Self-Regulatory Organizations; Notice of Amendment of Proposed Rule Change by National Association of Securities Dealers, Inc. Relating to the Small Order Execution System and the Proposed Nasdaq Primary Retail Order View and Execution System

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-35080; File Nos. SR-NASD-94-13 and SR-NASD-94-68]

Self-Regulatory Organizations; Notice of Amendment of Proposed

Rule Change by National Association of Securities Dealers, Inc.

Relating to the Small Order Execution System and the Proposed Nasdaq

Primary Retail Order View and Execution System

December 9, 1994.

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

(``Act''),\1\ notice is hereby given that in connection with File Nos.

SR-NASD-94-13\2\ and SR-NASD-94-68,\3\ on October 24, 1994 the National

Association of Securities Dealers, Inc. (``NASD'') filed with the

Securities and Exchange Commission (``SEC'' or ``Commission'') an

econometric analysis conducted by the NASD's Economic Research

Department. In addition, in connection with File No. SR-NASD-94-13\4\

on December 2, 1994 the NASD filed with the Commission an analysis of

the potential for order queues to develop in its proposed Nasdaq

Primary Retail Order View and Execution System (``NPROVE'').

The econometric analysis and the NPROVE order queuing analysis

are set forth in Items I and II below respectively, which Items have

been prepared by the NASD. Accompanying Nasdaq's analyses were certain

graphs, charts and tables which are not included in this notice, but

are available for inspection in the Commission's Public Reference Room.

The Commission is publishing this notice to solicit comments from

interested persons.

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

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

59 FR 29649 (June 8, 1994) (notice of File No. SR-NASD-94-13,

incorporating Amendment No. 1), Securities Exchange Act Release No.

34453 (July 28, 1994), 59 FR 39808 (Aug. 4, 1994) (notice of

Amendment No. 2) and Securities Exchange Act Release No. 35024 (Nov.

29, 1994), 59 FR 62755 (Dec. 6, 1994) (notice of Amendment No. 3).

\3\See Securities Exchange Act Release No. 35077 (Dec. 9, 1994)

(notice of File No. SR-NASD-94-68).

\4\See supra note 2.

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I. Impact of the SOES Interim Changes on the Quality of The Nasdaq

Stock Market

In SEC Release No. 34-33377\5\ (the ``Release''), the SEC approved

certain changes to the NASD's Small Order Execution System (``SOES'')

on a pilot basis. Specifically, the SEC approved the following changes

to SOES: (1) A reduction in the maximum size order eligible for SOES

execution to 500 shares from 1,000 shares;\6\ (2) a reduction in the

minimum exposure limit for ``unpreferenced'' SOES orders to two times

the maximum exposure limit from five times the maximum exposure; (3)

the elimination of exposure limits for ``preferenced'' orders; (4) the

implementation of an automated function for updating market maker

quotations when the market maker's exposure limit has been exhausted;

and (5) the prohibition of short sale transactions through SOES. These

changes, collectively referred to hereinafter as the ``SOES changes,''

went into effect on January 31, 1994.

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\5\Securities Exchange Act Release No. 33377 (Dec. 23, 1993), 58

FR 69419 (Dec. 30, 1993) (approval of File No. SR-NASD-93-16 on a

one-year pilot basis).

\6\Thus with this change, the SOES maximum order size for Nasdaq

National Market (NNM) securities is 200 shares or 500 shares,

depending upon the trading characteristics of the particular

security. All Nasdaq SmallCap securities are subject to a SOES

maximum order size of 500 shares.

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Due to the pilot nature of these changes, the Commission stated

that ``[a]ny further action the NASD seeks with respect to SOES--

extension of these modifications upon expiration, or introduction of

other changes--will require independent consideration under Section 19

of the Act.'' In addition, the SEC stated that, should the NASD desire

to extend these SOES changes or modify SOES, the Commission would

expect, ``the NASD to monitor the quality of its markets and assess the

effects of the approved SOES changes on market quality for Nasdaq

securities.'' Also, if feasible, the SEC instructed the NASD to provide

a quantitative and statistical assessment of the effects of the SOES

changes on market quality; or, if an assessment is not feasible, the

SEC stated that the NASD should provide a reasoned explanation

supporting that determination.\7\

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\7\The SEC also expressed the view that it is not possible to

determine from the correlation and regression analyses submitted in

support of the SOES changes whether increased stock price volatility

definitely leads to trading by SOES active trading (SAT) firms or

trading by SAT firms results in additional stock price volatility.

