Self-Regulatory Organizations; Notice of Filing and Order Granting Partial Accelerated Approval of Proposed Rule Change by National Association of Securities Dealers, Inc., Relating to Actions Taken During Extraordinary Market Conditions

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-36115; File No. SR-NASD-95-33]

Self-Regulatory Organizations; Notice of Filing and Order

Granting Partial Accelerated Approval of Proposed Rule Change by

National Association of Securities Dealers, Inc., Relating to Actions

Taken During Extraordinary Market Conditions

August 17, 1995.

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

(``Act'')\1\ and Rule 19b-4 thereunder, \2\ notice is hereby given that

on July 21, 1995, the National Association of Securities Dealers, Inc.

(``NASD'' or ``Association'') filed with the Securities and Exchange

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

described in Items I, II, and III below; Items I and II have been

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

solicit comments on the proposed rule change from interested persons.

As discussed below, the Commission has also granted accelerated

approval to a portion of the proposal.

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

\2\ 17 CFR 240.19b-4 (1994).

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

of the Proposed Rule Change

The NASD seeks the authority to modify temporarily the operation of

its SelectNet service and its Small Order Execution System (``SOES'')

during periods of unusually high Nasdaq broadcast volume. Specifically,

the NASD proposes that, during periods with a high number of quotation

updates, SelectNet broadcast orders and/or trade reports, it be

permitted to take the following action without having to file a

proposed rule change with the Commission:

(a) Suspend the entry of SelectNet broadcast orders from 9:30 to

10:30 a.m.;

(b) Execute immediately matched or crossed customer limit orders in

the SOES limit order file (i.e., rather than delay execution for five

minutes); and

(c) Increase from five minutes to ten minutes the standard grace

period in which market makers must refresh their SOES minimum exposure

limit.

The NASD requests the Commission to find good cause, pursuant to

Section 19(b)(2) of the Act, for approving the proposed rule change

prior to the thirtieth day after publication in the Federal Register.

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

1. Purpose

Pursuant to article VII, section 3 of the NASD By-Laws, a special

committee of the NASD Board of Governors was convened on July 20, 1995

to authorize action regarding the operation of certain Nasdaq automated

systems. Article VII, section 3 permits a committee consisting of the

Chairman, an Executive Committee member and the President of the NASD,

in lieu of full Board consideration, to take immediate action when

extraordinary market conditions exist.\3\ Extraordinary market

conditions are such conditions where the market is experiencing highly

volatile trading conditions that require prompt intervention to permit

continued efficient operation of the market. Until the new network \4\

is completely implemented later this year, and as long as Nasdaq

continues to experience trading activity exceeding the existing

network's stated capacity of 450 million shares per day, the NASD

believes Nasdaq must be considered to be experiencing extraordinary

market conditions that must be immediately addressed by appropriate

steps that will permit the continued efficient operation of the

market.\5\

\3\ In the event of an emergency or extraordinary market

conditions, Article VII, Section 3 permits the NASD to take any

action regarding the trading in or operation of the over-the-counter

securities market, the operation of any automated system owned or

operated by the NASD, and the participation in any such system of

any or all persons or the trading therein of any or all securities.

See NASD Securities Dealers Manual para.1182A.

\4\ That is, the migration from Nasdaq Workstation I to Nasdaq

Workstation II.

\5\ For example, on Wednesday, July 19, 1995, the NASD

experienced its highest trading volume ever, 597.5 million shares.

In addition, quotation updates were up to four times higher than the

previous peak update traffic.

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Therefore, until the new network is fully implemented, the special

committee of the NASD Board authorized the following actions to be

taken to permit its network to operate efficiently during such periods

as the Nasdaq market is experiencing, or reasonably anticipates, heavy

trading activity in excess of 450 million shares per day:

1. Between the hours of 9:30 to 10:30 a.m., SelectNet orders must

be directed to specific market makers;

2. The standard grace period for a market maker in a National

Market security to restore its minimum exposure limit in SOES will be

expanded from five minutes to ten minutes; and

3. Priced orders entered into the SOES limit order file on the

opposite side of the market from each other that match or cross in

price will be executed against each other immediately rather than after

five minutes.\6\

\6\ The NASD notes that the Committee also authorized and

approved the actions and regulatory changes described above for the

extraordinary market conditions experienced on July 19-21, 1995.

