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. 34-35024; File No. SR-NASD-94-13, Amendment No. 3]

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

November 29, 1994.

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

(``Act''),\1\ notice is hereby given that on November 21, 1994, the

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

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

(``Commission'' or ``SEC'') an amendment to a proposed rule change

previously published for comment.\2\ The amendment is 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, as amended, from interested persons.

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

\2\See Securities Exchange Act Release No. 34145 (June 1, 1994),

59 FR 29649 (June 8, 1994) (notice of filing, incorporating

Amendment No. 1) and Securities Exchange Act Release No. 34453 (July

28, 1994), 59 FR 39808 (Aug. 4, 1994) (notice of Amendment No. 2).

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

of the Proposed Rule Change

The NASD is amending its proposed rules governing the operation of

The Nasdaq Primary Retail Order View and Execution System

(``NPROVE''), a new system developed by The Nasdaq Stock

Market, Inc. (Nasdaq) for the execution of small-sized customer orders

that provides individual investors enhanced limit order protection and

important price improvement opportunities through an enhanced automated

system. Specifically, the NASD is proposing a variety of amendments to

NPROVE designed to: (1) Enhance the operational efficiency of

the system; (2) increase the breadth of exposure of limit orders

entered into the system priced between the inside bid or offer, which

increased limit order exposure will facilitate greater opportunities

for order interaction within the inside market on Nasdaq; (3) further

improve the opportunities for price improvement available through

NPROVE; (4) expand the types of orders (i.e., short sales) that

may be entered into NPROVE, and, thereby, afford a broader

spectrum of retail orders in Nasdaq an opportunity to take advantage of

NPROVE's price improvement and limit order protection features;

and (5) facilitate the efforts of NASD members to provide their

customers with the same quality of order execution that they would have

received had their orders been entered into NPROVE. Following

is the text of the proposed rule change. (Additions are italicized;

deletions are bracketed.)

Rules of Operation and Procedures for the NPROVE System

(1) Definitions

a.-g. No change.

h. The term ``preferenced order'' shall mean an order entered into

NPROVE and directed to a particular market maker or an order

entered by a market maker that is self-preferenced. Each market maker

has the ability to select order entry firms from which it will accept

preferenced orders.

(2)-(3) No Change

(4) Participant Obligations in NPROVE

a. Market Makers

1. No change.

2. Participation as an NPROVE market maker obligates the

firm, upon presentation of [preferenced or] a designated, unpreferenced

market order or marketable limit order[s] (as that term is defined in

subsection (5)c. below) through the service, to execute [those] such

order[s]; provided, however, that for a designated, unpreferenced

order[s], the NPROVE market maker shall have an

opportunity,a consistent with Rule 11Ac1-1 promulgated under the

Act to decline the order[; if no action is taken the order will be

automatically executed against the market maker]. The market maker may

decline to execute the designated, unpreferenced NPROVE order

only if the market maker has executed an order (or is in the process of

executing an order) in the security and has updated its quotation (or

is in the process of updating its quotation) for the security. An

NPROVE market maker that receives an undesignated,

unpreferenced market order or marketable limit order (as that term is

defined in subsection (5)c. below) through NPROVE also may

decline such order consistent with Rule 11Ac1-1 promulgated under the

Act. If a market maker rejects a designated, unpreferenced

NPROVE order and no other market maker accepts the order within

the 15-second period, upon expiration of the 15-second period, the

system will automatically execute the order against the market maker

next in rotation who received the order on an undesignated basis that

has not rejected the order. [If a market maker rejects the

NPROVE order, it will be displayed to all other market makers

at the inside quotation simultaneously and executed against the market

maker that accepts the order, or if no market maker accepts the order,

the next market maker in rotation that has not rejected the order will

receive the execution.] If all market makers reject an unpreferenced

[the] order because they have had an execution (or are in the process

of effecting a trade) and have updated their quotations (or are in the

process of updating their quotations), the order will be automatically

executed against the market maker next in rotation at the new inside

quotation. [delivered to the first market maker at the new inside quote

on Nasdaq and that market maker will not be able to reject that order].

