Solicitation of Members' Comments on Proposals to Curb SOES Abuse; Last Date for Comments: June 21, 1991

EXECUTIVE SUMMARY

The NASD Board of Governors has approved two additional proposals to curb Small Order Execution System (SOES) abuse — expanding the definition of "day trading" and permitting a short period between executions (such as 15 seconds) for market makers to update their quotations. The Securities and Exchange Commission (SEC) has published these proposals in the Federal Register (SEC Release No. 34-29181 and 34-29182), and we urge members that use SOES to comment on the proposals. Send your comments before June 21, 1991 to the SEC addressed to:

Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549.

BACKGROUND

The NASD's Small Order Execution System (SOES) is designed to improve the efficiency of executing small-sized customer orders in Nasdaq securities by offering an alternative to traditional telephone contact and negotiation with market makers. SOES provides automated execution of small customer orders with Nasdaq market makers at the best available market price. Since the exclusive purpose of the service is to facilitate the execution of small customer orders, the Association has taken steps in the past to ensure market-maker presence in the service¹ and to prohibit misuse of the service by professional traders.² In furtherance of that purpose, the Association is proposing amendments to curb further misuse of the SOES system by professional traders.

The NASD is proposing to define professional trading accounts to include accounts with day trades that have one or both sides executed through SOES. This rule change would prevent professional traders using SOES from automatically executing one side of a day trade against a market maker while executing the other side of the day trade outside of SOES to elude the "five day trade" criteria currently in the SOES rules. The term "professional trading account" in the SOES rules includes accounts in which there have been five or more day trades executed through SOES.

Second, the NASD is proposing a period of time (i.e., 15 seconds) following an execution to allow a market maker to update a quotation before being obliged to execute a second transaction in the same security on the same side through SOES. Currently, the SOES service can almost instantaneously execute multiple orders against a market maker until the market maker's exposure limit in the security is exhausted. Exposure limits assure liquidity in the Nasdaq issues traded through SOES, but currently do not allow time for market makers to update their quotations in response to executions occurring through the system.

This proposal for a quotation update period would not diminish market makers' responsibilities to participate in SOES or to post mandatory size in quotations; the update period would give market makers time to react to executions and adjust their markets, if appropriate, to reflect an execution or altered market conditions.

SEC Rule 11 Ac1-1, the "firm quote rule," requires brokers and dealers to execute orders to buy and sell securities at their published quotations unless the broker-dealer is communicating a revised bid or offer to the NASD or has effected a transaction in the security and is updating its quotation.³ Nasdaq market makers are required to maintain firm quotes and be willing to execute trades at their quotations. Allowing time in between these automated executions of SOES, while still retaining the automated features of the SOES service, strikes an appropriate balance between the small customer's desire for efficiency and immediacy in executions and the NASD's responsibilities to operate a system that provides a fair, responsive trading environment for the parties extending the capital commitment to the Nasdaq market.

Following receipt of an execution report of a purchase or sale through SOES, a market maker would have a period of time (15 seconds) to update its quote prior to executing any subsequent purchase or sale at the same quote. If a market maker has executed a sale, and subsequently receives a purchase order, SOES would execute that order. If a customer order is executed against the market maker's bid and the market maker subsequently updates its offer or its size in the security, the quotation update period would expire immediately because any update to the market maker's quotation terminates the update period. If an update is accomplished before the period expires, executions would resume immediately after the update. Executions would also resume against the market maker after the update period has elapsed, regardless of whether the quote has been changed.

Comments on these rule proposals should be sent to the SEC at the address referenced in the Executive Summary. Questions on the proposals may be directed to Beth E. Mastro, Assistant General Counsel, at (202) 728-6998.

¹ See SR-NASD-88-01, Release 34-25791, 53 FR 22594, approved June 16, 1988, mandating participation in SOES by Nasdaq market makers in Nasdaq National Market System securities.

² See SR-NASD 88-43, Release No. 34-26361, 53 FR 51605, approved December 22, 1988.

³ SEC Rule