[Federal Register Volume 63, Number 49 (Friday, March 13, 1998)]
[Notices]
[Pages 12559-12569]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-6528]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39729; File No. SR-NASD-97-56]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Amendment No. 1 Thereto and Notice of Filing and Order
Granting Accelerated Approval to Amendment Nos. 2, 3, 4, 5, and 6 to
Proposed Rule Change by the National Association of Securities Dealers,
Inc., To Amend Rule 3110 and to Adopt New Rules 6950 Through 6957
Relating to the Creation of an Order Audit Rail System
March 6, 1998.
I. Introduction
On July 29, 1997, NASD Regulation, Inc. (``NASDR''), a wholly-owned
subsidiary of the National Association of Securities Dealers, Inc.
(``NASD'' or ``Association''), submitted to the Securities and Exchange
Commission (``SEC'' or ``Commission'') on behalf of the NASD, pursuant
to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to
adopt new rules relating to the creation of an order audit trail system
(``Order Audit Trail System'' or ``OATS''). On August 25, 1997, the
NASDR submitted Amendment No. 1 to the proposed rule change.\3\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Letter from Joan C. Conley, Corporate Secretary, NASDR,
to Katherine A. England, Assistant Director, Division of Market
Regulation (``Division''), Commission, dated August 25, 1997
(``Amendment No. 1''). In addition to proposing technical
corrections, Amendment No. 1: (1) expands the proposal's definition
of ``order,'' (2) clarified that the proposed requirements of Rule
3110(c) (regarding required books and records) would be temporary
and only in effect from January 1, 1999, to January 31, 2000; (3)
conforms the discussion section to the language of the proposed rule
regarding effective dates for orders other than electronic orders;
and (4) notices that the NASDR consulted generally with industry
representatives and received a number of comment letters. The
changes proposed in Amendment NO. 1 were incorporated into the
Commission's notice of filing of the proposal prior to its
publication in the Federal Register.
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The proposed rule change was published for comment in the Federal
[[Page 12560]]
Register on September 5, 1997.\4\ The Commission received eighteen
comments on the proposal.\5\ On October 9, 1997, the NASDR filed
Amendment No. 2 to the proposed rule change.\6\ The NASDR filed
Amendment No. 3 to the proposed rule change on October 29, 1997.\7\ On
February 3, 1998, the NASDR filed Amendment No. 4 to the proposed rule
change.\8\ The NASDR filed Amendment No. 5 to the proposed rule change
on February 11, 1998.\9\ On March 5, 1998, the NASDR filed Amendment
No. 6 to the proposed rule change.\10\ This order approves the proposed
rule change and Amendment No. 1. In addition, the Commission is
publishing this notice to solicit comments on Amendment Nos. 2, 3, 4,
5, and 6 to the proposed rule change and is simultaneously approving
those amendments on an accelerated basis.
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\4\ See Securities Exchange Act Release No. 38990 (August 28,
1997) 62 FR 47096.
\5\ See Letters to Jonathan G. Katz, Secretary, Commission from:
Edward J. Johnsen, Vice President and Assistant General Counsel and
Christopher R. Franke, Vice President and Compliance Manager, J.P,
Morgan Securities, Inc. (``J.P. Morgan''), dated September 25, 1997;
John B. Morgan, Director of Legal and Compliance, Mabon Securities
Corp. (``Mabon''), dated September 24, 1997; John A. Goc, Senior
Vice President, Equity Trading, Boston Institutional Services
(``BIS''), dated September 19, 1997; Steven Alan Bennett, Senior
Vice President and General Counsel, Banc One Corporation (``Banc
One''), dated September 26, 1997; H. Michael Reese, Chief Financial
Officer, HBK Finance L.P. (``HBK Finance''), dated September 23,
1997; Allen J. Thomas, Vice President, A.G. Edwards & Sons, Inc.
(``A.G. Edwards''), dated September 26, 1997; Charles R. Hood,
Senior Vice President and General Counsel, Instinet Corporation
(``Instinet''), dated September 26, 1997; Brooke Berstein, Vice
President and Counsel, Morgan Stanley & Co. Inc. (``Morgan
Stanley''), dated September 29, 1997; James M. Davis, Managing
Director of Compliance, The Franklin Templeton Group (``Franklin
Templeton''), dated September 26, 1997; Richard O. Scribner,
Director for Regulation, Salomon Brothers, Inc. (``Salomon Bros.''),
dated September 30, 1997; Timothy F. McCarthy, Charles Schwab & Co.,
Inc. (``Schwab''), dated September 30, 1997; Bernard L. Madoff,
Chair, OATS Ad Hoc Committee, Securities Industry Association
(``SIA''), dated October 6, 1997; James R. Orvis, Senior Vice
President and Director of Operations, Advest, Inc. (``Advest''),
dated October 7m 1997; John M. Ivan, Managing Director Compliance,
Wheat First Butcher Singer (``Wheat First''), dated October 10,
1997; Robert B. Sloan, Partner, Director/Information Services, J.C.
Bradford & Co. (``J.C. Bradford''), dated October 8, 1997; John J.
Sanders, Jr., Principal, BancAmerica Robertson Stephens
(``BancAmerica''), dated October 6, 1997; Kathryn G. Casparian,
Director of Regulatory Affairs, Oppenheimer & Co., Inc.
(``Oppenheimer''), dated October 15, 1997; and Robert E. Maina,
First Vice President, Merrill Lynch (``Merrill Lynch''), dated
October 17, 1997. Two additional letters were forwarded to the
Commission subsequent to the close of the comment period. These
consist of a letter from Bernard L. Madoff, Chair, OATS Ad Hoc
Committee, SIA, to Richard G. Ketchum, Executive Vice President and
Chief Operating Officer, NASD, dated December 3, 1997 and a letter
to James M. Cangiano, Senior Vice President, Market Regulation,
NASDR, from Charles R. Hood, Senior Vice President and General
Counsel, Instine, date November 25, 1997.
\6\ See Letter from John M. Ramsay, Deputy General Counsel,
NASDR, to Katherine A. England, Assistant Director, Division
Commission, dated October 7, 1997 (``Amendment No. 2''). In
Amendment No. 2, the NASDR consent to an extension of the time
periods specified in Section 19(b)(2) of the Act.
\7\ See Letter from Joan C. Conley, Corporate Secretary, NASDR,
to Katherine A. England, Division, Commission, dated October 28,
1997 (``Amendment No. 3''). In Amendment No. 3, the NASDR proposes
to modify the numbering of the text of the proposed rules from 6900
through 6970 to 6950 through 6957.
\8\ See Letter from Mary N. Revell, Associate General Counsel,
NASDR, to Howard Kramer, Associate Director, Division, Commission,
dated February 3, 1998 (``Amendment No. 4''). In Amendment No. 4,
the NASDR proposes to amend the proposal to, among other things: (1)
modify the specifications for electron orders to conform to the
industry standard of an eight character order identifier and to
delete the requirement to pass the order origination date; (2)
extend the phase-in of the OATS implementation schedule, as
discussed in section III.E. below; (3) revise the definition of the
term ``electronic order,'' (4) define the terms ``Electronic
Communication Network'' and ``manual order,'' (5) clarify the
treatment of bunched orders; (6) revise the test of proposed Rule
6954 to separately address four different order transmittal
scenarios; (7) limit the reporting requirements of ECNs; and (8)
make technical corrections.
\9\ See Letter from Mary N. Revell, Associate General Counsel,
NASDR, to Howard Kramer, Associate Director, Division, Commission,
dated February 11, 1998 (``Amendment No. 5''). In Amendment No. 5,
the NASDR proposes to amend the text of proposed Rule 6954(c) and
Amendment No. 4 to delete provisions stating that the information to
be recorded by a Reporting Member operating an ECN is that
information provided to the ECN by the transmitting Reporting
Member.
\10\ See Letter from Mary N. Revell, Associate General Counsel,
NASDR, to Howard Kramer, Associate Director, Division, Commission,
dated March 5, 1998 (``Amendment No. 6''). In addition to several
clarifying technical amendments, the NASDR proposes in Amendment No.