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\a\This period of time shall initially be established as 15

seconds, but may be modified upon appropriate notification to

NPROVE participants.

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With the exception of those instances where a market order or

marketable limit order has matched with a limit order and is processed

according to the procedures contained in subsection (5)c. below,

participation as an NPROVE market maker obligates the firm,

upon presentation of a preferenced market order or marketable limit

order through the service, to automatically execute such order at the

inside bid or offer displayed by Nasdaq when the order is processed

through NPROVE. NPROVE market makers are [will also]

not [be] permitted to reject orders preferenced to the firm pursuant to

a preferencing arrangement acknowledged by the market maker.

The system will transmit to the market maker on the Nasdaq

Workstation screen and printer, if requested, or through a computer

interface, as applicable, an execution report generated following each

execution.

3. Notwithstanding subsection (5)c. below, a[A]n NPROVE

market maker that improves the best bid or offer in Nasdaq is eligible

to receive all unpreferenced orders entered into NPROVE on an

exclusive basis (for a specific period of time or number of executions

as established by the NASDb) so long as the market maker manually

accepts the orders prior to automatic execution of the orders.

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\b\The parameters for market makers receiving priority in the

rotation when they have created an improved inside market have been

initially established as five minutes or five executions (whichever

occurs first) after one or more market makers have changed their

quote to equal the improved price. The NASD may modify these

parameters upon notification to members.

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4.-6. No change.

7. Aside from market makers entering self-preferenced orders into

NPROVE, f[F]or each security in which a market maker is

registered, the market maker may not enter orders on an agency basis

into NPROVE, unless a locked or crossed market exists for that

security. This prohibition against use of NPROVE does not

obviate the market maker's duty to give its agency orders best

execution in the prevailing market, according to the Board of

Governor's Interpretation on Executions of Retail Transactions, Article

III, Section 1 of the NASD Rules of Fair Practice.

8. No change.

9. Notwithstanding the provisions of subsection (8) above, (i) a

market maker that obtains an excused withdrawal pursuant to Part V of

Schedule D to the NASD By-Laws prior to withdrawing from NPROVE

may reenter NPROVE according to the conditions of its

withdrawal; and (ii) a market maker that fails to maintain a clearing

arrangement with a registered clearing agency or with a member of such

an agency, and is thereby withdrawn from participation in ACT and

NPROVE for Nasdaq [National Market] securities, may reenter

NPROVE after a clearing arrangement has been reestablished and

the market maker has complied with ACT participant requirements.

Provided however, that if the Association finds that the ACT market

maker's failure to maintain a clearing arrangement is voluntary, the

withdrawal of quotations will be considered voluntary and unexcused

pursuant to Schedule D and these rules.

10. No change.

b. NPROVE Order Entry Firms

1.-5. No change.

[6. No short sales may be entered into NPROVE.]

(5) Execution of NPROVE Orders

a. Orders in Nasdaq equity securities entered into NPROVE

may be preferenced or unpreferenced. Preferenced market orders will be

automatically executed against the preferenced market maker pursuant to

subsection (4)a.2. above. Preferenced limit orders to buy (sell) will

not be treated as preferenced orders unless the limit order price is at

or above (below) the inside offer (bid), in which case the orders will

be automatically executed against the preferenced market maker pursuant

to subsection (4)a.2. above. Preferenced odd-lot orders (orders of less

than 100 shares) that are market orders or marketable limit orders also

will be automatically executed against the preferenced market maker.

[Preferenced orders will be delivered to the designated market maker.

Except as provided in subparagraph (c) below, unpreferenced orders will

be delivered to market makers at the current inside bid or offer in

rotation.]

Unpreferenced market orders and limit orders will be processed

according to the procedures established in subsections (5)b. and c.

below. Unpreferenced o[O]dd-lot orders [(orders of less than 100

shares)] that are market orders or marketable limit orders will be

automatically executed in NPROVE against the market maker next

in rotation at the inside market and execution reports will be

delivered to the order entry firm and the market maker.

