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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

EXECUTIVE SUMMARY

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.

BACKGROUND

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.

Sincerely,

Frank J. Wilson
Executive Vice President and General Counsel

Attachments

RULES OF PRACTICE AND PROCEDURE FOR THE SMALL ORDER EXECUTION SYSTEM

Note: New language is underlined; deleted language is in brackets.

a) DEFINITIONS



7. The term ["limited size" as it pertains to] "maximum order size" shall mean the maximum size of individual orders for a security [which] that may be entered into or executed through SOES^ [shall mean the amount established] The maximum order size for each security shall be published from time to time by the Association.* [for application to the System, which shall initially be 500 shares or less of an active SOES security.] In establishing the maximum order size for each NASDAQ/NMS security, the Association will give consideration to the average daily non-block volume, bid price, and number of market makers for each security.
Note: Insert new subsections 8 and 9 as follows and renumber existing subsection 8 as subsection 10.
8. The term "exposure limit" means the number of shares of a security on either side of the market specified by a market maker that it is willing to have executed for its account by SOES.
9. The term "minimum exposure limit" for a security means the aggregate number of shares of the security equal to five times the maximum order size for that security.
b) SOES PARTICIPANT REGISTRATION



Note: Insert a new subsection 2 as follows and renumber existing subsections 2-4 as subsections 3-5.

2. Pursuant to Part VI, Section 1 of Schedule D to the By-Laws, participation as a SOES market maker is required for any NASDAQ market maker registered to make a market in a NASDAQ National Market System (NASDAQ/NMS) security.
c) PARTICIPATION OBLIGATIONS IN SOES
1. Registration — Upon the effectiveness of registration as a [SOES] Market Maker or SOES Order Entry Firm, the SOES Participant may commence activity within SOES for exposure to orders or entry of orders, as applicable. The operating hours of SOES [are currently 10:00 a.m. to 4:00 p.m. Eastern Time, but] may be [modified] established as appropriate by the Association. A [SOES] Market Maker in a security other than a NASDAQ/NMS security may withdraw from and reenter SOES at any time, and without limitations, during the operating hours of SOES. The extent of participation in the System by a SOES Order Entry Firm shall be determined solely by the firm in the exercise of its ability to enter orders into the System.
[A. SOES Market Makers]
2. Market Makers — (A) A SOES Market Maker shall commence participation in SOES by initially contacting the SOES Operation Center to obtain authorization for the trading of a particular SOES security and identifying those terminals on which the SOES information is to be displayed and thereafter by an appropriate keyboard entry which obligates [him to execute transactions of limited size, as herein defined, so long as the SOES Market Maker remains active in SOES] the firm, so long as it remains a market maker in SOES, (i) for any security for which it is a SOES Market Maker, to execute individual orders in sizes equal to or smaller than the maximum order size; and, (ii) for any NASDAQ/NMS security for which it Is a Market Maker, to execute individual orders equal in the aggregate to the minimum exposure limit. All entries in SOES shall be made in accordance with the requirements set forth in the SOES User Guide.
(B) For each security in which a market maker is registered, the market maker may enter into SOES an exposure limit. For a NASDAQ/NMS security, that limit may be any amount equal to or larger than the minimum exposure limit. If no exposure limit is entered for a NASDAQ/NMS security, the firm's exposure limit will be the minimum exposure limit.
(C) At any time a locked or crossed market, as defined in Part VI, Section 2(e) of Schedule D to the NASD By-Laws, exists for a NASDAQ/NMS security, a market maker with a quotation for that security in the NASDAQ System that is causing the locked or crossed market may have orders representing shares equal to the minimum exposure limit or the firm's exposure limit, whichever is greater, executed by SOES for that Market Maker's account at its quoted price if that price is the best price. Those orders will be executed irrespective of any preference indicated by the Order Entry Firm.
(D) The [SOES] Market Maker may terminate his obligation by keyboard withdrawal from SOES at any time. However, the [SOES] Market Maker has the specific obligation to monitor his status in SOES to assure that a withdrawal has in fact occurred. Any transaction occurring prior to the effectiveness of the withdrawal shall remain the responsibility of the [SOES] Market Maker. In the case of a security that is not a NASDAQ/NMS security, a market maker whose exposure limit is exhausted will be deemed to have withdrawn from SOES and may reenter at any time pursuant to Section (c)(l) of these rules.
(E) In the case of a NASDAQ/NMS security, a Market Maker will be suspended from SOES if its exposure limit is exhausted and will be permitted a standard grace period, the duration of which will be established and published by the Association, within which to take action to restore its exposure limit. A market maker that fails to renew its exposure limit in a NASDAQ/NMS security within the allotted time will be deemed to have withdrawn as a market maker. Except as provided in (F) below, a market maker that withdraws in a NASDAQ/NMS security may not reenter SOES as a market maker in that security for twenty (20) business" days.
(F) Notwithstanding the provisions of subsection (E) above, a Market Maker that obtains an excused withdrawal pursuant to Part VI, Section 7 of Schedule D to the NASD By-Laws prior to withdrawing from SOES may reenter SOES according to the conditions of its withdrawal.
(G) Article IX of the Code of Procedure shall apply to proceedings brought by Market Makers seeking review of (i) their removal from SOES pursuant to Subsection E above, (ii) the denial of an excused withdrawal pursuant to Part Vl7 Section 7 of Schedule D to the NASD By-Laws, or (iii) the conditions imposed on their reentry.
(H) In the event that a malfunction in the [SOES] Market Maker's equipment occurs, rendering on-line communications with SOES inoperable, the SOES Market Maker is obligated to immediately contact the SOES Operations Center by telephone to request withdrawal from SOES. For NASDAQ/NMS securities, such request must be made pursuant to Part VI, Section 7 of Schedule D to the NASD By-Laws. If withdrawal is granted, SOES operational personnel will [in turn] enter the withdrawal notification into SOES from a supervisory terminal. Such manual intervention, however, will take a certain period of time for completion and the SOES Market Maker will continue to be obligated for any transaction executed prior to the effectiveness of his withdrawal.
[B SOES Order Entry Firms]
3. SOES Order Entry Firms —
[(i)]
(A) All entries in SOES made by a SOES Order Entry Firm shall be made in accordance with the procedures and requirements set forth in the SOES User Guide. Orders may be entered in SOES by the SOES Order Entry Firm through either its NASDAQ terminal or computer interface. The firm will receive an immediate execution report on the terminal screen and printer, if requested, or through the computer interface, as applicable.
[(ii)]
(B) SOES will accept both market and limit orders for execution made by a SOES Order Entry Firm; however, limit orders not immediately executed due to price will be returned to the SOES Order Entry Firm. Orders may be preferenced to specific SOES Market Maker or may be unpreferenced, thereby resulting in execution in rotation against SOES Market Makers.
[(iii)]
(C) Only agency orders [of limited] no larger than the maximum order size, as defined herein, received from public customers may be entered by a SOES Order Entry Firm into SOES for execution against a SOES Market Maker. Agency orders in excess of [limited] the maximum order size may not be divided into smaller parts for purposes of meeting the size requirements for orders entered into SOES.
[(iv)]
(D) No member or person associated with a member shall utilize SOES for the execution of agency orders in a security in which the member is a NASDAQ Market Maker but is not a SOES Market Maker.

