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NASD Rulemaking:
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| I. | Introduction | |||
| II. | Executive Summary | |||
| A. | Background of the Nasdaq System | |||
| B. | Overview of the SuperMontage Proposal | |||
| 1. | Quote/Order Collection | |||
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2. | Display of Quotes/Orders | ||
| 3. | Execution Services | |||
| C. | Summary of Conclusions | |||
| 1. | Execution Procedures and Quote/Order Priority | |||
| 2. | Inherent Conflicts of NASD Roles | |||
| III. | Description of the Proposal | |||
| A. | Nasdaq Order Display Facility | |||
| 1. | Enhanced Display of Trading Interest | |||
| 2. | Size MMID and Summary Scan | |||
| 3. | Reserve Size | |||
| B. | Order Collector Facility | |||
| 1. | Entry of Quotes/Orders | |||
| 2. | Order Execution and Delivery | |||
| C. | Non-Directed Orders | |||
| 1. | Quote Decrementation of Non-Directed Orders | |||
| 2. | Quote Refresh and Revised SOESed-Out-of-the Box Procedures | |||
| D. | Order Execution Algorithms | |||
| E. | Directed Orders | |||
| F. | Locked/Crossed Markets | |||
| G. | UTP Exchange Participation | |||
| H. | ECN Participation | |||
| I. | Odd-Lot Processing | |||
| J. | Nasdaq SmallCap | |||
| K. | System Roll Out | |||
| IV. | Summary of Comments | |||
| V. | Discussion | |||
| A. | Nasdaq Order Display Facility | |||
| 1. | Non-Attributable Quotes and Other Factors | |||
| 2. | Reserve Size | |||
| B. | Order Collector Facility | |||
| 1. | Order Entry and Access | |||
| 2. | Non-Marketable Limit Orders | |||
| C. | Quote Refresh and Revised SOESed-Out-of-the-Box Procedures | |||
| D. | Order Execution Algorithms | |||
| 1. | Matching Against a Participant's Own Quote/Order at the BBO | |||
| 2. | Preferenced Orders | |||
| 3. | ECNs | |||
| a. | Order Execution Algorithms | |||
| b. | Time Restrictions on the Order Delivery Feature | |||
| c. | ECN's Automatic Execution Function | |||
| 4. | UTP Exchange Priority | |||
| 5. | Five-Second Interval Delay | |||
| E. | Directed Orders | |||
| F. | Locked/Crossed Markets | |||
| G. | UTP Exchange Participation as Automatic Execution Participants | |||
| H. | Odd-Lot Processing | |||
| I. | Issues Relating to Competition | |||
| 1. | Centralization | |||
| 2. | Other Issues Relating to Competition | |||
| 3. | Nasdaq as an Exclusive Securities Information Processor | |||
| 4. | Commission's Conclusion on Competition Issues | |||
| J. | Technology Issues | |||
| K. | Impact on Competition, Efficiency and Capital Formation | |||
| VI. | Amendment No. 9 | |||
| VII. | Solicitation of Comments | |||
| VIII. | Conclusion | |||
On October 1, 1999, 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 ("SEC" or "Commission"), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 ("Act" or "Exchange Act"),1 and Rule 19b-4 thereunder,2 proposed rule changes to establish the Nasdaq Order Display Facility ("NODF") and the Order Collector Facility ("OCF") and to modify its primary trading platform, the Nasdaq National Market System ("NNMS"), collectively referred to as the SuperMontage proposal. On October 26 and October 29, 1999, respectively, Nasdaq filed Amendment Nos. 1 and 2 to the proposal.3 The SuperMontage proposal and Amendment Nos. 1 and 2 were published for comment in the Federal Register on December 6, 1999.4 On March 16, 2000, Nasdaq filed Amendment No. 3 to the proposal.5 On March 23, 2000, Nasdaq filed Amendment No. 4 to the proposal,6 which was published for comment in the Federal Register on March 30, 2000.7 On May 19, 2000, Nasdaq filed Amendment No. 5 to the proposal;8 on June 7, 2000, Nasdaq filed Amendment No. 6;9 and on August 8, 2000, Nasdaq filed Amendment No. 7.10 Amendment Nos. 5, 6 and 7 were published for comment on August 15, 2000.11 On October 23, 2000, the NASD filed Amendment No. 8,12 which was published for comment on November 15, 2000.13 On January 9, 2001, the NASD filed Amendment No. 9.14 The Commission received 104 comments regarding the proposal.15 The Commission is approving the SuperMontage proposal, as amended, and is soliciting comments on Amendment No. 9 from interested persons.16
The Nasdaq System originated 30 years ago for the purpose of collecting and displaying quotations posted by individual dealers in the over-the-counter market regulated by the NASD, which sponsored the system. Nasdaq's quotation management system currently collects and displays quotations of registered market makers and ECNs that are members of the NASD (collectively, "Nasdaq Quoting Market Participants"). By agreement, Nasdaq also collects and displays quotations in Nasdaq securities from UTP Exchanges.17
The existing quotation management system permits each Nasdaq Quoting Market Participant and UTP Exchange to enter a single quotation into the system at any one time. This single quotation may reflect the Nasdaq Quoting Market Participant's or UTP Exchange's proprietary trading interest or customer limit orders handled by that participant, or both.18 The quotations of Nasdaq Quoting Market Participants and UTP Exchanges are displayed on a quotation montage (arranged by price and time) that can be viewed on a Nasdaq screen, and are disseminated to vendors for further redistribution to broker-dealers and other subscribers.
Other Nasdaq systems facilitate a Nasdaq participant's ability to interact with the quotations of Nasdaq Quoting Market Participants and UTP Exchanges. In 1984, Nasdaq introduced the Small Order Execution System ("SOES"), which allows Nasdaq participants to execute small orders automatically against the quotation of a market maker at the best bid or offer ("BBO").19 Nasdaq's SelectNet system, introduced in 1988, allows Nasdaq participants to route orders to a particular market maker or ECN.20 Although SelectNet is an order delivery service, rather than an execution service, a SelectNet order presented to a market maker or ECN at its displayed quotation obligates the market maker or ECN to execute the order at the price and size of its quote consistent with the Commission's Firm Quote Rule.21 The SOES and SelectNet systems currently are not integrated, so that it is possible for a market maker to receive a SelectNet order that it is obligated to execute and a SOES execution against the same quote, creating a double liability exposure.22
Nasdaq's SOES and SelectNet systems supplement the separate order execution services offered by market makers, ECNs, and UTP Exchanges, but do not supplant those services. In fact, the large majority of orders are executed outside Nasdaq's order delivery and execution services through direct links - by telephone, dedicated line, or other means - among order entry firms, market makers, ECNs, and UTP Exchanges.
In recent years, changes in technology and market structure have placed increasing demands on, and created new challenges for, Nasdaq's systems. For example, while Nasdaq's existing quotation management system displays the best bid and offer of a Nasdaq Quoting Market Participant or UTP Exchange, many market participants are interested in seeing more of a Nasdaq Quoting Market Participant's or UTP Exchange's trading interest outside its best bid and offer. In addition, the entry of ECNs and UTP Exchanges trading Nasdaq securities has increased competition among execution service providers, including Nasdaq.
The changing competitive environment has been accompanied by changes in Nasdaq's structure and ownership. The NASD's ownership of Nasdaq was reduced to 60% on a fully diluted basis by a private placement sale of shares and warrants on June 28, 2000 and was further reduced to 40.6% by a second private placement just completed. The warrants are exercisable over a four year period beginning June 28, 2002. Under the terms of the sale, the voting rights for NASD shares underlying warrants will shift to the warrant holders upon registration of Nasdaq as an exchange. Nasdaq filed an application for registration with the Commission on November 9, 2000 .23
Subsequently, the NASD Board adopted a resolution stating its intent to divest itself of all remaining shares of Nasdaq not subject to outstanding warrants by June 30, 2002, subject to existing contractual and legal arrangements and to the reasonable judgment of NASD management that market conditions permit.24 The NASD also has undertaken that during any interim period it intends to vote its shares in Nasdaq on any matter in proportion to the votes of all other shareholders.
The Commission has considered the SuperMontage proposal in the context of increased demand for information about trading interest, increasing competition among execution service providers, and changes in Nasdaq's ownership structure. The Exchange Act requires the Commission to approve the proposed rule changes if it finds that the changes are consistent with the requirements of the Exchange Act applicable to the NASD.
In this context, including Nasdaq's demutualization, application for registration as an exchange, and impending full separation of the NASD and Nasdaq, and for the reasons discussed in this release, the Commission finds that the proposed rule changes are consistent with the requirements of the Exchange Act applicable to the NASD and therefore approves the proposed rule changes.
The SuperMontage proposal is designed to modify Nasdaq's systems in three principal areas: (1) quote/order collection; (2) quote/order display; and (3) execution services.
SuperMontage will partially eliminate the distinction between quotes and orders and expand the ability of Nasdaq Quoting Market Participants and UTP Exchanges to represent quotes/orders in the Nasdaq market. It will permit, but not require, Nasdaq Quoting Market Participants and UTP Exchanges to enter multiple quotes/orders at the same price or at different prices.25 In addition, SuperMontage will allow Nasdaq Quoting Market Participants to enter quotes/orders on a non-attributable basis (i.e., anonymously), although market makers will be obligated to maintain a two-sided attributable quote/order consistent with Commission and NASD rules. UTP Exchanges will not be permitted to enter principal quotes on a non-attributable basis, but may enter agency quotes/orders on a non-attributable basis.
For Nasdaq Quoting Market Participants and UTP Exchanges that choose to enter multiple quotes/orders, SuperMontage will aggregate their best-priced attributable quotes/orders on each side of the market to create the Nasdaq Quoting Market Participant's or UTP Exchange's displayed quote, while maintaining the separate identity, price, and time of entry of each quote/order. Alternatively, a Nasdaq Quoting Market Participant or UTP Exchange may choose to maintain only its required quotation, and not enter additional quotes/orders.
