Executive Summary obligations CQS market makers3 NASD On November 26, 1997, the Securi- have with respect to the quotation ties and Exchange Commission (SEC and trading in exchange-listed securi- or Commission) approved changes to ties. Specifically, the SEC adopted a NOTICE TO National Association of Securities new rule 11Ac1-4 (Limit Order Dis- Dealers, Inc. (NASD¨) rules govern- play Rule) and amendments to SEC ing trading in exchange-listed securi- Rule 11Ac1-1 (Quote Rule).4 In par- MEMBERS ties in the over-the-counter market ticular, an amendment to the Quote (the Third Market). The amend- Rule expanded the quotation require- ments: (1) codify permissible uses of ments of substantial OTC market 98-5 computer-generated quote systems; makers and exchange specialists to (2) eliminate the excess spread rule; require that they publicly disseminate (3) reduce the minimum quotation continuous two-sided quotations for size applicable to Consolidated Quo- any exchange-listed security for tation System (CQS) market makers which they account for 1 percent or to one unit of trading (i.e., 100 more of the trading volume (com- SEC Approves Changes shares) regardless of whether the monly referred to as the 1 Percent To Third Market Trading market maker is displaying a cus- Rule).5 Prior to those rule changes, tomer’s limit order or quoting for its mandatory quotations were only Rules own proprietary account; (4) extend required from OTC market makers pertinent provisions of the NASD’s and exchange specialists who trans- limit order protection rule applicable acted more than 1 percent of the vol- to securities listed on The Nasdaq ume in a Rule 19c-3 security.6 Those Suggested Routing Stock MarketSM (the Manning Rule) rule changes are intended to improve Senior Management to exchange-listed securities; and transparency and provide the public (5) change the Computer Assisted with information about significant Advertising Execution SystemSM (CAESSM) to market participants. The NASD rule Continuing Education automatically execute at the firm’s changes are described below. displayed price and up to the firm’s Corporate Finance displayed size only. The rule Executive Representatives changes are effective December 16, Summary Of Rule Changes Government Securities 1997, with the exception of the rules 1. Codification Of Permissible Uses relating to computer-generated quo- Of Computer-Generated Quote Institutional tations, which are effective Decem- Updates For Non-Rule 19c-3 Insurance ber 22, 1997.1 Securities Internal Audit Questions concerning this Notice In expanding the 1 Percent Rule, and Legal & Compliance may be directed to Thom Bennett, requiring active market makers to ¨ Municipal Manager, Nasdaq Market Opera- quote in the Third Market, the Com- tions, at (203) 385-6305, or Andrew mission recognized that it raised Mutual Fund S. Margolin, Senior Attorney, issues with respect to the ability of Operations The Nasdaq Stock Market, Inc., at NASD members to employ comput- Options (202) 728-8869. er-generated quote systems in light of the constraints imposed by the plan Registered Representatives governing the Intermarket Trading Registration Background System (ITS Plan) and the NASD Research The SEC has approved several policy on autoquoting. Under the amendments to NASD rules govern- ITS Plan, exchange specialists and Syndicate ing trading in exchange-listed securi- CQS market makers can use “auto- Systems ties by market makers in the Third mated quotation tracking systems,” Market.2 The NASD proposed these provided that the quotations generat- Trading amendments in light of the imple- ed by such systems are for 100 Training mentation of the SEC’s Order Han- shares or less (100-Share Autoquot- Variable Contracts dling Rules, which enhanced the ing Limitation). Despite the ITS

NASD Notice to Members 98-5 January 1998 29 Plan’s allowance of 100-share auto- ITS, because lifting the ban on com- price, the CQS market maker could quotes, CQS market makers were puter-generated quotations for these not use the program to track such prohibited from using computer-gen- securities would still conflict with the inferior price. Thus, if the best offer erated quotes under the NASD’s ITS Plan in its current form. is 20 1/4, a CQS market maker could autoquoting policy, which prohibited use the program to improve its offer firms from using such systems to As amended, NASD Rule 6330(d) to 20 1/4. If the market responsible effect automated quote updates or now explicitly permits, for non-Rule for the 20 1/4 offer moved to 20 3/8, track the inside market. In addition, 19c-3 securities only, the following however, the CQS market maker the NASD’s rule requiring CQS mar- uses of computer-generated quote could not use the program to move ket makers to quote a minimum updates: its offer to 20 3/8. quote size of 500 