[Federal Register Volume 62, Number 233 (Thursday, December 4, 1997)]
[Notices]
[Pages 64242-64245]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-31754]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39367; File No. SR-NASD-97-53]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change and Notice of 
Filing and Order Granting Accelerated Approval of Amendment No. 2 to 
Proposed Rule Change Relating to Trading in Exchange-Listed Securities 
in the Third Market

November 26, 1997.

I. Introduction

    On July 28, 1997, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), through its wholly-owned 
subsidiary, The Nasdaq Stock Market, Inc. (``Nasdaq''), filed with the 
Securities and Exchange Commission (``SEC'' or ``Commission'') a 
proposed rule change pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Exchange Act'').\1\ The proposed rule change 
relating to automated quotations in exchange-listed securities in the 
third market, including Amendment No. 1, was published for comment in 
Securities Exchange Act Release No. 38985 (August 27, 1997).\2\ Two 
comment letters were received on the proposal.\3\ On October 10, 1997, 
the NASD filed Amendment No. 2, prepared by Nasdaq, which deferred the 
proposal for permissible uses of automated quotations with respect to 
exchange-listed securities included in the Intermarket Trading System 
(``ITS''). For the reasons discussed below, the Commission is approving 
the proposed rule change and granting accelerated approval to Amendment 
No. 2.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 62 FR 46787 (September 4, 1997).
    \3\ See letter from Steven Alan Bennett, Senior Vice President 
and General Counsel, BankOne, to Mr. Jonathan Katz, Secretary, SEC, 
dated September 25, 1997 (``BankOne Letter''); and letter from James 
E. Buck, Senior Vice President and Secretary New York Stock Exchange 
to Mr. Jonathan G. Katz, Secretary, SEC, dated September 29, 1997 
(``NYSE Letter'').
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II. Description of the Proposal

    The NASD's proposal included changes to several rules governing the 
trading in exchange-listed securities in the over-the-counter market, 
the so-called ``third market.'' Specifically, the NASD proposedl to 
amend rules of the NASD to: (1) Codify permissible uses of computer-
generated quote systems with respect to exchange-listed securities;\4\ 
(2) eliminate the excess spread rule for market makers in exchange-
listed securities; (3) reduce the minimum quotation size applicable to 
market makers in exchange-listed securities to one unit of trading 
(i.e., 100 shares), regardless of whether the CQS market maker \5\ is 
displaying a customer's limit order or quoting for its own proprietary 
account; (4) extend exemptive provisions of the NASD's limit order 
protection rule applicable to Nasdaq-listed securities (the ``Manning 
Rule'') to exchange-listed securities; and (5) reduce from 1000 to 100 
the number of shares that CAES will execute automatically.
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    \4\ However, with the approval of Amendment No. 2 to the 
proposal, exchange-listed securities that are included in the ITS/
Computer Assisted Execution System (``CAES'') linkage are not 
subject to the NASD's rule regarding permissible uses of computer-
generated quote systems.
    \5\ Quotations and quotation sizes in reported securities may be 
entered into the Consolidated Quotations Service (``CQS'') through 
The Nasdaq Stock Market only by an Association member registered 
with it as a CQS market maker. See NASD Rule 6320.
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a. Permissibility of the Use of Certain Automated Quotation Generation 
Systems

    The plan governing the ITS Plan currently provides that exchange 
specialists and CQS market makers may use ``automated quotation 
tracking systems,'' provided that the quotations generated by such 
systems are for 100 shares or less (``100-Share Autoquoting 
Limitation''). Despite the ITS plan's allowance of 100-share 
autoquotes, the NASD currently prohibits CQS market makers from using 
autoquote systems to effect automated quote updates or to track the 
inside market. In addition, the NASD currently requires CQS market 
makers to maintain a minimum quotation size of 500 shares, with the 
exception of displaying a customer limit order, which also effectively 
prohibits CQS market makers from autoquoting.
    The NASD's proposal explicitly accommodates computer-generated 
quotations that add value to the market and do not raise quotation 
accessibility concerns or compromise the capacity or integrity of 
Nasdaq. Specifically, the proposed rule change amends NASD Rule 6330 to 
permit computer-generated quotations in exchange-listed securities that 
generate proprietary quotes for 100 shares or more if such quote 
systems equal or improve either or both sides of the NBBO. For example, 
if a CQS market maker utilized a computer-generated quotation program 
to match the best offer (bid) and the market responsible to the best 
offer (bid) subsequently increased (decreased) its offer (bid) price, 
the CQS market maker could not use the program to track such inferior 
price. Thus, if the best offer is 20\1/4\, a CQS market maker could use 
the program to improve its offer to 20\1/4\. If the market responsible 
for the 20\1/4\ offer moved to 20\3/8\, however, the CQS market maker 
could not use the program to move its offer to 20\3/8\.
    In addition, the proposed rule change amends Rule 6330 to permit 
computer-generated quotations that add size to the NBBO, or are used to 
expose a customer's market or marketable limit order for price 
improvement opportunities. These uses would be in addition to three 
other forms of computer-enhanced quotation maintenance programs 
referenced in the NASD's Autoquote Policy which are also being 
incorporated into Rule 6330 with respect to exchange-listed 
securities.\6\ With the exception of these