The NASD seeks to be able to implement these changes under the

described conditions without having to submit a proposed rule change

with the Commission each time it implements one of these changes. Under

the NASD's emergency authority, the NASD is required, among other

things, to file a proposed rule change under section 19(b)(3)(A)

promptly after exercising this authority.\7\ Under section

[[Page 44096]]

19(b)(3)(A), an NASD proposal becomes effective upon filing with the

Commission, but is subject to abrogation by the Commission within 60

days.\8\

\7\ Securities Exchange Act Release No. 26072 (Sept. 12, 1988),

53 FR 36143 (Sept. 16, 1988) (order approving proposed rule change

to provide the NASD Board of Governors and a proposed committee the

authority to take action during extraordinary market conditions).

The NASD is also required to use best efforts to consult with the

Commission in advance of exercising its emergency authority, provide

the Commission with a written report describing the action taken and

the reasons therefore, and prepare and maintain with its corporate

records a record of any actions taken under the proposed rule

change.

\8\ 15 U.S.C. 78s(b)(3)(C).

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The NASD believes these modifications to the operation of its

systems and rules associated with its systems are necessary and

appropriate for the protection of investors and to maintain the orderly

operation of the Nasdaq Stock Market as long as it continues to

experience the extremely high levels of trading activity (which

includes quotation updates, trade executions through automated

execution systems operated by Nasdaq, cancellations of orders, and

trade reporting) associated with 450 million share days, and the new

network is not yet fully implemented. As a prophylactic measure until

the new network is in place, therefore, the NASD will operate its

market with these changes (or a subset thereof, at the NASD's

discretion) in effect unless market conditions subside to an average

daily trading volume of less than 450 million and the associated

network traffic drops to acceptable levels.\9\

\9\ The NASD will provide its Board and the SEC with regular

updates on the status of these actions and the need for continuation

of these special measures.

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The NASD states that during periods when these procedures have been

implemented, the Nasdaq operations have continued to experience

accurate and timely quotations. The primary concern of the NASD during

these extraordinary market conditions has been to maintain the accuracy

and timeliness of its pricing mechanism. All executions of customer

orders, whether such orders are delivered to member firms by means of

the telephone, SOES, SelectNet, or member firm internal execution

systems, are ultimately driven by the Nasdaq quotation. Therefore, the

NASD believes it is essential to price discovery and market integrity

that Nasdaq maintain the validity of the quotations it displays.

The NASD believes the modification to SelectNet is the most prudent

possible change to Nasdaq services that provides the greatest benefit

to system capacity while having the smallest effect on investors.

SelectNet messages generally consume greater amounts of network

capacity than other messages sent through the network. By eliminating

the broadcast feature of SelectNet,\10\ the network obtains

approximately 20 percent more capacity than when broadcast messages

were permitted. Compared to any other option, the elimination of the

broadcast of a SelectNet message provides the most significant capacity

benefits to the network.

\10\ By ``broadcast,'' it is meant that a single order is

broadcast over the network to all available market makers. The

broadcasting of a message of such length to multiple sources

consumes significantly more capacity than a message directed to a

single point. Thus, limiting SelectNet to directed orders minimizes

network traffic while continuing to allow a firm to communicate an

order directly to an individual market maker.

The NASD believes the immediate execution of matched or crossed

limit orders in SOES provides two benefits. First, it permits customers

that place priced orders in the file an increased opportunity for rapid

execution of their orders, a measure that should be beneficial in heavy

trading days. Second, the step provides some minor benefit to the

network capacity constraints in that it eliminates a small number of

last sale reports that would have occurred had the orders been executed

separately.\11\

\11\ Letter to Mark Barracca, Branch Chief, SEC, for Richard G.

Ketchum, Chief Operating Officer and Executive Vice President (July

31, 1995).

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The NASD also notes that the change to the standard grace period is

also important to the overall well-being of the market during these

conditions. Because of the extraordinary levels of market activity that

are occurring, member firm trading desks are extremely busy handling

the multiple points of order flow; Because of the extent of such

activity at the trading desks, the NASD fears that the standard grace

period of five minutes to update the market maker's minimum exposure

limit in SOES is not sufficient to provide market makers a reasonable

opportunity to update their exposure limit. If the market maker fails

to update the exposure limit in a security within five minutes under

current SOES rules, the market maker may be deemed to have withdrawn as

a market maker in that security.\12\ In extraordinary market

conditions, the NASD believes that it would be unwise to lose the

liquidity provided by a market maker because such market maker was

unable to direct attention to its exposure limit within five minutes.