6 to: (1) reinstate and amend the books and records provisions of
Rule 3110, previously deleted in Amendment No. 4, to require members
to record certain information; (2) revise proposed Rule 6954(c)(1)
to exempt from reporting to OATS orders routed from one department
within a member to the member's trading desk; (3) revise the
implementation date for electronic orders transmitted to a market
maker or an ECN to March 1, 1999; and (4) clarify the proposed
treatment of bunched orders.
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II. Background
OATS is intended to fulfill one of the undertakings contained in
the order issued by the SEC relating to the settlement of an
enforcement action against the NASD for failure to adequately enforce
its rules.\11\ Pursuant to the SEC Order, the Association agreed to
design and implement by August 8, 1998 (or as specified by further
order of the Commission) an order audit trail sufficient to enable the
Association to reconstruct markets promptly, conduct efficient
surveillance and enforce its rules.\12\ OATS is required, subject to
the Commission's approval, at a minimum, to (a) provide an accurate
time-sequenced record of orders and transactions, beginning with the
receipt of an order at the first point of contact between the broker-
dealer and the customer or counterparty and further documenting the
life of the order through the process of execution, and (b) provide for
market-wide synchronization of clocks used in connection with the audit
trail.\13\
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\11\ See In the Matter of National Association of Securities
Dealers, Inc.; SEC Release No. 34-37538, August 8, 1996;
Administrative Proceeding File No. 3-9056 (``SEC Order'').
\12\ Id.
\13\ Id.
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The SEC Order was issued in response to the filings of the
Commission's 21(a) Report.\14\ In the Appendix to its 21(a) Report, the
Commission stated that,
\14\ See Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market,
Release No. 34-37543, Commission, August 8, 1996.
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In the course of the investigation [of the NASD], the Commission
staff encountered significant difficulties reconstructing activity
in the Nasdaq market. Broker-dealer order tickets, among the most
fundamental of records, were too often unavailable or inconvenient
to retrieve. Timestamping was often unreliable for the purposes of
determining compliance with applicable rules, such as the firm quote
rule and limit order protection rules.
A further difficulty was the inadequate documentation of
telephone orders received at [over-the-counter] trading desks. As
noted above, order tickets if they were available at all, were not
always reliably timestamped. Having reliable and accurate records of
telephone orders is crucial to evaluating a market maker's
compliance with the firm quote rule and trade reporting rule.
Because telephone orders and transactions are a significant part of
the activity in the Nasdaq market, the documentation of these orders
and transactions is essential to adequate survelliance and
compliance in the market.
The NASD has automated surveillance capabilities with respect to
its current audit trail, although it has not consistently maintained
adequate routine automated surveillance capabilities over the audit
trail. Its surveillance and enforcement responsibilities with
respect to market conduct has increased substantially in recent
years. The adoption of limit order protection rules in 1994 and 1995
and the frequency of backing away from quotations and late trade
reporting revealed by this investigation, all indicate the need for
an improved surveillance capability. In light of the high volume of
trading on today's Nasdaq market and the dispersed nature of that
market, these rules cannot be efficiently enforced through current
NASD inspections and analysis of hard copies of order tickets and
other records. Automated surveillance is essential if there rules
are to be effectively enforced. This surveillance capability can
only be implemented with an improved audit trail.
[[Page 12561]]
Hunderds of millions of share trade very day on Nasdaq, and
effective regulation of this market requires a comprehensive
centralized and computerized recordkeeping system. Surveillance
methods employed in this market must keep pace with the rapidly of
trading done with computer technology. A comprehensive audit trail,
beginning with the time an order is placed and continuing to record
the life of the order through the process of execution, is essential
to maintaining the integrity of the Nasdaq market. Such an audit
trail would feature the computerized recordation of the time and
terms of an order, and of the sequence of steps to execute the
order. By providing the details, the enhanced audit trail would
allow for prompt surveillance on a scale that cannot be attained
with traditional methods of examination.\15\
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\15\ See Appendix to Report Pursuant to Section 21(a) of the
Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq
Market, Commission, August 8, 1996, at 100-101.
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III. Description of the Proposal
In response to the findings in the 21(a) Report and the
corresponding undertakings, the NASD proposed OATS. The proposed OATS
would capture order information reported by NASD members. This
information would be integrated with quote information and transaction
information reported to the Automated Confirmation Transaction Service
(``ACT'') \16\ to provide the Association with an accurate, time-
sequenced record of orders and other transactions. In general, the OATS
would impose obligations on member firms to record in electronic form
and to report to the NASDR certain information with respect to orders
originated, received, transmitted, modified, canceled, or executed
(``reportable events'') by NASD members relating to equity securities
traded on The Nasdaq Stock Market, Inc. (``Nasdaq'').\17\ In addition,
the proposal would require member firms to synchronize their business
clocks and continually to keep them synchronized with a specific time
designated by the Association.
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\16\ ACT is an automated system owned and operated by Nasdaq
that captures transaction information in real-time. See Amendment
No. 4, Supra note 8.
\17\ The proposed rules do not apply to orders for stocks traded
on the Bulletin Board, debt, and securities listed on national
securities exchanges. See NASD proposed Rules 6951(j) and 6952(c).
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The proposed OATS would be operated by the NASDR, the operating
subsidiary of the Association that is responsible for regulating member
firms and conducting surveillance of Nasdaq. The NASDR would obtain ACT
transaction data from Nasdaq on a daily basis for purposes of
constructing an integrated audit trail of transactions and order data,
and NASD members would be required to transmit ACT identifying
information to the OATS.
The OATS requirements are set forth in proposed new Rules 6950
through 6957 \18\ of the NASD's Conduct Rules relating to an audit
trail system owned and operated by the NASD. The proposed rules are
summarized in subsection A below and are discussed in detail in
subsection B-F.
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\18\ The original filing proposed numbering the text of the
proposed rule 6900 through 6970. Subsequently, the numbering of the
proposed rule was changed to 6950 through 6957. See Amendment No. 3,
supra note 7.
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In addition to adopting the new OATS rules, the proposal would
amend NASD Rule 3110 to impose recordkeeping requirements on NASD
members that are obligated to record and report information to the NASD
under the OATS rules. Such members would be required to record, with
respect to an order that is received or \19\ executed at the members'
trading department, the identification of each registered person who
receives an order directly from a customer and the identification of
each person who executes an order at a market maker's trading desk.\20\
In addition, the revised Rule 3110 would require members to record the
identification of the department of the member that originated an order
that is transmitted manually to another department within a member.
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\19\ As originally proposed, Rule 3110 would have required an
NASD member to record information pertaining to orders received and
executed at its trading department. [emphasis added]. This language
has been modified to require an NASD member to record information
relating to orders received or executed at its trading department.
Per phone conversation between Mary Revell, Associate General
Counsel, NASDR, and Deborah Flynn, Division, Commission, on March 6,
1998.
\20\ In Amendment No. 4, the NASDR deleted a proposed revision
to NASD Rule 3110, that was proposed in the original proposed rule
change and published for comment. The proposed provision required
members to record the identification of each registered person who
executes an order. See Amendment No. 4, supra note 8. In Amendment
No. 6, the NASDR proposes to reinstate that provision. See Amendment
No. 6, supra note 10.
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a. Summary of Proposed New Rules
(1) NASD Rule 6951--Definitions
Proposed NASD Rule 6951 sets forth the definitions that apply to
the new OATS rules. For example, the term ``order'' is defined as ``any
oral, written, or electronic instruction to effect a transaction in a
[Nasdaq] equity security that is received by a member from another
person for handling or execution, or that is originated by a department
of a member for execution by the same or another member.'' Proposed
Rule 6951 specifies that the term ``order'' does not include a market
maker's proprietary transactions originated by a trading desk in the
ordinary course of an NASD member's market making activities. Proposed
new Rule 6951, as amended, distinguishes between the terms ``electronic
order'' and ``manual order.'' An electronic order under the rule is an
order ``captured by a member in an electronic order-routing or
execution system.'' \21\ The term manual order is added to the amended
proposal and is defined as ``an order that is captured by a member
other than in an electronic order-routing or execution system.'' The
amended definition of the term electronic order makes clear that orders
that are received manually and subsequently entered into an automated
system will be considered electronic orders under the proposed OATS
rules. The proposed rule defines the term Reporting Member as an NASD
member that receives or originates an order and has an obligation to
record and report information about that order to the NASDR under the
applicable provisions of the OATS rules. Finally, the term ``Reporting
Agent'' is defined in the proposal as ``a third party member that
enters into an agreement with another member pursuant to which the
Reporting Agent agrees to fulfill such member's obligations under Rule
6955.''