To the extent Nasdaq Quoting Market Participants and UTP Exchanges use the quote/order collection system to represent more quotes and orders than they currently are able to represent, SuperMontage will show more information than the current quotation montage. SuperMontage will display the additional information in two ways. First, the best-priced non-attributable quotes/orders from all participants will be aggregated and displayed in the quotation montage as one buy and one sell price, each under the generic name "SIZE", along with the best-priced attributable quotes/orders of each Nasdaq Quoting Market Participant and UTP Exchange. Second, and more significantly, SuperMontage will aggregate all quotes/orders (attributable and non-attributable) at each price level, and display the three best prices with associated aggregate size on each side of the market through the NODF. This information will be distributed to market data vendors so that they can provide an equivalent display service to their customers. In addition, the NASD will make available to market data vendors individual attributable quotes/orders displayed in the three best price levels in the NODF.
Thus, to the extent Nasdaq Quoting Market Participants and UTP Exchanges voluntarily enter their "near the market" quotes/orders, investors and market professionals will be able to see the aggregate of this interest at three price levels in widely available displays.
SuperMontage will replace Nasdaq's current SOES and SelectNet services with two new processes: a directed order process and a non-directed order process. Nasdaq participants that wish to use either of these processes to interact with the quotes/orders of Nasdaq Quoting Market Participants and UTP Exchanges may enter orders into the same order collection facility used by Nasdaq Quoting Market Participants and UTP Exchanges to enter quotes/orders.
The directed order process will be functionally similar to the current SelectNet service in that it will allow a Nasdaq participant to direct an order to a particular Nasdaq Quoting Market Participant or UTP Exchange. As in SelectNet, a directed order can match a posted quote/order of the recipient (a Liability Order) or not match any quote/order of the recipient (a non-Liability Order).26 To avoid creating a risk of double liability, no Nasdaq Quoting Market Participant or UTP Exchange is required to receive directed Liability Orders through the OCF, but may elect to do so.
The non-directed order process will be the default execution process for marketable orders entered by a Nasdaq participant into Nasdaq's order collection facility. A marketable order entered into the non-directed order process will be matched with the highest ranked quotes/orders of Nasdaq Quoting Market Participants and UTP Exchanges on the opposite side of the market, and either will be executed automatically or delivered (on a liability basis) to the matched Nasdaq Quoting Participants and UTP Exchanges, depending upon how such participants participate in the non-directed order process.27
The ranking of Nasdaq Quoting Market Participant and UTP Exchange quotes/orders in the non-directed order process will be established pursuant to one of three order execution algorithms: price/time priority, price/size/time priority, or price/time priority that account for ECN fees. The Nasdaq participant entering a non-directed order may select the algorithm used for executing its order, but the system will default to the price/time priority algorithm if none is selected. Within each algorithm, a non-directed order entered by a Nasdaq participant that is also a Nasdaq Quoting Market Participant will be matched first against its own quote/order on the other side of the market, provided that its quote/order is at the BBO. In addition, a Nasdaq participant entering a non-directed order will be permitted to "preference" the order to a particular Nasdaq Quoting Market Participant or UTP Exchange, if that participant's quote/order is at the BBO.
Nasdaq participants are not required to use either the directed or non-directed order processes to execute their orders but may choose, instead, systematically or on an order-by-order basis, to continue to use other methods such as telephone access or direct connections to market makers, ECNs, and UTP Exchanges. Any Nasdaq member is free to offer a competing execution service, and may even use the Nasdaq service as one of its options.
The SuperMontage proposal generated significant controversy. Throughout a series of comment periods and revisions, commenters maintained that various aspects of the proposal were unfair or anti-competitive, and that the proposal as a whole fell short of the standards that ought to be required of National Market System facilities.
Many issues were resolved through the process of public comment and response. For example, under the original proposal Nasdaq Quoting Market Participants would have transmitted to Nasdaq multiple quotes/orders at the same price or at different prices, and Nasdaq would have aggregated the best priced orders on either side of the market to produce the participant's required quotation, which would then be distributed by Nasdaq, in its capacity as an exclusive processor for the OTC market.
In addition, Nasdaq would have distributed the aggregate amount of buying and selling interest at the three best price levels on either side of the market. Some commenters objected that the proposal in this form meant that Nasdaq alone would know the details of any quotes/orders not incorporated into participant quotations, and that it would be unfair for Nasdaq to keep such information to itself. In response, Nasdaq agreed to disseminate the details of all attributable quotes/orders in the three best price levels on either side of the market via a new information service, in addition to the aggregate amounts of interest at those prices. The result will be that all quote/order details will be generally available at the best price levels, except those quotes/orders that are submitted on an anonymous basis (non-attributable quotes/orders). The Commission believes that this additional information will be valuable to competitors that may offer execution services complementary to, or in competition with, Nasdaq's SuperMontage services, and that Nasdaq's proposal appropriately resolves the issue. Several other issues have been dealt with in similar fashion. All of these are described at length in the Discussion section below.
The remaining issues, which remain controversial, generally fall in two groups: 1) disagreements about the appropriate priority and protections afforded to quotes/orders represented in SuperMontage under the applicable execution procedures, and 2) questions concerning the conflicts inherent in NASD's multiple roles as SRO and default regulator for the OTC market, and as the principal owner of Nasdaq, which will be the operator of SuperMontage. These issues have been carefully weighed by the Commission and are described individually and in detail in the Discussion section below. A more general description and overview of the Commission's analysis and reasoning follow:
Following Amendment No. 7, the proposed execution procedures involved a single execution algorithm for non-directed orders (without any preferencing), and the directed order process. Preferencing through the non-directed order process had not yet been proposed. The single execution algorithm applicable to non-directed orders was based on price/time priority, but gave lower priority to quotes/orders of an ECN that charges a separate fee for accessing its quotes/orders, and last priority to the principal quotes of UTP Exchange specialists.28 Some ECNs and others objected to the treatment of quotes/orders involving payment of a separate fee, arguing among other things that many market participants preferred to deal with ECNs, even if they charged fees, because statistically the price improvement provided by certain ECNs exceeded the cost of their fees. Some also maintained that only displayed prices should be considered in assigning priority because any associated fees would be paid by brokers and not by customers. Still others argued that Nasdaq should not assign any priorities to quotes/orders but should only provide a means to access displayed quotes and leave the choice of priorities to participants.
In response to these arguments and others, the NASD in Amendment No. 8 proposed to offer participants much greater control of the execution process by creating two additional execution algorithms using price/time and price/size/time priorities respectively, ignoring any separate fees, and by creating the ability to send preferenced orders to any Nasdaq Quoting Market Participant or UTP Exchange at the discretion of the entering firm. This response was satisfactory to some earlier commenters that had sought greater control of the execution process, but not to certain ECNs that had wanted the execution process to ignore access fees. Moreover, the new approach embodied in Amendment No. 8 brought new objections from some commenters that it would be a step backward in achieving price/time priority that would encourage price competition.
The Commission believes that the competing interests of Nasdaq participants with respect to some of the issues of priority are essentially irreconcilable. For example, there is no way to simultaneously satisfy both those ECNs that want their orders executed and fees assessed when their orders have time priority at the displayed price, and other participants that want to avoid paying such fees when they can receive a better net price from other orders that do not have time priority. The Commission recognizes that there is merit to both sides of the discussion, but it believes that price priority ordinarily must take precedence over time priority. Because a quote that involves payment of a separate fee is, all other things equal, inferior to a quote at the same displayed price that does not involve payment of a fee, the Commission believes that it is reasonable to allow market participants to choose a method of execution that gives lower priority to quotes that require payment of a fee. It is true that price improvement may sometimes exceed the value of the required fee, but the fee is certain while price improvement is uncertain. The Commission believes that market participants are best able to exercise judgment in such cases.
The Commission shares the view expressed by some commenters that price/time priority tends to encourage price competition. The Commission notes, however, that although price priority is generally followed in the Nasdaq market, there is at present virtually no time priority across market centers. The proposal, in its present form, provides for more time priority than currently exists in the market, and may to that extent encourage more price competition. Moreover, for the reasons outlined above, a displayed price does not always represent the actual price to a participant and, indeed, the actual price is often not the same for all participants that might execute against a particular quote.29 The Commission does not believe that it is appropriate to require strict time priority based on such prices.
For these reasons, the Commission finds that the combination of choices offered in the current proposal is both fair to participants and reasonably designed to promote competition.
Many commenters raised issues that relate in one way or another to the multiple roles that the NASD has as an SRO and, through Nasdaq, as an exclusive processor of market information and as an operator of trading facilities. The Commission notes that conflicting roles are inherent in the self-regulatory model. Indeed, the Act specifically recognizes that SROs will act not only as regulators, but also as operators of markets, and exclusive processors of information derived from those markets. The Act authorizes the Commission to oversee SRO functions to address the inherent conflicts, and to ensure, among other things, that SROs do not abuse their regulatory powers,30 and when acting as exclusive processors, make available market information in a non-discriminatory, fair, and reasonable fashion. Thus, the Commission's role is to reach a fair and appropriate balance of the conflicts inherent in the SRO structure, not to eliminate those conflicts.
Prior to Amendment No. 8, many objections were raised that SuperMontage, as then proposed, would become a centralized, monopolistic execution system. The gist of these arguments was that because NASD is the default regulator for the OTC market,31 any market maker or ECN that wished to do business in Nasdaq securities must make its quotes available for execution through SuperMontage. Thus, SuperMontage would be, by the effect of NASD and Commission rules, the only execution system through which substantially all displayed trading interest could be reached. The only exception would have been any UTP Exchanges that chose not to participate in SuperMontage.
In response to these concerns, the NASD has agreed to provide an alternative quotation and transaction reporting facility for NASD members, including alternative trading systems ("ATSs"), ECNs, and market makers. In effect, this facility makes participation in SuperMontage voluntary. This facility will permit NASD members to comply with their obligations under Commission and NASD rules (including Rule 11Ac1-1(c)(5) and Regulation ATS) without participating in the Nasdaq execution facility. The facility will identify through the central processor the identity of the NASD member that is the source of each quote.32 The facility also will provide a market neutral linkage to the Nasdaq and other marketplaces, but not an execution service. NASD represents that the facility will be available upon the implementation of SuperMontage by Nasdaq. The Commission believes that this undertaking by NASD, in conjunction with other terms applicable to the NASD's interaction with the SuperMontage,33 provides an appropriate balance of NASD's role as regulator of the OTC market and its role (through Nasdaq) as operator of an execution service in a competitive market.