The SEC further determined that it is not possible to differentiate

between the effects on spreads and stock price volatility

attributable to active SOES trading and the effects attributable to

other factors such as stock-specific news or volatility.

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Accordingly, in order to facilitate and support approval of the

Nasdaq Stock Market's Nasdaq Primary Order View and Execution

(NPROVE) system, or an extension of the SOES changes, should

the Commission not approve NPROVE before termination of the

SOES changes, the NASD is submitting this economic study conducted by

the NASD's Economic Research Department on the impacts of the SOES

changes on the quality of the markets for Nasdaq securities.

In sum, the study found that:

Since the SOES changes went into effect in January 1994,

quoted spreads in Nasdaq securities experienced a decline in the

immediate period following implementation of the changes and have

continued to decline since then. In particular, quoted spreads for the

500 largest Nasdaq National Market securities experienced a sharp

decline from April 28 to May 12 and from June 23 to July 18.\8\

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\8\Some press reports have attributed the recent decline in

spreads for Nasdaq stocks to the publication, on May 26 and 27,

1994, of newspaper articles in The Wall Street Journal, The Los

Angeles Times and other publications reporting the results of an

economic study conducted by two academicians that illustrated the

lack of odd-eighth quotes for active Nasdaq stocks. Contrary to

these press reports, this study shows that spreads had indeed

narrowed before publication of these articles (from April 28 to May

12), stabilized at these narrower levels from mid-May until June 23,

and declined again from June 23 to July 18.

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With the exception of a brief, market-wide period of

volatility experienced by stocks traded on Nasdaq, the New York Stock

Exchange, and the America Stock Exchange during the Spring, the

volatility of Nasdaq securities appears to be unchanged in the period

following implementation of the changes.

The SOES changes were designed to correct a major market quality

problem caused by the establishment in mid-1988 of: (1) a requirement

that market makers in NNM securities must participate in SOES and (2)

minimum market maker exposure limits of 5000 shares for the most active

group of NNM securities (1988 SOES changes). While the 1988 SOES

changes were intended to ensure that order entry firms could obtain

executions for their customers in volatile markets, the changes also

had the unintended consequence of dramatically changing the dynamics

and economics of intra-day trading by investors in Nasdaq.

Specifically, the assurance of automatic order execution afforded

investors through SOES spawned trading by SAT firms that resulted in

market makers receiving multiple executions in brief periods of time

without the ability to update their quotes. This rapid-fire, intra-day

trading by SAT firms increased the cost of market making and, in turn,

resulted in a dramatic widening of displayed quotation spreads as

market makers avoided the trading risks associated with the mandated

5,000-share exposure limit in SOES.

The SOES changes noted above were an attempt by the NASD to

preserve the benefits of SOES for small retail investors and eliminate

the negative market impacts created by abuses of SOES. As detailed

below, the NASD's analysis illustrates that the SOES changes have been

associated with substantive improvements in the quality of the markets

for Nasdaq securities and that these positive improvements have become

more pronounced the longer the changes have been in effect, as market

makers have adjusted their trading practices to reflect the lower costs

and risks associated with SOES trading.

As the SEC stated in the release, market factors other than SOES

changes may be jointly or singly responsible for changes in market

quality. However, market quality measures are useful in indicating

whether the SOES changes have been associated with non-negative or

positive changes in market quality. Even though cause and effect cannot

be statistically proven, as pointed out succinctly in the Release, the

absence of negative market developments associated with the

implementation of the SOES changes, coupled with the apparent positive

market improvements associated with the SOES changes, provides useful

support for the SEC's evaluation of its decision to approve the SOES

changes.

