Self-Regulatory Organizations; Notice of Filing and Order Granting Accelerated Partial Approval to Proposed Rule Change by the National Association of Securities Dealers, Inc. To Implement, on a Pilot Basis, New Primary Nasdaq Market Maker Standards for all Nasdaq National Market Securities and To Extend the Short Sale Rule Pilot

Federal RegisterApr 6, 1998

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39819; Filed No. SR-NASD-98-26]

Self-Regulatory Organizations; Notice of Filing and Order

Granting Accelerated Partial Approval to Proposed Rule Change by the

National Association of Securities Dealers, Inc. To Implement, on a

Pilot Basis, New Primary Nasdaq Market Maker Standards for all Nasdaq

National Market Securities and To Extend the Short Sale Rule Pilot

March 30, 1998.

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

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

given that on March 19, 1998, the National Association of Securities

Dealers, Inc. (``NASD'' or ``Association''), through its wholly-owned

subsidiary, The Nasdaq Stock Market, Inc. (``Nasdaq''), filed with the

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

proposed rule changes as described in Items I and II below, which Items

have been prepared by Nasdaq. On March 25, 1998, Nasdaq submitted to

the Commission Amendment No. 1 to the proposed rule changes.\3\ On

March 26, 1998, Nasdaq submitted to the Commission Amendment No. 2 to

the proposed rule changes.\4\ The Commission is publishing this notice

to solicit comments on the proposed rule change from interested

persons. As discussed below, the Commission is also granting

accelerated approval to a portion of the proposal.

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

\2\ 17 CFR 240.19b-4.

\3\ See Letter from Robert E. Aber, Senior Vice President and

General Counsel, Nasdaq, to Katherine A. England, Assistant

Director, Division of Market Regulation, Commission, dated March 25,

1998.

\4\ See Letter from Robert E. Aber, Senior Vice President and

General Counsel, Nasdaq, to Richard Strasser, Assistant Director,

Division of Market Regulation, Commission, dated March 26, 1998.

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

Substance of the Proposed Rule Change

The NASD and Nasdaq propose to amend the Primary Nasdaq Market

Maker (``PMM'') standards for all Nasdaq National Market (``NNM'')

securities, which are found in NASD Rule 4612, and to implement the

proposed revised PMM standards on a pilot basis beginning on May 1,

1998, and extending until November 1, 1998. Additionally, the NASD and

Nasdaq are proposing to: 1) continue the current

[[Page 16842]]

suspension of existing PMM standards through May 1, 1998 (the start

date of the new PMM pilot); and 2) extend the pilot of the NASD's short

sale rule--NASD Rule 3350 (``Short Sale Rule'')--including the market

maker exemption to that rule and the definition of ``legal'' short sale

until November 1, 1998 (the end date of the proposed PMM pilot). As

noted below, as part of the PMM pilot program, the NASD and Nasdaq will

shortly submit amendments to the Short Sale Rule, which would exempt

from the Short Sale Rule certain customer facilitating, liquidity-

providing transactions, regardless of whether the broker/dealer is

qualified as a PMM. Proposed new language is italicized; proposed

deletions are in brackets.

* * * * *

NASD Rule 4612. Primary Nasdaq Market Maker Standards

(a) A member registered as a Nasdaq market maker pursuant to Rule

4611 may be deemed to be a Primary Nasdaq Market Maker in Nasdaq

National Market (``NNM'') securities if the market maker [complies

with] achieves the threshold standards [(as established and published

by the Association from time to time)] in the following qualification

criteria.

(1) [amount of time a dealer maintains a quotation that represents

the best bid or best offer as shown in] degree of liquidity

contribution to The Nasdaq Stock Market as measured by the Net

Liquidity Ratio \5\; and

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\5\ The net Liquidity Ratio (``NLR'') formula accords credit for

liquidity contribution: (1) in an ``up market'' by accumulating all

sales, irrespective of price; and (2) in a ``down market'' by

accumulating all purchases, irrespective of price. These trades are

then divided by total shares traded in both up and down markets,

excluding volume during neutral periods, sales at the inside offer

during down markets, and purchases at the inside bid during up

markets. In addition to excluding from the denominator of the NLR

sales at the inside offer during down markets and purchases at the

inside bid during up markets, these sales and purchases are excluded

from the numerator of the NLR. The result is expressed as a ratio

with a potential value between zero and one.