Some commenters also argued that automatic execution against market makers would give the SuperMontage an unfair advantage in attracting order flow, and make it difficult for others to offer competitive execution services. It appears that inherent in this argument is the view that Nasdaq should not be permitted to require its registered market makers to accept automatic executions, or that Nasdaq should not be permitted to operate a market itself, but should be restricted to providing connections among market makers and ECNs. Although the Commission is sensitive to the need to ensure that competition is fair, it cannot accept the view that Nasdaq should not be allowed to operate a market in which its registered market makers are required to accept automatic executions, particularly when participation in that market is voluntary. The Commission notes that compulsory automatic executions have been a feature of the Nasdaq market since at least 1988.34 The "SuperSOES" proposal approved in January 2000 further expanded the scope of automatic execution against market maker quotes. The Commission therefore finds that the requirement that registered market makers in Nasdaq accept automatic executions against their published quotes is not a new feature of the SuperMontage and that it remains an appropriate feature of a system designed to provide economically efficient executions to investors within a fair and orderly market.
Some commenters argued that Nasdaq's role as the exclusive processor of information for Nasdaq-listed securities will give SuperMontage an unfair advantage. On close examination, these criticisms pertained less to the operation of SuperMontage than to the requirement that market makers and ECNs quote through Nasdaq, as the sole consolidator of market data for Nasdaq securities. To address this issue, the NASD has agreed to provide an alternative quote and trade reporting mechanism, while Nasdaq has said that it is willing to confer with the other markets about establishing a separate central processor for information on Nasdaq securities under the UTP Plan.35 Nevertheless, the Commission believes that the current UTP plan must be revised to provide for a fair competitive environment in the future for all market centers trading in Nasdaq securities.36 The Commission believes that these undertakings, which are discussed in detail below, appropriately address the concerns about an advantage to Nasdaq arising from its role as the exclusive processor for Nasdaq securities.
Finally, the Commission believes that Nasdaq, as well as the traditional exchanges, must have the flexibility to alter their existing services and to create new services in response to changes in the marketplace. Congress instructed the Commission to seek to "enhance competition and to allow economic forces, interacting with a fair regulatory field, to arrive at appropriate variation in practices and services."37 The Commission believes that the SuperMontage proposal is consistent with these goals.
The SuperMontage proposal will enhance Nasdaq's quotation montage by adding a new display facility for trading interest, the NODF, and establishing a new system for collecting quotes/orders, the OCF. This proposal also will modify Nasdaq's primary trading platform, the NNMS, as approved on January 14, 2000.38
Today, the Nasdaq screen, commonly referred to as the Nasdaq Workstation II ("NWII"), is split into two primary display components. The top portion of the NWII contains, among other things: (1) the Market Minder Window, which allows market participants to monitor price activity (inside bid/offer and last sale) of selected stocks; and (2) the Dynamic Quote Window, which shows for a particular stock the inside bid and offer, the last sale, change in price from previous close, daily high and low, volume, and the short sale arrow indicator. The bottom portion of the NWII contains the Nasdaq Quotation Montage. The Nasdaq Quotation Montage shows for a particular stock two columns (one for bids, one for offers), under which is listed the market maker identification ("MMID") for each registered market maker, ECN, and UTP Exchange in the stock, and the corresponding quote (price and size). Nasdaq ranks the bids and offers along with the corresponding MMID in price/time priority. Accordingly, the market participant at the best bid who is first in time appears first in the montage, the market participant at the best bid (or the next best bid) who is next in time is ranked second, and so on.
Market makers that choose to participate in Nasdaq are required to submit a two-sided principal quote,39 which may reflect customer limit orders held by the market maker. ECNs, to qualify under the Order Handling Rules, must submit the prices and sizes of orders at the highest buy price and lowest sell price entered into the ECN by market makers.40 UTP Exchanges that have an interface with Nasdaq are required under the UTP Plan to submit to Nasdaq a two-sided quote, which represents the exchange's best quote in the stock at issue.
Under the proposal, Nasdaq will retain the bottom portion of the NWII, the Nasdaq Quotation Montage, which displays market maker, ECN and UTP Exchange attributable quotes ranked in price/time priority. Nasdaq proposes to add the NODF, which will be displayed in the top portion of the NWII. The NODF will display the three best price levels in Nasdaq on both the bid and offer side of the market. These displayed price levels will include, for the first time in the Nasdaq market, anonymous (or non-attributable) quotes/orders in addition to the attributable quotes/orders of market makers, ECNs, and UTP Exchanges. Each price level will be updated and will display the aggregate size of displayed trading interest (attributable and non-attributable, as explained below). In addition to displaying the aggregate size of displayed trading interest at the three best price levels, Nasdaq will create and make available a new vendor data feed called NQDS Prime. NQDS Prime will provide, on a real-time basis, all individual attributable quote/order information at the three best price levels displayed in the NODF.41
Nasdaq Quoting Market Participants will be required to designate a quote/order as attributable or non-attributable42 and will be able to indicate a reserve size for the quote/order.43 If a quote/order is designated as attributable, the price and size of the quote/order will be displayed next to the Nasdaq Quoting Market Participant or UTP Exchange's MMID in the Nasdaq Quotation Montage if it is the Nasdaq Quoting Market Participant or UTP Exchange's best-priced attributable quote/order. Attributable quotes/orders will be displayed in the NODF as part of the aggregate trading interest when the price of the quote/order is within the best three price levels (on either side of the market) in Nasdaq.
If a quote/order is designated as non-attributable, it will be displayed in the NODF as part of the aggregate trading interest when it is within the best three price levels. That quote/order will not, however, be displayed in the Nasdaq Quotation Montage next to the Nasdaq Quoting Market Participant's or UTP Exchange's MMID but instead may be displayed in a special "SIZE MMID," which is described in greater detail below, representing the aggregate size of the best priced non-attributable bids or offers. Pursuant to NASD Rule 4613, market makers will continue to be required to publish a two-sided quote that is attributed to their MMID in the Nasdaq Quotation Montage.
A SIZE MMID, representing the aggregate displayed size of the best-priced non-attributable bids or offers, will be shown in the Nasdaq Quotation Montage along with the other MMIDs for the Nasdaq Quoting Market Participants and UTP Exchanges displaying attributable size. The bid side and the offer side of the market each will have one SIZE MMID.44
The SuperMontage also will include a "Summary Scan" function. The Summary Scan will be a query-only function that will provide a snapshot of the total displayed size (attributable and non-attributable) for all levels below the three price levels in the NODF. The Summary Scan will anonymously display the aggregate interest (attributable and non-attributable) at each price level on both sides of the market, but will not be dynamically updated.
Nasdaq Quoting Market Participants will be able to use reserve size. According to the NASD, reserve size will work in virtually the same manner as approved in the NNMS Order.45 A Nasdaq Quoting Market Participant will be required to display (either as attributable or non-attributable) 1,000 shares in order to use reserve size. Reserve size will replenish displayed size (attributable or non-attributable) by at least 1,000 shares once displayed size is decremented to zero. Reserve size, along with displayed (both attributable and non-attributable) size, will be accessible through Nasdaq's trading platform, the NNMS. Reserve size, however, will not be displayed in either the NODF or the Nasdaq Quotation Montage. As described further below in the Order Execution Algorithms section of this Order, reserve size generally will be accessed after all displayed size at a given price in the Nasdaq market is exhausted.46
Nasdaq proposes to establish an OCF as part of the SuperMontage that will : (1) transmit to Nasdaq multiple quotes/orders at one price or quotes/orders at multiple price levels entered by Nasdaq Quoting Market Participants and UTP Exchanges;47 (2) accept orders to access quotes/orders displayed (as either attributable or non-attributable) in both the NODF and the Nasdaq Quotation Montage; and (3) unify Nasdaq's delivery of Liability Orders to Nasdaq Quoting Market Participants and UTP Exchanges,48 which should minimize the potential for dual liability.
Nasdaq proposes to allow Nasdaq Quoting Market Participants and UTP Exchanges to transmit multiple quotes/orders and quotes/orders at multiple price levels (subject to restrictions on a UTP Exchange's ability to send multiple quotes/orders for principal quotes/orders), which the system will manage and display in the SuperMontage consistent with a quote/order's parameters. Nasdaq will time stamp each quote/order upon receipt, and the time stamp will be used in determining the ranking of the quote/order for execution purposes. If a size increment is received from a Nasdaq Quoting Market Participant for an existing quote/order at a given price, the system will maintain the original time stamp for the original quantity and assign a separate time stamp for the augmentation, thus protecting the time priority of the originally-entered quantity. Subsequent decreases in size will be deducted from individually stamped components in reverse time priority. Once a displayed size is diminished to zero, however, the quote/order will no longer retain priority, although it may have a feature that automatically refreshes size.49
In addition, a Nasdaq Quoting Market Participant will designate a quote/order as either attributable or non-attributable, and could designate a reserve size.50 As noted above, for attributable quotes/orders, the prices and sizes of a Nasdaq Quoting Market Participant's or UTP Exchange's best-priced attributable quotes/orders on both the bid and offer side will be aggregated and displayed in the Nasdaq Quotation Montage under the participant's MMID, and also will be included in aggregate trading interest displayed in the NODF if the quotes/orders fall within the three best price levels (on either side of the market) in Nasdaq. For non-attributable quotes/orders, Nasdaq will display the aggregate size of such quotes/orders in the NODF when the quotes/orders fall within the three best price levels (on either side of the market) in Nasdaq. In addition, the best-priced non-attributable quotes/orders from all Nasdaq Quoting Market Participants and UTP Exchanges will be aggregated and displayed next to the SIZE MMID in the Nasdaq Quotation Montage.