Note: Insert new Section d) as follows and renumber existing Sections d) and e) as Sections e) and f).

d) CLEARANCE AND SETTLEMENT
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.



PART VI

REQUIREMENTS APPLICABLE TO NASDAQ MARKET MAKERS

Sec. 1. Registration as a NASDAQ Market Maker



(f) Unless otherwise specified by the Association, each NASDAQ Market Maker that is registered as a market maker in a NASDAQ National Market System (NASDAQ/NMS) security shall also at all time be registered as a market maker in the Small Order Execution System (SQES) with respect to that security and be subject to the Rules of Practice and Procedures for SOES.

Sec. 2. Character of Quotations



(e) Locked and Crossed Markets. A market maker shall not, except under extraordinary circumstances, enter or maintain quotations in the NASDAQ System during normal business hours if:
[(l)]
(i) the bid quotation entered is equal to or greater than the asked quotation of another market maker entering quotations in the same security; or
[(2)]
(ii) the asked quotation is equal to or less than the bid quotation of another market maker entering quotations in the same security.
(2) A market maker shall, prior to entering a quotation that locks or crosses another quotation, make reasonable efforts to avoid such locked or crossed market by executing transactions with all market makers whose quotations would be locked or crossed. Pursuant to the provisions of paragraph (b) of this section, a market maker whose quotations are causing a locked or crossed market is required to execute transactions at its quotations as displayed through the NASDAQ System at the time of receipt of any order.



Sec. 6. Clearance and Settlement

(a) A market maker shall clear and settle transactions in NASDAQ securities other than securities in SOES through the facilities of a registered clearing agency where clearing facilities are located within 25 miles of the market maker.
(b) Notwithstanding its proximity to a particular clearing facility, a market maker may also clear and settle its transactions in a security that is not a SOES security through a registered clearing facility using a continuous net settlement system; enter into a correspondent clearing arrangement with a member that clears through a continuous net settlement clearing facility; settle transactions "ex-clearing" provided both parties to the transaction agree; or use direct clearing services.
(c) All SOES transactions shall be cleared and settled through a registered clearing agency using a continuous net settlement system.

Sec. 7. Withdrawal of Quotations

(a) A market maker that wishes to withdraw quotations in a security shall contact NASDAQ Operations[-Members] to obtain excused withdrawal status prior to withdrawing its quotations. Excused withdrawals shall be granted by NASDAQ Operations only upon the demonstration of the existence of one of the circumstances set forth in paragraph (b) of this section.
(b) Excused withdrawal status based on [illness, vacation or] physical circumstances beyond a market maker's control may be granted for up to five (5) business days, unless extended by NASD Operations[-Members]. Excused withdrawal status based on [investment banking activity or the advice of legal counsel], demonstrated legal or regulatory requirements, supported by appropriate documentation and accompanied by a representation that the condition necessitating the withdrawal of quotations is not permanent in nature, may, upon written request, be granted for not more than sixty (60) days. Excused withdrawal status based on religious holidays may be granted only if notice is received by the Association five business days in advance and is approved by the Association. The withdrawal of quotations because of pending news, a sudden influx of orders or price changes, or to effect transactions with competitors shall not [normally] constitute acceptable reasons for granting excused withdrawal status.

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.



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