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\21\ See Amendment No. 4, supra note 8. In the original
proposal, the term electronic order was defined as an order
``captured by members in electronic form upon or promptly after
receipt.''
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(2) NASD Rule 6952--Applicability
Proposed Rule 6952 establishes the scope of the proposed OATS
rules. Specifically, proposed Rule 6952 clarifies that the proposed
rules would apply to all NASD member brokers and dealers and to their
associated persons and to all executed and unexecuted orders for equity
securities traded on Nasdaq. In addition, proposed Rule 6952 makes
clear that, notwithstanding their obligations under the proposed OATS
rules, NASD members would be required to continue to comply with the
other requirements contained in the Association's rules and By-Laws.
(3) NASD Rule 6953--Synchronization of Member Business Clocks
Proposed Rule 6953 would require each NASD member to synchronize
its business clocks used for purposes of recording the date and time of
any event that must be recorded pursuant to the By-Laws or other rules
of the Association, with reference to a time source designated by the
Association for this purpose, and to maintain the synchronization of
business clocks in
[[Page 12562]]
conformity with procedures that the Association may prescribe.
(4) NASD Rule 6954--Recording of Order Information
Proposed Rule 6954 delineates the specific information that must be
recorded, in terms of hours, minutes, and seconds, by NASD members in
connection with the origination, receipt, transmission, modification,
cancellation, or execution of an order for a Nasdaq equity security.
The proposed rule would establish varying requirements, which are
discussed in detail in section III.B. below, depending on, for
instance, how the order is transmitted to the Reporting Member (i.e.,
electronically or manually) and the intended recipient of the
transmission (i.e., another department within the same member, an ECN,
or another member).
(5) NASD Rule 6955--Order Data Transmission Requirements
Proposed rule 6955 would mandate that the data required to be
recorded under proposed Rule 6954 be transmitted by each Reporting
Member or its designated Reporting Agent to the OATS in electronic
form. The proposed rule would require the requisite information to be
transmitted on the day the reportable event occurred, or the day that
such information first becomes available. In addition, proposed Rule
6955 would specifically allow members to enter into written agreements
with Reporting Agents under which such agents agree to fulfill the
Reporting Member's reporting obligations arising under the proposed
rule. Such agreements would not, however, relieve the member that
originally receives or originates the order from its regulatory
responsibilities under OATS.
(6) NASD Rule 6956--Violation of Order Audit Trail System Rules
Penalties for noncompliance with the OATS requirements are set
forth in proposed Rule 6956. This provision makes clear that members'
or associated persons' failure to comply with the proposed OATS rules
would be considered conduct in violation of NASD Rule 2110. As a
result, penalties that result from violations of NASD Rule 2110 also
could apply to violations of the OATS rules.
(7) NASD Rule 6957--Effective Date
Finally, proposed Rule 6957 would establish the implementation
schedule for the proposed new OATS rules.
B. Information That Must Be Recorded
Proposed Rule 6954 would require certain identifying information to
be recorded at various important points during the life of an order. In
addition to uniquely identifying the order, this information would
assist the NASDR in carrying out its regulatory responsibilities with
respect to that order. The required information items relate to: (1)
the origin of an order (i.e., in-house, customer, or another member);
(2) whether the member relies upon a Reporting Agent to fulfill its
reporting obligations; (3) how the order was received (i.e., manually
or electronically); (4) the terms of the order; (5) whether the order
was transmitted for execution to another department within the member
(other than to the trading department),22 to another member,
or to an electronic communications network (``ECN'') and how it was
transmitted (i.e., manually or electronically); and (6) whether the
order was modified, canceled or executed.
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\22\ The NASDR proposes to revise proposed Rule 6954(c)(1) to
require members to report to OATS only orders transmitted to
departments within the firm other than to the trading department.
See Amendment No. 6, supra note 10. OATS will assume that
transmissions for which there is no routing report have been
transmitted to the member's trading desk.
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(1) Origin of the Order
At the point that an order is received or originated, the Reporting
Member must record certain information items to identify where the
order came from and when it was received or originated, including: an
order identifier assigned by the Reporting Member for the date the
order was received; 23 the market participant symbol
assigned by the Association to the Reporting Member; 24 the
date and time the order was originated or received; 25 an
identification of any department or the identification number of any
terminal where an order is received directly from a customer;
26 and where an order is originated by a Reporting Member,
an identification of the department of the member where the order
originated.27
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\23\ See proposed Rule 6954(b)(1).
\24\ See proposed Rule 6954(b)(3).
\25\ See proposed Rule 6954(b)(16).
\26\ See proposed Rule 6954(b)(4).
\27\ See proposed Rule 6954(b)(5).
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(2) Reliance Upon a Reporting Agent
Under the terms of the proposal, a member would be required to
record, at the time of origination or receipt of an order, the
identification of the Reporting Agent if the member relies upon a
Reporting Agent to fulfill its reporting obligations arising under the
OATS rules.28
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\28\ See proposed Rule 6954(b)(6).
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(3) How an Order is Received
The proposed rules would not require specific information items to
be recorded to identify how the original Reporting Member received the
order (i.e., electronically or manually). Nonetheless, as discussed in
section III.A.(1) above, proposed Rule 6951 distinguishes between
electronic and manual orders. For purposes of the OATS rules, the
distinction between electronic and manual orders is particularly
significant as it relates to the implementation schedule set forth in
proposed Rule 6957, details of which are provided in section III.E.
below.
(4) Terms of the Order
Proposed Rule 6954 also would require certain information items
directly related to the terms of the order itself to be recorded at the
time of origination or receipt of an order. These information items
include: the identification symbol assigned by the Association to the
security; 29 the number of shares to which the order
applies; 30 the designation as a buy or sell order;
31 the designation as a short sale order; 32 the
designation as a market order, limit order, stop order or stop limit
order; 33 any limit or stop price prescribed in the order;
34 the time limit during which the order is in force;
35 any special handling requests 36 contained in
the order; 37 any request by a customer that an order not be
displayed, or that a block size order be displayed pursuant to Rule
11Ac1-4(c); 38 the date on which the order expires, and if
less than one day, the time when the order expires; 39 the
type of account for which the order is placed; 40 and
whether the order is related to a Program Trade or an Index Arbitrage
Trade.41
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\29\ See proposed Rule 6954(b)(2).
\30\ See proposed Rule 6954(b)(7).
\31\ See proposed Rule 6954(b)(8).
\32\ See proposed Rule 6954(b)(9).
\33\ See proposed Rule 6954(b)(10).
\34\ See proposed Rule 6954(b)(11).
\35\ See proposed Rule 6954(b)(13).
\36\ According to the NASDR, examples of special handling
requests include the following types of requests: Kill or Fill, All
or None, Not Held, Immediate or Cancel, Market at Open, Market at
Close, Over the Day, Scale, Work, Minimum Quantity, and Peg. See
Amendment No. 4, supra note 8.
\37\ See proposed Rule 6954(b)(15).
\38\ See proposed Rule 6954(b)(14).
\39\ See proposed Rule 6954(b)(12).
\40\ See proposed Rule 6954(b)(18).
\41\ See proposed Rule 6954(b)(17). Transaction data for trades
that are part of a program trade or index arbitrage strategy is
required by the New York Stock Exchange to be transmitted to ACT
with respect to securities listed on that exchange.
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[[Page 12563]]
(5) Transmission of an Order
Proposed Rule 6954 also requires information to be recorded
regarding how and to whom an order is transmitted.
Transmitted to Another Department Within the Member-Firm--Pursuant
to proposed Rule 6954(c)(1), when a Reporting Member transmits an order
to another department within the member other than to the trading
department,\42\ the member would be required to record the following
information: the order identifier assigned to the order by the member;
the market participant symbol assigned by the Association to the
member; the date the order was first received or originated by the
member; an identification of the department to which the order was
transmitted; and the date and time the order was received by that
department.
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\42\ See note 22, supra.