[[Page 64243]]

types of computer-generated quotation and maintenance systems, all 
other types of computer-generated quotations would continue to be 
prohibited. Thus, market makers could not use computer-generated 
quotations to track away from the inside market (``autoquoting away'').
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    \6\ See NASD IM-4613. Specifically, these three forms are: (1) 
Quotation updates in response to an execution in the security by 
that firm (such as execution of an order that partially fills a 
market maker's quotation size); (2) quotation updates that require a 
physical entry (such as manual entry to the market maker's internal 
system which then automatically forwards the update to Nasdaq); and 
(3) quotation updates that reflect the receipt, execution, or 
cancellation of a customer limit order.
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b. Elimination of the Excess Spread Rule

    The NASD also proposed to enhance the quotation flexibility of CQS 
market makers by eliminating the excess spread rule for CQS securities. 
The NASD determined that the potential adverse competitive consequences 
on highly automated CQS market making firms who are prohibited from 
autoquoting away could be minimized if the excess spread rule was 
eliminated. Specifically, by eliminating the excess spread rule for CQS 
securities, the NASD believes that CQS market makers will have more 
flexibility in quoting, Nasdaq capacity will not be needlessly consumed 
by processing voluminous quote updates autoquoting away from the 
market, and the competitiveness of the third market will not be 
compromised.

c. Changes to the Minimum Quote Size Rule for CQS Market Makers

    In an environment where investors are able to directly impact 
quoted prices in the third market by having their limit orders 
displayed publicly, the NASD believes it is appropriate to treat CQS 
market makers in a manner equivalent to exchange specialists and not 
subject them to minimum quote size requirements. The NASD believes the 
increased order-driven nature of the third market brought about by the 
SEC's Limit Order Display Rule obviates the justification for the 500 
Share Quote Rule. Accordingly, the NASD proposed to amend the 500 Share 
Quote Rule to permit a CQS market maker to post quotations commensurate 
with their own freely-determined trading interest, provided, however, 
that the quotations must be for at least one normal unit of trading.

d. Modifications to CAES

    The implementation of the Order Execution Rules has required market 
makers to display customers limit orders, thereby compelling CQS market 
makers, who are not only obligated to execute trades up to 1,000 shares 
at another market maker's quote, to execute trades at superior-priced 
limit orders displayed by any other CQS market maker, even if such 
limit orders are only for 100 shares. In addition, because Nasdaq no 
longer processes CQS quotes,\7\ CAES executes orders at the best bid or 
offer price in the third market instead of the national best bid or 
offer (``NBBO''). As a result, when there are no CQS market makers at 
the NBBO, CAES is providing inferior executions to customer orders.
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    \7\ See Exchange Act Release No. 37663, September 10, 1996 (61 
FR 48725) (order approving File No. SR-NASD-96-26).
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    In order to facilitate the best execution of customer orders and 
not subject CQS market makers to automatic executions at prices other 
than their posted quotes, the NASD believes it is imperative that CAES 
be appropriately modified. Accordingly, the NASD has proposed to amend 
the operation of CAES so that it automatically executes orders up to 
100 shares instead of 1,000 shares. An order can be preferenced for 
larger than 100 shares to a CQS market maker and, although the order 
will not be automatically executed, the order will be processed by the 
CQS market maker pursuant to its firm quote obligations.\8\
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    \8\ See 17 CFR 240.11Ac1-1.
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e. Modifications to the Limit Order Protection Rule Applicable to CQS 
Securities

    NASD proposed to amend Rule 6440 to permit a member to negotiate 
special terms and conditions with a customer that would enable the firm 
to trade ahead of, or at the same price as, the limit order price. 
Specifically, under the Manning Rule, member firms may attach terms and 
conditions with respect to the handling of limit orders that are 
either: (1) For institutional accounts,\9\ or (2) limit orders that are 
for 10,000 shares or greater, regardless of whether they are for 
institutional accounts, provided that the order is $100,000 or more in 
value. The NASD proposed to extend the ``terms and conditions'' 
language of the Manning Rule to the CQS limit order protection rule.
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    \9\ Institutional limit orders are orders for institutional 
accounts. NASD Rule 3110(c) defines an institutional account as an 
account for: (1) Banks, savings and loan associations, insurance 
companies, or registered investment companies; (2) investment 
advisers registered under Section 203 of the Investment Advisers Act 
of 1940; and (3) any other entity (whether a natural person, 
corporation, partnership, trust, or otherwise) with total assets of 
at least $50 million.
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III. Discussion