The proposal will not require Nasdaq Quoting Market Participants and UTP Exchanges to post multiple quotes/orders at multiple price levels. A market maker could continue to send only its best bid/best offer to Nasdaq, and an ECN could continue to send Nasdaq only its top of the book. In addition, UTP Exchanges may elect to provide only their best quotes for display in the Nasdaq Quoting Montage.51
Even under NNMS (i.e., the SOES and SelectNet integration), the SOES and SelectNet systems continue to operate on separate platforms, and from the end-user's perspective there are still two separate systems.52 In order to further integrate the systems and minimize the potential for market maker dual liability, Nasdaq proposes to route all Liability and non-Liability Orders in the Nasdaq system through the OCF portion of the SuperMontage.
To access quotes/orders through the OCF, order entry firms, market makers, ECNs, and UTP Exchanges may enter either a directed or non-directed (including preferenced) order into the OCF.53 The order can be up to 999,999 shares (there will be a separate odd-lot process), and must indicate whether it is a buy, sell, sell short, or sell short exempt order.54 The order must be a priced or market order. Non-directed orders entered by order-entry firms will be designated as immediate or cancel orders. Orders entered by Nasdaq Quoting Market Participants or UTP Exchanges may be designated as immediate or cancel.55
Nasdaq will affix the MMID of the sender to all delivered orders. Further, preferenced orders and non-directed orders that are executed against a market maker or other market participant that participates in the automatic execution functionality of the system will result in an execution report being sent to each party to the trade immediately upon execution that identifies all counterparties to the trade. This is true whether a non-directed order is executed against an attributable quote/order or a non-attributable quote/order.56
The NASD represents that the SuperMontage improves the current SelectNet order cancellation process for ECNs and other participants that take order delivery. Today, a firm entering an order into SelectNet can cancel the order after 10 seconds regardless of the order's status -- i.e., regardless of whether the market participant that received the order is attempting to execute the order. In SuperMontage, an order that is in delivery to an ECN or UTP Exchange cannot be canceled. Thus, if a market participant requests to cancel an order that has been delivered to an ECN or UTP Exchange, the system will hold the cancel request until the ECN or UTP Exchange has completed interacting with the delivered order (i.e., once the ECN or UTP Exchange executes, partially executes, or declines the order) or fails to respond within the allowable time. For example, if an order is delivered to an ECN and the entering market participant requests to cancel, the system will hold the cancel request. If the ECN declines or partially executes the order, the cancel request will be honored, thus canceling the original order (or the unexecuted balance of the original order for partially-executed orders).57
Under the proposal, a market participant will be able to immediately access the best prices in Nasdaq by entering a non-directed order into the OCF. A non-directed order is an order that the market participant does not route to a particular Nasdaq Quoting Market Participant or UTP Exchange, or a preferenced order (as further described below). A non-directed order must be a market order or a marketable limit order.58 Upon receipt of a non-directed order that is not a preferenced order, the OCF will ascertain the next Nasdaq Quoting Market Participant or UTP Exchange in the queue due to receive an order pursuant to one of three Order Execution Algorithms and deliver either an execution or a Liability Order, depending on how the Nasdaq Quoting Market Participant or UTP Exchange participates in Nasdaq.59 However, as described below in the Order Execution Algorithms section of this Order, a Nasdaq Quoting Market Participant's non-directed orders first will be matched against its own quotes/orders if the participant is at the Nasdaq BBO.
A new type of non-directed order called a "preferenced order" also can be entered into the non-directed order process, and will be considered a Liability Order. The market participant entering the preferenced order must designate the particular Nasdaq Quoting Market Participant or UTP Exchange against which the order is to be executed or delivered. When a preferenced order is next to be executed within the non-directed order queue it will be delivered to the designated party as an order or as an execution depending on how the party participates in Nasdaq. The SuperMontage will execute against (or deliver an order in an amount up to) both the displayed and reserve size of the preferenced Nasdaq Quoting Market Participant or UTP Exchange, but only if it is at the BBO. Any unexecuted portion will be returned to the entering market participant.60
For Nasdaq Quoting Market Participants and UTP Exchanges accepting automatic executions, the SuperMontage will deliver an execution up to the size displayed by the participant, then to other displayed orders at that price, and then to the participant's reserve size (if any).61 The SuperMontage will automatically decrement the aggregate quote in the NODF by the size of the delivered execution, and decrement the Nasdaq Quoting Market Participant's or UTP Exchange's quote/order in the Nasdaq Quotation Montage if the quote/order is attributable. Displayed (attributable or non-attributable) size will be replenished from reserve size for Nasdaq Quoting Market Participants accepting automatic executions if the participant's displayed size has been decremented to zero and the participant has reserve size. If an ECN accepts automatic executions and its attributable quotes/orders and reserve sizes are exhausted without the ECN updating or transmitting another attributable quote/order to Nasdaq, Nasdaq will zero out the side of the quote that is exhausted. If both sides of the ECN's quote are reduced to zero without the ECN updating or transmitting another attributable quote/order, the ECN will be placed into an excused withdrawal state until the ECN transmits a revised attributable quote/order to Nasdaq. However, Nasdaq will continue to access any non-attributable quotes/orders in NNMS while the ECN is in an excused withdrawal state.
For Nasdaq Quoting Market Participants and UTP Exchanges not participating in automatic executions (i.e., order delivery ECNs and UTP Exchanges), Nasdaq will deliver a Liability Order. Nasdaq will automatically decrement the participant's quote by the size of the delivered order and the remaining quote, if not decremented to zero, will retain its priority in the queue.62
If an order delivery ECN or UTP Exchange declines or partially fills an order, or fails to respond in any manner within thirty seconds of order delivery, Nasdaq will immediately re-route the order (or unexecuted portion thereof) to the next Nasdaq Quoting Market Participant or UTP Exchange in the queue.63 In addition, in the case of an order delivery ECN that has declined or partially filled an order without immediately transmitting a revised quote/order or that has failed to respond within 30 seconds, Nasdaq will zero out the ECN's quotes/orders at that price level on that side of the market. In the case of an order delivery UTP Exchange that has declined or partially filled an order without immediately transmitting a revised quote/order or that has failed to respond within 30 seconds, Nasdaq will move the side of the UTP Exchange's quote/order, to which the declined or partially filled order was delivered, to the lowest bid or highest offer in Nasdaq for 100 shares.64
Nasdaq also will apply a shorter uniform turn-around standard of a maximum of 5 seconds to order delivery ECNs. The purpose is to establish a general standard (as opposed to an order-by-order standard) that measures whether an ECN is providing an automated response in a time period that ensures market quality. Thus, Nasdaq proposes to monitor an ECN's order turnaround time based on information received from the ECN's Nasdaq Service Display Platform ("SDP"). Nasdaq will use SDPs linked to each ECN to assign a time-stamp for when an order is delivered to the ECN. Nasdaq also will capture the time-stamp via the SDP of when the ECN sends a response to the delivered order. Nasdaq will then calculate and monitor, on a real-time basis, the difference between the two time stamps and determine whether the ECN is meeting the 5 second maximum order-response standard. On an ongoing basis, Nasdaq will monitor ECN response times and provide each ECN with its own order responsiveness time statistics, which will not be made public. If an ECN regularly fails to meet the 5 second response time over a number of orders, Nasdaq will place that ECN's quote in a closed quote state. The closed quote state will be lifted when the ECN can certify that it can meet the 5 second response time requirement.65
As noted previously, market makers are required to maintain a two-sided, attributable principal quote in Nasdaq at all times. To assist with this requirement, market makers will be able to use the Quote Refresh ("QR") function.66 QR allows a market maker to designate a refresh size (with a default refresh size of 1,000 shares) and price (e.g., a tick amount away from the price of its decremented quote) to which it wishes to refresh if its quoted size is decremented to zero. If a market maker is using QR but has an attributable quote/order in the system that is priced at or better than the quote that will be created by the QR, Nasdaq will display the better-priced or equally-priced attributable quote/order that is already in the system, not the QR-produced quote. If a market maker is not using QR and the market maker has given Nasdaq multiple attributable quotes/orders, Nasdaq will display the market maker's next best-priced attributable quote/order when its best-priced attributable quote/order is decremented to zero.
If a market maker's quote/order is decremented to zero and the market maker does not update its principal quote via QR, transmit a revised attributable quote/order to Nasdaq, or have another attributable quote/order in the system, Nasdaq will place the market maker's quote (both sides) in a closed state for three minutes. At the end of that time, if the market maker did not voluntarily update or withdraw its quote from the market, Nasdaq will refresh the market maker's quote/order to its normal unit of trading (generally 100 shares) at the lowest bid and highest offer currently being displayed in that security and reopen the market maker's quote.67
The Order Execution Algorithm was substantially modified by Amendment Nos. 4, 6, 7, and 8 to the proposal. See supra notes 6, 9, 10, and 12.
The OCF will execute non-directed orders, other than preferenced orders, against Nasdaq Quoting Market Participant's and UTP Exchange's quotes/orders based on price/time priority unless the market participant chooses to override this default algorithm and select one of the alternative algorithms made available by the OCF. These alternative algorithms are: (1) price/size/time priority; and (2) price/time priority that accounts for ECN quote access fees.
In the price/time algorithm, non-directed orders other than preferenced orders will be executed (within each price level) as follows: displayed quotes/orders of market makers, ECNs, and non-attributable agency interest of UTP Exchanges, in time priority; (2) reserve size of market makers and ECNs, in time priority; and (3) principal quotes of UTP Exchanges, in time priority.69
In the alternative order execution algorithm based on price/size/time priority, non-directed orders other than preferenced orders will be processed (within each price level) as follows: (1) displayed quotes/orders of market makers, ECNs, and non-attributable agency interest of UTP Exchanges, in size/time priority; (2) reserve size of market makers and ECNs, in size/time priority, with size priority based on the size of the related displayed quote/order; and (3) principal quotes of UTP Exchanges, in size/time priority.