Accordingly, the NASD has determined to expand the standard grace

period to ten minutes.\13\

\12\ See SOES Rules of Procedure, (c) 2.(G). NASD Securities

Dealers Manual para. 2460.

\13\ The NASD has taken similar action in other extraordinary

market conditions. See e.g., Securities Exchange Act Release No.

27369 (Oct. 19, 1989), 54 FR 45832 (Oct. 31, 1989) and Securities

Exchange Act Release No. 29664 (Sept. 10, 1991), October 1989 Market

Break and the political upheaval in the former Soviet Union in

August 1991.

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2. Statutory Basis

The NASD believes that the proposed rule change is consistent with

the provisions of section 15A(b)(6) of the Act \14\ in that the

proposed changes are designed 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

fair and open market. The actions taken by the NASD and proposed herein

facilitate the continued operation of the systems during those periods

of extraordinary market conditions until the expanded network is ready

to be fully implemented.

\14\ 15 U.S.C. 78o-3.

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(B) Self-Regulatory Organization's Statement on Burden on Competition

The NASD does not believe that the proposed rule change will result

in any burden on competition that is not necessary or appropriate in

furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the

Proposed Rule Change Received From Members, Participants, or Others

Written 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 self-regulatory organization 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.

The NASD has requested, however, that the Commission find good

cause pursuant to section 19(b)(2) for approving the proposed rule

change prior to the 30th day after publication in the Federal Register.

As discussed below, the Commission finds that the portion of the

proposed rule change that modifies the operation of SOES to execute

immediately matched or crossed customer limit

[[Page 44097]]

orders in the SOES limit order file is consistent with the requirements

of the Act. Further, the Commission finds good cause for approving,

prior to the 30th day after the date of publication of notice of filing

in the Federal Register, the proposal to execute immediately matched or

crossed limit orders in SOES. The Commission believes that accelerated

approval of this portion of the proposal will benefit investors by

creating a greater assurance that the Nasdaq market will continue to

operate efficiently during periods of market stress and high volume.

IV. Commission's Findings and Order Granting Partial Accelerated

Approval of Proposed Rule Change

The Commission finds that the proposal to permit the NASD to modify

the operation of SOES to allow matched or crossed customer limit orders

in the SOES limit order file to execute immediately against each other

(i.e., rather than be delayed for five minutes) is consistent with the

Act and the rules and regulations promulgated thereunder. Specifically,

the Commission finds that the proposed rule change is consistent with

the requirements of Section 15A(b)(6) which requires that the NASD

rules be designed, among other things, to facilitate securities

transactions and protect investors and the public interest. Removing

the five-minute delay in the execution of matched or crossed limit

orders in the SOES limit order file will facilitate the NASD's load

shedding efforts by increasing the speed of execution and removing

orders from the Nasdaq system more quickly. Moreover, the greater

likelihood that an investor will receive an execution of a limit order

placed in SOES may encourage greater use of the SOES limit order file.

This will further decrease the burden on market makers and increase the

message handling capabilities of Nasdaq during high volume periods.

Finally, the Commission notes that the proposal will further the

Congressional objective to increase the opportunity for investors'

orders to be executed without the participation of a dealer.\15\

\15\ Id. section 78k-1(a)(1)(C)(v).

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Nonetheless, the Commission is concerned about the effects of

service changes on the Nasdaq market. Accordingly, the Commission

directs the NASD to notify, prior to implementing this change to SOES

or as soon as practicable thereafter, its members via the Nasdaq

Workstation and the staff of the Division of Market Regulation by

telephone. In addition, on a weekly basis, the NASD should submit a

written report to the Division of Market Regulation providing

information on any service changes since the last report.\16\ The

information provided should include: (a) a brief description of the

change; (b) the event(s) triggering the change; and (c) the NASD's

assessment of the effect of the change on the Nasdaq system.

\16\ The NASD's notification via the telephone and its written

report to the Commission should be directed to the Branch Chief,

Office of Automation & International Markets, Division of Market

Regulation or his designee.

