[Federal Register Volume 62, Number 8 (Monday, January 13, 1997)]
[Notices]
[Pages 1788-1790]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-690]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38119; File No. SR-CHX-96-16]


Self-Regulatory Organizations; the Chicago Stock Exchange, Inc.; 
Order Granting Approval to Proposed Rule Change Relating to the Trading 
of Nasdaq/NM Securities on the CHX

January 3, 1997.

I. Introduction

    On June 14, 1996, the Chicago Stock Exchange, Inc. (``CHX'' or 
``Exchange'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend Article XX, Rule 37 and 
Article XX, Rule 43 relating to the trading of Nasdaq National Market 
(``Nasdaq/NM'') securities (previously known as NASDAQ/NMS securities) 
on the Exchange.\3\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On Dec. 19, 1996, the CHX filed Amendment No. 1 to its 
proposal. Letter from J. Craig Long, Attorney, Foley & Lardner, to 
Howard L. Kramer, Associate Director, Division of Market Regulation, 
SEC, dated Dec. 19, 1996. In Amendment No. 1, the CHX requested that 
the Commission approve the proposal on a pilot basis for a one year 
period.
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    The proposed rule change was published for comment in the Federal 
Register on July 2, 1996.\4\ No comments were received on the proposal.
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    \4\ See Securities Exchange Act Release No. 37369 (June 25, 
1996), 61 FR 34462 (July 2, 1996) (notice of File No. SR-CHX-96-16) 
(``Notice'').
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II. Background

    On May 4, 1987, the Commission approved certain Exchange rules and 
procedures relating to the trading of Nasdaq/NM securities on the 
Exchange.\5\ Among other things, these rules made the Exchange's BEST 
Rule guarantee (Article XX, Rule 37(a)) applicable to Nasdaq/NM 
securities and made Nasdaq/NM securities eligible for the automatic 
execution feature of the Exchange's Midwest Automated Execution System 
(``MAX system'').\6\
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    \5\ Securities Exchange Act Release No. 24424 (May 4, 1987), 52 
FR 17868 (May 12, 1987) (order approving File No. SR-MSE-87-2). See 
Securities Exchange Act Release Nos. 28146 (June 26, 1990), 55 FR 
27917 (July 6, 1990) (order expanding the number of eligible 
securities to 100); 36102 (August 14, 1995), 60 FR 43626 (August 22, 
1995) (order expanding the number of eligible securities to 500).
    \6\ The MAX system may be used to provide an automated delivery 
and execution facility for orders that are eligible for execution 
under the Exchange's BEST Rule and certain other orders. See CHX, 
Art. XX, Rule 37(b).
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1. BEST Rule \7\
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    \7\ See CHX Manual, Art. XX, Rule 37(a).
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    Currently, under the BEST Rule, Exchange specialists are required 
to guarantee executions of all agency \8\ market and limit orders for 
Dual Trading System issues \9\ and all agency market orders for Nasdaq/
NM securities, from 100 up to and including 2099 shares. Subject to the 
requirements of the short sale rule,\10\ the specialist must fill all 
agency market orders at a price equal to or greater than the national 
best bid or best offer (``NBBO''). For all agency limit orders in Dual 
Trading System issues, the specialist must fill the order if: (1) the 
NBBO at the limit price has been exhausted in the primary market; (2) 
there has been a price penetration of the limit in the primary market 
(generally known as a trade-through of a CHX limit order); or (3) the 
issue is trading at the limit price on the primary market unless it can 
be demonstrated that the order would not have been executed if it had 
been transmitted to the primary market or the broker and specialist 
agree to a specific volume related to, or other criteria for, requiring 
a fill.
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    \8\ The term ``agency order'' means an order for the account of 
a customer, but shall not include professional orders as defined in 
CHX, Article XXX, Rule 2, interpretation and policy .04. The Rule 
defines a ``professional order'' as any order for the account of a 
broker-dealer, the account of an associated person of a broker-
dealer, or any account in which a broker-dealer or an associated 
person of a broker-dealer has any direct or indirect interest. Id.
    \9\ According to the Exchange, Dual Trading System Issues are 
issues that are traded on the CHX, pursuant to unlisted trading 
privileges, and listed on either the New York Stock Exchange or 
American Stock Exchange. Telephone conversation on June 5, 1996 
between David T. Rusoff, Attorney, Foley & Lardner, and George A. 
Villasana, Attorney, Division of Market Regulation, SEC.
    \10\ While the Commission and the NASD have rules that prohibit 
short sales, under certain conditions, or securities registered on, 
or admitted to unlisted trading privileges on, a national securities 
exchange and short sales of securities traded on Nasdaq, there is no 
rule governing short sales in Nasdaq/NM securities traded on the 
CHX. See 17 CFR Sec. 240.10a-1 and NASD Rule 3350.
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2. MAX System

