[Federal Register Volume 60, Number 51 (Thursday, March 16, 1995)]
[Notices]
[Pages 14310-14313]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-6504]



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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-35471; File No. SR-NASD-95-9]


Self-Regulatory Organizations; Notice of Proposed Rule Change by 
National Association of Securities Dealers, Inc., Relating to the 
Trading of Exchange-Listed Securities in the Over-the-Counter Market

March 10, 1995.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on March 6, 
1995, the National Association of Securities Dealers, Inc. (``NASD'' or 
``Association'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by the 
NASD.\1\ The Commission is publishing this notice to solicit comments 
on the proposed rule change from interested persons.

    \1\The NASD originally submitted the proposed rule change on 
February 21, 1995. As a result of discussions on March 6, 1995, 
between the Commission staff and the NASD certain minor amendments 
to the filing were agreed upon. This notice reflects those 
amendments.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD is proposing to make three significant changes to rules 
governing NASD members' over-the-counter (``OTC'') trading in exchange-
listed securities. First, the NASD proposes to require NASD members 
registered as Consolidated Quotations Service (``CQS'') market makers 
to display certain customer limit orders in their quotes. Second, the 
NASD proposes to prohibit NASD members who are not Intermarket Trading 
System/Computer Assisted Execution System Automated Interface (``ITS/
CAES'') market makers from effecting a transaction in any ITS/CAES-
eligible security that ``trades-through'' (i.e., a purchase below the 
lowest bid or a sell above the highest offer) the best bid or offer 
displayed by any ITS/CAES market maker or any ITS Participant Exchange 
in that stock. Third, the NASD proposes to require all NASD members 
executing customer orders in ITS-eligible securities to afford such 
orders some opportunity for price improvement.
    The full text of the proposed rule change is set forth below. (New 
language is italicized.)

Schedule D

PART VI

CONSOLIDATED QUOTATIONS SERVICE

(CQS)

Sec. 2. Obligations of CQS Market Makers

    (a) No Change
    (b) No Change
    (c) A CQS market maker shall be required to process customer 
limit orders in securities eligible for inclusion on the ITS/CAES 
linkage in the following manner:
    (i) if the limit order is for 500 shares or less, the CQS market 
maker either must execute the limit order immediately or display it 
in its quotation with a minimum size of 500 shares (unless the 
specified minimum for that security is less than 500 shares); or
    (ii) if the limit order is for greater than 500 shares, the 
order's price must be reflected in the market maker's quotation, 
provided however, that if the size displayed with that updated 
quotation price is less than the limit order's size, the balance of 
the limit order must be executed at a price at least as favorable as 
the displayed price.
* * * * *

Schedule G

* * * * *

Sec. 1. Definitions

* * * * *
    (g) The terms ``Participant Market,'' ``ITS System,'' ''ITS/CAES 
Market Maker,'' and ``ITS Security'' shall have the same meanings as 
set forth in section (a) of The Rules of Practice and Procedure for 
Intermarket Trading System/Computer Assisted Execution System 
Automated Interface.
* * * * *

Sec. 4. Trading Practices

* * * * *
    (j) No member shall effect a trade in a security eligible for 
inclusion in the ITS/CAES Linkage, whether as principal or agent, at 
a price that is lower than the best bid or higher than the best 
offer currently displayed by an ITS/CAES Market maker or another 
Participant market (hereinafter referred to as a ``trade-through'') 
between 9:30 a.m. and 4:00 p.m. Eastern Standard Time (or such 
shorter period of time coinciding with the time that the primary 
market for a particular ITS/CAES security is open) unless one of the 
following conditions exists: (1) the size of the bid or offer that 
is traded through is for 100 shares; (2) the transaction that 
constitutes the trade-through is not a ``regular way'' contract; (3) 
the bid or offer that is traded-through is being displayed from a 
Participant Market whose members are relieved of their obligations 
under paragraph (c)(2) of Securities Exchange Act Rule 11Ac1-1 with 
respect to such bid of offer; or (4) the bid or offer that is 
traded-through has caused a locked or crossed market in the affected 
ITS Security. The foregoing requirements shall not apply to trade-
throughs effected by ITS/CAES Market Makers and governed by Sections 
(h)(1)(A)-(H) of the ITS/CAES Rules.
    (k) Between 9:30 a.m. and 4:00 p.m. Eastern Standard Time (or 
such shorter period of time coinciding with the time that the 
primary market for a particular ITS-eligible security is open), no 
member shall accept customer orders in securities eligible for 
inclusion in the ITS System for execution in the over-the-counter 
market, either as agent or principal, unless the member affords such 
orders some opportunity for price improvement over the best bid (in 
the case of a retail sell order) or best offer (in the case of a 
retail buy order) prevailing among the Participant Markets in the 
ITS System. A member can satisfy this requirement either by a manual 
procedure or an algorithm built into its internal order processing 
system. The specific parameters for granting price improvement at a 
member firm will be determined by competitive forces and the 
business judgment of the firm's management.

