GUIDANCE
Market Order Protection
Effective Date: January 9, 2006
|
SUGGESTED ROUTING |
KEY TOPICS |
Internal Audit
Legal & Compliance
Operations
Senior Management
Systems
Trading |
[IM-2110-2]
Manning Rule
Market Orders
[Rule 2111] |
Executive Summary
In October 2005, NASD issued Notice to Members (NTM) [05-69]
informing members of Securities and Exchange Commission (SEC)
approval of new [Rule 2111], Trading Ahead of Customer Market
Orders. Among other things, new [Rule 2111] prohibits a firm that
accepts and holds a customer market order from trading for its own
account at prices that would satisfy the customer market order,
unless the firm immediately thereafter executes the customer
market order. [Rule 2111] becomes effective on January 9, 2006. In
this Notice, NASD staff is providing questions and answers regarding
the application of the new rule to assist member firms in their
implementation. NASD filed this Notice with the SEC as a proposed
rule change on January 6, 2006.1 The proposed rule change became
effective upon filing pursuant to [Section 19](b)(3)(A)(i) of the
Securties Exchange Act and [Rule 19b-4](f)(1) thereunder, in that
the proposed rule change constitutes a stated policy, practice or
interpretation with respect to the meaning, administration or
enforcement of an existing NASD rule. The compliance date of the
proposed rule change will be January 9, 2006, which coincides with
the compliance date for [Rule 2111].
Questions/Further Information
Questions regarding this Notice may be directed to the Legal
Section, Market Regulation, at (240) 386-5126; or Office of General
Counsel, Regulatory Policy and Oversight, at (202) 728-8071.
Background
As further described in NTM [05-69], the SEC approved new [Rule 2111], which prohibits a
firm that accepts and holds a customer market order from trading for its own account
on the same side of the market as the customer market order at prices that would
satisfy the customer's market order, unless the firm immediately thereafter executes the
customer market order up to the size and at the same price or better at which the firm
traded for its own account.2
In addition, if a member is holding a customer market order that has not been
immediately executed, [Rule 2111] requires that the member make every effort to
match the pending market order against any market orders, marketable limit orders
or non-marketable limit orders priced better than the best bid or offer, received by the
member on the other side of the market. Such orders must be executed at a price that
is no less than the best bid, no greater than the best offer at the time the subsequent
order is received by the member, and consistent with the terms of the pending market
order. In the event that a member is holding multiple orders on both sides of the
market that have not been executed, the member must make every effort to cross or
otherwise execute such orders in a manner that is reasonable and is consistent with
the objectives of the rule and with the terms of the orders. Members must have a
written methodology in place governing the execution priority of all such pending
orders, whether the member is holding one order or multiple orders on both sides of
the market, and must ensure that such methodology is consistently applied. The new
rule becomes effective on January 9, 2006.
Questions and Answers Relating to Market Order Protection
To help members implement [Rule 2111], NASD is publishing the following questions
and answers relating to the application of new [Rule 2111].
Q1 To which securities does Rule 2111 apply?
A [Rule 2111] applies to all NASDAQ and exchange-listed securities.
Q2 Does Rule 2111 apply to non-market makers?
A Yes. [Rule 2111] applies to all firms that accept and hold customer market orders,
irrespective of whether the firm is a market maker in the security.
Q3 Does Rule 2111 apply to orders accepted by a firm on a "not held" basis?
A An order for which a customer has granted the firm discretion with respect to time
or price would not be considered a "market" order for the purposes of [Rule 2111]
and therefore would not be subject to the requirements of [Rule 2111]. However, this
in no way changes a firm's best execution obligations with respect to the order under
[Rule 2320].
Q4 Do the requirements under paragraphs (b) and (c) of Rule 2111 apply to odd-lot
orders?
A No. In other words, odd-lot orders are not subject to the requirements under [Rule 2111]
(b) and (c); nor does the receipt of such orders on the other side of the market of a
protected market order trigger the firm's requirement to cross orders under [Rule 2111](c).
However, [Rule 2111] does apply to mixed-lot orders (e.g.,150 shares) in both cases. In
addition, firms are required to make every effort to execute odd-lot orders fully and
promptly as required by [Rule 2111](a) and must comply with [Rule 2320](a) with respect
to those orders.
Q5 Does Rule 2111 apply to customer market orders received from other broker-dealers?
A Yes. Similar to [IM-2110-2], protected customer market orders include orders received
from the firm's own customers as well as customer orders of another broker-dealer.
Q6 For purposes of Rule 2111, what does "accepts and holds" a customer market
order mean?
A A firm that has accepted a customer market order and does not immediately execute
the order or immediately route the order to a market center for which the firm has a
reasonable expectation that the order will be executed consistent with [Rule 2320] will
be deemed to have "accepted and held" the order for purposes of [Rule 2111].
