[Federal Register Volume 59, Number 88 (Monday, May 9, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11075]
[[Page Unknown]]
[Federal Register: May 9, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34000; File No. SR-NASD-93-61]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc; Order Instituting Proceedings to Determine Whether to
Disapprove Rule Change Relating to the SelectNet Service
May 3, 1994.
I. Introduction
On November 1, 1993, the National Association of Securities
Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities
and Exchange Commission (``Commission'' or ``SEC''), pursuant to
section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') and
Rule 19b-4 thereunder, a proposed rule change to modify the operational
features of the SelectNet service.\1\ The NASD is proposing to install
a price validation screen that will prohibit entry of orders into
SelectNet priced away from the inside market on Nasdaq. If approved,
the NASD will amend the SelectNet User Guide to clarify that orders
entered into SelectNet during normal market hours (9:30 a.m. to 4 p.m.)
will be prohibited by the system if the orders are priced outside the
best bid or offer in the Nasdaq system, unless unusual market
conditions, such as locked, crossed, one-side, or no-quote markets
exist in a security.
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\1\The NASD originally filed the proposed rule change on October
25, 1993 pursuant to section 19(b)(3)(A) of the Act. On October 29,
1993, the Commission issued an Order of Summary Abrogation
abrogating the NASD's October 25th rule change. The Commission's
Order of Summary Abrogation suggested that the procedures provided
by section 19(b)(2) of the Act provide a more appropriate mechanism
for determining whether the NASD's rule change is consistent with
the Act. Thus, on November 1, 1993, the NASD refiled its rule change
under section 19(b)(2).
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Notice of the proposed rule change appeared in the Federal Register
on November 9, 1993.\2\ Three comments opposing the NASD's proposal
were received in response to the Commission release. The substance of
these comments is discussed in detail below.
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\2\Securities Exchange Act Release No. 33141 (Nov. 3, 1993), 58
FR 59504 (Nov. 9, 1993).
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II. Description of SelectNet's Prohibition Against Entering Orders
Outside the Inside Nasdaq Market
In response to the difficulties experienced in the Nasdaq market
during the market break of October 1987, the NASD developed an
auxiliary service, the Order Confirmation Transaction Service
(``OCT''), to process orders during market extremes by providing an
alternative method of negotiating trades when traditional telephone
negotiation is difficult or infeasible. The Commission originally
approved OCT in January 1988.\3\ OCT, renamed SelectNet in 1990,
currently operates from 9 a.m. to 5:15 p.m. Eastern Time,\4\ and
increases communications capacity by enabling eligible firms to enter
electronic messages. SelectNet supports the continuous, orderly
operation of the Nasdaq Stock Market during difficult or unusual market
conditions. Since in inception, the NASD has enhanced SelectNet in an
effort to provide greater flexibility in the automated execution of
orders and to facilitate market maker's and order entry firms'
(collectively referred to as ``participants'') use of SelectNet.\5\
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\3\Securities Exchange Act Release No. 25263 (Jan. 11, 1988), 53
FR 1430 (Jan. 19, 1988) (order approving SelectNet, previously
referred to as the Order Confirmation Transaction Service, on a
Temporary accelerated basis). See also, Securities Exchange Act
Release No. 25523 (Mar. 28, 1988), 53 FR 10965 (Apr. 4, 1988) (order
extending temporary approval of SelectNet); Securities Exchange Act
Release No. 25690 (May 11, 1988), 53 FR 17523 (May 17, 1988) (order
granting permanent approval of SelectNet).
\4\Securities Exchange Act Release No. 30581 (Apr. 14, 1992), 57
FR 14596 (Apr. 21, 1992).
\5\Securities Exchange Act Release No. 28636 (Nov. 21, 1990), 55
FR 49732 (Nov. 30, 1990).