Given the SEC's prior determination that it is virtually impossible

to measure the impacts on market quality of changes in SAT firm

activity and given the applicability of the SOES changes to all NNM

securities, NASD monitoring has focused on a before-and-after analysis

of commonly accepted measures of market quality, without trying to

distinguish the impacts of trading by SAT firms. The SOES changes are

treated as a partial reversal of a microstructure change made in mid-

1988 (the 1988 SOES changes) and analyzed on a before-and-after basis.

The impacts of such structural changes do not occur completely on

the immediate day after their introduction. For example, spreads did

not widen immediately after the mandatory SOES exposure limits were put

in place in mid-1988. Rather, adjustments to such changes and their

impacts are gradual and distributed out over a period of time.

Competitive forces cannot be expected to reverse instantaneously the

quality of market conditions that evolved from microstructure

restrictions and related arrangements that were in place for nearly six

years.

Moreover, the SOES changes impact indirectly the measures of market

quality. Each change, while important, can be expected to have

different adjustment time periods. While a change in the maximum size

order permitted to be entered into SOES is immediate, changes to

market-maker exposure limits require adjustments by traders, as they

reevaluate their quotation and inventory management procedures and

their use of order-driven systems (rather than displayed quotations) to

adjust inventories. Also the new automated quotation update, permitted

after a transaction, cannot be implemented without varying time lapses

by the many different market makers.

Nonetheless some improvement in the quality of the market for

Nasdaq stocks has occurred in the period following the SOES changes.

The analysis of the impact of the SOES changes on market quality

focuses on the associated movements in Nasdaq market spreads, stock-

price volatility, volume of SOES trading, the average size of SOES

trades, and other indicators of market quality. The objective is to

determine whether any apparent changes in market quality measures

followed the reduced SOES regulations on market makers.

To evaluate the impact of these changes, the NASD established a

data set for the one-year pilot, beginning with November 11, 1993, and

including complete audit trail information for a sample of days that

includes approximately two days each month during the pilot. Although

the pilot period is not over, enough data is available to derive some

findings as to the changes in market quality that followed these SOES

changes.

Impact of the SOES Change on the Level of SOES Activity

The average daily share volume of SOES transactions and the number

of SOES trades declined sharply following the SOES changes (see Chart

1). The immediate decline in average daily SOES volume approximated 52

percent from January to February, and the decline in the number of SOES

trades was 17 percent. Moreover, the average SOES trade size declined

43 percent from January to February. The average trade size, which had

risen from 310 shares in mid-1988, when the mandatory minimum exposure

limits were instituted (see Chart 2) to 581 shares in January 1994,

dropped sharply to 332 in February.

It is the average trade size in SOES that appears to best reflect

SOES activist trader presence in the data. It is apparent from Chart 2

that SOES activists entered the market as proprietary traders

immediately after the imposition of the mandatory SOES exposure limits

in mid-1988. Because this activity violated SOES rules however, the

NASD took action to preclude such trading through SOES and they

withdrew as proprietary traders. Later, in 1989, these SAT firms began

coaching individuals to trade through SOES in a similar fashion. As a

result the average size of a SOES trade began its long uptrend in 1989,

ending in January 1994, with a resulting substantial widening of

spreads of large, actively traded stocks (See Chart 6).

Whether some SOES activist volume merely shifted to one of the many

alternative execution systems following the January 1994 SOES changes

or whether some trading activities ceased because they were only

profitable in a regulatory environment with higher market-maker

exposure requirements has not been determined. Some traders apparently

have resumed using SOES at the 500 share level even with the lower

exposure limits. This is suggested by the fact that the SOES average

trade size continues above the mid-1988 level and the decline in the

number of SOES trades was much less than the decline in SOES share

volume. SOES activist traders generally trade in the maximum order size

permitted in SOES.