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

priced at the Nasdaq inside market (e.g., the bid side for a sell

order) when the order is delivered to an NPROVE market maker

will be handled as a market order. Limit orders priced away from

[outside] the Nasdaq inside bid or offer (as the case may be) [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 within [better than] the

inside market upon entry or thereafter will establish the minimum price

at which subsequent incoming market orders on the other side of market

will [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). All Nasdaq Level 2 and 3 subscribers [Market makers] will

receive notification on their quote retrieval screens of the existence

of a limit order priced better than the inside market along with an

indication of which side of the market it is on. [on their quote

retrieval screens,] regardless of whether the limit order is

preferenced or unpreferenced [; provided, however, that notification of

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

the designated market maker]. A separate dissemination of

NPROVE limit orders priced between than the inside market

consisting of the price of the highest priced limit order to buy and

the price of the lowest priced limit order to sell and the aggregate

size of all orders at such prices also will be made available to

securities information processors. 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. For

preferenced market orders, if there is no limit order residing in

NPROVE priced between the inside market on the opposite side of

the market from the market order, the order will be automatically

executed against the preferenced market maker at the inside bid or

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

the best bid) displayed in Nasdaq when the order becomes subject to

NPROVE's order execution methodology. For unpreferenced market

orders, except as provided in subsection (4)a.3. above, if there is no

limit order residing in NPROVE priced between the inside market

on the opposite side of the market from the market order, the order

will be broadcast to all NPROVE market makers at the applicable

inside market (i.e., market makers at the inside bid will receive

market orders to sell and market makers at the inside offer will

receive market orders to buy) displayed in Nasdaq when the order

becomes subject to NPROVE's order execution methodology for

acceptance within 15 seconds, with the market maker next in rotation

for an NPROVE execution receiving an indicator that the system

will execute the order against him should be fail to reject the order

or if no other market maker accepts the order (for purposes of these

rules, market orders with such notifications appended to them are

referred to as ``designated, unpreferenced orders'' and orders without

such a notification are referred to as ``undesignated, unpreferenced

orders''). If a market maker rejects a designated, unpreferenced

NPROVE order and no other market maker accepts the order within

the 15-second period, upon expiration of the 15-second period, the

system will automatically execute the order against the market maker

next in rotation who received the order on an undesignated basis that

has not rejected the order. If all market makers decline the order

consistent with Rule 11Ac1-1 promulgated under the Act, the order will

be automatically executed against the market maker next in rotation at

the new inside quotation. [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 a price equal to the limit order price plus 1/16th

of a point in the case of a limit order to buy or the limit order price

minus a 1/16th of a point in the case of a limit order to sell [match

the price of the limit order] and will be displayed for 15 seconds to

all market makers whose current quotation equals the applicable inside

quote[, in the case of an unpreferenced market maker in the case of a

preferenced 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 at the limit order

price. In addition, if adding (subtracting) 1/16th of a point to the

price of a limit order to buy (sell) would cause the acceptance price

of the market order to sell (buy) to be at or above (below) the current

inside offer (bid), then the market order and the limit order will be

automatically executed against each other at the limit order price

without the participation of a market maker. [All market orders entered

into NPROVE will be executed in compliance with market maker

obligations as established in subsection (4).]

(6)-(9) No Change

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 amendment to 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

On March 28, 1994, the NASD proposed rules governing the operation

and procedures for a new service for the delivery, handling and

execution of individual investors' small-sized agency orders.\3\ The

NPROVE service, operated by Nasdaq, will provide automated

executions of individual investors' small agency orders in Nasdaq

equity securities, and will offer small retail investors new

opportunities for price improvement of market orders. The new service

will also heighten protections for individual investors' limit orders

while enhancing the ability of market makers to monitor and maintain

competitive quotations accessible to investors participating in an

automated execution environment.

