Self-Regulatory Organizations; Proposed Rule Change by National Association of Securities Dealers, Inc. Relating to Non-member Access to SelectNet

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33938; File No. SR-NASD-94-9]

Self-Regulatory Organizations; Proposed Rule Change by National

Association of Securities Dealers, Inc. Relating to Non-member Access

to SelectNet

April 20, 1994.

Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934

(``Act''),\1\ notice is hereby given that on March 31, 1994 the

National Association of Securities Dealers, Inc. (``NASD'' or

``Association'') filed with the Securities and Exchange Commission

(``Commission'' or ``SEC'') the proposed rule change as described in

Items I, II, and III below, which Items have been prepared by the

NASD.\2\ The Commission is publishing this notice to solicit comments

on the proposed rule change from interested persons.

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\1\15 U.S.C. 78s(b)(1) (1988).

\2\The NASD amended the proposed rule change once subsequent to

its original filing on February 15, 1994. This amendment clarified

the NASD's basis for the rule change and provided a discussion of

and the NASD's response to the objections of a commenter. File No.

SR-NASD-94-9 (Amendment No. 1).

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I. Self-Regulatory Organization's Statement of the Terms of Substance

of the Proposed Rule Change

The NASD is proposing two modifications to the operation of

SelectNet, the system designed to facilitate communication, negotiation

and execution of orders between NASD member firms. The first such

modification will provide real-time access to non-members to view all

``broadcast'' orders in SelectNet immediately as they are entered. The

second modification provides for the transmission of such orders solely

on an anonymous basis through the service.

II. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, the NASD included statements

concerning the purpose of and basis for the proposed rule change and

discussed any comments it received on the proposed rule change. The

text of these statements may be examined at the places specified in

Item IV below. The NASD has prepared summaries, set forth in Sections

(A), (B), and (C) below, of the most significant aspects of such

statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

The Nasdaq Stock Market is proposing modifications to the

operations of the SelectNet service that would permit access by non-

members who are subscribers to the Nasdaq Workstation Level 2 service

to view broadcast orders immediately as they are entered into the

service. SelectNet is the service operated by The Nasdaq Stock Market

that permits NASD member firms to enter buy or sell orders in Nasdaq

securities into the system, direct those orders to a single market

maker (preferenced orders) or broadcast the order to all market makers

in the security. Originally implemented in its predecessor form in 1988

as the Order Confirmation Transaction service,\3\ the primary function

of that service was to offer an automated alternative to the telephone

as a method of contacting market makers in times of market stress. To

this end, order entry firms could direct or preference an order to buy

or sell a Nasdaq security to a single market maker in the issue. When

the service was enhanced and renamed SelectNet in 1990,\4\ the

broadcast feature was added to permit a wider dissemination of orders

to all market makers in an issue. In addition, the redesigned system

allowed market makers in a subject security to send a broadcast order

to all member firms that had designated that security in their

SelectNet ``watch file,''\5\ whether the firm was a market maker or

not. In 1992, the service was expanded to add pre-opening and after-

hours sessions,\6\ so that today SelectNet is available for members to

negotiate and execute orders from 9 a.m. until 5:15 p.m. Eastern

Time.\7\

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\3\Securities Exchange Act Release No. 25263 (Jan. 11, 1988), 53

FR 1430 (Jan. 19, 1988).

\4\Securities Exchange Act Release No. 28636 (Nov. 21, 1990), 55

FR 49732 (Nov. 30, 1990).

\5\The SelectNet watch file is established by each member firm

and may contain as many as 300 securities. The member will then

receive any preferenced or broadcast order selected for inclusion in

the watch file.

\6\Securities Exchange Act Release No. 30581 (Apr. 14, 1992), 57

FR 14596 (Apr. 21, 1992).

\7\In 1992, the NASD also proposed expanding SelectNet to

include exchange-listed securities in the service, but this proposal

met with resistance from the exchanges and is still pending

Commission action. Securities Exchange Act Release No. 30961 (July

27, 1992), 57 FR 34158 (Aug. 3, 1992).

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The Nasdaq Stock Market operates SelectNet to provide investors and

members with an automated system to facilitate communication of trading

interest between members, negotiation of orders with the possibility of

price improvement with automated, locked-in executions, and

dissemination of last sale reports to the tape. In addition, SelectNet

retains the original functionality of the service as a replacement for

one-on-one communication between members, especially in times of market

stress. Since its enhancement in December 1990, the service has grown

in popularity with members and traffic has increased significantly--

from an average of 3,000 transactions and 6 million shares daily in the

first half of 1991 to over 11,000 transactions and more than 16 million

shares daily in the last quarter of 1993. As the system's usage has

increased, institutions and other non-members have expressed a desire

to see the orders broadcast within the service. The NASD believes that

it is now appropriate to disclose SelectNet broadcast orders to non-

member Nasdaq Workstation Level 2 subscribers, in order to render the

orders in the system more transparent to investors.