For the purposes of calculating NLR, the direction fo the market

is defined by looking at the five minute period prior to the trade

report. If there has been no change in the bid price during that

time, the last bid direction governs. That is, if the current best

(inside) bid displayed in The Nasdaq Stock Market is below the

preceding best (inside) bid (''down bid''), the market is deemed

down, and if the current best (inside) bid displayed in The Nasdaq

Stock Market is above the preceding best (inside) bid (``up bid''),

the market is deemed up. If there has been a change during the

previous five minutes, then the formula looks to the prior four

changes and takes the predominant direction as the indicator. Thus,

if at least three of the last four changes are down bids the market

is deemed down, and if at least three of the last four changes are

up bids the market is deemed up. If the changes are evenly split,

the market is deemed neutral.

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(2) [relation of individual dealer spread to average dealer spread]

a market maker's proportionate share of proprietary share-volume

(``proportionate volume'') or the market maker's proportionate share of

proprietary trades (``proportionate trades'').\6\ [; and

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\6\ A market maker's proportionate volume shall be determined

by: dividing the market maker's total proprietary share-volume in a

stock by all market maker proprietary share-volume for that stock;

and then multiplying that ratio by the total number of registered

market makers in the stock. For example, if a market maker transacts

10% of the total proprietary share-volume in a stock with 10

registered market makers, the market maker's proportionate volume

would be 1.0. A market maker's proportionate trades shall be

determined by: dividing the market maker's total number of

proprietary trades in a stock by the total number of proprietary

trades by all market makers in that stock; and then multiplying that

ratio by the total number of registered market makers in the stock.

Subparagraph (b)(1)(ii) establishes the applicable thresholds for

proportionate volume and proportionate trades.

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(3) frequency of dealer quotation updates without a corresponding

execution in the security occurring within three minutes before or

after a quotation update.\7\]

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\7\ [The threshold standards initially shall be established as:

(a) a market maker must maintain the best bid or best offer as

shown on Nasdaq no less than 35% of the time;

(b) a market maker must maintain a spread no greater than 102%

of the average dealer spread;

occur without being accompanied by a trade execution of at least one

unit of trading.

The Board of Governors reserves the authority to rescind or

modify one or more of the threshold standards immediately upon a

finding that the standard is operating in a manner that is unfair to

a class of investors or members, or that continued imposition of the

standard results in a substantial adverse impact on the liquidity or

market quality of the Nasdaq market.]

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[(b) A market maker for a Nasdaq National Market security must

satisfy the threshold standards in at least two of the criteria in

paragraph (a) in order to be designated a Primary Nasdaq Market Maker

in that security; provided however, that if a market maker satisfies

only one of the criteria, it may qualify as a Primary Nasdaq Market

Maker if it also accounts for a threshold level of proportionate volume

in the security (as established and published by the Association from

time to time.) \8\ ]

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\8\ [The threshold proportionate volume standard initially shall

require a market maker to account for volume of at least 1\1/2\

times its proportionate share of overall volume in the stock for the

review period.]

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(b)(1) Except as provided in subparagraphs (b)(2) and (b)(3), to be

designated as a Primary Nasdaq Market Maker in a particular NNM

security a market maker must achieve:

(i) the NLR threshold; and \9\

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\9\ The NLR threshold initially shall be established as 0.67.

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(ii) the threshold for proportionate volume or the threshold for

proportionate trades.\10\

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\10\ The threshold for proportionate volume and proportionate

trades shall be 1.0 for each. Accordingly, a market maker must

account for at least one times its proportionate share of all share-

volume in the stock or must account for at least one times its

proportionate share of all trades for the stock during the review

period. For example, if during the review period a stock had 10

market makers and had an overall share-volume of 1,000,000 shares

and 15,000 trades, a market maker would have to transact one-tenth

of all share-volume or trades--100,000 in share-volume or 1,500

trades.