Q7 Once my firm has immediately routed a market order to another market center,
does it still have any obligations under Rule 2111?
A Yes. Although a firm will not be deemed to have "accepted and held" a market order
if the firm immediately routes the order to a market center for which the firm has a
reasonable expectation that the order will be executed consistent with [Rule 2320], the
firm has a continuing obligation under [Rule 2111] to monitor whether the order is, in fact,
executed in accordance with [Rule 2320] and the specific terms of the order. In this regard,
it may be necessary for the firm to retract its order from the recipient market center to
comply with [Rule 2111] if it appears that the market center will not provide the order
best execution.
Under these circumstances, once the firm has retracted the order, the firm is obligated
to comply with the provisions of [Rule 2111] with respect to the order if the firm accepts
and holds the order at that time. However, in all cases, if the firm traded for its own
account on the same side of the market as the routed customer order while the customer
order was pending at another market center, the firm must immediately fill the customer
order at the best price(s) and up to the size it traded for its own account while the order
was pending.
Q8 Does Rule 2111 apply to institutional-sized market orders or market orders placed
by large institutions?
A Yes. However, as orders for institutions and institutional-sized orders generally involve
best-effort commitments and substantial capital commitments by the firm, firms handling
such orders can negotiate specific terms and conditions to permit the firm to trade along
side of, or ahead of, the institution or an institutional-sized order without violating [Rule 2111]. Such terms and conditions are permissible only if the market order is placed on
behalf of an institutional account, as defined in [Rule 3110](c)(4), or is greater than 10,000
shares (and the value of that order is $100,000 or greater), and the customer agrees to
the terms and conditions.
Q9 How should the firm disclose such terms and conditions, as described in Question
8, to customers?
A As noted above, [Rule 2111] allows firms to negotiate specific terms and conditions that
would permit the firm to trade along side of, or ahead of, the market order only with
respect to institutional accounts or market orders that are 10,000 shares or more and the
value of that order is $100,000 or more. The firm imposing the terms and conditions on
the market order must ensure that those terms and conditions are clearly disclosed and
explained to the customer. The appropriate method of disclosure will depend on the
customer's level of sophistication and understanding. For example, generalized, arms-length
disclosure and acceptance procedures may be sufficient where the customer is
sophisticated and clearly understands the disclosures being provided. A firm relying on
this exclusion to [Rule 2111] must document such disclosures and be able to demonstrate
that it has met the conditions of the exclusion.
Q10 Does Rule 2111 mandate any particular methodology for market order handling
priority procedures?
A NASD has not mandated any particular order handling procedures and execution priorities
among market orders. Thus, a firm may choose any reasonable methodology for the way
in which it executes multiple orders that it receives, but the firm must ensure that such
methodology is applied consistently and complies with applicable rules and regulations. Such methodology must address the order handling and execution priority of all of the
firm's orders, including, but not limited to, market orders, marketable limit orders and
limit orders, as well as order handling procedures and execution priorities for orders that
have been retracted as described in Question 7.
For example, a firm could use a first in first out (FIFO) methodology or some other
objective methodology or formula. It would be inappropriate, however, for a firm's
methodology to give priority, for example, to orders of certain "preferred accounts"
or to give preference to institutional orders over retail orders.
To the extent a firm elects a specific methodology, the firm must document that
methodology and have written supervisory procedures and systems in place to ensure
that the methodology it has chosen is consistent with, among other things, the duty of
best execution. Further, simply because a firm employs a methodology for order execution
and that methodology is followed in a particular circumstance does not automatically
mean that any or all customer orders executed pursuant to such a methodology have
received best execution under [Rule 2320].
Q11 Does Rule 2111 apply to orders for accounts where the firm is bound by another
regulation limiting or prohibiting principal transactions with customer orders?
A Consistent with prior interpretations concerning the application of [IM-2110-2],3 the
obligation to execute a protected customer market order following a proprietary
transaction on the same side of the market would not apply where the order is for an
account for which the firm is limited or prohibited from executing a principal transaction
with the customer order and the order subject to these restrictions has been sent to
another broker-dealer for execution.
Q12 Assume the inside market for security ABCD is 10 to 10.05 and Firm A accepts
and holds a market order to buy 1,000 shares of ABCD from Customer C1. If Firm
A buys 1,000 shares of ABCD at 10 from Firm B (or from any other source), what
obligations would Firm A have under Rule 2111?
A Firm A would be required to fill C1's order at 10 or better. Similarly, if Firm A bought
shares for its own account below the best bid of 10, it would be required to fill C1's
order at that same price below the bid or better.
Q13 Assume that the inside market for security ABCD is 10 to 10.05 and Firm A accepts
and holds a market order to buy 1,000 shares of ABCD from Customer C1 and
immediately thereafter, receives a market order to buy 500 shares of ABCD from
Customer C2. If Firm A purchases 1,000 shares at 10 to fill C1's order on a riskless
principal basis and otherwise meets the requirements of the riskless principal
exception to Rule 2111, what are Firm A's obligation to C2?