An important facet of the Division of Market Regulation's Market

2000 study was increasing transparency in SelectNet by making SelectNet

orders more visible for investors.\8\ The Division recommended that the

NASD examine how to improve access to information regarding orders

entered into SelectNet, consistent with goals of increased

transparency. Specifically, the Division stated that expanded

dissemination of SelectNet information is essential for providing data

to investors regarding the prices at which investors and dealers are

willing to transact business in a particular security.\9\ Accordingly,

this rule proposal directly responds to one of the Division's key

suggestions designed to improve the transparency of orders broadcast

through the SelectNet service.

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\8\Market 2000: An Examination of Current Equity Market

Developments, Division of Market Regulation, United States

Securities and Exchange Commission, (Jan. 1994).

\9\The Division also recommended that SelectNet orders be

disseminated to the public before the Commission took any action on

the pending proposal to include exchange-listed securities in the

service. The NASD believes this rule filing is a full response to

the Division's request.

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Because of the additional non-member constituencies that will be

able to view all broadcast orders, the NASD is also proposing to modify

its order-entry procedure for SelectNet to ensure that broadcast orders

are entered into and displayed through SelectNet anonymously. This

feature is proposed for two reasons: To preserve incentives for dealers

to continue to make markets that add liquidity to the market and to

avoid conditioning the market in one direction or another by orders

identified with particular market makers or order entry firms. First,

the NASD believes that it is very important to retain incentives for

market makers to participate in the market. Market makers put quotes in

the Nasdaq system as a form of advertisement that they stand ready and

willing to transact business at their quoted prices and sizes. There

are obligations that accrue to those market makers, however, the NASD

and the SEC require market makers to be firm for their quotes and to

participate in order execution systems. Enabling order entry firms to

advertise buy and sell interest freely, with no concomitant market

maker obligations, by attaching their names to SelectNet orders so that

anyone with a Workstation would be able to contact the entity directly

by telephone, would eviscerate the positive attributes of being a

market maker with a quote in the Nasdaq system.

Second, allowing market makers (or order entry firms) to put their

names on broadcast orders might condition or influence the market in a

security by advertising the buying or selling power of the member firm.

For example, if a broker/dealer that is considered a lead market maker

or a major institutional block positioner in a security was interested

in buying shares in the stock, it might broadcast a sell order in

SelectNet, identify its name on the order, and cause the market to

react to the sell interest and the power of the firm's name.

Accordingly, other market makers in the stock might react to the sell

interest by dropping their bids and the lead market maker would be able

to buy stock at a lower price than would otherwise have been the case,

simply because it was advertising its name, or conditioning the market.

Indeed, similar conditioning effects might be caused by an firm, order

entry firm or market maker, by entering orders that are quickly

canceled without actual trading interest by the entry firm.

Accordingly, the NASD proposes that member firms enter all broadcast

orders anonymously.

Although orders must be entered on an anonymous basis, once two

firms are in negotiation over the terms of the broadcast order, the

order entry firm may of course identify itself to the contra side.\10\

The information on SelectNet broadcast orders will be made available to

members and non-member subscribers in the Nasdaq Workstation Level 2

service. This proposal is intended to avoid conditioning the market

with orders that might be canceled at any time without actual trading

interest by the order entry firm.

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\10\Presently, SelectNet provides members the option of

identifying themselves on broadcast orders through their market

maker identification symbol, although this alternative is seldom

used.

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Accordingly, the Nasdaq Stock Market is proposing modifications to

SelectNet to permit non-member, viewing access, to all SelectNet

broadcast orders immediately as the orders are entered into the system;

and to require all broadcast orders to be entered and disseminated on

an anonymous basis.

