Self-Regulatory Organizations; Notice of Proposed Rule Changes by the National Association of Securities Dealers, Inc. Relating to Primary Market Maker Standards

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38091; File No. SR-NASD-96-55]

Self-Regulatory Organizations; Notice of Proposed Rule Changes by

the National Association of Securities Dealers, Inc. Relating to

Primary Market Maker Standards

December 27, 1996.

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

(``Act''),\1\ notice is hereby given that on December 23, 1996, the

Nasdaq Stock Market, Inc. (``Nasdaq'') filed with the Securities and

Exchange Commission (``SEC'' or ``Commission'') the proposed rule

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

been prepared by Nasdaq. The Commission is publishing this notice to

solicit comments on the proposed rule change from interested persons.

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

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

of the Proposed Rule Change

Nasdaq, a wholly owned subsidiary of the National Association of

Securities Dealers, Inc. (``NASD'' or ``Association''), proposes to

temporarily waive NASD Rule 4612, regarding primary Nasdaq market maker

standards for the remainder of the current pilot period of the Nasdaq

Short Sale Rule \2\ or until new primary market maker standards can be

devised.

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\2\ On November 1, 1996, the Commission extended the pilot

period of the NASD Short Sale Rule through October 1, 1997.

Securities Exchange Act Release No. 37917 (November 1, 1996), 61 FR

57934 (or approving on an accelerated basis an extension to the

NASD's Short Sale Rule through October 1, 1997).

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

Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, Nasdaq 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. Nasdaq has prepared summaries, set forth in Sections

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

statements.

[[Page 779]]

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

Statutory Basis for, the Proposed Rule Change

Nasdaq has evaluated its existing qualification criteria in the

primary market maker standards rule, Rule 4612 (a) and (b), in light of

the new SEC rules regarding a Nasdaq market maker's order handling

obligations (``Order Handling Rules'').\3\ Nasdaq strongly believes

that because of the potential changes in quotation and trading activity

in Nasdaq securities when the Order Handling Rules become effective,

the existing numerical criteria used to qualify a registered market

maker as a primary market maker will be significantly affected. Because

the precise effects on market maker quotes and trades are not possible

to predict until Nasdaq can develop practical experience with new

patterns of activity under the Order Handling Rules, Nasdaq believes

that it should attempt to minimize the possible harmful unintended

consequences that could occur by leaving the current standards in

place. Accordingly, Nasdaq believes that the existing standards should

be temporarily suspended on the same schedule for the phase in of the

Order Handling Rules which commence on January 10, 1997.

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\3\ These rules include Rule 11Ac1-4, the customer limit order

display rule and amended Rule 11Ac1-1, amendments to the firm quote

rule regarding the display of priced orders entered by market makers

or specialists into electronic communications networks. See

Securities Exchange Act Release No. 37619 (September 6, 1996); 61 FR

48290 (Order Handling Rules Adopting Release).

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Under existing Rule 4612, a registered Nasdaq Market Maker may be

deemed to be a primary market maker in national market securities if

the market maker meets two of three criteria: (1) The market maker

maintains the best bid or best offer as shown on Nasdaq no less than

35% of the time; (2) a market maker maintains a spread no greater than

102% of the average dealer spread; and (3) no more than 50% of a market

maker's quotation changes occur without a trade execution. In addition,

if a registered market maker meets only one of the above criteria, it

may nevertheless qualify as a primary market maker if the market maker

accounts for volume at least 1\1/2\ times its proportionate share of

overall volume in the stock. The review period for meeting any of these

criteria is one calendar month.

Commencing on January 10, 1997,\4\ the Order Handling Rules will go

into effect. These new rules will require Nasdaq market makers to

change their quotes when they are in receipt of customer limit orders

that improve upon their current quotations. Furthermore, under newly

refined best execution principles enunciated by the SEC, market makers

will be required to execute orders under different circumstances from

today. Finally, entities that are not market makers, (e.g., electronic

communication networks (``ECNs'')), will participate in Nasdaq and may

have a substantial impact on quotations and executions. Nasdaq believes

that each of the current criteria will be affected. For example, as to

the 102% of average dealer spread test, dealer quotes will not be

driven not merely by the market maker's proprietary interests, but also

the interests of customers that place limit orders with the market

maker. Under the new rules, a quote of a market maker driven by a

customer limit order will be indistinguishable from that of a quote

driven by a customer order. In addition, the test regarding the

percentage of time in which the market maker's quote is at the inside

will also be driven to some extent by customer limit order interest.

Further, because ECNs will be able to drive the inside price, the

parameters for this factor may need to be reevaluated. Finally, Nasdaq

believes that the ``quote change to executed trade ratio test'' will

also be affected by customer limit orders which may be changed or

cancelled by the customer without the market maker being involved in an

execution. At this time, however, Nasdaq believes it is virtually

impossible to predict with any accuracy precisely how market makers

will change their quotation and execution patterns.