As a third choice, market participants will be able to indicate that their order should be executed in a manner that accounts for an ECN's separate quote access fee.70 Under this option, non-directed orders other than preferenced orders will be executed (within each price level) as follows: (1) displayed quotes/orders of market makers, ECNs that do not charge a separate quote access fee, and non-attributable agency interest of UTP Exchanges, as well as quotes/orders of ECNs that charge a separate quote access fee where the ECN indicates that the price improvement offered by the quote/order is equal to or exceeds the quote access fee, in time priority; (2) displayed quotes/orders of ECNs that charge a separate quote access fee to non-subscribers that do not indicate that the price improvement offered by the specific quote/order is equal to or exceeds the access fee, in time priority;71 (3) reserve size of market makers and ECNs that do not charge a separate quote access fee to non-subscribers, as well as reserve size of quotes/orders from ECNs that charge a separate quote access fee to non-subscribers where the ECN entering such quote/order has indicated that the price improvement offered by the specific quote/order is equal to or exceeds the quote access fee, in time priority; (4) reserve size of ECNs that charge a separate quote access fee to non-subscribers that do not indicate that the price improvement offered by the specific quote/order is equal to or exceeds the quote access fee, in time priority; and (5) the principal interest of UTP Exchanges, in time priority.
Each of these algorithms will make an exception for non-directed, non-preferenced orders entered by a Nasdaq Quoting Market Participant when that Nasdaq Quoting Market Participant's quote/order is at the inside market. In that case, the SuperMontage will first attempt to match orders entered by the Nasdaq Quoting Market Participant against its own quote/order if the Nasdaq Quoting Market Participant is at the BBO. Finally, market participants may preference an order to a Nasdaq Quoting Market Participant or UTP Exchange at the BBO, as described above.
In all three algorithms, there will be a five-second interval delay in certain instances before an order moves to the next price level. As a general rule, where an order might be partially filled at one price level but the remaining shares of the order will not be filled in full within the next two minimum trading increments (i.e., price ticks) away, there will be a five-second interval delay or pause before the order moves to the next price level. At any point after a delay, if the remainder of the order can be entirely filled within the next two price ticks away, there will be no further delays and the order will be filled completely. Thus, a large market order moving through many price levels could pause for five seconds before every price move except for the last two.72
To reduce these interval delays, a market participant will be able to designate an individual order as a "Sweep Order." A Sweep Order will trade through all interest (i.e., displayed and reserve interest) at the three price levels being displayed in the NODF at the time of entry, without pausing five seconds between each displayed price. If the order is not executed in full at the third price level, the order will pause for five seconds between each subsequent price level.73
A directed order is one that is routed by the market participant entering the order to a specific Nasdaq Quoting Market Participant or UTP Exchange. Unless the participant to which a directed order is being sent has agreed to accept directed orders that are Liability Orders, a directed order must be a non-Liability Order, and as such, must be designated as: (1) All-or-None ("AON") with a size at least one unit of trading greater than the size of the attributable quote/order of the market participant to which the order is directed; or (2) a Minimum Acceptable Quantity order ("MAQ") with a MAQ value of at least one unit of trading greater than the size of the attributable quote/order of the participant to which the order is directed. If a Nasdaq Quoting Market Participant or UTP Exchange is at the inside or is displaying (attributable or non-attributable) interest in the NODF and receives a directed non-Liability Order that it wants to fill, to avoid double execution, it may request to cancel its displayed quote/order in Nasdaq before it fills the non-Liability Order. Nasdaq will not decrement a quote/order upon the delivery of a directed non-Liability Order.
Nasdaq Quoting Market Participants and UTP Exchanges also can elect to receive directed orders that are Liability Orders (i.e., orders that when delivered to market participants' quotes/orders impose an obligation to respond in a manner consistent with the Commission's Firm Quote Rule).74 If a market participant chooses to accept directed Liability Orders, Nasdaq will append an indicator to the Nasdaq Quoting Market Participant's or UTP Exchange's MMID, showing that the market participant is available to receive directed Liability Orders.
A locked market occurs when a market participant's bid equals the lowest offer of another market participant. A crossed market occurs when a market participant's bid exceeds the lowest offer of another market participant. Under the NASD's proposal, if a Nasdaq Quoting Market Participant or UTP Exchange enters a quote/order that will lock or cross the market, the SuperMontage will not display the quote/order, but instead will reformat the quote/order as a marketable limit order and enter it into the SuperMontage as a non-directed order for execution.75 The reformatted order will be routed to the displayed quote/order (attributable or non-attributable) next in the queue that will be locked or crossed, and the order will be executed at the price of the displayed quote/order. Once the lock or cross is cleared, if the Nasdaq Quoting Market Participant's or UTP Exchange's quote/order that would have locked or crossed the market has not been completely filled, the SuperMontage will reformat the order again and display it (consistent with the parameters of the quote/order) as a quote/order on behalf of the entering Nasdaq Quoting Market Participant or UTP Exchange. It should be noted, however, that a market participant will receive a system warning (as it does today) if it attempts to send a quote/order that will lock or cross the market. To complete the order entry, the participant will be required to override the system warning. This override will help market participants avoid automatic executions resulting from inadvertent locking or crossing quotes/orders by not overriding the system warning.76
If the market is locked or crossed at 9:30 a.m., Nasdaq will clear out the locked or crossed quotes by executing the oldest bid (offer) against the oldest offer (bid) which it is marketable against, at the price of the oldest quote/order. Nasdaq then will begin processing non-directed orders that are in the queue.77
Under the proposal, UTP Exchanges will be able to enter orders into the SuperMontage. Orders from UTP Exchanges that offer automatic execution reciprocity to Nasdaq will receive automatic execution against Nasdaq Quoting Market Participants that take automatic executions.78 Participating UTP Exchanges that do not offer automatic execution reciprocity to Nasdaq will have their orders delivered to the next Nasdaq Quoting Market Participant in the queue according to their choice of the Order Execution Algorithms.79 Otherwise, UTP Exchanges will be able to use the directed80 and non-directed order processes of SuperMontage in the same way as Nasdaq Quoting Market Participants. Also, UTP Exchanges will be able to enter multiple non-attributable quotes/orders representing agency interest. UTP Exchanges, however, will only be able to submit a single, two-sided attributable quote, and will not be able to use reserve size or QR.
As discussed above, pursuant to the Order Execution Algorithms, non-attributable agency interest of UTP Exchanges generally will be executed on parity with displayed quotes/orders (attributable and non-attributable) of market makers and ECNs.81 The principal interest of UTP Exchanges will be last in priority under the Order Execution Algorithms, and will be executed after the system does a complete sweep of the agency interest of UTP Exchanges and the displayed and reserve size of all Nasdaq Quoting Market Participants.
As discussed above, ECNs that are NASD members will have the choice of participating in order delivery or automatic execution. Regardless of the method of participation, these ECNs will have full access to the SuperMontage for order entry and order delivery. Specifically, ECNs that are NASD members will be able to designate quotes/orders as attributable or non-attributable, and will be able to transmit multiple quotes/orders at the same price or at multiple prices. All ECNs will be able to use the SuperMontage's reserve size feature for quotes/orders. ECN participation in Nasdaq will continue to be governed by rule and private contract.
The system's odd-lot processing function was substantially modified by Amendment No. 4 to the proposal. See Amendment No. 4, supra note 6.
The SuperMontage will accept and execute orders for less than one normal unit of trading (i.e., odd-lot orders). The SuperMontage will provide a separate mechanism for processing and executing odd-lot orders including: (1) an "odd-lot exposure limit" for market makers; (2) an interval delay between odd-lot executions against the same market maker; and (3) an odd-lot order entry limitation of one order per second, per firm.
Odd-lot orders will be processed in a round-robin fashion against market makers with an available exposure limit and will be executed at the BBO, even if the market makers are not at the inside. A market maker can set its exposure limit, on a security-by-security basis, from 0 to 999,999 shares. The SuperMontage will not execute an odd-lot order against a market maker unless the market maker has a sufficient exposure limit to fill the odd-lot order. When a market maker's odd-lot exposure limit is reduced to zero, it will be taken out of the odd-lot rotation unless and until the market maker sets a new exposure limit. If no market maker has an odd-lot exposure limit, the SuperMontage will suspend the processing of odd-lots until an exposure limit is refreshed. Odd-lot executions will decrement the exposure limit (but not the quote/order sizes displayed in the Nasdaq Quotation Montage or NODF) by the size of the odd-lot order. To ensure continuity of price, if a mixed-lot is entered into the system, the odd-lot portion will be executed against the next market maker in the rotation at the round-lot portion price once the round-lot portion has been executed.
The odd-lot processing mechanism also will provide a maximum five-second interval delay between executions against the same market maker in the same security. A market maker will be able to adjust its interval-delay time down (i.e., down to 0 - 4 seconds), so that it may receive odd-lot executions more frequently than five seconds apart. Thus, after an odd-lot has been executed against a market maker with an available exposure limit, there will be at most a five-second interval delay before the market maker will be subject to another odd-lot execution. During the five-second (or less) interval delay, the market maker could adjust its odd-lot exposure limit up or down. Finally, the system will be programmed to accept odd-lot orders at a rate no faster than one order per second from any single participant.
Nasdaq proposes to use the SuperMontage for all Nasdaq securities, including SmallCap securities. Nasdaq proposes to delete the current SOES rules excluding SmallCap securities from the NNMS.
Nasdaq described its proposed system roll out in Amendment No. 5 to the proposal. See Amendment No. 5, supra note 8.
Nasdaq intends to implement the SuperMontage as soon as practicable after decimal pricing is fully implemented in Nasdaq.84 Nasdaq plans to give market participants and vendors at least 90 days notification of changes in system specifications. At the time of such notification, market participants will be given new specifications in order to begin analyzing the system changes. Nasdaq has represented that its staff will work throughout this period with market participants to address any system and specification-related questions and issues.
At least 60 days prior to system implementation, Nasdaq plans to give participants notice of specific testing dates and of the availability of a testing environment. In addition, at least 30 days prior to system implementation, Nasdaq plans to make available a testing environment in which firms may begin testing their software and hardware (if applicable). Finally, Nasdaq plans to hold at least two full-day, mock trading sessions on a weekend. This will allow market participants to train their personnel on the new system and to participate in a real-time trading environment.
