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94-81 SEC Approves NASD Proposal To Require CQS Market-Maker Participation In ITS/CAES And CAES

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Executive Summary

On June 29, 1994, the Securities and Exchange Commission (SEC) approved several proposed rule changes by the NASD concerning trading in exchange-listed securities by NASD Consolidated Quotation System (CQS) market makers.1 Specifically, the following rules will be effective on October 31, 1994:

  • All CQS market makers in Rule 19c-3 securities2 must register as ITS/CAES market makers;3

  • All CQS market makers in non-Rule 19c-3 securities must register as Computer Assisted Execution System (CAES) market makers;4

  • All CQS market makers must input a minimum size of 500 shares in their quotations;5

  • All CQS market makers must abide by the excess spread parameters for CQS securities in Part V of Schedule D to the NASD By-Laws; and

  • All CQS market makers will be permitted to enter principal orders into CAES.

The NASD and The Nasdaq Stock Market, Inc., believe these changes will enhance the quality and liquidity of the markets provided by CQS market makers in exchange-listed securities, improve opportunities for customers to receive automated executions of their orders in the third market, and make ITS a more effective market link mechanism in exchange-listed securities. The text of the amendments follows the discussion below.

Background And Description

In an effort to enhance the quality of the markets provided by CQS market makers in exchange-listed securities, promote competition among exchange markets and markets provided by CQS market makers, and facilitate better order interaction among ITS Participant Markets, the NASD proposed various amendments to Schedules D and G and the Rules of Practice and Procedure for ITS/CAES. Following is a more detailed explanation of the specific rule changes approved by the SEC.6

1. Mandatory Inclusion Of CQS Market Makers In Rule 19c-3 Securities In ITS/CAES

One of the most significant amendments approved by the SEC is the requirement that all CQS market makers in Rule 19c-3 securities must register as ITS/CAES market makers, thereby subjecting all CQS market makers in these securities to the obligations and protections afforded participants in the ITS Plan. This rule change is designed to eliminate confusion by exchange participants and others concerning the accessibility of quotations disseminated by CQS market makers. Currently, the quotes of all CQS market makers in exchange-listed securities are consolidated into a composite third-market quote and disseminated to vendors and to the floors of competing exchanges on CQS. The quotes of CQS market makers that are not ITS-linked are included in the consolidated quote, but are not accessible through the facilities of ITS or ITS/CAES to other ITS Participants or ITS/CAES market makers. ITS has its own display of quotations, available only to ITS Participants, and this dual system of quotation information is sometimes confusing. Specifically, when other market centers send ITS commitments to the NASD in response to non-ITS/CAES market-maker quotes seen through CQS, the commitments expire unexecuted and the other market centers may believe that an ITS/CAES market maker has backed away from its quotes. With this rule change, there will be no confusion as to the accessibility of CQS market makers' quotes in Rule 19c-3 securities through ITS.

In addition, by requiring all CQS market makers in Rule 19c-3 securities to participate in ITS, the rule change facilitates better interaction between CQS market makers and the exchanges. Currently, other ITS Participant Markets cannot execute transactions through ITS with CQS market makers that are not ITS/CAES market makers, even though these market makers may be quoting superior prices. Conversely, non-ITS-linked CQS market makers cannot access, through ITS, superior quotes displayed by the exchanges. With this rule change, orders received by all CQS market makers in Rule 19c-3 securities will be able to interact, through ITS, with orders placed on the exchanges, thus promoting the best execution of investors' orders.

Non-ITS-linked CQS market makers also are presently not bound by the ITS Plan or operating procedures. The ITS Plan contains provisions regarding treatment of trade-through occurrences, block trades, pre-opening procedures, and resolution of obvious errors and intermarket disputes. The new rule will eliminate the current disparate regulatory treatment between those CQS market makers bound by the ITS Plan and those not bound by the Plan. In addition, pursuant to Section (b)(2) of the NASD's ITS/CAES Rules, members are reminded that they must execute an ITS/CAES Market Maker Application Agreement at least two days before the date they intend to be registered as an ITS/CAES market maker in a CQS security.

Members are reminded, however, that if they effect and report a transaction in a CQS security that is included within the ITS/CAES linkage after 9:30 a.m. Eastern Time, but before any ITS/CAES market maker in that security has commenced quoting or trading the issue, then all ITS/CAES market makers in that security may be precluded from participating in the ITS pre-opening procedure for that security on that trading day.
2. Mandatory Participation In CAES For Non-Rule 19c-3 Securities/Permitting Principal Transactions Through CAES

The SEC approved the requirement that all CQS market makers in non-Rule 19c-3 securities must register as CAES market makers. Mandatory participation in CAES will enhance the liquidity provided through CAES and permit CAES to be a more efficient mechanism for trading exchange-listed securities in the third market. In addition, with mandatory CAES participation, the NASD believes it is appropriate for CAES market makers to be able to access each other through CAES, reducing reliance on telephone contact. Accordingly, the SEC also approved an NASD proposal to modify CAES to permit market-maker-to-market-maker executions within the system.
3. Minimum Quotation Sizes For CQS Market Makers

