31574 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

4 15 U.S.C. 78f(b)(5).

1 15 U.S.C. § 78s(b)(1) (1988).

2The NASD initially filed the proposed rule

change on September 22, 1995 and, on November

9, 1995, the NASD filed Amendment No. 1. Notice

of the original filing and Amendment No. 1 was

provided by publication in the Federal Register.

Securities Exchange Act Release No. 36548 (Dec. 1,

1995), 60 FR 63092 (Dec. 8, 1995).

3Commission Note: The NASD’s use of the term

‘‘price improvement’’ in this proposal differs from

the use of the term in recent Commission releases.

Specifically, the Commission has used the term

when referring to the opportunity to receive a price

that is superior to best bid or offer. See, e.g., 17 CFR

11Ac1–3(a)(2); Securities Exchange Act Release No.

34902 (Oct. 27, 1994), 59 FR 55006 (Nov. 2, 1994)

at text accompanying n. 32. The NASD’s use of the

term in this proposal, on the other hand, refers to

the opportunity to receive a price that is better than

the best market maker quotation, which may not be

the best bid or offer to the extent NAqcess limit

orders are included. In its recent rule proposal

concerning the obligations of market makers

executing customer orders, the Commission asked

for comment on whether automated systems that

include the possibility of the interaction of market

orders with limit orders should be deemed to satisfy

the proposal’s requirement that market orders be

provided with an opportunity for price

improvement. Securities Exchange Act Release No.

36310 (Sept. 29, 1995), 60 FR 52792 (Oct. 10, 1995).

substandard performance in any one

objective measure, currently set at two out of

three consecutive review periods, will be

changed to the first instance of substandard

performance;

(9) The standard for Market Performance

Committee review for substandard

performance in any one objective measure,

currently set at three out of four consecutive

review periods, will be changed to two out

of three consecutive review periods;

(10) The standard for Market Performance

Committee review for substandard

performance on the overall program,

currently set at two out of three consecutive

review periods, will be changed to the first

instance of substandard performance; and

(11) The Overall Program score, currently

at 5.80, should be increased to 6.70 to

account for the proposed changes to the

threshold levels and weights.

The threshold levels for Turnaround

Time, Holding Orders Without Action

and the Questionnaire, as well as the

staff review standards, will remain

unchanged. The Exchange believes that

together, these modifications will

enhance the SPEP by providing:

(A) More appropriate threshold levels

when overall performance has improved

beyond the current limits;

(B) More effective measure weightings

which reflect the industry’s current market

quality focus; and,

(C) A more realistic approach to committee

review in view of the time horizon required

to address substandard performance.

In addition, the Exchange is currently

reviewing additional market quality

statistics in an effort to develop other

measures of performance for inclusion

in the SPEP, and hopes to file for

additional modifications to the program

in the near future.

2. Statutory Basis

The basis under the Act for the

proposed rule change is Section 6(b)(5)

of the Act 4 in that the SPEP results

weigh heavily in stock allocation

decisions and, as a result, specialists are

encouraged to improve their market

quality and administrative duties,

thereby promoting just and equitable

principles of trade and aiding in the

perfection of a free and open market and

a national market system.

B. Self-Regulatory Organization’s

Statement on Burden on Competition

The Exchange does not believe that

the proposed rule change will impose

any burden on competition that is not

necessary and 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 on the proposed rule

change were neither solicited nor

received.

III. Date of Effectiveness of the

Proposed Rule Change and Timing for

Commission Action

Within 35 days of the 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 self-regulatory organization

consents, the Commission will:

(A) by order approve the 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 file six copies thereof with the

Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W.,

Washington, D.C. 20549. Copies of the

submission, all subsequent

amendments, all written statements

with respect to the proposed rule

change that are filed with the

Commission, and all written

communications relating to the

proposed rule change between the

Commission and any person, other than

those that may be withheld from the

public in accordance with the

provisions of 5 U.S.C. 552, will be

available for inspection and copying at

the Commission’s Public Reference

Section, 450 Fifth Street, N.W.,

Washington, D.C. 20549. Copies of such

filing will also be available for

inspection and copying at the principal

office of the Exchange. All submissions

should refer to File No. SR–BSE–96–05

and should be submitted by July 11,

1996.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 96–15664 Filed 6–19–96; 8:45 am]

BILLING CODE 8010–01–M

[Release No. 34–37302; File No. SR-NASD–

95–42, Amendment No. 2]

Self-Regulatory Organizations; Notice

of Filing of Amendment No. 2 to

Proposed Rule Change by National

Association of Securities Dealers, Inc.

Relating to the NAqcess System and

Accompanying Rules of Fair Practice

June 11, 1996.

Pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934

(‘‘Act’’),1 notice is hereby given that on

June 6, 1996,2 the National Association

of Securities Dealers, Inc. (‘‘NASD’’ or

‘‘Association’’) filed with the Securities

and Exchange Commission (‘‘SEC’’ or

‘‘Commission’’) an amended version of

the proposed rule change as described

in Items I, II, and III below, which Items

have been prepared by the NASD. The

Commission is publishing this notice to

solicit comments on the proposed rule

change from interested persons.

I. Self-Regulatory Organization’s

Statement of the Terms of Substance of

the Proposed Rule Change

Pursuant to Section 19(b)(1) of the

Act, the NASD and The Nasdaq Stock

Market, Inc. (‘‘Nasdaq’’) propose to

amend the proposed rules governing the

operation of Nasdaq’s NAqcess system,

a new system that would offer

nationwide limit order protection and

price improvement 3 opportunities for

orders entered in the proposed system.

Specifically, the NASD is proposing

several amendments to NAqcess

designed to allow the entry into

NAqcess of: (1) Proprietary orders by

registered Nasdaq market makers and
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31575

4Securities Exchange Act Release No. 36548 (Dec.

1, 1995); 60 FR 63092 (Dec. 8, 1995).

5Securities Exchange Act Release No. 36310

(Sept. 29, 1995); 60 FR 52792 (Oct. 10, 1995)

(‘‘Order Exposure Release’’).

6The NASD has chosen 9,900 shares as the largest

limit order eligible for entry into NAqcess because

such size is the largest round lot size below 10,000

shares, the order size traditionally defined as ‘‘block

size.’’ The SEC’s proposed Rule 11Ac1–4, as

currently proposed, would exempt orders 10,000

shares and larger from its display requirements.

Because the NASD is attempting to develop

NAqcess to parallel the SEC’s rule, it has chosen to

permit certain limit orders below 10,000 shares into

NAqcess. An order size of 9,999 shares, however,

would have an odd-lot of 99 shares embedded in

it that would present difficulties in execution.

Accordingly, the NASD plans to program the

system to accept orders up to the largest round-lot

below 10,000 shares, i.e., 9,900.

7The NASD also notes other significant benefits

that a competing dealer structure brings to the

marketplace in addition to issuer sponsorship and

liquidity. Dealers also provide immediacy of

execution to persons demanding such and willing

to pay the costs associated with immediacy.

Additionally, dealers provide significant capacity to

Continued

other specific categories of brokerdealers performing a registered market

making function (collectively, ‘‘market

makers’’); and (2) limit orders by

investors and market makers of up to

9,900 shares in the 250 most active

Nasdaq National Market Securities as

measured by median daily dollar

volume during the most recent calendar

quarter; and (3) other technical changes

to the proposed rule language. The

NASD also proposes to revise the

opening process for NAqcess. Finally, in

conjunction with the approval of an

expanded NAqcess by the Commission,

the NASD intends to discontinue the

SelectNet service, except for the

purpose of maintaining a

communications facility for use in

special market conditions. Exhibit A

contains a revised version of the

NAqcess Rules, Exhibit B contains the

new Interpretations and the new rule in

its Rules of Fair Practice related to

NAqcess and Exhibit C contains

proposed amendments to the Schedules

to the By-Laws. Additions are italicized

and deletions are bracketed.

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

On September 22, 1995, the NASD

proposed rules governing the operation

of NAqcess, a new service for the

delivery, handling and execution of

investors’ agency orders.4 As originally

proposed, NAqcess would have been a

new system that offers nationwide limit

order protection and price improvement

opportunities for customer orders.

NAqcess was a significant advance in

terms of both the transparency of the

Nasdaq Stock Market and increased

access to faster executions and better

prices by retail customers.

Subsequent to the NASD’s filing of

NAqcess, the SEC proposed four

significant changes to SEC rules that

could have far-reaching and wideranging effects on the overall U.S. equity

markets, including the Nasdaq Stock

Market.5 The Commission’s goals in

proposing these change are fully

consistent with the views of the NASD

regarding investor protection and

transparency of limit orders in the

Nasdaq Stock Market. While the NASD

believes that NAqcess, as originally

filed, was consistent with the

Commission’s Order Exposure Release,

the NASD has determined to seek the

Commission’s approval of refinements

of NAqcess that are even more closely

configured to the SEC’s approach.

Through this amendment, the NASD

proposes to further enhance Nasdaq’s

transparency and customer access to

prompt executions by increasing the

size of limit orders eligible for entry and

permitting market makers to enter

proprietary market and limit orders.

These proposed amendments to

NAqcess closely parallel certain of the

SEC’s proposals regarding order

exposure and handling, in particular

those rules relating to the display of

customer limit orders (proposed Rule

11Ac1–4). The changes to NAqcess that

are proposed herein are responsive to

the goals of the SEC’s proposed rules,

and also maintain an environment

where the substantial benefits to issuers

and investors that the Nasdaq

competing dealer system provides can

be continued.

A. Increased Eligibility Size for Limit

Orders Entered Into NAqcess

The NASD proposes to increase the

size of limit orders eligible for entry into

NAqcess to 9,900 shares for the 250

most active Nasdaq National Market

securities as measured by median daily

dollar volume over the previous

calendar quarter.6 The NASD believes

that this increase in the size of NAqcesseligible limit orders should enhance

market transparency and increase the

likelihood that there will be sufficient

trading interest available in NAqcess for

other orders to execute against in a

timely manner. Through this change,

the NASD envisions that customer limit

orders will more likely be executed

because customers with larger orders,

including the institutions that make up

a significant portion of the investor base

of many highly liquid Nasdaq securities,

will be able to enter orders into

NAqcess. At the same time, the

approach that the NASD is taking with

a revised NAqcess (limiting the increase

size eligibility to the 250 most active

National Market securities) attempts to

balance the transparency objectives

against other core market and regulatory

objectives, such as maintaining market

liquidity and improving market quality

for all investors.

As explained in greater detail below,

the proposed limitation provides the

NASD and market makers with an

opportunity to develop experience with

larger limit orders to determine if or

when the size requirements may be

expanded to less liquid securities. The

NASD believes at this time that the

trading activity in securities below the

most active 250 Nasdaq securities may

not be sufficient to provide the

incentive for substantial market maker

participation if limit orders up to 9,900

shares were eligible for NAqcess. Market

makers bring significant amounts of

capital to bear in support of the trading

of new and smaller-capitalized

companies in which there may not be

significant natural liquidity. A market

maker’s willingness to sponsor new

companies is directly related to its

return on capital for the risks incurred.

Market maker participation could

diminish if Nasdaq did not provide

market makers a reasonable opportunity

to obtain a fair return on investment. In

turn, lack of market maker sponsorship

could seriously damage the capitalraising abilities of small issuers at an

early stage in their growth. As is wellknown, Nasdaq’s competing dealer

market structure historically has

provided strong support for smaller

issuers as they built investor interest

and support. It is appropriate, then, to

permit Nasdaq to constructively refine

its market structure as it seeks to

provide greater benefits to investors

using the market, while continuing to

maintain market maker incentives in its

structure.7 The NASD believes that its
31576 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

deal with unbalanced order flow in times of market

imbalances or in cases of very large trades by

institutions, such as pension funds and mutual

funds, that represent large numbers of individual

investors.

The NASD notes that other markets in the U.S.

and around the world have developed special

arrangements to encourage and facilitate dealer

participation to handle block trading and order

imbalances. For example, the specialist system in

U.S. exchange markets requires dealer participation

in what are typically referred to as ‘‘auction

markets.’’ Block trading rules used at exchanges in

the U.S. and the Paris Bourse’s special rules

regarding the ‘‘contra partie’’ system also encourage

dealer participation to accommodate block trades.

The NASD refers to these hybridized market

structure approaches only to note that it is

important that the regulator allow market forces,

within a strong regulatory framework, to determine

an appropriate, flexible, balanced approach to

serving the diverse needs of all market

participants—issuers, retail and institutional

customers, and market professionals, including

market makers.

8The NASD believes that the best measure for

determining trading activity for these purposes is

the median daily dollar volume over the course of

a quarter. Dollar volume provides a clearer measure

than share volume because it normalizes across

diverse share prices. Because of merger activity

among Nasdaq issuers and other phenomena that

can cause temporary volume surges, share trading

statistics can be skewed. The temporary spikes in

share volume could displace from the most active

list more substantial companies that regularly trade

in heavy volume. The median is a measure of

central tendency that limits the importance of

temporary volume surges.

However, even with the median daily dollar

volume calculation, the trading history in an initial

public offering (‘‘IPO’’) may be skewed to such an

extent that the NASD does not have an accurate

picture of the true trading characteristics of that

security. For that reason, the NASD will exclude an

IPO from the Top 250 calculation until the security

has two full calendar quarters of trading history

after which a more accurate determination can be

made. The NASD will use the second full calendar

quarter of trading to determine whether an IPO falls

into the list of the Top 250 securities. The first full

calendar quarter will not be used in the calculation.

9These statistics were derived from the first

thirteen Thursdays of trading in 1996 (January 4–

March 28, 1996). The NASD excluded Small Cap

issues and any issue that did not trade on each day

of the sample period. The calculation was derived

by first finding the median daily dollar volume for

each issue and then finding the median value across

the grouping.

10Under the original NAqcess proposal, market

makers would have been able to enter ‘‘marker

orders.’’ A marker order was defined as a principal

order that a market maker entered for the purpose

of effecting, in essence, a riskless principal

transaction with a customer. The proprietary order

proposal eliminates the need for the marker order

concept. Under the proposed revision, market

makers may enter priced or unpriced principal

orders for their own account, or principal orders on

behalf of a customer as part of a riskless principal

transaction.

approach provides an appropriate

balance of these competing objectives.

Based upon an analysis of the trading

activity in Nasdaq securities for the first

quarter in 1996, the 250 most active

National Market securities are

significantly more liquid than other

Nasdaq securities. For instance, median

daily dollar volume for the 250 most

active securities was $13,788,823.8 For

the next 250 most active securities, first

quarter median daily dollar volume was

$3,604,481. The median daily dollar

volume for the remaining securities in

the Nasdaq National Market list was

$268,228.9

These figures demonstrate a drop off

in trading activity in stocks ranked

below the 250 most active securities.

Market makers currently are willing to

quote in these securities on a regular

and continuous basis and will buy from

or sell to any customer that seeks to

trade. Market makers may not be

willing, however, to incur the

substantial risk to their capital in low

liquidity securities when forced to

compete with limit orders that in effect

could act as fair-weather market makers,

i.e., displaying priced orders when there

is natural investor interest on the

opposite side of the market, but

disappearing as soon as market

conditions turn unfavorable. Market

makers that must compete on such

unfair terms would likely seek more

productive uses for their capital and

would withdraw from market making in

such securities.

In addition, if market makers

withdraw, the NASD believes at this

time that other sources of liquidity may

not provide an adequate replacement.

The liquidity provided by typical

investor order flow through limit orders

in low-liquidity stocks is likely to be

overwhelmed or non-existent, and

accordingly, it may be difficult to

sustain price continuity. The NASD

believes volatility may increase and

investors will receive poorer executions

as a result. Ultimately, investors may

seek investment opportunities in other

securities and issuers may find it more

difficult to raise capital.

It is important to emphasize that these

less liquid securities would continue to

have the NAqcess limit order facility

available for limit orders of 1,000 shares

or less. This feature clearly permits the

average retail investor the opportunity

to compete with market makers and to

seek price improvement opportunities

over the dealer quote. The NASD notes

that in the SOES limit order file, the

typical retail investor limit order size

(excluding day traders) averaged under

500 shares. Based on this information

and information from NASD members,

for securities below the Top 250, the

eligible limit order size provision

should satisfy retail investors.

Accordingly, the NASD believes it is

appropriate to create two different size

levels of limit orders eligible for entry

into NAqcess.

Moreover, both the NASD and the

SEC, together with market participants,

will be able to learn from the experience

gained in expanding the limit order size

for the most active Nasdaq securities.

The tempered approach proposed by the

NASD will permit it to determine the

empirical effect that larger-sized limit

order exposure has on these securities,

especially on liquidity and continued

market maker participation. After a

sufficient study period of two years (if

not sooner), the NASD will be in a better

position to evaluate additional steps

that may be warranted.

The NASD also notes that under the

proposed rules it would permit a

continuing, gradual expansion in the list

of securities eligible for large-sized limit

order entry. This gradual expansion

would occur because the NASD would

not delete issues from the list even if

supplanted by other issues in

subsequent recalculations of the 250

most active securities. For example, if

securities ranked 240 through 250 as

measured in the initial ranking were to

be replaced by other securities not

previously ranked, the NASD would

add the new most active securities to

the eligibility list but would not delete

those supplanted. In this way, the list

would eventually expand in size,

providing investors with additional

opportunities to place larger limit

orders.

Of course, if a security ranked in the

250 most active list were to experience

a fundamental change in trading

characteristics, the NASD would delete

the security from the list. By

fundamental change, the NASD means it

would examine the median daily dollar

volume activity to determine if its dollar

volume had fallen below the 1,500 most

active securities, or that it no longer

qualified as a National Market security.

In either case, the security would be

deleted from eligibility for larger limit

orders entry into NAqcess.

B. Market Maker Proprietary Orders in

NAqcess

The NASD also proposes to amend

the NAqcess rules to permit brokerdealers that are registered as NAqcess

market makers, or other broker-dealers

that perform market making functions

(defined as ‘‘eligible market makers’’ in

the amended rule), the opportunity to

enter proprietary orders into NAqcess.

Proprietary orders are orders entered by

a market maker for the firm’s own

principal account or as a part of a

riskless principal trade on behalf of a

customer.10 Eligible market makers may

enter proprietary orders that are priced

orders (i.e., limit orders), unpriced

orders (i.e., market orders), or priced

orders entered at the current best dealer
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31577

11A proprietary limit order may be entered by the

firm as principal for the firm’s own account or as

part of a riskless principal transaction. In riskless

principal transactions, the limit order entered may

be of representative size, i.e., it does not have to be

for as large a size as the customer order the firm

holds. However, this type of proprietary order may

not be representative of an order larger than that

eligible for NAqcess in the first instance. Entry of

split orders, whether as part of an agency order or

as part of a riskless principal proprietary order

transaction, is not permitted.

12Because marketable limit orders are the

equivalent of market orders, this amendment also

permits the entry of proprietary marketable limit

orders. When used in this discussion, the term

‘‘market orders’’ encompasses marketable limit

orders as well.

13With respect to options market makers, the

NASD notes that this approach should address the

concerns expressed by the Commission in its

approval order regarding the NASD’s Limit Order

Protection Interpretation (NASD Rules of Fair

Practice, Article III, Section 1, Interpretation .07).

Securities Exchange Act Release No. 35751, May 22,

1995. In that order, the Commission stated that it

‘‘recognized the importance of price discovery and

market efficiency and liquidity for options

specialists and market makers to have efficient and

economical opportunities for laying off risk in the

Nasdaq market.’’ Id. at 21. Because of the important

options market liquidity role that options market

makers have, and because options market makers’

orders will enhance liquidity and the likelihood of

prompt executions in NAqcess, the NASD

determined that proprietary orders from these types

of firms should be allowed.