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(b)(2) If less than 50% of all registered market makers qualify as

Primary Nasdaq Market Makers under subparagraph (b)(1), Nasdaq shall

rank those market makers that achieve only the NLR threshold by:

(i) the market makers' proportionate volume, and shall designate

(from highest to lowest ranked) such market makers as Primary Nasdaq

Market Makers until the total number of market makers qualifying under

subparagraphs (b)(1) and (b)(2)(i) reaches an amount up to but not

exceeding 50% of all the registered market makers in that security; and

(ii) the market makers' proportionate trades, and shall designate

(from highest to lowest ranked) such market makers as Primary Nasdaq

Market Makers until the total number of market makers qualifying under

subparagraphs (b)(1) and (b)(2)(ii) reaches an amount up to but not

exceeding 50% of all the registered market makers in that security.\11\

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\11\ The 50% levels set forth in subparagraphs (b)(2)(i) and

(b)(2)(ii) shall be fixed and not subject to modification by Nasdaq,

so that if a market maker meets the NLR threshold and falls within

the top 50% of market makers when ranked by proportionate volume or

the top 50% of market makers when ranked by proportionate trades,

and market maker shall automatically be designated as a Primary

Nasdaq Market Maker. The only instance in which Nasdaq would

designate Primary Nasdaq Market Makers in an amount less than 50% of

all registered market makers, would be if less than 50% of the

registered market makers achieve the NLR threshold.

When there is an odd number of registered market makers in a

security, Nasdaq will round up to calculate the ``50%'' level (i.e.,

50% level = (number of market makers +1)/2).

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(b)(3) If the number of registered market makers in a NNM security

is eight (8) or fewer, a market maker shall qualify as a Primary Nasdaq

Market Maker without regard to its proportionate volume or

proportionate trades in that stock, provided it achieves the NLR

threshold.

market maker performance in each of the

[[Page 16843]]

qualification criteria in [paragraph] subparagraphs (a), (b),

[paragraph] and (g)[(1)(B), and paragraph (g)(2)(B)(ii)] shall be one

calendar month; provided, however, that if a market maker that is a

Primary Nasdaq Market Maker would fail to maintain that status based on

the application of the applicable thresholds for a particular month,

the review period shall be that month (up to and including the last

trading day of the month) and the prior month.

(d) If, after the applicable review period, a market maker does not

satisfy the threshold standards for the criteria in [paragraph]

subparagraphs (a) and (b), the Primary Nasdaq Market Maker designation

shall be withheld commencing on the next business day following notice

of failure to [comply with] achieve the standards.

(e) Market makers may requalify for designation as a Primary Nasdaq

Market Maker by satisfying the threshold standards for the next review

period.

(f) A market maker may request reconsideration of the notice to

withhold the Primary Nasdaq Market Maker designation.

(1) Grounds for requests for reconsideration shall be limited to:

(A) system failure; or

(B) excused market maker withdrawal status [; or

forth in paragraph (a)(3) because of activity in a related derivative

or convertible security, or activity in a security subject to

derivative pricing mechanisms, such as currency differentials with

foreign stocks.]

(2) Requests for reconsideration must be sent in writing to Nasdaq

Market Operations [within 24 hours of the determination to withhold

the Primary Nasdaq Market Maker designation].

(3) Requests for reconsideration will be reviewed by the Market

Operations Review Committee, whose decisions are final and binding on

the members.

(g) In registration situations:

(1) To register and immediately become a Primary Nasdaq Market

Maker in a Nasdaq National Market security, a member must be a Primary

Nasdaq Market Maker in 80% of the securities in which it has

registered. If the market maker is not a Primary Nasdaq Market Maker in

80% of its stocks, it may qualify as a Primary Nasdaq Market Maker in

[that stock] a particular Nasdaq National Market security if the market

maker registers in [the stock] that security as a regular Nasdaq market

maker and satisfies the qualification criteria for the next review

peirod, except that if the market maker is registered in the security

on or before the fourteenth calendar day of the month, the review

period shall be that calendar month.

(2) Notwithstanding paragraph (g)(1) above, after an offering in a

stock has been publicly announced or a registration statement has been

filed with the Securities and Exchange Commission, no market maker may

the requirements set forth below:

(A) For secondary offerings:

(i) the secondary offering has become effective and the market

maker has satisfied the qualification criteria in the time period

between registering in the security and the offering becoming

effective; provided, however, that if the member is a manager or co-

manager of the underwriting syndicate for the secondary offering and it

is a [PMM] Primary Nasdaq Nasdaq National Market Maker in 80% or more

of the Nasdaq National Market securities in which it is registered, the

member is eligible to become a [PMM] Primary Nasdaq Market Maker in the

issue prior to the effective date of the secondary offering regardless

of whether the member was a registered market maker in the stock before

the announcement of the secondary offering; or

(ii) the market maker has satisfied the qualification criteria for

40 calendar days.

