Notice To Members 94-1

SEC Approves New Small Order Execution System Rules

Published Date:

SUGGESTED ROUTING

Senior Management
Institutional
Legal & Compliance
Operations
Systems
Trading

Executive Summary

On December 23, 1993, the Securities and Exchange Commission (SEC) issued an order approving amendments to the Rules of Practice and Procedure for the Small Order Execution System (SOESSM). The new rules prohibit short sales in SOES; reduce the largest eligible SOES order from 1,000 shares to 500 shares; reduce market makers' exposure limits in SOES to two times the tier size; and establish an automated quote update capability that market makers may use to have Nasdaq refresh their quotations. The amendments will become effective Monday, January 10, 1994. The text of the amendments follows the discussion below.

Background And Description Of Amendments

The SEC has approved the following operational modifications to SOES and amendments to SOES rules for a pilot period of one year, beginning on January 10, 1994. The changes:

  • Decrease the maximum size order in SOES from 1,000 shares to 500 shares.

  • Reduce the required exposure limits from five to two times the tier level and decrease SOES exposure limits using unpreferenced order flow only.

  • Enhance the system to include the ability to automatically refresh a quote when the market maker's exposure limit has been exhausted and permit this update feature to be employed by market makers after each execution.

  • Prohibit short sales in SOES.1

SOES is designed to improve the efficiency of executing small-sized retail investor orders in Nasdaq securities by offering an alternative to traditional telephone contact and negotiation between retail firms and market makers. SOES provides efficient mechanisms for the automated execution of small-investor orders with Nasdaq market makers at the best available market price. Since the exclusive purpose of the system is directed toward the small investor, the NASD has taken steps in the past to maximize market maker presence in the system and prohibit any misuse of the system that would detract from the broadest participation of market makers or adversely impact the quality of the Nasdaq market.

In the past, in recognition that SOES was developed to accommodate small-sized retail investor orders in Nasdaq securities, the NASD took measures to curb specific misuses of the SOES system by adopting rules prohibiting certain trading patterns deemed to be professional trading techniques, rather than investor-oriented activity. The NASD adopted procedures to allow participants in the system to reflect more accurately actual trading practices by allowing market makers to update their quotes in between executions and to designate specific order-entry firms from which they would accept preferenced orders. In light of the limited effects of these rules, the NASD withdrew the professional trading account rules from SOES in December 19932 and urged the SEC to approve the interim modifications to SOES. These broad-based, fundamental modifications to the operations and rules governing SOES apply across-the-board to all participants without regard to their status as professional traders and are being made for the benefit of all investors in Nasdaq securities.

New SOES Rules

1. The largest order size now acceptable for SOES is 500 shares.
  • No retail order greater than 500 shares may be entered into SOES. Retail orders larger than 500 shares may be entered into the SelectNet™ service or negotiated over the telephone.

  • No order larger than 500 shares may be broken into smaller-sized orders to fit under the maximum size limit of 500 shares.

  • Any orders based on a single investment decision that are entered by a SOES order-entry firm for accounts under the control of an associated person or public customer will be deemed to constitute a single order and will be aggregated for determining compliance with the SOES order-size limits. Trades entered within any five-minute period in accounts controlled by an associated person or a public customer will be presumed to be based on a single investment decision. An associated person or customer will be deemed to control an account if: the account is a personal account; the person exercises discretion over the account; the person has been granted a power of attorney to exe cute transactions in the account; or the account is the account of a member of the immediate family of the person as that term is defined in the NASD Free-Riding Interpretation.3
Even though the SOES maximum order size is now 500 shares, the criteria established in the SOES rules and cross-referenced in Schedule D for a 1,000 share display of size for certain Nasdaq National Market issues remains unchanged. Market makers will continue to be required to display size of 1,000 shares in their quotations for those securities, and market makers must fulfill their firm quote obligations for their published quotations for orders up to 1,000 shares for any negotiated transaction.

In its order approving the new SOES rules, the SEC stated it expects rigorous enforcement of market makers' firm-quote obligations. The NASD takes backing-away complaints seriously, and fully expects market makers to comply with their firm-quote obligations.
2. No short sales are permitted to be entered into SOES.

Execution of short sales in an automated environment such as SOES is inappropriate and may substantially contribute to the increased volatility in the market. Accordingly, the NASD has prohibited entry of short sales into SOES. Short sales may, of course, be executed by firms through SelectNet or over the telephone. Members are currently required to ask customers whether sale orders are long or short, and short-sale orders may not be entered into SOES. There are no exceptions available to this rule and the customer must be long the security for the member to effect a sale in SOES.
3. Mandatory exposure limits have been reduced to two times the maximum order size.