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Electronically Transmitted to Another Member--When an order is
electronically transmitted to another member, other than for execution
on an ECN, proposed Rule 6954(c)(2) would require certain information
to be recorded by the transmitting and receiving members. The
transmitting Reporting Member must record the following information:
the order identifier assigned to the order by that firm; the respective
market participant symbols assigned by the Association to the
transmitting member and to the member to which the order is
transmitted; the date the order was originally received or originated
by the Reporting Member; the date and time the order is transmitted;
and the number of shares to which the transmission applies.
The receiving member would be required to capture all of the
elements prescribed in proposed Rule 6954(b) that apply with respect to
the order. In addition, the receiving member would be required to
record: the order identifier assigned to the order by the transmitting
member; and the transmitting member's market participant symbol
assigned by the Association.
Electronically Transmitted to an ECN--Pursuant to proposed Rule
6954(c)(3), when a member electronically transmits an order for
execution on an ECN, the transmitting member would be required to
record: the fact that the order was transmitted to an ECN; the order
identifier assigned to the order by the transmitting member; the
respective market participant symbols assigned by the Association to
the transmitting member and to the ECN; the date the order was first
originated or received by the transmitting Reporting Member; the date
and time the order is transmitted; and the number of shares to which
the transmission applies.
The receiving Reporting Member operating the ECN would be required
to record, in addition to the applicable information items specified in
proposed Rule 6954(c)(3)(B)(iii), the fact that the order was received
by an ECN and the market participant symbol assigned by the Association
to the member transmitting the order to the ECN.
Manually Transmitted to Another Member Other Than and ECN--Proposed
Rule 6954(c)(4) sets forth the recording obligations for manual
transmissions of orders between members other than ECNs. Pursuant to
the proposal, transmitting members would be required to record: the
fact that the order was transmitted manually; the order identifier
assigned to the order by the transmitting member; the respective market
participant symbols assigned by the Association to the transmitting and
receiving members; the date the order was first originated or received;
the date and time the order is transmitted; the number of shares to
which the transmission applies; and for each order to be included in a
bunched order, the bunched order route indicator.\43\
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\43\ See Amendment No. 6, supra note 10. In Amendment No. 6, the
NASDR proposes to clarify the rule language with respect to bunched
orders. Amendment No. 6 revises the rule language to make clear that
a bunched order route indicator must be reported for each manual
order included in a bunch.
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The member receiving a manual transmission would be required to
record, in addition to all other applicable information items set forth
in proposed Rule 6954(b), the fact that the order was received manually
and the market participant symbol assigned by the Association to the
transmitting member.
Manually Transmitted to an ECN--Proposed Rule 6954(c)(5) specifies
the obligations that would arise under the rules when a member manually
transmits an order to an ECN. The transmitting member would be required
to record: the fact that the order was transmitted manually; the order
identifier assigned to the order by the transmitting member; the
respective market participant symbols of the transmitting member and
the ECN; the date the order was first originated or received; the date
and time the order is transmitted; the number of shares to which the
transmission applies; and for each order to be included in a bunched
order, the bunched order route indicator.\44\
---------------------------------------------------------------------------
\44\ Id.
---------------------------------------------------------------------------
The receiving ECN would be required to report: the fact that the
order was received manually; the market participant symbol assigned by
the Association to the transmitting member; and all other applicable
information with respect to the order as set forth in proposed Rule
6954(c)(5)(B)(iii).
(6) Modifications, Cancellations, and Executions
Proposed Rule 6954 also requires NASD members to record certain
information to identify the disposition of the order (i.e., whether it
was modified, canceled, or executed).
Modifications--Pursuant to proposed Rule 6954(d), whenever an NASD
member modifies the terms of an order that it has originated, or
receives a modification to the terms, the OATS would treat the
modification effectively as a cancellation of the original order and a
replacement by the modified order. Accordingly, all information
prescribed by the rule would need to be recorded pursuant to proposed
Rule 6954(b) as if the order was originated or received at the time of
the modification. In addition, to permit the linkage by the OATS of the
modified order to the original one, the proposal would require the
member to record the following information: the order identifier that
was assigned to the order by the member prior to the modification; the
date and time the modification was originated or received; and the date
the original order was first originated or received by the member.
Cancellations--In the event of a cancellation of an existing order,
whether it is a total or partial cancellation, the following elements
would be required to be recorded pursuant to proposed Rule 6954(d)(2):
the order identifier assigned by the member; the market participant
symbol assigned to the Reporting Member by the Association; the date
the order was first originated or received by the member; the date and
time the cancellation was originated or received; if the open balance
of an order is canceled after a partial execution, the number of shares
canceled; and whether or not the order was canceled at the instruction
of the member, or a customer.
Executions--For executed orders, members would be required, under
proposed Rule 6954(d)(3), to record: the order identifier assigned by
the member; the market participant symbol assigned
[[Page 12564]]
by the Association to the member; the date the order was first
originated or received by the member; the member's number assigned for
purposes of identifying transaction data in ACT; the designation of the
order as fully or partially executed; the number of shares to which a
partial execution applies and the number of unexecuted shares
remaining; the identification number of the terminal where the order
was executed; and the date and time of execution.
C. Information That Must Be Reported to the OATS
Proposed Rule 6955 requires that all applicable order information
that must be recorded under proposed rule 6954 be reported to the OATS
by either the member or by a Reporting Agent under a written agreement,
as described in paragraph (c) of proposed Rule 6955.\45\ The proposal
would require order information to be submitted to the OATS in either
single or multiple electronic file transmissions on the same day that
the order was received, originated, canceled, modified, transmitted to
another department within the member or to another member, or executed.
Where information concerning a particular order is not complete or
changes, proposed Rule 6955 would require the additional information to
be reported to the OATS on the day that the information first becomes
available.
---------------------------------------------------------------------------
\45\ As discussed above, proposed Rule 6955(c) contains a
special provision that allows a member to enter into a written
agreement with a Reporting Agent pursuant to which such agent agrees
to report order information to OATS on its behalf. However, the
member that actually receives or originates the order would remain
primarily responsible for fulfilling each of its obligations under
the proposal.
---------------------------------------------------------------------------
D. Synchronization of Clocks
In addition to the recordkeeping and reporting requirements
discussed above, proposed Rule 6953 would require that the business
clocks of all member firms that are used for purposes of recording the
date and time of any event that must be recorded pursuant to the By-
Laws or other rules of the NASD be appropriately synchronized to one
time source designated by the NASD. Market-wide synchronization of
business clocks was included as a element of one of the undertakings
contained in the SEC Order.\46\ Proposed Rule 6953 would require
members to initially synchronize their clocks and to follow procedures
prescribed by the NASD to continuously maintain synchronization.
---------------------------------------------------------------------------
\46\ SEe note 11, supra.
---------------------------------------------------------------------------
E. Effective Dates
The proposed effective dates for the requirements of the proposal
are set forth in proposed Rule 6957. As amended, the proposal would
require all members to synchronize their computer system clocks and all
mechanical clocks that record times for regulatory purposes by August
7, 1998, and July 1, 1999, respectively.\47\ In addition, the
implementation schedule, as amended,\48\ would require that electronic
orders received at the trading department of a member that is a market
maker in the subject securities and those received by ECNs be entered
into the OATS \49\ as of March 1, 1999 (``Phase One'').\50\ Information
items relating to all electronic orders would be required to be
reported to the OATS by August 1, 1999 (``Phase Two'').\51\ Further,
the proposed OATS rules would apply to all manual orders as of July 31,
2000 (``Phase Three'').\52\ With respect to manual orders and all
orders received by ECNs, however, the data required to be
electronically recorded and transmitted to the OATS is limited to
information that is expected to be readily available at the trading
desk.\53\
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\47\ As originally filed, the proposal required NASD members to
synchronize their business clocks by February 2, 1998. In Amendment
Nos. 4 and 6, the NASDR proposed to delay the effective date of the
implementation of this requirement. See Amendment Nos. 4 and 6,
supra notes 8 and 10.
\48\ In response to concerns raised by commenters that the
proposed implementation dates did not provide sufficient time for
necessary systems changes, the NASDR proposes to amend the
implementation schedule to allow NASD member firms additional time
to develop and test their systems' capabilities to record and
transmit orders to the OATS. See Amendment No. 4, supra note 8.