(B) For initial public offerings (IPOs):

(i) the market maker may register in the offering and immediately

become a Primary Nasdaq Market Maker if it is a Primary Nasdaq Market

Maker in 80% of the securities in which it has registered; provided

however, that if, at the end of the first review period, the Primary

Nasdaq Market Maker has withdrawn on an unexcused basis from the

security or has not satisfied [the qualification criteria] the

applicable thresholds, it shall not be afforded a Primary Nasdaq Market

Maker designation on any subsequent initial public offerings for the

next 10 business days; or

(ii) the market maker registers in the stock as a regular Nasdaq

market maker and satisfies the qualification criteria for the next

review period, except that if the market maker is registered in the

security on or before the fourteenth calendar day of the month, the

review period shall be that calendar month.

(i) an issue ceases to be an IPO once it has traded on Nasdaq for

five (5) business days; and

(ii) the applicable first review period for IPOs that come to

market during the last five (5) business days of a month is the

calender month after the month in which the IPO commenced trading on

Nasdaq.

(3) Notwithstanding subparagraph (g)(1) or (g)(2) above, after a

merger or acquisition has been publicly announced, a Primary Nasdaq

Market Maker in one of the two affected securities may immediately

acquisition security pursuant to the same-day registration procedures

in Rule 4611.

(h) [The Board of Governors may modify the threshold standards set

forth in paragraphs (a) and (b) above if it finds that maintenance of

such standards would result in an adverse impact on a class of

investors or on Nasdaq.] This rule shall be in effect beginning May 1,

1998, and remain in effect until November 1, 1998.

* * * * *

NASD Rule 3350

(a)-(k) No Changes.

(1) This Rule shall be in effect until [April 15, 1998] November 1,

1998.

* * * * *

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

The NASD and Nasdaq are proposing to amend the PMM standards, as

described below, and to implement these revised PMM standards on a six-

month pilot basis beginning May 1, 1998, and continuing until November

1, 1998. The NASD and Nasdaq are also proposing to extend the current

suspension of the former PMM standards until the proposed PMM pilot

program is implemented on May 1, 1998, and to extend the pilot program

of the Short Sale Rule until November 1, 1998.

Background

On January 20, 1997, the Commission began phasing in new order

handling rules (``Order Handling Rules''), which,

[[Page 16844]]

among other things, require Nasdaq market makers to display in their

quotes customer limit orders that improve the market maker's quoted

price or size.\12\ With the implementation of the Order Handling Rules,

trading in Nasdaq migrated to a more order-driven, rather than quote-

driven, environment because market maker's now are required to reflect

customer limit orders (not only proprietary interests) in their

quotations. The implementation of the Order Handling Rules, however,

rendered the PMM standards significantly less relevant because the

criteria in NASD Rule 4612 \13\ were premised on a quote-driven market;

that is, these standards were based primarily on a market maker's

quotes in relation to the inside quote and the quotes of other market

makers, and the ratio of executions to quote changes.\14\ Accordingly,

these PMM standards were suspended from February 3, 1997, through April

1, 1998,\15\ during which time all market makers have qualified as PMMs

and have been able to avail themselves of the PMM exemption to the

NASD's short sale rule.\16\

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\12\ See Securities Exchange Act Release No. 37619A (September

6, 1996) 61 FR 48290 (September 12, 1996) (``Order Handling Rules

Adopting Release''). Specifically, the SEC adopted Rule 11Ac1-4, the

Limit Order Display Rule, which requires the display of customer

limit orders: (1) that are priced better than a market maker's

quote; or (2) that add to the size of a market maker's quote when

the market maker is at the best price in the market. Id.

\13\ Under the suspended PMM standards in NASD Rule 4612, which

this proposal seeks to continue to suspend, a Nasdaq market maker is

deemed to be a PMM if it meets two of three criteria: (1) the market

maker maintained the best bid or best offer as shown on Nasdaq no

less than 35% of the time; (2) a market maker maintained a spread no

greater than 102% of the average dealer spread (``102% test''); and

(3) no more than 50% of a market maker's quotation changes occurred

without a trade execution. In addition, if a registered market maker

meets only one of the above criteria, it nevertheless qualifies if

the market maker accounts for volume at least 1\1/2\ times its

proportionate share of overall volume in the stock.

