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87-77 Request for Comments on Proposed Amendments to the Rules of Practice and Procedures for the NASD's Small Order Execution System and to Schedule D to the NASD By-Laws

TO: All NASD Members and Other Interested Persons

LAST DATE FOR COMMENT: DECEMBER 21, 1987.

EXECUTIVE SUMMARY

The NASD is requesting comments on proposed amendments to the Rules of Practice and Procedures for the Small Order Execution System (SOES) and to Schedule D to the NASD By-Laws. In pertinent part, the proposed rule amendments would:

(1) 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 30 days;
(2) limit the acceptable reasons for an excused withdrawal from NASDAQ;
(3) make SOES participation mandatory for all market makers in NASDAQ National Market System (NASDAQ/NMS) securities;
(4) enable the NASD to establish different levels of maximum order size limits (e.g., 1,000, 500, and 200 shares) for SOES orders, depending on the characteristics of different securities;
(5) provide that SOES executions will continue in a NASDAQ/NMS security when quotes are locked or crossed, with executions occurring at the best price; and
(6) eliminate preferencing of market makers during a locked or crossed market situation.

The text of the proposed amendments is attached.

BACKGROUND

The Small Order Execution System (SOES) was established to permit small orders in NASDAQ securities to be executed efficiently at the best price for the public customer. SOES average weekly volume doubled during the week of October 19, 1987. Notwithstanding the extraordinary volume during that and subsequent weeks, SOES remained open and operating and continues to provide investors an effective means for executing smaller orders. However, problems did occur. As a result, 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.

ANALYSIS OF RULE PROPOSALS

Penalty for Withdrawal as a NASDAQ Market Maker. The proposed amendments to Schedule D to the NASD By-Laws (which contain rules governing the NASDAQ System) would 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 30 days. Currently, market makers may withdraw from and re-enter SOES without penalty and as a NASDAQ market maker after a two-day delay. The Committees and the NASD Board have concluded, however, that it is necessary to impose a penalty on unexcused withdrawals from NASDAQ securities to help ensure that investors in those securities have access to a continuous, liquid market supported by as many market makers as possible.

Market makers will continue to be able to obtain excused withdrawals. However, the conditions under which those withdrawals will be permitted would be limited under the proposal to withdrawals due to physical circumstances (e.g., equipment malfunction or relocation) or legal considerations (e.g., compliance with SEC Rule 10b-6). A market maker obtaining an excused withdrawal could re-enter NASDAQ according to the conditions of the withdrawal (e.g., withdrawals for purposes of equipment relocation would permit market makers to re-enter upon installation at the new location).

Mandatory Participation in SOES. The SOES rules and Schedule D would each be amended to require that every market maker in every NASDAQ/NMS security also be a SOES market maker in that security. SOES participation for market makers in NASDAQ securities that are not NASDAQ/NMS securities would continue to be voluntary. As participants in SOES, all NASDAQ/NMS market makers would be required to clear and settle trades through a registered clearing facility.

This change will facilitate the automatic execution of customers' small orders for every NASDAQ/NMS security without the need for telephone contact between the order-entry and executing firm. Every firm making a market in a NASDAQ/NMS security will be participating in the automatic execution system. By mandating wider participation in SOES, the Committees and the NASD Board believe that the NASD will significantly improve investor access to the NASDAQ/NMS market, particularly in times of high volume.

Tiered Order Limits. The SOES rules would be amended to provide that the NASD could establish different maximum order size limits for different securities. As a small-order system, SOES is available for retail agency orders of limited size. The size limits are currently 1,000 shares for NASDAQ/NMS securities and 500 shares for other NASDAQ securities. On the basis of experience, however, the Board has concluded that the efficiency and liquidity of SOES could be improved by refining order size limits so that different categories of securities having certain trading characteristics would be subject to different size limits.

Under this concept, the NASD will study the trading, volume, and price patterns of all NASDAQ/NMS securities to determine appropriate categories of size limits and those securities which should be in each category. For example, orders in some securities may be restricted to a maximum size of 200 shares, others 500 shares, and still others 1,000 shares. It is contemplated initially that different tiers will be established only for NASDAQ/NMS securities. The NASD specifically solicits comments on appropriate categories of order size and characteristics of securities and on the question of whether all NASDAQ securities (i.e., including non-NASDAQ/NMS securities) should be categorized by tier.