Nasdaq plans to phase-in Nasdaq securities similar to the way the SEC's Order Handling Rules were introduced. Specifically, Nasdaq intends to initially implement the system for a limited number of securities (e.g., 100) representing a cross-section of Nasdaq-listed stocks. On a regular basis thereafter, Nasdaq will add 100 new stocks until the system is implemented for all Nasdaq-listed securities. Nasdaq will select a cross section of stocks to be included in each group of 100 securities to be rolled out during a particular week.
The purpose of the system roll out is to give Nasdaq and its members the opportunity to observe and gain experience with the new system, and to give Nasdaq the opportunity to make any adjustments to the system (subject to approval by the Commission), if necessary. Nasdaq intends to work closely with the Commission during the roll-out phase to ensure a smooth transition to the new system.
The Commission received 21 comment letters in response to the December 6, 1999 notice.85 Ten commenters supported86 and five commenters opposed87 the proposal to establish the SuperMontage. Six commenters did not clearly state a position on the proposal.88 Of the commenters who supported the proposal, all expressed reservations regarding certain aspects of the proposal.89
In response to the comment letters, the NASD and Nasdaq made several amendments to the proposal. These proposed changes were published for comment in the Federal Register on March 30, 2000 as Amendment No. 4.90 The Commission received 31 comment letters from a total of 27 commenters in response to Amendment No. 4.91 Of these 27 commenters, 20 generally supported the proposal,92 while five opposed the proposal, including the proposed changes.93 Two commenters expressed neither support nor opposition to the proposal.94 Of those commenters who expressed support for the proposal, three expressed reservations about certain aspects of the proposal.95
In response to these comments, the NASD and Nasdaq made additional revisions to the proposal. The proposed changes were published in the Federal Register as Amendment Nos. 5, 6, and 7 on August 15, 2000.96 The Commission received 28 comment letters in response to these Amendments.97 Twelve expressed support for the proposal,98 while 13 continued to oppose it.99 Three commenters supported the general concept of the SuperMontage, but expressed concerns about specific provisions contained in the proposal, or did not clearly state a position on the proposal.100
In response to these comments, the NASD and Nasdaq made several additional changes to the proposed rule change. The proposed changes were published in the Federal Register as Amendment No. 8 on November 15, 2000.101 The Commission received 24 comment letters in response to Amendment No. 8. One commenter expressed support for the proposal,102 while 6 continued to oppose it.103 Eight commenters supported the general concept of the SuperMontage, but expressed concerns about specific provisions contained in the proposal.104 Nine commenters, while objecting to certain aspects of the proposal, did not clearly state a position on the proposal as a whole.105
After carefully considering the comments, the Commission finds, for the reasons discussed below, that the SuperMontage proposal is consistent with the requirements of the Act and the rules and regulations thereunder applicable to the NASD. In particular, the Commission finds that the proposal is consistent with the requirements of Sections 15A(b)(6), (9), and (11), and 11A(a)(1)(C) of the Act.106 Section 15A(b)(6)107 requires that the rules of a registered national securities association be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles 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. Section 15A(b)(9) requires that the rules of an association not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.108 Section 15A(b)(11)109 requires that the rules of an association be designed to produce fair and informative quotations, prevent fictitious or misleading quotations, and to promote orderly procedures for collecting, distributing, and publishing quotations. And finally, in Section 11A(a)(1)(C),110 Congress found 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) the 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) 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.
As discussed more fully below, the Commission finds that the proposed changes are in the public interest and are designed to assure the economically efficient execution of securities transactions by increasing the availability of pre-trade information in Nasdaq securities, as well as the opportunity for the orders of market makers, public customers, and order entry firms to interact. Several commenters believed that the proposal will improve the Nasdaq market by either providing more information to investors, promoting greater efficiency in executions, or increasing overall market transparency.111 The ICI, for example, stated that "creating a system that provides investors with greater access to priced orders and allows them to execute against those orders will greatly enhance the quality of the Nasdaq market."112 MSDW stated that the "ability to enter multiple proprietary/agency quotes/orders at multiple price levels will greatly assist market makers in managing their limit orders."113 TRPA stated that "the SuperMontage concept furthers the goals of unifying the markets and providing a means for orders to interact with one another, while allowing for continuing innovation."114 The Commission agrees with these commenters that there is good reason to conclude that the SuperMontage, by providing for the enhanced display of trading interest in Nasdaq securities and by expanding the availability of automatic execution, will facilitate the price discovery process and promote quote competition among Nasdaq Quoting Market Participants and UTP Exchanges, thus helping to ensure the best execution of customer orders.
In addition, by introducing features to: (1) assist market makers with the management of their quotes/orders; (2) reduce instances of double liability for market makers; and (3) encourage the entry of larger sized quotations and orders by market makers and ECNs, the proposal likely will add liquidity to the market and help assure the economically efficient execution of transactions in Nasdaq securities. The proposed changes thus should enhance the efficiency and increase the depth and liquidity of the market for Nasdaq securities, to the benefit of all investors.
The NODF will increase the availability of information about quotations by displaying the three best price levels in Nasdaq on both the bid and offer side of the market to supplement the Nasdaq Quotation Montage. Each price level will be updated and will display aggregate trading interest at that price level.
Several commenters stated this aspect of the proposal will result in more information to investors, promote greater efficiency in executions, promote liquidity, increase market transparency, and reduce market fragmentation.115 For example, several commenters believed that the proposal will provide a better overall picture of the market's depth by enabling market participants to display (and accept) multiple levels of priced orders.116 In addition, one commenter believed that the enhanced display of trading interest will promote investor protection by decreasing trade-throughs (i.e., trades at prices worse than those available for a security) and giving market participants more options for meeting best execution, firm quote, and limit order display obligations.117 Another commenter stated that the proposal will help improve the current state of fragmented trading in Nasdaq securities, and offer an improved execution system over SOES and SelectNet.118 A third commenter believed that the NODF "will offer an enhanced means for market participants to gauge trading interest at the Nasdaq inside market and prices near the inside market."119
Two commenters, however, questioned the need for the NODF.120 One of these commenters believed that fragmentation was no longer a problem in the Nasdaq market.121 Further, this commenter argued that if the NASD was concerned about the fragmentation and transparency of pre-trade information, the NASD should allow market participants to display all of their bids and offers under their MMID.122 Another commenter argued that the NODF would create a false perception of liquidity in Nasdaq because orders below a market participant's top of book will not be attributed to the firm representing the order.123 This commenter believed, as a result, that liquidity will appear to reside in Nasdaq, rather than with the broker/dealer that represents the liquidity in Nasdaq.124
One commenter also believed that the NODF was unnecessary because ECNs and market makers have created their own limit order books, and that the proposed NODF will not provide any additional capability to the market.125 Another commenter believed that the SuperMontage proposal did not provide complete transparency because of its anonymous display and reserve size features.126 This commenter urged the Commission to review this issue to ensure that large players do not receive an unfair trading advantage that is not available to small investors.127 Two commenters also suggested that the NODF should display the five best price levels in Nasdaq on both the bid and offer side of the market to allow investors to better gauge the market128 and to constrain volatility.129 Another commenter believed that Nasdaq should display information for individual market makers and ECNs up to three price levels.130
The Commission finds that the NODF, as part of the SuperMontage, is consistent with Sections 15A(b)(6) and 15A(b)(11) of the Act131 in that, among other things, it is designed to facilitate transactions in securities and to produce fair and informative quotations. Further, the Commission finds that the order aggregation characteristics of the proposed rule change are consistent with Sections 11A(a)(1)(B) and 11A(a)(1)(C) of the Act.132 In particular, in Section 11A(a)(1)(B), Congress found that new data processing and communications techniques create the opportunity for more efficient and effective market operations.133
The Commission believes that the NODF has the potential to facilitate securities transactions by enhancing the display of trading interest. Currently, when Nasdaq receives a quote, it cannot discern whether that quote represents a single order or multiple orders at one price. Nasdaq Quoting Market Participants and UTP Exchanges can send Nasdaq only a single, two-sided quote. In contrast, under the proposal, Nasdaq Quoting Market Participants and UTP Exchanges generally will have the ability to transmit multiple orders at multiple price levels for display at their discretion.134 In addition, the NODF has two other features designed to enhance the display of trading interest -- the size of displayed interest will be aggregated at the best three price levels on both sides of the market and the Summary Scan function will show the total displayed size (attributable and non-attributable) for all levels below the first three price levels. With the implementation of decimals, market participants will need to view and access greater depth. At a penny quotation increment, for example, a best offer of $20 for 100 shares may be less meaningful than a second best offer at $20.01 for 1,000 shares. As discussed in more detail below, because the NODF is designed to enhance the display of trading interest among participants, it should facilitate trading in a decimals environment.135 While the Commission agrees with certain commenters that display of depth beyond three levels may be necessary once the markets move to decimals, the Commission understands that Nasdaq will consider expanding the number of levels as it further develops the system.
With respect to concerns that Nasdaq should display even greater information, the Commission believes that Nasdaq's proposed NQDS Prime, which will provide on a real-time basis, all individual attributable quote and order information at the three best price levels displayed in the NODF,136 will help to address these concerns. NQDS Prime will enhance the display of trading interest and provide market participants greater information in making order-routing decisions. The Commission believes that this will provide investors with more options since market participants will be able to use this information to access liquidity through Nasdaq or non-Nasdaq systems (such as proprietary links).
Under the proposed rule change, a SIZE MMID, representing the aggregate size of the best-priced non-attributable bids or offers, will be displayed in the Nasdaq Quotation Montage along with the other MMIDs for the Nasdaq Quoting Market Participants and UTP Exchanges displaying attributable size.