\14\ Specifically, the implementation of the Order Handling

Rules raised the following concerns with the PMM standards in NASD

Rule 4612: (1) it became impossible to tell when market maker quote

changes were being driven by customer interests that are entered and

then subsequently canceled without any execution, thus making it

difficult for market makers to meet the 102% test; (2) the test

regarding the percentage of time in which the market maker's quote

was at the inside became less relevant because market maker quotes

were driven to an extent by customer limit orders; and (3) SOES

decrementation had a significant impact on individual market maker

quotations as they could be decreased to zero and automatically

refreshed at a designated price. See Securities Exchange Act Release

No. 38294 (February 14, 1997) 62 FR 8289 (February 24, 1997) (order

granting temporary accelerated approval of suspension of PMM

standards).

\15\ Id.; Securities Exchange Act Release No. 39198 (October 3,

1997) 62 FR 53365 (October 14, 1997) (order granting temporary

accelerated approval of continuing suspension of PMM standards until

April 1, 1998; File No. SR-NASD-97-73).

\16\ This exemption to NASD Rule 3350 allows ``qualified''

market makers (i.e., PMMs) to sell short on a down bid (i.e., when

the current bid is lower than the previous inside bid) when engaging

in bona fide market making activity. See NASD Rule 3350(c)(1).

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Since February 1997, the NASD and Nasdaq have worked to develop PMM

standards that are more meaningful in an order-driven environment and

better identify firms that are engaging in responsible market maker

activity deserving of the benefits associated with being a PMM, such as

being exempt from the short sale rule. The proposed PMM standards

reward market makers that provide meaningful liquidity to the market

based on the market makers' buying and selling activity in up and down

markets and their relative buying and selling activity (in terms of

share-volume and trading) in comparison to other market makers.

Specifically, to determine whether the market maker is a provider

of liquidity, Nasdaq applies the net liquidity ratio (``NLR'' or ``NLR

Test''). As explained below, a market maker must meet a certain

numerical threshold to be considered a provider of liquidity, and thus

``pass'' the NLR threshold. Next, Nasdaq calculates a market maker's

proportionate share of proprietary share-volume (``proportionate

volume'') and proportionate share of proprietary trades

(``proportionate trades'') \17\ in a stock, and determines whether the

market maker needs a certain numerical threshold for proportionate

volume or a certain numerical threshold for proportionate trades

(collectively, the ``Proportionality Test'').\18\ If the market maker

passes both the NLR and Proportionality Tests, the market maker

qualifies as a PMM. As further described below, the proposed rule

contains alternative approaches for stocks where the number of market

makers meeting the NLR and Proportionality Tests is less than 50% of

registered market makers and for stocks with fewer than eight

registered market makers.

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\17\ A market maker's proportionate volume shall be determined

by: dividing the market maker's total proprietary share-volume in a

stock by all market maker proprietary share-volume for that stock;

and then multiplying that ratio by the total number of registered

market makers in the stock. A market maker's proportionate trades

shall be determined by: dividing the market maker's total number of

proprietary trades in a stock by the total number of proprietary

trades by all market makers in that stock; and then multiplying that

ratio by the total number of registered market makers in the stock.

For example, if a market maker transacts 10% of the total

proprietary share-volume in a stock with 10 registered market

makers, the market maker's proportionate volume would be 1.0.

\18\ The threshold for proportionate volume and proportionate

trades shall be 1.0 for each. Accordingly, a market maker must

account for at least one time its proportionate share of all share-

volume in the stock or its proportionate share of all trades for the

stock during the review period. For example, if during the review

period a stock had 10 market makers and had an overall share-volume

of 1,000,000 shares an 15,000 trades, a market maker would have to

transact one-tenth of all share-volume or trades--100,000 in share-

volume or 1,500 trades.

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NLR Test and Proportionality Test. Under the NLR Test, Nasdaq first

determines the direction of the market (i.e., whether the market is

``up'' or ``down''),\19\ and then examines whether the market maker is

engaging in liquidity-providing activity during up and down market

periods. Specifically, a market maker will receive credit for all

proprietary purchases in down markets, and all proprietary sales during

up markets. The accumulated proprietary share-volume of these liquidity

trades is divided by the total proprietary volume traded during up and

down markets, excluding volume during neutral periods, sales at the

inside offer during down markets, and purchases at the inside bid

during up markets.\20\ The NASD and Nasdaq believe that these trades

demonstrate a positive liquidity contribution to the market; that is,

the market maker is providing liquidity and market stabilization by

buying during down markets (when there is significant selling

interest), and by selling in up markets (when there is significant

buying interest). The resulting number provides an NLR with a potential

value between 0 an 1. An NLR of 1.0, for example, indicates that each

transaction was done in a liquidity-providing, stabilizing manner.

