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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.
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:
The text of the proposed amendments is attached.
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
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.
Frank J. Wilson
Executive Vice President
Legal and Compliance
PROPOSED AMENDMENTS TO SCHEDULE D TO THE NASD BY-LAWS*
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) 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/
b) SOES PARTICIPANT REGISTRATION
[Subsections 2 through 4 are renumbered 3 through 5, respectively.]
c) PARTICIPATION OBLIGATIONS IN SOES
A. SOES Market Makers
* 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.