    In August 1996, the Commission adopted new Rule 11Ac1-4 (``Limit 
Order Display Rule'') and amendments to Rule 11Ac1-1 (``Quote 
Rule'').\10\ As amended, the expanded definition of ``subject 
security'' \11\ within the Quote Rule obligates any NASD member that 
acts in the capacity of an over-the-counter (``OTC'') market maker \12\ 
to provide continuous two-sided quotations for any exchange-listed 
security \13\ in which that member, during the most recent calendar 
quarter, comprised more than 1% of the aggregate trading volume for 
such security as reported in the consolidated system (``1% Rule'').\14\ 
An OTC market maker must, within 10 business days of the end of each 
calendar quarter, compute its trading volume for each subject security, 
and if the volume exceeds 1%, the market maker must begin publishing 
two-sided quotations.
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    \10\ See Exchange Act Release No. 37619A (September 6, 1996), 61 
FR 48290 (September 12, 1996) (``Adopting Release'') adopting the 
Limit Order Display Rule and amendments to the Quote Rule 
(collectively the ``Order Execution Rules'').
    \11\ Rule 11Ac1-1(a)(25).
    \12\ See Rule 11Ac1-1(a)(13).
    \13\ See Rule 11Ac1-1(a)(10) which defines ``exchange-traded 
security'' to mean any covered security or class of covered 
securities listed and registered, or admitted to unlisted trading 
privileges, on an exchange; provided, however, that securities not 
listed on any exchange that are traded pursuant to unlisted trading 
privileges are excluded.
    \14\ The 1% Rule, prior to being expanded in the Order Execution 
Rules, applied only to 19c-3 securities. Exchange Act Rule 19c-3 
prohibits the application of off-board trading restrictions to 
securities that: (1) Were not traded on an exchange on or before 
April 26, 1979; or (2) were traded on an exchange on April 26, 1979, 
but ceased to be traded on an exchange for any period of time 
thereafter. Accordingly, exchange-traded securities not subject to 
off-board trading restrictions are referred to as Rule 19c-3 
securities, and exchange-traded securities subject to off-board 
trading restrictions are referred to as non-Rule 19c-3 securities. 
The 1% Rule was expanded to include all exchange-listed securities, 
both Rule 19c-3 and non-Rule 19c-3.
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    The Commission began implementing the Order Execution Rules on 
January 20, 1997. The Commission, however, deferred implementation of 
the expanded 1% Rule until September 30, 1997.\15\ In light of the 
implementation of the 1% Rule to all exchange-listed securities, the 
NASD proposed the aforementioned amendments to its rules governing 
trading in exchange-listed securities in the third market.
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    \15\ See Securities Exchange Act Release Nos. 38110 (January 2, 
1997), 62 FR 1279 (January 9, 1997); 38490 (April 9, 1997), 62 FR 
18514 (April 16, 1997); and 38870 (July 24, 1997), 62 FR 40732 (July 
30, 1997). Therefore, until September 30, 1997, OTC market makers 
were only obligated to publicly disseminate quotations when they 
were responsible for 1% or more of the trading volume in a 19c-3 
security.
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    The Commission received two comment letters on the proposed rule 
change. The BankOne comment letter supported the NASD's proposal. The

[[Page 64244]]