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\3\See Securities Exchange Act Release No. 34145 (June 1, 1994),

59 FR 29649 (June 8, 1994).

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The purpose of this proposal is to modify NPROVE to further

enhance the operational efficiency of the system and enhance the limit

order protection and price improvement benefits of NPROVE to

retail investors. As described in more detail below, the NASD proposes

to enhance the operational efficiency of NPROVE by collapsing

the current proposal for three rounds of NPROVE order

processing for unpreferenced orders into one 15-second round. With this

streamlined order execution procedure, NPROVE will be less

susceptible to the development of order queues during peak volume

periods and retail investors will have greater assurance that they will

receive a timely execution through NPROVE. The NASD also

proposes to further enhance the price improvement opportunities

afforded small retail investors through NPROVE by modifying

NPROVE's order processing algorithm for the execution of

matched market orders and limit orders. In addition, the NASD proposes

to modify the limit order processing features NPROVE to provide

for a broader, more detailed dissemination of NPROVE limit

order information. With these changes, market participants will have a

greater opportunity to interact with limit orders in NPROVE,

thereby enhancing the limit order protection and price improvement

features of NPROVE. Following is a more detailed description of

these proposed changes.

1. Collapsing of NPROVE Order Processing Rounds

As currently designed, the execution of unpreferenced market and

marketable limit orders may involve up to three 15-second rounds in

NPROVE.\4\ In light of these three rounds of NPROVE

order processing, some comment letters submitted to the SEC regarding

NPROVE have expressed concern that it may take 45 seconds to

process each order entered into NPROVE.\5\ These commenters

believe that executing NPROVE orders in 45-second intervals

will create substantial order queues that will paralyze the system and

result in investors receiving significantly delayed executions through

NPROVE at prices wholly unrelated to the quotes that were

displayed when their orders were entered into the system.

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\4\ In Round 1, an unpreferenced order will be routed to the

market maker at the inside bid or offer that is next in line for an

NPROVE execution. The market maker may manually execute the

order or allow the system to automatically execute the order after

15 seconds. If the market maker has effected a trade (or is in the

process of executing a trade in that security) and has updated its

quotation (or is in the process of updating), it may reject the

NPROVE unpreferenced order. When, consistent with the

requirements of Rule 11Ac1-1 under the Act, an order is rejected by

the first market maker in rotation, the order will enter Round 2 and

will automatically be displayed to all remaining market makers at

the inside quote. All of these market makers will have the

opportunity to execute the order during a 15 second period. If no

market maker manually accepts the order, it will be automatically

executed against the first market maker in rotation. In the unlikely

event that all of these market makers reject the order during Round

2 pursuant to a valid exception from Rule 11Ac1-1, the order will be

executed automatically by the first market maker in rotation quoting

at the new inside market. This is called Round 3.

\5\See, e.g., letters from John C. Coffee, Jr., Adolf A. Berle

Professor of Law, Columbia University in the City of New York,to

Jonathan G. Katz, Secretary, SEC, dated August 22, 1994 (``Coffee

Letter''); and Simon S. Kogan, J.D., L.L.M., Attorney at Law, to

Jonathan G. Katz, dated August 26, 1994.

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Given market makers' obligations to adhere to Rule 11Ac1-1

promulgated under the Act, the NASD believes most NPROVE orders

would be executed during Round 1 and that it would be extremely rare

for an NPROVE order to ever go beyond Round 2 order processing.

As a result, the NASD does not believe that the commenters concerns are

realistic. Nevertheless, while the NASD does not believe that prolonged

order queues will develop under the current configuration of

NPROVE, the NASD thinks it is appropriate to take prudent steps

to ensure that such order queues do not develop. Accordingly, with one

limited exception discussed below, the NASD proposes to collapse the

three rounds of NPROVE order processing into one 15-second

round.

Specifically, under the revised order processing methodology,

unpreferenced market orders entered into the system will be broadcast

to all NPROVE market makers at the applicable inside market for

acceptance within 15 seconds, with the market maker next in rotation

for an NPROVE execution receiving an indicator that the system

will execute the order against him should he fail to reject the order

or if no other market maker accepts the order (market orders with such

notifications appended to them are referred to as ``designated,

unpreferenced orders'' and orders without such a notification are

referred to as ``undesignated, unpreferenced orders'').\6\ If a market

maker rejects a designated, unpreferenced NPROVE order and no

other market maker accepts the order within the 15-second period, upon

expiration of the 15-second period, the system will automatically

execute the order against the market maker next in rotation who

received the order on an undesignated basis that has not rejected the

order. If all market makers decline the order consistent with Rule

11Ac1-1 promulgated under the Act, the order will be automatically

executed against the market maker next in rotation at the new inside

quotation. Thus, with this proposal, Rounds 1 and 2 would be

effectively collapsed into one round and Round 3 would be eliminated

because orders rejected by all market makers would be executed

automatically at the new inside market.