    The Exchange's MAX system provides for the automatic execution of 
orders that are eligible for execution under the Exchange's BEST Rule 
(i.e., agency market orders in securities listed on the NYSE or AMEX 
and Nasdaq/NM securities, as discussed above), and certain other 
orders.\11\
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    \11\ A MAX order that fits under the BEST parameters must be 
executed pursuant to BEST Rules via the MAX system. If the order is 
outside the BEST parameters, the BEST Rules do not apply, but MAX 
system handling rules do apply.
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    The MAX system has two size parameters which must be designated by 
the specialist on a stock-by-stock basis. Currently, the specialist 
must set the auto-execution threshold at 1099 shares or greater and the 
auto-acceptance threshold at 2099 shares or greater. In no event may 
the auto-acceptance threshold be less than the auto-execution 
threshold. If the order-entry firm sends an order through the MAX 
system that is greater than the specialist's auto-acceptance threshold, 
a specialist may cancel the order within three minutes of it being 
entered into MAX. If not canceled by the specialist, the order is 
designated as an open order.\12\ If the order-entry firm sends an order 
through MAX that is less than the auto-acceptance threshold but greater 
than the auto-execution threshold, the order is not available for 
automatic execution but is designated in the open order book. A 
specialist may manually execute any portion of the order; the 
difference must remain as an open order. If the order-entry firm sends 
an order through MAX that is less than or equal to the auto-execution 
threshold, the order is executed automatically.
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    \12\ If an oversized market or limit order is received by the 
specialist, he will either reject the order immediately or display 
it. If the order is displayed, the specialist will check with the 
order entry broker to determine the validity of the oversized order. 
During the three minute period, the specialist can cancel the order 
and return it to the order entry firm, but until it is cancelled the 
displayed order is eligible for execution. Although these procedures 
currently exist under CHX rules, the Commission has concerns as to 
whether the three minute period is necessary and urges the CHX to 
reduce the time period or otherwise address the necessity of the 
specialists' discretion during the three minute period. Moreover, 
the handling of orders by CHX specialists must still comply with the 
Commission's recently adopted Order Execution Rules (Securities 
Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290 (Sept. 
12, 1996)) and any subsequently issued interpretations of the Order 
Execution Rules.
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    The MAX system currently provides for a fifteen second delay 
between the time an agency market order is entered into the MAX system 
and the time it is automatically executed at the NBBO in

[[Page 1789]]

order to provide the specialist with an opportunity to provide price 
improvement to the order. If, however, the spread between the NBBO in a 
stock eligible for automatic execution in the MAX system is \1/8\ point 
at the time an order is entered into the MAX system, that order is 
executed immediately without the fifteen second delay. Non-marketable 
agency limit orders, subject to the BEST Rule, are automatically filled 
at the limit price when there is a price penetration of the limit price 
in the primary market.\13\
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    \13\ If, however, the difference between the trade-through price 
and the last sale price is greater than \1/4\ point or 1% of the 
value of the trade-through price, whichever is less, a second print 
at a trade-through price, which is less than \1/4\ point or 1% away 
from the previous trade-through price is necessary before that MAX 
system will automatically execute the agency limit order.
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III. Description of Proposal