14The NASD notes that NAqcess rules continue

to allow any NASD member to enter customer limit

orders on behalf of their customers and to enter

takeout orders on behalf of customers or for their

own accounts.

bid or offer (i.e., marketable limit

orders), consistent with the general

order entry requirements for NAqcess.

1. Proprietary Limit Orders

The entry of proprietary limit orders

in NAqcess should increase the size and

depth of the limit orders in the facility

and may help to further tighten the

spreads in stocks. Market maker limit

orders should permit such firms to

aggressively price securities

anonymously and to attract additional

orders to them through this anonymous

display. Consequently, the NASD

believes that this amendment will

increase the likelihood that customer

orders will be executed more quickly,

more frequently, and at better prices.

In addition, the entry of proprietary

limit orders responds to the

transparency concerns that the SEC

raised with respect to orders placed in

widely disseminated electronic

communications networks (‘‘ECNs’’)

and will assist market makers in

managing their risk by eliminating the

potential for double executions that

would be possible under the SEC’s

proposal. The SEC’s proposed Rule

11Ac1–1(c)(5) would require that

market makers reflect in their quotes the

prices of orders that they place in ECNs.

As the NASD noted in its comment

letter on the Commission’s proposed

rules, this part of the SEC proposal may

act as a major disincentive to market

making because it would destroy the

benefit of anonymity provided by ECNs.

Every quote from a market maker in

Nasdaq has the market maker’s own

unique identifier. The quote-display

requirement with the attached identifier

increases substantially the risk that a

market maker would incur in

establishing or liquidating a larger

position because it telegraphs to the

entire market the inventory position of

the market maker. Moreover, displaying

a better price in both the individual

quote and in an ECN exposes the market

maker to the risk of multiple executions

at the same price.

The proposed revision to NAqcess

that would allow proprietary limit

orders by market makers in the NAqcess

file addresses both the transparency

concern and the double execution issue.

NAqcess limit orders, whether agency or

principal, that establish the best prices

on the market would be reflected in the

Nasdaq best bid and offer, i.e., the inside

market.11 Because the inside market is

publicly disseminated, price discovery

would be enhanced and best execution

obligations would be more readily met.

In other words, small investors would

have access to the same prices that

institutional and professional traders

have in ECNs. Further, because the

order would be anonymously reflected

in the inside market, the problems that

surface under the SEC proposal are

diminished. In sum, this change to

NAqcess should enhance the price

discovery function of the Nasdaq Stock

Market, while continuing to promote the

liquidity that multiple market makers

bring.

2. Proprietary Market Orders

Additionally, the NASD is amending

the filing to permit eligible market

makers to enter market orders for their

own accounts, i.e., proprietary market

orders.12 Proprietary market orders

would be handled in the same manner

as agency market orders. In other words,

proprietary market orders would be

subject to the same maximum order

sizes and would be processed and

executed in the same way agency

market orders are to be handled. The

intention in this amendment is to

promote market maker participation in

Nasdaq and to aid market makers in

their ability to reduce risk from

inventory by laying off positions

through an automated means.

The NASD believes, at this time, that

the proprietary market order entry

feature provides a significant benefit to

market makers and the marketplace as a

whole. The ability to enter proprietary

market orders allows market makers the

ability to swiftly access other market

makers’ quotes and receive executions

at those displayed prices. As a result,

the accessibility of these quotes will

encourage market makers to take

positions in those securities and thereby

aid in the liquidity of the market. The

NASD believes that it is appropriate to

limit use of NAqcess for proprietary

trading to market maker orders. The

purpose of proprietary trading in

NAqcess is to enhance price discovery

and to provide market makers with the

tools to continue to function effectively

as a market maker.13 The NASD’s goal

is to promote liquidity and to provide

incentives to market makers to maintain

that liquidity and to continue to sponsor

new issuers.

Accordingly, to the extent that

proprietary trading capability is not

extended to other broker-dealers and

thus considered a competitive burden,

the NASD believes that any such burden

is appropriate and in furtherance of the

purposes of the Act. In particular, by

quoting firm, two-sided markets on a

regular and continuous basis in addition

to entering proprietary limit orders,

market makers perform an important

liquidity-provider function that is at the

core of the Nasdaq Stock Market. Nonmarket-makers do not provide such

liquidity. In fact, broker-dealers that

seek execution of orders for their own

account without incurring any of the

risks associated with the display of firm

quotes reasonably related to the current

market could potentially harm the

market and investors. They are

demanders of liquidity competing with

investors for a scarce commodity. It

does not further the purposes of the Act

to create a market structure that could

harm investors by allowing market

professionals to exhaust market

liquidity for their own gain without

imposing a corresponding obligation to

provide support to the market. Any

broker-dealer seeking access to this

particular feature of NAqcess may seek

to register as a NAqcess market maker

and contribute to Nasdaq liquidity.14

3. Proprietary Orders—Generally.

The NASD believes that it would be

appropriate to extend the capability to

enter proprietary orders to registered

Nasdaq market makers and to other

broker-dealers that perform Nasdaqsecurity-related market-making

functions in other markets. The
31578 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

15To clarify the rule on takeout orders, the NASD

also proposes to amend the rule to specifically

allow takeout order entry on behalf of registered

options market makers, as well as customers. In the

original proposal, takeouts were described as

principal orders or orders entered as agent for a

customer. Under NASD rules generally, customer is

defined not to include brokers or dealers. The

NASD has added the term ‘‘customer’’ to the list of

definitions in the NAqcess rules and have redefined

‘‘takeouts’’ to include options market maker orders.

Because UTP Exchange specialists will have access

to Nasdaq Workstations, they will be permitted to

enter takeout orders directly. In adding the

definition of customer, the NASD reiterates that

agency orders entered within a five minute period

may be deemed to be based on a single investment

decision. In this regard, it also noted that entry of

computer generated orders could be considered

orders based on a single investment decision. See

Securities Exchange Act Release No. 36548, at n. 16

(60 FR 63095).

16The equivalent price protection rule does not

apply to proprietary limit orders because such rules

only apply to customer orders. Thus, to the extent

that a member firm holds a limit order from an

options market maker outside of NAqcess, the firm

is not obligated to provide equivalent price

protection for such order.

17A member entering a proprietary order on

behalf of an options market maker must ensure

itself that the firm placing the order is eligible to

do so. Thus, if a member receiving an order from

another firm claiming to be eligible as a registered

options market maker knew or should have known

that the firm claiming the right to enter the order

did not in fact qualify, the member could be

deemed to have violated the NAqcess rules.

Members entering such orders are required to

document that the order is eligible for entry.

Members will be required to place an appropriate

indicator in the order entry window on the Nasdaq

Workstation to denote whether a limit order is an

agency order, a principal order, a riskless principal

order, or an order on behalf of an options market

maker.

proposed amendments specify that

proprietary orders may be entered by

three separate groups of market makers:

(1) Registered Nasdaq market makers

that also have registered as NAqcess

market makers; (2) UTP exchange

specialists; and (3) registered options

market makers. Market makers must be

registered as market makers for the

specific security for which they seek to

enter a proprietary order. Thus, a market

maker registered and actively quoting as

a market maker in one Nasdaq security

(or, in the case of options market

makers, an option on a Nasdaq security)

may not enter a proprietary market or

limit order in another Nasdaq security,

unless separately registered as a market

maker in that security as well. It is

important to note that mere registration

as a market maker is not sufficient to

allow the entry of proprietary orders. A

market maker must also have

commenced quoting the security and

the quotation must be active, i.e., the

market maker may not enter proprietary

orders when it is in a closed quote state.

Additionally, all proprietary orders

must be entered by an associated person

of the eligible market maker who is

actively engaged in a market making

capacity for Nasdaq securities. The

NASD seeks to ensure that the entry of

proprietary orders is properly managed

by the eligible market maker.

As to UTP exchange specialists, the

exchange specialist must be registered

with an exchange that is a signatory to

the Nasdaq/NMS/UTP Plan and must

accept responsibility for market order

executions at its quotation pursuant to

the NAqcess market order execution

process. Specifically, the NASD notes

that the extension of this privilege to

UTP specialists is contingent upon UTP

exchanges and Nasdaq coming to terms

on access to UTP exchange quotes for

the purpose of market order executions.

The best way to provide the reciprocal

capability of one market being able to

access the other is through the provision

of Nasdaq Workstations to UTP

Exchanges. In that way, UTP Exchange

specialists will be able to enter

proprietary orders into NAqcess and in

return, NASD members can directly

access exchange quotes in Nasdaq

securities through NAqcess. Until such

time as NASD members can obtain

executions of market orders in NAqcess

against the UTP exchange specialist

when a UTP exchange is setting the best

price in a security, the NASD believes

that it would be unfair to allow UTP

specialists to enter proprietary orders

into NAqcess. The NASD is fully willing

to negotiate with UTP exchanges an

appropriate approach to access to all

Nasdaq systems as a part of the Nasdaq/

NMS/UTP Plan. In this regard, prior to

filing this amendment to the rule filing,

the NASD has contacted the UTP

Exchanges to inform them of this

proposed function and to commence

discussions on reaching a successful

resolution of the access issue.

A registered options market maker

that seeks to enter a proprietary order in

a security must be registered as an

options market maker in that same

security on an exchange that trades

options on that security. Options market

makers that are not NASD members

with access to Nasdaq Workstation II

equipment may place NAqcess orders

through an NASD member, whether a

market maker or a NAqcess order entry

firm.15

All proprietary orders will be

accorded the same priorities and, for

limit orders, price protection as

provided to any other order in NAqcess.

Accordingly, a proprietary limit order in

NAqcess that has price or time priority

over any other limit order will be

executed ahead of all other limit orders.

Further, the price protection rule also

applies to proprietary limit orders in

NAqcess in the same way that the rule

would apply to an agency order.16

Proprietary limit orders will not have

any distinguishing characteristic

viewable to market participants to

differentiate them from other limit

orders.17 Similarly, proprietary market

orders will be handled in the same order

delivery and execution process as

agency orders. In addition, proprietary

orders, both limit and market orders,

may not be entered for sizes larger than

the maximum order sizes permitted

under the rules, i.e., 9,900 and 1,000

shares for limit orders, and 1,000, 500,

and 200 for market orders. It should be

noted, however, that proprietary orders

will not be aggregated under a single

investment concept approach when the

proprietary orders are strictly for the

market maker’s own account. On the

other hand, to avoid allowing a

customer to circumvent the maximum

order size rules, a market maker may not

enter a series of proprietary orders in

order to execute as riskless principal a

customer order that is in excess of the

maximum order size. For example, if a

market maker receives a customer limit

order for 20,000 shares, the firm is not

permitted to enter four 5,000 share

orders at that same price with the

expectation that the firm will pass along

the benefit of the executions to the

customer.

4. Elimination of SelectNet

The entry of proprietary orders and

larger sized limit orders provides

significantly greater functionality in the

NAqcess system. It is the NASD’s view

that this new functionality provides

members with the capabilities

substantially equivalent to the most

used functions in SelectNet. Members

use SelectNet in several ways. Members

most frequently broadcast smaller or

medium size orders in an attempt to

obtain price improvement for a

customer order over the current dealer

quotation. NAqcess provides a similar

ability in a more efficient book display

and interaction environment.

Market makers also occasionally use

SelectNet to send orders to other market

makers when they cannot reach them by

telephone. NAqcess will provide market

makers similar capabilities and because

orders will not scroll off the screen

unexecuted as occurs in SelectNet, it

will provide for more efficient

executions.

Members also can use SelectNet to

broadcast larger orders in an attempt to

seek negotiation or execution of those

orders. NAqcess will provide the ability

to send orders up to 9,900 shares for

certain securities, but, unlike SelectNet,
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31579

18NASD Economic Research examined SelectNet

activity on Thursdays in the first quarter in 1996.

19The NASD also plans to develop a new

approach to the requirement related to updating a

market maker’s quotation after its exposure limit

has been exhausted. Currently, NAqcess rules

provide that a market maker has up to five minutes

to update its quotation after the exposure limit has

been exhausted. The NASD plans to submit a

system and rule revision to the Nasdaq Board for

review and approval. The proposed revision would

be to create a system alert function that would

advise a closed quote market maker after one

minute that it should refresh its quotation. If the

market maker does not take any action by the end

of three minutes in a closed quote status, the market

maker would have a choice between systemassisted reentry of a quotation in accordance with

market maker predetermined parameters or

suspension as a market maker in the security for 20

business days.

it will not permit unlimited size for all

securities. The NASD notes, however,

that although SelectNet allows the

display of unlimited size orders, it is

rare that orders larger than the NAqcess

size limits are executed in SelectNet.

The NASD examined certain trading

days in the first quarter of 1996 to

determine a representative picture of

SelectNet use.18 Of the 250 most heavily

traded issues as determined by median

dollar volume, there were 52 trades in

SelectNet larger than 9,900 shares on

the days studied. Over the same time

period, the total number of trades for

these securities was 2,085,544. Thus,

SelectNet trades greater than 9,900

shares accounted for .0025% of total

trades. The numbers related to other

securities present a very similar pattern.

There were 27,646 SelectNet trades

greater than 1,000 shares for all other

Nasdaq securities in this time period, as

compared to a total number of trades of

1,827,282. This represents 1.51% of

total trades.

Overall, NAqcess provides a very

similar opportunity for market makers

to lay off positions and to obtain a better

execution for their customer and

proprietary orders. Further, and more

important, NAqcess will consolidate

market information that previously was

fragmented and not transparent to the

entire market. Moreover, merging

SelectNet trading activity into NAqcess

should increase the likelihood that

public limit orders displayed in

NAqcess will receive a quick and

advantageous execution. Because

NAqcess provides capabilities

analogous to the most used capabilities

permitted in SelectNet, the NASD

believes that SelectNet is no longer

necessary. Accordingly, through this

filing, the NASD proposes to terminate

the SelectNet service.

Finally, the NASD intends to

maintain the communications capability

of SelectNet to provide an emergency

communications mechanism among

members in case of market exigencies.

This feature is essentially the original

SelectNet service first provided after the

1987 market break. Nasdaq will

maintain this feature running in the

background on the host processor

operated by Nasdaq, and if necessary to

provide additional communications

capabilities during special market

circumstances, Nasdaq will commence

operation of this communications

facility. Under such limited

circumstances, NASD members would

be able to direct an order through

SelectNet to a particular market maker

in lieu of calling on the telephone.

C. Other Changes

The NASD has made several other

changes to the NAqcess rules, in

particular with respect to the

preopening procedures.

1. Opening

The NASD has revised the opening

process it will use at the startup of

NAqcess to greatly simplify the process

of opening NAqcess. The NASD has

deleted all of the opening procedures

previously described in the original rule

filing. In its place, the NASD proposes

the following procedures: NAqcess will

not accept any limit or market orders

entered into NAqcess outside of normal

market hours, i.e., 9:30 a.m. to 4:00 p.m.

Eastern Time. Members will be able to

cancel resident GTC agency or

proprietary limit orders prior to the

opening, as well as after the market has

opened. This will allow members to

exercise their fiduciary duties as to their

customers when material news in a

security occurs after the market has

closed on the previous day.

The rules regarding the opening will

provide a special exception to the

normal mechanism for dealer quotations

that match or cross orders not executed

the previous day or cancelled prior to

the opening. Under the newly proposed

opening process, a dealer quotation that

matches or crosses limit orders on the

file at 9:30 is subject to immediate

execution of the limit orders at its

quotation price. Thus, if a market maker

were to move its opening offer at 9:30

to 197⁄8 to set the inside market when a

limit order to buy 8,000 shares at 20 was

resident on the file at 9:30, the 8,000

share limit order would automatically

execute against the market maker at its

197⁄8 quotation. Moreover, the execution

would not deplete the market maker’s

minimum exposure limit. If multiple

market makers quote through resident

limit orders, each limit order quoted

through will be distributed to the

market makers at the best dealer bid or

offer on a time sequence basis. In other

words, if two GTC limit orders to buy

3,000 shares each at 20 are resident in

the file at 9:30, and at 9:30, two market

makers set the inside by quoting on the

asked side of the market at 197⁄8, each

market maker will receive an execution

report for 3,000 shares at 197⁄8 delivered

to it. The executions against their quotes

will not have an effect on their exposure

limits.

Orders entered at 9:30 and thereafter

and any limit orders already resident in

NAqcess from the previous day will be

processed according to the normal

market procedures described in the

NAqcess rules.

2. Inside Market—Best Dealer Bid and

Offer

The NASD revised the use of the term

‘‘inside market’’ and added the term

‘‘best dealer bid and offer’’ throughout

the proposed rule.19 The NASD has

made these revisions to provide a

clearer definitional framework for

several reasons. The new definition of

‘‘best dealer and offer’’ is necessary to

establish, for example, when a limit

order is to be treated as a ‘‘marketable

limit order.’’ This new definition sets

the condition that a limit order is to be

handled as market order when the limit

order is priced the same as or outside

the dealer bid or offer, as the case may

be. Similarly, the two definitions,

working in tandem, are critical to

determine when limit orders establish

the inside market and when such limit

orders are to be automatically executed

against each other.

3. Self-Directed Orders

Consistent with the proprietary

market order change discussed above,

the NASD has also eliminated the

requirement set out in the original

proposal concerning agency market

orders entered by market makers for

their customers. The original proposal

required that such orders be selfdirected to the market maker. The

NASD does not believe that requirement

is necessary in an environment where

market makers can enter proprietary

orders. Nonetheless, market makers will

be able to self-direct any market order.

4. Odd-Lot Orders

The NASD has amended the proposal

regarding the eligibility of odd-lot

orders in NAqcess. The smallest normal

unit of trading in Nasdaq is a round lot

of 100 shares. At least for the initial

operation of NAqcess, the NASD has

determined that odd-lot orders (i.e.,

orders 99 shares or less) should not be

handled through NAqcess, because of
31580 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

20See changes to proposed definition I. G. and

Order Entry Restrictions IV. B. 3 and 4. 22See e.g., letter from Harold Bradley and IRC.

21See changes to Section 11A(a)(1)(C)(i), (iv) and

(v) of the Act (‘‘It is in the public interest and

appropriate for the protection of investors * * * to

assure * * * economically efficient execution of

securities transactions, * * * the practicability of

brokers executing investors’ orders in the best

market; and an opportunity * * * for investors’

orders to be executed without the participation of

a dealer.’’).

the potential adverse cost impact that

odd-lot executions may have on roundlot customer orders. Thus, the proposed

Rules are being amended to delete

references to the entry of odd-lot orders,

except insofar as a partial execution of

a mixed lot order (i.e., an order

consisting of at least one round lot and

an odd-lot) may occur. In the case of a

partial fill of a mixed lot order, the

remaining unfilled odd-lot, if it is a

limit order, will be stored in the

NAqcess limit order file. However, it

will not establish the inside market if it

is the best priced limit order, nor will

it be displayed in the Top of File

display. The unfilled odd-lot will not be

matched against incoming limit or

market orders. Execution of the odd-lot

limit order will occur when the best

dealer bid or offer matches or crosses

the odd-lot order; the odd-lot will

automatically execute against the dealer

quote. If the order was a mixed-lot

market order that obtained a partial fill

against a limit order, the unfilled

remainder will be automatically

executed against the next available

market maker at the inside market

without the possibility of being

declined. The NASD also has amended

the Rules of Fair Practice regarding the

customer’s discretion on NAqcess order

entry to reflect this limitation on oddlot order entry.

The NASD will continue to assess the

need for development of an odd-lot

order handling facility and may propose

to revise NAqcess at a future date to

permit such a capability.

