SEC Request For Comments on NASDAQ Options Proposal (Comment Period Ends on June 15, 1984)

I M P O R T A N T

Officers * Partners * Proprietors

TO: All NASD Members

On April 12, 1984, the SEC issued Release No. 34-20853 requesting public comments on the NASDAQ Options Program. The text of this release, together with a document which provides an overview of the NASDAQ Options Program and a fact sheet highlighting major features of the program, are enclosed with this notice.

The Commission's release also solicits comments on proposals by the Chicago Board Options Exchange and the American, Pacific, Philadelphia and New York Stock Exchanges to trade options on NASDAQ NMS securities.

The SEC's decisions on vital issues raised in the enclosed release will determine whether you, as NASDAQ market makers, will be permitted to trade standardized options on NASDAQ NMS securities in the NASDAQ market or whether these options will be traded on the exchanges.

In sum, the Commission's decisions on important questions raised in the attached release, as influenced by comments received, will determine the future market structure for standardized options trading. Because of the importance of the issues involved, the Board of Governors strongly urges members to comment on the release.

This notice and the enclosed material have been prepared to assist members in reviewing the Commission's release and preparing comments thereon.

Review of the NASDAQ Options Proposal and SEC Request for Comments

As explained in the enclosed fact sheet and overview, the NASDAQ Options Program will permit the quotation display of standardized put and call options on certain actively traded NASDAQ National Market System ("NMS") securities and certain NASDAQ and NASDAQ NMS indices.

Several new and innovative second generation concepts in options trading are being built into the NASDAQ Options Program. These include a small order execution system and the introduction of facilities for creating "locked-in" trades for purposes of trade reporting, confirmation, comparison and clearance.

The NASD's Board of Governors believes that the NASDAQ Options Program represents a major step forward in the evolution of industry facilities which will provide an options market that is superior to any that is in place today.

Comments on the SEC's Release

The Commission's release solicits comments on many details of the NASDAQ Options Program and members are encouraged to carefully read the Commission's Release and provide their input in this regard.

In addition to these specific comments, the SEC is raising certain threshold issues, resolution of which will shape the future market structure for standardized options trading. These issues, which the Board urges members to comment on, are as follows:

• "Integrated" or "side-by-side" trading in the NASDAQ Options Program.
• Decisions as to which markets will be permitted to trade NASDAQ options.
• The desirability of automatic executions and locked-in trades for options and other advanced features of the NASDAQ Options Program.
• Surveillance requirements for NASDAQ options trading involving both options and underlying securities.

Integrated Trading

The focal point of the Association's proposed program is the ability of members to make markets simultaneously in both options and their underlying securities, i.e., "side-by-side" or "integrated" market making. Integrated market making will be permitted only when there are a minimum of ten market makers in an underlying NASDAQ security and five market makers in its related NASDAQ option. Having carefully studied this issue, the Association's Board has concluded that the ability of firms to make side-by-side markets is not only appropriate but also extremely desirable given the highly competitive nature of the NASDAQ market. In the competitive NASDAQ market, there is little justification for prohibiting members from simultaneously making markets in both stocks and options.

In this regard, an analysis of integrated trading in warrants and underlying equities via NASDAQ has shown to the Board's satisfaction that this practice does not raise undue regulatory concerns and, in fact, may increase market maker participation in both equity and derivative securities markets and may improve the quality of markets for underlying securities. The results of this study on integrated trading in warrants and equities are contained in a document entitled An Analysis of the Economic and Regulatory Issues Relating to Integrated Market Making in Options and Underlying Securities on NASDAQ. This study, which was filed with the SEC on December 22, 1983, may be obtained from the Association upon request.

Because integrated trading will benefit NASDAQ market makers and the NASDAQ market without raising concomitant regulatory concerns, the Board of Governors strongly urges members to support integrated trading in the NASDAQ Options Program in their comments to the SEC on the enclosed Release.

Exchange vs. NASDAQ Trading of Options on NASDAQ NMS Securities

In addition to requesting comments on the NASDAQ Options Program, the Commission's release also solicits comments on proposals by the Chicago Board Options Exchange and the American, Pacific, Philadelphia and New York Stock Exchanges to trade options on NASDAQ NMS securities.

Current SEC policies do not permit the trading of an options class in more than one market, a practice referred to as "multiple trading." The exchanges' and the NASD's proposals to trade options on NASDAQ NMS securities have caused the Commission to revisit the question of whether it should continue to prohibit multiple trading.

Today, as an alternative to multiple trading, optionable underlying securities are allocated among the exchanges by lottery. Once allocated, options on selected securities become the exclusive franchise of an exchange.

These allocation procedures, if extended to underlying NASDAQ NMS securities which the options exchanges propose to trade, would, in the Board's view, have adverse competitive impacts on the NASDAQ Options Program. Because an extension of the lottery system to options on NASDAQ NMS securities might result in the allocation of NASDAQ options stocks among the exchanges and the NASD, the NASDAQ Options Program might receive an insufficient number of underlying securities to justify the cost of developing options related automated systems.

Of equal concern to the Board and NASDAQ issuers is the fact that under existing allocation procedures, issuers of underlying securities cannot choose whether options should be traded on their stocks nor, if they are, the market in which such options should be traded.

The Board believes that NASDAQ issuers should have the right to determine whether options are traded on their securities and should be able to choose their market of preference.

The Board therefore urges members in their comments to the Commission on the enclosed release to support the position that NASDAQ options should be traded in the NASDAQ market subject to issuer approval and should not be allocated to the exchanges under existing lottery procedures.

NASDAQ Options Systems

The automatic execution system for NASDAQ options ("NOAES") and the locked-in trade feature, ("OCT") will, in the Board's view, greatly increase the efficiency of executions, reconciliation, clearing and surveillance in the NASDAQ options market.

For these reasons, the Board urges members to support the trading systems proposed for the NASDAQ Options Program in their comments on the Commission's release.

Surveillance

In determining whether to move forward with the NASDAQ Options Program, the Board carefully considered the fact that any adverse consequences of stock/options manipulations involving NASDAQ options might far outweigh any benefits flowing to members and the investing public created by options trading.

The locked-in trade features of NOAES and OCT, together with the NASD's ability to capture and retain all quotations entered into the system, will create a complete record of NASDAQ options transactions, permitting the NASD to compare transaction reports with market maker quotation changes to determine if frontrunning and other abuses have occured.

Another key element of the integrated surveillance system will be an audit trail for equities underlying NASDAQ options which is currently under development.

A document entitled A Discussion of the NASDAQ Options Surveillance Program was filed with the SEC on December 22, 1983, and will be provided to members by the Association upon request.

The Board views integrated stock/options surveillance as an essential ingredient for investor protection under any program which would propose to trade options on NASDAQ securities.

Therefore, the Board asks members in comments on the Commission's release to request that the Commission not approve any proposal to trade NASDAQ options until the NASD's surveillance systems and related equity audit trail are in place.

* * * *

Please note that the deadline for comments is June 15, 1984. Letters to the SEC should include reference to File No. SR-NASD 80-10 and should be addressed as follows:

George A. Fitzsimmons, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

The Association would appreciate receiving copies of letters sent to the Commission. Please address such correspondence to:

Peter T. Canada
Assistant Director, NASDAQ Operations
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006

Members who wish to obtain additional materials or information concerning the NASDAQ Options Program or the SEC's release may do so by contacting Mr. Canada at (202) 728-8479.

