Market-Maker Obligations in SelectNet^SM

EXECUTIVE SUMMARY

Since November 1990, members have been able to negotiate transactions through the SelectNet^SM service, which was enhanced from the original Order Confirmation Transaction (OCT) service. The enhancements to SelectNet were approved by the Securities and Exchange Commission (SEC) in November for six months with three operational rules in place. The NASD has requested that the SEC extend the SelectNet rules for an additional six-month period in order to consider whether to make the rules permanent or to recommend additional modifications to SelectNet. The rules are described below.

BACKGROUND AND DISCUSSION

On November 21, 1990, the SEC approved certain modifications to Nasdaq's OCT service, renamed SelectNet. Among other things, SelectNet was enhanced to permit easier negotiation of trades, including counteroffers and broadcasts of orders to all market makers in a security. In addition, the NASD implemented three operational rules to ensure the integrity of SelectNet as a trading system with negotiation features.

The SelectNet rules are:

• SelectNet will be available only for agency or principal orders that are greater than the SOES tier size.
  
  
• Market makers receiving orders through SelectNet will not be required to execute partial orders, but may elect to execute partials at their discretion.
  
  
• In the event of an emergency or during extraordinary market conditions, either one or both of the aforementioned conditions may be eliminated pursuant to the authority granted to the Board of Governors and its designees in Article VII, Section 3 of the NASD By-Laws.

The NASD believes that SelectNet should retain its current operational structure to allow more time to evaluate whether the rules should be made permanent or be modified in any way. These rules were implemented for SelectNet in November because the mandatory display of size that requires market makers to post quotations at the Small Order Execution Service (SOES) tier level took effect on December 1, 1990, and the SEC firm-quote rule requires broker-dealers to execute orders presented to them at their quoted size. The NASD believed that the same sort of abuse taking place in SOES might occur in SelectNet, especially since SelectNet allows principal as well as agency orders, and therefore sought Commission approval of these rules.

The NASD believes that SelectNet should continue operating as it does today — voluntary for market makers posting the mandatory SOES tier size in their quotations. SelectNet should retain its interactive, negotiation features, with market-maker participation truly voluntary — as opposed to a system that takes on the characteristics of an automatic execution system with mandatory participation requirements — recognizing that, during emergency market conditions, the fundamental nature of the system may be modified to include mandatory market-maker obligations.

The NASD notes that, although SelectNet is available for orders larger than the SOES tier size, smaller orders are not precluded by the system and, although market makers are encouraged to execute those orders, they are not required to do so.

Market-maker obligations when responding to orders in SelectNet must also be clarified, the NASD believes. When market makers are displaying size in their quotations that is larger than the SOES tier size, they are obligated to execute orders directed to them in SelectNet when the orders are larger than SOES tier size up to and including the market maker's posted size. For example:

• If a market maker in a 1,000-share tier size stock quotes 1,000 shares in its displayed size, it does not have to execute any order through SelectNet.
  
  
• If the market maker is quoting 2,000 shares in the same issue and an order greater than 1,000 shares up to and including 2,000 shares is directed to it at its bid or offer quote through SelectNet, such as for 1,100 shares, 1,500 shares, or 2,000 shares, it is obligated to execute that order, pursuant to the firm-quote rule and SelectNet operational rules.
  
  
• An order larger than the market maker's posted size, for example an order of 2,500 shares when the market maker is quoting 2,000 shares, would not be required to be executed in SelectNet, because market makers are not required to execute partial orders.

Market makers should be aware of these obligations in SelectNet as well as in dealings over the telephone when quoting in sizes larger than SOES tier size, especially because market makers are now required to execute orders at their posted size from all members, including competing market makers. (See Notice to Members 91-37.)

Questions regarding SelectNet operational rules and market-maker obligations should be addressed to Jeff Englander, Market Surveillance Department, at (301) 590-6450.