Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the National Association of Securities Dealers, Inc. and Amendment No. 1 thereto Relating to the Entry of Locking/Crossing Quotations Prior to the Nasdaq Market Opening

Pursuant to Section 19(b0(1) of the Securities Exchange Act of 1934 (“Act”), and Rule 19b-4 thereunder, notice is hereby given that on April 13, 2000, the National Association of Securities Dealers, Inc. (“NASD” or “Association;”), through its wholly owned subsidiary, the Nasdaq Stock Market, Inc. (“Nasdaq”, filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I, II, and III below, which Items have been prepared by Nasdaq. On April 18, 2000, the NASD and Nasdaq submitted Amendment No. 1 to the proposal. The Commission is publishing this notice, as amended, to solicit comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change

Nasdaq proposes to amend NASD Rule 4613(e) as it relates to the entry of locking/crossing quotations prior to the market's open. Proposed new language is italicized.

4613. Character of Quotations

(a)-(d) No Changes

(e) Locked and Crossed Markets

(1) A market maker shall not, except under extraordinary circumstances, enter or maintain quotations in Nasdaq during normal business hours if:

(A) the bid quotation entered is equal to (“lock”) or greater than (“cross”) the asked quotation of another market maker entering quotations in the same security; or

(B) the asked quotation is equal to (“lock”) or less than (“cross”) the bid quotation of another market maker entering quotations in the same security.

(C) Obligations Regarding Locked/Crossed Market Conditions Prior to Market Opening

(i) No Change.

(ii) Locked/Crossed market Between 9:20 and 9:29:59 a.m.—If a market maker locks or crosses the market between 9:20 and 9:29:59 a.m. Eastern Time, the market maker must immediately send through SelectNet to the market maker whose quotes it is locking or crossing a Trade-or-move Message that is at the receiving market maker's quoted price and that is for at least 5,000 shares (in instances where there are multiple market makers to a lock/cross, the locking/crossing market maker must send a message to each party the lock/cross and the aggregate size of all such messages must be at least 5,000 shares) ; provided, however, that if a market participant is representing an agency order (as defined in subparagraph (iv) of this rule), the market participant shall be required to send a Trade-or-Move Message(s) in an amount equal to the agency order, even if that order is less than 5,000 shares. A market maker that receives a Trade-or-Move Message during this period and that is a party to a lock/cross, must within 30 seconds of receiving such message either: fill the incoming Trade-or-Move Message for the full size of the message; or move its bid down (offer up) by a quotation increment that unlocks/uncrosses the market. A market participant shall not be subject to the 5,000 share requirement of this rule if the market participant is representing agency interest only.

(iii) No Change.

(iv) For the purposes of this rule “agency order”shall mean an order(s) that is for the benefit of the account of a natural person executing securities transactions with or through or receiving investment banking services from a broker/dealer, or for the benefit of an “institutional account” as defined in NASD Rule 3110. An agency order shall not include an order(s) that is for the benefit of a market maker in the security at issue, but shall include an order(s) that is for the benefit of a broker/dealer that is not a market maker in the security at issue.

(2)-(3) No Change.

II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, Nasdaq included statements concerning the purpose of, and basis for, the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. Nasdaq has prepared summaries, set forth in Sections (A), (B), and (C) below, of the most significant aspects of such statements.

(A) Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

Nasdaq is proposing a rule to amend NASD Rule 4613(e), to permit market participants, when representing agency interests, to lock/cross the market at the actual size of the agency order, instead of 5,000 shares as currently required by rule.

1. Background

On February 7, 2000, the Commission approved amendments to NASD Rule 4613(e), which relate to the entry of locking/crossing quotes by Nasdaq market participants—market maker and electronic communications networks (“ECNs”)—prior to the market's open. As amended and approved by the Commission, NASD Rule 4613(e) provides that if a market participant locks/crosses the market between 9:20 a.m. and 9:29:59 a.m. Eastern Time, the market participant must send the market maker(s) or ECN(s) being locked/crossed, a SelectNet® message that has appended to it a “TRD OR MOV” administrative message (“Trade-or-Move Message”) The aggregate size of these Trade-or-Move Messages must be at least 5,000 shares. (Thus, in order to lock/cross the market during this 10 minute before the market opens, a market participant must send a Trade-or-Move Message for 5,000 shares and be willing to trade at least this amount.) The party being locked or crossed must respond to the Trade-or Move Message within 30 seconds by trading in full with the incoming message or moving its quotation to a price level that resolves the locked/crossed market.

2. Purpose

The 5,000 share requirement that is currently in the rule requires market makers, ECNs, and customers thereof, who initiate a lock/cross to send a Trade-or Move(s) for a total of a least 5,000 shares. This requirement applies even if the market maker or ECN is representing an agency order for less than 5,000 shares. Therefore, as currently written and approved, an ECN, market maker, and customer thereof, may not lock/cross the market unless he/she is willing to trade at least 5,000 shares. Some market participants have raised concerns that NASD Rule 4613(e) may exclude certain agency interests from being reflected in the pre-opening market if that interest is less than 5,000 shares.