5. Agency Orders—Family Members

The NASD is proposing to change the

prohibition regarding the entry of

agency orders on behalf of an immediate

family member. The current proposal

retained the SOES prohibition that

stated an order is not considered an

‘‘agency order’’ if it is for any account

of a member of the immediate family of

an associated person who has physical

access to a device capable of entering

orders into NAqcess.20 These provisions

were intended to prevent the creation of

multiple accounts by a firm to evade the

maximum order size limit in SOES.

Upon consideration of the purpose of

the restriction on immediate family

members in light of the new order

delivery risk management features in

NAqcess (i.e., the ability of a market

maker to decline an order if it has just

effected a trade and is in the process of

updating its quotation), the NASD has

determined at this time to eliminate the

restriction. However, it should be noted

that the restriction’s elimination is being

done based upon preliminary views that

the order delivery function of NAqcess

should provide sufficient tools to

market makers to handle multiple

market orders sent for execution at a

dealer’s quotation. If experience in

NAqcess teaches that firms attempt to

set up multiple accounts using family

members as a technique to evade the

order size restrictions, the NASD will

seek to amend the NAqcess rules to

address such subterfuges.

6. Amendment to Schedule D, Part V,

Section 2(a)

The NASD has amended this rule to

be consistent with the criteria for

maximum market order size in NAqcess.

(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. The NASD

has attempted to consider the various

perspectives and competing interests

and to determine an approach that

provides maximum benefits for

investors while reducing the costs to the

lowest level possible. The NASD has

carefully weighed the competitive

implications of these changes, including

the effect that larger orders and

proprietary limit orders will have on

competing systems and markets, and

has determined that the benefits

provided by greater transparency of

limit orders and the increased

likelihood of execution of public limit

orders resident in NAqcess outweigh

any competitive concerns. Specifically,

NAqcess provides a limit order display

that drives the inside market, thereby

generally increasing competition in

Nasdaq through the increased

transparency of limit orders. The

changes involving proprietary limit

orders proposed in this amendment

further increase the competition among

orders. Increased competition among

orders and quotations is inherently procompetitive. Further, by permitting

market makers to enter proprietary

market orders, market makers can access

other market makers’ quotations more

readily, resulting in an increased

willingness to provide liquidity.

Finally, the NASD believes that any

adverse competitive impact resulting

from the entry of proprietary orders to

market makers is far outweighed by the

positive impact that the change will

have on market liquidity and market

making competition.21

The NASD notes that NAqcess will

provide new opportunities to satisfy

investor demand that Nasdaq provide an

investor with an ability to interact with

another customer’s order without the

intermediation of a dealer, a goal stated

in Section 11A of the Act. In comment

letters on NAqcess and the SEC Order

Exposure Release, institutional investors

and companies listed on Nasdaq noted

that this was an important feature that

they wanted.22 The NASD believes that

it is important that every market listen

to its ultimate customers and provide

capabilities that those customers

request. Further, it is critical that

Nasdaq market makers, and other firms

that perform market making functions in

Nasdaq securities, or options related to

Nasdaq securities, maintain incentives

to continue to make markets and

provide liquidity for those securities.

Opening NAqcess to proprietary orders

from any broker-dealer would permit

any firm to effectively operate as a fairweather market maker by competing

with market maker quotes through limit

orders. This would allow non-market

makers to compete risk-free with market

makers and would drive market makers

from the risk position they occupy when

they enter two-sided quotes on a regular

and continuous basis. Because market

makers are a significant source of

market liquidity, it is essential that the

system is structured to provide

incentives to continued market maker

presence.

As to the competitive effect on ECNs,

the NASD emphasizes that NAqcess is

voluntary in nature. The decision as to

whether to enter orders into NAqcess

will be determined by investors seeking

the best available market in which to

obtain an execution of their orders,

priced and unpriced. NAqcess does not

restrict broker-dealer opportunities to

offer a competing service. Accordingly,

the NASD believes that NAqcess as

revised herein provides significant

investor benefits that outweigh any

competitive effects on others. Finally, as

to the general benefits that the NASD

believes will result from the

implementation of NAqcess and its

accompanying rules, the NASD’s

Economic Research Department has

developed a report regarding the

benefits NAqcess will bring to investors
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31581

23The NASD has consented to an extension until

August 30, 1996 for the Commission to act on the

proposal. Letter from Eugene A. Lopez, Assistant

General Counsel, Nasdaq, to Michael J. Ryan, Jr.,

Special Counsel, SEC (June 11, 1996).

in Nasdaq stocks. The report is attached

as Exhibit D to this filing.

(C) Self-Regulatory Organization’s

Statement on Comments on the

Proposed Rule Change Received From

Members, Participants, or Others

Written comments on the

amendments 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 self-regulatory

organization consents,23 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.

The Commission requests comments

generally concerning whether the

NASD’s proposal is consistent with the

Act. In addition, the Commission invites

interested persons to address the

following specific issues:

(1) The NASD proposes to allow limit

orders up to 9,900 shares in the 250

most active Nasdaq securities,

determined by the median dollar

volume over the previous calendar

quarter. Further, once a security is

included in the 250 most active Nasdaq

securities, the NASD proposes to

continue to allow limit orders up to

9,900 shares in the security until the

security’s median daily dollar volume

brings it below the 1,500 most active

Nasdaq National Market securities. The

Commission seeks comment on:

(a) Whether the median dollar volume

is the most appropriate measure for

determining the most active Nasdaq

stocks or whether a different measure or

alternative measures should also be

considered;

(b) Whether it is appropriate, as the

NASD has proposed, to exclude IPOs

from the quarterly assessment of which

securities meet the median dollar

volume test until the second full

calendar quarter after the IPO; and

(c) Whether it is appropriate to

maintain the maximum limit order size

for the top 1,500 most active securities

or a lesser of greater number of

securities.

(2) As under the SOES rules, the

NAqcess rules generally would prohibit

members from splitting orders to

comply with the NAqcess order size

limitations. Two or more orders based

on a single investment decision would

be considered one order for purposes of

determining whether an order was split.

As a general rule, orders entered by an

order entry firm within any five minute

interval would be presumed to be based

on a single investment decision.

Notwithstanding the single investment

decision limitation, market makers

would be permitted to enter multiple

proprietary orders, unless the order is a

riskless principal order. The

Commission seeks comment on whether

the exception to allow market makers to

enter multiple proprietary orders is

appropriate.

(3) The proposed NAqcess

‘‘equivalent price protection’’ rule

would require member firms that do not

enter NAqcess-eligible customer limit

orders into NAqcess (e.g., firms that

internalize) to provide these orders

price protection at least equivalent in

substance to that which the order would

have received had the order been

entered into NAqcess. This rule,

however, would not apply to

proprietary (i.e., non-customer) limit

orders. Thus, if a firm internalizes a

limit order it receives from an options

market maker, it would not be required

to provide it print protection. The

Commission seeks comment on whether

this exception is appropriate. In

addition, the Commission seeks

comment on the practical impact of the

‘‘equivalent price protection’’ rule.

Specifically, the Commission is

interested in commenters’ views on

whether this rule, in effect, would

require member firms to place their

customers’ limit orders in NAqcess.

(4) The NASD developed SelectNet in

response to the difficulties experienced

in the Nasdaq market during the market

break of October 1987. SelectNet is an

electronic screen-based order routing

system allowing market makers and

order-entry firms to negotiate securities

transactions in Nasdaq securities

through computer communications

rather than relying on the telephone.

Through SelectNet, NASD members can

either direct an order to another member

or broadcast an order to all market

makers in the security or all members

watching the security. The NASD

proposes to terminate its SelectNet

service but intends to maintain for

‘‘special market conditions’’ the ability

of market makers to use the directed

feature in SelectNet. The Commission

seeks comment on whether the NASD

should continue to operate the directed

feature at all times, rather than reserving

it for ‘‘special market conditions,’’ if

NAqcess is approved.

(5) At least for the initial operation of

NAqcess, the NASD proposes to

prohibit the entry of odd-lot orders (i.e.,

orders of less than 100 shares). The

NASD is concerned that the cost

imposed on a round-lot customer order

that matches with an odd-lot order

might be excessive. The NASD

recognizes, however, that even though

the entry of odd-lots would be

prohibited, round-lot orders might be

partially executed and result in an oddlot remaining. Under this situation, the

NASD proposes to immediately execute

the remaining odd-lot automatically

against a market maker as soon as the

order becomes marketable (i.e.,

immediately if the order is a market

order or, if it is a limit order, after the

inside market moves so that a buy (sell)

limit order equals the inside ask (bid)).

The Commission seeks comment on

whether odd-lot orders should be

entered in NAqcess and the appropriate

methodology for executing these orders,

including consideration of immediate

automatic execution of marketable

orders.

(6) Under the proposed NAqcess

rules, a limit order priced at the quote

(i.e., buy (sell) order priced at the bid

(ask)) would not have time priority over

market makers’ quotes. For example, if

the inside market consists of two market

makers bidding $20 in a security and a

limit order to buy at $20 is placed in

NAqcess after the market makers began

bidding $20, incoming market orders

would be directed to the market makers

before they are matched with the limit

order priced at $20. Given that market

makers would have an opportunity to

decline market orders entered into

NAqcess (consistent with the Firm

Quote Rule), but market orders matched

with limit orders would be executed

immediately, the Commission seeks

comment on whether limit orders

should have priority over market maker

quotes, so that incoming market orders

would be matched with limit orders

first.

(7) Under the NASD’s original

NAqcess proposal (similar to current

SOES Rules), members would have been

permitted to enter orders during nonmarket hours (market orders: 8:30 a.m.

to 9:28 a.m.; limit orders: 8:30 a.m. to

9:28 a.m. and 4:00 p.m. to 6:00 p.m.).
31582 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

24 17 CFR 200.30–3(a)(12).

Immediately prior to the opening,

NAqcess would have applied to the

orders in its book special pre-opening

procedures that, generally, would have

first matched limit orders with limit

orders and then market orders with

limit orders. Any orders that remained

unexecuted after the pre-opening

procedure would have been subject to

the normal intra-day procedures. Under

the amended proposal, the NASD

proposes to prohibit entry of any orders

outside of Nasdaq market hours. The

Commission seeks comment on the

appropriateness of eliminating the entry

of orders outside of Nasdaq market

hours. Further, to the extent

commenters believe that pre-opening

and post-closing orders should be

permitted, the Commission seeks

comment on the appropriate preopening procedures.

(8) Like SOES, the current NAqcess

proposal would provide a market maker

up to five minutes to update its

quotation after its exposure limit has

been exhausted. The NASD has

represented, however, that it intends to

recommend that the Nasdaq Board

adopt a new approach. Specifically, the

NASD is expected to create a system

alert function to advise a closed quote

market maker after one minute that it

should refresh its quotation. If the

market maker does not take any action

by the end of three minutes in a closed

quote status, the market maker would

have a choice between a system-assisted

reentry of a quotation in accordance

with market maker predetermined

parameters or suspension as a market

maker in the security for 20 business

days. The Commission seeks comments

on:

(a) Whether the one minute and three

minute parameters are appropriate; and

(b) Whether, after three minutes have

lapsed, the NASD should allow a market

maker to choose between having its

quotation updated and being suspended

or whether the system should then

automatically reestablish the market

maker’s quotation, with the market

maker being limited to selecting the

update parameters.

(9) The NASD proposes to allow UTP

exchange specialists to enter proprietary

limit and market orders in NAqcess. To

obtain access, UTP exchange specialists

must, among other things, provide

electronic access that permits NAqcess

market and limit orders to be executed

against the specialist’s published quote.

The Commission seeks comment on

the most appropriate mechanism for

providing this electronic access.

(10) The NASD has represented that

many of its member firms have

expressed an interest in integrating

NAqcess into the firms’ internal order

handling systems. The Commission

understands the NASD has provided its

members with the technical

specifications necessary to begin

integrating NAqcess. The Commission

requests that commenters provide an

estimate of the time necessary from

Commission approval of NAqcess to

complete the changes necessary to

integrate NAqcess. Further, the

Commission seeks comment on

members’ and other commenters’ views

on the capacity for the current Nasdaq

network and Workstation to manage

expected NAqcess order flow.

Persons making written submissions

should file six copies thereof with the

Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W.,

Washington, D.C. 20549. Copies of the

submission, all subsequent

amendments, all written statements

with respect to the proposed rule

change that are filed with the

Commission, and all written

communications relating to the

proposed rule change between the

Commission and any person, other than

those that may be withheld from the

public in accordance with the

provisions of 5 U.S.C. 552, will be

available for inspection and copying in

the Commission’s Public Reference

Room. Copies of the filing will also be

available for inspection and copying at

the principal office of the NASD. All

submissions should refer to the file

number SR–NASD–95–42 and should be

submitted by July 26, 1996.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.24.

Margaret H. McFarland,

Deputy Secretary.

Exhibit A—Rules of Operation and

Procedures For the NAqcess System

I. Definitions

[The terms used in this Section shall

have the same meaning as those defined

in the Association’s By-Laws and Rules

of Fair Practice, unless otherwise

specified.]

A. The term ‘‘NAqcess’’ shall mean

the limit order and market order

delivery and execution system owned

and operated by The Nasdaq Stock

Market, Inc. (a wholly owned subsidiary

of the National Association of Securities

Dealers, Inc.).

B. The term ‘‘NAqcess participant’’

shall mean either a market maker or an

order entry firm registered for

participation in NAqcess.

C. The term ‘‘NAqcess eligible

security’’ shall mean any Nasdaq

National Market or Nasdaq SmallCap

equity security.

D. The term ‘‘open quote’’ shall mean

a market maker’s quotation price and

size (up to its designated exposure limit)

in an eligible security against which

orders may be executed through the

NAqcess system during normal market

hours, as specified by the NASD. For the

purposes of these Rules, a market maker

has a ‘‘closed quote’’ when its exposure

limit in NAqcess has been exhausted or

it has been deemed ‘‘closed’’ pursuant

to Section IV. A. 9 below.

E. The term ‘‘NAqcess market maker’’

shall mean a member of the Association

that is registered and quoting with an

open quote as a Nasdaq market maker

pursuant to the requirements of

Schedule D to the NASD By-Laws and

as a market maker in one or more

NAqcess eligible securities.

F. The term ‘‘NAqcess order entry

firm’’ shall mean a member of the

Association that is registered as an order

entry firm for [participating]

participation in NAqcess which permits

the firm to enter agency orders of

limited size [for delivery to and

execution against] that may be (1)

delivered to NAqcess market makers

[and customer limit orders in NAqcess

that are included in] or UTP Exchange

specialists that are at the best dealer bid

and/or offer or (2) executed against limit

orders that are at the inside market.

G. The term ‘‘agency order’’ shall

mean an order from a [public] customer

that is entered by the NAqcess order

entry firm or NAqcess market maker on

an agency basis.

An order will not be considered an

agency order if it is for any account of

a person associated with any member

firm or any account controlled by such

an associated person.

[An order will not be considered an

agency order if it is for any account of

a member of the ‘‘immediate family’’ (as

that term is defined in the NASD FreeRiding and Withholding Interpretation,

Article III, Section 1 of the Rules of Fair

Practice) of an associated person who

has physical access to a terminal

capable of entering orders into

NAqcess.] H. The term ‘‘customer’’ shall

have the same meaning as set forth in

the Rules of Fair Practice, Article II,

Section 1(f).

[H] I. The term ‘‘directed order’’ shall

mean an order entered into NAqcess

and directed to a particular NAqcess

market maker or an order entered by a

NAqcess market maker that is selfdirected. Each market maker has the

ability to select order entry firms from

which it will accept directed orders.
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31583

1The applicable maximum market order size for

each Nasdaq National Market security is

determined generally by the following criteria:

(i) A 1,000 share maximum market order size

shall apply to Nasdaq National Market securities

with an average daily non-block volume of 6,000

shares or more a day, a bid price of less than or

equal to $100, and three or more market makers;

(ii) A 500 share maximum market order size shall

apply to Nasdaq National Market securities with an

average daily non-block volume of 2,000 shares or

more a day, a bid price of less than or equal to $150,

and two or more market makers; and

(iii) A 200 share maximum market order size

shall apply to Nasdaq National Market securities

with an average daily non-block volume of less than

2,000 shares a day, a bid price of less than or equal

to $250, and that have two or more market makers.

2 [The Nasdaq 100 Index is an index comprised

of many of the largest capitalized issues quoted in

the Nasdaq National Market. The securities that

make up the Nasdaq 100 are changed from time to

time and The Nasdaq Stock Market publishes notice

of such changes as they occur.]

[I] J. The term ‘‘non-directed order’’

shall mean an order entered into

NAqcess and not directed to any

particular market maker [,] or [a

directed] an order that has been directed

to a market maker that has not identified

the order entry firm as one from which

it will accept directed orders, or a

directed order sent to a [firm] member

that is not registered as a market maker

in that security.

[J] K. The term ‘‘limit order’’ shall

mean an order entered into NAqcess

that is a priced order.

[K] L. The term ‘‘marketable limit

order’’ shall mean a limit order that, at

the time it is entered into NAqcess, if it

is a limit order to buy, is priced at the

current [inside] best dealer offer or

higher, or if it is a limit order to sell, is

priced at the [inside] best dealer bid or

lower.

[L] M. The term ‘‘executable limit

order’’ shall mean a limit order that, at

the time a limit order, market order, or

marketable limit order on the opposite

side of the market is entered, is either

[included in the inside market] within

the best dealer bid and offer or is equal

in price to the inside market and has

time priority over other [limit] orders or

[dealer quotations included] quotes in

the inside market.

N. The term ‘‘proprietary order’’ shall

mean an order for the principal account

of a broker or dealer. A proprietary

order may be a limit order, a market

order or a marketable limit order.

O. The term ‘‘UTP exchange

specialist’’ shall mean a broker-dealer

registered as a specialist in Nasdaq

securities pursuant to the rules of an

exchange that: (1) Is a signatory as

either a participant or limited

participant in the Joint Self-Regulatory

Organization Plan Governing the

Collection, Consolidation and

Dissemination Of Quotation and

Transaction Information For ExchangeListed Nasdaq/National Market System

Securities Traded On Exchanges On An

Unlisted Trading Privilege Basis

(‘‘Nasdaq/ NMS/UTP Plan’’); (2) provide

for electronic access that permits a UTP

exchange specialist to enter proprietary

orders and permits NAqcess market and

limit order executions against a UTP

exchange specialist at its published

quote; and (3) permit all transactions to

be cleared and settled through a

registered clearing agency using a

continuous net settlement system.

P. The term ‘‘registered options

market maker’’ shall mean an exchange

member registered with a national

securities exchange as a market maker

or specialist pursuant to the rules of

such exchange for the purpose of

regularly engaging in market making

activities as a dealer or specialist in an

option on a Nasdaq-listed security.

Q. The term ‘‘eligible market maker’’

shall mean a NAqcess market maker, a

UTP exchange specialist or a registered

options market maker. Eligible market

makers may enter proprietary orders

only for those Nasdaq securities for

which they are registered as a NAqcess

market maker or an exchange specialist

or for a Nasdaq security for which they

are registered as an options market

maker in an option on the underlying

Nasdaq security.

R. The term ‘‘takeout [M. The term

‘‘marker] order’’ shall mean an order

entered by an NASD member firm or a

UTP exchange specialist, acting as

principal or as agent on behalf of a

customer or a registered options market

maker, that executes against [NAqcess

limit orders viewable by that firm.] limit

orders consolidated in the inside market

or displayed in the NAqcess Full File

Display.

[O] S. The term ‘‘inside market’’ shall

mean the best dealer bid, UTP exchange

bid, or NAqcess limit order(s) to buy

and the best dealer offer, UTP exchange

offer or NAqcess limit order(s) to sell, as

the case may be, displayed by Nasdaq.