The NASD believes the proposed rule change is consistent with

sections 15A(b)(6) and 11A(a)(1)(C) of the Act and is a particularly

timely and germane response to the recommendations contained in the

Market 2000 study. Section 15A(b)(6) requires that the rules of a

national securities association be designed to prevent fraudulent and

manipulative acts and practices, to promote just and equitable

principles of trade, to foster cooperation and coordination with

persons engaged in regulating, clearing, settling, processing

information with respect to, and facilitating transactions in

securities, to remove impediments to and perfect the mechanism of a

free and open market and a national market system and in general to

protect investors and the public interest. Section 11A(a)(1)(C) finds

that it is in the public interest to, among other things, assure the

availability to brokers, dealers, and investors of information with

respect to quotations for and transactions in securities and

economically efficient execution of securities transactions. The

SelectNet service has served as an alternative to the telephone in

times of market stress and as a system to broadcast orders to market

makers for economically efficient negotiations and executions. By

permitting non-members to view those broadcast orders, the NASD is

removing impediments to transparency of market information and is

facilitating transactions for those non-members who will now be able to

see all broadcast orders in the service and timely arrange for the

execution of such orders by a member. Although the orders in SelectNet

do not represent quotations or trades reports, which are customarily

disseminated to the public by Nasdaq, the NASD believes that the

information is valuable to investors and market participants and should

be transparent and disseminated to non-members.

B. Self-Regulatory Organization's Statement on Burden on Competition

The NASD believes that the proposed rule change will not result in

any burden on competition that is not necessary or appropriate in

furtherance of purposed of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed

Rule Change Received From Members, Participants, or Others

The issue of non-member access to SelectNet has been the topic of

careful, in depth discussion of many different committees of the NASD

and its subsidiaries for the past two years. Discussions have fully

aired the concerns of members with permitting disclosure to non-members

of order information in an NASD-operated order negotiation system.

While the constituencies agreed to open up SelectNet to non-members,

differing degrees of non-member access were considered and debated.

Some members recommended allowing non-member access to SelectNet

following a short interval for market makers to interact with orders in

the system. Non-members advocated immediate dissemination of SelectNet

broadcast orders. All concurred that the original functionality of

SelectNet as an alternative to the telephone should be preserved. After

extensive venting of germane issues in numerous committees of members

and non-members, a consensus position was achieved recommending Board

approval of immediate non-member access to SelectNet broadcast orders.

The Board received two comment letters on the proposal, one from the

Investment Company Institute (``ICI'') advocating approval of the

proposal and another from the Security Traders Association (``STA'')

recommending disapproval. The ICI argued that in order for mutual funds

and other institutions to be able to fulfill their fiduciary

obligations it was vital that they be given access to all relevant

market information. The STA took the opposite position and stated that

since SelectNet was developed as a private means for market makers to

communicate with each other and negotiate orders, it was not

appropriate to make these private business communications available to

customers. The STA also argued that the vocal institutional proponents

of access to SelectNet are customers of NASD member firms and that

there must be a separation between members, non-members and their

customers without jeopardizing the customers' entitlement to best

execution. The STA also predicted that non-member access to SelectNet

might result in greater volatility, wider spreads and less liquidity

because non-members may not demonstrate the same ethical standards with

which members are required to abide. The NASD Board considered these

arguments carefully. The SelectNet service retains its capacity for

private communication between members in that the preferencing

functions have not been modified or opened up to non-member access. In

addition, the NASD Board concluded that displaying SelectNet orders to

all investors who subscribe to Nasdaq Level II service would increase

the efficiency of the market and enhance their ability to monitor the

quality of executions they receive. Moreover, the Board concluded that

there is no basis to assume that greater transparency of order

information to investors will result in wider spreads or less

liquidity; indeed, historically the opposite has proven to be the case.

Accordingly, the Board approved non-member access to SelectNet

broadcast orders in the interests of enhanced transparency of order

information and more open market operations.

III. Date of Effectiveness of the Proposed Rule Change and Timing for

Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period (i) as the Commission may

designate up to 90 days of such date if it finds such longer period to

be appropriate and publishes its reasons for so finding or (ii) as to

which the NASD consents, the Commission will:

A. By order approve such proposed rule change, or

B. Institute proceedings to determine whether the proposed rule

change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and

arguments concerning the foregoing. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549.

Copies of the submission, all subsequent amendments, all written

statements with respect to the proposed rule change that are filed with

the Commission, and all written communications relating to the proposed

rule change between the Commission and any person, other than those

that may be withheld from the public in accordance with the provisions

of 5 U.S.C. 552, will be available for inspection and copying in the

Commission's Public Reference Room. Copies of such filing will also be

available for inspection and copying at the principle office of the

NASD. All submissions should refer to the file number in the caption

above and should be submitted by May 19, 1994.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\11\

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\11\17 CFR 200.30-3(a)(12) (1993).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-10093 Filed 4-26-94; 8:45 am]

BILLING CODE 8010-01-M