Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Approving Proposed Rule Change By the NASD To Extend From 15 Seconds to 17 Seconds the Amount of Time a Market Maker Has To Update Its Quote After an Order Execution in SOES Before Being Required To Execute a Subsequent Order

SECURITIES AND EXCHANGE COMMISSION

[Release No. 39490, File No. SR-NASD-97-50]

Self-Regulatory Organizations; National Association of Securities

Dealers, Inc.; Order Approving Proposed Rule Change By the NASD To

Extend From 15 Seconds to 17 Seconds the Amount of Time a Market Maker

Has To Update Its Quote After an Order Execution in SOES Before Being

Required To Execute a Subsequent Order

December 24, 1997.

On July 14, 1997, the National Association of Securities Dealers,

Inc. (``NASD'' or ``Association''), filed with the Securities and

Exchange Commission (``Commission'' or ``SEC'') a proposed rule change

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

(``Exchange Act''),\1\ and Rule 19b-4 thereunder.\2\ The proposal

amends NASD Rule 4730(b)(1) to indicate that once the Nasdaq Stock

Market, Inc.'s (``Nasdaq'') Small Order Execution System (``SOES'')

executes an unpreferenced market order or a marketable limit order

against a SOES market maker, that market maker is not required to

execute another unpreferenced SOES order at the same bid or offer in

the same security until 17 seconds have elapsed, absent a quotation

update by the market maker within such 17-second period. On July 24,

1997, notice of the proposed rule change, including the substance of

the proposal, was published for comment in the Federal Register.\3\ The

Commission received 64 comment letters, which are discussed below. The

Commission is hereby approving the proposed rule change.

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

\2\ 17 CFR 240.19b-4.

\3\ Securities Exchange Act Release No. 38849 (July 17, 1997) 62

FR 39883 (July 24, 1997).

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I. Description

The proposed rule change specifies the obligations of SOES market

makers during non-locked and non-crossed market situations. As amended,

NASD Rule 4730(b)(1) would provide that once SOES executes an

unpreferenced market order or a marketable limit order against a SOES

market maker, that market maker is not required to execute another

unpreferenced SOES order at the same bid or offer in the same security

until 17 seconds have elapsed, absent a quotation update by the market

maker within that 17-second period.

Currently, NASD Rule 4730(b)(1) provides that:

Market Makers shall have a period of time following their

receipt of an execution report in which to update their quotation in

the security in question before being required to execute another

unpreferenced order at the same bid or offer in the same security.

This period of time shall initially be established as 15 seconds,

but may be modified upon appropriate notification to SOES

participants.

This language was originally added to the NASD's rules in October

1991 to give a SOES market maker a brief opportunity to update its

quotations in response to executions it received through SOES (``15-

Second SOES Execution Response Period''). As the current language of

NASD Rule 4730(b) reflects, the ``15-Second SOES Execution Response

Period'' commences when a market maker has received notification of a

SOES execution through the system.\4\ Because SOES does not have the

capability to determine the exact time when a market maker receives a

SOES execution report, at the time this rule was implemented Nasdaq

estimated that it took up to five seconds for SOES to execute an order

against a market maker and for the market maker to receive a report of

the execution (the ``SOES Execution Report Communication Period''). As

a result, SOES was programmed to add uniformly a five-second period to

the ``15-Second SOES Execution Response Period,'' with the effect that

the system executes unpreferenced market orders against a market maker

in twenty-second intervals, absent a quotation update by the market

maker.

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\4\ See Exchange Act Release No. 29810 (October 10, 1991) 56 FR

52098, 52099 (October 17, 1991) (order approving file no. SR-NASD-

91-18) (``[f]ollowing receipt of an execution report of an

unpreferenced purchase or sale through SOES, a market maker will

have a period of time (15 seconds) to update its quote prior to

executing any subsequent transaction on the same side of the market

at the same price.'' [Footnote omitted].).

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Nasdaq now estimates that on average, the SOES Execution Report

Communication Period is between two and three seconds, although the

actual time may vary depending on activity and communications traffic

during different periods of the day. Based on this data, the NASD

determined that it was appropriate to assign a two-second period to the

SOES Execution Report Communications Period for purposes of the rule.

The NASD proposes to incorporate explicitly this two-second period

into NASD Rule 4730. The proposed rule change is designed to retain the

ability of a market maker to respond to SOES executions while

recognizing that,

[[Page 898]]

under normal circumstnaces, a minimal period of time is necessary for

reports of those executions to be received by the market maker. The

proposed amendments to NASD Rule 4730(b) also would clarify that:

(1) A market maker becomes immediately eligible to receive

another execution through SOES if it updates its quote (its bid,

offer, or size) during the 17-second period,\5\ and

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\5\ The proposed amendments to NASD Rule 4730(b) do not change

in any way the current functionality of SOES whereby preferenced

orders are continuously executed against a market maker without any

delay between executions. In addition, as is presently the case

during locked and crossed markets, SOES will execute orders (both

preferenced and unpreferenced against a market maker that is locked

or crossed in five second intervals. See NASD Rule 4730(b)(3).

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(2) The 17-second period arises regardless of whether the market

maker executes an unpreferenced market order or an unpreferenced

marketable limit order.

This rule change is intended to eliminate ambiguities in Nasdaq's

implementation of this rule and among market participants concerning

the manner in which unpreferenced orders are executed in SOES.

II. Summary of Comments

The Commission received 64 comment letters from the public. Of

these, 58 letters concerned other NASD filings, and thus were

irrelevant and one comment letter was submitted twice. Of the five

remaining comment letters, three were in favor of the proposed rule

change and two were against it. None of these comment letters contained

any reason for the positions taken.