The Commission received several comment letters addressing this display feature in response to the December 6, 1999 notice.137 One commenter believed that there is a risk that non-attributable proprietary orders will be susceptible to manipulation because a market maker could post a small bid under its own MMID and post a larger sell order anonymously.138 Another commenter argued that because Nasdaq Quoting Market Participants and UTP Exchanges can display quotes/orders anonymously under the proposed rule change, a "moral hazard" might be created.139 The commenter expressed concern that participants with weaker credit might "hide behind unattributable quotations in times of market stress."140 Further, this commenter noted that because the solvency of a participant's counterparty may be unknown, investor confidence could be threatened.141 This commenter also opined that the anonymous display feature will deny viewers the opportunity to access secondary or tertiary quotations directly.142 In addition, one commenter believed that order entry firms could use the feature to access ECNs without paying an access fee.143
Another commenter pointed out that the NASD has not revealed how it proposes to provide participants with transaction reports.144 This commenter stated that the counterparty to a transaction should be disclosed at the time an order is executed, not at the end of the trade day.145 This commenter explained that disclosure of a counterparty's identity at the time of execution is critical in order for a market participant to monitor its intraday credit risk exposure.146
In response to some of the issues raised by commenters, the NASD has committed to assist market participants in their efforts to manage operational and credit risk.147 Nasdaq will affix the MMID of the sender to all directed orders, delivered non-directed orders, and delivered preferenced orders. Further, preferenced orders and non-directed orders that are executed against a market maker or other market participant that participates in the automatic execution functionality of the system will result in an execution report immediately upon execution that identifies all of the parties to the trade. This is true if a non-directed order is executed against an attributable order or a non-attributable order.148
Two commenters believed that these features will allow ECNs to deny access to their quotes through SuperMontage to non-subscribing firms that do not pay their fees.149 One of these commenters believed that "[s]anctioning the denial of quote access through SuperMontage also conflicts with [b]est [e]xecution, as a firm who has been denied access may be unable to hit the inside bid or offer."150
As an initial matter, the Commission notes that market makers currently can enter multiple quotes/orders by submitting a quote/order to Nasdaq and orders to multiple ECNs. Under the Commission's Order Handling Rules,151 a market maker can place a better-priced order with an ECN anonymously without updating its quote to reflect the better-priced order, as long as the ECN displays the order in the public market. Other market participants also may submit orders to ECNs and have their orders traded on an anonymous basis. As a result, market participants trading with ECN quotes currently are subject to a certain level of uncertainty regarding their ultimate counterparty. The SuperMontage proposal merely provides market makers with the ability to display multiple quotes in Nasdaq on an attributable and non-attributable basis, which is consistent with the ability of market makers and other market participants to display orders on ECNs today.
The Commission believes that the use of non-attributable quotes (i.e., SIZE MMID) in the SuperMontage has the potential to promote the display of greater market interest and encourage greater transparency in the Nasdaq market. The ability to display non-attributed market interest may encourage certain market participants to submit larger quotes/orders, particularly institutions wishing to minimize the market impact of their orders. Furthermore, the Commission believes that the NASD has minimized the concerns raised by commenters regarding the identity of those with whom they are trading by affixing the MMID of the sender on delivered orders and identifying the counterparties in execution reports. Moreover, because only Nasdaq market makers, ECNs, and UTP Exchanges can enter non-attributable orders into the system, the range of participants that are responsible for non-attributable orders on their own behalf or for an anonymous customer is limited. All Nasdaq Quoting Market Participants have established clearing arrangements and credit standings monitored by the NASD and the National Securities Clearing Corporation ("NSCC"). UTP Exchanges have similar provisions to ensure financial responsibility. Moreover, the Commission fully expects that the NASD will monitor the use of these quotes/orders with a view towards preventing manipulation. Finally, as discussed further below, the Commission notes that market participants that wish to interact with a specific market participant still will be able to direct or preference orders to Nasdaq Quoting Market Participants and UTP Exchanges, including ECNs.
The proposed reserve size function will allow Nasdaq Quoting Market Participants to publicly display part of the full size of their order or interest, with the remainder held in reserve on a non-attributable basis.152 The reserve size function requires Nasdaq Quoting Market Participants to initially display a minimum of 1,000 shares, and to refresh the displayed size by a minimum of 1,000 shares each time the displayed size is decremented to zero. As originally described in the December 6, 1999 notice, reserve size would have been accessed based on time priority and status as a market maker, automatic execution ECN, or order delivery ECN.
Several commenters expressed support for the reserve size feature.153 One commenter felt that the reserve size feature would benefit investors,154 while another believed it would minimize the adverse market price impact associated with a larger-sized order.155 Another commenter, however, suggested that the reserve size feature should be altered to provide market participants with incentives to display large size attributable quotations.156
In response to the commenter, in Amendment No. 4, the NASD added the "size/time priority" characteristic to the reserve size function to provide order execution priority for orders with the larger displayed size (after being refreshed out of reserve) over smaller displayed sizes (refreshed out of reserve size), with time priority being given to identically sized quotes.157 In addition, the NASD revised its original Order Execution Algorithm so that it no longer distinguished between the reserve size of order delivery and automatic execution ECNs.158 Instead, the reserve size of market makers and ECNs that did not charge a separate access fee received priority over ECNs that charged a separate access fee.
In response to the NASD's change in Amendment No. 4, one commenter questioned the Order Execution Algorithm's size/time prioritization of reserve size.159 The commenter expressed concern that the proposed algorithm would discourage market participants from displaying orders greater than 1,000 shares.160 Another commenter believed that size/time priority was inconsistent with the basic premise of time priority and that the first quote accessed should maintain priority regardless of size.161
In Amendment No. 7, the NASD again revised the reserve feature to give equal priority to quotes/orders of ECNs that charge separate access fees if they indicate that the price improvement exceeds the fee for that particular quote/order.162 In further response to the various concerns of commenters concerning the Order Execution Algorithm, Nasdaq amended the Order Execution Algorithm for non-directed orders to allow market participants to take into account their objectives in executing their orders against the displayed and reserve size of Nasdaq Quoting Market Participants and UTP Exchanges.163 Nasdaq now permits market participants to select one of three Order Execution Algorithms: price/time priority; price/size/time priority; and price/time priority that accounts for ECN fees.
As an initial matter, the Commission notes that all Nasdaq Quoting Market Participants can use reserve size.164 As a result, the Commission believes that the reserve size feature should give market participants greater flexibility in handling large orders. In particular, the reserve size could prove useful to institutions that wish to minimize the market impact of their orders. Increased participation should, in turn, enhance the depth and liquidity of the market for Nasdaq securities, to the benefit of all market participants. In this regard, the Commission notes that ECNs have used reserve size features for years with considerable success.
Two requirements should ensure that market participants continue to have an incentive to display their quotes/orders. First, market participants must display a minimum of 1,000 shares to use the reserve size feature. Second, all displayed quotations at the same price level in the SuperMontage generally will have priority up to their displayed size over all reserve size at the same price level. Third, market forces and competition may encourage Nasdaq Quoting Market Participants to display greater size if the price/size/time algorithm is widely used. In sum, the Commission concludes that Nasdaq's use of the reserve size feature is reasonable and could result in increased depth and liquidity in Nasdaq. The Commission, however, expects the NASD to monitor trading to ensure the proper use of the reserve size feature and compliance with the requirements applicable to the use of reserve size.
Under the proposal, the OCF will: (1) transmit to Nasdaq multiple quotes/orders and quotes/orders at multiple price levels entered by Nasdaq Quoting Market Participants and UTP Exchanges;165 (2) accept orders to access quotes/orders displayed (as either attributable or non-attributable) in both the NODF and the Nasdaq Quotation Montage; and (3) unify Nasdaq's delivery of Liability Orders to Nasdaq Quoting Market Participants and UTP Exchanges, which should minimize the potential for dual liability. Upon receipt of an order seeking to access displayed quotes/orders, the OCF will determine whether to deliver an order or an execution based on the manner in which the market participant receiving the order participates in the Nasdaq market. For example, market makers will take automatic execution,166 and ECNs and UTP Exchanges will have the option of taking automatic execution or order delivery.167
As discussed further below, the Commission believes that the proposed OCF is consistent with Sections 15A(b)(6)168 and 11A(a)(1)(C)(i) of the Act,169 particularly with Congress' finding that it is in the public interest, and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure the economically efficient execution of securities transactions. The OCF should provide market participants with greater flexibility to reflect their buying and selling interest at various price levels by allowing them to transmit multiple attributable quotes/orders at multiple price levels, as well as non-attributable quotes/orders that conceal the identity of the responsible participant until executed.
Under the proposal, order entry firms, market makers, ECNs, and UTP Exchanges will be able to access quotes/orders by submitting directed or non-directed orders up to 999,999 shares in the OCF.170 Large orders may be submitted as non-directed orders and receive automatic execution, subject to the possible application of a 5-second interval delay between successive price levels if the order is not categorized as a Sweep Order or cannot be filled completely at the inside price plus (or minus) two price ticks.
Five commenters expressed concern about access to the system.171 One of these commenters stated that the SuperMontage, as proposed, was too limited, and should permit all NASD members to enter non-attributable limit orders in the system.172 One commenter specifically expressed concern that order entry firms would be excluded from receiving automatic executions for proprietary orders sent to the system.173
The Commission believes that the NASD has adequately addressed the commenters' concerns that access to the proposed system is too limited. First, the NASD has stated that order entry firms, as well as Nasdaq Quoting Market Participants and UTP Exchanges, may enter either directed or non-directed orders intended for execution into the OCF. Moreover, order entry firms sending proprietary orders to the system to access market maker quotes/orders will receive automatic execution of those orders. Second, the Commission believes that it is reasonable for Nasdaq to limit the ability to display quotes/orders to registered market makers, ECNs, and UTP Exchanges. These participants have certain obligations under the Exchange Act, including those under the Order Handling Rules. Market makers in particular have unique obligations under NASD rules, such as the requirement to maintain continuous two-sided markets. ECNs offer efficient display and execution systems for limit orders. Limiting the ability to enter non-attributable limit orders into the system to market makers and ECNs encourages their participation in the Nasdaq market, which strengthens the Nasdaq market as a whole. Accordingly, the Commission concludes that the OCF is reasonably designed to provide order entry firms, as well as market makers, ECNs, and UTP Exchanges, with prompt access that is not unfairly discriminatory to the current inside market in Nasdaq securities.174 By facilitating the prompt and efficient execution of orders at the best available prices in Nasdaq, the OCF should strengthen the Nasdaq market, which will benefit market participants and investors.
