Self-Regulatory Organizations; Notice of Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to Amendments to the NASD's Proposed NbulletPROVE System for Price Improvement and Execution of Small Orders

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-34453; File No. SR-NASD-94-13, Amendment No. 2]

Self-Regulatory Organizations; Notice of Proposed Rule Change by

the National Association of Securities Dealers, Inc. Relating to

Amendments to the NASD's Proposed NPROVE System for Price

Improvement and Execution of Small Orders

July 28, 1994.

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

(``Act''),\1\ notice is hereby given that on July 25, 1994,\2\ the

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

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

(``Commission'' or ``SEC'') Amendment No. 2 to the proposed rule change

as described in Items I, II, and III below, which Items have been

prepared by the NASD. The Commission is publishing this notice to

solicit comments on the proposed rule change from interested persons.

---------------------------------------------------------------------------

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

\2\The NASD initially filed the proposed rule change on March 4,

1994. On March 28, 1994, the NASD filed Amendment No. 1, which

expands and clarifies the description of the system. Notice of the

original filing and Amendment No. 1 was provided by publication in

the Federal Register. Securities Exchange Act Release No. 34145

(June 1, 1994), 59 FR 29649 (June 8, 1994).

---------------------------------------------------------------------------

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

of the Proposed Rule Change

The NASD and The Nasdaq Stock Market, Inc. (``Nasdaq'') propose to

amend the proposed rules governing the operation of The Nasdaq Primary

Retail Order View and Execution System (``NPROVE''), a new

Nasdaq system for execution and price improvement of small-sized

customer orders. Specifically, the NASD proposes to amend Sections 6.b

and 6.c. of the Rules of Operation and Procedures for the

NPROVE service to provide that a limit order entered at a price

between the best bid or offer displayed on Nasdaq will be immediately

executed against a limit order subsequently entered into NPROVE

on the opposite side of the market priced at or superior to the limit

price of the first limit order. Following is the text of the proposed

rule change. (Additions are in italics; deletions are bracketed.)

RULES OF OPERATION AND PROCEDURES FOR THE NPROVE SYSTEM

(6) EXECUTIONS OF NPROVE ORDERS

* * * * *

a. No change.

b. Limit orders may be entered into NPROVE. A limit order

priced at the Nasdaq inside market when the order is delivered to an

NPROVE market maker will be handled as a market order. Limit

orders priced outside the Nasdaq inside market will be stored in the

NPROVE limit order file, and when the inside market equals or

betters the limit price, the order will be handled as a market order.

Limit orders priced better than the inside market upon entry will

establish the price at which subsequent incoming market orders on the

other side of market may be priced and executed (e.g., a sell order

priced between the best bid and offer would improve the price of an

incoming buy order). Market makers will receive notification of the

existence of a limit order priced better than the inside market on

their quote retrieval screens; provided however, notification of the

existence of a preferenced limit order will only be delivered to the

designated market maker. [A limit order priced better than the inside

market in Nasdaq may also be matched and executed against an incoming

market or limit order, on the other side of the market, without the

participation of a market maker.] A limit order priced better than the

inside market on Nasdaq shall be automatically executed against a

subsequent limit order on the opposite side of the market at a price

equal or superior to the limit price of the initial limit order (a sell

(buy) limit order priced at or below (above) a limit order to buy

(sell)), up to the size of the initial limit order or the subsequent

limit order, whichever is smaller, and without the participation of a

market maker.

c. Market orders may be entered into NPROVE. A market order

will be delivered to a market maker for execution at the current inside

market (buy orders will be executed at the best offer and sell orders

at the best bid). If a limit order has previously been entered into

NPROVE at a price superior to the best bid or offer, the

incoming market order will be repriced to match the price of the limit

order and will be displayed for 15 seconds to all market makers [at]

whose current quotation equals the applicable inside quote, in the

case of an unpreferenced order, and to the preferenced market maker in

the case of a preferenced order. [That order will either be executed by

a market maker or will be matched and executed against the limit

order.] If no market maker accepts the incoming market order within the

15-second period, the market order will be automatically executed

against the limit order. All market orders entered into NPROVE

will be executed in compliance with market maker obligations as

established in subsection (4).

