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[Federal Register Volume 62, Number 6 (Thursday, January 9, 1997)]
[Notices]
[Pages 1351-1353]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-445]

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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38115; File No. SR-NASD-95-54]

Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by National Association of Securities Dealers, Inc., Relating to 
a Modification of the Operation of the Small Order Execution System 
During Locked and Crossed Markets

January 3, 1997.
    On November 15, 1995,\1\ the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities 
and Exchange Commission (``Commission'' or ``SEC'') a proposed rule 
change pursuant to Section 19(b)(1) of the Securities Exchange Act of 
1934 (``Act'') \2\ and Rule 19b-4 thereunder.\3\ The rule change amends 
NASD Rule 4730(b)(4) \4\ to provide that during locked or crossed 
markets, SOES will execute orders in five-second intervals against a 
locked or crossed market maker at the best price, regardless of whether 
the market maker entered the quotation locking or crossing the market.
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    \1\ The NASD amended the proposed rule change four times 
subsequent to its initial filing. Amendment No. 4 filed October 16, 
1996, changed the narrative in the proposed rule change. Amendment 
No. 3, filed October 2, 1996, replaced Amendment No. 2, which was 
filed September 23, 1996. Amendment No. 2, in turn, replaced 
Amendment No. 1, which was filed August 5, 1996.
    The proposed rule change, as originally submitted, would have 
provided market makers with a 15-second grace period following their 
receipt of a Small Order Execution System (``SOES'') execution 
report during locked and crossed markets in which to update their 
quotation in that security before being required to execute another 
SOES order in that security. The filing as amended would establish a 
5 second grace period between SOES executions in locked and crossed 
markets. See letter from Robert E. Aber, Vice President and General 
Counsel, The Nasdaq Stock Market to Katherine England, Assistant 
Director, Division of Market Regulation, Commission (October 2, 
1996).
    \2\ 15 U.S.C. Sec. 78s(b)(1).
    \3\ 17 CFR 240.19b-4.
    \4\ NASD Manual, Marketplace Rules (CCH), Rule 4730.
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    Notice of the proposed rule change, together with the substance of 
the proposal, was provided by issuance of a Commission release 
(Securities Exchange Act Release No. 37845, October 21, 1996) and by 
publication in the Federal Register (61 FR 55342, October 25, 1996). 
One comment letter was received.\5\ This order approves the proposed 
rule change.
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    \5\ Letter from Edward J. Johnsen, Vice President & Counsel, 
Morgan Stanley & Co. Inc. (``Morgan Stanley''), to Jonathan G. Katz, 
Secretary, Commission, dated November 14, 1996.
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I. Description of Rule Change

    The rule change approved today modifies SOES to provide that during

[[Page 1352]]