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\19\ For the purposes of calculating NLR, the direction of the

market is defined by looking at the five minute period prior to the

trade report. If there has been no change in the bid price during

that time, the last bid direction governs. That is, if the current

best (inside) bid displayed in Nasdaq is below the preceding best

(inside) bid (``down bid''), the market is deemed down. If the

current best (inside) bid displayed in Nasdaq is above the preceding

best (inside) bid (``up bid''), the market is deemed up. If there

has been a change during the previous five minutes, then the formula

looks to the prior four changes and takes the predominant direction

as the indicator. Thus, if at least three of the last four changes

are down bids the market is deemed down. If at least three of the

last four changes are up bids the market is deemed up. If the

changes are evenly split, the market is deemed neutral.

\20\ These trades are included neither in the equation's

numerator nor the equation's denominator because they do not clearly

demonstrate that the market maker is providing stabilizing liquidity

to the market. Because these trades are eliminated from the

equation, they count neither for nor against a market maker in

calculating the market maker's NLR.

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After the NLR is calculated, Nasdaq applies the Proportionality

Test and examines whether the market maker transacts either its

proportionate volume or its proportionate trades for the

[[Page 16845]]

security at issue. The Proportionality Test recognizes that market

makers may add to liquidity by effecting specified levels of share-

volume or trades. Similarly, this test takes into account situations in

which a stock may have a few lead market makers that transact a large

percentage of the share-volume (thus providing liquidity), but also may

have other market makers that effect a fair share of trades--but a

comparatively lower percentage of share-volume--in the stock (thus also

providing liquidity).\21\ A market maker automatically will qualify as

a PMM in a particular stock if the market maker: (1) passes the NLR

Test by achieving a liquidity ratio of 0.67 or greater; and (2) passes

the Proportionality Test by transacting either the market maker's

proportionate volume or proportionate trades.

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\21\ For example, Stock X has 12 market makers. Market makers

ABCD and EFGH attract a large percentage of order flow from

institutions and account for 30% of the share-volume, but only 15

percent of the trades in the stock. Market makers QRST and UVWX

attract a high percent of retail order flow and thus account for 30%

of the trades, but account only for 15% of the share-volume of the

stock. Each of these market makers provides liquidity to the market,

and each would receive credit under the formula.

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50% Analysis. If after the application of the NLR and

Proportionality Tests, the number of firms earning PMM status is less

than 50% of all registered market makers in a stock, Nasdaq will

augment the number of PMMs using the following method. If there are

market makers that meet the NLR Test but not the Proportionality Test

(``Remaining Market Makers''), Nasdaq will calculate the number of

market makers that will bring the total number of PMMs to 50% of all

registered market makers in the stock.\22\ (If there are no market

makers that meet the NLR, Nasdaq will not apply the ``50% Analysis''

and will not augment the number of PMMs.) Nasdaq then will rank these

Remaining Market Makers by proportionate volume, and will designate

(from highest to lowest ranked) the Remaining Market Makers as PMMs

until the total number of PMMs (i.e., those market makers that meet

both the NLR and Proportionality Tests an the top-ranked Remaining

Market Makers by proportionate volume) reaches a number not more than

50% of all registered market makers.\23\ Nasdaq also will rank the

Remaining Market Makers by proportionate trades, and will designate

these Remaining Market Makers as PMMs until the total number of PMMs

(i.e., those market makers that meet both the NLR and Proportionality

Tests and the top-ranked Remaining Market Makers by proportionate

trades) reaches a number not more than 50% of all registered market

makers.\24\

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\22\ For example, if Stock Q has 24 market makers, and 9 meet

the NLR and Proportionality tests, there would be 3 open slots which

could be filled when the Remaining Market Makers were ranked by

volume and then by trades.

\23\ The 50% levels shall be fixed and not subject to

modification by Nasdaq, so that if a market maker meets the NLR

threshold and falls within the top 50% of market makers when ranked

by proportionate volume or the top 50%of market makers when ranked

by proportionate trades, the market maker automatically shall be

designated as a PMM. The only instance in which Nasdaq would

designate PMMs in an amount less than 50% of all registered market

makers, would be if less than 50% of the registered market makers

achieve the NLR.

