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88-43 Adoption of Amendments to the Rules of Practice and Procedures for the NASD Small Order Execution System and to Schedule D to the NASD By-Laws, Effective June 30, 1988
TO: All NASD Members and Other Interested Persons
The Securities and Exchange Commission (SEC) approved amendments to the Rules of Practice and Procedures for the Small Order Execution System (SOES) and to Schedule D to the NASD By-Laws, which will become effective June 30, 1988. The new rules significantly alter the obligations of NASDAQ market makers. Major changes to the rules:
- Prohibit a firm that withdraws, on an unexcused basis, as a NASDAQ market maker in a security from re-entering NASDAQ as a market maker in that security for 20 business days.
- Limit the acceptable reasons for an excused withdrawal from NASDAQ.
- Make SOES participation mandatory for all market makers in NASDAQ National Market System (NASDAQ/NMS) securities.
- Enable the NASD to establish different levels of maximum order-size limits for SOES orders, depending on the average daily non-block volume, bid price, and number of market makers for each security.
- Provide that SOES executions will continue in a NASDAQ/NMS security when quotes are locked or crossed, with executions occurring at the best price.
- Eliminate preferencing of market makers during a locked or crossed market situation.
To permit market makers to become familiar with operating under the new rules and procedures for mandatory SOES, the NASD will delay imposition of the 20-business-day penalty for unexcused market-maker withdrawal until July 11, 1988 (six business days following implementation of mandatory SOES).
The text of the amendments is attached.
The SEC approved significant amendments to the Rules of Practice and Procedures for SOES and Schedule D to the NASD By-Laws (which sets forth requirements applicable to NASDAQ market makers), which become effective June 30, 1988.1/
SOES was established to permit small orders in NASDAQ securities to be executed efficiently at the best price for the public customer. Notwithstanding extraordinary volume during October 1987, SOES remained open and operating and continues to provide investors with an effective means for executing smaller orders. Because of certain problems that surfaced during the October market break, however, the NASD Trading and SOES Users Committees concluded that certain improvements should be made to the NASDAQ/NMS market to ensure that investors have access to an even more efficient and liquid market, especially during periods of high volume. The Committees concluded that the most effective way to ensure greater investor access is through enhancements to SOES and the NASDAQ System that will help alleviate the need for firms to rely on telephone contact. Therefore, the Committees recommended certain rule changes to the NASD Board of Governors, who authorized their publication for comment. Those proposals were published for comment in NASD Notice to Members 87-77 (November 20, 1987). After considering the comments received, the NASD Board of Governors approved the amendments January 18, 1988.
EXPLANATION OF AMENDMENTS
- Mandatory Participation in SOES. The amended rules require that every market maker in every NASDAQ/NMS security also be a SOES market maker in the security. This will ensure that an automated means of efficiently executing customer orders in every NASDAQ/NMS security will be available under any market condition.
Penalty for Withdrawal as a NASDAQ Market Maker. The amendments to Schedule D prohibit a firm that withdraws from making a market in a NASDAQ security on an unexcused basis from re-entering as a market maker in that security for 20 business days. Market makers can obtain excused withdrawals only for the following reasons: (1) physical circumstances beyond a market maker's control (e.g., equipment malfunction or relocation); (2) legal or regulatory considerations (e.g., compliance with Rule 10b-6 under the Securities Exchange Act of 1934); or (3) religious holidays (if notice is received by the NASD five business days in advance and is approved by the NASD).
This amendment places a significant incentive on market makers to continue their market-making activity throughout all market conditions. The NASD believes this change will ensure investors of a more liquid market even during periods of high volume.
To permit market makers to become familiar with operating under the new rules and procedures of mandatory SOES, the NASD will postpone imposition of the 20-business-day penalty for unexcused market-maker withdrawal until July 11, 1988 (six business days following the imposition of mandatory SOES).
SOES Executions in Locked or Crossed Markets. The amended SOES rules provide for automatic SOES executions in NASDAQ/NMS securities in a locked market (i.e., one in which at least one market maker publishes a quotation indicating it is willing to buy for the same price at which at least one market maker has indicated it is willing to sell) or a crossed market (i.e., one in which at least one market maker publishes a quotation indicating it is willing to buy at a higher price than the price at which another market maker has indicated it is willing to sell). Under the amended rules, SOES will continue to operate and will execute against the market maker with the best bid or offer (i.e., the market maker causing the locked or crossed market).2/
This change should accomplish two results. First, SOES will continue to operate during periods of rapidly changing prices, notwithstanding locked or crossed markets. Secondly, market makers will have an economic incentive to keep their quotes current at all times to avoid creating a locked or crossed market.
- Clearance and Settlement. The amended SOES rules provide that, as participants in SOES, all NASDAQ/NMS market makers are required to clear and settle SOES transactions through a registered clearing agency using a continuous net settlement system.
- Tiered Order Limits. The amended SOES rules include a definition of "maximum order size" and provide guidelines that permit the NASD to establish various maximum order-size levels in SOES.
The maximum sizes for SOES orders most recently have been 1,000 shares for NASDAQ/NMS securities and 500 shares for regular NASDAQ securities. The amendments will permit different order sizes to be set for different categories of NASDAQ/NMS securities. The definition of "maximum order size" provides that in establishing the maximum order size for a SOES security, the NASD will consider average daily non-block volume, bid price, and number of market makers for each security. By using general market parameters (instead of exact criteria), the amended rules provide the NASD with the flexibility to address the volatility exhibited by the marketplace in recent months. The exact number of tier levels, the characteristics for each tier, and the securities assigned to each tier will be established and published by the NASD from time to time.
As of June 30, 1988, the maximum SOES order sizes for NASDAQ/NMS securities will be 1,000, 500, or 200 shares. The applicable maximum order size for each NASDAQ/NMS security has been established as follows.