All CQS market makers, regardless of whether they are ITS/CAES market makers or CAES market makers, are now required to input a minimum size of 500 shares in their quotations. The minimum quotation size for an individual CQS security may be lowered from 500 shares to 200 shares from time to time by the NASD depending on unique circumstances, however.7 The minimum quotation size for each CQS issue will be displayed to the left of the issue's name in the bid/ask quotation display on the Nasdaq Workstation®.
4. Excess Spread Parameters To CQS Market Makers

All CQS market makers will be required to adhere to the excess spread parameters established in Part VI, Section 2 of Schedule D to the NASD By-Laws. Specifically, the maximum permissible spread for a dealer's quote in a CQS security will be equal to 125 percent of the average of the narrowest three dealer spreads in that issue, provided that the maximum allowable spread will never be less than 1/4 a point. In determining the maximum allowable spread, quotations of exchange participants will be included in the calculation.

Questions regarding this rule change should be directed to Glen Shipway, Senior Vice President, Nasdaq Market Operations, at (203) 385-6250, or Thomas R. Gira, Assistant General Counsel, at (202) 728-8957. Questions concerning the ITS/CAES Market Maker Application Agreement should be directed to Market Data Services at (301) 948-6162.


1 The third market is the market for exchange-listed securities away from exchange markets.

2 SEC Rule 19c-3 prohibits the application of off-board trading restrictions to securities that: (1) were not traded on an exchange before April 26, 1979; or (2) were traded on an exchange on April 26, 1979, but ceased to be traded on an exchange for any period of time thereafter. The Intermarket Trading System (ITS) Plan limits the securities eligible for trading through the ITS/CAES linkage to Rule 19c-3 securities.

3ITS/C AES is the NASD's link to ITS that enables ITS/CAES market makers in Rule 19c-3 securities to direct agency and principal orders to and receive orders from the floors of participating ITS exchanges. Only CQS market makers registered as ITS/CAES market makers with the NASD are eligible to participate in the ITS/C AES link.

4 CAES is an automated system regulated by the NASD and operated by The Nasdaq Stock Market, Inc., that allows NASD members to direct agency orders (and principal orders with this rule change) in exchange-listed securities to CAES for automated execution in the third market. CAES market makers are CQS market makers that have registered as CAES market makers.

5 The NASD's new rule with respect to minimum quotation sizes in CQS securities provides that" CQS market makers shall be required to input a minimum quotation size of 200 or 500 shares in each reported security (as established and published from time to time by the Association) depending on trading characteristics of the security ...." In this connection, the NASD has determined to require a minimum quotation size of 500 shares for all CQS market-maker quotations.

6 See Securities Exchange Act Release No. 34280 (June 29, 1994), 59 FR 34880

7 See infra note 5.


Text Of Amendments To Schedules D And G To The NASD By-Laws And The Rules Of Practice And Procedure For ITS/CAES

(Note: New text is underlined; deleted text is bracketed.)

Schedule D, Part VII Consolidated Quotation Service (CQS)

Sec. 1 Registration as a CQS Market Maker

(a) through (d) No change.
(e) All COS market makers registered in reported securities shall be registered as market makers in the Computer Assisted Execution System (CAES): all COS market makers registered in reported securities that are eligible for inclusion in the Intermarket Trading System/ Computer Assisted Execution System (ITS/CABS') shall be registered as market makers in ITS/CAES and shall be subject to the Rules of Practice and Procedure for the ITS/CAES System Automated Interface.

Sec. 2 Obligations of CQS Market Makers

(a) Pursuant to SEC Rule 1 lAcl-1, a CQS market maker's quotation in reported securities are required to be firm for the size displayed or, if no size is displayed, for a normal unit of trading. If a market maker displays quotations in a reported security on both a national securities exchange and the NASD's CQS [and the Nasdaq] System, the market maker shall maintain identical quotations in each system [service].
(b) COS market makers shall be required to input a minimum quotation size of 200 or 500 shares in each reported security (as established and published from time to time by the Association) depending on trading characteristics of the security, and shall be subject to the excess spread parameters established for Nasdaq market makers in Part VI. Schedule D of the NASD By-Laws.

Schedule G

Reporting Transactions In Listed Securities

This Schedule has been adopted pursuant to Article VII, Section 1(a)(6) of the Corporation's By-Laws and shall apply to all over-the-counter transactions in listed securities that are required to be reported to the Consolidated Tape ("eligible securities") as provided in the Plan filed by the Association pursuant to Rule HAa3-1 under the Securities Exchange Act of 1934 ("Plan"). Section (2) of this Schedule shall not apply to transactions executed through CAES (Computer Assisted Execution System) or ITS/CAES (Intermarket Trading System/Computer Assisted Execution System) by market makers registered as COS market makers.

Rules Of Practice And Procedure For The ITS/CAES Automated Interface

(a) Definitions
(1) No change.
(2) The term "ITS/CAES Market Maker" shall mean a member of the Corporation that is registered as a market maker with the Corporation for the purposes of participation in ITS through CAES with respect to one or more specified ITS securities in which he is then actively registered. Registration as an ITS/CAES market maker is mandatory for all registered COS market makers in securities eligible for inclusion in the ITS/CAES linkage.

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