Displayed Quotation Spreads

Displayed Quotation Spreads declined in the six months following

the January 31 SOES changes. The improvement in displayed spreads\9\ is

evident in the pattern of average bid/ask spreads of the largest NNM

stocks (see Chart 3). Average spreads of the largest 500 NNM stocks,

those most affected by SOES trading, appear flat immediately following

the SOES changes; but they then decline sharply (see Chart 4) as market

makers became aware of the lower risks involved in moving their

displayed spreads closer to the actual trade-to-trade price changes

that were occurring in the order-driven segments of the market. The

first sharp decline in spreads is evident between the April 28 and May

12 sample days (see Chart 4). A second sharp break occurred between the

June 23 and July 18 sample days. However spreads appear to be narrowing

throughout the post-SOES change period.

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\9\Measure of spread used is the average of the observed market

displayed spread each time a trade occurs.

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Confirmation of the improvement in displayed quotation is the

proportion of share volume occurring in stocks with closing displayed

bid/ask spreads of one-quarter or less. The percentage of volume

accounted for by such stocks fluctuated around 61 percent until May

1994, when it rose to 62.5 percent, another clear indication that

spreads were tightening (see Table 1). It rose further to 65.6 percent

in June, to 66.2 percent in July, and to 68.7 percent by September.

Additional supporting information, in Charts 5 and 6, shows SOES

average trade size and the number and percentage of NNM stocks with

end-of-day quotation spreads less than 50 cents. SOES average trade

size reflects the entry and activity of SOES activist traders. Firms

effecting proprietary trades through SOES caused the average to rise

briefly in 1988, but SOES volume attributable to individual traders

active in SOES started in 1989 and expanded until January 1994. A major

decline in the percentage of NNM stocks with end-of-month spreads less

than 50 cents per share is apparent as SOES traders took advantage of

the mid-1988 institution of the 5,000-share minimum exposure limit for

SOES active stocks. An uptrend in that percentage has emerged following

the January reduction in market-maker exposure minimums.

To examine further these quotation spread patterns, regressions

were prepared using NNM stocks grouped by various characteristics. The

regressions controlled for market factor influences on spread including

volume, stock price, and intra-day price volatility. A dummy variable

(0,1) was used to reflect the periods before (0) and after (1) the SOES

changes. Regressions were run using all NNM stocks, the largest 500 NNM

stocks, 1,000- share tier, 500-share tier and 200-share tier stocks and

stocks with a proportionate decline in SOES activity after the January

1994 changes. These regressions confirm that spreads narrowed in the

six months following the SOES changes for all groups of stocks except

for those stocks in the 500- and 200-tier categories, even after

controlling for volume, price and intra-day price volatility. For the

500-and 200-tier groups the before and after changes overall were not

statistically significant.

A negative beta coefficient for the dummy variable indicates a

decrease in spreads from the period before the changes to the periods

after the SOES changes. For the first three months after the changes,

the beta coefficient for the dummy variable is generally negative but

statistically insignificant. However, by the second three-month period

the coefficients were negative and statistically significant for all

NNM stocks, the 1,000 share tier group and the largest 500 group,

indicating that quotation spreads were indeed narrowing. Because SOES

volume for the largest 500 NNM stocks represents 65 percent to 75

percent of the total SOES volume, the significance of the statistical

results is critical for this group.

Successive regressions then were for the largest 500 group using

for each stock the average of the pre-change days, and separately the

average for each of the post-change days to observe changes in the beta

coefficient of the dummy variable. The negative value of beta depicts a

negative difference between the pre-change average spreads and the

post-change individual day observation sets for every day in the post-

change period. Beta coefficients are negative for each day and

statistically significant for each day except for February 17, April

14, April 28, and May 26, 1994.

It is clear that the changes is SOES reduced uncontrollable or

mandated market-maker risk exposure across all NNM stocks and the

changes appear to have resulted in significantly lower spreads for the

largest 500 group.

Volatility

As the SEC pointed out in the release, differentiating between the

effects on spreads and stock-price volatility attributable to active

SOES traders and the effects attributable to other factors may not be

possible. Market volatility, in particular, surges and recedes. This

makes exceedingly difficult measurement of temporary impacts on price

volatility of unnecessary market-maker risk exposures that provide

profitable trading situations to opportunistic traders.