T. The terms ‘‘best dealer bid,’’ ‘‘best

dealer offer’’ or ‘‘best dealer bid and/or

offer’’ shall mean the highest priced bid

quotation from a Nasdaq market maker

or a UTP exchange specialist and/or the

lowest priced offer quotation from a

Nasdaq market maker or a UTP

exchange specialist.

U [P]. The term ‘‘UTP exchange’’ shall

mean any registered national securities

exchange that has unlisted trading

privileges in Nasdaq securities [.]

pursuant to the Nasdaq/ NMS/UTP

Plan.

[Q] V. The term ‘‘matched or crossed

file’’ shall mean the entry of: (1) a bid

quotation by a market maker equal to or

greater than a limit order to sell resident

in the NAqcess file in the same security;

or (2) an offer quotation by a market

maker equal to or less than a limit order

to buy resident in the NAqcess file in

the same security.

[R] W. The term ‘‘maximum market

order size’’ shall mean the maximum

size of individual market orders for a

NAqcess eligible security that may be

entered into or executed through

NAqcess. The maximum market order

size for each security shall be advertised

in the system and published from time

to time by the Association. In

establishing the maximum market order

size for each Nasdaq National Market

security, the Association generally will

give consideration to the average daily

non-block volume, bid price, and

number of market makers for each

security. Maximum market order size

for Nasdaq National Market securities

shall be 200, 500 or 1,000 shares,

depending upon the trading

characteristics of the securities.1 These

sizes may be adjusted on an issue by

issue basis, depending upon trading

characteristics of the issue and other

relevant factors as determined by the

Association. Maximum market order

size for Nasdaq SmallCap securities

shall be 500 shares.

[S] X. The term ‘‘maximum limit

order size’’ shall mean the maximum

size of a limit order for a security that

may be entered into or matched through

NAqcess. The maximum limit order size

for Nasdaq National Market securities

shall be 1,000 shares for each tier of

Nasdaq National Market securities,

except for the [securities that comprise

the Nasdaq 100 Index 2] 250 most active

Nasdaq National Market securities as

measured by a security’s median daily

dollar volume over the most recent

completed calendar quarter, which shall

have a maximum limit order size of

[3,000 shares.] 9,900 shares. A National

Market security that is the subject of an

initial public offering (‘‘IPO’’) shall not

be considered for inclusion in the list of

Top 250 securities until such security

has had two full calendar quarters of

trading history on Nasdaq. Initial

inclusion of an IPO in the Top 250

category will be based on the IPO’s

median daily dollar volume in its

second full calendar quarter. A security

designated as eligible for the entry of

limit orders of 9,900 or less shall not be

deleted from this list of eligibility if its

median daily dollar volume causes it

not to be included in subsequent

calculations of the 250 most active

securities, unless there is a fundamental

change in its trading characteristics that

causes the median daily dollar volume

to fall below the highest 1,500 most
31584 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

a [Commission Note: The NASD has stated that it

plans to submit to the Nasdaq Board a proposal to

revise NAqcess to create a system alert function that

would advise a closed quote market maker after one

minute that it should refresh its quotation. Under

the expected change, if the market maker does not

take any action by the end of three minutes in a

closed quote status, the market maker would have

a choice between a variety of system-assisted

reentry of a quotation in accordance with market

maker predetermined parameters or suspension as

a market maker in the security for 20 business days.

See supra note 19 of the Commission’s notice.]

b [Commission Note: But see supra note a of this

Appendix.]

active Nasdaq National Market

securities. Maximum limit order size for

Nasdaq SmallCap securities shall be

1,000 shares.

[T] Y. The term ‘‘exposure limit’’ shall

mean the number of shares of a NAqcess

eligible security specified by a NAqcess

market maker that it is willing to have

executed for its account by non-directed

orders entered into NAqcess on either

side of the market.

[U] Z. The term ‘‘minimum exposure

limit’’ for a security shall mean an

exposure limit equal to the maximum

market order size for that security.

[V] AA. The term ‘‘automated

quotation update facility’’ shall mean

the facility in the NAqcess system that

allows the system to automatically

refresh a market maker’s quotation in

any security that the market maker

designates when the market maker’s

exposure limit has been exhausted. The

facility will update: (1) Either the bid or

the offer side of the quote using a

quotation interval designated by the

market maker, depending upon the side

of the market on which the execution

has occurred and refresh the market

maker’s exposure limit; or (2) close the

market maker’s quote for five minutes,

within which time the market maker

shall update its quote or be placed in a

suspended state for [20] twenty (20)

business days.a

[W] BB. The term ‘‘Automated

Confirmation Transaction service’’

(‘‘ACT’’), for purposes of the NAqcess

rules, shall mean the automated system

owned and operated by The Nasdaq

Stock Market, Inc. which accommodates

trade reporting of transactions executed

through NAqcess and submits locked-in

trades to clearing.

II. NAqcess Participant Registration

A. All members participating in

NAqcess shall register and be

authorized as NAqcess market makers

and/or order entry firms. Registration as

a NAqcess participant shall be

conditioned upon the member’s initial

and continuing compliance with the

following requirements: (1) Membership

in a clearing agency registered with the

Securities and Exchange Commission

which maintains facilities through

which NAqcess compared trades may be

settled; or entry into a correspondent

clearing arrangement with another

member that clears trades through such

clearing agency; (2) registration as a

market maker (if applicable) in Nasdaq

pursuant to Schedule D of the NASD

By-Laws and compliance with all

applicable rules and operating

procedures of the Association and the

Securities and Exchange Commission;

(3) maintenance of the physical security

of the equipment located on the

premises of the member to prevent the

unauthorized entry of orders or other

data into NAqcess or Nasdaq; and (4)

acceptance and settlement of each trade

[for which it is responsible] that is

executed through the facilities of the

NAqcess service, or if settlement is to be

made through another clearing member,

guarantee of the acceptance and

settlement of such identified NAqcess

trades by the clearing member on the

regularly scheduled settlement date.

B. Upon effectiveness of the member’s

registration to participate in NAqcess,

participants may commence activity

within NAqcess for entry and/or

execution of orders, as applicable, and

their obligations as established in this

rule will commence.

C. Pursuant to Schedule D to the

NASD By-Laws, participation as a

NAqcess market maker is required for

any Nasdaq market maker registered to

make a market in a Nasdaq National

Market security. A market maker in a

Nasdaq SmallCap security may

withdraw from and reenter NAqcess at

any time, and without limitations,

during the operating hours of the

service.

D. Each NAqcess participant shall be

under a continuing obligation to inform

the Association of noncompliance with

any of the registration requirements set

forth above.

III. Operating Hours of NAqcess

The operating hours of NAqcess will

be the normal market hours specified for

The Nasdaq Stock Market.

IV. Participing Hours of NAqcess

A. Market Makers

1. A NAqcess market maker shall

commence participation in NAqcess by

initially contacting the Market

Operation Center to obtain authorization

for market making in particular Nasdaq

securities and identifying those

terminals on which the NAqcess trade

information is to be displayed.

Thereafter, on-line registration on a

security-by-security basis is permissible,

consistent with the requirements of

Schedule D to the NASD By-Laws.

2. Participation as a NAqcess market

maker obligates the firm, upon

presentation of a market order or

marketable limit order through the

service, to execute such order as

provided in Section V.A.5. below.

NAqcess market makers are not

permitted to decline orders directed to

the firm pursuant to a directed order

arrangement acknowledged by the

market maker.

The system will transmit to the

market maker on the Nasdaq

Workstation screen and printer, if

requested, or through a computer

interface, as applicable, an execution

report generated following each

execution.

3. For each NAqcess eligible security

in which a market maker is registered,

the market maker shall enter into

NAqcess [its] an exposure limit. For a

Nasdaq National Market security, that

limit shall be any amount equal to or

larger than the minimum exposure limit

for the particular security. If no

exposure limit is entered for a Nasdaq

National Market security, the firm’s

exposure limit will be either the default

size selected by the particular market

maker or the minimum exposure limit.

‘‘Default size’’ shall mean an exposure

limit equal to or greater than the

minimum exposure limit that may be

selected by a market maker for

individual securities or for all securities

in which it makes a market.

4. A NAqcess market maker may elect

to use the automated quotation update

facility in one or more securities in

which it is registered. The facility will

[update] refresh the market maker’s

quotation automatically by a quotation

interval designated by the market

maker, once its exposure limit in the

security has been exhausted. The

facility will [update] refresh the market

maker’s quotation in either the bid or

the offer side of the market by the

interval designated and will reestablish

the market maker’s displayed size and

either the default exposure limit size or

the minimum exposure limit; or the

facility will close the market [maker]

maker’s quote for five minutes.b

5. Matched or crossed file. If a market

maker’s quotation change matches or

crosses a limit order residing in the

NAqcess limit order file, the system will

automatically provide a notification to

the market maker that informs the

market maker of its obligation to protect

all limit orders residing in the NAqcess

file that would be affected by the

quotation change. If the market maker

enters the matching or crossing
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31585

c [Commission Note: But see supra note a of this

Appendix.]

quotation change after this notification,

limit orders in the file for the particular

security will be automatically executed

against the matching or crossing market

maker, provided however, that if the

number of shares in the limit order file

that would be matched or crossed is

greater than five times the maximum

market order size for that particular

security, or if the quotation change

matches and crosses multiple price

levels, the quotation change will be

rejected. To effect such quotation

change, the market maker first must

manually enter a takeout order for the

affected orders in the file prior to reentering its quotation update.

6. The NAqcess market maker may

terminate its obligation by keyboard

withdrawal from NAqcess at any time.

However, the market maker has the

specific obligation to monitor its status

in NAqcess to assure that a withdrawal

has in fact occurred. Except as

otherwise permitted by Section 70 of the

Uniform Practice Code regarding the

Association’s authority to declare

clearly erroneous transactions void,

(‘‘UPC Section 70’’), any transaction

occurring prior to the effectiveness of

the withdrawal may remain the

responsibility of the market maker. In

the case of a Nasdaq SmallCap security,

a market maker whose exposure limit is

exhausted will be deemed to have

withdrawn from NAqcess and may

reenter at any time. In the case of a

Nasdaq National Market security, a

market maker whose exposure limit is

exhausted will have a closed quote in

Nasdaq and NAqcess and will be

permitted a standard grace period of five

minutes within which to take action to

restore its exposure limit, if the market

maker has not authorized use of the

automated quotation update facility. A

market maker that fails to renew its

exposure limit in a Nasdaq National

Market security within the allotted time

will be deemed to have withdrawn as a

market maker.c Except as provided in

subsection 7 below, a market maker that

withdraws from a Nasdaq National

Market security may not re-register in

NAqcess as a market maker in that

security for twenty (20) business days.

7. Notwithstanding the provisions of

subsection 6 above, (i) a market maker

that obtains an excused withdrawal

pursuant to Part V of Schedule D to the

NASD By-Laws prior to withdrawing

from NAqcess may reenter NAqcess

according to the conditions of its

withdrawal; [and] (ii) a market maker

that fails to maintain a clearing

arrangement with a registered clearing

agency or with a member of such an

agency, and is thereby withdrawn from

participation in ACT and NAqcess for

Nasdaq National Market securities, may

reenter NAqcess after a clearing

arrangement has been reestablished and

the market maker has complied with

ACT participant requirements, provided

however, that if the Association finds

that the ACT market maker’s failure to

maintain a clearing arrangement is

voluntary, the withdrawal of quotations

will be considered voluntary and

unexcused pursuant to Schedule D and

these rules; or (iii) Nasdaq Market

Operations Review Committee may

reinstate market makers that voluntarily

withdraw or fail to obtain excused

withdrawal status pursuant to Schedule

D, Part V, Section 8, prior to the

expiration of twenty (20) business days

in the interest of ensuring market

liquidity and the protection of investors.

8. In the event that a malfunction in

the market maker’s equipment occurs

rendering on-line communications with

the NAqcess service inoperable, the

NAqcess market maker is obligated to

immediately contact the Market

Operations Center by telephone to

request a closed quote status from

NAqcess. [For Nasdaq securities, such]

Such request must be made pursuant to

the requirements of Part V, Schedule D

to the NASD By-Laws. If the closed

quote status is granted, Market

Operations personnel will enter such

status notification into NAqcess from a

supervisory terminal. Such manual

intervention, however, will take a

certain period of time for completion

and, unless otherwise permitted by the

Association pursuant to its authority

under UPC Section 70, the NAqcess

market maker may continue to be

obligated for any transaction executed

prior to the effectiveness of its closed

quote.

B. Order Entry—Agency Orders

1. [Only] Except as provided in

subsection C below, only market and

limit agency orders may be entered in

NAqcess by the NAqcess order entry

firm or the NAqcess market maker

through either its Nasdaq Workstation

or computer interface. The system will

transmit to the market maker or order

entry firm on the Nasdaq Workstation

screen and printer, if requested, or

through a computer interface, as

applicable, an execution report

generated following each execution.

[NAqcess market makers may enter limit

agency orders in NAqcess for any

NAqcess eligible security, but may not

enter agency market orders or

marketable limit orders in securities in

which they make markets, unless such

orders are self-directed. As a limited

exception to the prohibition of the entry

of proprietary orders into NAqcess,

NAqcess market makers may place

marker orders into NAqcess. The benefit

of any such marker order execution

must be passed immediately to one or

more customer limit orders held by the

firm placing the marker order. Marker

orders may not be placed with respect

to customer limit orders held by the

firm that exceed the maximum limit

order size permitted by these rules.]

2. NAqcess will accept both market

and limit agency orders of appropriate

size for execution. Agency orders may

be directed to a specific NAqcess market

maker, self-directed by the NAqcess

market maker, or may be non-directed,

thereby resulting in execution against

the next available NAqcess market

maker. If an order is directed to a market

maker by an order entry firm from

which it has not agreed to accept

[direct] directed orders, the order will

be executed on a non-directed basis.

3. [Only agency] Agency orders no

larger than the maximum market and

limit order sizes may be entered by a

NAqcess [order entry firm into NAqcess

for execution against an NAqcess]

market maker or order entry firm into

NAqcess for execution against a

NAqcess market maker or UTP

exchange specialist or against an

executable limit order. [Orders] Agency

orders in excess of the maximum order

sizes may not be divided into smaller

parts for purposes of meeting the size

requirements for orders entered into

NAqcess. All agency orders based on a

single investment decision that are

entered by a NAqcess market maker or

order entry firm for accounts under the

control of associated persons or [public]

customers, whether acting alone or in

concert with other associated persons or

[public] customers, shall be deemed to

constitute a single order and shall be

aggregated for determining compliance

with the maximum order size limits.

[Orders] Agency orders entered by the

NAqcess market maker or order entry

firm within any five-minute period in

accounts controlled by associated

persons or [public] customers, acting

alone or in concert with other associated

persons or [public] customers, shall be

presumed to be based on a single

investment decision. An associated

person or customer shall be deemed to

control an account if the account is [his

or her] a personal account [or an

account in which he or she has a

beneficial interest]; the person exercises

discretion over the account; or the

person has been granted a power of

attorney over the account; [or the

account is the account of an immediate
31586 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

family member as that term is defined

in the Board of Governors Interpretation

on Free-Riding and Withholding, Article

III, Section 1 of the NASD Rules of Fair

Practice].

4. No order will be considered an

agency order from a [public] customer if

it is for any account of a person

associated with any member firm or any

account controlled by such an

associated person. [No order will be

considered an agency order from a

public customer if it is for any account

of a member of the ‘‘immediate family’’

(as that term is defined in the NASD

Free-Riding and Withholding

Interpretation, Article III, Section 1 of

the Rules of Fair Practice) of an

associated person who has physical

access to a terminal capable of entering

orders into NAqcess.]

5. No member or person associated

with a member shall utilize NAqcess for

the execution of agency orders in a

SmallCap security in which the member

is a Nasdaq market maker but is not a

NAqcess market maker in that security.

6. NAqcess will accept the following

types of agency orders during normal

market hours: (a) day orders; (b) goodtill-canceled (‘‘GTC’’); and (c) good till

date (‘‘GTD’’).

C. Order Entry—Proprietary Orders

1. As an exception to the general

prohibition of the entry of proprietary

orders into NAqcess, eligible market

makers may place proprietary orders for

their market making accounts into

NAqcess. All such proprietary orders

must be entered by an associated person

of the eligible market maker who is

actively engaged in a market making

capacity for Nasdaq securities.

Proprietary orders placed by a registered

options market maker may be entered

through a NAqcess market maker or

NAqcess order entry firm.

2. Proprietary orders may be entered

only for NAqcess-eligible securities for

which the NAqcess market maker or

UTP exchange specialist is registered as

a market maker or specialist. Registered

options market makers may enter such

proprietary orders for NAqcess-eligible

securities for which they are registered

as a market maker or specialist in an

option overlying such securities. A

member that enters a proprietary order

must designate the order with the

appropriate designator for surveillance

and examination purposes: ‘‘P’’ for a

proprietary order entered by a NAqcess

market maker; ‘‘E’’ for a proprietary

order entered by a UTP exchange

specialist; and ‘‘D’’ for a proprietary

order entered by a registered options

market maker.

3. Proprietary orders will be subject to

the same display and execution

requirements and protections as agency

orders. Proprietary orders will be

entered and displayed anonymously,

i.e., no special indicator will be

displayed. Proprietary orders entered by

eligible market makers may not exceed

the maximum market or limit order

sizes for NAqcess eligible securities.

Proprietary market and marketable limit

orders are not subject to the limitations

regarding a single investment decision

imposed on agency market orders in

subsection B.3 above, provided,

however, that an eligible market maker

may not enter a series of proprietary

market and/or marketable limit orders

to effect transactions on behalf of a

customer order that is in excess of the

maximum order sizes. Such orders may

not be divided into smaller parts for the

purposes of meeting the size

requirements for orders entered into

NAqcess.

4. A member accepting and entering

proprietary orders on behalf of a

registered options market maker must

maintain in its records documentation

that clearly indicates that such orders

are for principal accounts of persons

eligible to enter proprietary orders. A

member entering proprietary orders for

a person not eligible to enter such orders

violates the terms of the NAqcess rules,

unless the member can demonstrate

that the member did not know or have

reason to know that the order was in

contravention of NAqcess rules.

V. Execution of Naqcess Orders

A. General Execution Procedures [:]

Orders in [Nasdaq equity] NAqcesseligible securities entered into NAqcess

may be directed or non-directed. Nondirected market orders and non-directed

marketable limit orders will be

processed according to the procedures

established below. [Non-directed oddlot orders that are market orders or

marketable limit orders will be

automatically executed in NAqcess

against the next available market maker

at the inside market and execution

reports will be delivered to the order

entry firm and the market maker]

NAqcess will accept orders in sizes

equal to or greater than the normal unit

of trading up to the applicable

maximum order sizes. An unexecuted

odd-lot portion of a mixed-lot order will

be handled according to procedures set

forth below.

1. Entry of Limit Orders [:] Limit

orders may be entered into NAqcess by

order entry firms and by eligible market

makers up to the maximum limit order

size allowed for a particular security.

Limit orders priced away from the

Nasdaq inside bid or offer (as the case

may be) as well as limit orders

[consolidated in the inside market]

priced at or within the best dealer bid

and offer will be stored in the NAqcess

limit order file. Limit orders in

securities priced at $10 or more shall be

priced in increments of an eighth or

more; limit orders in securities that are

priced at under $10 may be placed in

increments of a sixteenth or less

depending upon the dealer quotation

increments permitted.