A Firm A's riskless principal trade would not trigger an obligation by Firm A to execute C2's
order under [Rule 2111]. Similarly, if Firm A were to execute C2's order for 500 shares on a
riskless principal basis prior to executing C1's order, the riskless principal trade would not
trigger an obligation by Firm A to execute (or partially execute) C1's order.
Q14 Assume the inside market for security ABCD is 10 to 10.05 and Firm A accepts and
holds a market order to buy 1,000 shares of ABCD from Customer C1. Subsequent
to the receipt of this order, Firm A receives a not held order from an institutional
Customer C2 to sell 1,000 shares of ABCD on a net basis for a negotiated fee of
.02 per share. If Firm A sells 1,000 shares of ABCD to the street at 10.02 and then
buys and reports 1,000 shares of ABCD from Customer C2 at the net price of 10,
at what price must the firm sell to Customer C1 to fill C1's pending market order
to buy and still be in compliance with Rule 2111?
A [Rule 2111] requires that Firm A execute Customer C1's order at a price of 10, the same
price at which it traded for its own account, or better.
Q15 May a trading desk other than the market-making desk of the firm trade ahead
of or along side a market order held by the market-making desk?
A As described in NTM [95-43] (June 1995) and NTM [03-74] (November 2003) relating to
the application of [IM-2110-2], if the firm implements and utilizes an effective system
of internal controls, such as appropriate information barriers, that operate to prevent
non-market-making desks engaged exclusively in proprietary trading from obtaining any
knowledge of customer orders held at the market-making desk, those other proprietary
non-market-making desks may continue to trade in a principal capacity at prices that
would satisfy the customer market orders held at the market-making desk. As specifically
noted in NTM [03-74], NASD will continue to examine and review firms' information
barriers for compliance with this and other applicable information barrier standards to,
among other things, ensure that there are proper information barriers in place to ensure
that other desks are not able to access or benefit in any way from the information
regarding trading by customer accounts at other desks.
Q16 If a firm accepts and holds a customer market order, but has not bought or sold
securities for its own account on the same side of the market as the customer
order and has not received a market order or marketable limit order on the other
side of the market, what obligations does the firm have under Rule 2111?
A [Rule 2111] and [Rule 2320] require the firm to execute that customer market order fully
and promptly. Under these facts and circumstances, [Rule 2111] would not impose any
additional specific obligations on the firm beyond the firm's current obligations to market
orders. However, it is important to note that, to the extent a firm does not execute a
market order fully and promptly, compliance with [Rule 2111] would not safeguard the
firm from potential liability due to non-compliance with its best execution responsibilities.
Q17 Assume that the inside market for security ABCD is 10 to 10.05 and Firm A accepts
and holds a market order to buy 1,000 shares of ABCD from Customer C1 and
immediately thereafter receives a market order to sell 1,000 shares of ABCD from
Customer C2. Can Firm A price improve the execution of Customer C2's market
order and not be required to execute C1's order?
A No. [Rule 2111] requires that Firm A make every effort to cross C1's order at a price that
is no less than the best bid (10) and no greater than the best offer (10.05) at the time
that C2's market order to sell is received by Firm A. Unlike [IM-2110-2], there is no ability
to price improve an incoming order to avoid a [Rule 2111] obligation to an unexecuted
market order.
Q18 Once a firm trades through a customer market order, how quickly must it execute
the market order to comply with Rule 2111?
A If a firm trades through a customer market order that it has accepted, the Rule provides
that it must immediately execute such market order. To meet this obligation, a firm must
execute the market order as quickly as possible. For further guidance, see NTM [95-67]
(Question and Answer No. 5) (August 1995) and NTM [98-78] (September 1998).
Q19 Does the guidance provided by NASD in NTM 98-78 (September 1998) concerning
the application of IM-2110-2 during unusual market conditions apply to Rule
2111?
A Yes. As described in more detail in NTM [98-78], under appropriate circumstances, orders
need not be filled within one minute if activated during unusual market conditions and
if all reasonable steps are taken to execute the transaction as soon as possible following
activation.4
1See File No. SR-NASD-2006-003. See also 15
U.S.C. 78s(b)(3)(A)(i) and 17 CFR 240.19b-4(f)(1).
2See Securities Exchange Act Release No. 52226
(August 9, 2005), 70 FR 48219 (August 16, 2005)
(File No. SR-NASD-2004-045).
3See Letters from The Nasdaq Stock Market,
Inc., dated July 3, 1997, re: Exemption from
Limit Order Protection Rule for Registered
Investment Advisers Maintaining a Wrap Fee
Account Programs, and dated April 16, 1997,
re: Exemption from Limit Order Protection
involving ERISA.
4See NASD NTM [98-78] (September 1998).