Sincerely,

Gordon S. Mackin
president

Attachments

THE NASDAQ OPTIONS PLAN: AN OVERVIEW

INTRODUCTION

The National Association of Securities Dealers, Inc. (the "NASD" or "Association"), has developed a program for the quotation display of put and call options written on certain designated NASDAQ securities and indexes. For purposes of this program, the securities upon which NASDAQ options will be written will be chosen from those which are designated as National Market System (NMS) securities pursuant to Securities and Exchange Commission (SEC) Rule HAa2-l and certain exchange-listed securities which are trading pursuant to Rule 19c-3. In addition, certain NASDAQ and NMS indexes will be utilized for cash settled index options, including the NASDAQ composite index and sub-indexes such as the NMS industrial index.

The options eligible for NASDAQ display ("NASDAQ options") will be selected in accordance with criteria established by the NASD, the Options Clearing Corporation (OCC) and the Securities and Exchange Commission. As is the case with options listed on the various exchanges, OCC will act as the issuer of all NASDAQ options including NASDAQ index options. Rules which are applicable to NASDAQ options will also apply to NASDAQ index options, except where stated.

Standardized as to exercise price, expiration date, and unit of trading in accordance with NASD and OCC rules, continuous markets for NASDAQ options will be maintained by qualified NASDAQ options market makers registered as such with the NASD. In that connection, an essential element of the NASDAQ Options Program will be the ability of certain market makers in NASDAQ securities to make markets simultaneously in NASDAQ options written on those securities. This practice, referred to as "side-by-side" or "integrated" market making, will be permitted under very carefully supervised, rigorously surveilled conditions providing appropriate regulatory safeguards.

NASDAQ options will be registered under the Securities Act of 1933 and in the various states by OCC. Covered by OCC's prospectus and a risk disclosure document meeting the requirements of Rule 9b-l of the Securities Exchange Act of 1934, as amended, each NASDAQ option will be exercisable through OCC, which will also serve as the obligor of all NASDAQ options.

In order to utilize the services and facilities of OCC, the NASD will acquire OCC stock subsequent to its plan being filed with and approved by the Securities and Exchange Commission and following the approval of such stock acquisition by OCC's Board of Directors and its existing participant owners.

In structuring the NASDAQ Options Program, the NASD determined to preserve the essential elements of a competitive dealer market and to incorporate standards comparable to those applied to exchange-traded options, including rules and regulations governing members' trading and sales practices. Included among these are a provision for the last sale price reporting of completed transactions in NASDAQ options contracts to the Options Price Reporting Authority (OPRA). In this connection, an automated execution system and other automated features are being designed for the NASDAQ Options Program. These features, which are discussed below, will create "locked-in" trades for price reporting and clearing purposes and advanced, automated market surveillance capabilities for NASDAQ options.

The NASDAQ Options Automated Execution System ("NOAES") is being designed to provide automated executions of options trades. Initially, this system will provide for automatic executions for trades up to three (3) contracts. NOAES will facilitate execution of such options trades against the best bids or offers for options in the system on a preferenced or non-preferenced basis. Only customer orders will be subject to automatic executions. NOAES will provide for "locked-in" trades and automatic confirmation of trades to both parties and reporting of trades to OPRA. In addition, NOAES will capture clearing data for timely submission to OCC at the end of the trading day.

In addition to automated execution of small orders, NOAES will also provide for a new transaction, the Order Confirmation Transaction ("OCT"). In this mode, transactions in options will take place along conventional lines, i.e., negotiated via the telephone. Immediately thereafter, the "seller" will enter the trade detail into his NASDAQ terminal and the message will be routed to the contraparty. When an OCT is entered into NOAES and the entry is accepted by the contra-party, both parties will have the advantages of the "locked-in trade" and the reporting features of NOAES. The OCT mode will be utilized by the options participants to execute and/or report negotiated trades not subject to an automatic execution.

All NASDAQ options transactions will be required to be executed or reported via NOAES. Therefore, all trades in NASDAQ options will be either automatic executions or negotiated transactions which are affirmatively accepted by both parties through an OCT. In either event, option trades will be "locked-in" for clearing purposes. For this reason, an options trade comparison processor for NASDAQ options will not be needed and awkward, inefficient and costly procedures associated with the reconciliation of options transactions will be eliminated.

UNDERLYING SECURITIES

The selection of the underlying securities eligible to be subject to NASDAQ options will be governed by the Association in accordance with established requirements.

Prior to securities being authorized by the Association as underlying securities for NASDAQ options, the issuer of the underlying security will be given the opportunity to approve or disapprove the use of its securities for options purposes.

The Association's eligibility criteria, designed to demonstrate and assure that each underlying issue meets the maxim of being "widely held and actively traded," will conform to the standards approved by the SEC and presently in force among OCC and its participant exchange owners. The NASDAQ Options Program will, of course, permit the writing of options on underlying issues traded in the NASDAQ National Market System (NMS). As of May 4, 1984, 872 NASDAQ securities were traded in the National Market System.

In addition to being NMS designated, issuers of underlying securities must be registered under the Securities Exchange Act of 1934 and subject to certain reporting and disclosure requirements of the Exchange Act, unless specifically exempted therefrom by the SEC. Further, the underlying securities must satisfy the following additional requirements which are identical to those to those of the options exchanges for underlying listed issues; a 7,000,000 share public float, a price per share of $10, cummulative net earnings of $1,000,000 for the preceding eight quarters, 6,000 beneficial shareholders, an annual trading volume of 2.4 million shares and no defaults by the issuer in the preceding year.

The Association also has established minimum requirements as maintenance standards for the continued approval of underlying securities previously selected for NASDAQ options. These standards conform to those approved by the SEC and adopted by the various exchanges.

There are currently 253 NASDAQ NMS issues named in the Association's options filing with the Securities and Exchange Commission. Of these securities, the Association has identified 94 issues which it believes would be suitable for inclusion in the NASDAQ Options Program during its initial phase.

NASDAQ OPTIONS CONTRACTS

The Association will establish classes of options (that is, all options contracts of the same type in the same underlying security) eligible for NASDAQ display. Within each class of options, there will be three or more series of options contracts. A series of options will include all options in an underlying security having the same exercise price, expiration date and unit of trading. A unit of trading for each NASDAQ option contract relating to common stock will cover 100 shares of the underlying security. The unit of trading for NASDAQ index options will be the stated value of the underlying index multiplied by an index multiplier specified by the Association. The Association currently intends to utilize an index multiplier of $10 for all NASDAQ index options. The expiration dates or cycles for NASDAQ options will be set at three, six and nine month intervals.

The exercise prices of NASDAQ options will be set at prices which are reasonably close to the market price of the underlying security or the most recent computation of the underlying index at the time a series is opened for display on the NASDAQ System.

A new series of options could be opened with the same expiration date but with a different exercise price to reflect price movements in the underlying security. Presently, it is contemplated that the exercise prices of NASDAQ options will be fixed at five-dollar intervals for underlying securities trading below $100 and ten-dollar intervals for underlying securities trading at or above $100. NASDAQ index options will have five point strike price intervals. By way of example, assume that options in XYZ are authorized by the Association in April for display on NASDAQ at a time when the last reported sale in XYZ securities is $52. The Association will authorize series of call options having strike (exercise) prices of $50 and $55. Such options will expire in July, October and January. If the bid in XYZ securities moved to 55 1/8, additional series of options would be established with strike prices of $60 and with similar expiration cycles.