2. Display of NAqcess Limit Orders [:]

(a) Consolidated Display of Limit Orders

In Inside Market: If a NAqcess limit

order to buy or sell for 100 shares or

more is better than the best dealer bid

or offer, the limit order to buy or sell

will be displayed in the Nasdaq inside

market. Such display will contain the

limit order price, size (which shall be

aggregated if two or more limit orders

are at the same best price) and an

indicator to note that the inside market

consists of a limit order rather than a

market maker or UTP exchange

quotation. If a NAqcess limit order of

100 shares or more is at the same price

as the best dealer bid or offer, the size

displayed in the inside market will be

an aggregation of any same-priced limit

orders and a single dealer quote at the

best price.

(b) Top of the file display: The

Nasdaq Stock Market, Inc. will make

available via Nasdaq Workstations and

to securities information processors the

prices and aggregate size of the best

limit order(s) to buy and the best limit

order(s) to sell. This top of the file

display will be displayed separately

from the inside market and will be

dynamically updated.

(c) Full Limit Order File Display: All

Nasdaq market makers in a particular

security may request via Nasdaq

Workstations a display of all limit

orders in such security entered in the

NAqcess limit order file. Such displays

will be available on a query basis only

to a registered market maker in a

particular security.

3. Execution of Limit Orders [: A limit

order that matches or crosses a limit

order on the opposite side of the market

will be automatically executed against

the matching or crossing order when

such orders are at the inside market or

better, and have priority over the dealer

quotation] Matching or crossing limit

orders on opposite sides of the market

priced better than the best dealer bid or

offer on Nasdaq upon entry or thereafter

will be automatically executed against

each other. The priority rules for limit

order interaction shall be that orders

that are best in price shall be executed

against each other first. If two or more
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31587

orders are at the same price on the same

side of the market, then the order that

was received first in time shall be

accorded priority over other orders at

the same price. Limit orders that cross

each other in price shall be executed at

the price of the order that entered the

file first. A limit order matches a limit

order on the file when: the limit orders

are [consolidated in the inside market]

within the best dealer bid and offer on

Nasdaq; are on opposite sides of the

market; and are equal in price. A limit

order crosses a limit order on the file

when: [both limit orders are either

consolidated in the inside market or

better than the inside market;] one limit

order is within the best dealer bid and

offer; they are on opposite sides of the

market from each other; and the

subsequent limit order is at a superior

price to the existing limit order (i.e., the

sell (buy) limit order is priced below

(above) a limit order to buy (sell)).

Execution of limit orders will occur up

to the size of the initial limit order or

the subsequent limit order, whichever is

smaller, and without the participation of

a market maker. The unexecuted

balance of a limit order is entered into

the NAqcess file for subsequent

matching, unless such balance is less

than 100 shares, in which case the

balance is automatically executed

against the next available market maker,

if equal to the [inside quotation] best

dealer bid or offer.

If there is a limit order at the same

price as the best dealer [quotation] bid

or offer (i.e., if a limit order to buy is

the same as the best dealer bid, or a

limit order to sell is the same as the best

dealer offer), the order or quote that has

time priority shall be matched against

the incoming limit order.

4. Takeouts of Limit Orders [:] Any

NASD member firm or UTP exchange

specialist, acting as principal or as agent

on behalf of a customer or a registered

options market maker, may enter into

NAqcess an order or orders that

execute(s) any limit order(s)

[consolidated in the inside market or

otherwise] displayed in the NAqcess

limit order file. Such orders shall be

known as ‘‘takeout’’ orders. A takeout

order may be for any size up to the

aggregate amount of shares displayed in

the NAqcess limit order file at a

particular price. Takeout orders must be

executed against limit orders on the

opposite side of the market in order of

price and time. A firm entering a

takeout order for limit orders at multiple

prices may enter a single takeout order

at a price either at or above or below the

NAqcess limit orders, as the case may

be, and each limit order will be

executed at each such price. Unfilled

takeout orders have no standing in the

system. Takeout orders do not reduce a

firm’s exposure limit.

5. Entry and Execution of Market

Orders[:] (a) Market orders up to the

maximum market order size for a

NAqcess eligible security may be

entered into NAqcess. If at the time a

market order is entered into NAqcess

there is a limit order on the opposite

side of the market that resides in the

NAqcess limit order file [and is reflected

in] at a price superior to the best dealer

bid or offer, the incoming market order

will be automatically executed against

the limit order at the limit order price

without the participation of a market

maker. If a market order is not fully

executed against the limit order file, the

balance of such market order will be

treated as any other market order as set

forth in subparagraph (b) below,

provided that if the balance of the

market order is odd-lot size, the balance

will be automatically executed against

the next available market maker at the

[inside quotation] best dealer bid or

offer. If there is a limit order

[consolidated in the inside market] at

the same price as [a] the best dealer bid

or offer (i.e., if a limit order to buy is

the same as the best dealer bid, or a

limit order to sell is the same as the best

dealer offer), the order or quote that has

time priority shall be matched against

the incoming market order.

(b) If there is no limit order residing

in NAqcess [that has been consolidated

in the inside market] priced at or within

the best dealer bid or offer on the

opposite side of the market from the

market order, each market order will be

assigned to a market maker at the inside

market and will be executed against the

next available market maker at the

current inside market after a [display]

period of [15–]20 seconds. The market

maker to which a market order is

displayed may decline the market order

within the [15–]20 second period if the

market maker has contemporaneously

executed another transaction and is in

the process of updating its quotation

pursuant to SEC Rule 11Ac1–1 ll.

The quotation update should be entered

prior to declining the order. If a market

order or a marketable limit order is

declined by a market maker, the order

is returned to the system for distribution

to the next available market maker. If

that market maker is at the same price

level as the first market maker who

declined the order, the second market

maker has [15] 20 seconds to react to the

order. If the originally declined order is

re-presented to a market maker at a

price level different from its original

presentation(s), the order is

automatically executed at that price

level without any market maker ability

to decline.

(c) If the NAqcess limit order file does

not have any executable limit orders at

the time a directed market order is

entered, the directed market [orders]

order will be automatically executed at

the inside market price against the

directed order market maker without a

[15-second] decline capability. Directed

limit order that are not matched by

incoming limit or market orders will be

automatically executed against the

directed order market maker when the

inside market is changed to match the

directed limit order price. [Directed

odd-lot orders (orders of less than 100

shares) that are market orders or

marketable limit orders also will be

automatically executed against the

directed order market maker. Nondirected odd-lot orders that are market

orders or marketable limit orders will be

automatically executed against the next

available market maker at the current

inside market. An odd-lot limit order

that is not executable at time of entry

will be stored and executed against the

best dealer bid or offer, as the case may

be, when such quotation reaches the

limit order price.]

6. Entry and Execution of A

Marketable Limit Order [:] Marketable

limit orders that meet the maximum

market order size requirements will be

accepted and treated as market orders.

Marketable limit orders greater than the

maximum market order size will be

returned to the order entry firm for

handling outside of NAqcess.

7. NAqcess Opening [Procedures:

NAqcess will permit the entry of limit

orders and market:] NAqcess will

commence the processing of orders at

9:30. The system will not accept orders

outside of normal market hours. Limit

orders not executed or cancelled during

normal market hours (‘‘resident limit

orders’’) may be cancelled at any time

that the system is opened for the

purpose of entering quotations prior to

the opening. If the best opening dealer

bid or offer matches or crosses resident

limit orders not cancelled prior to the

open, then the market maker that

quoted through the limit order(s) must

execute the full share size of the order(s)

at its quoted price. If multiple market

makers change their quotations to

match or cross the NAqcess file at the

open, resident limit orders will be

distributed to each market maker at the

best dealer bid or offer for immediate

execution at their quotation in time

sequence. Quote-through executions at

the opening do not deplete a market

makers’s exposure limit. Resident limit

orders at market open and limit orders

and market orders entered into NAqcess
31588 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

at market open will be processed

according to normal market processing

rules set forth in Section V, above[,

except that market orders will not be

accepted between 4:00 and 6:00 p.m.

Orders entered at such times will not be

executed but will be stored for matching

and execution at the next market

opening. NAqcess permits the entry of

such orders between 4:01 p.m. to 6:00

p.m. and 8:00 a.m. to 9:28 a.m. (Orders

entered from 9:28 to 9:30 will be stored

and handled according to normal

market procedures after the opening

procedures are concluded.)

Matching and execution at the

NAqcess opening will occur according

to the following procedures:

At 9:28 a.m., NAqcess will stop

accepting orders for execution in the

NAqcess file for opening purposes. At

9:30 a.m., NAqcess will commence

execution procedures for opening orders

in NAqcess by first ranking and

matching limit orders in NAqcess in

sequence of the highest price buy order

against the lowest price sell order.

When all available limit orders are

matched and executed, market orders on

a time priority basis will be matched

and executed against any remaining

limit orders in the NAqcess file within

the inside quotation at the limit order

price(s). Any remaining market limit

orders will be stored in the NAqcess

file. Any remaining orders will be

subject to normal order execution

processes].

VI. Clearance and Settlement

All transactions executed in NAqcess

shall be transmitted to the National

Securities Clearing Corporation to be

cleared and settled through a registered

clearing agency using a continuous net

settlement system.

VII. Obligation To Honor System

Trades

If a trade reported by a NAqcess

participant, or clearing member acting

on its behalf, is reported by NAqcess to

clearing at the close of any trading day,

or shown by the activity reports

generated by NAqcess as constituting a

side of a NAqcess trade, such NAqcess

participant, or clearing member acting

on its behalf, shall honor such trade on

the scheduled settlement date.

VIII. Compliance With Procedures and

Rules

Failure of a NAqcess participant or

person associated with a NAqcess

participant to comply with any of the

rules or requirements of NAqcess may

be considered conduct inconsistent with

high standards of commercial honor and

just and equitable principles of trade, in

violation of Article III, Section 1 of the

Rules of Fair Practice. No member shall

effect a NAqcess transaction for the

account of a customer, or for its own

account, indirectly or through the

offices of a third party, for the purpose

of avoiding the application of these

rules. Members are precluded from

doing indirectly what is directly

prohibited by these rules. All entries in

NAqcess shall be made in accordance

with the procedures and requirements

set forth in the NAqcess User Guide.

Failure by a NAqcess participant to

comply with any of the rules or

requirements applicable to NAqcess

shall subject such NAqcess participant

to censure, fine, suspension or

revocation of its registration as a

NAqcess market maker and/or order

entry firm or any other fitting penalty

under the Rules of Fair Practice of the

Association.

IX. Termination of NAqcess Service

The Association may, upon notice,

terminate NAqcess service to a

participant in the event that a

participant fails to abide by any of the

rules or operating procedures of the

NAqcess service or the Association, or

fails to pay promptly for services

rendered.

Exhibit B—Interpretations Related to

Member Firm Responsibilities

Regarding Orders in NAqcess

In its efforts to maximize the

protection of investors and to enhance

the quality of the marketplace, the

NASD and [The] the Nasdaq Stock

Market, Inc. have developed a

nationwide limit order protection, price

improvement, and market order

handling facility of The Nasdaq Stock

Market. This nationwide facility is

herein referred to as ‘‘NAqcess’’.

The NASD Board of Governors is

issuing these Interpretations to the

Rules of Fair Practice to provide: (1)

Customers the right to have their orders

entered and protected in NAqcess; and

(2) member firm provision of equivalent

protection for limit orders held in a

member firm’s proprietary limit order

system. These Interpretations are based

upon a member firm’s obligation to

provide best execution to customer

orders under Article III, Section 1 of the

Rules of Fair Practice and a member

firm’s obligations in dealing with

customers as principal or agent to buy

and sell at fair prices and charge

reasonable commissions or service

charges under Article III, Section 4 of

the Rules of Fair Practice. Accordingly,

it shall be deemed a violation of Article

III, Section 1 of the Rules of Fair

Practice for a member or a person

associated with a member to violate the

following provisions:

1. Member Firm Obligation Regarding

Investors Directions on Order Handling

NAqcess will provide individual

investors with significant opportunities

to achieve limit order protection and

price improvement. The NASD

recognizes that member firms operating

as market makers also operate trading

systems which offer significant

protection and execution opportunities

for customer limit orders. Accordingly,

nothing herein is intended to limit a

member’s ability to recommend use of

its own or another member firm’s

proprietary system for handling limit

and market orders where equivalent

protection is afforded. In light of the

significant benefits offered to customers

by the NAqcess system, however,

members must abide by the directions of

its customers who request that the firm

enter their eligible orders in NAqcess.

Further, nothing in this Interpretation

requires a member firm to accept any or

all customer limit orders. Member firms

accepting limit orders that are placed in

NAqcess or otherwise may charge fair

and reasonable commissions,

commission-equivalents, or service

charges for such handling, provided that

such commissions, commissionequivalents, or service charges do not

violate Article III, Section 4 of the Rules

of Fair Practice. In no event, however,

shall a member impose any fee or charge

that effectively operates as a

disincentive to the entry of orders in the

nationwide facility and thereby

interferes with the investor’s ability to

choose order handling alternatives.

2. Equivalent Protection for Orders

Held Outside of NAqcess

As a further adjunct to a member

firm’s best execution obligations, the

NASD Board of Governors has

interpreted Article III, Section 1 of the

Rules of Fair Practice to require member

firms that do not enter customer limit

orders into NAqcess, but hold such

protectible orders in their own

proprietary system, to provide such

orders with price protection at least

equivalent in substance to that which

the order would have received had the

order been entered into NAqcess. For

the purposes of this Interpretation, a

‘‘protectible limit order’’ shall mean a

limit order that meets the maximum

limit-order size criteria as set forth in

the Rules of Operation and Procedure

for NAqcess at Section [I.S] I(s). For the

purposes of this Interpretation,

equivalent price protection shall mean:
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31589

A. Print Protection

If a transaction in a Nasdaq security

is reported via the Automated

Confirmation Transaction Service

(‘‘ACT’’) at a price inferior to the price

of customer limit order(s) that the firm

is holding (i.e., if the reported price is

a price lower than a buy limit order or

higher than a sell limit order being held

by the firm), the firm holding the limit

order(s) is required on a

contemporaneous basis to execute the

limit order(s) at the limit price(s) up to

the size of the reported transaction.

B. Matching Limit Orders

If the firm holds a customer buy (sell)

limit order in its proprietary limit order

file and that limit order matches a sell

(buy) limit order in NAqcess, the firm

holding the limit order must either

provide its customer with an immediate

execution at the limit order price or

must immediately direct the order to

NAqcess. A limit order held by a firm

would match a limit order in NAqcess

when the limit order in NAqcess is at

the same price or is priced lower than

the firm’s customer’s limit order to buy

or higher than the firm’s customer limit

order to sell (‘‘offsetting limit orders’’).

C. Matching Limit Order Interaction

Within A Firm’s File

If the firm holds two or more

offsetting customer limit orders within

its own proprietary file, the firm must

execute the offsetting limit orders.

D. Interaction Between Limit and Market

Orders Held Within a Firm’s File

While holding a customer limit order

that is priced equal to or better than the

best bid or offer in the security

disseminated in Nasdaq, if a firm

accepts customer market orders for

automated execution against the best

bid or offer in the security disseminated

in Nasdaq, the firm, pursuant to its

obligation set forth in the Interpretation

to the Rules of Fair Practice, Article III,

Section 1, (the so-called ‘‘Manning

Interpretation’’), must first permit the

market orders to execute against any

applicable limit orders it holds before

the firm may execute the market orders

for its own account.

E. Examples of Equivalent Protection

The NASD Board of Governors has

provided the following examples to

further explain a member firm’s

equivalent protection obligation for

orders held outside of NAqcess:

Print Protection The best dealer bid

and offer in Nasdaq [(the] (‘‘the inside

price[)]’’) is 20 bid—201⁄4 offer. Firm

ABCD holds a customer limit order of

1,000 shares to buy at 201⁄8 in its own

proprietary file. Firm MNOP reports a

transaction in the subject security via

ACT, disseminating a price of 201⁄16 for

500 shares. Contemporaneous with the

dissemination of the trade report, firm

ABCD is required to provide an

execution of its customer limit order for

at least 500 shares at 201⁄8.

Matching Limit Orders The inside

price is 20 bid—201⁄4 offer. NAqcess is

displaying a 1,000 share customer limit

order to buy at 201⁄8 for customer X.

Firm ABCD thereafter receives from

customer Y a 1,000 share limit order to

sell at 201⁄8 that the firm ABCD retains

for handling outside of NAqcess. Upon

receipt of the limit order, firm ABCD

must execute customer Y’s limit order

for 1,000 shares at 201⁄8.

Matching Limit Order Interaction

Within a Firm’s File The inside price is

the same as above. Firm ABCD holds a

customer limit order to buy 1,000 shares

at 201⁄8. Firm ABCD thereafter receives

a customer limit order to sell 1,000

shares at 201⁄8. Firm ABCD must match

the orders and execute the trade.

Interaction Between Limit and Market

Orders Held Within A Firm’s File

The inside price is the same as above.

Firm ABCD holds a customer limit order

to buy 1,000 shares at 201⁄8. Firm ABCD

thereafter receives a customer market

order to sell 1,000 shares. Firm ABCD

must match the two orders and execute

the trade at 201⁄8. Similarly, if the limit

order to buy were priced at 20, the firm

would have to execute the market order

against the limit order at 20.

Price Protection for NAqcess Limit

Orders Rules of Fair Practice, Article

III, Section [XX]

No member firm shall execute an

order as principal or as agent at a price

inferior to any limit order(s) viewable in

NAqcess to the member firm, provided

however, that a member firm executing

a transaction that is larger than the limit

order(s) viewable in NAqcess at an

inferior price must contemporaneously

satisfy the limit order(s) viewable in

NAqcess. An ‘‘inferior price’’ means an

execution price that is lower than a buy

limit order or higher than a sell limit

order that is viewable in NAqcess. The

term ‘‘limit orders viewable in

NAqcess’’ shall mean those orders that

the member firm is able to view either

as consolidated in the Nasdaq inside

market or as reflected in the Full Limit

Order File Display as the firm is

authorized to view under the Rules of

Operation and Procedure.

Exhibit C—Schedule D, Part V

Sec. 1. No Change

Sec. 2. Character of Quotations

(a) Two-Sided Quotations. For each

security in which a member is registered

as a market maker, the member shall be

willing to buy and sell such security for

its own account on a continuous basis

and shall enter and maintain two-sided

quotations in The Nasdaq Stock Market

subject to the procedures for excused

withdrawal set forth in Section 8 below.

Each member registered as a Nasdaq

market maker in Nasdaq National

Market equity securities shall display

size in its quotations of 1,000, 500, or

200 shares and the following guidelines

shall apply to determine the applicable

size requirement: (i) A 1,000 share

requirement shall apply to Nasdaq

National Market securities with an

average daily non-block volume of

[3,000]6,000 shares or more a day, a bid

price of less than or equal to $100, and

three or more market makers; (ii) a 500

share requirement shall apply to Nasdaq

National Market securities with an

average daily non-block volume of

[1,000]2,000 shares or more a day, a bid

price of less than or equal to $150, and

two or more market makers and (iii) a

200 share requirement shall apply to

Nasdaq National Market securities with

an average daily non-block volume of

less than [1,000]2,000 shares a day, a

bid price of less than or equal to $250,

and that have two or more market

makers. Each member registered as a

Nasdaq market maker in Nasdaq

SmallCap Market equity securities shall

display size in its quotations of 500 or

100 shares and the following guidelines

shall apply to determine the applicable

size requirement: (i) A 500 share

requirement shall apply Nasdaq

SmallCap Market securities with an

average daily non-block volume of 1,000

shares or more a day or a bid price of

less than $10.00 a share; and (ii) a 100

share requirement shall apply to Nasdaq

SmallCap Market securities with an

average daily non-block volume of less

than 1,000 shares a day and a bid price

equal to or greater than $10.00 a share.