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

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

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

    This proposal is intended to respond to specific recommendations 
contained in the SEC's Market 2000 Report for improving the efficiency 
and effectiveness of the OTC dealer markets in exchange-listed 
securities, including ITS/CAES eligible securities.\2\ The 
[[Page 14311]] instant proposal would effect the following changes in 
selected NASD rules governing members' OTC trading in exchange-listed 
securities.

    \2\Operation of ITS/CAES is governed by a national market system 
plan known as the ``Plan for the Purpose of Creating and Operating 
an Intermarket Communications Linkage pursuant to Section 
11A(a)(3)(B) of the Securities Exchange Act of 1934 (``Act'')'' 
(hereinafter referred to as the ``ITS Plan''). Under the ITS Plan, 
NASD members participating as ITS/CAES market makers must confine 
their market making to ``Rule 19c-3 securities.'' This grouping 
consists of securities that were (1) not traded on a national 
securities exchange prior to April 26, 1979 or (2) traded on such an 
exchange on April 26, 1979, but thereafter ceased to be traded on an 
exchange for some period of time.
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1. Display of Customer Limit Orders
    Part VI of Schedule D to the NASD By-Laws establishes various 
regulations applicable to member firms that utilize the CQS to support 
their OTC market making in exchange-listed securities. Under the 
proposal, new Section 2(c) would specify the circumstances in which a 
CQS market maker in an ITS/CAES eligible security would be required to 
reflect customer limit orders in the firm's displayed CQS quotation. 
First, for customer limit orders of 500 shares or less, a CQS market 
maker would be required either to provide an immediate execution at the 
limit price or update its CQS quotation to reflect the customer's by/
sell interest at the limit price. The size associated with that 
quotation must be 500 shares unless the NASD has designated a lower 
minimum size for CQS quotations in that particular security.\3\ (This 
would be true even if, for example, the pending limit order were only 
for 200 shares.) Second, if a customer's limit order exceeds 500 
shares, the market maker must update its CQS quotation to reflect the 
superior price of the customer limit order. If the market maker elects 
not to reflect the entire size of the pending limit order in the firm's 
updated quotation, the balance of the limit order must be executed at a 
price at least as favorable as the displayed price. In sum, this 
modification would result in the exposure of customer limit orders in 
ITS/CAES eligible securities to other CQS market makers as well as 
exchange specialists who would have the ability to interact with such 
orders through the ITS/CAES Linkage\4\ or CAES.\5\