It is apparent from the volatility of the various indexes (see

Chart 7) that dramatic changes occurred in market volatility during the

six months following the SOES changes. The average absolute value of

daily percent changes of the Nasdaq Composite Index fluctuates from

over 0.03 percent in January 1994 to practically no change in February

and March. Then it jumps to nearly 0.07 percent in April.

Substantial effort would be required to empirically sort out the

effects on volatility of the SOES changes, if indeed it is possible to

sort them out. NASD attempts to isolate these effects statistically

have not been successful. Nonetheless an analysis was performed of

stock volatility distributions on the sample days. Valatilty is

calculated by taking the standard deviation of the absolute percent

changes in the bid price. A frequency distribution of each stock's bid

volatility was constructed for each day in the analysis, and the

skewness of these distribution curves was computed.

Skewness is a measure that describes to what extent a curve

deviates from a normally distributed bell shape. The distribution of

stock volatilities is found a contain a smaller right tail in the post-

change period than in the pre-change period as evidenced from the

declining measure of skewness (see Chart 8). The smaller right tail

reflects a smaller percentage of stocks with extreme relative price

volatility in the post-change period. Also the measures of dispersion

of the individual stock volatilities are smaller for the post-change

days. These distributional differences suggest a reduction in relative

volatilities in the post-change period.

Other Considerations

Major improvements, other than the SOES changes in January 1994,

are being instituted in Nasdaq trading to enhance market quality. New

requirements affecting the handling of customer limit orders were

adopted on July 9, 1994; a shore-sale bid test took effect in early

September; and the proposed NPROVE system to replace SOES is

awaiting SEC action.

As a result, identifying the delayed impacts of the SOES changes

may not be possible beyond the first few months included here.

Conclusion

The reduction in the mandatory minimum exposure limits and SOES

order sizes, which in turn decrease market-maker risk exposure, clearly

have been associated with positive changes in market quality. In

particular, displayed spreads have narrowed. More importantly, there is

no evidence of negative impacts on market quality.

While the impacts of the SOES changes cannot be precisely

segregated from the impacts of other factors with 100 percent

certainty, the absence of negative changes in measures of market

quality and the presence of positive changes in such measures following

the introduction of the SOES changes in late January 1994 support a

conclusion that the changes resulted in improved market quality. The

higher mandated exposure requirements and larger order sizes in place

from mid-1988 to January 31, 1994, in retrospect, were not necessary

and appear to have caused wider spreads as market makers adjusted their

activities to avoid the transactions of active traders in SOES.

II. Analysis of Potential for Order Queues to Develop in

NPROVE

In a letter dated August 16, 1994, Commission staff requested that

Nasdaq provide an assessment of the potential for queues to develop and

the basis for this assessment.\10\ In a letter dated December 7, 1994,

Nasdaq responded in writing to the request. The relevant portions of

Nasdaq's letter are as follows:

\10\Letter from Katherine A. England, Assistant Director, SEC,

to Robert E. Aber, Vice President and General Counsel, Nasdaq (Aug.

16, 1994).

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In sum, as the attached graphs and tables indicate, Nasdaq

believes the potential for sustained, lengthy order queues to

develop in NPROVE for any given security is minimal.\11\ In

fact, for the days analyzed by the staff, the data shows that over

98 percent of the orders transmitted by non-SOES activist firms\12\

would have received an execution within 30 seconds. In addition,

while our analysis illustrates that queues for a given security will

develop for brief periods of time, our analysis also indicates that

these occasional queues appear likely to abate in a matter of

minutes. Moreover, and perhaps most importantly, our analysis

demonstrates that, to the extent that there would be noticeable

queues in NPROVE, these queues would be directly

attributable to a narrow segment of orders originating from SOES

activists that were transmitted in waves during discreet, short

periods of time. When these queues do develop, however, a small

percentage of retail customer orders (2 percent) may be delayed by

the queue created by the SOES activists' orders. Aside from these

episodic queues attributable to SOES activists, the data indicates

that lengthy queues in NPROVE would be rare. Accordingly,

Nasdaq does not believe it is very likely that significant, on-going

order queues will develop in NPROVE during peak volume days.