Share size display requirements in

individual securities may be changed

depending upon unique circumstances

as determined by the Association, and a

list of the size requirements for all

Nasdaq equity securities shall be

published from time to time by the

Association.
31590 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

*Prepared by the NASD’s Economic Research

Staff.

1Since 1971, the Nasdaq Stock Market has grown

to become the second largest equity market

worldwide. Share volume on Nasdaq has increased

over 4,000 percent since its inception, while dollar

volume has grown over 5,000 percent. In 1995,

share volume broke 100 billion shares and dollar

volume exceeded $2.4 billion. Over the last ten

years, Nasdaq’s share volume has grown over 380

percent compared to 212 percent for the NYSE and

Amex combined. Nasdaq’s share volume has grown

200 percent over the last five years versus 115

percent for the NYSE and Amex combined. Dollar

volume on Nasdaq has grown at an even greater

rate: over 900 percent for the last ten years and 430

percent for the last five years, compared to 216

percent and 132 percent for the NYSE and Amex

combined. In 1994 Nasdaq share volume exceeded

NYSE share volume for the first time; as of March

1996 Nasdaq share volume was 121 percent of

NYSE share volume for the year, comprising 54

percent of the volume traded in all U.S. equity

markets combined.

2 It is the absence of time priority that allows

preferencing on Nasdaq, which is likely to enhance

a stock’s sponsorship and liquidity characteristics.

Preferencing can improve competition among

market makers by allowing small brokerage firms to

achieve the same cost advantages as those

experienced by large, vertically-integrated

brokerage firms. Since many of the brokers that use

preferencing arrangements are discountcommission brokers, customers can benefit from

preferencing through reduced commission costs.

Empirical research on the topic of preferencing

suggests that it may improve market quality.

Battalio, et. al. study the short-term effects of the

introduction of preferencing programs by the

Cincinnati Stock Exchange and the Boston Stock

Exchange on market share, displayed spreads, and

liquidity. The study finds no adverse market effects

as the market share of these two markets increases

in conjunction with the introduction of

preferencing programs. Marketwide, displayed

spreads and liquidity premiums decline with the

introduction of preferencing programs, suggesting a

possible improvement in market quality. Also, since

retail brokers use preferencing and internalization

to reduce commissions to customers, investor

welfare may be improved as a result. (See Robert

Battalio, Jason Greene, and Robert Jennings, ‘‘How

Do Competing Specialists and Preferencing Dealers

Affect Market Quality? An Empirical Analysis,’’

unpublished manuscript, 1995.)

3For example, if the market in a stock is 20–201⁄4

on the basis of market maker quotes and an investor

or a market maker places a buy order for 500 shares

at 201⁄8, then the market becomes 201⁄8–20 1⁄4. A 500

share market sell order placed in NAqcess will

execute strictly against the limit buy order at 201⁄8

on the basis of its price and time priority, regardless

of whether market maker quotes had subsequently

joined the buy order at 201⁄8. On the other hand,

the same 500 share market order communicated

outside of NAqcess, say over the phone, can execute

against any market maker at 201⁄8 but cannot trade

through the limit buy order at a lower price. It is

important to note that a firm placing a customer

order into NAqcess is still subject to the NASD’s

Limit Order Protection Rule (Article III, Section 1,

Rules of Fair Practice): the firm cannot trade at a

price equal or inferior to that of the customer limit

order it holds without filling the customer order.

So, if the limit order in the example is the market

maker’s customer order, other firms can buy the

stock at 201⁄8, but the firm that placed the order into

NAqcess cannot buy at 201⁄8 without filling the

order.

Exhibit D—The Introduction of

NAqcess into the Nasdaq Stock Market:

Intent and Expectation *

I. Introduction

The Nasdaq Stock Market proposes

NAqcess with the intent of increasing

investor access to the market by

providing a new mode for investors and

dealers to trade among each other.

Individual investors and market makers,

willing to supply liquidity to the

market, will be able to display priced

limit orders in a central public file.

Orders in the central file will compete

directly with other orders and with

market maker quotes, and other

investors and market makers will have

the ability to access orders and quotes

electronically. NAqcess is intended to

augment, not replace, Nasdaq’s dealer

market, which Nasdaq and NASD staff

(the Staff) believe has been central to the

success of the Nasdaq Stock Market.1

NAqcess constitutes a major step in

the evolution of the Nasdaq market. The

principles that guided the design of

NAqcess build upon the Nasdaq

market’s tradition of innovation and

include the intent to provide greater

market access across participant

categories. Application of these

principles now and beyond the

initiation of NAqcess should simplify

market rules and expand the options

available to both retail and institutional

investors.

All of the effects of introducing

NAqcess into the Nasdaq Stock Market

cannot be measured with precision. But

the Staff believe that the effects of

NAqcess will be valuable to investors.

The Staff base that belief on (1) the

practical experience of other equity

markets with limit order files; (2) theory

and evidence in the economic literature

regarding limit order trading; (3)

evidence regarding the use of limit

orders in the pre-NAqcess Nasdaq Stock

Market; and (4) the results of research

conducted by and for the NASD.

Following a brief description of the

changes to the Nasdaq Stock Market that

will be effected by the introduction of

NAqcess, this report presents a

discussion of the four bases on which

the Staff rely in forming its expectation

that NAqcess will benefit investors in

Nasdaq stocks.

II. Description of NAqcess

In the spring of 1996, Nasdaq is

primarily a dealer-based, quote-driven

market. Much of the liquidity that is

available in the market is communicated

through dealer quotes and provided

through dealer involvement. In general,

retail limit order information is not

explicitly broadcast to all other market

participants. Limit orders placed and

executed through alternative systems

such as Instinet, however, are important

sources of liquidity and reduce the costs

associated with market making.

NAqcess is intended to maintain the

strength of Nasdaq’s dealer market

while augmenting the market with a

system that allows all customer orders

to meet each other directly. The balance

between dealer quotes and customer

orders under NAqcess can be seen by

comparing time and size priority rules.

A dealer system thrives in the absence

of time priority rules; 2 the viability of

an order-based system, on the other

hand, is enhanced by time priority

rules, because standing orders take

precedence over new orders at a given

price, increasing the incentive to enter

them. In introducing NAqcess, Nasdaq

balances these competing objectives by

instituting strict price/time priority for

unpreferenced orders within NAqcess,

while allowing time priority (but not

price priority) to be suspended for

trades that occur on Nasdaq but outside

of NAqcess.3

Table 1 on the following page details

the NAqcess time and size priority

rules, by market participant type. These

rules are summarized in Sections A and

B, following Table 1.

BILLING CODE 1810–01–M
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31591

BILLING CODE 8010–01–C
31592 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

4The following information is presented as an aid

in defining the terms, ‘‘NASD Member,’’ ‘‘Nasdaq

Dealer,’’ and ‘‘Nasdaq Market Maker.’’ As of March

29, 1996, the NASD had 5,468 members; 531 of

them were dealers in the Nasdaq Stock Market; a

dealer that makes a market in a particular stock is

a registered market maker in that stock. For

example, Intel had 46 registered market makers.

5Market makers will be allowed to query the

entire limit order file. All other market participants

will be allowed to see the top of the limit order file.

6 Direct entry into NAqcess is open to all

members and, pending current negotiations, to nonmember market makers at regional exchanges.

Options market makers and other non-member

market makers will not have direct entry capability

under NAqcess, nor will non-member buy-side

firms, who will have access only through a member

firm.

7Proprietary orders are orders for a brokerdealer’s own account.

8For both National Market and SmallCap agency

orders, a single order may not be separated into

many orders for purposes of NAqcess execution.

9NASD SOES Rules state that a market maker has

15 seconds following an automatic trade to update

its quotes, yet an additional 5 second allowance for

communications transmission is made. Therefore, a

market maker is actually given up to 20 seconds

following an automatic trade in the pre-NAqcess

environment to update its quotes, depending on

messaging time.

10Though preferenced marketable orders cannot

be declined, they may be accepted during the 20

second review period. Otherwise, they are

automatically executed after 20 seconds.

11Nasdaq Market Surveillance will police this

policy with a process that uses a set of parameters

to determine if a trade was legitimately declined.

12 If the marketable order was a limit order and

the execution price is inferior to the order’s price,

then the arriving limit order becomes the new

inside. For example, if all market makers at 20 bid

decline a marketable limit order to sell at 20,

revising their bids to 19 7/8, the sell order is no

longer marketable and becomes the market at the

inside ask; i.e. the market is now 19 7/8 to 20.

13Non-member market markers from regional

exchanges that permit automated orders access to

their quotes will be able to enter limit orders as well

as proprietary marketable orders.

14Market makers in SmallCap issues may opt out

of the order delivery and execution features of

NAqcess on a stock-by-stock basis.

In essence, NAqcess is an order

delivery system with features that

augment the extant multiple dealer

market system with a public limit order

file. NAqcess guarantees execution of

market orders against posted dealer

quotes; it allows customer orders to

interact with each other and displays

limit orders that are not executed.

A. Order Entry

NAqcess provides market participants

with a central file that facilitates the

ability of investor and dealer orders to

compete with market maker quotes in

supplying liquidity.4 This facilitation,

via the dissemination of the top of the

limit order file of investor and dealer

orders, is intended to enhance price

improvement opportunities, lowering

the price of immediacy and liquidity for

the investors and dealers who demand

it.5 That is, in the NAqcess

environment, limit orders are expected

to execute more frequently and inside

market spreads are expected to narrow.

Non-marketable limit orders, which

will compete directly with market

maker quotes, can be placed into

NAqcess by entities that have direct,

interactive access to a Nasdaq

workstation.6 While any dealer can

enter these orders on an agency basis,

only broker-dealers making a market in

a stock may enter proprietary orders.7

Limit orders can be placed for up to

9,900 shares for the top 250 dollar

volume Nasdaq National Market stocks

and for 1,000 shares for all other Nasdaq

stocks, including SmallCap.8 These

limits are consistent with an

incremental approach to NAqcess’

implementation, affording Nasdaq staff

the opportunity to evaluate whether it is

appropriate to expand the system.

B. Automated Execution

In the pre-NAqcess Nasdaq Stock

Market, firms not making a market in a

stock may enter customer orders into

the SOES system for automatic

execution at the inside quotes against

those market makers at the inside or

against market makers with which a

preferencing agreement exists. These

orders are for a maximum size of 1,000,

500, or 200 shares, depending on the

stock’s SOES tier size. These executions

occur automatically, with the market

maker being informed of the trade that

has just occurred. Following the trade,

a market maker may adjust its quotes (1)

‘‘manually’’ with a 20-second

opportunity to update its quotes; 9 (2)

via Nasdaq’s automatic update system,

following trading activity equal to the

maximum order size for the security at

the original quote; or (3) with an

internal automatic update system,

following trading activity equal to the

maximum order size for the security at

the original quote. In practice, those

market makers who use an automatic

update feature frequently set their

exposure levels such that several trades

are accepted before quotes are adjusted.

In contrast, NAqcess provides for

automated executions. Instead of market

makers having 20 seconds following an

automatic trade to adjust their quotes,

they have 20 seconds, upon receipt of

the marketable order (a market or

marketable limit order), to accept or

decline it.10 A market maker may not

decline an order at its quote unless it

has just traded and is in the process of

updating its quotes.11 The execution

will occur automatically if the market

maker takes no action within 20

seconds. This constitutes a change to

the ‘‘manual’’ quote update method. In

the NAqcess environment, both internal

and Nasdaq automated update systems

will continue to allow quote

adjustments to be made following

trading activity of one or more times the

maximum order size for the security at

the original quote.

If a market maker declines a

marketable order, it is delivered (in time

precedence) to the next available market

maker (i.e. not currently reviewing

another marketable order) at that price,

with the same obligations. If all market

makers decline the order at that price,

the trade is automatically executed by

the first market maker quoting at the

next price level with no waiting

period.12

Because NAqcess limit orders will be

integrated with dealer quotes by time

priority within price levels, a

marketable order may be delivered to a

NAqcess limit order, in which case it is

automatically executed. If the

marketable order is delivered to a limit

order of a smaller size, the order is

partially executed against the limit

order, and a marketable order for the

residual size is delivered to the next

quote or limit order in time priority.

In the NAqcess environment, market

makers will continue to maintain twosided quotes and Nasdaq market

surveillance will ensure that the quotes

are firm. Because a market maker has

liquidity provision obligations, it will be

authorized to enter proprietary market

orders (including marketable limit

orders) into NAqcess for sizes

commensurate with the pre-NAqcess

SOES tier sizes.13 This puts market

makers on a par with other users of the

automation technology, facilitating

liquidity provision. Unlike SOES,

NAqcess can be used for agency market

orders by any Nasdaq dealer, making a

market in a stock or not.

C. Other Changes to the Status Quo

Because most of the services provided

to investors through SOES and

SelectNet are subsumed within and

improved upon by NAqcess, these

systems will be eliminated upon

implementation of NAqcess. As with

SOES, participation in NAqcess by

market makers will be mandatory for

National Market stocks and voluntary

for SmallCap stocks.14 While SOES is

used almost exclusively to execute

market orders and marketable limit

orders, SOES also has a limit order

processing facility that stores limit

orders priced off the inside market,

executing them if they become
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31593

15For the 13 Thursdays in the first quarter of

1996, there were 52 SelectNet trades of more than

9,900 shares in the top 250 dollar volume stocks,

accounting for .003% of all trades for these stocks.

For all other Nasdaq stocks, there were 27,646

SelectNet trades of more than 1,000 in this time

period, representing 1.513% of all trades for these

stocks. Combined, the 27,698 SelectNet trades that

could not be achieved via NAqcess constitute

.708% of all Nasdaq trades in the period.

16Other improvements to the trading of Nasdaq

securities include the following: In 1988, Nasdaq

introduced the Advanced Computerized Execution

System (ACES) which allowed a participant to

automatically direct retail orders to any designated

ACES market maker with which it had an

established business arrangement. In 1989, Nasdaq

introduced Automated Confirmation Transaction

(ACT) to automate the trade comparison and

clearing process and enhanced OCT by allowing

market makers to counter-offer. In 1992, Nasdaq

introduced a new Nasdaq Workstation, Workstation

II, that allowed Nasdaq traders to use windows, hot

buttons, and programmable features to facilitate

trading in Nasdaq securities. Also in 1992,

SelectNet service hours were expanded to be

available from 9:00 a.m. to 5:15 p.m. EST. In 1994,

the NASD Board approved the dissemination of

SelectNet orders and executions to non-members to

increase the transparency of Nasdaq.

marketable. This facility also matches

offsetting limit orders and will execute

matched orders if no market maker

executes either order within five

minutes of the match. The limit order

processing features of NAqcess are

superior to those of SOES.

SelectNet is a system that permits

NASD members to direct buy or sell

orders in Nasdaq securities to a single

market maker (preferenced orders) or

broadcast such orders to all market

makers in the security. Accordingly,

SelectNet provides investors and

members with an automated means to

facilitate the communication of trading

interest among members and to seek

price improvement. SelectNet also

serves as an alternative mechanism to

telephone communication between

members, especially in times of market

stress. Because limit orders placed in

NAqcess will be incorporated in the

calculation of the inside market and

immediately executable upon the entry

of a ‘‘takeout’’ order or offsetting market

or limit orders, the price improvement

and order communication and

execution features of NAqcess are far

superior to those of SelectNet. While

SelectNet allows the display of

unlimited size orders and NAqcess will

not, SelectNet orders larger than the

NAqcess size limits are rarely executed,

so the restriction will have a minimal

effect.15 Moreover, limit orders entered

into NAqcess will be accessible to and

executable by a broader spectrum of

market participants than currently is the

case with SelectNet.

Critics of NAqcess have argued that it

would be harmful to small investors to

replace SOES, an immediate automatic

execution system, with NAqcess, an

automated execution system. The NASD

believes these arguments are invalid for

the following reasons. First, though an

automated execution system, automatic

executions may still occur in NAqcess.

In fact, of the four means by which an

order can be executed through NAqcess,

three of them involve an automatic

execution process. Specifically,

automatic executions occur when: (1) a

market order matches a limit order; (2)

a limit order matches a limit order; and

(3) a takeout order matches limit orders

residing on the NAqcess file. Second, to

the extent that NAqcess is functioning

as an automated order execution system

(i.e. marketable orders delivered to

market makers at the inside market), it

has a short-term (20 second) automatic

execution default feature. Third, the

NAqcess order execution algorithm is

wholly consistent with the SEC’s firm

quote rule, Rule 11Ac1–1: a market

maker can decline a marketable order

only in cases consistent with the

exceptions to Rule 11Ac1–1.

Specifically, a market maker will only

be allowed to decline a NAqcess order

if it received the order while in the

process of effecting a transaction and

updating its quotation. To ensure that

market makers are not declining orders

in violation of the firm quote rule, the

NASD has developed on-line, real-time

surveillance systems.

In essence, through its enhanced limit

order execution and display

capabilities, NAqcess builds upon the

core market order execution features of

SOES and limit order facilities of both

SOES and SelectNet, to enhance the

transparency of Nasdaq and to provide

investors with increased opportunities

for price improvement and limit order

protection.

With the implementation of NAqcess,

Nasdaq will add a market-wide print

protection policy to its Rules of Fair

Practice. A firm holding a NAqcesseligible limit order outside of NAqcess

will be required to protect (execute) the

order if an unmodified (e.g. not a .SLD)

trade in the stock is reported at an

inferior price. NAqcess print protection

augments, but does not replace,

Manning order protection, which does

not allow a firm to trade ahead of an

internally-held customer limit order (i.e.

trade at a price equal or inferior to that

of the customer order). Additionally,

Manning will apply to orders placed in

NAqcess; the firm placing the order into

NAqcess cannot trade at the price level

of the order without protecting it.

D. NAqcess in Historical Perspective

It is useful to view NAqcess in

historical perspective, where it can be

seen as a logical step in the evolution of

Nasdaq. The precursor to Nasdaq

existed as a completely decentralized

dealer market for trading non-listed

stocks. The inauguration of the

computerized system for the

dissemination of quotes that constituted

the start of Nasdaq in 1971 was a major

step towards allowing dealers to interact

more closely. Since that time, Nasdaq

has used technology to continually

improve the dissemination of

information and the execution of orders

in the Nasdaq market. These

improvements have created an everincreasing degree of centrality to the

marketplace, not in physical space, but

in cyberspace.

A major step forward for Nasdaq came

in 1982 with the advent of last-sale

reporting in certain Nasdaq National

Market Securities. This change allowed

traders to depend more on the Nasdaq

system as their window to the world.

Computerized trading started with the

Computer Assisted Execution System

(CAES), used for the first time in 1983,

to execute transactions in Nasdaq

National Market issues. In 1984, the

implementation of Nasdaq’s Small

Order Execution System (SOES)

represented another step toward

facilitating execution of market orders.

Subsequent to the market break in 1987,

Nasdaq took steps to significantly

increase the number of orders executed

over the computer, without the need for

a telephone. To enhance liquidity and

execution capabilities during heavy

volume periods, participation in SOES

became mandatory for all Nasdaq

National Market market makers.