NASDAQ OPTIONS QUOTATIONS SYSTEM

The NASDAQ System will be technically modified to accommodate the display of NASDAQ options. Once modified, the NASDAQ options quotation system and the present NASDAQ securities quotation system will be substantially the same. Accordingly, the three levels of service described below will provide for similar registration, updating and retrieval techniques.

• Level 1 terminals will provide up-to-the-minute last-sale reports for each NASDAQ option.
• Level 2 terminals will display each NASDAQ option and list each registered options market maker with its most recently entered quotations, in addition to the last reported sales prices for both the option and its underlying security, daily high and low, daily volume, time of last sale and inside quotations.
• Level 3 terminals will provide registered NASDAQ options market makers with the ability to enter or update quotations in a particular NASDAQ option.

The NASDAQ System will provide for the last-sale price reporting of completed transactions in NASDAQ options contracts. The Association will interface with the Consolidated Options Tape administered by OPRA and last sale trade price information in NASDAQ options will be transmitted to OPRA and distributed by OPRA over the OPRA Tape. Last-sale reports for transactions which are automatically executed will be simultaneously and automatically reported to OPRA. Last sale price reports for OCT transactions will be reported at the time the OCT message is entered. The party currently responsible for NMS trade reporting, normally the seller, will have the responsibility for entering OCT's into the system.

NASDAQ OPTIONS AUTOMATED EXECUTION SYSTEM (NOAES)

As noted, the Association's proposed Options Program will provide for the automatic execution of orders in stock options and index options as an integral part of the service. The system will automatically execute entered trades creating a "locked-in trade" by reporting the trade to OPRA, forwarding confirmations to both sides of the execution, and producing clearing data and forwarding such to OCC.

This capability will be limited to small customer orders and will function in a manner which is similar to the Association's proposed Small Order Execution System ("SOES"). Additionally, a new transaction, the Order Confirmation Transaction, will permit trades which are not automatically executed to be captured by the system. When this type of transaction is entered into the system and the entry is accepted by the contra-party, both parties will have the advantage of a "locked-in" trade and the reporting features of the automatic execution system. The following describes, in general terms, features of the NASDAQ Options Automatic Execution System.

The NASDAQ Options Automatic Execution System will automatically execute orders in NASDAQ stock and index options. The system will permit the execution of orders initially for up to three (3) contracts in any NASDAQ stock or index option. NOAES orders will be executed against only one market maker and may be preferenced or non-preferenced. Preferenced market makers will receive a NOAES execution only if such market maker has the best displayed quotation. Non-preferenced orders will be executed on a rotating basis against market makers displaying the best NOAES quotation.

Participation in NOAES will be mandatory for all options market makers. Therefore, all NASDAQ options quotations displayed will reflect prices at which automatic executions may be effected. The automatic execution system will thus able to automatically execute transactions at the "best" displayed NASDAQ option bid or offer.

NOAES market makers may set exposure limits on individual option series which may be changed on-line during the trading day. When a market maker's exposure limit is exhausted, the market maker's quotations will be deleted from NOAES. However, the market maker's symbol identification will continue to be displayed.

In the event that there is only one market maker at the best NOAES bid or offer and such market maker's exposure limit is exhausted, the next best remaining quotation will automatically become the new best bid or offer for purposes of automatic executions.

In the event all market makers' exposure limits in a particular option are exhausted, NOAES will display the bid and offer of the last market maker whose exposure limit was exhausted and automatic executions will continue on a rotating basis among all registered market makers in the option at that price until new quotations and/or exposure limits are entered into NOAES by affected market makers.

ORDER CONFIRMATION TRANSACTIONS (OCT)

The Order Confirmation Transaction will allow an order entry firm to contact a NASDAQ options market maker via telephone and negotiate a trade which is not subject to an automated execution. The "sell" side of such transaction will then be required to enter an OCT message into the system within 90 seconds. Fields will be provided in the OCT to indicate information to be reported to the OPRA Tape and the trade will be reported to OPRA upon the entry of the OCT. The party receiving the confirmation message via the system will be given a time limit of 90 seconds in which to accept the message which will provide all the fields of trade information required to be "locked-in" for clearing purposes. If the message is accepted, the transaction becomes a "locked-in" trade to be reported to OCC at the end of the trading day. In the event a member fails to respond to an OCT message, such message will be retained in NOAES for reconciliation at the close of the trading day. The OTC feature combined with the automatic execution system will permit both large and small orders to become "locked-in" trades.

SIDE-BY-SIDE MARKET MAKING

Secondary markets for NASDAQ options will be maintained in a manner comparable to the secondary markets for NASDAQ equity securities. Market makers, qualified and registered with the Association specifically for NASDAQ options, will create and maintain over-the-counter markets in NASDAQ options. They will purchase and sell (write) for their own accounts and maintain inventories in the NASDAQ options in which they make a market. Thus, a firm having a customer's order to buy or sell a NASDAQ option, whether acting as a broker or dealer, will go to a market maker to make the purchase or sale.

An essential element of the NASDAQ Options Program will be the ability of market makers in underlying securities quoted on the NASDAQ System to make markets simultaneously in NASDAQ options written on those securities. Such side-by-side market making was approved in principle by the Securities and Exchange Commission on September 24, 1976. In giving its approval, the Commission stated, in part, that:

". . . an options program along the lines discussed in the NASD's analysis would be consistent with the Securities Exchange Act of 1934 and that, in an environment of vigorous competitive market making, it would be appropriate to permit market makers, if they choose, to make markets in both the options and the underlying securities. In reaching that conclusion, the Commission recognized that the market operated through the NASDAQ System is relatively free of anti-competitive restraints and should therefore provide an opportunity to test the extent to which competition can be an effective regulator of a unified market for options and their underlying securities." ^1/

The Commission went on to express concern over the environment in which side-by-side trading may be permitted, wishing to be certain ". . . that environment provides for appropriate regulatory safeguards." ^2/

In connection with and in response to these concerns, the Association's rules will impose specific requirements on side-by-side market makers who will also be bound by rules which are applicable to all members. The special rules applying to side-by-side market makers are as follows:

• In order for a member to make a market simultaneously in an underlying security and the options relating thereto, there will have to be a total of at least ten (10) registered market makers in such underlying security and at least five (5) registered market makers in each option group in respect to which side-by-side market making is intended.
• Side-by-side market makers will be required to report information with respect to transactions and positions in conventional, over-the-counter options covering those securities in which NASDAQ options markets are being made.
• In effecting a NASDAQ option transaction with or for a customer, a side-by-side market maker will be required to disclose such function on the confirmation sent to the customer.
• Once side-by-side market making has begun, permission for further side-by-side market making in new options series will be withdrawn if there are fewer than seven (7) registered NASDAQ market makers displaying quotations on the NASDAQ System in the underlying security or there are fewer than three (3) registered NASDAQ options market makers displaying quotations on the NASDAQ System in the NASDAQ options group. Whenever the Association withdraws its approval for side-by-side trading in a particular options series, it will not reinstate side-by-side trading until there are again ten (10) market makers in the underlying security and five (5) in the option series.

The Association's plan will permit side-by-side market making only by members who agree to be "primary" market makers. "Primary market makers" will be those members who register as such with the Association and agree to be subject to the commitment and penalty rules discussed below.