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\6\Market orders matched against limit orders (preferenced or

unpreferenced) priced between the inside bid or offer also will be

processed pursuant to this one-round order processing procedure. See

infra Section 5 for a more detailed description of how market orders

matching with limit orders will be processed under the NASD's

proposed revision to NPROVE.

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Accordingly, with this one-round order processing format, the NASD

believes even more strongly that significant order queues will not

occur in NPROVE, during normal trading days or peak volume

days, and that investors will receive timely executions at prices at or

superior to the quotes displayed when they entered their orders into

NPROVE.

The NASD proposes, however, to retain the ability of NPROVE

market makers to improve upon the inside bid or offer and achieve a

``priority market maker'' status; thus, providing a meaningful

incentive for market makers to narrow their spreads. In particular, as

currently proposed, when a market maker improves its bid or offer to

better the inside best bid or offer and it becomes a ``priority market

maker.'' Thereafter, for a short period of time (initially established

as five minutes or five executions, whichever occurs first, after one

or more market makers have changed their quote to equal the improved

price) all unpreferenced NPROVE orders will be directed only to

that market maker for acceptance within 15 seconds. The priority market

maker will retain its ``priority'' status only if it does not reject an

order, allow the system to automatically execute an order after 15

seconds, or a new inside has been established. Even if other market

makers adjust their quotes to match the new inside quote established by

the priority market maker, the priority market maker will be able to

maintain its priority status, provided the priority market maker

manually accepts each order within 15 seconds.

Because of the retention of the ``priority market maker'' feature,

it is conceivable that an order rejected by a priority market maker

could take 30 seconds to receive an execution in NPROVE. The

NASD notes, however, that this potential delay will be limited to a

single order directed to a priority market maker and that a delay will

occur only if the market maker declines the order in compliance with

Rule 11Ac1-1 promulgated under the Act. If a priority market maker

allows one order to execute against him automatically after 15 seconds

or it manually accepts all orders, all orders sent to the market maker

on a priority basis will receive an execution within 15 seconds.

Moreover, unless the priority market maker declines an order at the

last second, the maximum length of time the order will be delayed will

be less than 30 seconds. Accordingly, in weighing the de minimis costs

to the marketplace resulting from the possibility that a maximum of one

order directed to any given priority market maker will be delayed for

no more than 30 seconds, if at all, against the benefits to the

marketplace derived from providing market makers with an incentive to

narrow their spreads and improve the prices at which individual

investors may execute their orders, the NASD believes it is appropriate

and consistent with the maintenance of fair and orderly markets to

retain the priority market maker feature of NPROVE.

2. Automatic Execution of Preferenced Market Orders

Consistent with the NASD's desire to minimize the potential for

order queues in NPROVE, the NASD is proposing to modify

NPROVE to provide that preferenced market orders or marketable

limit orders will be automatically executed against the preferenced

market maker at the inside bid or offer displayed on Nasdaq when the

order is processed through NPROVE.\7\ As explained in more

detail in Section 5 below, preferenced market orders will only be

automatically executed if they did not match against a limit order

residing in NPROVE.

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\7\Previously, preferenced market makers had 15 seconds to

accept a preferenced market order. They could not decline the orders

and, if they failed to accept them within 15 seconds, the orders

would be automatically executed against them.

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3. Modifications to NPROVE's Execution Algorithm for Limit

Orders to Provide Greater Limit Order Protection and Enhanced Price

Improvement Opportunities

As currently 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 in 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. 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.