locked or crossed markets, SOES will execute orders in five-second 
intervals against a market maker whose quotation is locked or crossed 
at the best price, regardless of whether the market maker entered the 
quotation locking or crossing the market. Currently, when markets are 
not locked or crossed, SOES provides market makers with a 15-second 
period of time following their receipt of a SOES execution report to 
update their quotation before being required to execute another order 
in that security through SOES. The NASD represented in its filing that 
when the market for a Nasdaq National Market security is locked or 
crossed,\6\ however, SOES is currently designed so that the market 
maker whose quotation is locked or crossed and the market maker who has 
entered a locking or crossing quotation will have SOES orders 
representing shares equal to the SOES minimum exposure limit \7\ or the 
firm's exposure limit, whichever is greater, executed by SOES against 
the market maker's account without any delay between SOES executions 
(``locked and crossed market rule'').\8\ Thus, in such instances, 
unlike the operation of SOES during non-locked or crossed markets, the 
market maker's account will receive SOES executions without any delay 
between executions until its exposure limit is exhausted. In addition, 
during locked or crossed markets, SOES orders are executed against 
market makers whose quotations are locked or crossed irrespective of 
any preference indicated by the SOES order entry firm.
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    \6\ Quotations are ``locked'' when the bid price quoted by one 
market maker in a security equals the ask price quoted by another 
market maker in the same security. Quotations are ``crossed'' when 
the bid price quoted by one market maker in a security is greater 
than the ask price quoted by another market maker in the same 
security.
    \7\ The minimum exposure limit for SOES is currently twice the 
maximum SOES order size for a given security. Thus, the minimum 
exposure limit for a Nasdaq/National Market security in the 1,000-
share tier size is 2,000 shares. The NASD has filed a proposed rule 
change that would, among other things, eliminate minimum exposure 
limits in SOES. See Securities Exchange Act Release No. 38008 
(December 2, 1996), 61 FR 64550 (December 5, 1996) (publishing 
notice of filing of SR-NASD-96-43).
    \8\ See Rule 4730(b)(4). The Commission notes that Rule 
4730(b)(4) currently provides that ``a Market Maker with a quotation 
for that security in the Nasdaq System that is causing the locked or 
crossed market may have orders representing shares equal to the 
minimum exposure limit or the firm's exposure limit, whichever is 
greater, executed by SOES for that Market Maker's account at its 
quoted price if that price is the best price.'' Rule 4730(b)(4) by 
its terms does not apply to market makers whose quotations have been 
locked or crossed. The proposed rule would change this distinction 
and both types of firms to the Rule.
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    The locked and crossed market rule was intended to increase the 
accuracy of displayed quotations in NNM securities by providing an 
incentive for market makers to reduce the frequency and duration of 
locked and crossed markets.\9\
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    \9\ See Securities Exchange Act Release No. 25791 (June 9, 
1988), 53 FR 22594 (order approving SR-NASD-88-1). The NASD stated 
in its filing that prior to the approval of SR-NASD-88-1, SOES would 
not execute orders in locked and crossed markets.
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    The NASD stated in its filing that the magnitude of SOES orders 
received and executed during locked and crossed markets is such that 
market makers execute significant volume through SOES before they are 
able to rectify locked and crossed markets. The NASD further stated the 
rule change was intended to continue to provide market makers an 
incentive to update their quotations in locked and crossed markets 
while enhancing market makers' ability to react to SOES transactions in 
locked and crossed markets.\10\
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    \10\ The NASD indicated that many locked and crossed markets 
occur after trading halts are lifted or when market makers are 
adjusting their quotations in response to material news disclosed 
concerning the issuer of the security.
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II. Comments

    Morgan Stanley opposes the proposed rule change. It states that the 
interval proposed is too short for it to react to a locked or crossed 
market. It recommends a 15 second interval at a minimum, but argues 
that a SOES market maker whose quotation has been locked or crossed 
should not be subject to SOES executions for: (i) 90 seconds after its 
quotation has been locked or crossed; or (ii) whatever period of time 
is needed for the locking or crossing market maker to notify the NASD, 
and for the NASD, in turn, to notify the market maker that its 
quotation has been locked or crossed. It also recommends that NASD 
provide a market maker whose quotation has been locked or crossed with 
a warning window on its screen.