Primary market makers will be obligated, upon undertaking this designation, to continuously quote all options in their primary markets through the completion of all expiration cycles which are open for trading in such markets at the time the member's registration as a primary market maker becomes effective. Such obligation will also apply to any new option series added in those expiration cycles during the term of the market maker's commitment. Thus, a member becoming a primary market maker in XYZ options at the expiration of the October options will be required to remain in the market through the expirations of all January, April and July XYZ options, a period of approximately nine months.

Further, should the primary market maker elect to commence quotations in options series in a subsequent expiration cycle, the market maker's commitment to continuously quote options will extend through the expiration of such options. This will extend the market maker's commitment for three additional months.

Thus, in the above-referenced example, if the primary market maker in XYZ options commences quotations in new October XYZ options upon the commencement of trading in these options in January, the member will be obligated to quote all XYZ options in the October expiration cycle until the end of that expiration cycle, i.e., for a period of nine months.

Any primary market maker failing to abide by these commitments will have its market maker registration revoked and will not be permitted to re-register as an options market maker in such options until the expiration of both the near term expiration cycle and the expiration cycle which follows. Thus, a primary market maker in XYZ options withdrawing quotations from the NASDAQ System for any open XYZ option contract in, say, September, will have its registration as a market maker in XYZ options terminated and will not be permitted to re-register as a market maker in XYZ options until the expiration of the January options.

In addition to the above-referenced penalties, primary market makers failing to abide by the commitment rules could have their market maker registration in the underlying security revoked for a period of time, subject to disciplinary procedures which will offer rights of due process to the member. In addition, primary market makers whose quotations are withdrawn during the fifteen (15) business days preceding the expiration of an option series may be found in violation of Article III, Section 1 of the Association's Rules of Fair Practice which obligates members to act in accordance with high standards of commercial honor and just and equitable principles of trade. The application of Article III, Section 1 in such situations will, of course, follow Association procedures providing members with due process and rights of appeal.

Other specialized rules have been developed to govern NASDAQ options trading, not only by side-by-side market makers, but also by other market makers, retail firms and their customers as well. These rules are comparable to the standards presently applied to options trading on the various exchanges. They are intended to prevent manipulative abuses in NASDAQ options and their underlying securities and to assist in the detection of manipulative activities. These rules include the following:

• Position Limits
• Exercise Limits
• Liquidation of Positions in Excess of Position/Exercise Limits
• Limits on Uncovered Short Positions
• Restrictions on Options Transactions and Exercises
• Reporting of Options Positions

MARKET AND MEMBER SURVEILLANCE

A key feature of the NASDAQ Options Program will be the unified surveillance and regulation of the trading markets for both NASDAQ options and their underlying NASDAQ equity securities. This simultaneous surveillance and regulation will be performed by the Association's Market Surveillance Section in a manner comparable to that in which NASDAQ equity securities are presently surveilled.

The locked-in trade features of NOAES will provide an unimpeachable audit trail for options transactions when NOAES trade data is integrated with clearing data. Thus, the Association will be able to capture and analyze all trade data for options in addition to all quotations and quotation changes.

An equity audit trail will be implemented which will allow the NASD to reconstruct transactions in underlying equities as well. The audit trail will be augmented by the SOES system which will create a significant volume of "locked-in" trades in underlying stocks.

From quotation and last-sale data for options and their underlying equity securities, a series of daily computerized reports will be produced by the NASDAQ System. The information on these reports will be displayed in such a way as to facilitate the review by a market surveillance analyst of every transaction and/or quotation for an option and its underlying security, particularly those which exceed pre-established parameters.

In addition to the reports produced in-house, the Market Surveillance Section will receive for review various reports produced by OCC and the National Securities Clearing Corporation (NSCC). From time to time, it will also receive various reports from members concerning options positions in various types of accounts. By means of these reports, the Association will have the capability to conduct a thorough and comprehensive monitoring of trading in both NASDAQ options and their underlying securities and to perform such surveillance on a comparative basis.

The comparative surveillance procedures developed by the Association will aid in the prompt and early detection of fraudulent activities in a NASDAQ option or its underlying security from quotation on the NASDAQ System. Because markets for options and underlying securities will be integrated, the problems of inter-market surveillance of options and underlying securities will be eliminated.

OPTIONS COMMITTEE AND BOARD OF GOVERNORS OVERSIGHT

Subsequent to the commencement of NASDAQ options trading, the Options Committee together with the Association's Board of Governors will closely monitor the operation of the NASDAQ Options Program and the initial package of specialized options rules as adopted. Based on such review and as deemed appropriate, alteration, amendment, supplementation or abrogation of certain rules will be made and filed with the Securities and Exchange Commission for its approval.

* * * *

NASDAQ OPTIONS FACT SHEET

The NASDAQ Options Program will provide quotation, execution, trade reporting and comparison facilities necessary for NASDAQ market makers to trade standardized put and call options on NASDAQ NMS securities and indexes in the over-the-counter market. The Program will also provide for comprehensive regulation of the NASDAQ options market and unified surveillance of markets for NASDAQ options and underlying equities.

Underlying Securities

The NASDAQ Options Program will permit registered options market makers to trade options on approved NASDAQ NMS securities. The selection criteria for these underlying securities, which are identical to those of the options exchanges, are:

• Annual trading volume of 2.4 million shares
• Public float of 7 million shares
• Price of $10 per share
• 6,000 beneficial shareholders
• Cummulative earnings of $1,000,000 for eight quarters preceding authorization
• No defaults by the issuer in the 12 months preceding authorization

Prior to the commencement of trading in options on eligible securities the issuer would have the right to approve the use of its securities for options.

NASDAQ Options

NASDAQ options will be standardized as to strike price and expiration. Expirations will be at three, six and nine month intervals and strike prices will be established in the same manner as listed options.

NASDAQ options will be issued by the Options Clearing Corporation ("OCC") and subject to OCC rules relating to their exercise and settlement.

Market Making in NASDAQ Options

Market makers in NASDAQ options will quote firm, continuous markets in options via NASDAQ. The NASDAQ system will be modified to permit market makers to enter and update options quotations through the system. Inside quotations will be disseminated to subscribers, the Options Price Reporting Authority ("OPRA"), vendors and wire services.

Integrated Market Making

Subject to special registration requirements and rigorous surveillance, members will be permitted to make markets simultaneously in both options and underlying securities, a practice referred to as "integrated" or "side-by-side" market making.

As a pre-requisite for side-by-side market making, there must be at least ten registered market makers in the underlying security and five market makers in related options. Integrated market making will not be permitted in new options series if the number of market makers in the stock and related options falls below seven and three, respectively. As NASDAQ options will be permitted only on the largest, most active underlying issues, dealer competition in the trading of these securities will deter abuses in the integrated trading of stocks and options.

Members who wish to make side-by-side markets must agree to continuously quote all options series through three expiration cycles, a period of approximately nine months. Members agreeing to the commitment rules are referred to as "primary" market makers.

If the primary market maker commences quotations in an options series subsequent to the initial three cycle commitment, the market makers' commitments will be extended through the expiration of that series.