shares when they were not displaying a customer limit ¥ an update in response to an execu- 2. Elimination Of Excess Spread order effectively prohibited CQS tion; Rule For All Exchange-Listed market makers from autoquoting. Securities • a manual entry into a firm’s system The Commission, however, believes that then routes the update to the In conjunction with the amendments that the existing prohibition on the Nasdaq system; to permit only certain types of com- use of computer-generated quotes is puter-generated quote updates while no longer appropriate. Such an • an update to reflect the receipt, exe- retaining the ban on autoquoting approach may excessively limit the cution, or cancellation of a customer away as discussed above, the NASD use of sophisticated trading strategies limit order; determined to enhance the quotation that rely on automation in the quota- flexibility of CQS market makers by tion process for their success. It also ¥ exposing an order for price eliminating the current excess spread may act as a competitive disadvan- improvement; and rule, Rule 6330(c). That rule, as tage to market makers and specialists applied to CQS securities, provided that would otherwise rely on technol- ¥ equaling or improving either or that a CQS market maker could not ogy to meet their quotation obliga- both sides of the national best bid or enter a quotation spread in excess of tions more efficiently.7 Given the offer (NBBO), or adding size to the 125 percent of the average of the enhanced quotation obligations NBBO. three narrowest market maker imposed on some market participants spreads in such security, which aver- under the revised Quote Rule, there- These changes explicitly accommo- age spread calculation should include fore, the Commission urged the date computer-generated quotations quotations from national securities NASD, ITS participants, and other that add value to the market and do exchanges. In an environment that interested market participants to not raise quotation accessibility con- retains the ban on autoquoting away, develop revised standards that would cerns or compromise the capacity or the elimination of the excess spread permit the use of computer-generated integrity of Nasdaq. In this regard, rule will provide CQS market mak- quotes, provided that such quotations it is important to note that market ers with the ability to update their contribute value to the market. makers are prohibited from using quotes in an efficient and cost-effec- computer-generated quotes to tive manner while minimizing the To this end, the NASD has eliminat- track away from the inside market impact on the operation and capacity ed certain restrictions on the use of (“autoquoting away”). Thus, the of Nasdaq systems that collect, pro- automation to update quotes in new rule will permit computer-gen- cess, and disseminate quotation exchange-listed securities.8 These erated quotations in exchange-listed changes. This should serve to mini- changes do not apply to securities list- securities that generate proprietary mize the potential adverse competi- ed on The Nasdaq Stock Market. The quotes for 100 shares or more if such tive consequences on highly rule governing automated quote quote systems equal or improve automated CQS market making. updates for Nasdaq securities (IM- either or both sides of the NBBO. 4613) is being retained in its current 3. Changes To Minimum Quote form. Furthermore, it should be For example, if a CQS market maker Size For CQS Market Makers noted that these restrictions have utilized a computer-generated quota- been eliminated only for non-Rule tion program to match the best offer NASD Rule 6330(b) previously pro- 19c-3 securities. Thus, restrictions (bid) and the market responsible for vided that a CQS market maker must will remain for those exchange-listed the best offer (bid) subsequently display a minimum quotation size of securities eligible for trading through increased (decreased) its offer (bid) 500 shares, with the exception of dis-

NASD Notice to Members 98-5 January 1998 30 playing a customer limit order, which to execute trades up to 1,000 shares Text Of Amendments could be for less than 500 shares. In at another market maker’s quote, (Note: New text is underlined; deletions are an environment where CQS market they must also execute trades at bracketed.) makers were the only market partici- superior-priced limit orders dis- pants who could impact quotes in the played by any other CQS market 6330. Obligations of CQS Market Third Market, it was desirable and maker, even if such limit orders are Makers appropriate to impose a minimum only for 100 shares. quotation size requirement to ensure (a) No Change an acceptable level of market liquidi- Accordingly, CAES has been modi- ty and depth. fied in order to facilitate the best exe- (b) [CQS market makers shall