Several comment letters submitted to the SEC regarding

NPROVE have expressed concern that this order processing

methodology places limit orders at an unfair disadvantage.\8\ In

particular, these commenters maintain that the limit orders, which

provide liquidity to the marketplace at prices inside the best bid or

offer, are disadvantaged because market makers can trade through them

by taking out the market order at the limit order price within 15

seconds and deprive the limit order of an execution for an indefinite

period of time. To address this concern, the NASD is proposing to

modify NPROVE to provide that market makers must improve upon

the limit order price if they want to execute the matched market

order.\9\ Specifically, under the proposal,\10\ if a limit order is

residing in NPROVE priced superior to the best bid or offer,

any incoming market order on the opposite side of the market will be

repriced to a price equal to the limit order price plus 1/16th of a

point in the case of a limit order to buy or the limit order price

minus a 1/16th of a point in the case of a limit order to sell. The

market order will then be displayed for 15 seconds to all market makers

whose current quotation equals the applicable inside quote.\11\ 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 at the limit order price. In addition, if adding

(subtracting) 1/16th of a point to the price of a limit order to buy

(sell) would cause the acceptance price of the market order to sell

(buy) to be at or above (below) the current inside offer (bid), then

the market order and the limit order will be automatically executed

against each other at the limit order price without the participation

of a market maker.\12\

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\8\See, e.g., letter from Lawrence R. Glosten, Associate

Professor, Columbia University Graduate School of Business, to

Jonathan G. Katz, Secretary, SEC, dated August 24, 1994; and Coffee

Letter, supra note 3.

\9\As discussed infra at Section 5, preferenced limit orders

matching against market orders will be processed the same way as

unpreferenced limit orders.

\10\In this connection, the NASD notes the contribution of the

Board of the Securities Traders Association in the formulation and

endorsement of this concept.

\11\For example, if the inside market for a security is 10--

10\1/4\ and a limit order to buy at 10\1/8\ is residing in the

NPROVE limit order file when a market order to sell is

entered into the system, NPROVE will reprice the market

order to 10\3/16\ for flash display and acceptance to all market

makers in that security at the inside bid or offer.

\12\For example, if the inside market for a security is 10--

10\1/4\ and a limit order to buy at 10\3/16\ is residing in the

NPROVE limit order file when a market order to sell is

entered into the system, these orders will be automatically executed

against each other at a price of 10\3/16\.

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The NASD believes the proposal strikes a reasonable balance between

the concern that matched limit orders could remain unexecuted while

market makers are able to trade at the limit order price without

executing the limit order and the need to preserve the liquidity of the

market by ensuring that market makers have an ability to interact with

customer orders. In this connection, the NASD notes that 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 and that this capital is critically dependent on the

ability of market makers to interact with customer order flow. The NASD

also notes that the proposal will provide an even greater opportunity

for price improvement for market orders matching against limit orders,

as market makers will have to accept them at a price at least a \1/

16\th of a point superior to the price at which they otherwise would

have matched against the limit orders. 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.

4. Broader Dissemination of NPROVE Limit Order Information

The NASD is proposing several amendments to NPROVE and

other Nasdaq services to achieve a broader, more detailed dissemination

of NPROVE limit order information. The NASD believes these

system modifications will facilitate the ability of market participants

to readily observe and react to limit orders entered into

NPROVE priced better than the inside market, which, in turn,

will maximize order interaction in NPROVE and maximize the

price improvement and limit order protection benefits available to

investors through NPROVE.

First, the NASD proposes to create a separate feed of

NPROVE limit order information to vendors. This feed will

consist of the price of the highest priced limit order to buy and the

price of the lowest priced limit order to sell that are inside the best

bid or offer displayed in Nasdaq, along with the aggregate size of all

limit orders at such prices. Second, the NASD proposes to modify the

``NPRV'' indicator displayed when a limit order is residing in

NPROVE between the spread to indicate which side of the market

the limit order is on. Third, the NASD is proposing to modify the

functionality of Nasdaq Workstation I and Nasdaq Workstation II so that

subscribers can readily obtain information on all limit orders residing

in NPROVE, including those limit orders priced within the

inside market on Nasdaq. This ready display of NPROVE limit

order information will be accomplished with one key stroke in the

Nasdaq Workstation I environment and one mouse click in the Nasdaq

Workstation II environment. Fourth, the NASD is proposing to develop a

separate feed of NPROVE transaction information and limit order

information to registered market makers. Specifically,, the feed to the

market makers will include all NPROVE orders, cancellations,

corrections, and executions. With this information, which is in

response to a comment letter received by the SEC regarding

NPROVE,\13\ market makers will be able to assure their

customers that they are receiving the same quality of execution that

they would have received had their orders been entered into

NPROVE. Accordingly, with this feed, while a market maker's

customer order may not interact directly with a limit order in

NPROVE, it would benefit indirectly from the existence of the

limit order in NPROVE. In sum, the NASD believes these changes

will enhance the limit order protection and price improvement benefits

available to retail investors through NPROVE.