Members who violate the above-referenced commitment rules may have their registration in an option suspended through the expiration of both the near-term options and the expiration cycle which follows. In addition, primary market makers violating the commitment rule may have their market maker registration in the underlying security suspended for up to 30 days. Unexcused absences from the system by primary options market makers during the fifteen business days preceding the expiration of an option series may result additional disciplinary actions against the member. The commitment rules will assure continuous, liquid markets for NASDAQ options.

Systems for NASDAQ Options

Advanced systems are being designed for NASDAQ options trading. In addition to modification to the quotation system to accommodate options, the NASDAQ Options Program will include an automated execution system for small customer orders and "locked-in" trades for larger transactions.

NASDAQ Options Automatic Execution System ("NOAES")

All NASDAQ options market makers will be required to participate in NOAES, which will provide for automatic executions of agency trades of up to three contracts in all NASDAQ options. NOAES will be the first automatic execution system of its kind for options.

Orders routed to the automatic execution system may be preferenced or non-preferenced. Preferenced orders will be executed against the preferenced market maker if that member has the best displayed NOAES quotation. Non-preferenced orders will be executed on a rotating basis against those market makers having the best displayed quotation.

Market makers will be permitted to set exposure limits on the number of automatic executions they will accept at their NOAES quotation. Once a market maker's exposure limit is exhausted, the member's quotes will be deleted from NOAES and the member will be taken out of the NOAES rotation until new exposure limits are entered. Such market maker's symbol identification will, however, continue to be displayed.

Automatic executions via NOAES will automatically generate contra-broker confirmations, trade reports and clearing information.

Order Confirmation Transactions ("OCT")

The OCT will permit principal transactions and orders exceeding three contract size to be "locked-in" for clearing and reporting purposes.

OCT's will be negotiated via telephone in the traditional manner. Within 90 seconds thereafter, trade detail will be entered into a NASDAQ terminal by the member who would be responsible for NMS trade reporting. The OCT entry will immediately generate a trade report.

The OCT message will then be transmitted to the contra-party. Upon acceptance of the OCT message by terminal entry, the trade will be locked-in for clearing purposes and confirmations to both parties will be automatically generated.

OCT messages which are not accepted within 90 seconds will be retained in the system for subsequent confirmation. The OCT facility will also be available after the close of trading for corrections and reconciliation of unconfirmed messages. Because all transactions in NASDAQ options will be locked-in by OCT or by automatic executions, the costly and inefficient procedures normally associated with the over-night settlement of options transactions will be eliminated.

Market Surveillance

The locked-in trade features of NOAES and OCT, together with the NASD's ability to capture and retain all quotations entered into the system, will create a complete record of NASDAQ options transactions, permitting the NASD to compare transaction reports with market maker quotation changes to determine if frontrunning and other abuses have occured.

To compliment its surveillance of the NASDAQ Options Program, the NASD will implement an audit trail for underlying equities which will integrate trade and clearing data, thus enabling the NASD to identify contra-brokers representing agency orders and to reconstruct trading activity through automated reports.

The NASDAQ options and equity audit trail data will be merged into automated surveillance reports which will enable the Association to readily detect stock/options manipulations, frontrunning and other potential abuses associated with options trading. The unified surveillance of markets for both NASDAQ options and underlying securities utilizing highly automated systems augumented by field surveillance will advance NASDAQ options surveillance procedures because one regulatory organization, the NASD, will have oversight responsibilities for both options and underlying equity markets.

* * * *

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-20853; File Nos. SR-NASD-80-10; Amex-83-33; CBOE-83-53; NYSE-84-4; PSE-84-2; and Phlx-83-27]

Over-the-Counter Trading of Standardized Options and Exchange Trading of Options on Over-the-Counter Securities

ACTION: Extension of comment period and request for additional comments.

SUMMARY: The Commission has published notice of proposed rule changes submitted by the National Association of Securities Dealers, Inc. and five Securities exchanges to trade options on over-the-counter securities. In view of the significant issues raised by these proposals, the Commission has determined. to extend to June 15, 1984, the period for public comment on the proposals and to solicit additional written submissions of data, views and comments from interested persons, particularly with respect to the issues discussed in this release.

DATES: Comments should be received by June 15, 1984.

ADDRESSES: Interested persons should submit 15 copies of their views and comments to George A. Fitzsimmons, Secretary, Securities and Exchange Commission, 450 Fifth Street N.W., Washington, DC 20549, and should refer to File Nos. SR-NASD-80-10 or Amex-83-33, CBOE-83-53, NYSE-84-4, PSE-84-4, or Phlx-83-27, as appropriate. All submissions will be made available for public inspection at the Commission's Public Reference Room.

FOR FURTHER INFORMATION CONTACT:

Alden Adkins or Sharon D. Lawson, Division of Market Regulation, 450 Fifth Street N.W., Washington, DC 20549, (202-272-2843 and 202-272-2855).

SUPPLEMENTARY INFORMATION: .

I. Introduction

On June 12, 1960, the National Association of Securities Dealers, Inc. ("NASD") pursuant to Section 19(b)(l) of the Securities Exchange Act of 1934 (the "Act") submitted to the Commission a proposed rule change to establish an over-the-counter ("OTC") market in standardized put and call options on certain individual securities.¹ On June 28,19C2. the NASD submitted to the Commission Amendment No. 1 to this proposed rule change. Amendment No. 1. among other things, proposed to establish an OTC market in standardized put and call options on certain stock indices.² On December 1, 1982, the NASD submitted to the Commission Amendment No. 2 to the proposed rule change. Amendment No. 2 provided for the OTC trading of additional stock indices.³ In addition, on December 22, 1983, the NASD submitted to the Commission several documents describing the proposed rule change, as amended; proposing certain changes to the proposal; and discussing certain issues raised in previous comments on the proposal.⁴

From November 1983 to February 1984. the Chicago Board Options Exchange, Incorporated ("CBOE"); American Stock Exchange, Inc. ("Amex"); Pacific Stock Exchange, Inc. ("PSE"); Philadelphia Stock Exchange. Inc. ("Phix"), and New York Stock Exchange, Inc. ("NYSE") filed with the Commission pursuant to Section 19(b)(l) of the Act proposed rule changes to permit the listing and exchange trading of standardized options on securities that are not listed and registered on a national securities exchange under Section 12(a) of the Act ("OTC securities") but are designated as national market system securities under Rule HAa2-l(b)(l) under the Act ("NASDAO/NMS Tier I securities").⁵ In connection with their proposed rule changes, the CBOE, Phlx and PSE have requested that the Commission amend Rule 12a-6 under the Act, which effectively bars exchange trading of options on OTC securities.⁶ In a separate release the Commission has proposed amendments to Rule 12a-6.⁷ Those amendments, if approved, would remove the Rule's effective ban on exchange trading of options on OTC securities; Commission approval of those amendments would not, however, authorize any exchange to list and trade such options. Authorization of the actual exchange trading of options on OTC securities can be provided only by Commission approval of the exchanges' proposals described and discussed in this release.

In this release, the Commission describes the NASD proposal and the proposals submitted by the exchanges to list and trade options on NASDAQ/NMS Tier I securities. The purpose of this release is to extend the comment period on these proposals to June 15, 1984, and to solicit additional written submissions of data, views and comment regarding these proposals.