\49\ Not all information relating to electronic orders received
by market makers will be required to be reported to the OATS as of
this date. Specifically, the NASDR proposes that market makers be
required to report information item (18) (type of account for which
the order is submitted) of Rule 6954(b) only to the extent that such
information item is available. Market makers would not be required
to report information items (5) (identification of the department of
the member originating an order) and (18) (type of account for which
the order is submitted) of proposed Rule 6954(b) and information
items (2)(A) (recordkeeping requirements of the transmitting member
for an order electronically transmitted to another member),
(2)(B)(i) (order identifier assigned to the order by the
transmitting member), (3)(A) (recordkeeping requirements of the
transmitting member for an order electronically transmitted to an
ECN), (4)(A) (recordkeeping requirements of the transmitting member
for an order manually transmitted to another member) and (5)(A)
(recordkeeping requirements of the transmitting member for an order
manually transmitted to an ECN) of Rule 6954(c) until August 1,
1999. See Amendment No. 4, supra note 8.s, 4 and 6, supra notes 8
and 10.
\50\ In Amendment No. 6, the NASDR proposes to implement Phase
One by March 1, 1999, rather than February 1, 1999, as proposed in
Amendment No. 4, See Amendment Nos. 4 and 6, supra notes 8 and 10.
\51\ See Amendment No. 5, supra note 8.
\52\ Id.
\53\ Specifically, with respect to manual orders, information
item (18) (type of account for which the order is submitted) of Rule
6954(b) would be required to be reported only to the extent that
such information item is available. Information items (4)
(identification of any department or the identification number of
any terminal where an order is received) and (5) (identification of
the department of the member originating an order) of proposed Rule
6954(b) and (1) (recordkeeping requirements for orders transmitted
to another department within the member) specified in proposed Rule
6954(c) would not be required to be recorded and reported with
respect to manual orders. In addition, information items (4)
(identification of any department or identification number of any
terminal where an order is received), (5) (the identification of the
department of the member that originates the order), (9) (the
designation of the order as a short sale), (14) (any request by a
customer that an order not be displayed or that a block size order
be displayed, pursuant to Rule 11Ac1-4(c)), (17) (the identification
of the order as related to a Program Trade or an Index Arbitrage
Trade), and (18) (the type of account for which the order is
submitted) specified in proposed Rule 6954(b) would not be required
to be recorded and reported by ECNs receiving orders either
electronically or manually. See Amendment Nos. 4 and 6, supra notes
8 and 10.
---------------------------------------------------------------------------
The proposed books and records requirements, set forth in Rule
3110(c)(1) and (2), pertaining to the identification of the registered
representative who receives an order directly from a customer and the
identification of each registered person who executes the order, would
be effective on March 1, 1999.\54\ The proposed recordkeeping
requirements, set forth in Rule 3110(c)(3), applicable to orders
originated by a member and manually transmitted to another department
within the member firm, would be effective on July 31, 2000.\55\
---------------------------------------------------------------------------
\54\ See Amendment No. 6, supra note 10.
\55\ Id.
---------------------------------------------------------------------------
F. Penalties for Noncompliance
Finally, pursuant to proposed Rule 6956, a member's failure to
comply with any of the requirements set forth in the proposed rules may
be considered conduct that is inconsistent with high standards of
commercial honor and just and equitable principles of trade, in
violation of NASD Rule 2110.
IV. Summary of Comments
The Commission received 18 comment letters on the proposed rule
change, 16 of which were submitted by broker-dealers.\56\ One comment
letter was submitted by a trade association representing securities
firms, and one was submitted by an ECN.\57\ The commenters generally
supported the proposal, recognizing the importance to the NASD's
surveillance efforts of a
[[Page 12565]]
reliable mechanism for reconstructing orders from the time of receipt
through execution. As discussed below, however, the commenters
expressed a number of concerns regarding the feasibility of the
proposal, as originally submitted.
---------------------------------------------------------------------------
\56\ See note 5, supra.
\57\ Id.
---------------------------------------------------------------------------
A. Implementation Schedule
Twelve commenters stated that the proposed implementation schedule
was unrealistic and overly ambitious and should be delayed.\58\
Thirteen commenters believed the industry would be unable to meet the
proposed deadlines due to the existing burdens on the industry's
technical resources caused by the Year 2000 conversion, the
implementation of the Commission's Order Handling Rules, the move to
trading in sixteenths and efforts to prepare for the move to decimal-
based pricing.\59\ Four commenters noted that the Association's failure
to provide timely technical specifications made the proposed
implementation dates unworkable.\60\ Two commenters recommended that,
similar to the implementation of the Order Handling Rules, the
implementation of the new OATS rules should be phased-in incrementally,
beginning with a small group of issues.\61\ A moratorium on enforcement
for some specified period of time also was suggested by one
commenter.\62\
---------------------------------------------------------------------------
\58\ See Letters from J.P. Morgan, Mabon, Banc One, A.G.
Edwards, Instinet, Morgan Stanley, Salomon Bros., Schwab, SIA,
Advest, BancAmerica, and Oppenheimer, supra note 5.
\59\ See Letters from J.P. Morgan, Mabon, A.G. Edwards,
Instinet, Morgan Stanley, Salomon Bros., Schwab, SIA, Advest, Wheat
First, J.C. Bradford, BancAmerica, and Oppenheimer, supra note 5.
\60\ See Letters from J.P. Morgan, HBK Finance, SIA, and J.C.
Bradford, supra note 5.
\61\ See Letters from SIA and Merrill Lynch, supra note 5.
\62\ See SIA Letter, supra note 5.
---------------------------------------------------------------------------
In response to the commenters, the NASDR has proposed to delay the
implementation schedule for the proposed rules, as discussed above in
section III.E.\63\ However, the NASDR has neither proposed to modify
the implementation schedule to phase-in a certain number of stocks
incrementally nor proposed a moratorium on enforcement.
---------------------------------------------------------------------------
\63\ See Amendment Nos. 4 and 6, supra notes 8 and 10.
---------------------------------------------------------------------------
B. Costs of Proposal
As noted above, thirteen commenters noted the significance of the
existing burdens on the industry's technical and financial resources
associated with the Year 2000 conversion, the implementation of the
Commission's Order Handling Rules, the move to trading in sixteenths
and efforts to prepare for the move to decimal-based pricing.\64\
Similarly, six commenters expressed concerns regarding the substantial
initial costs to be incurred as a result of the implementation of the
proposal.\65\ The commenters complained that such costs were not
justified by the NASD in its proposal. Several commenters also
expressed concerns that OATS would reduce market liquidity, increase
costs to investors and place smaller firms at a competitive
disadvantage.\66\ In addition, two commenters complained that the
proposed OATS would slow customer executions.\67\
---------------------------------------------------------------------------
\64\ See note 59, supra.
\65\ See Letters from Mabon, Banc One, HBK Finance, Instinet,
Morgan Stanley, and Franklin Templeton, supra note 5.
\66\ See Letters from Mabon, BIS, Banc One, and Schwab, supra
note 5.
\67\ See Letters from Instinet and Morgan Stanley, supra note 5.
---------------------------------------------------------------------------
In response to cost concerns, the NASDR notes that while it has
considered the costs to firms of implementing the system, the proposed
OATS is directly responsive to a mandate issued by the Commission.\68\
In addition, the NASDR notes that the proposed modifications to the
recordkeeping and reporting requirements, coupled with the proposed
delay in the implementation schedule and the OATS' reliance on
historical, rather than real-time data, should help to reduce the cost
of the proposal.\69\
---------------------------------------------------------------------------
\68\ See note 11, supra.
\69\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------
C. Technological Interface Concerns
Three commenters cited potential problems created by the
incompatibility of different order routing and execution systems used
both within firms and between firms.\70\ One of those commenters
further noted potential issues arising from the fact that within
certain firms, orders received electronically (which would have fit
within the definition of ``electronic order'' as originally proposed)
may be dealt with manually at some point and therefore, should not be
considered electronic for purposes of the proposal.\71\ In response to
concerns regarding the distinctions between electronic and manual
orders, the NASDR amended proposed Rule 6951 to revise the definition
of the term ``electronic order'' and add a definition of the term
``manual order.'' \72\ In addition, the NASDR proposes to amend
proposed Rules 6954 and 6957 to modify the recordkeeping requirements
and the implementation dates, respectively, applicable to manual
orders.\73\
---------------------------------------------------------------------------
\70\ See Letters from Morgan Stanley, Schwab, and BancAmerica,
supra note 5.
