39322 Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices

9As in the current rule, if no official statement

in final form is being prepared, such dealer would

deliver to the customer by settlement the official

statement in preliminary form, if any, and written

notice to the effect that an official statement in final

form is not being prepared. If neither a final nor a

preliminary official statement is being prepared, the

dealer would only be obligated to deliver by

settlement the written notice to the effect that no

official statement in final form is being prepared.

10The Commission has considered the proposed

rule’s impact on efficiency, competition and capital

formation. The amendment conforms the

requirements of MSRB Rule G–32 with those of SEC

Rule 15c2–12. Making the rules consistent lessens

the dealers’ burden of complying with one rule

while attempting to avoid violating the other. Also,

the dealer’s procedural and operational efficiency

should be enhanced as the date for determining

compliance will be that of receipt of some type of

notification from the issuer, which should make for

ease of recordkeeping and review. 15 U.S.C. 78c(f).

11Section 15B(b)(C) requires the Commission to

determine that the Board’s rules are 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 municipal securities, to

remove impediments to and perfect the mechanism

of a free and open market in municipal securities,

and, in general, to protect investors and the public

interest.

12See supra note 5 at p. 28810.

13 15 U.S.C. 78s(b)(2).

14 17 CFR 200.30–3(a)(12).

1 15 U.S.C. 78s(b)(1).

2 17 CFR 240.19b–4

3Concurrent with the March 5, 1998, filing,

NASD Economic Research published an economic

study entitled ‘‘Evidence from the Pilot Expansion

on November 10, 1997, and the Market Stress of

October 27 and 28, 1997’’ (‘‘March 1998 Study’’).

This study followed an earlier study the NASD

conducted to analyze the effects of the Actual Size

Rule entitled ‘‘Effects of the Removal of Minimum

Sizes for Proprietary Quotes in The Nasdaq Stock

Market, Inc.’’ (‘‘June 1997 Study’’). The findings the

NASD made in each of these studies are discussed

below. Both studies were made publicly available

through the NASD’s web site.

On January 10, 1997, the Commission approved

an NASD proposal to implement the Actual Size

Rule on a pilot basis from January 20, 1997 through

April 18, 1997. Exchange Act Release No. 38156, 62

FR 2415 (January 16, 1997) (SR–NASD–96–43).

Under the initial three-month pilot, Nasdaq market

makers could quote in minimum sizes of 100 shares

in the 50 Nasdaq securities subject to mandatory

compliance with Exchange Act Rule 11Ac1–4

(‘‘Limit Order Display Rule’’). The remaining

Nasdaq securities were still subject to the existing

minimum quotation display requirements for

proprietary quotes.

On April 15, 1997, the Commission approved an

NASD proposal that extended the 50-stock pilot

from April 18, 1997 to July 18, 1997. Exchange Act

Release No. 38512, 62 FR 19373 (April 21, 1997)

(SR–NASD–97–25). On July 18, 1997, the

Commission approved the NASD’s request to

extend the 50-stock pilot from July 18, 1997 to

December 31, 1997. Exchange Act Release No.

38851, 62 FR 39565 (July 23, 1997) (SR–NASD–97–

49).

On October 29, 1997, the Commission approved

the NASD’s proposal to extend the pilot from

December 31, 1997 through March 27, 1998, and to

customer by settlement, together with a

written notice that the official statement

in final form will be sent to the

customer within one business day of

receipt. Thereafter, once the dealer

receives the official statement in final

form, it must send a copy to the

customer within one business day of

receipt. If no official statement in

preliminary form is being prepared, the

dealer would only be obligated to

deliver by settlement the written notice

regarding the official statement in final

form and to send the official statement

in final form upon receipt.9

The amendment provides an alternate

method of compliance with Rule G–32

in the case of Exempt VRDOs where the

final official statement is either

unavailable or incomplete. However, in

those limited circumstances where

dealers may in fact receive the official

statement in final form in sufficient time

to deliver it to customers by settlement

(e.g., if an issuer approves completion of

the official statement in final form prior

to execution of the purchase contract),

dealers must comply with the existing

provision of the rule by delivering the

official statement in final form to the

customer by settlement. If the final

official statement is available or if the

issuer approves the final official

statement prior to settlement, then the

existing provision of the rule would

control. The dealer’s compliance in this

case would not be optional.

III. Discussion

The Commission believes the

proposed rule change is consistent with

the Act and the rules and regulations

promulgate thereunder.10 Specifically,

the Commission believes that approval

of the proposed rule change is

consistent with Section 15B(b)(2)(C) 11

of the Act. This proposed rule change

should remove any potential timing

discrepancies concerning dealer and

customer receipt of official statements.

The rule clarifies dealers’ disclosure

requirements; if a dealer receives an

official statement from the issuer,

concerning exempt VRDOs, then it must

deliver this official statement within

one business day of receipt.

The Commission recognizes the

Board’s effort to make the disclosure

requirements in Rule G–32 consistent

with the requirements delineated in

Rule 15c2–12 under the Act. The

Commission understands that the use of

securities with a demand feature (e.g.

VRDOs) allows issuers to acquire the

necessary financing while protecting

against interest rate risk. These types of

obligations permit the issuer to convert

outstanding debt from short-term

variable rate notes to long-term fixed

rates.12 It is possible that the maturities

or reset dates of these VRDOs could be

so brief (i.e, one day) that the issuer is

unable to provide an official statement

at settlement. Given the sophisticated

nature of these instruments and the

rapidity with which they can be

converted, the Commission urges

dealers to facilitate full and timely

disclosure to investors. While the

requirements of Rule 15c2–12 are

inapplicable to these obligations, sound

business practice and general antifraud

provisions of the federal securities laws

should dictate access to and disclosure

of information covered by this rule.

IV. Conclusion

For the above reasons, the

Commission believes that the proposed

rule change is consistent with the

provision of the Act, and in particular

with Section 15B(b)(2)(C).

It is therefore ordered, pursuant to

Section 19(b)(2) of the Act,13 that the

proposed rule change (SR–MSRB–98–

04), is hereby approved.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.14

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 98–19445 Filed 7–21–98; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–40211; File No. SR–NASD–

98–21]

Self-Regulatory Organizations;

National Association of Securities

Dealers, Inc.; Order Approving a

Proposed Rule Change to Permanently

Expand the NASD’s Rule Permitting

Market Makers to Display Their Actual

Quotation Size

July 15, 1998.

I. Introduction

On March 5, 1998, 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 (‘‘Commission’’ or ‘‘SEC’’)

a proposed rule change pursuant to

Section 19(b)(1) of the Securities

Exchange Act of 1934 (‘‘Exchange

Act’’), 1 and Rule 19b–4 thereunder,2 to

amend NASD Rule 4613(a)(1)(C)

permanently to allow market markers to

quote their actual size by reducing the

minimum quotation size requirement

for all Nasdaq securities to one normal

unit of trading (‘‘Actual Size Rule’’ or

‘‘ASR’’).3 The Commission issued the
Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices 39323

expand the pilot to 150 Nasdaq securities. Exchange

Act Release No. 39285, 62 FR 59932 (November 5,

1997) (SR–NASD–97–26). On March 25, 1998, the

Commission approved the NASD’s proposal to

extend the 150-stock pilot from March 27, 1998

through June 30, 1998. Exchange Act Release No.

39799, 63 FR 15467 (March 31, 1998) (SR–NASD–

97–26).

4Exchange Act Release No. 39760 (March 16,

1998) 63 FR 13894 (March 23, 1998) (File No. SR–

NASD–98–21).

5The text of the rule, as adopted, is as follows:

NASD Rule 4613 Character of Quotations

(a) Two-Sided Quotations

(1) No change.

(A)–(B) No change.

(C) A registered market maker in a security listed

on The Nasdaq Stock Market must display a

quotation size for at least one normal unit of trading

(or a larger multiple thereof) when it is not

displaying a limit order in compliance with SEC

Rule 11Ac1–4, provided, however, that a registered

market maker may augment its displayed quotation

size to display limit orders priced at the market

maker’s quotation.

6 17 CFR 240.11Ac1–4.

7 17 CFR 240.11Ac1–1.

8Exchange Act Release No. 37619A (September 6,

1996) 61 FR 48290 (September 12, 1996). With

respect to Nasdaq securities, the Order Handling

Rules were implemented according to the following

schedule: 50 Nasdaq securities became subject to

the rules on January 20, 1997; 50 more securities

became subject to the rules on February 10, 1997;

and an additional 50 securities became subject to

the rules on February 24, 1997. The remaining

Nasdaq securities wee phased in by October 13,

1997. Exchange Act Release No. 38490 (April 9,

1997) 62 FR 18514 (April 16, 1997); and Exchange

Act Release No. 38870 (July 24, 1997) 62 FR 40732

(July 30, 1997).

9 In the alternative, a market maker may

immediately execute the order or delivery the order

to an exchange or national securities association

sponsored system or an electronic communications

network (‘‘ECN’’) that complies with the ‘‘ECN

Display Alternative,’’ as described below.

10This amendment is known as the ‘‘ECN Rule.’’

11Access must be ‘‘[e]quivalent to the ability of

any broker-dealer to effect a transaction with an

exchange market maker or OTC market maker

pursuant to the rules of the exchange or association

to which the [ECN] supplies such bids and offers.’’

SEC Rule 11Ac1–1(c)(5)(ii)(B)(1).

12This alternative is known as the ‘‘ECN Display

Alternative.’’

13 In particular, NASD Rule 4613(a)(2) required

each market maker in a Nasdaq issue other than

those in the first 50 to enter and maintain two-sided

quotations with a minimum size equal to or greater

than the applicable SOES tier size for the security

(i.e., 1,000, 500 or 200 shares for Nasdaq National

Market securities and 500 or 100 shares for Nasdaq

SmallCap Market securities).

14See Exchange Act Release No. 38513 (April 15,

1997) 62 FR 19369 (April 21, 1997) (SR–NASD–97–

26).