\24\ Under the 50% Analysis, the group of market makers

designated as PMMs by volume and then by trades may not be the same,

and thus the final number of PMMs may be more than 50% of the total

number of market makers. Conversely, the number of PMMs may be less

than 50% of all market makers because all PMMs must meet the NLR

threshold. For example, Stock Q has 24 market makers, and 9 market

makers are PMMs because they meet both the NLR and the

Proportionality Test. If no other market maker (aside from the 9

PMMs) meet the NLR threshold, no other market makers will be

designated as PMMs. If there are 3 or more market makers that meet

the NLR, then these Remaining Market makers will be ranked by

proportionate volume and then by proportionate trades and the top 3

from each of these two groups (which may or may not overlap in

identity) will be designated as PMMs.

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Securities with Eight or Fewer Market Makers. If the number of

market makers in a particular NNM security is eight or fewer, a market

maker will earn PMM status by satisfying the NLR threshold only. Thus,

for stocks with eight or fewer market makers, Nasdaq will consider

neither volume nor trades in determining PMM status. The NASD and

Nasdaq believe that this approach is appropriate because it makes the

PMM status more attainable in these circumstances and gives firms an

incentive to make markets in smaller or less widely-covered securities.

One Month Look-Back Provision. Proposed NASD Rule 4612 generally

provides that a market maker may qualify as a PMM for a particular

stock if the market maker meets the applicable thresholds for the

particular stock during the review period, which generally is one

calendar month. The proposed rule, however, contains a one-month

``look-back'' provision. Under this provision, Nasdaq will consider the

previous calendar month and the current month to determine a market

maker's continued PMM eligibility if the market maker attained PMM

status in a security during the previous month, but fails to meet the

applicable thresholds for the current month. Specifically, if a market

maker that is a PPM fails to meet the applicable thresholds during a

given month (and thus would lose its PMM status for the next month)

Nasdaq will: (1) calculate the market maker's NLR and proportionate

volume and trade levels for the month in question (using trade data up

to and including the last trading day of the month) and the prior

month; and (2) use these figures to determine if the market maker meets

the PMM thresholds. Thus, a market maker will retain its PMM status if,

based on the NLR and proportionate trade and volume numbers for the

month at issue and the previous month, the market maker meets the

applicable PMM thresholds.\25\ In effect, this retains the requirement

that a market maker earn PPM status on a stock-by-stock basis, but

provides some flexibility in that short-term fluctuations or anomalies

in a market maker's performance are smoothed out over a longer period.

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\25\ Similar to the previous PMM standards, if the market maker

meets the PMM thresholds for the applicable review period, Nasdaq

will append a ``P'' next to the market maker's identification symbol

on the Nasdaq WorkStation beginning the first day of the next month.

Additionally, if a PMM fails to meet the thresholds for the

applicable review period, Nasdaq will notify the PMM of such failure

and remove the ``P'' designation on the next business day following

notification.

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Timing For Implementation of New PMM Standards. As proposed, the

new PMM standards will become effective May 1, 1998. The NASD and

Nasdaq note that currently all market makers registered in a security

are PMMs due to the suspension of previous PMM standards, and will

continue to be so designated on the pilot's proposed start date of May

1, 1998. The NASD and Nasdaq recognize that once the pilot begins on

May 1, 1998, PMMs will not have the ability to avail themselves of the

one-month look-back provision because there will be no meaningful

trading to analyze prior to May 1, 1998. Thus, in order to give PMMs

the full benefit of the one-month look-back period and to allow market

makers time to adjust their trading activity to the new standards, the

NASD and Nasdaq propose to implement the new standards so that no

market maker that is designated as a PMM when the pilot begins on May

1, 1998, will lose its PMM status--based on a failure to meet the new

PMM standards--until July 6, 1998. The NASD and Nasdaq believe that it

is fair to give market makers this time to adjust their training

activity before they lose their PMM designation, particularly since PMM

standards have been suspended for more than a year and since the new

PMMs are more stringent than the previous standards.\26\

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\26\ Subparagraph (f) of NASD Rule 4612 permits market makers to

request reconsideration of a notice to withhold PMM designation

based on a market maker's excused with drawal status. The NASD and

Nasdaq note that the rules governing withdrawals from market making

(i.e., NASD rules 4619-4620, and 4730) recently were amended. See

Securities Exchange Act Release No. 39423 (December 10, 1997) 62 FR

66160 (December 17, 1997). Furthermore, the NASD and Nasdaq recently

submitted a rule proposal (SR-NASD-98-17) to implement a new older

delivery and execution system to replace SelectNet and SOES. See

Securities Exchange Act Release No. 39718 (March 4, 1998) 63 FR

12124 (March 12, 1998). If approved, this proposal also would amend

the procedures relating to withdrawal for ``SOES-ed out of the box''

situations.

