eliminated.
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    \5\ SEC Rule 11Ac1-4 requires the display of customer limit 
orders that are priced better than a market maker's quote or that 
add to the size associated with a market maker's quote when the 
market maker is at the best price in the market. See Securities 
Exchange Act Release 37619A (September 6, 1996), 61 FR 48290 
(September 12, 1996) (``Order Handling Rule Adopting Release'').
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    While Nasdaq and the NASD believe the proposed ``150 percent test'' 
will help to ensure that market makers maintain at least a minimal 
level of commitment to their issues, Nasdaq and the NASD, nevertheless, 
believe it would be prudent to not impose the ``150 percent test'' on a 
permanent basis until there is a substantial basis to conclude that the 
``150 percent test'' has not contributed to or fostered the same 
unintended consequences created by the current excess spread rule 
(e.g., the interdependence of market maker quote movements and the 
exacerbation of locked and crossed market situations). Accordingly, 
Nasdaq and the NASD propose that the ``150 percent test'' be 
implemented on a one-year pilot basis until January 31, 1998. During 
the pilot period, Nasdaq and the NASD will analyze market maker 
quotation behavior to determine whether the rule

[[Page 438]]

has met its dual objectives of removing constraints on market maker 
quotation movements and ensuring some minimal level of commitment by 
market makers to their issues. Throughout the pilot period, Nasdaq and 
the NASD also will proactively explore whether there are other 
alternative means to achieve these objectives without reliance on a 
quotation-based evaluation criteria.
    In addition, because a market maker would be precluded from 
functioning as a registered market maker in a particular Nasdaq 
security for twenty business days if it failed to meet the ``150 
percent test'', the proposal also amends NASD Rule 4613(d) to afford 
market makers the opportunity to request reconsiderations of their 
withdrawal notices. Requests for reconsideration will be reviewed by 
the Market Operations Review Committee, whose decisions will be final 
and binding on the members. Because Nasdaq and the NASD believe that 
such reconsiderations should be exclusively limited to an evaluation as 
to whether the ``150 percent test'' was indeed satisfied, the proposed 
rule change provides that the grounds for reconsideration shall be 
limited to claims that Nasdaq's calculation of the market maker's 
average spread for the month was in error.
    The NASD believes that the proposed rule change is consistent with 
Sections 15A(b)(6), 15A(b)(9), 15A(b) (11) and 11A(a)(1)(C) of the Act. 
Among other things, Section 15A(b)(6) requires that the rules of a 
national securities association be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system and in general to 
protect investors and the public interest. Section 15A(b)(9) provides 
that the rules of the Association may not impose any burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Act. Section 15A(b)(11) empowers the NASD to adopt rules 
governing the form and content of quotations relating to securities in 
the Nasdaq market. Such rules must be designed to produce fair and 
informative quotations, prevent fictious and misleading quotations, and 
promote orderly procedures for collecting and distributing quotations. 
Section 11A(a)(1)(C) provides that it is in the public interest to, 
among other things, assure the economically efficient execution of 
securities transactions and the availability to brokers, dealers, and 
investors of information with respect to quotations for and 
transactions in securities. Specifically, because Nasdaq and the NASD 
believe the proposed ``150 percent test'' will help to ameliorate 
adverse consequences the current excess spread could potentially have 
on the competitiveness and independence of quotations displayed on the 
Nasdaq market, Nasdaq and the NASD believe the proposed rule change 
will promote the integrity of quotations on the Nasdaq market and 
enhance competition among market makers, thereby contributing to 
greater market liquidity, improved price discovery, and the best 
execution of customer orders. At the same time, while Nasdaq and the 
NASD believe the proposed ``150 percent test'' will remove a constraint 
on market maker quote movements, Nasdaq and the NASD also believe that 
the proposal will help to ensure that all registered market makers are 
providing some threshold level of market making support in their 
issues. Nasdaq and the NASD also believe that use of the ``150 percent 
test'' will avoid fostering a market environment where registered 
market makers can maintain inordinately wide spreads and still receive 
the benefits of being a market maker. Accordingly, the NASD and Nasdaq 
believe the proposed rule change is consistent with all of the above-
cited Sections of the Act and the rules thereunder.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD believes that the proposed rule change will not result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    The NASD and Nasdaq request that the Commission find good cause to 
accelerate the effectiveness of the proposed rule change pursuant to 
Section 19(b)(2) of the Act by January 10, 1997. As noted above in the 
text accompanying footnote 5, Nasdaq and the NASD believe that serious 
market consequences could potentially result from retention of the 
current excess spread rule in a market environment where customer limit 
orders are required to be displayed. Accordingly, since implementation 
of the SEC's new limit order display rule is scheduled to commence on 
January 10, 1997, Nasdaq and the NASD believe good cause exists to 
accelerate approval of the proposed rule change on or prior to January 
10, 1997. In addition, in a separate rule filing, SR-NASD-96-43, Nasdaq 
and the NASD proposed to modify the SOES Automated Quotation Update 
Feature so that only one side of a market maker's quote would be 
updated when its quote size has been decremented to zero through SOES 
executions. By updating the bid or the offer, but not both, the NASD 
and Nasdaq believe the auto-refresh feature will not exacerbate or 
contribute to locked or crossed markets, as has been the case with the 
current update feature during turbulent market conditions. Accordingly, 
Nasdaq and the NASD believe that the instant rule filing and SR-NASD-
96-43 should be approved in tandem and, therefore, that good cause 
exists to accelerate approval of the instant rule filing if such 
acceleration is necessary to ensure that both filings are approved at 
the same time.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to file number SR-NASD-96-50 and 
should be submitted by January 24, 1997.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\6\
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    \6\ 17 CFR 200.30-3(a)(12).

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[[Page 439]]

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-20 Filed 1-2-97; 8:45 am]
BILLING CODE 8010-01-M