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The service currently allows participants to broadcast orders to
all market makers in a security or direct order to a specific market
maker. In addition, market makers can broadcast to all participants
watching a particular security (a feature known as ``all call''). To
enter an order in SelectNet, a participant enters the normal trade
information (i.e., security symbol, side, size, and price). In
addition, the participant may provide that an order or counter-offer
will be in effect for anywhere from 3 to 99 minutes, specify a day
order, or indicate whether price and/or size are negotiable or whether
a specific minimum quantity is acceptable.\6\ Participants may accept,
counter or decline a SelectNet order. In the event that a participant
elects to counter an offer, the service allows negotiations to be
conducted between the participants by exchanging counter-offers until
an agreement is reached.
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\6\The identity of a participant entering an order is anonymous
when broadcasting an order, unless the participant elects to
identify itself; once the order is executed, each participant to the
transaction learns of the identity of the other. In contrast, the
recipient of a directed order is provided with the identity of the
participant who sent the order.
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A. The NASD's Basis for the Prohibition
The NASD seeks to amend the SelectNet operating manual\7\ to
prohibit entry of orders in SelectNet priced outside the inside Nasdaq
market during normal market hours (:30 a.m. to 4 p.m.), unless unusual
market conditions, such as locked, crossed, one-sided, or no-quote
markets exist in a security. The NASD had represented that it is
proposing to prohibit entry of orders priced outside the inside Nasdaq
market to eliminate a large number of what it believes to be erroneous
transactions occurring through the service.
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\7\The current SelectNet rules are contained in the SelectNet
User Guide, but are not included in the NASD Manual. See SelectNet
User Guide (Nov. 1990). The NASD has represented that it will update
these rules and submit, by March 31, 1994, a rule filing, pursuant
to section 19(d) of the Act and Rule 19b-4 thereunder, to
incorporate the SelectNet rules into the NASD Manual. Letter from
Beth E. Weimer, Associate General Counsel, NASD, to Selwyn
Notelovitz, Branch Chief, SEC (Jan. 14, 1994). To date, the
Commission has not received this filing.
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The NASD believes that these orders are put into SelectNet in two
ways: (1) as errors, where the party intended to place the order at or
within the inside bid and offer and mistyped the trade information into
SelectNet, ignored the reverse colored warning screen and instructed
the computer to override the warning, or (2) as a ``concerted attempt
to trick'' recipients of the orders into executing obviously erroneous
trades.\8\
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\8\For example, if the inside market in a Nasdaq security is 20
bid, 20\1/4\ offer, and order entry firm may place an order to buy
stock priced at 19\1/8\. According to the NASD, traders
traditionally deal in fractions, frequently not even stating the
integer amount of a price when transacting business over the
telephone, and an order priced at 19\1/8\ could be read or
interpreted as 20\1/8\. Thus, the market maker would accept the
order, believing that it was executing an order priced within the
spread, at 20\1/8\. Instead, the market maker would have executed
the order a full point below the price it thought it was getting,
and \7/8\ of a point below the best bid.
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In support of its position, the NASD included in its filing with
the Commission part of the results of an analysis of SelectNet orders
and trades during September 1993. According to the NASD, the analysis
demonstrates that, on average, over 1,000 orders a day are placed in
SelectNet at prices outside the inside Nasdaq market. According to the
NASD, this resulted, on average, in more than 100 executions a day at
prices the NASD has concluded, without input from the parties of the
transactions, are erroneous and wholly unrelated to current market
prices. The NASD further represented that during September 1993 it
received, in total, 46 requests to reverse trades as clearly
erroneous,\9\ notwithstanding the daily average of 100 executions at
prices outside the inside Nasdaq market.
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\9\Letter from Robert E. Aber, Vice president and General
Counsel, NASD, to Selwyn Notelovitz, Branch Chief, SEC (Jan. 14,
1994).
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Subsequently, the NASD provided the Commission with more specific
information concerning the NASD's analysis of SelectNet orders and
trades during September 1993.\10\ This information indicated that
during the month, 34,957 (on average, 1.665/day) orders were entered in
SelectNet outside the inside Nasdaq Market and that 2,802 (on average,
133/day) of these orders were executed. In addition, this information
indicated that during September 1993 the NASD received 44 requests to
deem trades clearly erroneous where the trade occurred outside the
inside Nasdaq Market. This information further indicated that the NASD
granted 32 of these requests.