In 1988, the Order Confirmation

Transaction (OCT) system was

introduced to automatically direct

priced orders of any size to specific

market makers, where they could then

reject or accept the order. This was the

first step in facilitating the execution of

priced orders on Nasdaq. As an

additional step towards the

enhancement of limit order execution

on Nasdaq, the SOES limit order file

was introduced in 1990. The SOES limit

order file allowed for the input of priced

retail orders and the matching of these

orders. This system provided small,

retail orders with a facility to get

executions within the best bid and best

ask prices. SelectNet, a screen-based

negotiation and execution service with

major enhancements to OCT’s broadcast

and negotiation features, was

introduced in 1990 to replace OCT and

also provide for enhanced limit order

execution ability.16

In 1993, the NASD Board proposed a

Rule to the SEC, subsequently approved,
31594 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

17Sources for this section include the following

articles:

Domowitz, Ian (1993). ‘‘A Taxonomy of

Automated Trade Execution Systems,’’ Journal of

International Money and Finance 12:607–631.

Eisenhammer, John. ‘‘OFT Calls For Fresh Curbs

on Market-Makers,’’ The Independent, 24 April

1996, p. 19.

Harris, Lawrence and Joel Hasbrouck (1992).

‘‘Market vs. Limit Orders: The SuperDOT Evidence

on Order Submission Strategy,’’ NYSE Working

Paper 92–02. Forthcoming in the Journal of

Financial and Quantitative Analysis.

Hedvall, Kaj (1994). ‘‘Essays on the Market

Microstructure of the Helsinki Stock Exchange,’’

Ph.D. Dissertation at the Swedish School of

Economics and Business Administration, Helsinki.

Stoll, Hans R. (1992). ‘‘Principles of Trading

Market Structure,’’ Journal of Financial Services

Review 6:75–107.

Stoll, Hans R. and Roger Huang (1991). ‘‘Major

World Equity Markets: Current Structure and

Prospects for Change London, Toronto, Paris and

Tokyo,’’ Working Paper 90–32.

18While this description focuses on equities

markets, futures and options markets in the United

States have also incorporated central limit order

files, including the Chicago Board Options

Exchange and the Chicago Mercantile Exchange.

giving priority to customer limit orders

over the member firm’s orders. In 1995,

this limit order protection rule was

extended to include limit orders sent to

a market maker from another member

firm. In 1994, the NASD Board proposed

to replace SOES with Nasdaq Primary

Retail Order View and Execution

System (N*PROVE), which provided

enhanced execution capabilities for

small, retail limit orders. In 1995,

Nasdaq proposed NAqcess, a fullyautomated, centralized limit and market

order facility.

III. The Value of NAqcess for Nasdaq

Many commenters to the SEC on the

NAqcess proposals expressed concern

with the proposal due to what they

perceived as the NASD’s apparent lack

of economic analysis of the effects of the

proposals. In fact, the NASD has

analyzed these proposals through a

review of economic literature, an

internal empirical study, and simulation

research of a limit order file

environment. A summary of these

analyses is provided in this section. The

key innovation provided by NAqcess is

the establishment of a central limit

order file. The value of NAqcess

therefore depends on the value of such

a file. This section of the report first

considers NAqcess in the context of

other equity markets worldwide. Then,

it discusses the current state of Nasdaq

in a pre-NAqcess setting, pointing out

the limit order functionality that is

currently present. Finally, the results of

internal and sponsored NASD research

regarding the use of limit orders is

reported.

A. Experiences of Other Equity

Markets 17

Nasdaq’s adoption of a central limit

order file is consonant with systems in

place in equity markets around the

world. Many of the world’s largest

equity markets rely on the operation of

a central limit order file to route and

execute orders, including New York,

Toronto, Paris, Australia, and Tokyo.

Although this is not an exhaustive list,

its breadth signals that world exchanges

have acknowledged the utility of central

limit order files and have incorporated

them into their markets.

Every stock and options exchange in

the United States operates central limit

order files to facilitate trade execution.18

The New York Stock Exchange’s

SuperDOT system routes orders in price

and time priority to the specialist for

execution against other SuperDOT

orders, the specialist’s inventory, or

orders from the exchange floor. An

analysis of 1991 SuperDOT orders by

Harris and Hasbrouck (1992) shows that

SuperDOT orders account for about

50% of total orders, and because

SuperDOT orders are smaller than

average, about 30% of share volume.

Most limit orders are day orders (82%),

and limit orders tend to be larger than

market orders. Orders that are part of

program trades are more likely to be

market orders, especially index arbitrage

orders, which are virtually always

market orders. This finding makes sense

given the high priority for execution for

index arbitrage trades. The

Philadelphia, Pacific, and Boston Stock

Exchanges also operate centralized

order files with automated execution

features.

Internationally, the presence of limit

order books is even more pronounced.

A handful of those systems is described

below.

The Toronto Stock Exchange operates

a fully automated execution system

called CATS (Computer Assisted

Trading System), accounting for about

27 percent of the Exchange’s volume.

CATS is a central limit order file with

a unitary price opening mechanism,

operating on price and time priority.

Market orders entered into CATS are

converted into limit orders at the

current price. For example, a market

order to sell becomes a limit order at the

best bid. CATS handles trading for

about half of the stocks listed on the

TSE, although the TSE’s ‘‘Equity Floor

Closure’’ project will create a central

limit order file for all listed stocks, thus

eliminating all floor trading. Toronto’s

CATS system has served as a prototype

for other exchanges. Paris, Brussels, and

Barcelona have adapted the CATS

system while Stockholm, Helsinki, and

Tokyo have developed systems

resembling CATS.

The Paris Bourse converted from a

periodic call market system to a fully

computerized central limit order file

when it launched the CAC (Cotation

Assiste en Continu) system in the mid1980s. Relevant to Nasdaq’s joint order

and quote capability with NAqcess,

Paris determined that CAC alone could

not best meet the needs of all trade

types, particularly block orders. Block

orders trade on London’s SEAQ system,

a dealer-based, quote-driven system,

rather than through CAC. In response,

Paris has instituted procedures allowing

for an ‘‘upstairs’’ for block trade

negotiations as well as more formal

market making for less active stocks.

Similarly, Amsterdam responded to

diminishing block volume business by

adding a negotiation facility to

complement its limit order file system.

The London Stock Exchange, a dealerbased market, plans the creation of a

central limit order file. It is expected

that the order file will be used on a

limited basis upon introduction, to

evaluate the system’s impact

incrementally. The dealer market will

continue to play an important role in

the market, for instance, by meeting the

liquidity needs of larger trades.

In 1995, the Deutsche Borse AG

(DBAG) announced Project ZEUS, a

plan to automate and centralize all

German bourse trading. Although the

particulars are still in the formation

stages, a major component of the project

is the creation of an open order book

with market maker participation.

One criticism of the NAqcess proposal

has been that the mixing of dealer

quotes and the limit order file in one

display is misleading and disruptive.

Another criticism has been that the

inclusion of limit orders in the Nasdaq

inside quote would give NAqcess an

unfair competitive advantage over other

execution systems. The New York Stock

Exchange specialist, however, has been

disseminating a mixed quote for many

years with no significant informational

difficulties. Also, execution systems,

such as Madoff’s, have developed and

expanded over time to trade NYSElisted securities even with the eligibility

of limit orders being included in the

NYSE inside quotes. The dissemination

of the top-of-the-file, reflecting limit

orders at the best prices, and the

consolidated inside market, reflecting

orders and quotes at the best prices, will

provide investors in the Nasdaq market

with more information than is currently

available. When one or more NAqcess

orders join the dealer quotes to create

the consolidated inside market, a market

identifier is displayed to alert market
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31595

19A ‘‘Z’’ identifier will appear when an inside bid

or offer represents NAqcess orders only, and a ‘‘Y’’

identifier will appear when the inside bid or offer

represents both NAqcess orders and dealer quotes.

20Handa, Puneet and Robert A. Schwartz (1996).

‘‘Limit Order Trading,’’ forthcoming in Journal of

Finance.

21Harris, Lawrence and Joel Hasbrouck (1992).

‘‘Market vs. Limit Orders: The SuperDOT Evidence

on Order Submission Strategy,’’ NYSE Working

Paper #92–02. Forthcoming in the Journal of

Financial and Quantitative Analysis.

participants that these orders are part of

the current inside market.19 The

participation of orders in the Nasdaq

inside market will give all Nasdaq

investors, not just proprietary system

users, the chance to get better execution

prices.

In sum, many other world markets

have recognized the importance of limit

orders and have responded by

incorporating central order files into

their market structures, as Nasdaq plans

to do with NAqcess. In fact, most world

equity markets are, at their foundation,

limit order books, without an explicit

role for dealers. In this regard, Nasdaq

is something of an exception. It is

interesting to note, however, from the

experience of Paris and Amsterdam, that

the need for a dealer market modality

exists even when a strong order book

foundation exists. This point suggests

the appropriateness of alternative (and

competing) market modalities within a

single market. With these experiences in

mind, NAqcess is intended to

strengthen Nasdaq’s limit order

modality without weakening the dealer

market modality.

B. Theory and Evidence from the

Economic Literature on Limit Order

Trading

The economic literature supports the

view that limit order trading can be a

superior form of trading for some types

of investors. This section briefly

discusses some examples of this

literature as it relates to (1) the rationale

for order-driven trading, and (2) the

international experience with order

driven trading.

1. The Rationale for Order-Driven

Trading

The key question motivating the

academic limit order trading literature

concerns the relative advantages of

market and limit orders. The question is

addressed in two recent papers written

by well-known market microstructure

academics: ‘‘Limit Order Trading’’ by

Handa and Schwartz 20 and ‘‘Market vs.

Limit Orders: The SuperDOT Evidence

on Order Submission Strategy’’ by

Harris and Hasbrouck,21 discussed

previously.

Handa and Schwartz analyze the

fundamental rationale for limit order

trading. They point out that when the

market price is driven solely by

information, placing a limit order is a

lose-lose strategy. The opportunity for

profitable limit order trading arises

when short-term, self-reversing price

movements take place in a stock. This

type of fluctuation can occur when

demanders of liquidity enter market

orders that require immediate

execution. In this case, limit orders, like

market maker quotes, supply liquidity

to the market, and can be rewarded for

doing so by obtaining favorable trading

terms.

Handa and Schwartz use the terms

‘‘information traders’’ and ‘‘liquidity

traders’’ to describe the two types of

counterparties that placers of limit

orders face. The limit order loses when

the counterparty is an information

trader, but can win when the

counterparty is a liquidity trader. Thus,

an investor contemplating the

placement of a limit order must weigh

the probabilities of facing each of these

two types of traders. Further, the

investor needs to determine the

importance of completing his trade. In

the extreme case, an investor who

absolutely must trade should not use a

limit order strategy since there is some

probability that the order will not be

filled. On the other hand a ‘‘patient’’

investor, one whose current portfolio is

already near optimal, and for whom the

lack of execution of the order is not a

serious concern, may find a limit order

strategy to be superior to a market order

strategy. Handa and Schwartz envision

a natural ‘‘ecology’’ in the marketplace,

wherein a paucity of limit orders would

result in price movement, which

compensates limit order placement and

thus induces the placement of limit

orders. Limit orders would work

towards reducing volatility, up to the

point where no new flow of limit orders

is induced.

Handa and Schwartz use actual 1988

trade data from the 30 NYSE stocks in

the Dow-Jones Industrial Average to

compare strategies. They calculate the

average purchase price for hypothetical

buy limit and market orders. They

consider a number of limit order

strategies differentiated by the

aggressiveness of the strategy. In

general, when the limit order is filled,

the purchase price is lower than that of

a comparable market order. But when it

is not filled after some period of time,

it must be substituted for a market order

at the then prevailing price, the average

purchase price of which is usually

higher. The authors find that, for buy

limit orders placed 2% below the

market, the average purchase price,

taking into account what happens when

the limit order does not execute, is only

0.2% lower than the price of a

comparable market order. For a threeday holding period, a limit order set at

2% below the market earns on average

a return of about 0.48% higher than that

of a comparable market order, though

there is substantial variability (risk) in

this return. The strategy of placing the

order 2% below the market appears to

be optimal relative to the other

percentages considered in the study.

In sum, Handa and Schwartz find

sufficient short-term liquidity-driven

price changes in their data to make limit

order trading a potentially superior

strategy to market order trading. The

more patient the investor, the more

likely a limit order strategy is superior.

Harris and Hasbrouck also analyze

data from NYSE stocks. Using order data

derived from the SuperDOT orderprocessing system in 1991, they are able

to compare the relative performance of

limit and market orders that were

actually submitted.

For each order, Harris and Hasbrouck

compute the ‘‘fill’’ price, which is either

the limit order price if the order was

filled, or an imputed price if the order

was canceled or expired. Comparing the

fill price with the appropriate quote (ask

for buy orders, bid for sell orders)

provides a measure of trading strategy

value appropriate for traders who are

precommitted to transacting. Limit

order performance is compared to

market order performance, with limit

orders categorized according to

aggressiveness of the order price.

Consider stocks with quoted spreads

of 1⁄8. The authors find that limit orders

placed at the market quotes placed at

the bid for buy orders and at the ask for

sell orders tend to do better than market

orders. For small orders, such limit

orders execute at prices on average of

about three cents better per share than

market orders. Limit orders placed away

from the market tend to do worse than

market orders. As the trade size

increases, the relative advantage of atthe-quote limit orders diminishes to

about one and a half cents. When stocks

with quoted spreads of 1⁄4 are

considered, the possibility of setting a

limit order between the quotes emerges.

In fact, this strategy tends to be optimal,

providing price improvement of around

two cents a share. The authors are

careful to note, however, that their

measure of performance is not

necessarily valid for any given trader.

The key imponderable factor is the

priority the investor places on

execution, and the corresponding action
31596 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

22Berkman, Henk (1991). ‘‘The Market Spread,

Limit Orders and Options,’’ Working Paper,

Department of Finance, Erasmus University,

Rotterdam.

23 In the U.S. the Chicago Board Options

Exchange (CBOE) also exemplifies a multi-modal

market by combining a dealer system, a floor-based

system, and a central limit order file. Dealers may

engage in proprietary or customer trading while

floor officials execute trades on behalf of customers

only. The CBOE maintains two limit order books,

RAES (Retail Automatic Execution System) the

EBook (the Electronic Book), which automatically

match options orders. The latter handles orders that

arrive prior to the opening and are outside the

current market quotes. This information is provided

by the Chicago Board Option Exchange’s Internet

home page—http://www.cboe.com.

24Lehmann, B.N. and D.M. Modest (1994).

‘‘Trading and Liquidity on the Tokyo Stock

Exchange: A Bird’s Eye View,’’ Journal of Finance

49: 951–984. Hamao, Yasushi and Joel Hasbrouck

(1995). ‘‘Securities Trading in the Absence of

Dealers: Trades and Quotes on the Tokyo Stock

Exchange,’’ The Review of Financial Studies 8, 3

(Fall).

25Biais, Bruno, Pierre Hillion and Chester Spatt

(1995). ‘‘An Empirical Analysis of the Limit Order

Book and the Order Flow in the Paris Bourse,’’ The

Journal of Finance 50, 5 (December): 1655–1689.

26The member of the Task Force did not specify

whether the 40 percent included marketable limit

orders.

taken by the investor when a limit order

does not execute.

Together, these two papers provide a

basic rationale for limit order. Sufficient

liquidity trading seems to occur on the

NYSE, creating the short-term price

volatility such that a relatively patient

investor can be consistently rewarded

for supplying liquidity. Application of

these results to NAqcess suggests that

the creation of a facility that enhances

a limit order trading strategy can benefit

certain types of investors.

2. Performance of Other Markets

Options exchanges combine the

elements of competing market makers

with a central limit order file, which is

of particular interest since this is the

model for Nasdaq under NAqcess.

Berkman examines the European

Options Exchange in Amsterdam.22 At

this exchange, dealers interact with each

other in an open outcry manner, typical

of options exchanges, as opposed to

interacting through a computer network.

Berkman seeks to determine the

influence of the limit order file on

spreads. His results indicate that when

the number of transactions executed

against limit orders as a percentage of

total transactions is high, the spread is

low. Berkman views this percentage as

an indication of the competition faced

by dealers from the limit order file.

Applying this result to NAqcess

suggests that limit orders create

competition even in an environment

characterized by competition among

market makers.23

A number of academic studies

analyze the characteristics and

performance of equity markets outside

the U.S. As mentioned above, the Paris

Bourse and the Tokyo Stock Exchange

operate fundamentally as centralized

limit order files without an explicit role

for dealers.

Lehmann and Modest, and Hamao

and Hasbrouck study the Tokyo Stock

Exchange.24 Both studies consider the

performance of a market that relies

exclusively on limit orders to provide

liquidity. By custom, brokers do not

engage in proprietary trading on both

sides of these markets. The authors

perform a variety of analyses which

demonstrate the viability of the Tokyo

Stock Exchange’s order-driven market.

Biais, Hillion, and Spatt study the

operation of the Paris Bourse, in

particular the flow of orders in response

to market developments.25 They find

that when the current bid-ask spread (as

determined from the limit order book) is

relatively high or the order book thin,

investors are more likely to submit limit

orders. Conversely, when the spread is

tight, investors tend to trade against

existing limit orders. ‘‘Thus, the

investors provide liquidity when it is

valuable to the marketplace and

consume liquidity when it is plentiful’’

(pg 1657). The market response to

market orders is rapid, reflecting

competition in the supply of liquidity.

They also find that the flow of order

placements tends to be concentrated at

or inside the best market quote, again

reflecting competition in the supply of

liquidity.

These two examples illustrate that

limit orders can be the primary or even

sole source of liquidity in a market. For

some types of trades and some types of

stocks, however, dealer markets appear

to provide an additional dimension of

market quality beyond that found in a

pure limit order market.

C. The Role of Limit Orders in the PreNAqcess Nasdaq Stock Market

In contemplating the role of a central

limit order file, it is important to

recognize that limit orders are currently

placed in the Nasdaq market. NAqcess

constitutes an enhancement in limit

order trading capabilities, not the

establishment of limit order trading. The

following two sections discuss the

submission of limit orders in the current

environment as well as the use of two

existing limit order facilities.

1. Evidence of Implicit (Internal) Limit

Order Use on Nasdaq

Although the NASD has never

conducted a comprehensive survey of

limit order activity in the Nasdaq

market, a 1994 review by an NASDappointed task force demonstrates that

limit orders account for a significant

amount of order flow between brokerdealers. As part of its review of limit

order protection rules in 1993, the

NASD Board of Governors (the Board)

created the Limit Order Task Force (the

Task Force) to explore issues related to

limit orders sent from one broker-dealer

to another for execution. The Task Force

included representatives from integrated

broker-dealers, wholesale market

makers, regional firms, firms with a

large institutional clientele, and a

Nasdaq issuer.

During roundtable discussions, one

member of the Task Force, representing

the interests of wholesale firms, stated

that of all orders entering the firm’s

trading systems daily, as many as 40

percent were limit orders for other

broker-dealers’ customers.26 Another

Task Force member, who represented a

full service firm, stated that 20 to 25

percent of its orders were limit orders.

In the summer of 1994, the Task

Force’s work prompted the NASD to

survey market makers to estimate the

flow of Nasdaq limit orders from brokerdealer to broker-dealer. The NASD

asked market makers for daily

percentages of orders received from

unaffiliated brokers for execution that

were limit orders, exclusive of

marketable limit orders. Survey

information was requested for five

specified days in both January, 1994 and

July, 1994. Eight market maker firms,

four multi-service and four wholesale,

responded to the survey. Limit order

flow from other broker-dealers ranged

from less than 10 percent to 30 percent

for multi-service firms and from 20

percent to 50 percent for wholesale

firms. The survey data show that limit

orders accounted for a significant

amount of member-to-member order

flow.