The order size limits establish, to a certain extent, the exposure of any SOES market maker to market risk. Because SOES will be mandatory for every NASDAQ/NMS market maker, a firm's willingness to be exposed to SOES executions may be a factor in its decision to be a market maker in NASDAQ/NMS securities. The NASD is therefore particularly interested in the comments of market makers concerning their willingness to participate in NASDAQ/NMS at various SOES order size limits for different types and prices of securities.

SOES Executions in Locked or Crossed Markets. The SOES rules would be amended to provide that orders in NASDAQ/NMS securities will continue to be executed in a security, notwithstanding that NASDAQ quotations for that security are locked (i.e., at least one market maker is willing to buy for the same price as at least one market maker is willing to sell) or crossed (i.e., at least one market maker is willing to buy at a higher price than another is willing to sell). Under current procedures, SOES orders are executed in rotation against all market makers offering the "inside," or best quotation,* but automatic executions cease if quotations become locked or crossed. In rapidly changing markets, it is more likely that quotations will be inadvertently locked or crossed as the use of telephones limits access to the market.

Under the proposal, automatic SOES executions in NASDAQ/NMS securities would continue even with locked or crossed quotes. All executions would be made against the firm causing the locked or crossed situation if its price is the best for the customer. An order-entry firm's indication of a preference for a particular market maker would not be recognized so that no other market maker would be required to execute at another dealer's locked or crossed quote. Although this change may create greater potential exposure for firms whose quotes are locked or crossed, it will help ensure that investors have continuous access to SOES throughout periods of high volume and rapid price movement. The change will also provide an economic incentive for firms to keep their quotations current.

The proposal contains a specific provision to protect market makers in NASDAQ/NMS issues from open-ended liability and repeated executions in the event they are unable to respond and update their quotes. Under the proposal, after a certain number of executions, market makers would be alerted that they have a period of time to respond and, if they have not done so at the expiration of the period, would be removed from the system as a market maker in that security. SOES currently permits each market maker to set a limit on the number of shares of any security that the system will execute against the firm's account each trading day. Since market making in NASDAQ/NMS securities requires SOES participation, a minimum limit capability will be required in those issues. The current capabilities will continue to be available for non-NASDAQ/NMS issues.

Since withdrawal as a SOES market maker in NASDAQ/NMS securities on an unexcused basis would now carry a 30-day penalty, the Board concluded that any NASDAQ/NMS market maker subject to automatic removal because its exposure limit has been reached should be given a grace period within which to renew its limit or re-enter a quote. Under the proposal, the grace period would be a standard established by the NASD from time to time depending upon market conditions and other factors. The NASD is continuing to study appropriate ways to address this issue. In any case, should a market maker be unable to respond because of equipment failure, it will be permitted to re-enter when the equipment failure is removed.

One possible approach to NASDAQ/NMS market-maker protection is to revise SOES operating procedures to automatically establish a minimum exposure limit (e.g., ten times the maximum order size) for a security each time the market maker changes its quote. If the exposure limit were exhausted (i.e., ten maximum size orders were executed), the market maker would have five minutes during which to update or re-enter its quotes, thereby renewing its exposure limit. Failure of a market maker in a NASDAQ/NMS security to update within five minutes for other than equipment failure reasons would result in its removal as a NASDAQ/NMS market maker with a 30-day penalty. Market makers would have the right to set higher limits in NASDAQ/NMS issues. Comments are specifically solicited on this and any other possible approaches.

Telephone Access to Trading Areas. Although the NASD is not proposing specific rules at this time, it is soliciting comments on the concept of a requirement that each NASDAQ market maker maintain at least one telephone line that would provide NASD surveillance staff with direct access to the firm's trading area at all times. Recent experience has demonstrated that it is important during periods of high volume for the NASD surveillance staff to reach the trading area of market-making firms irrespective of the volume of other telephone calls. During the week of October 19, 1987, a system of direct lines was established between the NASD and the trading desks of several firms. That system was instrumental in enabling the NASD staff to address questions and potential problems quickly. The Committees and the NASD Board therefore believe it may be desirable to require each market maker to participate in a system of direct links with the NASD. The NASD specifically solicits comments on this proposal.