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 purpose of this amendment is to amend NPROVE's

execution algorithm for limit orders to provide that, upon receipt of

limit orders that match between the inside spread, the system will

automatically execute the matching limit orders against each other

without any delay or separate display to market makers. The NASD

believes this amendment will further enhance the price improvement and

limit order protection benefits afforded retail investors through

NPROVE.

As currently proposed, if a limit order is entered into

NPROVE between the inside spread on Nasdaq, a subsequent limit

order on the opposite side of the market priced at the same or a

superior price to the limit price of the pending limit order (e.g., a

sell limit order priced at or below a limit order to buy) will be

matched against that pending limit order. If the incoming limit order

is unpreferenced, all market makers at the inside quotation will have a

15-second opportunity to execute the incoming limit order. If the

incoming limit order is preferenced, only the preferenced market maker

will have a 15-second opportunity to execute the incoming limit order.

If no market maker elects to execute the incoming limit order, the

system would automatically execute the pending limit order against the

incoming limit order.\3\

---------------------------------------------------------------------------

\3\For example, if the inside bid and offer were 20--20\1/2\,

and two limit orders were entered to buy and sell at 20\1/4\, the

system would allow the orders to match against each other within 15

seconds. In addition, if two limit orders crossed each other in

between the inside spread (i.e., a buy order priced at 20\3/8\ and a

sell order priced at 20\1/8\), the orders would be matched after 15

seconds and the price averaged between the orders (each would

receive 20\1/4\).

---------------------------------------------------------------------------

This amendment will change the execution methodology for matched

limit orders by eliminating the 15 second window for the display of the

incoming limit order prior to execution and permitting an immediate

match of offsetting limit orders received by NPROVE. By

providing retail customers a greater opportunity to receive immediate

and automatic executions of their limit orders priced between the

spread, the NASD believes the proposal will enhance NPROVE's

price improvement capabilities and limit order protection features.

Moreover, to the extent the NPROVE has received two priced

orders from retail customers that match or cross each other inside the

spread, the NASD believes no market benefit would be served by delaying

the execution of this transaction. Indeed, the NASD believes the

amendment is in furtherance of Section 11A(a)(1)(C)(v) of the Act,

which provides that investors' orders should be executed without the

intervention of a dealer to the maximum extent possible consistent with

the achievement of other critical market structure objectives, such as

the economically efficient execution of securities transactions.

The proposed execution algorithm for matching incoming market

orders against limit orders priced better than the inside market will

remain the same. Specifically, as proposed, if a limit order is entered

into NPROVE at a price between the spread, the next incoming

market order on the opposite side of the market (e.g., the limit order

is to sell stock and the market order is to buy stock) would

automatically ``pass over'' or read the limit order file to see if

there are any orders residing in the limit order file at prices

superior to the best bid or offer in the Nasdaq marketplace. If a limit

order resides on the file at a superior price, then the market order

will be flashed on the screen at that superior price for acceptance

within a brief 15-second period, instead of at the inside bid or offer,

as the case may be. In that event, all market makers at the inside

quotation would have the opportunity for 15 seconds to execute the

market order at the superior limit price. If no market maker elected to

execute the order at that improved price, the system would execute the

orders against each other at the limit price.

The NASD notes that both the limit order and the market order are

better off with this execution process--customers placing market orders

receive price improvement and customers placing limit orders will be

assured that NPROVE executions will not occur at prices

inferior to their limit order prices. Accordingly, the NASD believes

this execution process for a market orders is wholly consistent with

the protection of investors and the maintenance of fair and orderly

markets.