NYSE comment letter did not address the specifics of the NASD proposal. 
Nevertheless, the NYSE was concerned with the NASD proposal to amend 
Rule 6330 to effectively lift its ban on autoquoting because of the 
conflict with the ITS Plan. Although the ITS Participants are currently 
discussing whether to amend the ITS Plan with regard to permissible 
uses of computer-generated quotations, the current ITS Plan limits 
computer-generated quotations to 100 shares. The ITS Plan governs all 
ITS Participants, including the NASD. Therefore, the NYSE does not 
believe the NASD Rule permitting the use of computer-generated 
quotations should be extended to those exchange-listed securities that 
are included in the ITS.
    In response to the NYSE comment letter, and in recognition of the 
lack of unanimous consensus from ITS Participants, the NASD filed 
Amendment No. 2 to the proposal requesting the Commission to proceed 
with the proposed rule change with respect to non-Rule 19c-3 
securities. The NASD also noted that they are concerned that market 
makers may experience difficulty in using enhanced automation support 
if they are only permitted to do so for a portion (i.e., non-Rule 19c-3 
securities) of the exchange-listed securities they maintain quotations 
in. Therefore, the practical result of removing the burdens of 
complying with the 1% Rule would be lost.
    In expanding the 1% Rule, the Commission recognized that it raised 
an issue with respect to the ability of NASD members to autoquote. The 
Commission stated that ``a total prohibition on the use of computer 
generated quotes is not appropriate'' and that ``[s]uch an approach 
excessively limits the use of sophisticated trading strategies that 
rely on automation in the quotation process for their success, and it 
also may act as a competitive disadvantage to market makers and 
specialists that would otherwise rely on technology to meet their 
quotation obligations more efficiently.'' \16\ While the Commission 
noted that it ``recognizes traditional concerns related to the 
accessibility of computer generated quotes and the impact of such 
quotes on system capacity, it believes that more can and should be done 
in this area.'' \17\ The Commission stressed that more should be done 
particularly ``given the enhanced quotation obligations that will be 
imposed on some market participants under the revised Quote Rule.'' 
\18\ The Commission, therefore, urged the ``NASD, ITS Participants, and 
other interested market participants to develop revised standards that 
would permit the use of computer generated quotes that contribute value 
to the market.'' \19\
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    \16\ See Adopting Release at Section III.B.3.c.i.
    \17\ Id.
    \18\ Id.
    \19\ Id.
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    The Commission believes the NASD proposal provides its members with 
the ability to use computer-generated quotations that add value to the 
market and do not raise quotation accessibility concerns. The NASD 
proposal does not permit autoquoting away which would subject Nasdaq to 
capacity constraints as well compromise the value of quotations. The 
Commission believes the proposal facilitates the implementation of the 
Order Execution Rules, specifically, the 1% Rule by providing OTC 
market makers with the ability to use computer-generated quotations. 
The Commission notes, however, that permitting computer-generated 
quotations for only non-Rule 19c-3 securities may inhibit some market 
makers because they may not be able to distinguish those quotations 
from their quotations in other exchange-listed securities. The 
Commission expects that the ITS Participants will continue in their 
discussions to amend the ITS Plan to permit computer-generated 
quotations. In approving this rule, the Commission notes that it has 
also considered the proposed rule's impact on efficiency, competition, 
and capital formation.\20\
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    \20\ 15 U.S.C. 78c(f).
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    For the foregoing reasons, the Commission finds that the proposed 
rule change is consistent with the Exchange Act and the rules and 
regulations thereunder applicable to the NASD and, in particular, 
Sections 11A(a)(1)(D), 11A(a)(2) and 15A(b)(6) of the Exchange Act.\21\ 
Section 11A(a)(1)(D) of the Exchange Act states that the linking of all 
markets for qualified securities through communications and data 
processing facilities will foster efficiency, enhance competition, 
increase the information available to brokers, dealers and investors, 
facilitate the offsetting of investor's orders and contribute to best 
execution of such orders, and subsection (a)(2) thereunder directs the 
Commission to facilitate the establishment of a national market system 
for qualified securities. Section 15A(b)(6) requires that the rules of 
a national securities association be designed to prevent fraudulent and 
manipulative acts and practices, to promote just an 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.
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    \21\ In addition, the Commission notes that it has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. The proposed rule will likely contribute to more accurate 
and informative quotations because market makers are able to use 
automated measures to produce accessible quotations that add value 
to the market. The Commission believes that permitting the use of 
automated quotations by CQS market makers allows them to utilize 
technology to fulfill their quotation obligations efficiently. 
Moreover, allowing CQS market makers to utilize technology in this 
manner reduces any competitive disadvantage that the previous auto-
quote ban may have created. 15 U.S.C. Sec. 78c(f).
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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, 450 Fifth Street, N.W., Washington, 
D.C. 20549. Copies of such filing will also be available for inspection 
and copying at the principal office of the NASD. All submissions should 
refer to the file number in the caption above should be submitted by 
December 29, 1997.

V. Conclusion

    For the reasons discussed in this order, pursuant to Section 
19(b)(2) of the Exchange Act,\22\ the Commission finds good cause for 
approving the proposed rule change, as amended, prior to the thirtieth 
day after the date of publication of notice filing thereof in the 
Federal Register.
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    \22\ 15 U.S.C. 78s(b)(2).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,

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that the proposed rule change (NASD-97-53) be, and hereby is, approved.

    For the Commission, by the Division of Market Regulations, 
pursuant to delegated authority.\23\
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    \23\ 17 CFR 200.30-3(A)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-31754 Filed 12-3-97; 8:45 am]
BILLING CODE 8010-01-M