\71\ See Morgan Stanley Letter, supra note 5.
\72\ See Amendment No. 4, supra note 8. These definitions are
discussed above in section III.A.
\73\ See Amendment Nos. 4 and 6, supra notes 8 and 10.
---------------------------------------------------------------------------
D. Bunched Orders
Three commenters expressed concerns that the proposed prohibition
on bunching of orders or aggregation of order flow would result in
decreased market efficiency and increased transaction costs.\74\ In
response, the NASDR proposes to amend its proposal to explicitly allow
for bunched orders, aggregated prior to execution.\75\ As discussed
above, the NASDR proposes to amend Rule 6954 to require members
transmitting manual orders in a bunch to record and report for each
order to be included in a bunched order, the bunched order route
indicator assigned by the transmitting member.\76\
---------------------------------------------------------------------------
\74\ See Letters from A.G. Edwards, Instinet, and J.C. Bradford,
supra note 5.
\75\ See Amendment Nos. 4 and 6, supra notes 8 and 10.
\76\ See Amendment No. 6, supra note 10.
---------------------------------------------------------------------------
E. Preferred Stock
One commenter noted that because of its similarity to debt
instruments, many member firms trade preferred stock in their fixed
income departments.\77\ The commenter recommended that, as a result,
preferred stock should be excluded from the proposed OATS
requirements.\78\ The NASDR has not amended its proposal to provide a
specific exemption from the requirements of the OATS rules for
preferred stock.\79\
---------------------------------------------------------------------------
\77\ See Salomon Bros. Letter, supra note 5.
\78\ Id.
\79\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------
F. Unique Order Identifier and Other Order Transmission Issues
With respect to technical concerns raised by the proposal, three
commenters recommended that the proposal be amended to allow the unique
order identifier to consist of the eight characters currently
recognized by the industry as the Common Message Switch's standard
order format.\80\ One commenter stated that the mandated disclosure of
a unique order identifier, which may contain proprietary information
relating to a trader's strategies, would compromise the trader's
ability to work the market to receive the best execution for the
[[Page 12566]]
customer.\81\ Two commenters suggested that the OATS include a
mechanism to provide a recap or acknowledgment of the transmission to
be sent to the member firm.\82\ Another commenter noted that
transmission of data to the OATS must occur after-hours to allow member
firms adequate time to process all business transactions.\83\
---------------------------------------------------------------------------
\80\ See Letters from J.P. Morgan, SIA, and Merrill Lynch, supra
note 5.
\81\ See A.G. Edwards Letter, supra note 5.
\82\ See J.P. Morgan and SIA Letters, supra note 5.
\83\ See A.G. Edwards Letter, supra note 5.
---------------------------------------------------------------------------
In response to the expressed concerns, the NASDR proposes to
provide technical specifications that permit the order identifier for
orders transmitted electronically other than to ECNs to contain the
industry standard of only 8 characters, rather than the 12 characters
initially proposed.\84\ With respect to orders transmitted manually,
the NASDR proposes to amend proposed Rule 6954 to eliminate the
requirement that the order identifier and the order origination date be
passed when the order is transmitted.\85\
---------------------------------------------------------------------------
\84\ See Amendment No. 4, supra note 8. According to the NASDR,
where two or more orders share the same order identifier, additional
order details including information items in proposed Rule 6954(b)
can be used to uniquely identify a particular order.
\85\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------
G. Synchronization of Business Clocks
Several comments were addressed to the proposed synchronization of
business clocks. One commenter stated that it would be impossible for
member firms both to initially synchronize their manual business clocks
and to maintain synchronization of all business clocks.\86\ The same
commenter also cited the difficulties inherent in requiring each
registered representative to time-stamp and date every order,
particularly those orders received when the representative is not in
the office.\87\ Another commenter recommended that synchronization of
business clocks should be industry-wide and should include the
automatic order entry and execution systems operated by the various
exchanges.\88\
---------------------------------------------------------------------------
\86\ See A.G. Edwards Letter, supra note 5.
\87\ Id.
\88\ See Merrill Lynch Letter, supra note 5.
---------------------------------------------------------------------------
Other than to delay the implementation date of mandatory
synchronization to August 7, 1998, for computer system clocks and July
1, 1999, for mechanical clocks, the NASDR has not modified its proposal
in response to these comments.\89\
---------------------------------------------------------------------------
\89\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------
H. ECNs
One commenter noted the special problems the proposal would create
for ECNs.\90\ Specifically, this commenter observed that the proposal
would require ECNs to distinguish between market maker proprietary
orders and other orders, which existing technology does not currently
permit.\91\ In addition, this commenter noted that the proposed
treatment of order modifications as canceled or replaced is contrary to
ECN users' practice of negotiating and trading directly with each
other.\92\
---------------------------------------------------------------------------
\90\ See Instinet Letter, supra note 5.
\91\ Id.
\92\ Id.
---------------------------------------------------------------------------
In recognition of the unique characteristics of ECNs and in
response to the concerns expressed in the comment letter from Instinet,
an ECN, the NASDR proposes to limit ECN reporting to the OATS to the
events that occur within the ECN. ECNs would be required to record and
report only those information items that the member transmitting the
order to the ECN has provided. The NASDR proposes that all orders
transmitted to ECNs, regardless of how such orders were transmitted to
the ECN, be treated like manual orders.\93\
---------------------------------------------------------------------------
\93\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------
I. Modifications to ACT and Other Alternatives to the OATS
Several alternatives to OATS were recommended by the commenters.
For example, eight commenters recommended that rather than creating
OATS, the Association should focus its efforts on improving the
existing ACT system to incorporate the additional required
information.\94\ One commenter proposed that rather than requiring
further development, the NASD should recognize existing electronic
audit trails relied upon by member firms as appropriate vehicles for
surveillance.\95\ In addition, one commenter recommended that the NASD
develop a uniformly available technology platform to be used by all
industry participants for non-electronic orders.\96\
---------------------------------------------------------------------------
\94\ See Letters from J.P. Morgan, BIS, HBK Finance, Morgan
Stanley, SIA, BancAmerica, Oppenheimer, and Merrill Lynch, supra
note 5.
\95\ See Instinet Letter, supra note 5.
\96\ See J.P. Morgan Letter, supra note 5.
---------------------------------------------------------------------------
The NASDR has not modified the proposal in response to these
comments. The NASDR stated that modifying ACT would be detrimental to
the current function or capacity of the ACT system and might degrade
the performance or trade reporting function of ACT.\97\
---------------------------------------------------------------------------
\97\ See Amendment No. 4, supra note 8.
---------------------------------------------------------------------------
V. Discussion
After careful review, the Commission finds that the proposed rule
change is consistent with the requirements of the Act and the rules and
regulations thereunder applicable to a national securities
association.\98\ Specifically, the Commission believes the proposal is
consistent with the requirements of Section 15A(b)(6) of the Act.\99\
That section 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, processing information with respect to, and
facilitating transactions in securities, and in general, to protect
investors and the public interest.
---------------------------------------------------------------------------
\98\ In approving this rule, the Commission notes that it has
considered the proposed rule's impact on efficiency, competition,
and capital formation. 15 U.S.C. 78c(f).
\99\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------
As discussed in section II above, pursuant to the SEC Order, the
NASD agreed to design and implement by August 8, 1998 or such later
time as the Commission may order,\100\ an order audit trail system that
would enable the NASD to reconstruct markets promptly, conduct
efficient surveillance and enforce its rules. At a minimum, the audit
trail is required to: (a) provide an accurate, time-sequence record of
orders and transactions which documents the receipt and life of the
order and (b) market-wide synchronization of member firms' business
clocks. In the Appendix to its 21(a) Report, the Commission stated that
``[a] comprehensive audit trail, beginning with the time an order is
placed and continuing to record the life of the order through the
process of execution, is essential to maintaining the integrity of the
Nasdaq market.'' \101\ The Commission further noted that the
implementation of an enhanced audit trail would ``allow for prompt
surveillance on a scale that cannot be attained with traditional
methods of examination'' and ``would greatly facilitate the ability of
the NASD and the Commission to protect the interests of investors.''