    \3\At the present time, the NASD has not designated any CQS 
security as subject to a minimum quotation size of 200 shares.
    \4\As discussed infra at note 6 and accompanying text, all CQS 
market makers in ITS/CAES-eligible securities must now be registered 
as ITS/CAES Market Makers.
    \5\CAES is an automated system regulated by the NASD and 
operated by The Nasdaq Stock Market, Inc. that allows NASD members 
to direct agency orders (and principal orders with this rule change) 
in exchange-listed securities to CAES for automated execution in the 
third market. CAES market makers are CQS market makers who have 
registered as CAES market makers.
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2. Trade-Through Prohibition
    The proposal also contains two substantive changes to NASD trading 
practice regulations applicable to members effecting OTC trades in ITS/
CAES securities. The first addresses the possibility of a member firm 
effecting an OTC trade in a ITS/CAES eligible security at a price 
inferior to a displayed market for that security in the ITS system. 
Currently, NASD regulations in this area only cover members that have 
registered as ITS/CAES market makers pursuant to the NASD Rules of 
Practice and Procedure for the Intermarket Trading System/Computer 
Assisted Execution System Automated Interface (``ITS/CAES Rules''). The 
proposed prohibition would apply to all member firms that effect trades 
in ITS/CAES eligible securities without being registered as ITS/CAES 
market makers in those securities, e.g., block positioning firms and 
order-entry firms. It would also apply to the remote circumstance where 
a registered ITS/CAES market maker effects a trade-through in an ITS/
CAES eligible security in which the firm does not maintain a market 
making position.
    The NASD expects that instances of trade-throughs by its members 
should diminish with the recent implementation of an NASD requirement 
that all CQS market makers in ITS/CAES eligible securities become 
registered as ITS/CAES market makers pursuant to the ITS/CAES Rules.\6\ 
Nevertheless, it is still possible for an NASD member who is not a 
registered ITS/CAES market maker to effect a trade in an ITS/CAES 
eligible security at a price that constitutes a trade-through under the 
ITS/CAES Rules.\7\ Accordingly, the proposed rule would prohibit such 
conduct, unless the circumstances satisfied one of the four exceptions 
contained in the proposal: (1) the size of the market traded-through 
was 100 shares; (2) the transaction itself is not for regular-way 
settlement (e.g., a ``cash'' transaction settling the same day); (3) 
the bid/offer traded-through emanated from a market whose members are 
relieved of their obligations under the SEC's Firm Quote Rule;\8\ or 
(4) the bid/offer traded through had caused a locked/crossed market 
condition in the affected security. (These four exceptions also exist 
under the ITS/CAES Rules applicable to ITS/CAES market makers.) In 
addition, the proposed trade-through rule would apply only between 9:30 
a.m. and 4:00 p.m. Eastern Standard Time (``E.S.T.''), or such short 
period of time coinciding with time that the primary market for a 
particular ITS/CAES security is open.

    \6\See Securities Exchange Act Release No. 34280 (June 29, 
1994); 59 FR 34880 (July 7, 1994). This requirement took effect on 
October 31, 1994.
    \7\In order to comply with the trade-through prohibition, a 
member firm would need to access a CQS display on its Nasdaq 
Workstation device or subscribe to a vendor service offering 
equivalent display capabilities. From a surveillance perspective, 
the NASD would develop an exception report capable of identifying 
trade-throughs that constituted violations of the proposed rule.
    \8\See Securities Exchange Act Rule 11Ac1-1.
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    Essentially, the proposed trade-through prohibition impacts only 
those NASD members that conduct business in Rule 19c-3 securities 
without being registered as ITS/CAES market makers in those issues. As 
such, these firms cannot avail themselves of the procedural mechanisms 
prescribed by the ITS/CAES rules for resolving inter-market complaints 
of trade-throughs by providing stock to another ITS participant. For 
this reason, the NASD will regard a violation of the proposed 
prohibition as a course of conduct warranting referral to the NASD's 
Market Surveillance Committee for possible disciplinary action. The 
NASD will not, however, compel the offending member to provide 
satisfaction to any ITS participant that was traded-through, even if 
the latter promptly complains and requests satisfaction. This result is 
appropriate because the NASD does not wish to compel members who 
periodically trade ITS/CAES eligible securities (whether as agent or 
principal) to assume the obligations of an ITS/CAES market makers as a 
condition of continuing to trade such securities. On the other hand, 
the trade-through prohibition is designed to ensure that non-ITS/CAES 
market makers will not ignore the superior bids or offers in Rule 19c-3 
securities that may be displayed by ITS/CAES market makers or exchange 
participants in the ITS System.
3. Price Improvement
    The second substantive change involving Section 4 of Schedule G 
relates to price improvement respecting retail orders executed OTC in 
securities eligible for inclusion in the ITS System.\9\ This initiative 
also responds to a recommendation contained in the SEC's Market 2000 
Report. Basically, new Section 4(k) in Schedule G would require that 
members executing market orders from retail customers in ITS-eligible 
securities (either as principal or agent) afford such orders some 
opportunity for price improvement, i.e., [[Page 14312]] an execution at 
a price superior to the best bid or offer currently reflected in the 
ITS System. It is the NASD's understanding that most firms trading 
exchange-listed securities in the OTC market already provide some form 
of price improvement opportunity, depending on factors such as order 
size and the trading characteristics of the particular security, and 
that there is no uniform way to achieve price improvement. This is to 
be expected as affording customers price improvement opportunities is 
driven by competitive considerations to attract and retain order flow 
from order entry firms. Thus, in light of the varied means by which 
firms offer price improvement and the competitive nature of price 
improvement, the NASD has concluded that it would be too limiting and 
restrictive for the NASD to mandate and articulate specific parameters 
for granting price improvement to individual orders in ITS-eligible 
securities. Rather, the NASD believes that it is sufficient to adopt a 
more generalized provision specifying that members must afford some 
opportunity for price improvement in executing customer orders in 
exchange-listed securities. Accordingly, under the proposal, price 
improvement, at a minimum, would have to involve either exposing 
customer orders to an algorithm incorporated into the firms' in-house 
execution system or manually reviewing incoming orders prior to their 
execution. The NASD believes that this flexible approach to mandating 
price improvement is appropriate and that firms should be encouraged to 
experiment with the specific parameters for granting price improvement. 
In addition, the proposed price improvement requirement would apply 
only between 9:30 a.m. and 4:00 p.m. E.S.T., or such shorter period of 
time coinciding with the time that the primary market for a particular 
ITS-eligible security is open.