\11\To analyze the potential for order queuing in NPROVE

Nasdaq staff used actual trading data for Nasdaq's Small Order

Execution System (``SOES'') for certain trading days. To simulate

trading in NPROVE with this SOES data, the staff ``spaced

out'' the SOES orders so that, at a minimum there was at least a 15

second interval between the execution of these orders. For example,

if three orders in the same security were sent simultaneously into

SOES, fifteen seconds were inserted between the orders. In light of

the recent amendments to NPROVE submitted to the Commission

on December 1, 1994, Nasdaq notes that fifteen seconds will be the

maximum length of time it will take for an order to be executed in

NPROVE once that order becomes subject to NPROVE's

order execution methodology, although in very limited circumstances

NPROVE orders directed to a priority market maker may take

between fifteen and thirty seconds to be executed. Moreover, market

makers will have the ability to affirmatively execute against market

orders any time during the fifteen-second display period. See

Securities Exchange Act Release No. 35024 (November 29, 1994). Thus,

the insertion of fifteen seconds between SOES orders facilitates an

extremely conservative replication of how such orders would have

been processed through NPROVE.

\12\See text accompanying note 16 for the definition of a SOES-

activist firm for purposes of this study.

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In addition, Nasdaq notes that the recent proposed amendments to

NPROVE will further help to ensure that significant, on-going

order queues will not develop in NPROVE.\13\ Specifically,

under the proposed order processing methodology for NPROVE,

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 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'').\14\ If a market

maker rejects a designated, unpreferenced NPROVE order and no

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

system will automatically execute the order against the market maker

next in rotation that has not rejected the order upon expiration of the

15 second period. If all market makers decline the order consistent

with Rule 11Ac1-1 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 are effectively

collapsed into one round and Round 3 is eliminated because orders

rejected by all market makers would be executed automatically at the

new inside market. 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.

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\13\Id. As previously designed, the execution of unpreferenced

market and marketable limit orders through NPROVE may have

involved up to three 15-second rounds. In Round 1, an unpreferenced

order would have been routed to the market maker at the inside bid

or offer that was next in line for an NPROVE execution. The

market maker could have manually executed the order or allowed the

system to automatically execute the order after 15 seconds. If the

market maker had effected a trade (or was in the process of

executing a trade in that security) and had updated its quotation

(or was in the process of updating), it could have rejected the

unpreferenced NPROVE order. When, consistent with the

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

the first market maker in rotation, the order would have entered

Round 2 and would have been automatically displayed to all remaining

market makers at the inside quote. All of these market makers would

have had the opportunity to execute the order during a 15 second

period. If no market maker manually accepted the order, it would

have been automatically executed against the first market maker in

rotation. In the unlikely event that all of these market makers had

rejected the order during Round 2 pursuant to a valid exception from

Rule 11Ac1-1, the system would have automatically executed the order

against the first market maker in rotation quoting at the new inside

market after fifteen seconds. This was called Round 3.

\14\Market orders matched against limit orders (preferenced or

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

processed pursuant to this one-round order processing procedure.

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It is important to note that our response is not intended to be a

subjective commentary on the activities of SOES activists; rather it is

an objective reflection of the source of potential order queues in

NPROVE. It is axiomatic that episodic surges in order volume on

one or the other side of the market will impact the timing and price of

execution of these orders by virtue of fundamental economic principles

of supply and demand.

Following is a more detailed description of the attached graphs and

tables and the analytical process Nasdaq used to reach its conclusion

that significant order queuing likely will not occur with

NPROVE.

To analyze potential order queuing in NPROVE, the staff

examined SOES activity on two trading days--February 4, 1994 and July

13, 1994\15\ Exhibit 1 contains charts that provide aggregate data on

the extent to which order queuing would have occurred in NPROVE

on these days. Specifically, the charts identify all NASD members that

transmitted more than 50 orders into SOES on these days, with a

breakdown of how many of these orders would have been executed within

30 seconds, between 30 and 45 seconds, between 45 seconds and one

minute, and longer than a minute if NPROVE were in operation.