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\13\See letter from Leonard Mayer, Vice President & Chief

Operating Officer, Mayer & Schweitzer, Inc., to Jonathan G. Katz,

Secretary, SEC, dated July 13, 1994.

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5. Modifications to the Processing of Preferenced Limit Orders

As currently proposed, while preferenced limit orders are able to

take advantage of the limit order protection feature of NPROVE,

the existence of these orders are known only to the preferenced market

makers. Unlike unpreferenced limit orders, when a preferenced market

order is entered between the spread, it does not activate the

NPROVE limit order indicator and it is not retrievable by other

market makers in the summary scan of pending NPROVE limit

orders. In addition, when a preferenced limit order is matched against

an incoming market order, the matched market order is only displayed to

the preferenced market maker for acceptance. Accordingly, in order to

afford preferenced limit orders the same opportunity for order

interaction that is afforded unpreferenced limit orders, the NASD

proposes to amend NPROVE to provide that preferenced limit

orders priced within the inside bid or offer on Nasdaq will be

processed the same way as unpreferenced limit orders.\14\ However, once

the price of a preferenced limit order to buy (sell) is at or above

(below) the inside offer (bid), it will be automatically executed

against the preferenced market maker. The NASD also proposes to amend

the NPROVE rules to reiterate and clarify that market makers

may enter orders into NPROVE on self-preferenced basis and that

these orders will be processed like preferenced orders.

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\14\Arguably, only flashing matched market orders to the

preferenced market maker may increase the likelihood that the limit

order will be executed because the market order is not exposed to

multiple market makers for acceptance. It would be inappropriate and

confusing to market participants, however, to disseminate

information about preferenced limit orders and at the same time

preclude investors from interacting with them.

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6. Inclusion of Short Sales in NPROVE

As currently proposed, short-sales would be prohibited through

NPROVE, just as they are prohibited through the NASD's Small

Order Execution System rules currently in effect. In light of the SEC's

approval of the NASD's proposed short-sale rule in June 1994,\15\

coupled with NPROVE's order acceptance feature that enables

market makers to handle exposure to transactions such as short sales by

permitting them to reject trades if they have already traded, however,

the NASD believes it is appropriate to permit short sales through

NPROVE. By so doing, the NASD will expand the spectrum of

retail orders that are available to take advantage of NPROVES's

price improvement and limit order protection benefits. Nevertheless,

while NPROVE will provide a 15-second period for a market maker

to react to an NPROVE order, the NASD remains concerned that

this 15-second period is sufficiently short the there remains a risk of

destabilizing short term trading through the service. Accordingly the

NASD will review the volume and impact of short sales effected through

NPROVE on an on-going basis to determine whether it is

appropriate in the interests of maintaining fair and orderly markets to

continue to allow short-sales through NPROVE.

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\15\Securities Exchange Act Release No. 34277 (June 29, 1994),

59 FR 34885 (July 7, 1994).

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The NASD believes that the proposed NPROVE system, as

amended, is consistent with Section 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 individual investors

in achieving prompt, efficient executions of their small orders, to

provide individual investors an opportunity for price improvement

within an automated execution environment, and to afford individual

investors an automated and effective means to protect their limit

orders. 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 treats all

unpreferenced orders uniformly; to the extent that preferenced orders

are distinguished, by entering into preferencing arrangements with

known customers, market maker's effectively waive the protections

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

quotations in the Nasdaq market 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 that 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 Rule

11Ac1-1 promulgated under the Act.

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 it 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.

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 December 27, 1994.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\16\

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\16\17 CFR 200.30-3(a)(12) (1994).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-29932 Filed 12-5-94; 8:45 am]

BILLING CODE 8010-01-M