15 Id.

16Release No. 39285, supra note 3, 62 FR at

59936–37. The NASD subsequently amended the

Continued

proposed rule change for comment on

March 16, 1998.4 For the reasons

discussed below, the Commission is

approving the proposed rule change.5

II. Background

A. The SEC’s Order Handling Rules and

the Actual Size Rule Pilot Program

On August 29, 1996, the Commission

promulgated a new rule, the Limit Order

Display Rules,6 and adopted

amendments to the Quote Rule 7 which

together are designed to enhance the

quality of published quotations for

securities and promote competition and

pricing efficiency in U.S. securities

markets (collectively, the ‘‘Order

Handling Rule’’).8 The SEC’s Limit

Order Display Rule generally requires a

market maker to display customer limit

orders that (1) are priced better than a

market maker’s quote, or (2) add to the

size associated with a market maker’s

quote when the market maker is at the

best price in the market.9 The Limit

Order Display Rule gives investors the

ability to directly advertise their trading

interest to the marketplace, enabling

them to trade inside the current bid-ask

spread and thereby compete with

market maker quotations and narrow the

size of the bid-ask spread. The Order

Handling Rules amended the SEC’s

Quote Rule to require a market maker to

display in its quote any better priced

orders that it places into an ECN such

as the NASD’s SelectNet service

(‘‘SelectNet’’) or Instinet.10

Alternatively, instead of updating its

quote to reflect better priced orders

entered into an ECN, a market maker

may comply with the display

requirements of the ECN Rule through

the ECN itself, provided the ECN (1)

ensures that the best priced orders

entered by market makers into the ECN

are included in the public quotation,

and (2) provides ‘‘equivalent’’ access 11

to the ECN for brokers and dealers that

do not subscribe the ECN, so that those

brokers and dealer may trade with

orders entered into the ECN.12

On January 10, 1997, the Commission

approved certain amendments to

Nasdaq’s Small Order Execution System

(‘‘SOES’’) and SelectNet to help

implement the Order Handling Rules

and accommodate changes in the

Nasdaq market that these rules brought

about. For instance, the Commission

approved, on a temporary basis, the

Actual Size rule for the first 50

securities subject to the Order Handling

Rules. Under the Actual Size Rule pilot,

Nasdaq market makers were only

required to display a minimum

quotation size of one normal unit of

trading (100 shares) when quoting solely

for their own proprietary accounts in

the first 50 securities. Market makers

could display a grater quotation size if

they chose to (or if required to do so by

the Limit Order Display Rule). For

Nasdaq securities other than the first 50,

minimum quotation size requirements

of 1,000, 500, or 200 shares continued

to apply.13 Neither the minimum

quotation size requirements nor the

Actual Size Rule negate a market

maker’s obligation to display the full

size of a customer limit order. If a

market maker is required to display a

customer limit order for 200 or more

shares, for example, it must display a

quote size reflecting the size the

customer’s order, absent an exception to

the Limit Order Display Rule.

In its finding with the Commission

proposing the initial Actual Sizes Rule

pilot, the NASD contended that changes

to the dealer market brought about by

the Order Handling Rules rendered

mandatory minimum quote sizes

unnecessary. The NASD also contended

that economic theory suggested the

Actual Size Rule could result in longterm benefits such as increased

competition. Finally, the NASD’s noted

that empirical research indicated that

neither investors nor the Nasdaq market

would be adversely impacted by the

Actual Size Rule. Specifically, the

NASD argued that the Actual Size Rule

would give market makers more

flexibility to manage risk and quote

prices more favorable to small retail

investors. In addition, the NASD argued

that requiring a minimum commitment

of market maker capital while allowing

ECNs and investors (including

professional ‘‘day traders’’) to display

their orders without imposing a similar

minimum size commitment on them

could severely impair market makers’

ability to set competitive quotations.

April 11, 1997, the NASD filed a

proposal with the Commission to extend

the pilot until at least December 19,

1997, and to expand the number of

stocks in the pilot to include the next

100 stocks subject to the Order Handling

Rules.14 In that filing, the NASD

indicated that its research department

had studied the effects of the Order

Handling Rules and the Actual Size

Rule and found that: (1) The Order

Handling Rules dramatically improved

the quality of the Nasdaq market by,

among other things, narrowing quoted

spreads; (2) among those securities

subject to the Order Handling Rules,

there was no appreciable difference in

market quality between stocks subject to

the Actual Size Rule and stocks subject

to mandatory quote size requirements;

and (3) implementation of the Actual

Size Rule did not significantly diminish

the ability of investors to receive

automated executions through SOE,

Select Net, or proprietary systems

operated by broker-dealers.15 Based on

these findings, the NASD concluded

that mandatory quote size requirement

were no longer needed.16
39324 Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices

filing to change the extension date from December

19, 1997 to March 27, 1998, and to change the

selection methodology for the next group of 100

stocks to be subject to the pilot. The methodology

used to determine the next 100 securities is

discussed further below.

17See Exchange Act Release No. 38720 (June 5,

1997) 62 FR 31856 (June 11, 1997).

18 Id.

19See Exchange Act Release No. 38872 (July 24,

1997) 62 FR 40879 (July 30, 1997).

20See, e.g., letter from David K. Whitcomb,

Professor of Finance, Rutgers University, to

Jonathan Katz, Secretary, SEC, dated July 3, 1997.

21See letter from Robert E. Aber, Vice President

and General Counsel, Nasdaq, to Katherine A.

England, Assistant Director, SEC, dated September

15, 1997.

22One hundred and ten stocks were chosen to

replace four of the original stocks that were

delisted, to accommodate possible delistings, and to

ensure that 150 stocks would be available under an

expanded Actual Size Rule pilot.

23Release No. 39285.

24 Id. at 59936.

25On March 25, 1998, the Commission approved

a rule change proposed by the NASD to extend the

pilot from March 27, 1998 through June 30, 1998.

Exchange Act Release No. 39799, 63 FR 15467

(March 31, 998) (SR–NASD–97–26).

26 In particular, the Commission asked the NASD

to analyze: (1) the number and composition of the

market makers in each stock; (2) the average

aggregate dealer and inside spread; (3) the average

spread of each market maker by stock; (4) the

average depth by market maker (including limit

orders) and any change in depth over time; (5) the

fraction of volume executed by each market maker

that is at the inside quote per stock; and (6) the

amount of volume required to move the price of

each security one increment. Release No. 39285,

supra note 3, at 62 FR 59937.

27The study reviews data for 18 trading days

between October 13, 1997 and November 7, 1997,

(October 27, 1997 and October 28, 1997, are

excluded and analyzed separately) and compares

this data to 20 trading days between November 10,

1997 and December 9, 1997.

28See March 1998 Study at 84–89.

29Quoted dollar spread is the difference between

the inside ask and inside bid. Individual dollar

spreads were weighted by the amount of time each

spread was in effect for the day, i.e., the spread’s

duration.

30Effective spread is twice the absolute difference

between the trade price and the bid-ask midpoint

(‘‘BAM’’). Thus, the effective spread is intended to

account for trades executed at prices inside the

spread.

On June 3, 1997, the NASD

supplemented its proposal with its first

comprehensive study of the potential

impact of the Actual Size Rule on stocks

for which the mandatory size minimum

quote requirements were relaxed (‘‘pilot

stocks’’). The results of the study

indicated that implementing the Actual

Size Rule did not adversely affect the

market quality of pilot stocks. The June

1997 Study analyzed standard measures

of market quality, including spread,

volatility, liquidity, and depth. In

addition, the study examined investors’

ability to access market maker capital

through SOES and proprietary

automatic execution systems. The study

suggested that for pilot stocks, investors

continued to have reasonable and

substantial access to market maker

capital through automatic execution

systems.17 To provide the public with

an opportunity to review and comment

on the June 1997 Study, the

Commission extended the comment

period on the NASD’s proposal until

July 3, 1997.18 On July 17, 1997, the

NASD amended the filing at the

Commission’s request to extend the

pilot until March 27, 1998, to give the

Commission more time to evaluate the

economic studies on the proposal and to

review comments on the June 1997

Study.19

Notwithstanding the results of the

June 1997 Study, some commenters

expressed concerns about the proposal

to expand the Actual Size Rule. In

particular, some commenters noted that

the pilot had been limited to only 50

Nasdaq securities and that these

securities generally represent the most

liquid Nasdaq stocks.20 In addition, the

proposed expansion of the Actual Size

Rule would apply to those 100 stocks

that were subsequently phased in under

the Order Handling Rules. Those stocks

were also drawn from the most liquid

Nasdaq stocks. Thus, it was argued that,

even an expanded pilot would still be

skewed toward larger, more active

issues.

On September 15, 1997, in response

to these concerns, the NASD amended

its proposal to change the selection

methodology for the next group of

securities to be subject to the pilot to

provide an enhanced sample that better

represents the entire Nasdaq market.21

Specifically, the remaining Nasdaq

National Market issues were divided

into deciles based on average daily

dollar volume. One hundred and ten

stocks were then chosen by randomly

selecting approximately the same

number from each decile.22 As

expanded, the pilot provided additional

data across a range of securities, thereby

permitting an enhanced evaluation of

the effects of the Actual Size Rule pilot.

On October 29, 1997, the Commission

approved the NASD proposal, as

amended, to expand the Actual Size

Rule pilot to include 150 stocks and to

extend the pilot through March 27,

1998.23 In approving the proposal, the

Commission stated its belief that the

preliminary data indicated that the pilot

had not resulted in any degradation to

Nasdaq market quality, and that the

Actual Size Rule appeared to be a

reasonable means to provide market

making obligations that reflect the new

market dynamics produced by the Order

Handling Rules.24 Nonetheless, the

Commission decided that it would be

appropriate to consider additional data

that could be gathered using the more

representative sample of Nasdaq stocks

before determining whether to expand

the Actual Size Rule to the entire

Nasdaq market.25

The Commission asked the NASD to

continue evaluating the effects of the

Actual Size Rule and identified several

areas to be analyzed.26 The Commission

also asked the NASD to compare data

among deciles of Nasdaq stocks,

focusing attention on active versus

inactive stocks. In response, the NASD

produced a second study (‘‘March 1998

Study’’) which addressed the effects of

the Actual Size Rule, as expanded.

B. Findings of the NASD’s March 1998

Study

In the March 1998 Study, the NASD

sought to determine the impact of the

Actual Size Rule on Nasdaq market

quality and on investors’ access to

automatic execution systems (including

SOES). To do so, it compared securities

subject to the Actual Size Rule’s 100-

share minimum quote size with a

control group of peer stocks still subject

to mandatory minimum quote size

requirements. The March 1998 Study

compared these two groups of securities

after the Order Handling Rules had been

fully implemented, thus, quote size was

meant to be the only significant

difference between the two groups of

securities.