II. The NASD Proposal

A. Overview

The NASD proposes to display quotations in standardized put and call options on designated stocks ("NASDAQ options") and stock indices ("NASDAQ index options"). These quotations, to be displayed in the NASD's NASDAQ System, would be made by options market makers registered as such with the NASD. The options would be standardized as to exercise price, expiration date, and unit of trading, and would be registered with the Commission under the Securities Act of 1933 and in various states by the Options Clearing Corporation {"OCC"). NASDAQ options and index options would be exercisable through OCC, which would serve as issuer and guarantor of these options. The NASD proposal includes a provision for last sale reporting of completed transactions in NASDAQ options and index options contracts. In addition, the NASD proposes to establish an automated small customer order (three contracts or less) NASDAQ options execution system, and an "order confirmation transaction" feature that will "lock in" customer trades for more than three contracts in NASDAQ options and index options for price reporting, surveillance and clearing purposes. The NASD proposes to allow one entity to make markets contemporaneously in both NASDAQ options and their underlying securities, so long as certain conditions are satisfied. In addition, the NASD proposes to implement special surveillance measures to monitor trading in its proposed options.

B. Specific Features of the NASD Proposal

The security must also satisfy certain criteria identical to those established by exchanges for stocks underlying individual stock options;⁹ and the issuer of the security must consent to the inclusion of that security in the NASDAQ option program.¹⁰

If more than one market maker is displaying the best bid or offer, orders entered without designating a preferenced market maker will be automatically executed on a rotating basis against each market maker at that price. Preferenced orders, i.e., ones designating a particular market maker, would also be allowed. A preferenced order will be executed against the preferenced market maker if his quote is equal to the best NOAES price and .his exposure limit has not been exhausted. A firm would not be allowed to designate itself as the preferenced market maker. If the preferenced order cannot be executed against the preferenced market maker, the system will execute against the next market maker in the rotation at the best NOAES price.

The NOAES system will also permit the entry of preferenced pre-opening orders. Preferenced orders entered before the NOAES opening (which will occur at approximately 10:00 a.m., subject to the opening of trading in the underlying security) will be stored in the system and, if executed, will be executed at the best NOAES opening price. Each NOAES market maker will also be given the opportunity to decide how many of the pre-opening orders preferenced to him he wishes to accept for automatic execution at the best NOAES opening price. In the event a participating market maker elects not to accept for automatic execution all pre-opening orders preferenced to him, those orders will be retained in the NOAES system and executed automatically after the opening on a rotating basis against other NOAES market makers.

The NOAES system will automatically forward trade data from execution reports to the Options Price Reporting Authority ("OPRA") for dissemination to the distribution vendors. In addition, NOAES will forward to the clearing facility execution reports for both sides of the trade, resulting in a "locked-in" trade for clearing purposes.

If the message is accepted, the transaction becomes a "locked-in" trade to be reported to OCC at the end of the trading day. If a member fails to respond to an OCT message, the message will be retained in NOAES for reconciliation at the close of the trading day. All OCT messages, whether accepted or not, would be captured by the system.

Each side to a transaction would also be able to "break" the trade by mutual agreement in the event an incorrect OCT message is inadvertently accepted by the contra-party. Such "broken" trades will also be captured by the system.

In its December submission, the NASD stated that it is developing its equity audit trail for NMS securities by combining information collected through its price reporting system and the clearing process. The NASD Board of Governors at a meeting on March 16, 1984, voted to implement an equity audit trail for all NMS securities. The NASD has not yet worked out the full details of this equity audit trail, but expects to complete an audit trail "concept document" by June 1984.¹⁴

The NASD also describes the monitoring systems and reports it would modify or create to use the data collected in these audit trails. These systems would be comparable to those designed by the options exchanges and would be designed to detect known violations. In addition, these systems would monitor for specific possible problems raised by side-by-side trading such as stock option manipulation and fair pricing of customer orders. This section of the NASD submission is not described in detail here, but is available at the Commission or the NASD for those who are interested in reviewing it.

C. Request for Comments

The Commission invites comment on the specific aspects of the NASD proposal discussed below. We also encourage commentators to comment upon aspects of the NASD proposal not addressed here. Commentators are requested to be as specific as possible in recommending any changes they believe may be needed to the NASD proposal. The Commission will, of course, also consider comments previously made ¹⁵ regarding the NASD proposal. Previous commentators are encouraged to take into account any pertinent changes in the over-the-counter market and in the NASD proposal in submitting additional comments.

One major development in the OTC market since the submission of the NASD's proposal has been the advent of last sale reporting for certain OTC securities. Under Rule HAa2-l ("Rule") under the Act, adopted by the Commission in February 1981,¹⁶ certain actively traded OTC securities were mandatorily designated as NMS securities, while certain additional OTC securities meeting less stringent standards could be designated as NMS securities at the election of the issuer. The primary effect of designation as an NMS security at the present time is to require that transactions in the security be reported on a real time basis and that quotations in the security be firm for the size publicly displayed.

The first NMS securities were designated on April 1, 1982. Since that time, 831 securities have become designated and subject to last sale reporting in the OTC market. As the numbers of NMS securities have expanded, the NASD and the Commission have monitored the effects of the last sale reporting process ¹⁷ and have engaged in ongoing surveillance of trade reporting practices. In general, this monitoring has shown that market maker firms are meeting satisfactorily the Rule's reporting standards and that OTC last sale reporting it taking place in an accurate and reliable manner.

Despite the high overall quality of last sale reporting for NMS securities, the Commission believes that last sale reporting during peak periods of trading activity, such as the first and last hours of trading, can be further improved. The continued reliance by many firms on reporting by traders means that as the pace of trading accelerates during high pressure periods, the quality and timeliness of trade reporting may suffer at times. If options were to trade on an NMS security, it would be particularly important that last sale reports for the underlying security accurately reflect the activity and direction of the underlying market in that security. Consequently, the Commission urges that market makers in NMS securities to take steps to reduce their reliance on trader reporting, through greater use, of existing alternative facilities or restructuring their reporting systems.¹⁸

The NASD staff, recognizing the special importance of ensuring the timeliness and accuracy of last sale reports in the context of options trading, has concurred in a Commission staff suggestion that the NASD should ensure that conditions conducive to accurate last sale reporting pertain for firms that propose to engage in side-by-side market making. In this regard, the NASD staff has agreed to submit to the NASD Board a Commission staff suggestion that firms seeking to engage in side-by-side trading submit for NASD review a detailed description of their reporting procedures and systems in order to ensure that these procedures will sustain accurate trade reporting.

In view of the NASD's tentative concurrence in these steps to ensure further reporting accuracy, and the generally satisfactory quality of OTC last sale reporting to date, the Commission preliminarily relieves that the information provided by NMS last sale reporting is sufficiently timely and accurate to support options trading on NMS securities. However, in addition to the comments requested below on specific aspects of the NASD's proposal, the Commission invites comment on the concept of prior review by the NASD of reporting facilities as a condition to registration as a side-by-side market maker.