Reduction of the mandatory exposure limits in SOES will provide market makers with a better opportunity to react to market movements. Additionally, eliminating exposure limits for preferenced orders will reduce the potential for market makers to deplete their exposure limits and enhance the opportunity for customers to receive expeditious executions of their orders in SOES.

Members must manually change their exposure limits any time after the close on Friday, January 7, 1994, to implement the new minimums — the Market Operations Department will not reset member exposure limits.
4. An automated quotation update capability is now available for market makers.

The system will now be available to generate a quote update (in a fractional interval established by the member) when a market maker's exposure has been exhausted. The automated quote update will guarantee continuity in quotations and continuous accessibility to market prices by small investors. Currently, when a market maker depletes its exposure limit in SOES, its quote is closed and the market maker is granted a five-minute period to refresh its quote. If the dealer does not act within those five minutes, it is withdrawn from the issue on an unexcused basis and must wait 20 business days before it can reregister. To prevent inadvertent unexcused withdrawal of quotations and mitigate the potential for a five-minute interruption in pricing that could occur, Nasdaq will now offer a service to automatically refresh a market maker's quote when its exposure has been depleted. The NASD also has the ability to shut down the automated update capability for a member firm or for the entire network if emergency market conditions warrant such action.
  • The automated system to refresh a dealer's quote will be voluntary for market makers and will be available on an issue-by-issue basis. The system will refresh a dealer's quote when the exposure limit has been exhausted and reestablish the original quote size and the minimum exposure limit of two executions.

  • To use this feature, member firms must notify the Market Operations Department in Trumbull, Connecticut to request firm-wide authorization and establish the default quote interval for the firm (i.e., 1/8 point quotation changes). To contact Market Operations, the telephone number is (203) 378-0284 and fax number is (203) 385-6380. Once authorized to use the function, the firm may adjust the operation of the quote refresh security by security, and may turn the system on or off for each individual issue or change the quote interval for certain stocks. The system-wide default is set at 1/8 point. Members should watch their Nasdaq Workstation News frame for updates on how to implement these system changes.
The NASD has modified the operations and rules surrounding SOES for the benefit of public customers and the marketplace. The NASD will enforce compliance with all of the SOES requirements and cautions member firms that the NASD will consider any attempt to circumvent these rules or to do indirectly what is prohibited directly by the rules as conduct inconsistent with just and equitable principles of trade, in violation of Article III, Section 1 of the NASD Rules of Fair Practice.

The amendments are effective Monday, January 10, 1994. Questions regarding these changes may be directed to Glen Shipway, Senior Vice President, Market Operations at (212) 858-4448; James M. Cangiano, Senior Vice President, Market Surveillance, at (301) 590-6424; or Beth E. Weimer, Associate General Counsel, Office of General Counsel, at (202) 728-6998.

1 At NASD request, the SEC deferred consideration of a fifth proposal to use the l5-second interval for quote updates during locked and crossed markets.

2 Release No. 34-33307 (December 9, 1993).

3 The Interpretation of the Board of Governors — Free-Riding and Withholding under Article III, Section 1 of the NASD Rules of Fair Practice, NASD Manual, 12151.06, defines "immediate family" to include "parents, mother-in-law or father-in-law, husband or wife, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, and children. In addition, the term shall include any other person who is supported, directly or indirectly, to a material extent by the member [or] person associated with the member...."

Text Of Amendments To The Rules Of Practice And Procedures For The Small Order Execution System

(Note: New language is underlined; deletions are in brackets.)

a) Definitions

* * * * *
1.-6. No change.
7. The term "maximum order size" shall mean the maximum size of individual orders for a security that may be entered into or executed through SOES. The maximum order size for each security shall be published from time to time by the Association.1 In establishing the maximum order size for each NASDAQ/NMS security, the Association will give consideration to the average daily non-block volume, bid price, and number of market makers for each security. Maximum order sizes for NASDAQ/NMS securities shall be 200 or 500 shares depending upon trading characteristics of the securities. Maximum order size for NASDAQ securities shall be 500 shares. These sizes may be adjusted on an issue by issue basis, depending upon unique characteristics of the issue as determined by the Association.
8. The term "exposure limit" means the number of shares of a security on either side of the market specified by a Market Maker that it is willing to have executed for its account by unpreferenced orders entered into SOES.
9. The term "minimum exposure limit" for a security means the aggregate number of shares of the security equal to two [five] times the maximum order size for that security.
c) PARTICIPANT OBLIGATIONS IN SOES
1.-2.
(B) No change.
(C) For each security in which the Market Maker is registered, the Market Maker may elect to have the Nasdaq System refresh its quotation automatically by an interval designated by the Market Maker, once its exposure limit in the security has been exhausted. The Nasdaq System will refresh the Market Maker's quotation on the bid and offer side of the market by the interval designated, and will reestablish the Market Maker's displayed size and selected exposure limit. If the Market Maker elects to utilize the Nasdaq System automated update feature, it may establish an exposure limit equal to the maximum order size for the security regardless of the minimum exposure limit set forth in section (a)(9) of this part.
Subsections (C) through (I) relettered (D) through (J)
3. SOES Order Entry Firms —
(A)–(C) No changes.
(D) No short sales shall be entered