The study compared measures of

market quality for a group of stocks that

joined the pilot (pilot stocks) to a

control group of peer stocks (non-pilot

stocks) that remained subject to

mandatory minimum quote sizes.27 Like

the June 1997 Study, the March 1998

Study concluded that the Actual Size

Rule had no material effect on Nasdaq

market quality or investors’ access to

automatic execution systems (including

SOES).28

1. The Actual Size Rule’s Impact on the

Quality of the Nasdaq Market

The NASD analyzed several measures

of market quality in the March 1998

Study: spread, volatility, depth, and

liquidity. Each of these measures is

discussed below.

a. Spread Measures

The NASD used two methods to

calculate spreads: quoted dollar

spread 29 and effective spread.30 The

‘‘quoted dollar spread’’ of the pilot

stocks fell 3.8% from a time before the

Actual Size Rule was implemented to a

time when it applied to the securities in

the sample. The quoted dollar spread for

the non-pilot stocks fell 4.8% over the

same period. Based on a multivariate
Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices 39325

31See. e.g., March 1998 Study at 78.

32These measures are described fully in the

NASD’s March 1998 Study at 77–84.

33Roughly 85% of orders in the tested group of

pilot stocks during the periods analyzed by the

March 1998 Study were for the tier size maximum,

i.e., 1,000 shares. This proportion did not materially

change after these stocks became subject to the

Actual Size Rule.

34The participant firms were: Goldman, Sachs &

Co.; Herzog, Heine, Geduld, Inc.; Knight Securities,

L.P.; Bernard L. Madoff Investment Securities;

Mayer & Schweitzer, Inc.; Prudential Securities,

Inc.; PaineWebber, Inc.; Smith Barney, Inc.; and

Troster Singer Stevens Rothchild Corp.

regression analysis performed by the

NASD, which controlled for stockspecific changes in volume, price, and

interday volatility, the NASD concluded

that the decrease in the quoted dollar

spreads of the two groups of securities

is statistically insignificant.

The ‘‘effective spread’’ (for trades of

all sizes) of the pilot stocks fell 2.6%

post-implementation, while the effective

spread for the non-pilot stocks fell

5.7%. The NASD performed a

multivariate regression analysis and

concluded that the difference between

the declines in the effective spreads for

the two groups of stocks is statistically

insignificant. Thus, under either spread

measure, the NASD’s statistical data

suggests that the Actual Size Rule did

not have a material adverse impact on

the spreads for ASR securities compared

to non-ASR securities over the period of

the study.

b. Volatility

Intraday volatility decreased slightly

between the pre- and postimplementation periods for both the

pilot stocks and non-pilot stocks. Mean

volatility fell 5.8% for the pilot stocks

and 3.4% for the non-pilot stocks.

Again, the NASD performed a

multivariate regression analysis and

concluded that this difference is

statistically insignificant. Thus, the

NASD’s data suggests that implementing

the Actual Size Rule did not materially

adversely impact the intraday volatility

of ASR securities compared to non-ASR

securities over the period of the study.

c. Depth

The NASD’s study also looked at the

number of shares Nasdaq market makers

were willing to quote at the inside

market using a measure called ‘‘mean

aggregate quoted depth.’’ Using this

measure, the amount of depth provided

by market makers at the inside market

dropped by 5.2% for the pilot stocks,

and by 5.8% for the non-pilot stocks.

When ECN quotes at the inside are

included, mean aggregate quoted depth

fell by 2.0% for the pilot stocks and by

2.7% for the non-pilot stocks. Again,

based on multivariate regression

analysis performed by the NASD, these

differences are not statistically

significant. Thus, the NASD data

suggests that the Actual Size Rule did

not materially adversely impact the

depth of pilot securities compared to

non-pilot securities over the period of

the study.

Furthermore, neither the mean

number of market makers nor the mean

number of market makers at the inside

changed significantly for either stock

group after implementation.

d. Liquidity

While liquidity is an important

element of market quality, it is difficult

to measure empirically. A common

liquidity measure is ‘‘effective depth’’ 31

or the amount of volume it takes to

move the spread a predetermined

amount in one direction or the other. A

refinement to effective depth, called

‘‘normalized effective depth,’’ makes the

measure more precise across varying

stock prices.32 Using this measure of

liquidity, the NASD concluded in the

March 1998 Study that the Actual Size

Rule did not materially adversely

impact the liquidity of pilot securities

compared to non-pilot securities over

the period of the study.

2. Actual Size Rule’s Impact on

Investors’ Access to SOES

In the March 1998 Study, the NASD

also analyzed the potential impact of the

Actual Size Rule on investors’ access to

market makers through SOES or brokerdealers’ proprietary automatic execution

systems. According to the NASD, the

data suggests that implementation of the

Actual Size Rule has not materially

adversely impacted investors’ ability to

access Nasdaq market makers through

these systems.33 Specifically, the NASD

found that 98.5% of SOES orders in the

pilot stocks were fully executed at a

single price after these stocks became

subject to the Actual Size Rule. The

NASD also found that for the non-pilot

stocks, 98.9% of SOES orders were fully

executed at a single price, a statistically

insignificant difference. The average

size of an executed SOES order in the

pilot stocks fell by 18 shares after the

expansion of the pilot program; for the

non-pilot stocks, the average size of an

executed SOES order fell by 23 shares.

The NASD concluded that this is a

statistically insignificant difference.

The NASD also studied broker-dealer

automatic proprietary execution

systems. The March 1998 Study

analyzed data from nine broker-dealers

(‘‘Participant Firms’’) 34 and found that

these systems constitute a significant

proportion of trading activity by the

Participant Firms. The March 1998

Study found no evidence that the Actual

Size Rule had any effect on these

systems’ activity. Specifically, the mean

number of automatic execution trades as

a percentage of all trades for Participant

Firms increased from 37.8% to 38.4%

for the pilot stocks and from 34.5% to

36.2% for the non-pilot stocks. The

mean automatic execution volume as a

percentage of all volume for the pilot

stocks increased from 30.8% to 31.2%;

for the non-pilot stocks, it increased

from 27.8% to 29.5%. These differences

were not statistically significant. Based

on the March 1998 Study, the NASD

concluded that the implementation of

the Actual Size Rule did not materially

adversely impact the average SOES

trade size or investors’ access to market

makers through SOES or broker-dealer

proprietary systems in pilot versus nonpilot stocks over the period of the study.

The extreme market conditions of

October 27 and 28, 1997, provided

another test of the potential impact of

the Actual Size Rule on the Nasdaq

marketplace. On October 27, 1997, the

Nasdaq Composite Index fell by 7.02%

and cross-market circuit breakers were

implemented. On October 28, 1997, the

Nasdaq Composite index declined by

4.37% by 9:41 a.m. before rebounding

and ending up 4.43% for the day. Both

days experienced record trading

volume. The March 1998 Study

compared the market quality (as

measured by spreads, volatility, depth,

and liquidity, as discussed above) and

investor access to SOES (and other

automatic execution systems) for a

group of the original pilot stocks with

that of a group of peer stocks subject to

minimum quote size requirements. The

NASD concluded in the March 1998

Study that the Actual Size Rule had no

material adverse impact on market

quality during this period of intense

market stress. Further, the NASD

concluded that investors’ ability to

access market maker capital for pilot

stocks versus non-pilot stocks was not

materially adversely impacted during

this period.

III. Comment Letters

The Commission received 274

comment letters from numerous entities,

including market makers, full service

broker-dealers, order entry firms, SOES

traders, academics, individual investors,

professional associations, and a national

securities exchange. Of these, 53 favored

the Actual Size Rule, 218 opposed it,

and three did not clearly state a

position. Proponents included

representatives of the market maker and

institutional trading communities.

Among opponents were numerous

individuals associated with day trading
39326 Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices

35See NASD Response.

36The STA describes itself as having

approximately 7,700 individual members.

37The SIA describes itself as being composed of

nearly 800 securities firms, employing more than

380,000 individuals. The SIA also states that its

members include investment banks, broker-dealers,

and mutual fund companies that are active in all

markets and in all phases of corporate and public

finance.

38The ICI describes itself as the national

association of the investment company industry.

Founded in 1940, its membership includes 6,976

mutual funds, 447 closed-end funds, and 10

sponsors of unit investment trusts. Its mutual fund

members represent more than 63 million individual

shareholders and manage more than $5 trillion.

39The Chicago Stock Exchange, Inc. (‘‘CHX’’) also

submitted a letter, although it neither favored nor

opposed adoption of the Actual Size Rule. See CHX

Letter.

40ACIM Describes itself as managing over $70

billion for investors in the Twentieth Century,

Benham, and American Century families of mutual

funds.

41See, e.g., Merrill Letter; Credit Suissee Letter;

J.P. Morgan Letter; STA Institutional Letter; ICI

Letter.

42See, e.g., M.H. Meyerson Letter, Crawford,

Letter.

43See M.H. Meyerson Letter.

44See, e.g., JP Morgan Letter; Ohio Letter; Marino

Letter; Merrill Letter; Knight Letter; 4/29 and 4/1

STA Letter; Jefferies Letter; Howard Letter’ STANY

Letter; and Weeden Letter.

45See, eg., Cantor Letter; Morgan Letter; Knight

Letter; STANY Letter; Credit Suisse Letter; Salmon

Letter; Suntrust Letter; 3/6 and 4/1 Walters Letter;

and Morgan Keegan Letter.

46

47See ICI Letter.

48See Weeden Letter.

49See Credit Suisse Letter.

50See Interstate Letter.

51See STA Institutional Letter.

52See Kinnard Letter; R. King Letter; Marino

Letter; Singh Letter; STA Institutional Letter; and

Lehman Letter.

53See, e.g., NAIB Letter; Morgan Letter; Knight

Letter; Salomon Letter; Morgan Keegan Letter; 4/29

and 4/1 STA Letters; Interstate Letter; STANY

Letter; STA Institutional Letter; ICI Letter; Wood

Letter; Credit Suissee Letter; and ITAP Letter.

54See Mortgan Letter; Interstate Letter; and

Barone Letter.

55See, e.g., M.H. Meyerson Letter.

56See Kaplowitz Letter.

57See American Century Letter; Anonymous

Letter; and Morgan Keegan Letter.

58See Ohio Letter.

59See e.g., Howard Letter; Lopez-Rodriguez

Letter; TD Letter; and STANY Letter.

firms and users of the SOES system.

Although opponents of the proposal

raised concerns about the effects of the

Actual Size Rule on access to executions

and market maker capital as well as the

proposal’s impact on market factors

including liquidity, volatility, and

spreads, proponents countered that the

proposal would enable market makers to

manage risk better and to provide

capital to the market more efficiently.

The NASD also submitted a letter

addressing the comments the

Commission received.35

The Commission has considered all of

the comments it received on the

proposal. Due to the large number of

comment letters, a complete, separate

summary of comments has been

prepared and is available in the public

file. The most significant comments are

discussed below.