On February 4, 93 percent of these orders would have been executed with

30 seconds, and on July 13, 77 percent of the orders would have been

executed within 30 seconds. The staff also used these charts to

identify firms that are considered to be SOES activists. Specifically,

if a firm's ``OLIM'' percentage was greater than 75 percent it was

identified as a SOES activist.\16\ By differentiating between SOES

activists and non-activists, the staff was able to produce the summary

statistics at the bottom of the charts in Exhibit 1. These statistics

demonstrate that orders entered by SOES activists would have

experienced greater delays in execution than orders entered by non-

activists. Specifically, on February 4, 99.3 percent of all orders

entered by non-activists would have been executed within 30 seconds,

while 80.7 percent of all orders entered by SOES activists would have

been executed within 30 seconds. Similarly, on July 13, 98.4 percent of

all orders entered by non-activists would have been executed with 30

seconds, and 63.7 percent of all SOES activists' orders would have been

executed within 30 seconds.

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\15\On February 4, 1994, total Nasdaq share volume was

376,034,700 shares and on July 13, 1994, total Nasdaq share volume

was 342,162,600 shares. Both of these days were identified in your

August 16, 1994 letter as high volume days.

\16\``OLIM'' indicates the percentage of the firm's SOES order

that were entered at the maximum order size.

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Based on the finding illustrated in the charts in Exhibit 1 that

orders entered by SOES activists constitute the vast majority of orders

that would experience queues, the staff then identified those stocks

that received the highest number of orders from SOES activists that

would have been queued. Specifically, the tables in Exhibit 2 identify

those stocks that received more than 20 orders from SOES activists that

would have been queued. The staff then conducted a more detailed,

stock-by-stock analysis of the four ``top'' stocks on each of these

days.\17\ This analysis, as reflected in the NPROVE Order

Traffic & NPROVE Order Queues'' graphs contained in Exhibit 3,

reveals that the queues in these stocks would have occurred in

discreet, short-term clusters throughout the day, not in a random

fashion. The multi-colored bars in these graphs also illustrate that

orders entered by non-activists would only experience queuing when they

are tangled up in a queue created by a SOES activist. With the

exception of these isolated queues, the graphs also clearly illustrate

that orders entered by non-activists and activists would not have

experienced queuing throughout the remainder of the day. In addition,

as would be expected, the ``NPROVE Order Traffic'' graphs in

Exhibit 3 illustrate that these queues would have coincided with spikes

in transaction volume.

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\17\Specifically, the four stocks identified on February 4, 1994

were: (1) Lotus Development (LOTS); (2) DSC Communications Corp.

(DIGI); (3) 3COM Corp. (COMS); and (4) Cisco Systems, Inc. (CSCO).

The four days identified on July 13, 1994 were: (1) COMS; (2) Altera

Corp. (ALTR); (3) Adobe Systems, Inc. (ADBE); and (4) Microsoft

Corp. (MSFT).

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Accordingly, Nasdaq believes this information, along with the

NASD's proposed revisions to NPROVE to collapse the three

rounds of NPROVE order processing into one, illustrate that

queuing in NPROVE will not occur for sustained periods of time

in any one security and that only a very small percentage of retail

customer orders will be exposed to the risk that the market could move

against them while they are pending in NPROVE. In sum Nasdaq

believes the benefits that will be afforded small retail investors

through the price improvement and limit order protection features of

NPROVE, as well as the improvements to the integrity,

liquidity, and stability of Nasdaq that NPROVE likely will

produce, far outweight the potential costs to investors that may arise

from sporadic, short-lived order queues in NPROVE.\18\

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\18\Letter from Robert E. Aber, Vice President and General

Council, Nasdaq, to Katherine England, Assistant Director, SEC (Dec.

7, 1994).

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III. 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, 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 principal office of the

NASD. All submissions should refer to File Numbers SR-NASD-94-13 and/or

SR-NASD-94-68 and should be submitted by January 6, 1995.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\19\

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\19\17 CFR 200.30-3(a)(12) (1994).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-30915 Filed 12-15-94; 8:45 am]

BILLING CODE 8010-01-M