SOLICITATION OF COMMENTS

The NASD urges members and their counsel to comment on the proposed amendments. Comments should be addressed to:

Mr. Lynn Nellius
Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006-1506

Comments must be received no later than December 21, 1987. The NASD Trading Committee, SOES Users Committee, and the NASD Board of Governors will review the comments received and determine whether to adopt the proposals. Any rule amendment must be filed with and approved by the Securities and Exchange Commission prior to becoming effective.

Questions concerning this notice may be directed to either S. William Broka, Vice President, NASDAQ Operations, at (202) 728-8050, or Dennis C. Hensley, NASD Vice President and Deputy General Counsel, at (202) 728-8294, or the undersigned at (202) 728-8319.

Sincerely,

Frank J. Wilson
Executive Vice President
Legal and Compliance

Attachments

PROPOSED AMENDMENTS TO SCHEDULE D TO THE NASD BY-LAWS*

PART VI

REQUIREMENTS APPLICABLE TO NASDAQ MARKET MAKERS

Sec. 1. Registration as a NASDAQ Market Maker



(f) Each NASDAQ market maker that is registered as a market maker in a NASDAQ National Market System (NASDAQ/NMS) security shall also at all times be registered as a market maker in the Small Order Execution System (SOES) with respect to that security and be subject to the Rules and Procedures for SOES.

Sec. 2. Character of Quotations



(e) Locked and Crossed Markets
(1) A market maker shall not, except under extraordinary circumstances, enter or maintain quotations in the NASDAQ System during normal business hours if:
[(1)]
(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 NASDAQ/NMS securities 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 NASDAQ/NMS 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) A market maker shall clear and settle its transactions in NASDAQ/NMS securities through a registered clearing facility using a continuous net settlement system or enter into a correspondent clearing arrangement with a member that clears through such a registered clearing facility.

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-Members 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 NASDAQ Operations-Members. Excused withdrawal status based on investment banking activity or the advice of legal counsel, 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. 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) business] thirty (30) days. Withdrawal as a market maker in a NASDAQ/NMS security in SOES shall constitute termination of registration as a market maker in that security for purposes of this section.

RULES OF PRACTICE AND PROCEDURES FOR THE SMALL ORDER EXECUTION SYSTEM1/

a) DEFINITIONS



7. The term "limited size" as it pertains to the maximum size of individual orders for a security which may be entered into or executed through SOES shall mean the amount for that security published [established] 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.]



b) SOES PARTICIPANT REGISTRATION

2) Registration 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 pursuant to Part VI, Section 1 of Schedule 1) to the By-Laws.

[Subsections 2 through 4 are renumbered 3 through 5, respectively.]

c) PARTICIPATION OBLIGATIONS IN SOES

1) Upon the effectiveness of registration as a SOHS 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 re-enter 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

(1) 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, and for aggregate exposure limits so long as the SOES Market Maker remains active in SOES. All entries in SOES shall be made in accordance with the requirements set forth in the SOES User Guide.
(2) 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, any SOES market maker with any quotation in the NASDAQ System that is causing the locked or crossed market will have orders executed by SOES for that market maker's account at its quoted price if that price is the best price and orders will be executed against such quotes irrespective of any preference indicated by the Order Entry Firm.
(3) The SOES Market Maker may terminate his obligations 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. Except as provided in (4) below, a Market Maker that withdraws in a NASDAQ/NMS security may not reenter SOES as a market maker in that security for 30 days. A Market Maker that is suspended from SOES because its exposure limit is exhausted will be permitted a standard grace period (the duration of which will be established and published by the Association2/) within which to take action to restore, its exposure limit. A Market Maker that fails to renew its limit within the alloted time will be deemed to have withdrawn as a market maker.
(4) Notwithstanding the provisions of (3) 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 re-enter SOES according to the conditions of its withdrawal.

* An order-entry firm can send an order to the SOES market maker of its choice. This is referred to as "preferencing". If this is done, the order is executed at the best price for that market maker's account even if its quote is not the best.

* New language is underlined; deleted language is in brackets.

1/ New language is underlined; deleted language is in brackets.

2/ The initial grace period is expected to be five minutes.



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