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\10\Letter from Beth E. Weimer, Associate General Counsel, NASD,
to Selwyn Notelovitz, Branch Chief, SEC (Mar. 7, 1994). In its
letter to the Commission, the NASD requested confidential treatment
of the information accompanying its letter. The NASD requested this
treatment pursuant to 17 CFR 204.24b-2 and Exemption 4 of the
Freedom of Information Act (5 U.S.C. Sec. 552(b)(4)).
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B. Exceptions to the Prohibition
The NASD has determined to allow entry of orders on SelectNet
outside the inside Nasdaq market under three circumstances. Any order
entered during an exception period, described below, will remain active
in SelectNet even after the exception period has passed.
1. Pre-Opening and Post-Closing Exception
Because the inside Nasdaq market during non-market periods might
not reflect current market conditions and, therefore, may be one-sided
or may simply reflect the closing bid and offer on Nasdaq, the
prohibition of entering orders outside the inside Nasdaq market will
only be in effect during normal market hours (i.e., 9:30 a.m. until 4
p.m.)
2. Exception for Locked, Crossed, One-Sided Quote or No Quote Markets
If the market in a security becomes locked or crossed or
experiences a one-sided quote or no quote, the NASD will allow entry or
orders outside the inside Nasdaq market. In the event of these unusual
market conditions, SelectNet will be programmed to lift the prohibition
automatically for that security until the unusual condition no longer
exists.
3. Exception for Emergency Conditions or Extraordinary Market
Conditions
Under Article VII, Section 3 of the NASD By-Laws,\11\ the NASD will
retain authority to lift the prohibition during an emergency or when
extraordinary market conditions exist.\12\
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\11\NASD Manual, By-Laws, Art. VII, Sec. 3, (CCH) 1182A.
\12\``Emergency conditions'' include unexpected events such as a
declaration of war, a presidential assassination or an electrical
black-out. ``Extraordinary market conditions'' include market breaks
(such as October 1987), market declines and any other occasions
where the market is experiencing highly volatile trading conditions
such that prompt intervention is necessary for the market's
continued efficient operation. Securities Exchange Act Release No.
26072 (Sept. 12, 1988), 53 FR 36143 (Sept. 16, 1988) (order
approving rule to provide the NASD Board of Governors and a proposed
committee the authority to take action during an emergency or under
extraordinary market conditions). See also, Securities Exchange Act
Release No. 33292 (Dec. 6, 1993), 58 FR 65214 (Dec. 13, 1993) (NASD
Policy Statement on Market Closings in the event of an emergency or
extraordinary market conditions).
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III. Comment Letters
The Commission received three comments letters in response to the
NASD's proposed rule change.\13\ Two of these commenters opposed
approval of the NASD's proposed rule change. Without explicitly
opposing the NASD's proposed change, the third commenter generally
criticized the SelectNet Service and used its response to the NASD's
filing to support its continuing contention that SelectNet is a
``quotation driven trading system'' rather than a communication system.
The NASD responded to the issues raised by the commenters in a letter
dated January 14, 1994.\14\
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\13\Letter from James E. Buck, Senior Vice President and
Secretary, New York Stock Exchange (``NYSE''), to Jonathan Katz,
Secretary, SEC (Nov. 30, 1993). The NYSE's letter also referred to
another pending NASD proposed rule change which would include
exchange listed securities in SelectNet (File No. SR-NASD-92-16).
The focus of the NYSE's letter concerned SR-NASD-92-16 and SelectNet
in general.
\14\Letter from Robert E. Aber, Vice President and General
Counsel, NASD, to Selwyn J. Notelovitz, Branch Chief, SEC (Jan. 14,
1994).