As originally proposed, marketable limit orders entered into the SuperMontage that became unmarketable prior to execution would have been held in the queue for 90 seconds to enable the order to retain time priority should it become marketable again. One commenter opined that this treatment of limit orders would violate the Commission's Order Handling Rules.175
Under Amendment No. 8, non-directed orders entered by order-entry firms must be designated as immediate or cancel orders, while orders entered by Nasdaq Quoting Market Participants and UTP Exchanges may be designated as immediate or cancel. As a result, if an order-entry firm enters a marketable limit order that becomes unmarketable after entry into the system, Nasdaq will return the order (or the unexecuted portion thereof) to the entering party.176 If a Nasdaq Quoting Market Participant or UTP Exchange enters a marketable limit order that becomes unmarketable after entry and is not designated immediate or cancel, the system will reformat the order and display it as a quote/order on behalf of the entering participant.
The Commission believes that the NASD's amendment addresses concerns about the SuperMontage retaining undisplayed orders in the system. Further, the Commission notes that the NASD must comply with the Order Handling Rules and the dissemination of bids and offers.
Under the proposed rule change, market makers can refresh size and price using the QR function if their quotes are decremented to zero. If a market maker uses QR, but has an attributable quote/order in the system that is priced at or better than the quote/order created by QR, Nasdaq will display the better-priced or equally-priced attributable quote/order in the system. If a market maker is not using QR and the market maker has given Nasdaq multiple attributable quotes/orders, Nasdaq will display the market maker's next best-priced attributable quote/order if its displayed quote/order has been decremented to zero. In addition, if a market maker's quote is closed for three minutes, and the market maker has failed to transmit a revised attributable quote/order, the market maker's quote will be automatically reopened at the lowest bid and highest offer currently being displayed for a normal unit of trading.
One commenter applauded the NASD's decision to reduce the time period that market makers have for updating their quotes from five to three minutes.177 This commenter and another commenter, however, believed that the 3-minute grace period during which a quote could be closed was too long.178 In addition, the commenter believed that the NASD's proposal to restore a quote after the three-minute grace period to the outside displayed quote/order was contrary to the NASD's policy on autoquotes reflected in NASD IM 4613.179 Another commenter opined that there could be a large number of market makers that are not in the market as their size is decremented to zero, particularly during times of significant market volatility.180
The Commission believes that the QR function of the OCF, together with the reserve size refresh function, should help market makers maintain continuous, two-sided quotes and thereby facilitate market liquidity. In particular, the SuperMontage's automatic refreshing and reopening of the market maker's quote for a normal unit of trading (generally 100 shares) at the lowest bid and highest offer currently being displayed in that security should assist market makers in the management of their quotes and also ensure a market maker's continued participation in the market. Under the NASD's current rules, if a market maker fails to restore its quote in a security within five minutes after the quote is decremented to zero, then, subject to certain exceptions, that market maker is prohibited from re-entering its quote for 20 days. The current rule thus effectively eliminates the participation of market makers for 20 days (also known as being "SOESed-out-of-the-box"). In contrast, the revised procedures should help to ensure the presence of liquidity providers in the market.
The Commission believes that Nasdaq has struck an appropriate balance by eliminating the SOESed-out-of-the-box penalty while adding features to assist market makers with their quote management, and by reducing the time that a quote may be in a closed state from five minutes to three minutes. The Commission fully expects, however, that the NASD will monitor the use of the system defaults by market makers to ensure that they do not become a surrogate for meaningful market making, and that the NASD will reevaluate the penalties against market makers for failure to properly maintain two-sided quotes if there is a decline in the overall quality of market making, particularly during market volatility.
The originally proposed Order Execution Algorithm, described in the December 6, 1999 notice, distinguished between market makers and ECNs that participated in the automatic execution functionality of the system and ECNs that participated in the order delivery functionality of the system. Market participants that received automatic executions would have been given priority in the Order Execution Algorithm.
Six commenters criticized the NASD's proposed Order Execution Algorithm.181 Three of these commenters specifically opposed the Order Execution Algorithm's prioritization of automatic execution participants (i.e., market makers and ECNs that accept automatic executions) over order delivery participants.182
In response, the NASD amended the Order Execution Algorithm, eliminating the distinction between automatic execution participants and order delivery participants.183 In lieu of this distinction, the NASD proposed to give ECNs that do not charge a separate quote access fee priority over those that do.184 After receiving comments on this proposed change,185 the NASD again revised the Order Execution Algorithm.186
In Amendment No. 7, the NASD proposed that the Order Execution Algorithm would execute non-directed orders, based on time priority, against: (1) the displayed quotes/orders (attributable and non-attributable) of market makers, ECNs that do not charge a separate quote access fee to non-subscribers, ECNs that charge a separate quote access fee to non-subscribers but indicate that the price improvement offered by their quote/order exceeds the separate quote access fee, and non-attributable quotes reflecting agency interest of a UTP Exchange; (2) displayed interest of ECNs that charge a separate quote access fee and do not indicate that the price improvement offered by their quote/order exceeds the separate quote access fee; (3) reserve size of market makers, ECNs that do not charge a separate quote access fee, and ECNs that indicate that the price improvement for their quote/order is in excess of their quote access fee (in size/time priority); (4) reserve size of ECNs that charge a separate quote access fee and do not indicate that the price improvement offered by the specific quote/order exceeds the separate quote access fee (in size/time priority); and (5) principal quotes of UTP Exchanges.187
In response to these changes, certain commenters again expressed objections to the Order Execution Algorithm.188 Four commenters suggested that the Nasdaq system should be premised on strict price/time priority.189 Another commenter suggested that the NASD replace the Order Execution Algorithm with a purely directed system, similar to SelectNet.190 One commenter believed that access fees should not affect the determination of the BBO.191
In response to these commenters, in Amendment No. 8,192 the NASD amended the proposal to give market participants that enter non-directed orders several options as to how their orders will interact with quotes/orders in Nasdaq: price/time; price/size/time; price/time that accounts for ECN access fees; and preferencing at the best price.193 The SuperMontage will be programmed to default to the price/time priority algorithm for non-directed, non-preferenced orders. With all three algorithms for non-directed, non-preferenced orders, the system will make an exception for orders entered by a Nasdaq Quoting Market Participant when that Nasdaq Quoting Market Participant is at the inside market. 194
One commenter supported the NASD's revision of the system's algorithms stating that generally "market participants are better off when they can make informed choices."195 Another commenter also supported the NASD's elimination of the per se treatment of ECN order access fees.196
However, three commenters stated that giving participants a choice of algorithms was an unacceptable compromise because participants still would be offered an algorithm that discriminated against ECN orders.197 Specifically, one commenter believed that it would be market makers, not investors, making this election, and that marker makers would put investors' orders entered on ECNs behind market makers to avoid interacting with ECNs.198 Another commenter believed that the default algorithm, in part, provided "a level of institutional and regulatory legitimacy to ECN access fees, even though the vast majority of market participants consider those fees invalid and have never had the opportunity to debate or challenge them."199 Two commenters also believed that investors' orders should be executed against first.200 In addition, four commenters generally supported executions based on strict price/time priority.201
Seven commenters also objected to the addition of the price/size/time algorithm proposed in Amendment No. 8.202 Two of these commenters stated that granting size priority ahead of time priority would negate the incentive for price improvement.203 In addition, one of the commenters argued that the price/size/time algorithm would offer little, if any, benefit because, under the other two algorithms, participants would still have the ability to sweep through all orders at a given price level.204 Further, this commenter noted that participants could utilize directed orders to send an order to a participant displaying greater size.205 Another commenter believed that the price/size/time algorithm would handicap small retail traders that rely on limit orders to avoid the uncertain execution risk of market orders sold to wholesale trading interests.206 One commenter stated that the price/size/time algorithm was an unacceptable effort to attract larger orders.207
As discussed in more detail below, the Commission finds that the Order Execution Algorithms are consistent with Section 15A(b)(6) of the Act208 because they do not unfairly discriminate against customers, issuers, brokers or dealers. The Commission also finds that the algorithms are consistent with Section 11A of the Act209 in that they promote the creation of a national market system by helping to create the opportunity for more efficient and effective markets, maintain fair and orderly markets, and assure the economically efficient execution of securities transactions. Although none of the algorithms maintains pure price/time priority, they afford price/time priority to a wider range of orders than is currently available in Nasdaq.
The Commission believes that the NASD's decision to retain the algorithm that executes/delivers orders on a price/time priority basis, taking into account ECN quote access fees, as one of the algorithms offered, is acceptable. The Commission does not believe that the proposed algorithm unfairly discriminates against ECNs, particularly in light of the fact that participants may choose either of two other algorithms that do not consider ECN fees.210 The choice rests with the participant entering an order. By offering three algorithms, participants may interact with the SuperMontage based on their preferences and priorities. For example, at least one ECN commenter argued prior to Amendment No. 8 that market participants frequently place greater importance on price improvement offered by ECNs than on the access fees they charge, and therefore, they prefer to interact with ECNs.211 Thus, presumably, these market participants would use the SuperMontage's default algorithm based on price/time priority to interact with ECNs that offer price improvement. For the same reason, the Commission believes that the default algorithm is acceptable. Those market participants that elect to take into account ECN fees may do so under the price/time algorithm that takes into account ECN fees.
The Commission also concludes that the NASD's algorithm based on price/size/time priority is consistent with the statute. This algorithm will assist participants in quickly assessing liquidity in a dynamic trading environment, while rewarding liquidity providers, particularly in a decimals environment where liquidity may be spread over a greater number of trading increments. The Commission acknowledges concerns raised by commenters that the choice of algorithms lessens the importance of time priority, and thus may provide less incentive to aggressively enter better-priced quotes. However, as stated above, the three algorithms proposed by the NASD afford greater price/time priority than currently exists in the market.
The Commission notes that today most orders in Nasdaq securities are executed directly between Nasdaq participants, not using Nasdaq systems. No price/time priority rules apply to this