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As a more general matter, the Commission is concerned about

capacity limitations in the Nasdaq system. Since 1989, the Commission

has urged self-regulatory organizations, among other things, to develop

current and future capacity estimates, conduct capacity stress tests,

and contract with independent reviewers to assess annually whether

their systems can perform adequately under varying degrees of market

activity.\17\ While the Commission recognizes that the NASD expects

that its planned system changes will address these issues, we are

concerned about the ongoing stress in the Nasdaq system, as well as the

inability to resolve that stress without service reductions.

Accordingly, the Commission has requested the NASD to obtain an

independent review of its current capacity.

\17\ Securities Exchange Act Release No. 29185 (May 19, 1991),

56 FR 22490 (May 15, 1991) and Securities Exchange Act Release No.

27445 (Nov. 16, 1989), 54 FR 48703 (Nov. 24, 1989).

V. Solicitation of Comments

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

arguments concerning the foregoing. The Commission specifically

requests that commenters address the appropriateness of the NASD's

approaches to address system capacity during periods of market stress.

The Commission shares the NASD's concerns about timely and accurate

quotes and trade reports in high volume market conditions. While the

Commission understands that suspending SelectNet's broadcast feature

during high volume markets will free up broadcast capacity, the

Commission requests that the NASD elaborate on the effects of this

modification on quotes and trade reports. In this regard, it would be

helpful if the NASD and market participants described their experience

over the past month with the timeliness and accuracy of quotes and

trade reports during SelectNet broadcast suspensions.

In addition, the NASD has stated that suppression of the SelectNet

broadcast feature offers the greatest benefits in terms of system

capacity with the least effect on investors. The Commission invites

comment on the implications of this modification for investors and

firms in terms of market access, execution quality, transparency, and

price discovery. The Commission also invites comment on whether there

may be alternatives available for improving system capacity that would

have a smaller impact on market participants.

The Commission also seeks comments on the NASD's proposal to double

the length of the standard grace period in which market makers must

refresh their SOES minimum exposure limit. SOES--with mandatory market

maker participation and an automatic twenty-day suspension for failure

to refresh exposure limits within the grace period--was enhanced in

1988 to provide small investors with access to market during periods of

extraordinary activity. In the pending proposal, the NASD wishes to

reduce the availability of SOES under precisely those conditions. The

Commission invites comment on whether this proposal undermines the

purpose of SOES and any relevant experience from either of the last two

times that the NASD extended the grace period.

The Commission also notes that the practical effect of the NASD's

proposal is to limit the availability of automatic execution in order

to protect the liquidity of the overall market. That is, market makers

will be permitted to remain active in a security despite more lengthy

periods of inactivity on SOES. The Commission solicits comments on

whether there are alternatives available that would continue the

availability of automatic executions for small orders that would not

have a negative impact on the liquidity of the overall Nasdaq market.

For example, given the availability of auto-refresh in the Nasdaq

market, comments are invited on whether such a system is adequate to

address this concern, and whether private systems exist that can notify

market makers when they have been executed against the SOES and are

about to be taken off the screen because of the expiration of the grace

period.

Finally, given that the NASD will implement these changes based on

its continuing assessment of market conditions and the need to

implement any one or any combination of the changes, comment is invited

on the potential for confusion, both to investors and to other market

participants as to which changes are in place on any given day and the

implications of these changes for trading in the over-the-counter

market.

[[Page 44098]]

Persons making written submissions should file six copies thereof

with the Secretary, Securities and Exchange Commission, 450 Fifth

Street NW., Washington, DC 20549. Copies of the submission, all

subsequent amendments, all written statements with respect to the

proposed rule change that are filed with the Commission, and all

written communications relating to the proposed rule change between the

Commission and any person, other than those that may be withheld from

the public in accordance with the provisions of 5 U.S.C. 552, will be

available for inspection and copying in the Commission's Public

Reference Room. Copies of such filing will also be available for

inspection and copying at the principal office of the NASD. All

submissions should refer to the file No. SR-NASD-95-33 and should be

submitted by September 8, 1995.

It is therefore ordered, pursuant to Section 19(b)(2) of the Act,

that the portion of the proposed rule change (SR-NASD-95-33) providing

the NASD the authority to modify the operation of SOES by allowing

matched or crossed limit orders to execute automatically is approved

until January 5, 1996 or the completion of the roll-out of Workstation

II, whichever occurs first.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 95-21044 Filed 8-23-95; 8:45 am]

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