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One commenter opposing the proposal argued that there are
legitimate risk management and trading strategies that involve entering
orders outside the inside Nasdaq market.\15\ Another commenter opposing
the proposal argued that entering orders outside the inside market is
typical practice when dealing with large retail orders and during
volatile market conditions.\16\ This commenter took further exception
with the NASD's assertion that it must review and reverse as clearly
erroneous many of the orders executed outside the inside Nasdaq market,
offering examples of instances where the NASD refused to reverse a
trade executed outside the inside Nasdaq market. In addition, this
commenter argued that the NASD's proposed prohibition is not necessary
because SelectNet includes a feature that alerts participants who
accept orders priced outside the inside market and requires
confirmation of the participant's acceptance of such orders.
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\15\Letter from Harold S. Bradley, Vice President and Director
of Trading, Investors Research Corporation, to Jonathan G. Katz,
Secretary, SEC (Dec. 8, 1993).
\16\Letter from Simon S. Kogan to Margaret McFarland, Deputy
Secretary, SEC (Dec. 1, 1993).
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In response, the NASD acknowledged that legitimate bases exist for
entering orders outside the inside Nasdaq market.\17\ Nonetheless, the
NASD has determined that on balance, the benefits of the prohibition
outweigh the costs. The NASD argued that erroneous trades are costly to
the industry and, when reported to the tape, mislead and confuse
issuers and investors. Moreover, the NASD pointed out that the
alternative of negotiating a trade outside the inside Nasdaq market
over the telephone remains.
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\17\Letter from Robert E. Aber, Vice President and General
Counsel, The Nasdaq Stock Market, Inc., to Selwyn Notelovitz, Branch
Chief, SEC (Jan. 14, 1994).
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IV. Proceedings to Determine Whether to Disapprove SR-NASD-93-61
and Grounds for Disapproval Under Consideration
The NASD's proposal is presented as an effort to prevent market
makers from inadvertently executing SelectNet orders at prices outside
the inside market. Nevertheless, prohibiting the entry of SelectNet
orders at prices outside the inside market may be neither the most
effective means of accomplishing this objective nor the least
restrictive. Accordingly, the Commission is interested in the reasons
market participants may have for entering SelectNet orders outside the
inside market, and whether there may be less restrictive means of
preventing erroneous trades.
The Commission, therefore, is instituting proceedings pursuant to
Section 19(b)(2)(B) of the Act to determine whether the proposed rule
change should be disapproved. Institution of disapproval proceedings
appears appropriate at this time in view of the legal and policy issues
raised by the proposal. Institution of disapproval proceedings,
however, does not indicate that the Commission has formulated any
conclusions with respect to any of the issues involved and the
Commission seeks and encourages interested persons to comment on the
proposed rule change. The sections of the Act applicable to the
proposed rule change include:
Section 15A(b)(6), which requires that the rules of a national
securities association, among other things, 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, processing
information with respect to, and facilitating transactions in
securities, and to remove impediments to and perfect the mechanism of a
free and open market.
Section 11A(a)(1)(B), which sets forth the Congressional
finding that new data processing and communications techniques create
the opportunity for more efficient and effective market operations.
Section 11A(a)(1)(C), which sets forth the Congressional
finding that it is in the public interest to assure economically
efficient execution of securities transactions.
Section 11A(a)(2), which directs the Commission to facilitate
the establishment of a national market system for securities in
accordance with the findings set forth in Sections 11A(a)(1) (B) and
(C).
With respect to the proposal, the Commission specifically requests
that commenters address, if applicable, the following items:
(a) The NASD acknowledges that legitimate bases exist for entering
SelectNet orders at prices outside the inside market. These could
include: (i) Communicating limit orders to market makers; (ii)
negotiating large block transactions; (iii) obtaining executions in
fast markets; or (iv) exploring the level of market interest at the
prices quoted in Nasdaq. The Commission invites comment on the
circumstances in which a market maker or customer would use SelectNet
to enter orders outside the inside market.
