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94-79 NASD Solicits Member Comment On Board Proposals To Extend Customer Limit-Order Protection;
Comment Period Expires November 7, 1994
On September 19, 1994, the Board of Governors approved issuance of a Notice to Members soliciting comment on proposals to expand the scope of limit-order protection beyond that presently afforded by member firms to their customers in The Nasdaq Stock Market™. Currently, the NASD's Interpretation to the Rules of Fair Practice makes it a violation of just and equitable principles of trade for a member firm to trade ahead of its own customer's limit orders. The new proposals would extend this protection to the customer of a firm that sends a limit order of 1,000 shares or less to another member for execution (so-called member-to-member trades). In addition, the proposals would prohibit trading ahead of all other customer limit orders sent from one member to another when the member firm accepting the order trades for its own account at prices that are superior but not equal to the limit order price.
The NASD is soliciting comment on these specific proposals, described in more detail below, as well as any other concerns this action raises for members or interested parties. Comments received on or before November 7, 1994, will be considered by the Board at its November meeting.
In July 1994, a Limit Order Protection Rule became effective for NASD members accepting limit orders in Nasdaq securities.1 Under the Limit Order Interpretation to the Rules of Fair Practice, a member firm cannot accept and hold its customer's limit order in a Nasdaq security and continue to trade that security for its own account at prices that would satisfy the customer's limit order without filling that order.
The rule renders such trading activity ahead of the customer's order a violation of just and equitable principles of trade.
When the NASD initially proposed the limit-order rule, it solicited comment from members on the advisability of implementing trading-ahead restrictions for all customer limit orders, including those passed from one member firm to another for execution.2 The vast majority of members commented that limit-order protection for a firm's own customers was appropriate and beneficial to the market, but several cautioned against the potential adverse impact that could result from application of a rule to member-to-member orders. In recognition of the concerns raised, the Board deferred broader application of the rule and commissioned a special Limit Order Task Force to review the issue.
To gather information on the subject of limit-order protection in the Nasdaq market, the Limit Order Task Force held two roundtables with participation from various segments of the industry including discount brokers, wholesale market makers, integrated broker/dealers, the Security Traders Association (STA), and the STA of New York (STANY). Each of the participants supported the trading-ahead prohibition that would prohibit a market maker from executing transactions for its own account at prices equal to or better than its own customer's limit order. The participants expressed concerns, however, that NASD rulemaking expanding this prohibition to inter-dealer trades would interfere with a market maker's ability to manage risk and would reduce liquidity in the marketplace.
Roundtable participants believed that dealers would be reluctant to fill large buy orders (by shorting the stock) if their ability to cover short positions was curtailed by the requirement to execute pending customer limit orders before their own buying interest.
The Task Force devoted considerable attention to discussions of the impact such additional rulemaking would have upon the financial viability of the competing dealer system and the potential adverse impacts upon the quality and efficiency of that market structure. To balance the desire to extend limit-order protection to all customer limit orders with the concerns regarding potential disruptive effects of such an action on liquidity and market structure, the Task Force proposed a requirement that members not trade ahead of customer limit orders if members were allowed the opportunity for profit on such trades. Accordingly, the Task Force recommended limit-order protections for member-to-member trades that would make it a violation to trade ahead of customer limit orders when the market makers traded at a price superior to the limit-order price.
The Board of Governors accepted the recommendation of the Limit Order Task Force (which received Trading Committee approval) as it applied to large-sized customer orders. However, its concerns with respect to ensuring protections of all small-investor limit orders led it to its proposal to require equivalent limit-order protection for any customer orders of 1,000 shares or less whether held by the customer's firm or entrusted to another member for execution. The Board took this action after carefully weighing the ramifications of their actions on the liquidity in The Nasdaq Stock Market.
In a competitive dealer environment, institutional customers expect that market makers be willing to deal in large sizes at the best prices displayed in Nasdaq. Limit-order protection, in its broadest sense, means placing the customer's trading interest ahead of the dealer's interest. This is easily accomplished in a monopolistic environment, as an exchange specialist is compensated for its handling of customer limit orders, and the size reflected in the specialist's quote is frequently indicative of a small-customer limit order. There are few institutional expectations of depth or liquidity beyond the size of the displayed quote and customers interested in executing large trades negotiate in an upstairs, dealer environment. Because the Nasdaq dealer market is based on a competitive design rather than a monopolistic model, there is no readily apparent remuneration mechanism for dealers handling a limit order from another broker/dealer over and above potential profit from its trading activity. Removal of profit potential from inter-dealer trading involving large-sized limit orders would constitute a clear disincentive to the handling of limit orders.