A. Comments Favoring the Actual Size

Rule

Of the 274 comment letters the

Commission received, 53 support

permanent expansion of the Actual Size

Rule. Among these are letters from trade

groups such as the Security Traders

Association (‘‘STA’’),36 the Securities

Industry Association Industry

Association (‘‘SIA’’),37 and the

Investment Company Institute (‘‘ICI’’),38

as well as numerous brokerage firms.39

The Commission also received a

comment letter from American Century

Investment Management (‘‘ACIM’’)

supporting the proposal.40 Generally, a

number of market participants stated

that the NASD’s data and analysis—

including its conclusions based on both

economic theory and empirical results—

is consistent with the marketplace’s

experience with the Actual Size Rule.41

Proponents of the Actual Size Rule

contend that the rule contributes to a

more efficient and transparent market—

a market that, ultimately, benefits

investors. Several commenters state that

the Actual Size Rule aids their market

making activities and allows them to

better serve their customers.42 One firm

states that it has ‘‘become more active in

the stocks under the Pilot program due

to [its] ability to properly manage [its]

capital risk.’’ 43 Several commenters

note that by cutting barriers to entry, the

Actual Size Rule should encourage

market maker participation, including

that of smaller firms.44 Further, several

commenters believe that market makers’

ability to commit capital more freely

will enhance pricing efficiency and the

competitiveness of dealer quotations,

and increased price competition and the

entry of more market makers will help

investors.45

In addition, one commenter, whose

company’s stock was in the pilot, cites

benefits to his company’s stock from

pricing efficiencies.46 Another

commenter feels the Actual Size Rule is

in the best interest of investors,

including those households owning

shares of equity mutual funds.47 An

institutional firm commented that the

Actual Size Rule helps give a true look

at the depth and quality of markets and

helps to ensure fairer pricing of

institutional blocks.48

In addition to creating a market that

better represents trading interests,

commenters feel the Actual Size Rule

can make the Nasdaq market more

competitive with other securities

markets. One commenter notes that the

Actual Size Rule could remove

competitive burdens on Nasdaq market

participants by leveling the playing field

between primary markets in the United

States.49 Another commenter notes that

if Nasdaq market making requirements

were made more equivalent to other

equity markets that do not have a 1,000

share quotation minimum, Nasdaq

market makers could more efficiently

price stock absent a multitude of

‘‘unnatural and unwanted positions.’’ 50

One commenter posits that if, as studies

show, market quality is maintained

under the Actual Size Rule, Nasdaq

should not be the only equity market

forcing market makers to deploy capital

to create artificial liquidity.51

Commenters also considered the

impact of the Actual Size Rule on the

Nasdaq market and the need for the

Actual Size Rule in the context of more

general changes to markets. Some

commenters discussed what they

perceive as a move from a quote to an

order driven market due to institution of

the Ordering Handling Rules.52 For

some, this perceived movement removes

the need for a mandatory minimum size

requirement.53 Others note that

mandatory minimum quote size gave

investors access to the market, but now,

through the Limit Order Display Rule,

they have access by being able to impact

stock prices and the size of quotes by

displaying their limit orders.54 In sum,

several commenters feel that the Order

Handling Rules make mandatory size

requirements unnecessary by, among

other things, providing a new source of

liquidity.55 Several commenters

therefore believe that in this new, more

order driven market, if a market maker

mut display size greater than all other

market participants, it may avoid being

at the inside, which could reduce

liquidity.56

Commenters also evaluated the Actual

Size Rule’s impact on market quality.

For instance, several commenters

argued that the Actual Size Rule

enhances liquidity. Notwithstanding the

NASD’s data to the contrary, some

commenters believe that liquidity

improved for pilot stocks and can be

further improved by expanding the

Actual Size Rule.57 One commenter

believes that if the Actual Size Rule is

permanently expanded, market makers

should be able to make markets in more

issues.58 Another states that lower

barriers to entry and fewer reasons to

exit will increase liquidity.59

Some commenters believe that

mandatory size requirements (which
Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices 39327

60See ITAP Letter; and Weeden Letter.

61See American Century Letter.

62See Crawford Letter.

63See Edward Letter.

64See Crowell Letter; and Weedon & Co. Letter.

65See NAIB Letter.

66See Salomon Letter; and TD Letter.

67See JP Morgan letter; See also, Bandler Letter;

Barone Letter; Wilson-Davis Letter; M.H. Meyerson

Letter; French Letter; Hughes Letter; and Knight

Letter.

68See JP Morgan Letter; see also note 73 and

accompany text.

69See Barone Letter; Kinnard Letter; Howard

Letter; Lopez-Rodriquez Letter; M.H. Meyerson

Letter; SIA Trading Letter; STA Institutional Letter;

4/29 and 4/1 STA Letters; and ITAP Letter.

70See American Century Letter.

71See Credit Suisse Letter.

72See Hughes Letter.

73See JP Morgan Letter; and Knight Letter.

74See Credit Suisse Letter.

75ETA is an association of about 50 order entry

firms and others interested in trading via computer.

76Whitcomb is also President and CEO of

Automated Trading Desk, Inc. (‘‘ATD’’). ATD

provides software and services for automated and

computer-assisted limit order trading.

77The ETA and Whitcomb each submitted several

comment letters concerning the Actual Size Rule

proposal and each incorporated these letters by

reference in the last submission. The Commission

has carefully considered all of the comment letters

the ETA and Whitcomb submitted, but for ease of

reference, only the last letter each submitted has

been cited.

78Simaan is an Associate Professor of Finance at

Fordham University. Simaan’s research was

supported by a grant from ETA. ATD supplied the

data for and supported Whitcomb’s research.

79See CHX Letter.

80See Klug Letter; Paracha Letter; and White

Letter.

81See Leland Letter.

82See 4/2/98 Getz Letter; see also Marungo Letter;

Williams Letter; Yoon Letter; ETA Letter; and

Whitcomb Letter.

83See G. Hunter Letter.

84See Ghazi-Moghadam Letter.

85See e.g., Andrews Letter; Gardner Letter; Ripoll

Letter; Spencer Letter; Teitelman Letter; Thiagarajah

Letter; Tieu Letter; Tom Letter; Truong Letter;

Woods Letter; and Whitcomb Letter.

86See Bunda Letter, Klug Letter; and Truong

Letter.

87See 4/2/98 and 3/23/98 Getz Letters.

88See Carpenter Letter and Dubey Letter.

adoption of the Actual Size Rule would

serve to reduce) increase volatility.60

One commenter compares mandatory

size to a free option for professional day

traders using SOES that exacerbates the

direction and velocity of price moves

during times of high volatility.61 A

commenter from a company whose

stock was in the pilot stated that when

his company’s stock became subject to

the Actual Size Rule, SOES activity

decreased, thus lessening volatility.62 A

similar comment was made by an

official of a brokerage firm about

securities subject to the Actual Size

Rule.63 Others felt that SOES abuses

along with mandatory size cause

volatility,64 and that the Actual Size

Rule could help reduce this excess

volatility.65

Commenters also contemplate the

legal justifications for approving the

proposal. Some commenters note that

neither the Exchange Act nor

Commission rules require quote sizes

larger than 100 shares.66 Another notes

that since the NASD’s research indicates

no harm to investors or the market by

the Actual Size Rule, the absence of the

Actual Size Rule renders market makers

less competitive than ECNs and

customer orders, neither of which have

a minimum size requirement.67 The

commenter contends that this disparity

violates Exchange Act Section

15A(b)(9), which prohibits NASD rules

imposing burdens on competition that

are not necessary or appropriate.68

Finally, proponents focus on

empirical research from the pilot to

support their contentions. Several

commenters found the NASD’s March

1998 Study reassuring because it found

no adverse effects on market quality for

the 150 securities subject to the Actual

Size Rule pilot.69 Another commenter

notes that the pilot was well

documented.70 Another notes that the

March 1998 Study is good because it

was conducted after the implementation

of the Order Handling Rules and

assessed only one significant policy

change for the pilot stocks—the

implementation of the Actual Size

Rule.71 In addition, the March 1998

Study’s finding of no adverse effect on

market quality and investor access to

capital led a commenter to conclude

that the next logical step is an Actual

Size Rule for all stocks.72 In fact,

commenters believed that given

Nasdaq’s findings, no justification exists

under the Exchange Act, including

Section 15A, for continued mandatory

size.73 Another commenter feels that

because the study shows no harm to the

market by the Actual Size Rule, no

reasonable basis exists for the

Commission to adopt larger and more

punitive minimum quote requirements

for Nasdaq market makers.74

B. Comments Opposing the Actual Size

Rule

Two hundred and eighteen letters

opposed permanent expansion of the

Actual Size Rule. Many are from daytraders who regularly place SOES

orders. The Electronic Traders

Association (‘‘ETA’’) 75 and David

Whitcomb (‘‘Whitcomb’’),76 Professor of

Finance at Rutgers University, also

opposed permanent expansion. The

positions of ETA and Whitcomb are

largely based upon Whitcomb’s

independent research on the impact of

the Actual Size Rule.77 Whitcomb and

ETA each attached to their respective

comment letters a December 31, 1997,

economic study (‘‘Simaan-Whitcomb

Study’’) prepared by Yusif Simaan and

Whitcomb.78 This study is discussed in

detail in part III.C. below.

Opponents of the Actual Size Rule

question the proposal’s ability to

improve the market’s transparency and

efficiency. One commenter notes that

when the Commission originally

approved the NASD’s mandatory quote

size requirements, it criticized market

makers for not quoting for more than

100 shares and believed that a

mandatory quote size requirement

would give investors greater access to

market information on the depth of the

market for a particular security.79 Some

commenters expressed concern that

market makers underrepresent share

size available.80 Another was concerned

that market makers do not fill their

entire quoted size.81

Some commenters feel that if the

elimination of the excess spread rule

and the concomitant cut in market

maker exposure did not encourage a

market maker influx, then the Actual

Size Rule will not.82 Others do not see

mandatory size as a barrier to market

makers, but a way to eliminate ‘‘fair

weather’’ market makers,83 and fell that

market do not need an incentive to take

risks for which they already receive

compensation.84

Some commenters view the Actual

Size Rule as unfair because it removes

a market maker responsibility while

market markers continue to receive the

same benefits for performing that

function. In particular, some

commenters note that market markers

get several benefits, including the ability

to sell short, special margin

requirements, prestige and

advertisement, spreads, and profits, and

the possibility of more privileges from

new systems in exchange for fulfilling

their responsibility of providing

liquidity and market stability, especially

during volatile markets.85 Some

commenters argue that if the mandatory

quote size requirement is eliminated,

then market maker benefits also should

be discontinued.86 A commenter notes

that market maker advantages allow

them to profit or hedge long positions

during declining markets, while

individual investors rely solely on

liquidity from market makers.87

Some commenters also worried that

the Actual Size Rule could hurt

Nasdaq’s reputation, perhaps leading

investors to turn away from Nasdaq.88

Some commenters argued that the

Actual Size Rule could also discourage
39328 Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices

89See A. Friedman Letter and Maschler Letter.