\102\ The Commission believes that, as proposed, the OATS will satisfy
both conditions of the SEC Order and is consistent with the
requirements of Section 15A(b)(6) of the
[[Page 12567]]
Act \103\ in that it will greatly assist both the NASD's and the
Commission's efforts to more rapidly detect and punish fraudulent and
manipulative acts and practices involving Nasdaq equity securities.
OATS is designed to capture the type of information that the NASDR can
use to prevent the trading abuses that threatened to undermine the
integrity of its market and which harmed investors. In short, OATS is
an integral part of the NASD's efforts, as mandated by its settlement
with the Commission, to uphold its self-regulatory responsibilities to
enforce its rules.
---------------------------------------------------------------------------
\100\ The Commission notes that the NASDR is prepared to meet
the established August 1998 deadline. The implementation schedule
was delayed not to accommodate the NASDR, but rather, at the request
of the industry. The Commission finds the delayed implementation to
be reasonable to enable the industry to effect the necessary systems
conversions in an efficient and smooth manner.
\101\ See note 14, supra.
\102\ Id.
\103\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------
To the extent that commenters' suggestions could lessen the costs
of OATS without diminishing its effectiveness, they have been adopted
by the NASD in amendments to its proposal, as described below. As
discussed in section IV above, a number of commenters stated that the
proposed implementation schedule was unrealistic and should be delayed
to allow member firms to prepare to comply with the OATS rules. The
Commission notes that the NASDR responded to such comments by delaying
the effective dates of the proposal and by phasing in the requirements
more gradually. For example the Commission notes that under the
original proposal, all electronic orders were subject to the OATS rules
as of August 8, 1998. The amendment implementation schedule would apply
the OATS rules as of March 1, 1999 only to electronic orders received
by ECNs and the trading departments of members that are market makers
in the securities that are the subject of the orders. All electronic
orders will not be subject to the OATS rules until August 1, 1999,
pursuant to Amendment No. 4.
The Commission believes that the proposed changes to the
implementation schedule for the Order Audit Trail System are reasonable
as the additional time provided should allow member firms ample
opportunity to develop and test their systems to ensure compliance with
the requirements of the proposed rules. The Commission notes that
delaying the final effective date of the initial phase-in of the system
by six months should provide the NASDR, market-makers, and ECNs
adequate time for testing of the Order Audit Trail System prior to
March 1, 1999. Member firms not subject to the March 1999 deadline may
be expected to benefit from observing the implementation process and
thereby, to better focus their own efforts to successfully prepare
prior to their scheduled implementation dates.
Further, the Commission believes that, given the critical role that
market makers play in the market for Nasdaq equity securities, it is
appropriate that the requirements of OATS would be effective first for
the electronic orders received by market makers in those securities. In
addition, the Commission notes that, although the March 1, 1999
effective date also applies to electronic orders received by ECNs,
neither ECNs nor market makers will have to report any information to
the OATS that is not readily available at trading desks by March 1,
1999. Therefore, the Commission believes that both the NASDR and Nasdaq
market participants should have a sufficient opportunity to obtain
important insight into the OATS process and to make any necessary
systems changes prior to the August 1, 1999 effective date for all
electronic orders.
As discussed in the Summary of Comments section above, member firms
were particularly concerned about their ability to capture the required
information regarding orders that are received manually. The Commission
believes the proposed delay in implementing the requirements for manual
orders until July 31, 2000 should provide adequate time for all member
firms to either develop the necessary systems in-house or make
arrangements to have their reporting obligations arising under the OATS
rules fulfilled on their behalf by a Reporting Agent.
Several comment letters addressed the proposed synchronization of
business clocks. The Commission notes that the requirement for
synchronization of members' business clocks is a specified element of
the undertakings contained in the SEC Order.\104\ The Commission
believes the reliability and usefulness of the OATS is contingent upon
the synchronization of all applicable business clocks of all member
firms. Determining whether members have complied with the OATS rules
depends critically on establishing with confidence the time at which
order information is received as measured by a source that is standard
throughout the industry.\105\ As discussed in section IV.G. above, the
Commission notes that one commenter recommended that the proposed
synchronization of business clocks should be truly industry-wide and
should include the automatic order entry and execution systems operated
by the various exchanges.\106\ The Commission supports a move toward
industry-wide synchronization of clocks and believes the
synchronization requirement in OATS is an important first step.
---------------------------------------------------------------------------
\104\ See note 11, supra.
\105\ Synchronization of all business clocks also is important
in evaluating compliance with other rules to which member firms are
subject, including, among others, best execution obligations, firm
quote rules, and prohibitions on frontrunning customer orders.
\106\ See note 88, supra.
---------------------------------------------------------------------------
The Commission notes that NASD's members' obligation to maintain
the synchronization of business clocks will be ongoing. The technical
specifications proposed by the NASDR will require that the accuracy of
clocks be resynchronized every day before the market opens. The
proposed technical specifications further contemplate that business
clocks would be checked against the standard clock periodically
throughout the day at pre-determined intervals and re-synchronized, if
necessary. The Commission further notes that compliance examinations,
conducted by both the NASDR and the Commission, will include a review
of member firms' compliance with these requirements, including the
adequacy of procedures and the degree of accuracy of all business
clocks. The Commission believes the proposed procedures should ensure
the accuracy and reliability of business clocks that are used for
trading and reporting purposes. Accordingly, the Commission believes
that the proposed requirements relating to the synchronization of
member business clocks is consistent with the requirements of Section
15A(b)(6) of the Act \107\ insofar as a reliable record of the timing
of reportable events should greatly assist the NASDR's efforts to
detect and to punish fraudulent and manipulative activity more quickly.
---------------------------------------------------------------------------
\107\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------
The Commission also notes that a number of commenters expressed
concerns regarding the original proposal to use a non-industry standard
12 character order identifier and problems with passing the order
origination date. The proposed rules, as amended, would conform the
requirements of the unique order identifier to comply with the industry
standard, eight-character alphanumeric field and eliminate the
requirement to pass the order origination date. According to the NASDR,
the eight alphanumeric character order identifier will suffice to
gather the needed information required by OATS. In situations where the
unique order identifier is not transmitted, other order data required
to be reported should allow orders to be uniquely identified. The
Commission believes the proposed modifications to
[[Page 12568]]
the requirements relating to the unique order identifier should reduce
the requisite number of program changes and the amount of testing
required of member firms without jeopardizing the usefulness of the
data to be received by the NASDR. In turn, this amendment should lower
the cost of the proposal and thereby, address, to some extent, the
concerns expressed by several commenters relating to the costs
associated with implementation of the proposal.\108\
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\108\ See discussion in section IV.B. above. The Commission
recognizes that OATS will require some degree of systems changes by
NASD members that will vary depending upon the business mix of the
particular firm. These changes will entail costs for all NASD firms.
Nevertheless, the Commission believes any costs are far outweighed
by the substantial benefit to NASDR surveillance and enforcement
that will arise from OATS. Without the implementation of OATS, it
would be harder to detect and deter the types of trading abuses
described in the Commission's 21(a) Report.
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Moreover, the Commission notes that for orders transmitted manually
and all orders transmitted to ECNs, neither an order identifier nor an
order origination date will be passed when the order is routed. In
addition, in response to concerns expressed by several commenters,\109\
only certain information items would be required to be recorded and
reported to OATS. As these information items generally correspond to
data that is expected to be readily available at trading desks at the
time that the orders are received, the Commission believes that the
proposal acknowledges the unique challenges OATS presents to member
firms that handle manual orders and to ECNs. The Commission believes
that the proposal, as amended, appropriately addresses these concerns
as delineated above, while continuing to allow NASDR to track these
orders through the OATS. The Commission further believes that, so long
as manual orders and orders transmitted to ECNs can be manually matched
by the NASDR, the proposed elimination of these requirements is
appropriate.
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\109\ See discussion in section IV.H. above.
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In addition, the Commission believes the provisions of proposed
Rule 6954(c) permitting a Reporting Agent to fulfill a member's
reporting obligations should provide member firms with needed
flexibility. These provisions, which require a written agreement and
make clear that the member firm retains primary compliance
responsibility for recording and reporting order information, should
benefit smaller member firms by providing them with the option to rely
on third parties to comply with the reporting obligations arising under
the proposed rules. The Commission believes that the provisions
contained in proposed Rule 6955(c) should alleviate some of the
concerns expressed by commenters that OATS would place smaller firms at
a competitive disadvantage.\110\
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\110\ See note 66, supra.