- A 1,000-share maximum order size will be applied to those NASDAQ/NMS securities that have an average daily non-block volume of 3,000 shares or more a day, a bid price that is less than or equal to $100, and three or more market makers.
- A 500-share maximum order size will be applied to those NASDAQ/NMS securities that have an average daily non-block volume of 1,000 shares or more a day, a bid price that is less than or equal to $150, and two or more market makers.
- A 200-share maximum order size will be applied to those NASDAQ/NMS securities that have an average daily non-block volume of less than 1,000 shares or more a day, a bid price that is less than or equal to $250, and less than two market makers.
The NASD set these initial order-size tiers after extensive research and polls of all NASDAQ/NMS market makers. These tiers have been established in a manner that the NASD believes will provide public investors with the most efficient means of handling their small orders while ensuring that market makers are not required to assume unrealistic risks.
A list of all NASDAQ/NMS securities indicating the maximum order size for each security is attached.
Exposure Limits. The amended rules define "exposure limit" as the number of shares specified by a market maker that it is willing to have executed for its account by SOES and define "minimum exposure limit" as an amount equal to five times the maximum order size for a security. (For example, a security that has a maximum execution, or tier, size of 1,000 shares has a minimum exposure of 5 X 1,000, or 5,000 shares, on both the buy and sell sides.) Market makers will continue to be able to establish their own exposure limits so long as those limits in NASDAQ/NMS securities are equal to or larger than the minimum exposure limits.Under the amended rules, a NASDAQ/NMS market maker is obligated to execute SOES orders aggregating at least the minimum exposure limit (or the firm's exposure limit, if higher). After a market maker's exposure is exhausted, the market maker will be permitted a grace period within which to update its quotations and thus restore its exposure limit.4/
If the market maker has not updated its quotations within the grace period, it will be removed from SOES as a market maker in that security and, in the case of a NASDAQ/NMS security, may not re-enter SOES for 20 business days. Initially, the NASD will delay imposing the 20-business-day penalty until July 11, 1988, to allow market makers time to become familiar with the new rules and procedures of mandatory SOES.
- Participation Obligations in SOES. Section (c) under the SOES rules, regarding the obligations of SOES market makers and SOES order-entry firms, has also been amended. The amended rules obligate the market maker to execut individual orders in sizes equal to or smaller than the maximum order size an provide that a SOES market maker in any NASDAQ/NMS security must obligate itself to execute individual orders equal to the minimum exposure limit.
* * *
Questions regarding this notice can be directed to either Dennis C. Hensley, NASD Vice President and Deputy General Counsel, at (202) 728-8245, or S. William Broka, Vice President, NASDAQ Operations at (202) 728-8050.
Frank J. Wilson
Executive Vice President and General Counsel
RULES OF PRACTICE AND PROCEDURE FOR THE SMALL ORDER EXECUTION SYSTEM
Note: New language is underlined; deleted language is in brackets.
Note: Insert new subsections 8 and 9 as follows and renumber existing subsection 8 as subsection 10.
Note: Insert a new subsection 2 as follows and renumber existing subsections 2-4 as subsections 3-5.
Note: Insert new Section d) as follows and renumber existing Sections d) and e) as Sections e) and f).
All transactions executed in SOES shall be cleared and settled through a registered clearing agency using a continuous net settlement system
AMENDMENTS TO SCHEDULE D TO THE NASD BY-LAWS
Note: New language is underlined; deleted language is in brackets.
REQUIREMENTS APPLICABLE TO NASDAQ MARKET MAKERS
Sec. 1. Registration as a NASDAQ Market Maker
Sec. 2. Character of Quotations
Sec. 6. Clearance and Settlement
Sec. 7. Withdrawal of Quotations
Sec. 8. Voluntary Termination of Registration.
A market maker may voluntarily terminate its registration in a security by withdrawing its quotations from the NASDAQ System. A market maker that voluntarily terminates its registration in a security may not re-register as a market maker in that security for [two (2)] twenty (20) business days. Withdrawal from SOES participation as a market maker in a NASDAQ/NMS security shall constitute termination of registration as a market maker in that security for purposes of this section.
1/ File No. SR-NASD-88-1, Securities Exchange Act Release No. 25791 (June 9, 1988).
2/ Under the amended rules, during a locked or crossed market an order-entry firm's indication of a preference for a particular market maker will not be recognized so that no market maker will be required to execute at another dealer's locked or crossed quote. If more than one firm is locking or crossing the market, executions will be made against all such firms in rotation.
4/ The duration of this period will be established and published by the NASD from time to time. Initially, the grace period will be five minutes.
*In Notice to Members 88-43 (June 22, 1988) the NASD announced that the maximum order size for NASDAQ/NMS securities traded on SOES shall be 1,000, 500, or 200 shares and that the applicable maximum order size for each NASDAQ/NMS security would be determined generally by the following criteria:
- a 1,000-share maximum order size shall apply to NASDAQ/NMS securities on SOES with an average daily non-block volume of 3,000 shares or more a day, a bid price of less than or equal to $100, and three or more market makers;
- a 500-share maximum order size shall apply to NASDAQ/NMS securities on SOES with an average daily non-block volume of 1,000 shares or more a day, a bid price of less than $150, and two or more market makers;
- a 200-share maximum order size shall apply to NASDAQ/NMS securities with an average daily non-block volume of less than 1,000 shares a day, a bid price of less than or equal to $250, and that have less than two market makers.
The NASD announced the maximum order size for each security in NASDAQ/NMS and noted that individual securities may be reclassified from time to time depending upon unique circumstances as determined by the Association. The NASD also announced that the maximum order size for all NASDAQ securities not in NASDAQ/NMS shall be 500 shares.