90See Arakawa Letter, Baldante Letter;

Bhattacharyya Letter; Cook Letter; and Finn Letter.

91See Cianfrani Letter.

92See Carlsson Letter.

93See Aunio Letter and Samarasinghe Letter.

94See Downing Letter; Garza Letter; Klarsfeld

Letter; Maschler Letter; Rock Letter; Romanow

Letter; Rosen Letter; Singh Letter; Taub Letter;

Wilson Letter; and Woods Letter.

95See Gallagher Letter; 4/2/98 Getz Letter; and

Haber Letter.

96See Downing Letter; Mesh Letter; Roffman

Letter; Rosenberg Letter; Stolker Letter; and

Villanueva Letter.

97See Gussin Letter; Levin Letter; Nadan Letter;

and Romanow Letter.

98See CHX Letter.

99See Andrews Letter; Barry Letter; and Davar

Letter.

100See Fennell Letter.

101See Tom Letter.

102See Angelica Letter; Atreya Letter; Cianfrani

Letter; Gleeson Letter; and Ripoll Letter; see also

ETA Letter and Whitcomb Letter.

103See ETA Letter and Whitcomb Letter.

104See, e.g., Andrews Letter; Crabb Letter; CHX

Letter; ETA Letter; Foster Letter; Gorman Letter;

Hollander Letter; M. Kallman Letter; Leffler Letter;

Maschler Letter; Nemeroff Letter; Walker Letter; and

Whitcomb Letter.

105See ETA Letter and Whitcomb Letter.

106See, e.g., Arakawa Letter; Eisner Letter; Israel

Letter; Rock Letter; Rudd Letter; and Williams

Letter.

107See Valentine Letter.

108See Francis Letter.

109See e.g., Downing Letter; Haber Letter; Letter;

M. Lu Letter; Teitelman Letter; and Woods Letter.

110See A. Friedman Letter.

111See e.g.,Andrews Letter; J. Goldstein Letter;

Pak Letter; Teitelman Letter; Wei Letter; Williams

Letter; and CHX Letter.

112See e.g.,Atreya Letter; Pflugfelder Letter; Tom

Letter; Truong Letter; Weber Letter; and West Letter.

113See Barry Letter and Kiefer Letter.

114See e.g., Maschler Letter; McDonald Letter;

Nadan Letter; Ryan Letter; Verbeke Letter; Weber

Letter; Williams Letter; and Yoon Letter.

115 If one or more ECNs (and no market makers)

are the only firms quoting the best bid or offer for

a particular security, then ECNs may be said to be

alone at the inside (bid or offer) for that security.

companies, particularly small,

innovative ones, from coming to

Nasdaq, for fear that their stocks would

not be adequately supported.89

Some commenters feel that past and

current instances of market maker

manipulation militate against giving

market makers the benefits of the Actual

Size Rule. They worry that the Actual

Size Rule system may harm the markets

generally by permitting market makers

to post small sized quotes during large

supply/demand imbalances when depth

and liquidity are at a premium.90 One

commenter envisioned market makers

manipulating the system to cut risk

exposure 91 and another noted that

thinly traded issues are the most likely

to be subjected to abuse as a result of the

Actual Size Rule.92 Some commenters

cite various past events indicating

market maker problems like the

publication of the Commission’s Report

Pursuant to Section 21(a) of the

Securities Exchange Act of 1934

Regarding the NASD and The Nasdaq

Stock Market (‘‘21(a) Report’’) and

litigation and settlements involving the

Nasdaq market and market Makers.

Such a history of market maker abuses,

they contend, undermines markets

maker arguments relating to a

competitive disadvantage resulting from

mandatory size.93 Moreover,

commenters claims that historic and

continuing abuses by market markers

counsel against taking a change on the

Actual Size Rule or providing further

opportunities for manipulation.94 For

example, some commenters suggest that

market makers use 100 share ‘‘customer

order’’ at the inside to hold stocks,95

and that they hinder the momentum of

stock movements and give themselves

time to back away from quotes.96 In

addition, some commenters contend

that market have modified their trading

behavior during the Actual Size Rule

pilot and in bigger stocks to mask what

may be the true adverse impact of the

Actual Size Rule, should the

Commission permanently approve it for

all Nasdaq stocks.97

Opponents of the Actual Size Rule

also focused on specific factors related

to market quality. For instance, one

commenter is uncertain whether the

Commission should approve the Actual

Size Rule at this time, arguing that

liquidity is the near-exclusive function

of market marker proprietary trading,

unlike at exchanges where liquidity is

mostly from persons other than

specialists effecting transactions in their

own accounts.98 Some question the

basic premise of an order-driven market,

indicating that the market still is and

needs to be a quote-driven, dealer

market.99

One commenter contended that in an

order driven environment, mandatory

quote size requirements coupled with

SOES ensure investors receive fair

executions in extreme market

conditions.100 Another posited that

customer orders cannot sustain the

market, especially in times of duress.101

Even if there is an order-driven market,

some commenters reject removing

market makers’ basic quote size

responsibility.102 Other commenters

claimed the NASD shows the ASR does

not contribute to the narrowing of

market maker spreads.103 Commenters

also expressed concern that the Actual

Size Rule will harm market liquidity,

perhaps leading to price fluctuations

and unfair prices.104 Commenters also

question the NASD’s evidence that the

Actual Size Rule helps to lower barriers

to market maker participation and thus

aids liquidity and pricing efficiency.105

In addition, commenters are concerned

that the Actual Size Rule’s effect on

heavily-traded issues would differ from

its effect on thinly-traded issues.106 One

commenter expressed concern about

mysterious fluctuations of size with

changed volume in particular stocks.107

There was also concern about lesser

known and start up issues where

liquidity is low and volatility is high.108

Some commenters suggest the Actual

Size Rule can or does increase

volatility.109 Another commenter notes

that volatility is particularly

problematic for thinly traded

securities.110 Some commenters

emphasize that the Actual Size Rule

decreases liquidity in an especially

negative way when volatility is high and

market makers would likely take actions

like dropping to a 100 share size.111

Commenters worry that during volatile

times, large sized orders would be

executed at unfair prices on different

tier levels as prices rise or fall.112 Some

commenters viewed the Actual Size

Rule as legitimizing ‘‘backing away’’ by

market makers.113 Some felt the events

of October 1997 illustrate the need for

market makers to quote mandatory

minimum size.114

C. The Simaan-Whitcomb Study

Because letters from the ETA and

Whitcomb were the only letters that

provided empirical data that conflicts

with that in the NASD’s studies, the

Commission thought it appropriate to

address these comments in greater

detail. The ETA and Whitcomb

comment letters make three basic

assertions regarding the Actual Size

Rule; (1) the body of empirical evidence

suggests that both market quality and

the ability of investors to use SOES has

been adversely affected by the Actual

Size Rule; (2) Nasdaq market making is

not fully competitive, and hence

conclusions that assume marketplace

competition are invalid; and (3) the

methodology employed in the analyses

conducted by the NASD is flawed. Both

letters rely heavily on the SimaanWhitcomb Study, which states that its

purpose is to present preliminary

evidence on: (1) the percentage of the

time that ECNs are alone at the inside

bid or offer; (2) the aggregate ‘‘inside’’

quotation size of market makers and

ECNs; and (3) the ‘‘odd-sixteenths’’

quotation behavior of ECNs and selected

market makers.

The Simaan-Whitcomb Study first

discusses its preliminary findings

concerning the percentage of time ECNs

are alone at the inside bid or offer.115
Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices 39329

116Simaan-Whitcomb Study at 6.

117 Id. at 9.

118 Id. at 13.

119See NASD Response.

120 Id.; see also March 1998 Study at 64 for a

detailed description of the methodology the NASD

employed.

121 Id.

122See Release No. 38156, supra note 3, 62 FR at

2423.

123 Id. at 2424.

124See Exchange Act Release No. 28450

(September 18, 1990) 55 FR 39221 (September 25,

1990).

125 Id.

126 Id.

The Simaan-Whitcomb Study states

that:

On the one hand, this is evidence of

the power of the Order Handling Rules,

since any market maker filling a retail

customer order (e.g., pursuant to a

payment for order flow arrangement

with the customer’s broker) must match

the ECN price under ‘‘best execution’’

rules. On the other hand, retail

customers whose brokers do not have

preferencing arrangements with a dealer

can be disadvantaged. Most retail

brokers do not have direct order entry

interfaces with ECNs, and orders sent to

Nasdaq’s SOES are rejected when no

market maker is at the inside. Brokers

seeking automated execution of

customer orders must use SelectNet to

‘‘preference’’ the ECN, a somewhat

cumbersome and time-consuming

process. In a sense, the percentage of

time ECNs are alone at the inside is a

measure of a remaining imperfection in

the Nasdaq market.116

Next, the Simaan-Whitcomb Study

posits that the aggregate ‘‘inside’’

quotation size of market makers and

ECNs (a measure of liquidity) has been

harmed by the Actual Size Rule. The

Simaan-Whitcomb Study relies on

‘‘aggregate truncated size’’ and

‘‘aggregate quoted size’’ to measure

liquidity. The Simaan-Whitcomb Study

claims that the NASD’s liquidity

measure is flawed for the following

reason:

The problem with [using the NASD’s

liquidity measure] is that infrequent very

large bid sizes can have an inordinate impact

on sample mean aggregate sizes. This might

be fine if these large quotes were ‘‘real’’, but

NASD rules permit a dealer to decline to fill

an order larger than 1000 shares even if the

dealer’s quote exceeds the order size. Thus a

more realistic measure of aggregate electronic

liquidity is what we call ‘‘Aggregate

Truncated Size’’, the sum over market makers

of the portion of their quote sizes not

exceeding 1000 shares. (Footnote omitted,

emphasis added.) 117

The ultimate point the SimaanWhitcomb Study makes is that

market makers will reduce their quotes on

the side of the market that is experiencing

stress when they are free to do so. Putting it

differently, it appears that mandatory

minimum quotation sizes to effectively force

market makers to provide more liquidity to

the market, especially in times of stress.118

D. The NASD’s Response to Comments

By letter, the NASD responded to

comments submitted with regard to the

ASR proposal.119 The NASD’s letter

primarily focused on the comments

from the ETA and Whitcomb. The

NASD argues that those commenters’

empirical evidence is ‘‘incomplete,’’ and

that the Simaan-Whitcomb Study does

not appropriately analyze the improved

sample provided by the expansion of

the pilot program. The NASD also

disputes ETA’s and Whitcomb’s

conclusions that the ASR reduced

liquidity during extreme market

conditions on October 27 and 28, 1997,

and that the ASR diminished access

through SOES to market maker capital. The NASD also questions the basis for

the commenters’ beliefs about the

marketplace, particularly the notion that

it is not competitive. For instance, the

NASD cites a lack of empirical evidence

for the commenters’ claims that the ASR

would increase order flow preferencing.