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The Commission notes that in response to concerns express by
several commenters, the NASDR clarified that reporting of bunched
orders would be permitted and required additional information to be
recorded and reported with respect to such orders. The Commission
believes the NASDR's proposed treatment is appropriate as it will allow
those members that are accustomed to bunching their orders to continue
to do so while permitting those manual orders that are bunched to be
easily identified by the OATS.
The Commission notes that one commenter recommended that preferred
stock be excluded from the proposed requirements.\111\ The Commission
believes that the NASDR's decision to not provide a specific exemption
from the OATS, requirements for preferred stock is appropriate because
the preferred stock is an equity security that poses many of the same
surveillance concerns as common stock.
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\111\ See note 78, supra.
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The Commission recognizes that there may be, particularly with
respect to manual orders, information items not required to be recorded
and reported by the proposal that could prove helpful to the NASD or
the Commission in carrying out their regulatory responsibilities.
Nonetheless, the Commission believes that the NASDR's proposal
represents a significant and appropriate effort to satisfy the
Commission mandate to develop and implement OATS, while attempting to
minimize the costs imposed on the industry by such an undertaking. The
Commission expects that during the process of implementing and
reviewing OATS, the Commission and the NASDR will identify ways in
which to improve OATS. The Commission fully expects the NASDR to submit
proposals to modify the requirements of OATS, as needed, to enhance the
effectiveness of OATS as a regulatory tool.
The Commission notes that the proposed revisions to NASD Rule 3110
would impose recordkeeping requirements on Reporting Members in
addition to the recordkeeping and reporting requirements set forth in
the OATS rules. Proposed Rule 3110(c) would require members to record
the identification of the registered representative who receives an
order directly from a customer, the identification of each registered
person who executes the order, and the identification of the department
that originates an order that is manually transmitted to another
department within the member firm. The Commission notes that the
proposal, as originally submitted, required the identification of the
individual receiving and the department originating an order to be
recorded and reported to OATS. Although this information may be
critical to the Commission and the NASDR for surveillance and
enforcement purposes, the Commission believes, as noted above, that it
is reasonable to require this information to be recorded, but not
reported to OATS, to allow the implementation of OATS to proceed as
quickly as possible. Again, after the Commission and the NASDR have
gained experience with OATS, further modification to these requirements
may be deemed necessary.
The Commission finds good cause for approving proposed Amendment
Nos. 2, 3, 4, 5, and 6 prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register. The
Commission notes that Amendment Nos. 2 and 3 involve technical and
procedural matters relating to the extension of the Commission's
statutory review process and the numbering of the proposed rules.
Accordingly, the Commission believes that Amendments Nos. 2 and 3 raise
no issues of regulatory concern.
With respect to Amendment No. 4, the Commission notes that the
Amendment, among other things, clarifies the proposal and extends the
implementation schedule for the proposed changes. In Amendment No. 4,
the NASDR clarifies its original proposal by redefining certain terms,
such as ``electronic order,'' and adding defined terms, such as
``manual order,'' to more accurately reflect current industry
understanding of those terms. Amendment No. 4 also revises proposed
Rule 6954 to separately address four different order transmittal
scenarios. The Commission supports these clarifications and believes
they should assist member firms in their efforts to comply with the new
requirements. The NASDR also proposes to delay the phase-in of the OATS
implementation schedule to provide member firms with additional time to
develop and test their systems prior to the mandatory implementation
date. The Commission notes that the proposed extension of the effective
dates is directly responsive to the comment letters submitted on the
proposed rule.
[[Page 12569]]
In addition, Amendment No. 4 contains several proposed
modifications to the proposed rule change, the majority of which will
facilitate member compliance, often at a lower cost. For example, in
response to a number of commenters' concerns, Amendment No. 4 proposes
to modify the specifications for electronic orders to conform the
unique order identifier requirement to the industry standard of eight
characters and to delete the requirement to pass the order origination
date. The Commission believes that the proposed modifications relating
to the technical specifications for electronic orders should
substantially ease the compliance burden imposed on NASD members by the
proposed rule without undermining the purpose of the OATS. Further
proposed modifications contained in Amendment No. 4 would facilitate
the reporting requirements relating to bunched orders. Amendment No. 4
also proposes to modify the proposal by limiting the reporting
requirements applicable to ECN's to conform to those requirements
applicable to manually transmitted orders.
Moreoever, Amendment No. 5 proposes to delete the provisions in the
proposed rule text stating that the information required to be recorded
by the Reporting Member operating an ECN is that information provided
to the ECN by the transmitting Reporting Member. The Commission notes
that Amendment No. 5 proposes to conform the language of the text to
the technical specifications for OATS developed by the NASDR.
Consequently, the receiving ECN will be required to record the
applicable information items specified in Rule 6954(c) at the time the
order is received from the transmitting member. As discussed above, the
Commission notes that the proposed modifications to the proposed rule
change contained in Amendment Nos. 4 and 5 are directly responsive to
the concerns expressed in comment letters submitted to the Commission.
Finally, Amendment No. 6 provides a number of clarifying and
technical amendments which raise no issues of regulatory concern.
Amendment No. 6 clarifies the treatment of bunched orders, and modifies
the language of the proposed rule both to eliminate inapplicable
references and to make the rule text easier to understand. Amendment
No. 6 also revises the implementation date of Phase One of OATS to
allow market participants additional time to implement the required
systems changes and to conduct necessary testing.
Further, Amendment No. 6 eliminates the requirement under proposed
Rule 6954(c)(1) that an order that is transmitted from one department
to the trading desk of the same firm must be reported to OATS. As OATS
will assume that transmissions for which there is no routing report
have been transmitted to the member's trading desk, the Commission
believes that this amendment will allow OATS to obtain sufficient
information while reducing unnecessary recordkeeping and reporting
burdens imposed on member firms.
In addition, Amendment No. 6, by amending NASD Rule 3110,
reinstates the recordkeeping requirements initially proposed by the
NASDR and published for comment by the Commission. In particular,
Amendment No. 6 amends Rule 3110 to require information items
pertaining to the identification of persons and departments receiving
or originating orders to be recorded by Reporting Members. The
Commission notes that such items were initially proposed to be recorded
and reported to OATS and thus, Amendment No. 6 minimizes the reporting
obligations of member firms while ensuring that vital identifying
information continues to be available for regulatory purposes.
Accordingly, the Commission believes that it is consistent with the Act
in general and with Section 15A(b)(6) of the Act \112\ in particular to
approve Amendment Nos. 2, 3, 4, 5, and 6 to the proposed rule change on
an accelerated basis.
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\112\ 15 U.S.C. 78o-3(b)(6).
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VI. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning Amendments Nos. 2, 3, 4, 5, and 6, including
whether the proposed Amendments are consistent with the Act. 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 Section, 450 Fifth Street, N.W., Washington, D.C. 20549.
Copies of all such filings will also be available for inspection and
copying at the principal office of the NASD. All submissions should
refer to File No. SR-NASD-97-56 and should be submitted by April 3,
1998.
VII. Conclusion
The Commission believes that the proposal, as amended, should
significantly assist the NASDR's efforts in fulfilling its regulatory
responsibilities. The Commission further believes the proposed rules
meet the minimum requirements for an order audit trail system imposed
by the Commission in the SEC Order, which required a time-sequenced
record of orders and market-wide synchronization of all member firms'
business clocks. In addition, the OATS should provide a useful
surveillance tool that will allow earlier detection of fraudulent
activity for the benefit of investors and the public. Therefore, the
Commission believes the approval of the proposed Order Audit Trail
System, as amended, is appropriate and consistent with the requirements
of the Act applicable to a national securities association, and in
particular, with the requirements of Section 15A(b)(6) of the Act \113\
and the rules and regulations thereunder.
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\113\ 15 U.S.C. 78o-3.
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\114\ that the proposed rule change (SR-NASD-97-56), including
Amendment Nos. 1, 2, 3, 4, 5, and 6, is approved.
\114\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\115\
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\115\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-6528 Filed 3-12-98; 8:45 am]
BILLING CODE 8010-01-M