be cution of customer orders and not required to input a minimum quota- Now that the SEC’s Limit Order Dis- subject CQS market makers to auto- tion size of 200 or 500 shares in each play Rule permits investors to direct- matic executions at prices other than reported security (as established and ly impact quoted prices in the Third their posted quotes. Specifically, published from time to time by the Market by having their limit orders CAES will now automatically exe- Association) depending on trading displayed publicly, however, it is cute at the firm’s price and up to the characteristics of the security; pro- appropriate to treat CQS market firm’s displayed size. vided that a CQS market maker may makers in a manner equivalent to input a quotation size less than such exchange specialists and not subject 5. Modifications To The Limit minimum quotation size to display a them to minimum quote size require- Order Protection Rule Applicable limit order in compliance with SEC ments. Accordingly, Rule 6330(b) To CQS Securities Rule 11Ac1-4. A limit order dis- now provides that CQS market mak- played in a ] A CQS market maker’s ers may post quotations commensu- NASD Rule 6440 provides that no quotation [pursuant to SEC Rule rate with their own freely-determined member shall trade ahead of a cus- 11Ac1-4] must be for at least one trading interest, provided that the tomer limit order. Unlike the limit normal unit of trading [or a multiple quotations are for at least one normal order protection rule applicable to thereof]. unit of trading. Nasdaq securities (the Manning Rule), however, the limit order pro- [(c) Excess Spreads. 4. Modifications To CAES tection rule applicable to exchange- listed securities does not explicitly A market maker shall not enter quo- The implementation of the SEC’s permit a member to negotiate special tations in CQS securities that exceed Limit Order Display Rule exacerbat- terms and conditions with a cus- the parameters for maximum allow- ed a shortcoming in the design of the tomer. Specifically, under the Man- able spreads as approved by the CAES system.9 Specifically, while ning Rule, member firms may attach Association’s Board of Governors in the past CAES volume was mini- terms and conditions with respect to and that may be published from time mal, it permitted other CQS market the handling of limit orders that are to time by the Association. The makers to send preferenced orders of either: (1) for institutional accounts;10 maximum allowable spreads for up to 1,000 shares to another CQS or (2) limit orders that are for 10,000 CQS securities shall be 125 percent market maker for automatic execu- shares or greater, regardless of of the average of the three (3) nar- tion at the best bid or offer among whether they are for institutional rowest market maker spreads in each CQS market makers. CAES would accounts, provided that the order is security, which average spread calcu- execute such orders regardless of $100,000 or more in value. lations shall include quotations from whether the CQS market maker was national securities exchanges (if the at the best bid or offer, the quote The NASD believes there is no basis number of CQS market makers in a driving the BBO was for less than to differentiate between limit orders in security plus the number of national 1,000 shares, or the CQS market Nasdaq securities and limit orders in securities exchanges trading that maker wanted to accept preferenced exchange-listed securities with respect security is less than three (3), the orders from the order entry firm or to the protections afforded under maximum allowable spread will be market maker. NASD rules. Accordingly, the NASD 125 percent of the average spread); is extending the “terms and condi- provided, however, that the maxi- Now, because the Order Handling tions” language of the Manning Rule mum allowable spread shall never be Rules require market makers to dis- to the CQS limit order protection rule. less than 1/4 of a point.] play customer limit orders, CQS market makers are not only obligated (d) redesignated as paragraph (c)

NASD Notice to Members 98-5 January 1998 31 (d) Computer-Generated Quotations. (C) No Change ly, exchange-traded securities not subject to off-board trading restrictions are referred to (1) General Prohibition - Except as (D) to any purchase or sale for which as Rule 19c-3 securities. While the amend- provided below, this rule prohibits a member has negotiated specific ments to the Quote Rule extended the quota- the automatic updating or tracking of terms and conditions applicable to tion requirement to all exchange-listed inside quotations in CQS by comput- the acceptance of limit orders that securities, the Commission, by exemptive er-generated quote systems. This are: order, provided relief from compliance with ban is necessary to offset the