(b) The NASD submitted data indicating that during the month of
September 1993, although approximately 130 trades are executed daily
(2,730 per month) through SelectNet outside the inside market, it
received a total of only 44 requests to reverse trades as clearly
erroneous and granted 32 of these requests. One commenter opposed to
the proposal submitted copies of two NASD decisions upholding trades
executed through SelectNet outside the inside market. As such, the
Commission invites commenters to discuss whether such decisions reflect
aberrations based on special circumstances or reflect legitimate use of
SelectNet and of the Nasdaq market. The Commission also invites
SelectNet users to discuss whether they cancel executions outside the
inside by agreement with the other party (and therefore not reflected
in the NASD's data) and/or if they choose not to cancel/seek reversal
for other reasons (e.g., determination that cancelling/reversing is not
worth the administrative cost).
(c) The Commission invites suggestions for alternative means to
prevent erroneous SelectNet executions, such as the development by
member firms of facilities for preventing inadvertent executions.
(d) The extent, if any, to which investors may be confused by
reports to the type of trades effected outside the inside Nasdaq market
using SelectNet.
(e) The potential benefits of the proposal and whether those
benefits outweigh any costs or burdens imposed on members and/or public
customers.
(f) Order delivery systems exist in and among other markets. The
rules of some of these systems, such as the Intermarket Trading System
(ITS), prohibit limit orders and create a conclusive presumption that
an order executed outside the inside bid or offer is an obvious error.
Other systems, on the other hand, such as the New York Stock Exchange's
SuperDot System, allow limit orders and have no restrictions on the
price of orders. The Commission invites commenters to discuss the
distinctions among these systems with respect to the issues raised by
the NASD.
V. Procedure: Request for Written Comments
The Commission requests that interested persons provide written
submissions of their views, data and arguments with respect to the
concerns identified above as well as any other relevant concerns. In
particular, the Commission invites the written views of interested
persons concerning whether the proposed rule change is inconsistent
with the provisions of the Act and the rules and regulations
thereunder, specifically sections 15A(b)(6), 11A(a)(1) (B), and (C).
Although there do not appear to be any issues relevant to approval or
disapproval which would be facilitated by an oral presentation of
views, arguments and data, the Commission will consider, pursuant to
Rule 19b-4, any request for an opportunity to make an oral
presentation.\18\
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\18\Section 19(b)(2) of the Act, as amended by the Securities
Acts Amendments of 1975, Pub. L. 94-29 (June 4, 1975), grants the
Commission flexibility to determine what type of proceeding--either
oral or notice and opportunity for written comments--is appropriate
for consideration of a particular proposal by a self-regulatory
organization. See Securities Acts Amendments of 1975, Senate Comm.
on Banking, Housing & Urban Affairs, S. Rep. No. 75, 94th Cong., 1st
Sess. 30 (1975).
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Interested persons are invited to submit written data, views and
arguments regarding the proposed rule change by June 8, 1994. Section
19(b)(2) of the Act requires that proceedings to determine whether to
disapprove a proposed rule change be concluded within 180 days of the
date of publication of notice of the filing of the proposed rule
change, unless the Commission finds good cause to extend the time for
the conclusion of such proceedings. To provide ample opportunity for
commenters to submit views and for the Commission to give consideration
of these views, the Commission finds good cause to extend the time for
the conclusion of the proceedings.
Persons desiring to submit written data, views and arguments should
file six copies thereof with the Secretary of the Commission,
Securities and Exchange Commission, 450 Fifth Street, NW., Washington,
DC 20549. Reference should be made to File No. SR-NASD-93-61.
Copies of the submission, all subsequent amendments, all written
statements with respect to the proposed rule change which are filed
with the Commission, and all written communications relating to the
proposed rule change between the Commission and any person, other than
those which may be withheld from the public in accordance with the
provisions of 5 U.S.C. 552, will be available for inspection and
copying at the Commission's Public Reference Room. Copies of the filing
and of any subsequent amendments also will be available at the
principal office of the NASD.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-11075 Filed 5-6-94; 8:45 am]
BILLING CODE 8010-01-M