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February 1, 1998

The Challenges Ahead

By Howard L. Haykin

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Trading in 1998 will be driven in large part by the market rules and developments that were introduced in 1997, and the changes that are envisioned for this year. Let us look briefly at several key areas.

Limit Order Display Rule The Securities and Exchange Commission's new Limit Order Display Rule 11Ac1-4, introduced in August 1996 and implemented throughout 1997, was designed to improve the handling of customer orders. In general terms, Nasdaq market makers are required, upon receipt of a customer limit order that is priced equal to or better than its quote, to immediately that is, within 30 seconds display the price and full size of the order in its quote.

Traders may choose instead to execute the order or send it to another broker dealer (a market maker or an electronic communications network) to display the order. Certain block-sized or de-minimus orders, as well as working or not-held orders, need not be displayed. Customers may also request that the market maker not display their limit orders. Compliance is difficult and labor intensive, and National Association of Securities Dealers' examinations have found that traders frequently violate the rules. Traders are encouraged to read Notices to Members 96-65 and 97-49 for guidance.

Best Execution Best-execution obligations apply to all Nasdaq and OTC Bulletin Board securities. While the definition of best execution has been elusive, recent NASD Market Regulation examinations appear to focus on customer transactions executed outside the current inside market (NBBO, or National Best Bid and Offer).

In general, the rules obligate traders to seek out the most advantageous terms for their customers' orders and, in particular, limit orders. Reasonable care or diligence should be in evidence.

In September 1997, the NASD provided interpretive advice on a member's best-execution obligation when handling a customer order, especially in light of the SEC's Order Handling Rules and the NASD's Limit Order Protection (Manning) Rules. While not complete, Notice to Members 97-57 provides valuable guidance.

Amended Quote Rule and Minimum Quote Sizes NASD Market Regulation conducted an August 1997 investigation of market-maker quote displays. They found many rule violations. The SEC's Amended Quote Rule 11Ac1-1 requires market makers to update their quotes to reflect all orders (customer and proprietary) placed in an electronic communications network (ECN), unless the ECN's display is included in the Nasdaq system and there is access to that ECN. Unpreferenced orders broadcast on SelectNet do not qualify for an exemption. Market makers are also required to update quote sizes to at least the minimum SOES tier-size whenever they change quote prices. Traders should read Notice to Members 97-49 (Compliance With SEC Order Handling Rules and Nasdaq Trading Rules).

Next Nasdaq It remains to be seen if the SEC steps in again to foil the latest NASD intentions, as it did to a previous plan in 1996, replacing the proposed NAqcess trading system with the SEC-approved order handling rules. Many Nasdaq market makers and ECNs have expressed strong opposition to the proposed integrated trading platform, originally dubbed Next Nasdaq, while the NASD, several small trading firms and both institutional and retail investors have supported the plan.