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\4\ Nasdaq has requested relief from the January 10, 1997

commencement date of the Order Handling Rules. Nasdaq seeks to

commence compliance with the rules on January 13, 1997, because of

concerns that it would pose an untenable system change risk to

attempt to rush the introduction of new trading system software

during the trading week. If the SEC grants the relief sought, the

commencement date for this proposed rule change would also be

January 13, 1997. Thus, in the course of the filing on this proposed

rule change, while Nasdaq refers to January 10, 1997, as the

commencement date, if the SEC grants the relief requested, the

actual implementation date would be January 13, 1997.

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Because of this uncertainty, Nasdaq believes that it is in the

public investor's best interests to temporarily suspend the operation

of the primary market maker standards that currently exist. If the

standards are not suspended, and there is a significant shift in the

patterns of quotation and executions, Nasdaq believes that market

makers operating under the existing standards and earning the primary

market maker designation could conceivably lose that status. Nasdaq

believes that loss of the designation would mean that market makers

without the designation would not be permitted to avail themselves of

the short sale exemption for primary market makers. If a significant

number of registered market makers were to lose the short sale

exemption, or if a single market maker that handled a significant

portion of the order flow in a security were to lose the exemption,

Nasdaq believes liquidity in that particular stock could be seriously

harmed.

Therefore, Nasdaq is proposing that starting on February 1, 1997,

any market maker making a market in any of the initial 50 stocks

selected for the first phase of implementation of the Order Handling

Rules on January 10, 1997, will be able to avail itself of the short

sale exemption for qualified market makers found in Rule 3350(c)(1).

Similarly, Nasdaq proposes that as stocks are phased in to the new

Order Handling Rules, any registered market maker in the stock would be

deemed to be qualified for purposes of the short sale qualified market

maker exemption.

In seeking to temporarily suspend the use of the primary market

maker qualification criteria, Nasdaq believes that the suspension of

the criteria is an appropriate balance between the need for limitations

on the market maker short sale exemption and the potential for loss of

liquidity and market disruption in a period when new patterns and

practices of trading are first being developed. Nasdaq believes that

the period of time in which the Order Handling Rules are first being

implemented may be a period of uncertainty for market makers and

investors alike and that the prudent course of action would be to

identify and eliminate as many potential areas for increasing that

uncertainty as possible. Nasdaq has identified this issue as a critical

area of uncertainty and believes that the suspension of the market

maker qualification standards on a temporary basis is an appropriate

market quality response. Nasdaq believes that this relief will enable

Nasdaq market makers to better satisfy investor liquidity demands and

could help to promote pricing efficiency.

Nasdaq also plans to develop new standards as soon as practicable

after the Order Handling Rules become effective and Nasdaq can obtain

experience with the manner in which the new rules affect market makers.

Nasdaq plans to obtain the data from January and discuss the practices

among staff and with the Quality of Markets Committee.

Nasdaq believes that the proposed rule change is consistent with

Section

[[Page 780]]

15A(b)(6) of the Act \5\ in that it is designed to prevent fraudulent

and manipulative acts and facilitates transactions in securities. In

particular, Nasdaq believes this temporary amendment to the existing

rule should provide market makers with certainty regarding whether they

are entitled to an exemption under the rule which should promote market

efficiency and enhance the orderliness of the market during a

transition period. Nasdaq further believes the proposed rule change

should also help in reducing investor confusion at this time and

thereby promote efficient and fair markets.

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\5\ 15 U.S.C. 78o-3(b)(6).

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

Nasdaq 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

Nasdaq has requested that the Commission find good cause pursuant

to Section 19(b)(2) \6\ for approving the proposed rule change prior to

the 30th day after its publication in the Federal Register. The date

that the Order Handling Rules go into effect and Nasdaq must make

system changes to accommodate the new regulatory requirements is

January 10, 1997. Because Nasdaq believes that market makers must be

provided with information regarding the exemption from the short sale

rule as soon as possible before February 1, 1997, Nasdaq requests the

Commission to accelerate the effectiveness of the proposed rule change

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

The alternative is potential confusion and market disruption as market

makers may be unsure about whether they are in fact eligible to sell

short in the course of their market making activities.

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\6\ 15 U.S.C. 78s(b)(2).

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IV. Solicitation of Comments

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

arguments concerning the foregoing. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

Copies of the submission, all subsequent amendments, all written

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

the Commission, and all written communications relating to the proposed

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

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

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

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

available for inspection and copying at the principal office of the

NASD. All submissions should refer to File No. SR-NASD-96-55, and

should be submitted by January 16, 1997.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\7\

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\7\ 17 CFR 200.30-3(a)(12) (1996).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97-150 Filed 1-3-97; 8:45 am]

BILLING CODE 8010-01-M