New Requirement for Market Makers to Display Size in Quotations

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EXECUTIVE SUMMARY

On September 18, 1990, the Securities and Exchange Commission (SEC) approved an NASD proposal to require market makers in NASDAQ to display quotation size greater than or equal to the appropriate SOES tier size in their quotes on NASDAQ. The rule takes effect December 1, 1990. At the same time, the SEC granted a six-month exception to the firm-quote rule so that market makers are not obliged to execute more than 100 shares against competing market makers in the same issues. This exception also begins December 1 and expires June 1, 1991.

BACKGROUND AND DISCUSSION

In response to a recommendation by the NASD's Quality of Markets Committee, the NASD Board of Governors in 1989 approved a proposal to amend Schedule D to require market makers in NASDAQ securities that are also market makers in the Small Order Execution System (SOES) to display size in NASDAQ at least equal to the maximum size of an order eligible for automatic execution in SOES, and to extend such size to all parties except firms that are also market makers in the same security. The NASD believes that the new rule will enhance the quality, liquidity, and depth of NASDAQ and provide greater information to the investing public.

Under current practice, few market makers display quotations in excess of the normal unit of trading, 100 shares. Under the Rules of Practice and Procedure for SOES (SOES Rules), however, NASDAQ market makers that are also market makers in SOES are required to execute orders through SOES in sizes equal to or smaller than the "maximum order size" as published periodically by the NASD. These order-size limits are currently set at 1000 shares, 500 shares, and 200 shares, depending on the trading characteristics of the security. The NASD believes that mandatory size display would provide a realistic picture of the actual size of execution available and the depth of the market in each security. Display of size would enhance investor knowledge and would also be beneficial to issuers by publicizing the liquidity and depth of the market for their securities.

The new rule applies to all market makers that participate in SOES, and thus applies to National Market System (NASDAQ/NMS) securities as well as regular NASDAQ securities.

The new rule also has an impact on market makers using other NASD systems, such as the Order Confirmation Transaction (OCT) service and the Computer Assisted Execution System (CAES). For the most part, the application of the rule to OCT and CAES, as well as to telephone orders, should not result in multiple order exposure commitments. Under the SEC's "firm quote rule," Rule llAcl-1, a broker-dealer is relieved from the obligation of honoring its published quotation size if, prior to the presentation of an order, the broker-dealer has communicated to the NASD a revised quotation or if, at the time the order is presented, the broker-dealer is effecting a transaction and is about to send in a quote update. In most cases, therefore, the maximum exposure for market makers should be the maximum tier size for SOES, provided the market maker complies with the requirements of the firm-quote rule in revising its quote size.

There may be cases, however, in which a market maker will face multiple order exposure commitments due to the automated nature of SOES and the fact that the market maker is obliged to execute orders in SOES in amounts of up to five times the applicable maximum tier size. For example, if a phone order is followed by a SOES order that occurs during the course of the phone call, the market maker will be obligated to execute both orders. Likewise, a market maker could receive simultaneous orders through SOES and OCT and would be obligated to execute both up to the size displayed. Conversely, if a SOES order is received first, followed by either a phone order or an OCT order, if the market maker is revising its quotation, the market maker would not be obligated to fill the incoming phone or OCT order.

Finally, the new rule also contains an exception from filling sized orders from competing market makers in the same security. Although the SEC's firm-quote rule obligates a market maker to execute any order presented at its quoted price and size, the NASD has received an exception from the rule because extension of quote size to competing market makers would increase market-making risk to the extent a competitor may fail to honor its side of a transaction. Higher net capital standards are currently under consideration by the SEC, and the NASD believes that those higher standards may significantly reduce the risk that would be assumed by market makers if required to honor quote size to competitors. Accordingly, the exception to the firm-quote rule for competing market makers will last for six months, from December 1, 1990, to June 1, 1991. Afterwards, if higher net capital requirements have been adopted, this provision will be reexamined. Therefore, from December 1, 1990, until June 1, 1991, NASDAQ market makers will be required to execute only 100 shares of stock for competing market makers.

Questions concerning this notice may be addressed to Jeff Englander, Market Surveillance at (301) 590-6450.

(Note: New language is underlined.)

Schedule D

Part VI

Sec. 2 Character of Quotations