Moreover, the NASD emphasizes the

experience of market participants

suggesting an increasingly order driven

market.

In addition, as discussed below, the

NASD points out perceived flaws in the

studies producing the research relied

upon by Whitcomb and the ETA.

Finally, the NASD defends the

methodology employed for its own

research as being more representative

and complete than that used by its

detractors.120

IV. Discussion

The Commission approved the Actual

Size Rule on a pilot basis so that it could

assess the effects of the rule on Nasdaq

market quality and investor access to

automatic execution systems over a

several month long period. At the time

the pilot was adopted, the Commission

noted that it ‘‘preliminarily believes that

the proposal will not adversely affect

market quality and liquidity’’ 121 and

that it ‘‘believes there are substantial

reasons . . . to expect that reducing

market makers’ proprietary quotation

size requirements in light of the shift to

a more order-driven market would be

beneficial to investors.’’ 122 The

Commission also stated that, ‘‘based on

its experience with the markets and

discussions with market participants,

[it] believes that decreasing the required

quote size will not result in a reduction

in liquidity that will hurt investors.’’ 123

During the pilot, the Commission

assessed the potential impact of the

Actual Size Rule on the Nasdaq market

and on investors over periods of relative

market calm as well as over a period of

sudden market volatility (i.e., October

27–28, 1997). It also reviewed the

NASD’s two comprehensive studies on

the Actual Size Rule. In these studies,

the NASD analyzed the Actual Size

Rule’s impact on market quality and

investors’ access to capital, both before

and after the full implementation of the

Order Handling Rules. The Commission

also reviewed studies funded by the

ETA and hundreds of comment letters

from investors, broker-dealers, trade

groups, and others representing all

constituencies in the marketplace.

Based on this detailed record of

empirical data and comments regarding

the impact of an expanded Actual Size

Rule, the Commission still believes that

the Actual Size Rule will not adversely

affect the quality of the Nasdaq market.

Indeed, the Commission remains

convinced that the Actual Size Rule

removes a barrier to market making in

the Nasdaq market, as well as a

requirement that has been rendered

unnecessary by the Commission’s Order

Handling Rules. As a result, the

Commission believes that removing

Nasdaq’s minimum quote requirements

is consistent with the Exchange Act. In

particular, as discussed below, the

Actual Size Rule is consistent with

Sections 11A and 15A of the Exchange

Act.

In 1990, the Commission approved an

NASD proposal to require Nasdaq

market makers to quote size ‘‘at least

equal to the maximum size of an order

eligible for automatic execution in

SOES.’’ 124 In doing so, the Commission

noted that ‘‘[m]arket makers presently

are willing to execute trades well in

excess of the 100 share size that is

typically displayed on NASDAQ’’ 125

and that size was not being reflected in

their quotes to the public. In approving

the proposal, the Commission noted that

the minimum quote size requirements

could help provide ‘‘a more realistic

picture of the actual size of execution

available and the depth of the market in

each security.’’ 126 This rationale for

requiring Nasdaq market makers to

quote at least 1,000 shares (or 200 or 500

shares for less active stocks) when

exchange specialists need only quote

100 shares was pertinent to Nasdaq in

1990 when only market maker quotes

established the Nasdaq inside spread

and customer limit orders were rarely

reflected in market maker quotes. The

rationale has been removed by the

successful implementation of the Order
39330 Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices

127See March 1998 Study; see also NASD

Economic Research, ‘‘Implementation of the SEC

Order Handling Rules,’’ October 14, 1997 (‘‘October

1997 Study’’); and Simaan-Whitcomb Study at 4.

128The Commission believes there are substantial

reasons to expect that once the Actual Size Rule

reduces regulatory constraints on market maker

capital commitment for all Nasdaq securities, it will

become increasingly likely that, over time, barriers

to entry for market making will be reduced.

129See Release No. 39285, supra note 3, 62 FR

59936.

130 Id.

131 Id.

132 Id.

133See Letter from Richard Y. Roberts, on behalf

of the ETA, to Jonathan G. Katz, Secretary, SEC,

dated October 30, 1997.

134See M.H. Meyerson Letter.

135See, e.g., JP Morgan Letter; Ohio Letter;

Marino Letter; Merrill Letter; Knight Letter; 4/29

and 4/1 STA Letter, Jefferies Letter; Howard Letter;

STANY Letter; and Weeden Letter.

Handling Rules. The Order Handling

Rules enable investors’ limit orders and

limit orders displayed on ECNs to set

the Nasdaq inside quote, so that reliance

solely on market makers’ quotes is no

longer necessary. Data has demonstrated

that the Order Handling Rules have

helped to narrow Nasdaq spreads

considerably.127

As detailed by the NASD in the March

1998 Study, by permitting dealers to

quote their true trading interest, the

Actual Size Rule affords market makers

more flexibility to manage risk.

Removing minimum quote size

requirements also will enable market

makers to reflect size in their quotations

based on business and market factors

instead of regulatory imposed

minimums. This, over time, should

increase the information content of

market makers’ quotations. Further,

requiring market makers to maintain a

minimum quote size without imposing

a similar commitment on ECNs or

investors, which also may display

quotes, could impair the ability of

market makers to set competitive

quotations. Such a result is antithetical

to the intent of the Order Handling

Rules: That market maker quotes, limit

orders, and limit orders displayed on

ECNs all compete to set the Nasdaq

inside spread. The 1,000 share

minimum also can be viewed as a

barrier to entry of new firms to market

making in Nasdaq securities.128

After reviewing the June 1997 Study,

the Commission concluded that it

‘‘preliminarily believes that the data

indicates that the pilot has not resulted

in harm to the Nasdaq market.’’ 129

Nevertheless, the commission decided

that it would be appropriate to gather

further data before determining whether

to extend the Actual Size Rule to the

entire Nasdaq market.130 The

Commission also noted that certain

concerns raised by some commenters

could be addressed by extending the

pilot and expanding it to 150 securities.

The Commission determined that based

‘‘upon the expanded pilot, the

Commission will be in a better position

to evaluate the impact of the Actual Size

rule upon the Nasdaq market.’’ 131 The

Commission specifically asked the

NASD to conduct a second study to

analyze market quality measures (i.e.,

spreads, volatility, depth, and liquidity)

as well as investor access to market

maker capital. The pilot was expanded

to 150 Nasdaq securities on November

10, 1997, and extended to March 27,

1998.132

As the Commission requested, in this

second study (the March 1998 Study)

the NASD analyzed each market quality

measure. This expanded pilot study

permitted a more definitive comparison

of pilot and non-pilot securities as a

whole, providing a basis for a final

conclusion concerning the Actual Size

Rule’s effect on Nasdaq securities and

its effect on relatively active versus

inactive securities. In response to

concerns that the Actual Size Rule

would cause a ‘‘reduction of liquidity

during periods of stress,’’ 133 the NASD

also included in the March 1998 Study

an empirical analysis of trading on

October 27 and 28, 1997, a period in

which the U.S. securities markets

experienced a significant degree of

volatility.

The NASD’s March 1998 Study led

the NASD to conclude that there is no

empirical evidence that the

implementation of the Actual Size rule

is associated with any degradation of

Nasdaq market quality or of investors’

access to automatic execution systems.

Specifically, the NASD found no

statistically significant empirical

evidence that the Actual Size Rule

negatively impacted spreads, depth,

volatility, liquidity, or investors’ access

to automatic execution systems, even

during October 27 and 28, 1997. These

findings were consistent with those the

NASD made in its June 1997 Study.

The Commission has analyzed

carefully the NASD’s methodologies and

analyses and finds that they are

reasonable, rigorous, and credible. The

NASD’s decision to study the expanded

group of pilot stocks is appropriate, as

is the NASD’s choice of time periods

used to study the Actual Size Rule’s

potential effects. The NASD analyzed

various measures of market quality and

investor access to automatic execution

systems and explained in great detail

how the data was generated, analyzed,

and how it controlled for changes in

stock-specific trading characteristics

such as price, volume, and intraday

volatility. Commenters were given

ample opportunity to critique the

NASD’s studies and to conduct their

own studies.

The Commission extended and

expanded the pilot to give the NASD

time to produce data that could be used

to address concerns about the

representatives of the original 50-stock

pilot. The Commission is satisfied that

the March 1998 Study has adequately

addressed those concerns by studying a

wider range of securities over a longer

period. Based on those studies, the

Commission is satisfied with the

NASD’s determination that the

implementation of the Actual Size Rule

did not cause any degradation of the

Nasdaq marketplace or of investors’

access to automatic execution systems.

In determining whether to approve

the Actual Size Rule on a permanent

basis, the Commission gave careful

consideration to the many comments it

received in addition to the empirical

studies produced by the NASD. Many of

the positive comment letters were from

firms that either engage in market

making activities or have retail or

institutional customers they believe will

benefit from perceived gains in

competition. They believe that the

Actual Size Rule aids their market

making activities and allows them to

better serve their customers. One firm

states that it has ‘‘become more active in

the stocks under the Pilot program due

to [its] ability to properly manage [its]

risk.’’134 Several commenters note that

by cutting barriers to entry, the Actual

Size Rule should encourage market

maker participation, including that of

smaller firms.135 These comments

reflect the burdens of a minimum share

requirement on market making and the

potential benefits of the Actual Size

Rule.

The Commission also received a

comment letter from the ICI, a national

association of the investment company

industry, favoring the rule proposal. The

ICI’s membership includes 6,976 mutual

funds, 447 closed-end funds, and 10

sponsors of unit investment trusts. It

mutual fund members represent more

than 63 million individual shareholders

and manage more than $5 trillion.