nega- the 1 Percent Rule with respect to non-Rule tive impact on the capacity and oper- (i) for customer accounts that meet 19c-3 securities until September 30, 1997. ation of Nasdaq systems regarding the definition of an “institutional See Exchange Act Release No. 38870 (July certain systems that track changes to account” as that term is defined in 24, 1997), 62 FR 40732 (July 30, 1997). the inside quotation and automatical- Rule 3110(c)(4); or ly react by generating another quote 7 See Adopting Release at Section III.B.3.c.i. to keep the market maker’s quote (ii) for 10,000 shares or more, unless away from the best market, without such orders are less than $100,000 in 8 These uses are in addition to three other any cognizable human intervention. value. forms of computer-enhanced quotation main- tenance programs referenced in the NASD’s (2) Exceptions to the General Prohi- existing Autoquote Policy with respect to bition — Automated updating of Endnotes securities listed on Nasdaq, which are also quotations is permitted when: (1) the 1 A brief announcement of these rule changes being incorporated into Rule 6330 with update is in response to an execution was made by fax to members dated Decem- respect to exchange-listed securities. See in the security by that firm (such as ber 16, 1997, and posted on the Nasdaq NASD IM-4613. Specifically, these three execution of an order that partially TraderSM Web Site (www.nasdaqtrader.com). forms are: (1) quotation updates in response fills a market maker’s quotation to an execution in the security by that firm size); (2) it requires a physical, cog- 2 See Exchange Act Release No. 39367 (such as execution of an order that partially nizable entry (such as a manual entry (November 26, 1997), 62 FR 64242 (Decem- fills a market maker’s quotation size); (2) to the market maker’s internal sys- ber 4, 1997). quotation updates that require a physical tem which then automatically for- entry (such as manual entry to the market wards the update to a Nasdaq 3 Quotations and quotation sizes in reported maker’s internal system which then automati- system); (3) the update is to reflect securities may be entered into the Consolidat- cally forwards the update to Nasdaq); and (3) the receipt, execution, or cancellation ed Quotations Service (CQS) through The quotation updates that reflect the receipt, exe- of a customer limit order; (4) it is Nasdaq Stock Market only by an Association cution, or cancellation of a customer limit used to expose a customer’s market member registered with it as a CQS market order. With the exception of these types of or marketable limit order for price maker. See NASD Rule 6320. computer-generated quotation and mainte- improvement opportunities; or (5) it nance systems, all other types of computer- is used to equal or improve either or 4 See Securities Exchange Act Release No. generated quotations would continue to be both sides of the national best bid or 37619A (September 6, 1997), 61 FR 48290 prohibited. Thus, market makers could not offer (“NBBO”), or add size to the (September 12, 1997) (“Adopting Release”). use computer-generated quotations to track NBBO. away from the inside market (“autoquoting 5 See Adopting Release at 48317. An OTC away”). 6440. Trading Practices market maker must, within 10 business days of the end of each calendar quarter, compute 9 CAES is an automated system operated by (a) Ð (e) No Change its trading volume for each subject security, Nasdaq that allows NASD members to direct and if the volume exceeds 1 percent, the mar- both agency and principal orders (in stocks in (f)(1) No Change ket maker must begin publishing two-sided which they make a market) in exchange-list- quotations. ed securities to CAES for automated execu- (f)(2) No Change tion in the third market. All CQS market 6 Exchange Act Rule 19c-3 prohibits the makers must be CAES market makers. (3) The provisions of this paragraph application of off-board trading restrictions to shall not apply: securities that: (1) were not traded on an 10 Institutional limit orders are orders for exchange on or before April 26, 1979; or (2) institutional accounts. NASD Rule 3110(c) (A) No Change were traded on an exchange on April 26, defines an institutional account as an account 1979, but ceased to be traded on an exchange for: (1) banks, savings and loan associations, (B) No Change for any period of time thereafter. According- insurance companies, or registered invest-

NASD Notice to Members 98-5 January 1998 32 ment companies; (2) investment advisors reg- istered under Section 203 of the Investment Advisers Act of 1940; and (3) any other enti- ty (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of at least $50 million.

© 1998, National Association of Securities Dealers, Inc. (NASD). All rights reserved.

NASD Notice to Members 98-5 January 1998 33