    \9\Accordingly, this price improvement requirement would cover 
all non Rule 19c-3 securities as well as all Rule 19c-3 securities.
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    The NASD believes that this proposed rule change is consistent with 
the requirements of Sections 11A(a)(1) and 15A(b)(6) of the Act. 
Section 11A(a)(1) specifies the Congressional findings and objectives 
for a national market system. These include the fostering of 
economically efficient execution of securities transactions; the 
promotion of fair competition among brokers and dealers, and between 
exchange markets and over-the-counter securities markets; and 
facilitating the best execution of customers' orders. Section 15A(b)(6) 
requires, among other things, that the NASD's rules be designed to 
promote just and equitable principles of trade; foster cooperation and 
coordination with persons engaged in regulating and facilitating 
securities transactions; remove impediments to and perfect the 
mechanisms of the national market system; and in general to protect 
investors and the public interest. The NASD submits that its proposal 
will advance these objectives by facilitating the prompt execution of 
customer limit orders in ITS/CAES eligible securities in circumstances 
where the limit price is superior to the best bid/offer reflected in 
the ITS System; by curbing instances of trade-throughs in such 
securities by broker-dealers that are NASD members, but are not 
registered as ITS/CAES market makers in the affected securities; and by 
mandating all firms that accept and execute customer orders in 
securities eligible for inclusion in the ITS System provide some 
opportunity for price improvement in the execution of such orders. 
Collectively, these changes will enhance the protections afforded 
investors trading exchange-listed securities in the OTC market and 
promote the integrity, fairness and price discovery process of the OTC 
market for exchange-listed securities. These rule changes also will 
facilitate the execution of investors' orders in exchange-listed 
securities in the OTC market at the best available price; regardless of 
whether that price emanates from an exchange participant in ITS or an 
ITS/CAES market maker. Moreover, the new trade-through prohibition will 
diminish the confusion that occasionally results when the Consolidated 
Tape reflects a trade-through by an NASD member firm which is not 
registered as an ITS/CAES market maker.
    Furthermore, because the NASD believes these proposals are 
responsive to specific recommendations made in the SEC's Market 2000 
Report and because the NASD has addressed or responded to all of the 
other recommendations in the Report concerning trading in the third 
market, the NASD believes the SEC should take prompt action to expand 
the ITS/CAES Linkage to include non-Rule 19c-3 securities. Requiring 
NASD members to adhere to these new rules without expanding the ITS/
CAES linkage would be particularly burdensome and unfair given that 
NASD members will be obligated to comply with these new rules and 
automated access to the primary markets for non-19c-3 securities 
through ITS will facilitate compliance with these rules by NASD 
members. If the ITS/CAES linkage were expanded to include all ITS-
eligible securities, the NASD would correspondingly propose to expand 
the scope of the proposed trade-through rule and the limit order 
display rule to apply to all ITS-eligible securities.

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

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

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

    Comments were neither solicited nor received.

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

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the NASD consents, the Commission will:
    A. by order approve such proposed rule change, or
    B. institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should fix six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to the file number in the caption 
above and should be submitted by April 6, 1995.

    [[Page 14313]] For the Commission, by the Division of Market 
Regulation, pursuant to delegated authority.\10\

    \10\17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-6504 Filed 3-15-95; 8:45 am]
BILLING CODE 8010-01-M