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[[Page 16846]]

Examples of Operation of Proposed PMM Standards. Below are examples

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of how the proposed new PMM standards will operate:

Example 1. Stock WXYZ has six market makers. Four market makers

achieve an NLR of at least .67 or above. Because WXYZ has less than

eight market makers, all four of the market makers with an NLR of at

least .67 will be designated as PMMs, regardless of their volume or

trades.

Example 2. Stock ABCD has 20 market makers; 11 market makers

achieve an NLR of at least .67 or above. Of those 11 market makers,

six transact at least their proportional level of share-volume or

trades. These six market makers automatically are designated as

PMMS. Because the number of market makers that meet both the NLR and

Proportionality Tests is less than 50% of the total number of

registered market makers in ABCD, Nasdaq will rank the remaining

market makers that have an NLR of at least .67 (five in total)

according to their proportionate level of share-volume. The top for

qualify, yielding a total of 10 PPMs (i.e., 50% of the total number

of market makers). Next, the same five market makers are ranked

according to the proportionate level of trades and the top four are

designated as PMMs. In this example, the four market makers chosen

by ranking by proportionate volume and the four market makers chosen

by ranking by proportionate trades are the same. Thus, the final

number of PMMs is 10, or 50% of the total number of registered

market makers.

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Proportionate Proportionate

Market makers in stock ABCD NLR volume trades PMM?

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Market Maker 1............................ .76 3.80 0.88 YES.

Market Maker 2............................ .78 1.58 1.07 YES.

Market Maker 3............................ .83 1.17 1.00 YES.

Market Maker 4............................ .81 0.80 1.48 YES.

Market Maker 5............................ .84 0.79 1.41 YES.

Market Maker 6............................ .82 0.97 1.01 YES.

Market Maker 7............................ .80 0.98 0.84 YES.

Market Maker 8............................ .87 0.65 0.61 YES.

Market Maker 9............................ .79 0.54 0.94 YES.

Market Maker 10........................... .85 0.51 0.69 YES.

Market Maker 11........................... .80 0.16 0.24 NO.

Market Maker 12........................... .65 3.94 2.83 NO.

Market Maker 13........................... .66 0.83 1.84 NO.

Market Maker 14........................... .65 0.67 0.94 NO.

Market Maker 15........................... .64 0.51 0.93 NO.

Market Maker 16........................... .61 0.41 0.84 NO.

Market Maker 17........................... .61 0.40 0.49 NO.

Market Maker 18........................... .58 0.70 0.95 NO.

Market Maker 19........................... .51 0.16 0.24 NO.

Market Maker 20........................... .48 0.01 0.02 NO.

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Example 3. Stock IJKL has 19 market makers; 11 market makers

have an NLR of .67 or better. Of those 11 market makers, six

transact at least their proportional level of share-volume or

trades. These six market makers automatically are designated as

PMMs. Because the number of market makers that meet both the NLR and

Proportionality Tests is less than 50% of the total number of

registered market makers in IJKL, Nasdaq will rank the remaining

market makers that have an NLR of at least .67 (five in total)

according to their proportionate level of share-volume. The top four

are designated as PMMs, thus yielding a total of 10 PMMs.\27\ Next,

the same five market makers are ranked according to their

proportionate level of trades and the top four are designated as

PMMs, thus yielding a total of 10 PMMs. Unlike Example 2, the four

market makers chosen by ranking by proportionate volume and the four

market makers chosen by ranking by proportionate trades are not the

same. Three of the four market makers (i.e., market makers 7, 8, and

9, listed below) are the same; market maker 10, however, is

designated as a PMM according to its proportionate volume and market

maker 11 is designated a PMM according to its proportionate trades.

Thus, the final number of PMMs is 11, or 55% of the total number of

registered market makers.

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\27\ This example illustrates that when there is an odd number

of registered market makers, Nasdaq rounds up to calculate the

``50%'' level (i.e., 50% level = (number of market makers + 1)/2).

That is, in example 3 where there are 19 registered market makers,

Nasdaq would round up and would have 10 possible PMM slots when

ranking by proportionate volume and would have 10 possible slots

when ranking by proportionate trades (i.e., (19 + 1)/2 = 10).

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Proportionate Proportionate

Market makers in stock IJKL NLR volume trades PMM?