Manyu of the Opposing comment

letters were form firms or associations

that benefit in some way from the

mandatory minimum quote size

requirements. For instance, the ETA—

which represents about 40 order entry

firms and others interested in trading

via computer—opposes the Actual Size

Rule.
Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices 39331

136The Commission recognizes that, under one

possible economic theory, SOES day traders may

have an impact on pricing efficiency (while

imposing certain costs on market making).

According to this theory, SOES day traders’ ability

to exploit a price disparity between different market

makers’ quotations may provide an incentive for

market makers to monitor closely market

information and to incorporate quickly that

information into their quotations. An NASD study

suggests, however, that day traders have a reduced

role to play in pricing efficiency due to the SEC’s

Order Handling Rule. See October 1997 Study.

Further, based on the NASD’s March 1998 Study,

the Actual Size Rule’s impact on day traders—as

measured by the percentage of SOES orders fully

executed at a single price and by the average size

of an executed SOES order—appears to be minimal.

Finally, any minor impact the Actual Size Rule may

have on day traders should be outweighed by the

Actual Size Rule’s likely long-term benefits to

investors and the Nasdaq market, as discussed

throughout this order.

137 In addition, both the ETA and Whitcomb take

issue with the economic theory discussed in the

March 1998 Study. Briefly, Whitcomb argues that

Nasdaq is an oligopolistic market and both the ETA

and Whitcomb posit that the Actual Size Rule will

not benefit Nasdaq as the NASD believes. The ETA

and Whitcomb base these arguments primarily on

their assertions that Nasdaq market makers do not

engage in quotation price competition because of

preferencing arrangements, among other things.

They also argue that because Nasdaq market making

is already very profitable there is no threat that

market makers will drop Nasdaq stocks and

therefore no need to provide the Actual Size Rule

as an incentive. Neither the ETA nor Whitcomb

offer any evidence, however, concerning either

Nasdaq market makers’ profitability or about

preferencing.

138The first 50 stocks subject to the Order

Handling Rules were also the first 50 stocks subject

to the Actual Size Rule (‘‘First 50’’). The second

group of 50 stocks subject to the Order Handling

Rules (‘‘Second 50’’) were used as a control group,

since they were not initially subject to the Actual

Size Rule. Both groups include 40 stocks selected

from the first through fifth deciles of the 1,000 most

active Nasdaq stocks. These two groups were used

as peers by the NASD in its June 1997 Study and

by Professors Simaan and Whitcomb in the SimaanWhitcomb Study and are referred to as the ‘‘First

40’’ and the ‘‘Second 40.’’ The remaining 10 stocks

in the first tranche were roughly the top 10 stocks

(‘‘First 10’’) based on median daily dollar volume,

and the remaining 10 from the second tranche were

roughly stocks 11 through 20 (‘‘Second 10’’).

Consistent with the Commission’s request for a

‘‘matched pairs analysis,’’ the First 10 and Second

10 are excluded from this analysis, because these

groups do not demonstrate similar trading

characteristics and hence cannot be properly

compared. See Release No. 38156, supra note 3, at

62 FR 2425. Indeed, including the First 10 and

Second 10 would likely produce skewed results.

The market quality improvements produced by the

Order Handling Rules, however, are apparent in

both the First 10 and the Second 10. See June 1997

Study at 22.

139See March 1998 Study at Section III.C.2; see

also Release No. 39285, supra note 3, 62 FR at

59937 (In that order, the Commission stated that

100 securities added to the pilot ‘‘include securities

with significantly different trading volumes, so the

NASD will be better able to assess the impact of the

Actual Size Rule on the full panoply of Nasdaq

stocks. This will further the evaluation of the

Actual Size Rule and will assist the SEC in its

determination as to whether to expand the pilot

ultimately to all Nasdaq securities or to end it.’’).

140See Letter from David K. Whitcomb to

Jonathan G. Katz, Secretary, SEC, dated July 3,

1997.

A number of the opposing comment

letters were submitted by or on behalf

of day traders. Not surprisingly, these

commenters oppose the Actual Size

Rule, which limits their ability to affect

SOES executions large enough to

maximize day trading strategies.

Although the Commission weighed this

small group of professional investors’

concerns very carefully in determining

whether to approve the proposal,

ultimately the Commission has

concluded that it is in the best interests

of the majority of investors, as well as

the markets, to permit Nasdaq to remove

the minimum mandatory quote size

requirements.136 Thus, even though the

Actual Size Rule may alter somewhat

the dynamics of electronic trading in

Nasdaq securities (offset, however, by

the Order Handling Rules), the

Commission believes that the Actual

Size should operate evenhandedly to all

investors, should not impose

discriminatory or anti-competitive costs,

and should not impair transparency.

There is no basis for concluding that the

Actual Size Rule was designed to

benefit market makers at the expense of

the Nasdaq market.

Nevertheless, the Commission gave

serious consideration to the negative

comment letters. First the Commission

notes that several comment letters allege

market maker abuses any try to relate

them to the need for a minimum quote

sized requirement. The Commission

takes allegations of market maker abuse

very seriously and has and will

continue to monitor the NASD’s

surveillance of market-making activity

very closely. None of the comment

letters, however, provide any concrete

evidence to suggest that such abuses are

on-going or occur more frequently in

securities subject to the Actual Size

Rule than in the non-ASR securities.

Moreover, the Order Handling Rules are

a much more effective and marketoriented approach to prevent abusive

quoting behavior than artificial quote

size minimums, especially when

combined with the NASD’s enhanced

market maker surveillance.

Some commenters expressed concern

that the Actual Size Rule could hurt

Nasdaq’s reputation, perhaps leading

investors to turn away from Nasdaq.

Nasdaq’s reputation and ability to

compete without other markets will

likely rest, however, on measures of

market quality such a liquidity,

volatility, depth, and spreads. As

discussed above, the NASD’s March

1998 Study suggests that such measures

are not materially affected by the Actual

Size Rule.

The Commission gave careful scrutiny

to the Simaan-Whitcomb Study (which

was attached to comments from

Whitcomb and the ETA). Ultimately,

however, the Commission finds the

NASD’s analysis more complete and

persuasive. For example, for the reasons

discussed below, the data analyzed in

the NASD’s March 1998 Study differs

significantly from that analyzed in the

Simaan-Whitcomb Study, as do the

conclusions drawn by the NASD and

the Simaan-Whitcomb Study’s authors

and the ETA.137 In determining which

conclusions deserve greater credence,

the Commission compared the data sets

the studies analyzed. The Commission

also compared the economic analyses

undertaken by the NASD and Professors

Whitcomb and Simaan. As discussed

below, the Commission gave greater

weight to the NASD’s study because it

analyzed more securities for a longer

period of time and used, the

Commission believes, more rigorous

economic tools to reach its conclusions.

The Simaan-Whitcomb Study

analyzes Nasdaq trades and quotes for

two, ten-day periods, one in September

1997 and one in October 1997. The

NASD’s March 1998 Study compares 18

trading days between October 13 and

November 7, 1997, with 20 trading days

between November 10 and December 9,

1997—a significantly larger sample of

trading days.

Further, the Simaan-Whitcomb Study

generally compares the ‘‘First 40’’ stocks

(for which mandatory 1,000 share

proprietary quote sizes were waived)

with the ‘‘Second 40’’ (which are subject

to minimum proprietary quote sizes of

1,000 shares).138 The March 1998 Study

compares a much larger sample of

securities: the pilot stocks and a control

group of peer stocks (the non-pilot

stocks) that remained subject to

mandatory minimum quote sizes. The

pilot stocks group was a stratified

random sample that was more

representative of the entire Nasdaq

marketplace than the 50 stocks that

became subject to the Actual Size Rule

on January 20, 1997.139 The SimaanWhitcomb Study does not analyze this

improved sample, even though

Whitcomb, one of the SimaanWhitcomb Study’s authors, earlier

requested such sample improvements,

urging the Commission to ‘‘insist that

[the] NASD pick a stratified random

sample that is balanced across stock

groups.’’ 140

The Commission also discounted the

Simaan-Whitcomb Study because it

ignores significant changes to the

NASD’s rules. Specifically, the Simaan-
39332 Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices

141See Simaan-Whitcomb Study at 6-9.

142Exchange Act Release No. 39637 (February 10,

1998) 63 FR 8242 (February 18, 1998) (SR–NASD–

98–05).

143The Commission also notes that in criticizing

the NASD’s liquidity measure in favor of the

Simaan-Whitcomb Study’s methodology, the

Simaan-Whitcomb Study mischaracterizes a

dealer’s obligations under the Firm Quote Rule and

NASD Rule 4613(b). See SEC rule 11Ac1–1 (Firm

Quote Rule) and NASD Rule 4613(b). Both rules

require market makers to honor their quotes even

if those quotes exceed the mandatory minimum

quotation size. The Simaan-Whitcomb Study’s

rationale for claiming that the liquidity measures it

uses are better than the ones the March 1998 Study

uses is therefore suspect.

144See March 1998 Study at 92–100.

145See Simaan-Whitcomb Study at 9.

146See note 143, supra.

147See ETA and DRI/McGraw-Hill, ‘‘Analysis of

Automatic Executions on the Nasdaq Stock

Market,’’ May 1997, submitted as Attachment I of

Letter from Richard Y. Roberts, on behalf of the

ETA, to Jonathan G. Katz, Secretary, SEC, dated

May 12, 1997.

148See Letter from Richard Ketchum, Chief

Operating Officer, NASD, and Dean Furbuth, Chief

Economist and Senior Vice President, NASD, to

Jonathan G. Katz, Secretary, SEC, dated June 17,

1997.

Whitcomb Study expresses concern that

many investors do not have adequate

access to SOES trades while an ECN is

alone at the inside.141 As an initial

matter, this concern could exist whether

or not the Actual Size Rule was

approved, and its relevance to the size

of a market maker’s quote is

questionable. Nevertheless, this concern

was reduced by subsequent Nasdaq rule

changes. In particular, on February 10,

1998, the Commission noticed a

proposed change to NASD Rule

4730(b)(1) that became effective

immediately, pursuant to Section

19(b)(3)(A) of the Exchange Act and

Rule 19b–4(e)(5) thereunder.142 The

NASD proposed the rule change to

address problems associated with the

rejection of orders in SOES when there

is no market maker at the inside quote.

Previously, under NASD Rule

4730(b)(10), an ECN quote that was the

best bid or offer in a security would

effectively halt executions in SOES.

Orders that had execution priority

before the ECN order became the inside

bid or offer were rejected. Now, these

orders will be held in a queue for 90

seconds to allow the market to create a

new inside bid or offer.