III. Discussion

    The Commission finds that the rule change is consistent with the 
provisions of Sections 15A(b)(6), 15A(b)(9), 15A(b)(11) and 
11A(a)(1)(C) of the Act and Rule 11Ac1-1 (``Quote Rule'') 
thereunder.\11\ 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. The Commission believes that 
the rule change will remove impediments to and perfect the mechanism of 
a free and open market and a national market system by providing Nasdaq 
market makers with a brief period to update their quotations during 
locked and crossed markets before being subject to a SOES execution. 
The Commission recognizes that a locked or crossed market can occur 
during unusual market conditions. Consequently, it is not unreasonable 
to provide market makers with a very brief period to update their 
quotes. At the same time, market makers should have an incentive to fix 
a locked or crossed market as quickly as possible in order to correct 
the quotation anomaly. Thus, the quote update period for locked and 
crossed markets should be as short as possible. The Commission believes 
that the rule strikes this balance by encouraging market makers to 
remedy quickly locked and crossed markets that occur, given that market 
makers will continue to face executions at intervals that are less than 
one-third of the length of intervals between unpreferenced SOES 
executions during times when markets are not locked or crossed.
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    \11\ Section 15A(b)(9) provides that the rules of the NASD must 
not impose any burden on competition not necessary or appropriate in 
furtherance of the purposes of the Act. Section 15A(b)(11) directs 
the NASD to adopt rules designed to produce fair and informative 
quotations, prevent fictitious and misleading quotations, and 
promote orderly procedures for collecting and distributing 
quotations. Section 11A(a)(1)(C) of the Act states that it is in the 
public interest and appropriate for the protection of investors and 
the maintenance of fair and orderly markets to assure, among other 
things, (i) economically efficient execution of securities 
transactions; (ii) fair competition among brokers and dealers; and 
(iii) the practicality of brokers executing investor orders in the 
best market.
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    The Commission does not believe that the alternatives recommended 
by Morgan Stanley provide market makers with a sufficient incentive to 
remedy locked and crossed markets that occur. Therefore, it disagrees 
with Morgan Stanley's argument. The Commission also notes that the 
rules change will continue to permit retail investors to have immediate 
access to the best prices displayed by Nasdaq market makers on Nasdaq 
because SOES will continue to execute trades during locked and crossed 
markets. By contrast, Morgan Stanley's suggestion that the NASD not 
permit executions against a market maker's quotation that has been 
locked

[[Page 1353]]

or crossed until the locking or crossing market maker has notified the 
NASD, and the NASD, in turn, has notified the market maker that its 
quotation has been locked or crossed, would be highly inefficient and 
would be inconsistent with the NASD's statutory mandate that its rules 
remove impediments to and perfect the mechanism of a free and open 
market. The Commission also notes that each of the alternatives 
suggested by Morgan Stanley would inhibit the ability of investors to 
obtain executions at a market maker's displayed quotations if it were 
implemented. Thus, the Morgan Stanley alternatives do not give due 
recognition to the interests of investors or to the interest of the 
NASD in discouraging locked and crossed markets.
    The 5-second interval between SOES executions during locked and 
crossed markets will apply to all SOES users and participants. Although 
the proposal will limit to a small extent the ability to investors to 
obtain executions in locked and crossed markets by providing a 5-second 
interval between executions, the Commission believes that the rule 
change appropriately balances the interests of investors and the need 
for market makers to have a very brief period to update their 
quotations expeditiously in locked or crossed markets. The rule change 
also is intended to enhance the production of fair and orderly 
quotations in NNM securities. This, in turn, should encourage market 
makers to enter more competitive quotations.
    The Quote Rule requires that brokers and dealers execute orders to 
buy and sell securities at their published quotes unless communicating 
a revised bid or offer or unless updating their quotations in response 
to an execution. The 5-second interval is intended to provide market 
makers with an opportunity to update their quotations in response to an 
execution. Market makers who do not so will be required to execute 
further transactions at their published bid or offer. \12\ The 
Commission notes that if the NASD adopted either alternative suggested 
by Morgan Stanley, Nasdaq market makers would not be required to 
execute orders to buy and sell securities at their published quotes 
even when they are not communicating a revised bid or offer or updating 
their quotations in response to an execution. \13\
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    \12\ See Securities Exchange Act Release No. 29801 (October 10, 
1991), 56 FR 52098 (approving 15-second interval following a market 
maker's receipt of a SOES execution report to update its quotation 
before being required to execute another order in that security 
through SOES).
    \13\ Morgan Stanley argues that market makers whose quotes have 
been locked or crossed may not always have adequate notice that 
their quotation has been locked or crossed. It recommends that the 
NASD provide a market maker whose quotation has been locked or 
crossed with a warning window on its screen. While the suggestion 
has merit, the Commission does not believe that it is a necessary 
prerequisite for approving a rule change providing market makers 
with five additional seconds to update their quotations.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change SR-NASD-95-54 be, and hereby is, 
approved.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority. \14\
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    \14\ 17 CFR 200.30-3(a)(12) (1989).
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[FR Doc. 97-445 Filed 1-8-97; 8:45 am]
BILLING CODE 8010-01-M
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