Board Eliminates Disclosure Safe Harbor For Members Trading Ahead of Their Own Customers' Limit Orders
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Executive Summary
In July, the NASD Board of Governors solicited member comment on eliminating a safe harbor for members trading ahead of customer limit orders. After reviewing comments received from members and others, the Board has taken action to eliminate the disclosure safe harbor and to replace it with a prohibition against members' trading ahead of their own customers' limit orders. The new requirement must be approved by the Securities and Exchange Commission (SEC) before it is implemented. The text of the proposed rule follows the discussion below.
Background and Description of Rule
In July 1993, the Board reviewed the background of the Manning disclosure safe harbor and voted to replace it with an Interpretation of Article III, Section 1 of the Rules of Fair Practice that would eliminate the safe-harbor approach and effectively prohibit a member from trading ahead of a customer's limit order.1 Because of the significance of this change to The Nasdaq Stock MarketSM, the Board authorized a Notice to Members soliciting comment on how elimination of the safe harbor and adoption of rules prohibiting trading ahead of customer limit orders would affect the operation of member firms and the treatment of investors' orders. The Board also solicited comment on any unintended effects or unacceptable consequences of any new requirements on member firms. Specifically, comment was requested on the impact of the requirements on integrated broker/dealers handling their own customer order flow, on customer limit orders received from other member firms (so-called member-to-member trades), and on market liquidity.
In response to Notice to Members 93-49, the NASD received approximately 30 comment letters from members and others. The vast majority of commenters supported elimination of the disclosure safe harbor for market makers trading ahead of their own retail clients. Commenters noted that elimination of the safe harbor would level the playing field for investors, enhance the image of The Nasdaq Stock Market, and instill greater confidence in investors that their limit orders in Nasdaq® would be handled fairly.
Many commenters, however, responded that the NASD should draw a distinction between orders from a member's own customers and orders from another broker/dealer. They pointed out that if the new rule effectively requires a market maker to give a limit order from another broker/dealer priority over its own quote, the potential for profit would be severely reduced and market-maker commitment would also suffer.
After full consideration of the concerns articulated in the comment process, the Board decided to eliminate the disclosure safe harbor and to prohibit member firms that hold their own customer limit orders from trading ahead of those orders. The language of the Interpretation establishes that a member holding its customer's limit order may not continue to trade its market-making position without executing that limit order under the specific terms and conditions that the customer understands and accepts. A member trading ahead of its customer would violate Article III, Section 1 of the
Rules of Fair Practice regarding just and equitable principles of trade.
In this regard, some commenters noted that the NASD should distinguish between retail and institutional customer limit orders, so that a market maker's ability to commit capital to large institutional orders would not be impaired by a narrow reading of "trading ahead." The NASD believes, however, that filling institutional-sized orders generally involves best-effort commitments and trading strategies other than a straight acceptance of a limit order. Firms accepting institutional orders on a best-efforts basis that may involve trading to cover a short position or buying stock along with the institution would not violate the rule as long as the firm maintains a clear understanding with its institutional clientele of the terms under which the order is being executed. Accordingly, the NASD does not distinguish between institutional and retail customers in the Interpretation because the proposed language that allows members to establish specific terms and conditions on each order clearly encompasses institutional orders.
Further, to avoid any unintended consequences from a broader application of the rule, the Board authorized a special task force to examine ramifications of extending limit-order protections to include member-to-member transactions. The task force will analyze the proposal's effect on market liquidity, volume of limit orders, market-maker commitment, spreads, and volatility.
The Board has taken this action as a part of a broader program to ensure investor protection and enhance the quality of the Nasdaq marketplace. The affirmative obligation for firms to protect their customer limit orders and to give them standing over their own market-making activity enhances opportunities for price improvement that directly benefits public investors.
The rule must be approved by the SEC before it becomes effective. Questions regarding this Notice may be directed to Beth E. Weimer, Associate General Counsel, at (202) 728-6998.
1 See Notice to Members 90-37 (June 1990) and Notice to Members 93-49 (July 1993).
Text of Proposed Interpretation to Article III, Section 1 of the Rules of Fair Practice
(Note: Proposed language is underlined.)
A member firm that accepts and holds an unexecuted limit order from its customer in a Nasdaq security and that continues to trade the subject security for its own market-making account at prices that would satisfy the customer's limit order, without executing that limit order under the specific terms and conditions by which the order was accepted by the firm, shall be deemed to have acted in a manner inconsistent with just and equitable principles of trade, in violation of Article III, Section 1 of the Rules of Fair Practice. Nothing in this section, however, requires members to accept limit orders from their customers.