2. Evidence of Explicit Limit Order Use

on Nasdaq

Two well-known limit order facilities

for trading Nasdaq securities are Instinet

and SelectNet. Instinet is a proprietary

trading system owned by Reuters

Holdings PLC. Traders equipped with

Instinet terminals or Instinet feeds can

place limit orders into the system and

anonymously take out existing orders on

the file. Instinet executions are sent

directly to ACT, Nasdaq’s clearing

facility. Users of Instinet have

traditionally been institutional traders

and market makers. Though Instinet is

integrated into the Nasdaq system, it

competes with other Nasdaq trading
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31597

27 January 1996 data are from the Nasdaq Market

Data Server. Data from this relatively new source

provide more detail than was previously available

for calculating Instinet volume. Data from the

Nasdaq Equity Audit Trail extend back to January

1993, but are incomplete regarding Instinet trading.

Incomplete as it is, however, this source indicates

no trend in the Instinet share of volume during the

last three years.

28The 250 stocks with the highest median dollar

volume over the first quarter of 1996 were selected.

29The 250 stocks are the same as those mentioned

in the previous footnote.

30The sample is limited to those stock-days (a

stock-day is a unique combination of a stock and

trading day) having 20 or more trades; thus a stock

may not be included in the sample for all trading

days over the period. The 20 or more trades

criterion necessarily means that trading activity for

the sample is higher than for the Nasdaq market as

a whole. Daily share volume for stock-days in the

sample averages 252,300 shares compared to

106,108 shares for the Nasdaq market over the same

time period. Average trade sizes are 1,916 and 1,980

for the sample and the Nasdaq market, respectively.

31Note that this approach may bias our results in

the limit orders favor, because in theory, the worst

price at which a market order can be executed is

the inside quote. Many firms offer market orders

opportunities for price improvement or match them

with orders on an internal file, so market orders can

be executed at prices inside the dealer quotes.

32E(Limit Order Advantage) = P(Execution) *

Outperformance ¥ P (Non-Execution) * Cost of N–

E = (.9 * .25) ¥ (.1 * 2.00) = .025

modes in the sense that it offers an

alternative trading venue. In January

1996, Instinet share volume was about

15% of total Nasdaq volume. This share

appears to have been roughly constant

during the last three years, indicating

that limit orders have been and continue

to be an important part of Nasdaq

trading activity.27 Instinet share volume

for the top 250 Nasdaq issues accounted

for almost 20% of total share volume in

these stocks during January, 1996.28

As described in section II.C., Nasdaq’s

SelectNet service, which broadcasts

priced orders, will be discontinued

when NAqcess is implemented, as

NAqcess provides considerable

improvements to the SelectNet facility.

SelectNet volume has averaged about

4% of total Nasdaq volume over the last

three years. In January, 1996, SelectNet

accounted for 5% of total share volume

in the top 250 Nasdaq issues.29

SelectNet’s use provides further

evidence that limit order use is not

foreign to the current Nasdaq market.

As noted above, limit order trading,

by supplying liquidity to the market,

allows investors the opportunity to

trade at prices superior to those

represented by the prevailing inside bid

and offer. During January 1996, Instinet

trades occurred inside the spread 65%

of the time, and SelectNet trades

occurred inside the spread 36% of the

time. These figures contrast with the

rest of Nasdaq trading (excluding SOES,

ACES, SelectNet, and most Instinet

trades) which for the same month

executed between the quotes about 22%

of the time.

D. Research Conducted by and

Sponsored by the NASD

1. Replication of Handa and Schwartz

Study on Nasdaq Stocks

NASD Economic Research staff have

conducted a study similar in purpose to

the Handa and Schwartz study

discussed above. The purpose of the

study is to assess the potential

profitability of limit order trading in

Nasdaq stocks. Like the Handa and

Schwartz study, the method was to

construct hypothetical limit and market

orders for a stock, and compare the

relative profitability of the two order

types using actual historical trade price

data.

Using internal trade and quote data

for each Thursday from January 4 to

April 11, 1996, the performance of an

array of hypothetical limit orders at

various price levels was measured

against that of a hypothetical market

order.30 All hypothetical orders were

placed at the open, so the hypothetical

market buy (sell) order was executed at

the opening inside ask (bid).31 The array

of hypothetical limit buy (sell) orders

consisted of limit orders at each 1⁄8

interval between the opening ask (bid)

and the opening ask (bid) plus (minus)

$2. For example, if the opening bid was

$20, the performance of hypothetical

sell limit orders at $201⁄8, $201⁄4, $203⁄8,

. . . to $22 would be compared to that

of a sell market order executed at the

opening bid, $20. Hypothetical limit

order executions occurred if any

execution at an inferior price was

reported during normal trading hours.

For example, a sell limit order of $201⁄4

would be assumed executed if a price

greater than $201⁄4 were observed during

the day. This approach is conservative

in that, given Manning protection and

the fact that limit orders with time

priority may become the market, some

executions at prices equal to the limit

order price would yield an execution. If

no execution occurs, the limit order

converted to a market order which was

executed at the prevailing inside market

at the time of the last trade in the stock

that day.

Each combination of a stock during a

given day (stock-day) in the sample was

classified by two variables, spread class

and price range. A stock-day’s spread

class is determined by rounding the

trade-weighted average spread to the

nearest 1⁄8 (though some spread class

categories contain multiple 1⁄8s). Price

range classification is made using the

opening bid for the stock-day. Stockdays with less than 20 trades were

excluded from the analysis. For each of

the hypothetical limit orders, the

following measures were calculated: the

probability of execution, nominal

differential performance versus the

hypothetical market order, percentage

differential performance versus the

hypothetical market order, and the cost

of non-execution. For example, a buy

order 1⁄4 below the opening ask might

have a 90 percent probability of

execution. If executed, this order

outperforms the market buy order by

$0.25. If not executed, the order is

converted to an end-of-day market

order. As the limit order was not

executed, it is likely the market moved

against it, i.e., it rose. Suppose that a

stock’s price rises throughout the day,

never trading at a price inferior to the

limit order, and that the closing price

exceeds the opening price by $2. Then

an unexecuted limit order, converted to

an end-of-day market order,

underperforms the original market order

by $2. The limit order investor then

weighs the 90 percent probability of

saving $0.25 against a 10 percent

probability of losing $2.00 and forms the

expectation that, on average, the limit

order will out perform the market order

by $.025.32

Table 2 presents results for 2 crosssections: spread classes 1⁄8 and 1⁄4 both

for stock-days in the $10 to $20 price

range. The first column shows the limit

order price increment, with an

increment of zero representing a market

order. The second column shows

probability of execution, which is the

likelihood that a limit order will execute

at the given increment level. For

example, in the 1⁄8 spread class, a limit

sell (buy) order placed 1⁄8 above (below)

the bid (ask) has a 68.9% chance of

execution on an average day. The limit

order’s value of execution is $0.125,

which represents the savings the

investor gains by selling (buying) 1⁄8

above (below) the bid (ask). The

probability of non-execution is simply

100% minus the execution probability,

which equals 31.3%. The cost of nonexecution, found in the fifth column of

the table, represents the opportunity

cost associated with placing a limit

order that is not filled during the day.

As stated previously, if the hypothetical

limit sell (buy) order is not filled during

the day, it is executed at the closing

inside bid (ask). The cost of nonexecution is computed as the difference

between the closing inside bid (ask) and

the opening inside bid (ask), conditional

on the fact that the order was not filled

during the day. On average, this cost is

just under $0.24 for a limit sell (buy)
31598 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

order placed 1⁄8 above (below) the bid

(ask). The expected dollar value of the

limit order, shown in the sixth column,

represents the savings of executing the

limit order minus the opportunity cost

of non-execution, taking the probability

of both events into account. It is

computed as follows:

(column 6) expected dollar value of

limit order = (column 2) probability of

execution * (column 3) value of

execution—(column 4) prob. of nonexecution * (column 5) cost of nonexecution.

The expected dollar value of the limit

order is the overall summary measure of

what an investor might gain, on average,

from placing a limit order. Finally, the

seventh column divides the expected

value of the strategy by the opening

price of the stock. The resulting figure

is the percentage gain of the strategy,

and can be added to the overall

investment return from holding the

stock. While the discussion has focused

on savings for the investors placing

limit orders, it should be noted that a

savings exists for the investors whose

market orders execute against the limit

orders. For example, say a limit buy

order is placed at $15 1⁄8 for 500 shares

when the inside market is $15 to $15 1⁄4.

If a market sell order for 500 shares

executes against the limit order, both

the limit order and the market order

realize an execution value of $0.125.

Table 2 shows that, on average, for

stocks priced between $10 and $20 in

the 1⁄8 spread class, the only scenario in

which a limit order outperforms a

market order executed at the opening

bid or ask, is placing a buy (sell) limit

order 1⁄8 below (above) the inside ask

(bid). Because this cross-section of

stock-days are in the 1⁄8 spread class,

limit orders outperform market orders

even though they have been placed at

levels equivalent (on average) to inside

dealer quotes (i.e. buy orders at the bid,

sell orders at the ask). For a spread class

of 1⁄4, however, the optimum level at

which limit orders can be placed is 1⁄8

below (above) the inside ask (bid); as

might be expected, limit orders that

‘‘split’’ the dealer spread outperform

market orders.

BILLING CODE 8010–01–M
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31599

BILLING CODE 8010–01–C
31600 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

Table 3 contains results for the 1⁄8

spread class and the 3⁄8 and 1⁄2 spread

classes for stock-days in the $20 to $30

price range. Interestingly, no limit

orders placed near the market

outperform a market order on average

for stock-days in the 1⁄8 spread class. For

spread classes 3⁄8 and 1⁄2, a number of

price levels at which limit orders

outperform market levels exist. Those of

note are between the spread for these

stock-days, i.e. at 1⁄8, 1⁄4, and 3⁄8 off the

inside quotes. A limit order 3⁄8 off the

inside market does best; these orders

will be either at (for 3⁄8 spread stockdays) or 1⁄8 inside (1⁄2 spread stock-days)

the inside dealer market.

BILLING CODE 8010–01–M
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31601

BILLING CODE 8010–01–C
31602 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

Figure 1 plots the relative

performance of the limit order array for

5 spread classes of stock-days in the $10

to $20 price range. The graph shows that

for all but the 1⁄8 spread class (where no

orders can be placed inside the quotes),

the optimum limit order strategy is to

place ordes at prices 1⁄8 better than the

inside dealer market. This analysis

shows the when possible, limit orders

placed within the inside dealer market

can outperform market orders on

average.

BILLING CODE 8010–01–M
Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices 31603

33Sixteen graduate business school students and

eight NASD employees participated the simulation

as live traders. No professional traders participated.

34A fourth market structure, allowing live

participants to act as day traders, was also

developed and tested for use in an experimental

setting. In this environment, participants could use

market orders or input limit orders in the limit

order facility. Controlled experiments under this

market structure, however, have not been

conducted to date.

BILLING CODE 8010–01–C

This analysis suggests potential

benefits for investors from enhanced

limit order activity on the Nasdaq Stock

Market. Investors who do not require

immediate transactions will have an

incentive to place limit orders in

NAqcess, and may receive superior

prices as a result. Since these limit

orders augment the supply of liquidity,

those investors who demand immediacy

through the placement of market orders

may pay less for it.

While this study finds that limit order

strategies can result in gains for

investors, its implications for NAqcess

must take several factors into

consideration. The study examines

performance of hypothetical limit orders

in the current, pre-NAqcess trading

environment, which does not represent

what will exist in the NAqcess

environment. It is expected that the

introduction of a central limit order file

in the Nasdaq Stock Market will alter

the dynamics of the market, including

the performance of limit orders,

although the precise changes cannot be

known with certainty. For example, this

study measures savings relative to a

stock’s spread without taking

commissions into account. This is a

reasonable approach given the current

Nasdaq environment. In the NAqcess

environment, however, spreads could

become less relevant while commissions

become more so. Secondly, some

trading in the pre-NAqcess environment

does occur inside the spread, meaning

that some investors already realize the

type of savings identified in the study.

2. Preliminary Simulation Analysis

Beginning in 1995, Nasdaq retained

Robert A. Schwartz and Bruce W.

Weber, both with the Leonard N. Stern

School of Business, New York

University to develop a model of

Nasdaq trading that could be used to

simulate next-generation trading on

Nasdaq as exemplified by NAqcess.

Professors Schwartz and Weber are

experts in the field of market

microstructure and simulation.

Schwartz has written extensively and

has many published papers on market

microstructure. Weber, prior to his work

for Nasdaq, developed a simulation

model of London Stock Exchange

trading for the London Stock Exchange.

The Schwartz-Weber model is a

simplified representation of Nasdaq

order placement and execution.

Liquidity traders, momentum traders,

informed traders, market maker quote

setting, and inventory management

behavior are mechanically generated by

computer algorithms. Live traders

representing order entry firms interact

with the computer-generated

environment.33 The behavior of the live

traders can be analyzed under different

market structures. As an initial test of

their simulation model, Schwartz and

Weber conducted experiments with live

subjects on the usage of limit orders in

a Nasdaq limit order facility similar to

NAqcess and measured the impact that

a limit order facility had on limit order

usage, displayed spreads, and dealer

profitability.

Three different market structures were

used in the experiments.34 The first

market structure allowed live traders,

given a predetermined set of buy orders,

to use market orders and trade at the

quoted prices of market makers. The

second market structure allowed live

traders, given a predetermined set of

buy orders, to use market orders or

input limit orders in the limit order

facility with dealers uninformed to the

information available to them in order

flow. The third market structure

allowed live traders, given a

predetermined set of buy orders, to use

market orders or input limit orders in

the limit order facility with dealers

partially informed by the information

available to them in order flow. The

uninformed dealers in the second

market structure had wider spreads than

in the third market structure due to the
31604 Federal Register / Vol. 61, No. 120 / Thursday, June 20, 1996 / Notices

1 15 U.S.C. § 78s(b)(1) (1988).

2 17 CFR 240.19b–4 (1994).

3Securities Exchange Act Release No. 35074 (Dec.

9, 1994), 59 FR 64827 (Dec. 15, 1994) (order

approving File No. SR–NASD–94–58).

4The term ‘‘interest and dividends’’ includes

interest from a member’s customer margin accounts

and interest and dividends from a member’s trading

and investment positions, such as from repurchase

and reverse repurchase agreements and stock loan

and borrow transactions.

increased risk of transacting with more

informed traders.

The experimental results suggest that

the introduction of a limit order facility

narrows the displayed spread and

increases order placements. Under the

uninformed dealer scenario, the

displayed spread narrows by about 25

percent. Under the informed dealer

scenario, the displayed spread narrows

by about 50 percent. The addition of a

limit order facility increased limit order

placement to about 50 percent of all

orders and reduced market order

placement to about 50 percent of all

orders. Limit orders were executed 45

percent of the time under the

uninformed dealer scenario and about

50 percent of the time under the

informed dealer scenario. The addition

of a limit order facility increased overall

orders placed by about 18 percent but

decreased overall orders executed by

about 5 percent.

The experimental results also suggest

that the introduction of a limit order

facility is particularly important to

investors in stocks when spreads are

greater than 1⁄4. There is some evidence,

although not consistent over all

categories, that the greater the size of the

displayed spread, the greater the use of

limit orders. For three out of four

categories, a larger percentage of limit

orders were placed when displayed

spreads were 3⁄8 and 1⁄2 than when

displayed spreads were 1⁄8 and 1⁄4.

The simulation also measured dealer

profitability. The results on dealer

profitability changes after the

introduction of a limit order facility

were mixed. The marginal rate of dealer

profits in basis points decreased under

the uninformed dealer scenario but

increased under the informed dealer

scenario.

The results are taken from a small

sample of 24 experimental subjects.

Since subjects had a limited amount of

training in the simulated trading

environment, better trained subjects

may have led to different results. The

simulation model makes simplifying

assumptions about order flow

characteristics, dealer quote setting

behavior, and price movements in the

Nasdaq market. For instance, the exact

structure of NAqcess was not

completely determined when the

experiments were conducted. Thus, the

limit order book structure tested is not

identical to the structure ultimately

proposed. If any assumptions made by

the model are not valid, then the results

may not be representative of the impact

of NAqcess on the Nasdaq market.

IV. Conclusion: NAqcess Should Benefit

Investors

NAqcess represents a major

development for the Nasdaq Stock

Market. Its key feature is a central limit

order file with broad access to market

participants. Investors will have the

opportunity to place limit orders

directly into the file, and execute trades

against orders in the file in an

automated fashion. This central order

file will replace the current SelectNet

facility. The automated execution

system, fully consistent with the firm

quote rule, will allow investors to

execute market orders without need of

explicit market maker interaction. This

system will replace the current SOES

facility.

Nasdaq staff believe that NAqcess will

represent a significant benefit for

investors, as enhanced capabilities for a

limit order-oriented market modality are

created. This determination is amply

supported by the global experience of

equity trading, by economic theory and

evidence, by the current experience

within the Nasdaq market, and by

research conducted by and for the

NASD’s Department of Economic

Research.

As has been the experience with the

Paris Bourse, however, the dealeroriented market modality has distinct

advantages of its own. NAqcess is in no

way intended to replace the dealer

market. It can be expected that some

issues will tend to be traded within

NAqcess more than others, and that

some types of trades will be more likely

to be placed on NAqcess than others.

The forces of competition will

ultimately determine the usage of the

various modalities offered within the

Nasdaq Stock Market.

[FR Doc. 96–15448 Filed 6–19–96; 8:45 am]

BILLING CODE 8010–01–P

[Release No. 34–37310; File No. SR–NASD–

96–15]

Self-Regulatory Organizations;

National Association of Securities

Dealers, Inc.; Order Granting Approval

to Proposed Rule Change Relating to

Schedule A to the By-Laws to Amend

the Allowable Exclusions and

Deductions from the Definition of

Gross Revenue for Member

Assessment Purposes

June 13, 1996.

On April 4, 1996, the National

Association of Securities Dealers, Inc.

(‘‘NASD’’ or ‘‘Association’’) submitted

to the Securities and Exchange

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

pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934

(‘‘Act’’) 1 and Rule 19b–4 thereunder,2 a

proposed rule change to amend the

allowable exclusions and deductions

from the definition of gross revenue for

member assessment purposes.

The proposed rule change was

published for comment in Securities

Exchange Act Release No. 37169 (May 6,

1996), 61 FR 21517 (May 10, 1996). No

comments were received on the

proposal. This order approves the

proposed rule change.

I. Background

Gross revenue is defined for member

assessment purposes under Section 5 of

Schedule A of the NASD By-Laws

(‘‘Section 5’’) as total income reported

on FOCUS form Part II or IIA, with

certain limited exclusions and

deductions.3 Currently, Section 5

provides that revenue derived from

interest and dividends 4 may be

excluded by a member from gross

revenue for assessment purposes.

II. Description of Proposal

The Association’s proposal amends

Section 5 to remove interest and

dividends as an allowable exclusion for

assessment purposes. The proposal,

however, adds a new provision to allow

a member to deduct from gross revenue

for assessment purposes either: (i) its

interest and dividend expenses, but not

in excess of related interest and

dividend revenue; or, alternatively, (ii)

40% of interest earned by the member

on customer securities accounts. The

proposal also allows a member to

deduct from its gross revenue an

additional $50,000 of net interest and

dividend revenue. Lastly, the proposal

amends Section 5 to provide

alphabetical references to its two

primary subsections and to replace all

bullets referencing its secondary

subsections with numerical references.

The proposed rule will take effect for

the 1996 assessment based on revenues

generated in calendar year 1995. Based

on its data, the NASD estimates that the

proposed rule, if it had been adopted for

1995, would have generated assessment

revenue of $3 million based on the

budgeted level of assessment revenue of

$39 million for that year. Therefore, the

NASD believes that the rule proposal