Schedule D Part V

Requirements Applicable to Nasdaq Market Makers

Sec. 1 No change.

Sec. 2 Character of Quotations

(a) Two-Sided Quotations. For each security in which a member is registered as a market maker, the member shall be willing to buy and sell such security for its own account on a continuous basis and shall enter and maintain two-sided quotations, in the NASDAQ System, subject to the procedures for excused withdrawal set forth in Section 8 below. Each member registered as a NASDAQ market maker in National Market System equity securities shall display size in its quotations of 1,000, 500, or 200 shares and the following guidelines shall apply to determine the applicable size requirement: (i) a 1,000 share requirement shall apply to Nasdaq/NMS securities with an average daily non-block volume of 3,000 shares or more a day, a bid price of less than or equal to $100, and three or more market makers: (ii) a 500 share requirement shall apply to Nasdaq/NMS securities with an average daily non-block volume of 1,000 shares or more a day, a bid price of less than or equal to $150, and two or more market makers: and (iii) a 200 share requirement shall apply to Nasdaq/NMS securities with an average daily non-block volume of less than 1,000 shares a day, a bid price of less than or equal to $250, and that have two or more market makers. Each member registered as a Nasdaq market maker in Nasdaq SmallCap equity securities shall display size in its quotations of 500 or 100 shares and the following guidelines shall apply to determine the applicable size requirement: (i) a 500 share requirement shall apply to Nasdaq SmallCap securities with an average daily non-block volume of 1,000 shares or more a day or a bid price of less than $10.00 per share: and (ii) a 100 share requirement shall apply to Nasdaq SmallCap securities with an average daily non-block volume of less than 1,000 shares a day and a bid price equal to or greater than $10.00 a share. Share size display requirements in individual securities may be changed depending upon unique circumstances as determined by the Association, and a list of the size requirements for all Nasdaq equity securities shall be published from time to time by the Association. [shall display the size for each quotation, which size shall be published from time to time by the Association pursuant to paragraph (a)(7) of the Rules of Practice and Procedure for the Small Order Execution System. Maximum order sizes for NASDAQ/NMS securities shall be 200, 500 or 1,000 shares depending on trading characteristics of the securities. Maximum order size for NASDAQ Small-Cap securities shall be 100 or 500 shares depending on trading characteristics of the securities. A 500 share display size for NASDAQ Small-Cap securities shall apply to securities with an average daily non-block volume of 1,000 shares or more a day or a bid price of less than $10.00 per share. A 100 share display size for NASDAQ Small-Cap securities shall apply to securities with an average daily non-block volume of less than 1,000 shares a day and a bid price equal to or greater than $10.00 a share. Individual securities may be reclassified from time to time depending on unique circumstances as determined by the Association. These sizes shall not be applicable to convertible debt securities listed in NASDAQ.]

1 [In Notice to Members 88-43 (June 22, 1988) the NASD announced that the maximum order size for NASDAQ/NMS securities traded on SOES shall be 1,000, 500, or 200 shares and that the applicable maximum order size for each NASDAQ/NMS security would be determined generally by the following criteria: (i) a 1,000-share maximum order size shall apply to NASDAQ/NMS securities on SOES with an average daily non-block volume of 3.000 shares or more a day, a bid price less than or equal to $100, and three or more market makers; (ii) a] A 500-share maximum order size shall apply to NASDAQ/NMS securities on SOES with an average daily non-block volume of 1,000 shares or more a day, a bid price of less than or equal to $150, and two or more market makers and [(iii)] a 200-share maximum order size shall apply to NASDAQ/NMS securities with an average daily non-block volume of less than 1,000 shares a day, a bid price of less than or equal to $250, and that have [less than] two or more market makers. The maximum order size for all Nasdaq SmallCap securities shall be 500 shares. [The NASD announced the maximum order size for each security in NASDAQ/NMS and noted that i] Individual securities may be reclassified from time to time depending upon unique circumstances as determined by the Association. [The NASD also announced that the maximum order size for all NASDAQ securities not in NASDAQ/NMS shall be 500 shares.]