The rule change operates when an

ECN or a market participant with

unlisted trading privileges is alone at

the inside in a Nasdaq National Market

security. In this situation, executable

SOES orders that are in queue or

received at that moment will be held for

a specified period of time. This ‘‘hold

time,’’ initially set at 90 seconds, is the

maximum life of an order. Holding the

queued orders for 90 seconds will give

other market makers time to adjust their

quotes to create a new inside, join the

ECN at its price, or allow the ECN to

move away from the inside. If one of

these conditions is met and the order is

still executable, it will execute. If any of

these conditions do not occur, however,

the order will time out, under normal

time-out processing, and be returned to

the entering firm at the end of the 90-

second maximum life of the order.

Nasdaq SmallCap securities will

continue to execute against the next

available SOES market maker at the

ECN price. This concern raised by the

ETA and Whitcomb, while not a result

of the Actual Size Rule, therefore has

been reduced, because SOES orders

have a longer opportunity to be

executed when an ECN is at the inside

market.143

The Simaan-Whitcomb Study also

asserts that ‘‘market makers will reduce

their quotes on the side of the market

that is experiencing stress when they are

free to do so.’’ This assertion, which is

provided without empirical support, is

in conflict with the March 1998 Study’s

data and the NASD’s analysis showing

that liquidity and depth for both Actual

Size Rule and non-ASR stocks was

substantially the same.144 Given that the

better analysis of the data produced by

the pilot indicates that the Actual Size

Rule affected the liquidity and depth of

pilot and non-pilot securities similarly,

the Simaan-Whitcomb Study’s concerns

about liquidity appear unfounded.

The March 1998 Study and the

Simaan-Whitcomb Study also differ in

their analysis of data concerning market

quality measures. For example, as the

NASD notes in its June 1, 1998, letter

responding to commenters that

criticized the NASD proposal,

Both the ETA and Whitcomb Letters cite

evidence contained in the Simaan-Whitcomb

Study that purports to demonstrate that the

Actual Size Rule reduced liquidity during the

extreme market conditions of October 27 and

28, 1997. The analysis is based solely on

aggregate quoted size—a limited measure of

liquidity—and a flawed derivative measure,

‘‘aggregate truncated size.’’ Based on these

limited measures, the ETA and Whitcomb

Letters conclude that investors experienced a

reduction in access to market maker capital

during October 27 and 28, 1997 due to the

Actual Size Rule. A more direct analysis of

the issue—involving actual SOES orders—

was included in the [NASD’s] March 1998

Study, which found that 98.1% of SOES

orders in a group of Actual Size Rule stocks

were fully executed at a single price during

October 27 and 28, 1997, compared to 98.3%

of SOES orders in a group of stocks not

subject to the Actual Size Rule. (Footnotes

omitted.)

In addition, the NASD notes that the

liquidity measure called ‘‘aggregate

truncated size’’ used in the SimaanWhitcomb Study assumes quotes above

1,000 shares are not real. Use of this

measure is based on a misunderstanding

that ‘‘NASD rules permit a dealer to

decline to fill an order larger than 1,000

shares even if the dealer’s quote exceeds

the order size.’’ 145 As discussed above,

market makers must honor their quotes

even if they are for 1,000 shares or

more.146

Moreover, as noted by the NASD in its

June 1, 1998, letter, the SimaanWhitcomb Study compares levels of

quoted aggregate depth without

controlling for stock price. Citing the

Simaan-Whitcomb Study, the Whitcomb

letter states that the average quoted

depth of a group of stocks subject to the

Actual Size Rule (i.e., the First 40)

constituted 80% to 85% of the average

quoted depth for a comparable group of

stocks not subject to the Actual Size

Rule (i.e., the Second 40). As the NASD

notes, the Simaan-Whitcomb Study fails

to consider that the First 40 stocks are

more expensive than the Second 40

Stocks. According to the NASD, in

January 1997, the average share price of

the First 40 stocks was $39 and the

average share price for the Second 40

stocks was only $34. The NASD

concludes that the depth quoted by

market makers is, therefore, similar for

both groups in terms of dollars of capital

committed. The Commission believes

this conclusion is reasonable.

In addition, the letters from both the

ETA and Whitcomb cite the SimaanWhitcomb Study as well as a report

submitted by the ETA regarding

automatic executions in the Nasdaq

marketplace (‘‘ETA Report’’).147

Whitcomb cites the ETA Report for the

proposition that the completion rate for

SOES orders fell for ASR securities but

rose for non-ASR securities. The NASD

argues that the ETA Report’s measure is

seriously flawed because it (1) includes

orders that were actively canceled by

the order-entry firm, which were a

substantial majority of unexecuted

orders, and (2) fails to account for

substantial differences between trading

characteristics of stocks included in the

analysis.148 The NASD concludes, and

the Commission believes this

conclusion is reasonable, that the

evidence presented in the NASD’s June

1997 and March 1998 Studies

demonstrates that a substantial majority

of SOES orders are fully executed at a

single price level.
Federal Register / Vol. 63, No. 140 /Wednesday, July 22, 1998 / Notices 39333

149See, e.g., R. Chung Letter; Eisner Letter;

Meurer Letter; Sanbeg Letter; Sherwood Letter;

Wieser Letter; Wilson Letter; and Zatorski Letter.

150March 1998 Study at 87–88.

151 Id. at 89.

152 Id. at 90.

153 In approving this rule, the Commission has

considered the proposed rule’s impact on

efficiency, competition, and capital formation. As

discussed above, the proposed rule likely will

produce more accurate and informative quotations,

increase competition, and encourage market makers

to maintain competitive prices.

154 15 U.S.C. 78s(b)(2).

This conclusion rebuts some

commenters’ assertions that it is

difficult to fill orders over 100 shares

close to the inside market without

multiple executions, potentially

occurring at different price levels.149

The NASD concluded in the March

1998 Study, however, that

98.5% of SOES orders (98.3% of volume)

were fully executed at a single price for pilot

stocks after implementation of the Actual

Size Rule. For non-pilot stocks, 98.9% of

orders (98.8% of volume) were executed at a

single price during this period. Multiple

price SOES executions are rare for both

groups; only 1.3% and 0.9% of SOES orders

(1.5% and 1.1% of volume) were executed at

multiple prices for the pilot stocks and nonpilot stocks, respectively, postimplementation. Clearly, the Actual Size

Rule has had no measurable impact on SOES

order disposition. (Footnotes omitted.) 150

The March 1998 Study also made

important findings that rebutted claims

that investors’ access to automatic

executions was compromised by the

Actual Size Rule. The March 1998

Study found that

As with Nasdaq’s SOES system,

proprietary autoexecution systems provide

investors with immediate access to market

maker capital through automatic executions

at the inside market. Unlike SOES, however,

these systems often automatically execute

orders for sizes well above 1,000 shares,

which is the largest SOES tier size. Also

unlike SOES, these systems are operated at

the discretion of the market maker, which

generally sets size parameters for proprietary

autoexecution systems. Parameters usually

vary by stock and customer. Further, market

makers determine which customers may use

the systems. Accordingly, these systems are

not perfect substitutes for SOES. The

importance of these systems to individual

investors should not be underestimated,

however, because a number of the largest

national brokerage houses use them to

provide immediate, automated access to

market maker capital.151

* * * * *

Like Nasdaq’s SOES system, proprietary

autoexecution systems provide investors

immediate access to market maker capital.

Indeed, the analysis of data provided by

Participant Firms underscores the

importance of these systems to the

marketplace. The survey conducted by NASD

Economic Research and empirical analysis of

these data demonstrates that the Actual Size

Rule has not impacted these important

systems in any way.152

In sum, the Commission approved the

NASD’s rule change (to require Nasdaq

market makers to quote at least 1,000

shares) in 1990 out of concern that

market maker quotations at that time

did not provide a realistic picture of

execution size available and the depth

of the market. The NASD’s data shows

that this is no longer the case. Thus, in

light of the changes brought about by

the Order Handling Rules, which have

served to make the Nasdaq market

significantly more order-driven, and the

empirical research indicating no

material adverse impact of the Actual

Size Rule on investors or the Nasdaq

market, and after carefully considering

all of the comment letters, the

Commission has concluded that

minimum quotation sizes are no longer

necessary and should be removed for all

Nasdaq stocks.

The Commission therefore finds that

the proposed rule change is consistent

with the Exchange Act, including

Sections 11A(a)(1)(C), 15A(b)(6), and

15A(b)(11). Specifically, 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. 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)(11) requires that the

rules of a national securities association

be designed to produce fair and

informative quotations and to prevent

fictitious or misleading quotations,

among other things.

As discussed above, the Commission

believes that the Actual Size Rule

should not have a material adverse

impact on market spreads, volatility,

depth, liquidity, or investor access. In

addition, the Actual Size Rule should

give market makers more flexibility to

manage their risk. Removing the current

minimum size requirements enables

market makers to reflect size in their

quotations based on market and

business factors instead of a regulatoryimposed minimum. This should

increase the information content of

market makers’ quotes. Finally, by

removing the current regulatory size

requirements, the Actual Size Rule

removes a barrier to entry for making

markets in Nasdaq securities. The

Commission believes that the net longterm results of the Actual Size Rule

should benefit market makers and

investors without adversely affecting

market quality.

V. Conclusion

For the reasons discussed above, the

Commission finds that the NASD’s

proposal is consistent with the

Exchange Act (specifically, Sections

11A and 15A of the Exchange Act) and

the rules and regulations thereunder

applicable to a national securities

association and has determined to

approve the NASD’s proposal to amend

NASD Rule 4613(a)(1)(C) permanently

to allow Nasdaq market makers to quote

their actual size by reducing the

minimum quotation size requirement

for Nasdaq market makers in all Nasdaq

securities to one normal unit of

trading.153

It is therefore ordered, pursuant to

Section 19(b)(2) of the Exchange Act,154

that the proposed rule change, SR–

NASD–98–21, be and hereby is

approved.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 98–19436 Filed 7–21–98; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[(Release No. 34–40200; File No. SR–NASD–

98–33)]

Self-Regulatory Organizations;

National Association of Securities,

Dealers, Inc.; Order Granting Approval

to Proposed Rule Change and

Amendment 1 Thereto Relating to

Exemptions From Fidelity Bonding

Requirements

July 14, 1998.

I. Introduction

On April 20, 1998, the National

Association of Securities Dealers, Inc.,

(‘‘NASD’’ or ‘‘Association’’) filed with

the Securities and Exchange

Commission (‘‘SEC’’ or ‘‘Commission’’)

a proposed rule change pursuant to

Section 19(b)(1) of the Securities