Further, requiring dealers to yield precedence in all circumstances to the execution of large-sized customer interest ahead of their own trading position may have a profound effect on the market makers' ability to offer liquidity at the limit-order price. Market makers may not be willing to fill large orders out of their inventory positions since their activity to buy stock back will necessarily trigger obligations to fill limit orders. Thus it is foreseeable that limit-order protection for large-sized orders may cause a reduction in the liquidity currently available to institutional customers.
The Board believes that such restrictions on dealers would be onerous and would not be in the best interests of investors who rely on the Nasdaq market for depth and liquidity. Accordingly, the Board has determined that it is appropriate to propose limit-order protection standards which appropriately differentiate between small-sized and large-sized customer limit orders. For small limit orders (1,000 shares or less), the Board proposes to implement the same limit-order protection that is currently in place for a market maker's own customers — that a market maker may not trade ahead for its own account at a price that would satisfy the limit-order price. For larger-sized orders, however, the Board believes it is appropriate to impose a different standard. When a member accepts and holds a customer limit order greater than 1,000 shares from another member firm, the dealer's obligation to fill that limit order is triggered when the market maker trades at a price that is superior to the limit order price.
To illustrate, if the inside market in a Nasdaq issue were 20 – 20 1/4 and the market maker accepted a customer buy order from another broker/dealer priced at 20 for 2,000 shares, a firm, buying at any price superior to 20 (that is, purchases at a price lower than a buy limit order, in this example, purchasing at 19 7/8 or 19 15/16), would be required to sell to the customer at 20 or better. Using the same example, if the customer limit order were for 500 shares at 20, the rule would prohibit members from trading ahead at 20 without filling the customer order at 20. Accordingly, the proposal would require protection for orders greater than 1,000 shares when the dealer trades at a superior price, and protection for orders 1,000 shares or less when the dealer trades at a price that would satisfy the limit-order price.
The Board also believes that adopting such an approach to limit-order protection constructively addresses recent concerns that have been expressed with regard to market structure and competitive issues. It has been argued that mandating limit-order protection for all member-to-member trades will act as an incentive to vertical integration of member firms, to the detriment of non-integrated firms (wholesale dealers), because an integrated firm accepting a limit order from its customer would be able to protect that order at its market-making quote and still retain the opportunity to assess a sales charge on the order. Non-vertically integrated firms, on the other hand, have no privity with the ultimate customer and thus no opportunity to assess a sales charge to cover their expenses.
Similarly, arguments have been advanced that the rule will result in concentrations of orders being placed with large, active market makers because customers will look to maximize the probability that their limit orders will be triggered by market-maker activity. Such concentration of order flow, it could be argued, will create barriers to entry to smaller market makers. Comments have also been received indicating that market makers in less liquid Nasdaq securities may cease their sponsorship in those issues because of the negative impact on dealer profit that may result if a broader limit-order protection rule were implemented. The Board is concerned with diminution of sponsorship for the less active Nasdaq issues as well as barriers to entry and believes that structuring the limit-order proposals based on the size of the customer's order should respond to these concerns.
The Board also discussed a member request to commission an economic study on expansion of limit-order protection. Because a study reviewing handling of limit orders would necessarily involve many variables that could not be adequately weighted, the Board determined that a study would not provide useful quantitative information. A review of limit-order handling, using data from a time when a rule was not in effect, would not reflect modifications in trading techniques, order-entry firm adjustments to routing mechanisms, or alterations in payment-for-order-flow arrangements. Extrapolations from such a review could not accurately forecast future trading practices or order-routing modifications, nor could the NASD rely on the study to predict economic or structural upheavals. Accordingly, the Board believed that an economic analysis would not provide sufficient justification to defer the Board's recommendations for action. Nevertheless, if members wish to offer statistical or economic analyses on the issues, the Board will consider such information when making its final determination.
Finally, the Board's proposals for rulemaking reiterate that the proposed Interpretation would not interfere with a member's ability to establish specific terms and conditions with regard to the acceptance of limit orders provided that the member makes those conditions clear to the customer. Similarly, nothing in the proposed Interpretation obligates market makers to accept limit orders from any or all customers or member firms. The Board has also decided that the proposals would be reviewed after one year so that the market impact and economic ramifications of any future actions could be adequately assessed.
Request For Comments
The Board is soliciting comments from members and interested parties so that the proposals under consideration by the Board may be thoroughly reviewed. Comments must be received no later than November 7, 1994, and addressed to Joan C. Conley, Secretary, NASD, 1735 K Street, N.W., Washington, D.C. 20006-1500.
1 See Notice to Members 94-58 and Securities Exchange Act Release No. 34279 (June 29, 1994).
2 See Notice to Members 93-49 (July 23, 1993).