    The Exchange proposes to end its requirement that CHX specialists 
automatically execute orders in Nasdaq/NM securities when the 
specialist is not quoting at the NBBO.
    Under the proposed revisions to the BEST Rule, specialists must 
continue to accept agency market orders or marketable limit orders, but 
only for orders of 100 to 1000 shares in Nasdaq/NM securities rather 
than the 2099 shares limit previously in place.\14\ Specialists must 
accept all agency limit orders in Nasdaq/NM securities from 100 up to 
and including 10,000 shares for placement in the limit order book. As 
described below, however, specialists would be required to 
automatically execute Nasdaq/NM orders only when they were quoting to 
the NBBO when the order was received.
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    \14\ The 100 to 2099 share auto-acceptance threshold previously 
in place will only continue to apply to Dually Listed securities.
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    The proposal requires the specialist to set the auto-executive 
threshold at 1000 shares or greater for Nasdaq/NM securities. Orders 
for a number of shares less than or equal to the auto-execution 
threshold set by the specialist will be automatically executed if the 
CHX specialist is quoting at the NBBO for the lesser of the size of the 
order or the specialist's quote. The orders are executed automatically 
after a fifteen second delay from the time the order is entered into 
MAX. The size of the specialist's bid or offer will automatically be 
decremented by the size of the execution. When the specialist's quote 
is exhausted, the system will generate an autoquote at \1/8\ point away 
from the NBBO for 1000 shares.
    When the specialist is not quoting a Nasdaq/NM security at the 
NBBO, it can elect, on an order-by-order basis, to manually execute 
orders in that security. If the specialist does not elect manual 
execution, MAX market and marketable limit orders in that security that 
are of a size equal to or less than the auto-execution threshold will 
automatically be executed at the NBBO after a twenty second delay.\15\
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    \15\ The CHX has clarified that the twenty second delay is 
designed, in part, to provide an opportunity for the order to 
receive price improvement from the specialist's displayed quote. Id.
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    Under the proposal, if the specialist elects manual execution, the 
specialist must either manually execute the order at the NBBO or a 
better price or act as agent for the order in seeking to obtain the 
best available price for the order on a marketplace other than the 
Exchange.\16\ If the specialist decides to act as agent for the order, 
the proposed rule requires the specialist to use order-routing systems 
to obtain an execution where appropriate. Market and marketable limit 
orders that are for a number of shares greater than the auto-execution 
threshold are not subject to these requirements, and may be canceled 
within three minutes of being entered into MAX or designated as an open 
order.
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    \16\ Letter dated Aug. 1, 1996 from David Rusoff, Attorney, 
Foley & Lardner, to George A. Villasana, Attorney, Securities & 
Exchange Commission.
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IV. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, with the requirements of Section 6(b).\17\ In particular, 
the Commission believes the proposal is consistent with the 
requirements of Section 6(b)(5) that the rules of an exchange be 
designed to promote just and equitable principles of trade, to prevent 
fraudulent and manipulative acts, and, in general, to protect investors 
and the public interest. The Commission also believes that the proposal 
is consistent with Sections 11A(1)(D) and 11A(1)(C) of the Act.
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    \17\ 15 U.S.C. 78f(b).
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    The CHX's proposal to not require automatic execution for Nasdaq/NM 
securities when the specialist is not quoting at the NBBO, and to allow 
the specialist to execute the order as agent, is intended to conform 
CHX specialist obligations to those applicable to OTC market makers in 
Nasdaq/NM securities, while recognizing that the CHX provides a 
separate, competitive market for Nasdaq/NM securities. The rules 
establish execution procedures and guarantees that attempt to provide 
an execution reflective of the best quotes among OTC market makers and 
specialists in Nasdaq/NM securities without subjecting CHX specialists 
to execution guarantees that are substantially greater than those 
imposed on their competitors.
    The Commission does not believe that the Act necessarily requires 
the CHX to provide automatic execution of orders. Nonetheless, if the 
CHX chooses to make available an order-routing system to its members, 
to be consistent with the Act, this system must not be designed in a 
manner that will result in customer orders receiving executions at 
prices worse than those reasonably available in the market, which 
generally would be the NBBO. Otherwise, members could violate their 
best execution duty to their customers if they used the system. The 
CHX's proposed modification of its MAX system seeks to ensure that 
customer orders receive the best prices by requiring specialists, if 
they do not execute orders automatically at the NBBO or better, at a 
minimum to represent the orders as agent off the Exchange.
    Under these circumstances, CHX Rule 43 requires a specialist to use 
order-routing systems where appropriate. At present, however, CHX 
specialists have available only limited order-routing systems. A CHX 
specialist currently can route orders to Nasdaq market makers only via 
the telephone or, if the CHX specialist is an NASD member, through 
Selectnet and SOES.\18\ Clearly, a more efficient linkage between the 
CHX and Nasdaq would better enable CHX specialists to access OTC market 
makers quickly on a consistent basis.
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    \18\ The CHX has represented that a CHX specialist in Nasdaq/NM 
securities, if not an NASD member, currently may use a CHX member 
that is also an NASD member to route orders via SelectNet and SOES 
to Nasdaq/NM market makers. The CHX has explained further that this 
access currently is provided by the NASD member to an existing CHX 
specialist in Nasdaq/NM securities, but the arrangement may not 
necessarily apply to any future CHX specialists in Nasdaq/NM 
securities. Thus, the CHX has indicated that it will not allocate 
any Nasdaq/NM securities to any additional CHX specialists until an 
order-routing linkage is completed between the CHX and the Nasdaq. 
Telephone conversation on October 29, 1996 between Craig Long, Esq., 
Foley & Lardner, and Betsy Prout Lefler, Esq., Division of Market 
Regulation, SEC.
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    While operation of the proposed system is not necessarily 
inconsistent with the duty of CHX specialists to provide best execution 
of customer orders, the Commission believes that the arrangement in 
place for specialists to access OTC market makers is not an ideal 
linkage between two markets on a permanent basis. Consequently, the CHX 
has represented that it intends to

[[Page 1790]]

work towards quickly establishing a linkage between the CHX systems and 
Nasdaq systems in order to permit market makers in each market to route 
orders to the other market center.\19\ Consequently, the Commission is 
approving the CHX proposal for only one year, during which time the 
Commission expects the CHX and Nasdaq to effectuate a linkage. The 
Commission also expects the CHX to monitor closely the executions 
provided to CHX market and marketable limit orders for Nasdaq/NM 
securities that are not automatically executed at the NBBO (or better) 
at the time the order is received. The Commission further requests that 
the Exchange submit to the Commission a report, based on six months of 
trading data, on or before 240 days following the issuance of this 
order, that describes the executions provided these orders.
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    \19\ See Amendment No. 1, supra note 3.
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    The Commission is approving the CHX proposal on a pilot basis for a 
one-year period beginning in January 1997 and extending through 
December 1997. The Commission's approval is based, in part, on CHX's 
expressed commitment to work in good faith with the Nasdaq, during the 
one-year pilot period, to set up an order routing system between the 
Nasdaq and the CHX.\20\
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    \20\ Id.
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V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\21\ that the proposed rule change (SR-CHX-96-16) is approved.

    \21\ 15 U.S.C. 78s(b)(2)
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\22\
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    \22\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-690 Filed 1-10-97; 8:45 am]
BILLING CODE 8010-01-M