A key consideration for retaining NPROVE's flash display

and automated execution feature for market orders is the need to

maintain the liquidity and depth of The Nasdaq Stock Market. One of the

cornerstones of the success of Nasdaq's competing dealer system has

been the availability of market maker capital to satisfy investors'

liquidity demands. The extent to which market maker capital is

available, in turn, is critically dependent on the ability of market

makers to interact with customer order flow. Without the ability of

market makers to trade with their customers' orders, orders presented

to them by other members, or orders entered into Nasdaq execution

systems, market-maker profitability will suffer and, as a result,

market liquidity will diminish and investors will receive inferior

executions of their orders. Accordingly, if market makers are denied

any opportunity, however brief, to interact with incoming market orders

entered into NPROVE, the NASD believes that liquidity on Nasdaq

will inevitably be affected in an adverse manner to the detriment of

investors.

The NASD notes that an objective for a National Market System

contained in Section 11A of the Act regarding the execution of

investors' orders without the intervention of a dealer is premised

upon, and necessarily incorporates the corresponding assurance that,

such executions will be fully consistent with the economically

efficient execution of such securities transactions. The NASD maintains

that affording market makers an extremely narrow 15-second window of

exposure within which they may view, evaluate, and respond to incoming

market orders prior to the automated match of two investors' orders is

appropriate in a competing dealer market environment. The ability of

market makers to interact with customer order flow is essential to the

long-term well-being of Nasdaq and the efficient execution of customer

orders that results from vigorous competition among viable, aggressive

Nasdaq market makers.

In sum, the NASD believes the proposal significantly enhances the

price improvement and limit order protection features of NPROVE

and eliminates the possibility that a pending limit order will remain

unexecuted while other public customer orders receive executions at the

order's limit price, while preserving the liquidity and orderliness of

Nasdaq by allowing a minimal, yet essential, opportunity for market

makers to interact with retail order flow.

The NASD also believes the proposed NPROVE system is

consistent with Sections 15A(b)(6), 15A(b)(9), 15A(b)(11), and

11A(a)(1)(C) of the Act. 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 15A(b)(9) requires

that rules of an Association not impose any burden on competition not

necessary or appropriate in furtherance of the purposes of the Act.

Section 15A(b)(11) requires the NASD to formulate rules governing the

quality of fair and informative quotations. Section 11A(a)(1)(C) finds

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

economically efficient execution of securities transactions. The

fundamental purpose of NPROVE is to assist investors in

achieving prompt, efficient executions of their small orders and to

provide an opportunity for price improvement within an automated

execution environment. The integrity and efficiency of Nasdaq for

public investors and market-making participants is critical and the

NASD believes that NPROVE will provide benefits to both

constituencies. The design of NPROVE is not anti-competitive as

it affords all market and limit orders an equal opportunity for price

improvement regardless of whether the orders are preferenced or

unpreferenced. In addition, to the extent that preferenced orders may

be handled differently than unpreferenced orders, because market makers

have entered into preferencing arrangements with known customers,

market maker's effectively will have waived the protections offered

them by the system. NPROVE may also enhance the quality of

quotations in the Nasdaq marketplace as market makers participating in

the service may be encouraged to narrow the spread and improve the best

inter-dealer quotations in Nasdaq in order to be first in priority and

continue to receive unpreferenced order flow through NPROVE.

Lastly, the NASD believes the NPROVE is fully consistent

with the significant national market system objectives contained in

Section 11A of the Act. The facilities of NPROVE would advance

these objectives by offering efficient execution of investors' small

orders, by maintaining market maker participation through the automated

delivery of orders with the ability to reject those orders if trades

have already occurred, and by offering the opportunity for price

improvement to NPROVE orders. The system's functionality will

more accurately reflect market makers' affirmative obligations to

provide liquidity to the market, without depriving market makers of

legitimate exceptions from the firmness requirements contained in SEC

Rule 11Ac1-1.

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 the purposes of the Act.

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

Rule Change Received From Members, Participants, or Others

Comments were neither solicited nor received.

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, N.W., Washington, D.C. 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 principal office of the

NASD. All submissions should refer to file number SR-NASD-94-13 and

should be submitted by August 25, 1994.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\4\

---------------------------------------------------------------------------

\4\17 CFR 200.30-3(a)(12) (1994).

---------------------------------------------------------------------------

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-18965 Filed 8-3-94; 8:45 am]

BILLING CODE 8010-01-M