In addition, the Commission requests comment on the following issues:

III. The Exchange Proposals

A. Introduction

The CBOE, Amex PSE, Phlx and NYSE propose to list options on OTC stocks that have been designated as national market system securities pursuant to Tier I criteria under Rule HAa2-l{b)(l) under the Act ("Exchange proposals"). Under the exchange proposals, OTC securities would qualify for options trading on an exchange if they meet both the Tier I criteria under rule HAa2-l and the exchanges' existing numerical options eligibility standards.²⁸

The CBOE, PSE and Phlx have also requested that the Commission amend rule 12a-6 under the Act.²⁹ Rule 12a-6 effectively prohibits the exchange trading of options on securities not listed and registered under section 12(a) of the Act and thus effectively bars an exchange from trading options on OTC securities.³⁰

In 1976 and 1977, the CBOE, Amex, PSE and Midwest Stock Exchange ("MSE") also proposed to list standardized options on underlying securities traded exclusively in the OTC market.³¹ These proposals, however, were voluntarily withdrawn pursuant to an agreement between the Commission and the self-regulatory organizations that were participating in a moratorium on the introduction of new options products.³²

At the time the original proposals to trade options on OTC stocks were submitted, there was no real-time transaction reporting for OTC stocks. As indicated in the section relating to the NASD proposal, real-time last sale reporting is now required for transactions in NMS securities and the exchanges propose to trade options on NMS securities only. Although the changes in the OTC market brought about by the development of the national market system may alleviate some of the initial concerns the Commission had over exchange trading of options on OTC securities, the current proposals by the exchanges to list and trade options on NASDAQ/NMS Tier I securities presents a number of significant issues upon which the Commission is inviting public comment.

B. Request for Comments

The Commission invites comments on the specific questions presented below. Commentators are requested to be as specific as possible in recommending any changes they believe may be needed to the Exchange proposals. We also encourage commentators to discuss aspects of the exchange proposals not specifically addressed here.

All communications will be available for public inspection at the Commission's Public Reference Room. 450 Fifth Street, NW., Washington, DC 20549.

Dated: April 12, 1984.

By the Commission.
George A. Fitzsimmons,
Secretary

^1/ Letter to Gordon S. Macklin from Roderick M. Hills, dated September 24, 1976.

^2/ Id.

¹ Notice of the proposed rule change was given in Securities Exchange Act Release No. 16979. July 15, 1980; 435 FR 53295. August 11, 1980.

² Notice of Amendment No. 1 was given in Securities Exchange Act Release No. 18017. July 28, 1982, 47 FR 33575. August 3, 1982.

³ Notice of Amendment No. 2 was given in Securities Exchange Act Release No. 19330. December 13, 1962. 47 FR 57812, December 28, 1982.

⁴ Submission of December 22, 1983. accompanied by letter dated December 22, 1983 from Gordon Macklin. President. NASD, to Douglas Scarff. Director. Division of Market Regulation, SEC (the "December submission"). The December submission was not made pursuant to Section 19(b)(l) of the Act and Rule 19b-4 thereunder: while the changes it proposes to the proposed rule change will eventually have to be filed as amendment to the proposed rule change pursuant to Rule 19b-4. the contents of this submission are included in the description and discussion of the NASD proposal set forth below.

⁵ Notice of CBOE's proposal was given in Securities Exchange Act Release No. 20471, December 9, 1983, 48 FR 55939, December 16, 1983; notice of Amex's proposal was given in Securities Exchange Act Release No. 20498. December 16, 1983; FR 56875, December 23, 1983; notice of PSE's proposal was given in Securities Exchange Act Release No. 20538, January 6, 1984, 49 FR 1808, January 13, 1984; notice of Phix's proposal was given in Securities Exchange Act Release No. 20690, February 23, 1984, 49 FR 4684. March 1, 1984; and notice of NYSE's proposal was given in Securities Exchange Act Release No. 20691, February 23, 1984, 40 FR 7082, March 1,1G84.

⁶ Rule 12a-6 essentially allows an exchange to trade an option on a security without registering that security under Section 12(a) of the Act only if, among other things, the security is registered under Section 12(a) on some other national securities exchange. Amex and the NYSE also understand that an amendment to Rule 12a-6 is a necessary precondition to approval of their proposals.

⁷ See Securities Exchange Act Release No. 20854 (April 12, 1984).

⁸ The NASD also proposes to allow a security registered on a national securities exchange to underlie a NASDAQ option if that security is not a "covered security" under Rule 19c-3 under the Act and if the security does not at the time of qualification for NASDAQ options trading underlie an exchange traded option issued by the OCC. The NASD has agreed to a deferral of Commission consideration of this portion of its proposal. For this reason, the Commission in not at this time soliciting comment on this aspect of the NASD's proposal.

⁹ These eligibility criteria require in general: (1) A minimum public float of 7 million shares: (2) at least 6,000 beneficial owners of the security; (3) aggregate trading volume of at least 2.4 million shares during the 12 months preceding authorization of the option; and 14) a closing price of $10.00 per share on each business day for the 3 months preceding authorization of the option.
The NASD also proposes "maintenance criteria" for stocks underlying NASDAQ options that are identical to those used by the options exchanges. These criteria require that no new series be introduced in an option if, among other things, the , underlying stock falls below certain volume, float and price levels.

¹⁰ In addition to commenting on the specific issues discussed below, commentators might discuss the competitive implications of this proposed provision that the issuer's consent be required before NASDAQ options are traded on an otherwise eligible security.

¹¹ Under the NASD proposal, an option "group" defined as all options contracts of the same class of options having the same exercise price and unit of trading but separate expiration dates.

¹² The NASD also states that any side-by-side market maker who fails to abide by these commitment rules could have its market maker registration in the underlying security revoked for a period of time through the NASD's disciplinary procedures. The NASD also states that any side-by-side market maker whose options quotations in a side-by-side class were withdrawn during the fifteen days preceding expiration of an options series may be found in violation of Article III, Section I of the NASD's Rules of Fair Practice, which obligates members to act in accordance with high standards of commercial honor and just and equitable principles of trade.
Members who elect not become side-by-side market makers would not be bound by the commitment rule, and, while obligated to render firm quotations, would not be required to quote all open options series in options classes in which they were registered. for specific possible

¹³ See File No. SR-NASD-84-4, Securities Exchange Act Release No. 20719, March 6, 1984.49 FR 9523, March 13, 1984. Under this proposal, margin for market or "broad-based" index options would be set at premium plus 10 percent of contract value minus out-of-the-money amounts, with a minimum required deposit of 2 percent of the contract value. Margin for industry or "narrow-based" index options would be 30 percent of contract value plus or minus in- or out-of-the-money amounts, with a minimum required deposit of $250.00.

¹⁴ See letter dated March 22, 1984, from Frank J. Wilson. Executive Vice President, Legal and Compliance, NASD to Douglas Scarff, Director. Division of Market Regulation, SEC

¹⁵ See File No. SR-NASD-80-10.

¹⁶ See Securities Exchange Act Release No. 17549 (February 17, 1981), 48 FR 13992.

¹⁷ The NASD engaged In an extensive study of the results of last sale reporting during February through April 1983. See Securities Exchange Act Release No. 19797 (May 20, 1983 1. 48 FR 24823.

¹⁸ The Commission notes that the NASD currently offers a computer-to-computer interface that allows trade reports to be simultaneously entered into a firm's in-house order handling system and submitted to the NASD for trade reporting purposes. The NASD has informed the Commission that several major firms use this interface now, and a number of others have recently expressed interest in using the interface. Firms using this interface thus are able to use their clerks for both the necessary input into their own systems, and for trade reporting. Alternatively, firms could employ additional clerks to relieve traders of the task of reporting trades through their existing NASDAQ terminals. Separately, the NASD is developing a Small Order Execution System that will automatically execute and report orders of 300 shares or less entered into the system. This system should significantly reduce the number of individual trades handled by traders, while improving the reliability of their reports.