III. Discussion

The Commission finds the proposed rule change, by helping to ensure

that market makers stand willing to buy and sell securities at all

times, is consistent with the Exchange Act and in particular with

Sections 15A(b)(6), 15A(b)(9), 15A(b)(11) and 11A(a)(1)(C) of the

Exchange Act.

Among other things, 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, and processing

information with respect to, and facilitating transactions in

securities. Section 15A(b)(6) also requires that the rules of a

national securities association be designed 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) provides that the rules of the association

may not impose any burden on competition not necessary or appropriate

in furtherance of the purposes of the Exchange Act. Section 15A(b)(11)

requires the NASD, as an association, to adopt rules governing the form

and content of quotations relating to securities in the Nasdaq market.

Such rules must be designed to produce fair and informative quotations,

prevent fictitious and misleading quotations, and promote orderly

procedures for collecting, distributing, and publishing quotations.

Section 11A(a)(1)(C) provides that, among other things, it is in the

public interest to assure the economically efficient execution of

securities transactions and the availability to brokers, dealers, and

investors of information with respect to quotations for and

transactions in securities.

The Commission believes that the proposed amendments will help to

ensure that a market maker has no more time than necessary after

execution--i.e., 17 seconds--before it must update its quotes. This

requirement will help ensure that a market maker cannot attempt to

avoid its market making obligations by waiting a lengthy period of time

after a SOES execution before entering an updated quote.\6\ As a

result, the proposed rule change should increase a market maker's

compliance with its obligation to make continuous, two-sided markets

and promote quote competition among market makers. Such competition

among market makers should, in turn, enhance the integrity of the

Nasdaq market by helping to ensure the best execution of customer

orders and improving the price discovery process for Nasdaq securities.

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\6\ A market maker that can avoid updating its quote for a

period of time can take advantage of its temporary ability to avoid

SOES executions and wait to see how other market makers update their

quotes. This delay could serve to lessen competition among market

makers.

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The Commission also notes that the NASD filed the proposed rule

change in response to concerns about the rule the Commission raised in

its Report Pursuant to Section 21(a) of the Securities Exchange Act of

1934 Regarding the NASD and the Nasdaq Market (``SEC Report''). In

relevant part, the SEC Report notes that the

October 1991 SOES rule amendments as filed with the Commission also

allowed for the modification of the SOES operating software to

provide for a fifteen-second delay between executions by a

particular market maker. The purpose of this delay was to give the

SOES market maker an opportunity to update its quotations after

receiving a report of a trade executed through SOES. In fact, the

NASD implemented an effective delay of twenty seconds, which reduced

the ability of SOES users to obtain executions.\7\ The purported

rationale for the additional five-second delay was to allow for the

time taken for the electronic transmission of execution reports and

quote updates. According to internal NASD studies, however, any

delays in transmission occurred only at the opening of busy trading

days and the vast majority of any such delays were no more than two

to three seconds in length. The NASD should have set forth in its

filings with the Commission seeking approval for the delay that the

time between executions had been set at twenty seconds, but did not

do so. The existence of the additional five second delay was

discovered by the Commission staff during the investigation [that

led to the issuance of the SEC Report].\8\

\7\ The Release by the Commission approving the proposed rule

changes explicitly noted that the delay function was set at fifteen

seconds and stated that ``[a]ny change in the time period must be

submitted to the Commission for review pursuant to Section 19(b) of

the [Exchange] Act.'' Exchange Act Release No. 29810 (October 10,

1991) 56 FR 52098 (October 17, 1991) n.10. The NASD had never made

any such submission. (This footnote conforms to footnote 160 in the

Appendix to the SEC Report.)

\8\ Appendix to SEC Report at A-62-63.

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The proposed rule change addresses the concerns of the SEC Report

by clearly establishing the time delay between SOES executions against

a market maker. Moreover, the delay includes, in addition to the

previously established 15-second period, only the time measured by the

NASD for electronic transmission of an execution report.

Thus, the proposal to change NASD Rule 4730 is consistent with the

Exchange Act and in particular with the following sections of that Act:

(1) Section 15A(b)(6), because it is designed to prevent a

market maker from failing to meet its obligation to make a

continuous, two-sided market;

(2) Section 11A(a)(1)(C)(i)-(iii), because it assures:

economically efficient execution of securities transactions; fair

competition among brokers and dealers by encouraging timely, fair,

and accurate quotations; and the availability to brokers, dealers,

and investors of timely information concerning these fair and

accurate quotations.

Further, the proposed change to NASD Rule 4370 is consistent with

Section 15A(b)(9) of the Exchange Act, because it does not impose any

burden on competition not necessary or appropriate in furtherance of

the purposes of the Exchange Act, but merely alters, slightly, a timing

requirement for market makers.

Finally, the Commission believes that the proposal is consistent

with Exchange Act Section 15A(b)(11). In particular, by helping to

ensure that

[[Page 899]]

SOES market makers update their quotes promptly after executions, the

proposal should help to produce fair and informative quotations and

prevent fictitious and misleading quotations.

IV. Conclusion

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

Exchange Act, that the proposed rule change (SR-NASD-97-50) be, and

hereby is, approved.\9\

\9\ In approving this rule, the Commission notes that it has

considered the proposed rule's impact on efficiency, competition,

and capital formation. The proposed rule change likely will enhance

the efficiency and fairness of the process by which market makers

update their quotes. It likely also will enhance the ability of

investors to obtain updated market maker quotes quickly, thus

increasing Nasdaq's transparency. The net effect of approving the

proposed rule change will be positive. 15 U.S.C. 78c(f).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\10\

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\10\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 98-290 Filed 1-6-98; 8:45 am]

BILLING CODE 8010-01-M