Implementation of Matching Service in SOES Limit-Order File

EXECUTIVE SUMMARY

On December 10, 1990, the NASD implemented a new feature for the Small Order Execution System (SOES) Limit-Order File — a matching service. Matching allows an opportunity for customer limit orders, priced between the best Nasdaq bid and offer, to execute against each other if they match or better each other in price. The new feature includes a five-minute period prior to the automatic match for a market maker to execute one of the matching orders without moving its quote, and it permits execution of partial orders so long as an odd-lot order is not left in the file. The NASD believes the matching service enhancements will help build investor confidence and increase interest in The Nasdaq Stock Market.

BACKGROUND

The NASD's Small Order Execution System (SOES) is designed to improve the efficiency of executing transactions in Nasdaq securities by providing automated executions at the "inside" price for public, retail customers. The addition of limit-order processing capability serves the purpose of providing members (and in particular members not having proprietary systems with such capability) with the ability to enter and store limit orders.

In response to concerns articulated by the Securities and Commission in its order approving the limit-order file on a pilot basis,¹ the Association has modified the system to permit, in certain circumstances, matching and full or partial execution of customer limit orders at prices that are between the highest bid and lowest offer reflected in the Nasdaq system.

HOW THE MATCHING FUNCTIONS WORK

The new functions for the limit-order file provide market makers with notice that matching orders are resident in the system and allow them an opportunity to execute one or both sides of a matched order within a prescribed time frame (five minutes). If neither order is executed, the system thereafter executes the matching orders against each other. Enhancements to the SOES limit-order file also include alert messages sent to market makers regarding the presence of matching limit orders in the file and the ability for a market maker to take out, or execute, an order without changing its quote.

• Alert — The alert message brings to the SOES market maker's attention a limit order that has been priced within the inside (i.e., between the best bid and offer available at that moment) and that potentially matches another order already pending in the limit-order file. For example, if an order is entered that cannot be executed (because it is away from the inside), but its price is equal to or better than the price of a previously entered order on the other side, an alert message is displayed on the market maker's screen to indicate a potential match.
  
  
• Take-out — The limit-order file take out function is a new feature added to SOES that allows market makers to execute limit orders at a specific price without changing their quotes. Any active SOES market maker that has an open quote and available exposure in an issue may take out shares in that issue.
  
  Market makers are able to review a summary of resident limit orders in each security and enter take-out orders specifying the side of the market (buy/sell), the number of shares to be taken out, and the price at which the market maker is willing to execute. The system receives the take-out, screens it for accuracy, and executes orders from the file at the take-out price. Orders are executed on a price/time priority — first in/first out, on a full or partial basis, at the take-out price. Any takeout order processed will include remaining odd lots in the issue. For example, if there are 350 shares in the limit-order file, a take-out order for 300 shares will result in an execution of all 350 shares.
  
  Take-outs will not interfere with the regular processing of SOES limit or market orders. Orders will continue to be executed against the inside quote as long as there is available size in the market maker's exposure limit, while the take-out is being processed.
  
  
• Matching — If, after five minutes, neither of the matched orders has been executed, either as a result of a change to the inside quote, or because a market maker has entered a take-out, the orders on the file will be matched and executed. Matches will include partial execution of orders that match or improve price but do not match in size. Trades that are the result of a system order match will have a special identifier on both order-entry firms' Executed Order Scans, and the indicator will also be incorporated in the execution report on the Nasdaq screen.

MEMBERS' RESPONSIBILITIES TO CUSTOMERS

Members are reminded of the Interpretation of the Board of Governors regarding Execution of Retail Transactions in the Over-the-Counter Market, otherwise known as the "best execution" interpretation.² This interpretation states in pertinent part that "in any transaction for or with a customer, a member and persons associated with a member shall use reasonable diligence to ascertain the best inter-dealer market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions."

The introduction of the SOES limit-order matching capability will facilitate the execution of limit orders at prices between the inside bid and asked quotation, a capability previously unavailable in SOES. In addition, the system provides an opportunity for centralized interaction of orders in the Nasdaq system. Members accepting customer limit orders should therefore consider the existence of this capability in carrying out their obligation to use reasonable diligence to ascertain the best market for the security.

For example, members, including those utilizing proprietary trading systems, should include a review of pending customer orders in the SOES limit-order file carrying out their best-execution responsibilities.

In addition, members should remember that the limit-order capabilities of SOES do not impose priorities for the execution of customer limit orders, vis-a-vis members' proprietary transactions. Members are therefore cautioned that customer limit orders must be handled in a manner consistent with members' fiduciary obligation to their customers.³

Questions or comments on the SOES Limit-Order File may be directed to Market Operations, New York, at (800) 635-6485.

¹ See Release 34-26476, dated January 19, 1989.

²NASD Manual, CCH Edition, paragraph 2151.03.

³ Certain of these responsibilities are described in Notice to Members 85-12 dated February 15, 1985, and in the opinion and order of the Securities and Exchange Commission In Re E.F. Hutton Co., Inc. Securities Exchange Act Release No. 25887 (July 6, 1988).