¹⁹ Letter dated November 29, 1980, from Richard O. Scribner, Executive Vice President, Amex, to George A. Fitzsimmons. Secretary, SEC.

²⁰ As the NASD points out, the 1978 Special Study of the Options Market (the "Options Study"), recognizing the competitive market making system used in the over-the-counter market maker is likely to have the market information and competitive advantages or opportunities to engage in manipulative or other improper practices of the nature and dimension of these that integration would create for a unitary stock specialist on a primary stock exchange with a centralized stock limit order book to which he has access." At the same time, the Options Study observed that "* * * the opportunity to trade against the orders of retail customers in an OTC market may present market information and competitive advantages end regulatory concerns that do not have counterparts in exchange markets." Report of the Special Study of the Options Market to the Securities and Exchange Commission, H. Rep. No. IFC-3, 96th Cong., 1st Sees. (Comm. Print 1978) at pp. 955-958.

²¹ The complete NASD arguments on this issue are contained in the December submission which is available at the Commission for public inspection.

²² In addition, commentators are requested to consider whether any of the conditions proposed by the NASD are excessive to control the informational and other concerns raised by side-by-side trading.

²³ CBOE and the PSE. which employ a competitive market maker system, as well as the options exchanges employing a specialist system, impose certain maximum spread and price continuity limitations upon their market makers See. e.g., CBOE Rule 8.7(b)(i) and (u).

²⁴ "Self-preferencing" is also prohibited in SOES, NASD's automated small order stock execution system.

²⁵ A unique feature of the NASD proposal would be the use, for the first time in U.S. markets, of firm quotations for options. Quotations would be firm both with respect to orders entered through NOAES system and outside of NOAES in the past, the options exchanges have expressed the view that firm quotations are not feasible for options trading. See. e.g., letter dated September 22, 1980. from Walter E. Auch. Chairman and Chief Executive Officer. CBOE. to George A. Fitzsimmons. Secretary. SEC (File No. S7-772). Commentators are requested to evaluate this position in light of the NASD proposal.
The NASD relies on firm quotations to impose price discipline on market participants and as a check against manipulation. Outside of NOAES, however, there appears to be no obligation for quotes to be firm for more than a single contract. Commentators are urged to consider whether firm quotations under these circumstances will accomplish the objectives intended by the NASD. It should be noted that, although quotations in size can now be entered in the NASDAQ system for stocks, virtually no market makers have taken advantage of this feature.

²⁶ See e.g.. letter dated August 24, 1982, from Richard O. Scribner. Executive Vice President. Amex, to George A. Fitzsimmons, Secretary, SEC.

²⁷ The NASDAQ Composite Index and the sub-indices of the composite index presumably would be comprised of a large number stocks as to which there are no last sale reports.

²⁸ The exchanges' eligibility standards are described at n. 9 above.

²⁹ "The NYSE and Amex understand that an amendment to rule 12a-6 is a necessary precondition to approval of their proposals as well as the proposals of the other exchanges.

³⁰ The Commission has published today a companion release seeking comments on proposed amendments to Rule 12a-6. See Securities Exchange Au release No. 20854. These amendments, if approved, would remove the current statutory ban on exchange trading of options on OTC stocks.

³¹ Notice of CBOE's proposal was given in Securities Exchange Act Release No. 12703, August 12, 1976, 41 FR 358B4. August 23, 1976; notice of Amex'8 proposal was given in Securities Exchange Act Release No. 13095, December 22, 1976, 42 FR 2145. January 10, 1977; notice of PSE's proposal was given in Securities Exchange Act Release No. 12539, June 11, 1976, 41 FR 24787, June 18, W76; notice of MSE's proposal was given in Securities Exchange Act Release No. 130406. March 25, 1977, 42 FR 19200, April 12, 1977.

³² See Securities Exchange act Release No. 1S026 (August 3, 1978) and Securities Exchange Act Release No. 14878 (June 22, 1978).

³³ Securities Exchange Act Release No. 16701 at pages 26-27, March 26,19P0 ("Moratorium Termination Release") [45 FR 21426. April 1, 1980].

³⁴ The primary market phenomenon! refer* to the tendency of one exchange ultimately to receive the preponderance of trading volume in a particular option. Since most large retail firms generally designate one market to which they automatically route virtually all of their retail order flow in a particular options class, largely on the basis of the relative trading volume attracted by each exchange, primary market designation in effect becomes a "self fulfilling prophecy." and accordingly, any real intermarket competition for public order flow occurs for the short term only. See Options Study, at 853.

³⁵ Moratorium Termination Release at 27-31.

³⁶ Id. at n. 47. At the same time, the Commission made it clear that it did no regard the perpetuation of any particular exchange or exchanges to ha a legitimate objective of any options allocation policy This view is supported by the Commission's mandate under the Act. Although the Act requires the Commission to balance the perceived anticompetitive effects of a regulatory policy or decision against the purposes of the Exchange Act that would be achieved thereby and the costs of doing so. it docs not impose an obligation on the Commission to justify its actions as the anticompetitive approach to achieving its objectives. See Options Study at 870.

³⁷ These possible effects of multiple trading were also analyzed in detail in the Options Study. Options Study, at 800-643. The Options Study, however, declined to formulate any specific recommendations on the multiple trading issue

³⁸ To assist the SROs and expedite their deliberations, the moratorium termination release contained a discussion of several possible options market integration facilities, including a system similar to the Intermarket Trading System ("ITS") and the individualized routing of retail orders, as well as possible implementation of an order exposure system for public options orders.

³⁹ See letter from Nicholas A. Giordano, President. Phlx, to George Simon, Associate Director. Division of Market Regulation (September 2, 1981).

⁴⁰ Securities Exchange Act Release No. 18297 (December 2, 1981); 46 FR 60376 (December 9, 1981)

⁴¹ Securities Exchange Ac! Release Nos. 19264 and ZUO75. November 22, 1982 and August 12, 1983; 47 FR 53981 and 48 FR 37556. November 29, 1982 and August 18, 1983.

⁴² The possible multiple trading of options on NMS stocks raises at least one question in addition to those listed in the text above: viz. whether or not exchange off-board trading restrictions should continue to apply if multiple trading between the exchanger, and the NASD is permitted. Some of the exchange?, have rules that forbid the trading off the exchange of options on stocks on which the exchange offers options. See, e.g., CBOE Rule 8.49. These off-board trading restrictions were initially adopted to assure that all transactions in standardized options (except accommodation liquidations) occurred on an exchange floor. By their terms, however, these rules could also be applied to prevent exchange members from trading multiple traded standardized options on the NASDAQ system. The Commission preliminarily believes that as a precondition to Commission approval of any exchange proposal to trade options on NMS stocks an exchange would have to amend any off-board trading restriction it may have to allow its members to trade standardized options over-the-counter. The Commission welcomes, however, any comments on this preliminary position.

⁴³ Aside from audit trail and surveillance considerations, it would appear that there are few if any obstacles to prompt implementation of the exchange OTC options proposals. Implementation of the NASD proposal, however, would appear to be several months away et the earliest. Commentators are urged to address the competitive implications of asynchronous Commission consideration of the exchange and NASD proposals, particularly in light of the "primary market phenomenon."

⁴⁴ See, e.g.. In the Matter of Pacific Resources. Inc., Securities Exchange Act Release No. 175B4,