In light of these concerns, Nasdaq proposes to amend NASD Rule 4613(e) to allow a market participant to lock/cross the market for less than 5,000 shares if they are representing only agency orders. Under the amendment, if between 9:20 a.m. and 9:29:59 a.m., a market participant receives an agency order that would lock/cross the market, the market participant may lock/cross the market and sent a Trade-or Move Message for the “actual size” of the agency order, instead of 5,000 shares. (For purposes of the amended rule, an agency order would not include an order for the account of a market maker in the issue, but would include orders for individuals, institutions and broker/dealers whoa re not market makers in the security at issue). In essence, agency orders would be “exempt” from the 5,000 share requirement. Market participant whose proprietary quotes lock/cross the market between 9:20 and 9:29:59 a.m., would still be subject to the 5,000 aggregate share size requirement for Trade-or Move Messages. Thus, if a market participant wishes to lock/cross the market while acting as principal, the market participant must send an aggregate of at least 5,000 shares, through a Trade-or Move Message, to the parties being locket/crossed.

For example, at 9:21 a.m. the market is $20 to $201/8, and MMA is alone at the inside offer. ECN1 receives an order from a public customer to sell shares at $201/8. Under the current rule, ECN1 would be required to lock the market and then send a Trade-or Move Message to MMA for 5,000 shares. Under the proposed amendment, ECN1 would be required to send MMA a Trade-or Move message for the actual size of the agency order—800 shares. If the order that ECN1 received at 9:21 a.m. represented an order that was for the account of MMB, ECN1 would be prohibited from locking for only 800 shares.

As a second example, at 9:21 a.m. the market is $20 to $291/8, with MMA along at the inside offer. MMG receives an 800 share customer limit order to sell at $201/4, which the customer has requested be displayed in the pre-opening. MMG also wishes to cross the market at the $201/4 price, while acting in a proprietary capacity. Note that only the agency interest is exempt from the 5,000 share requirement. Accordingly, MMG must send a Trade-or Move Message for at least 5,800 shares—5,000 covering his proprietary interest and 800 covering the customer limit order/agency. In short a market maker is not permitted to meet the 5,000 share requirement by “free-riding” off of its customer orders that customers specifically have requested be displayed and executed in the market prior to the open.

The requirement that a market maker send a Trade-or Move Message for the actual size of agency interest plus 5,000 shares, only applies when a market maker wishes to lock/cross the market proprietary and simultaneously is displaying agency interest pursuant to an understanding with the customer. This requirement does not apply when the marker maker is holding agency interest where there is not understanding with the customer to have its order displayed and/or executed prior to the market's open, and the market maker otherwise is engaging in bona fide market making activity during the pre-opening period.

3. Statutory Basis

Nasdaq believes that the proposed rule change is consistent with the provisions of Section 15A(b)(6) and Sections 11A of the Act. Section 15A(b)(6) requires that the rules of a registered national securities association are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principals of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers. Section 11A(a)(1)(C) provides that it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure: (1) Economically efficient execution of securities transactions; (2) fair competition among brokers and dealers; (3) the availability to brokers, dealers and investors of information with respect to quotations and transactions in securities; (4) and the practicability of brokers executing investors orders in the best market; and (5) an opportunity for investors orders to be executed without the participation of a dealer.

Nasdaq believes that the amendment to NASD Rule 4613(e) is consistent with Sections 15A(b)(6) and 11A(a)(1)(C). The proposed amendments create equal access among market participants (market makers and ECNs) consistent with Sections 15A(b)(6) and 11A(a)(1)(C). Locked/crossed markets present serious market integrity and investor protection issues, as they disrupt the orderly function of the market and in turn have an impact on the processing of investor orders. Nasdaq believes that by allowing agency orders to be displayed in the market at their actual share sizes for purposes of resolving locked/crossed markets will increase investor protection by providing; (1) Greater access to the market, (2) increased liquidity, and (3) transparency of orders in the marketplace. Nasdaq believes that these benefits will provide greater trading, processing, and pricing efficiency and stability in the pre-opening market. Nasdaq also believes that by allowing agency quotes to be sent at “actual size” rather than at the 5,000 share size, market participants will have increased opportunities to evaluate and access the depth and liquidity of securities prior to the opening of the market.

(B) Self-Regulatory Organization's Statement on Burden on Competition

Nasdaq does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others

Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

Within 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the self-regulatory organization consents, the Commission will:

A. By order approve such proposed rule change, or

B. Institute proceedings to determine whether the proposed rule change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and arguments concerning the proposal, including whether the proposed rule change is consistent with the Act. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing will also be available for inspection and copying at the principal office of the NASD. All submissions should refer to the File No. SR-NASD-00-18 and should be submitted by May 31, 2000.