April 13, 1998 Via E-MAIL and Federal Express Mr. Jonathan G. Katz Secretary Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Re: NASD Proposal to Permit Market Makers To Display All Quotations in Actual Quotation Size, File No. SR-NASD-98-21, Exchange Act Release No. 39760, 63 FR 13894 (March 23, 1998) (the "Release). Dear Mr. Katz: J.P. Morgan Securities Inc. is a full-service broker-dealer that acts as a registered Nasdaq Market Maker in more than 150 Nasdaq National Market securities. We are writing to comment on the proposed rule change (the "Proposal") filed with the Securities and Exchange Commission (the "Commission" or "SEC") by the National Association of Securities Dealers Inc. (the "NASD"), through its subsidiary The Nasdaq Stock Market, Inc. ("Nasdaq"). The Proposal would permit market makers to quote all stocks in "Actual Size" by reducing the minimum quotation size requirement for market makers in all securities listed on Nasdaq to one normal unit of trading -- 100 shares (the "Actual Size Rule"). I. The Proposal Presently, market makers are required to display quotations in a minimum size of 1,000 shares in most Nasdaq securities (200 or 500 shares for certain, less active stocks). This requirement is unique to Nasdaq;the stock exchanges generally require only the display of 100 shares. This minimum quote requirement was originally imposed to facilitate trading through the Nasdaq Small Order Execution System ("SOES"), which itself was designed to be an efficient, cost-effective means of executing small orders in Nasdaq securities in a quote-based dealer market. The Commission's Order Handling Rules,[1] however, have transformed Nasdaq into a market that is far more order-driven -- one which now includes quotes from investors (through limit orders displayed by market makers) and Electronic Communications Networks ("ECNs"), in addition to those of market makers. In 1996, Nasdaq implemented an Actual Size Rule pilot program (the "Pilot Program") that included 50 Nasdaq stocks (later expanded to 150 stocks), allowing market makers to display their actual, freely-determined quotation size when not displaying a customer order. The changes resulting from the Order Handling Rules, and the results of the NASD's analyses and economic studies suggesting several long-term benefits and no adverse market impact resulting from the Actual Size Rule, have led the NASD to conclude that artificial minimum quotation sizes are no longer necessary and should be removed for all Nasdaq stocks. We agree with those conclusions and fully support the NASD's Proposal to extend the Actual Size Rule to all Nasdaq stocks. As stated in the Release, the Actual Size Rule will afford market makers more flexibility to manage risk and quote prices that are more favorable for small retail orders. (See Release, 63 FR 13894, 13895). Moreover, continuing to require a minimum commitment of market maker capital while allowing display of customer and ECN orders without a similar commitment, is inequitable and impairs the ability of market makers to set competitive quotations. (See id.) According to Nasdaq, rigorous empirical analysis of the Pilot Program, including a study of the extreme market conditions of October 27 and 28, 1997, have demonstrated that the Actual Size Rule has not materially affected Nasdaq market quality, as measured by spread, volatility, quoted depth, and liquidity, and that investors continue to have substantial access to reasonable amounts of market maker capital in stocks subject to the Pilot Program ("Pilot Stocks"). (Id.) As a result, there is no justification for continuing the artificial minimum quote sizes for Nasdaq stocks. II. Nasdaq Has Become An Order-Driven Market SEC Rule 11Ac1-4, (the "Limit Order Display Rule") requires market makers to display customer limit orders that are priced better than a market maker's quote, as well as those that add to the size of a market maker's quote when that quote is at the inside price. As a result, investors themselves can now directly show their interest to the market. They can also affect the size of bid-offer spreads and, in fact, compete with market maker quotations. Moreover, under the "ECN Rule," market makers must now display in their quote any better priced orders they place in electronic communications networks ("ECNs"), unless the ECN communicates to Nasdaq for public dissemination the best priced orders entered by market makers, and provides brokers and dealers who do not subscribe to the ECN with access to orders entered by market makers in that ECN. As a result, ECN quotes can also drive the inside market. The new, order-driven nature of Nasdaq brought about by the Order Handling Rules has eliminated any justification for minimum quote size requirements for market makers. While it may have been appropriate to impose mandatory quote size requirements to ensure an acceptable level of market liquidity and depth when market makers were the only market participants who could impact quotation prices and sizes, this is no longer the case.[2] The Limit Order Display Rule now permits investors to directly impact quoted prices by placing better-priced limit orders with market makers, which the market makers must include in their quotes.[3] It is therefore no longer necessary to subject market makers to minimum quote size requirements when they are not representing customer orders. Moreover, as the NASD argues in the Release, permitting dealers to quote in the size that reflects their true trading interest should enhance pricing efficiency in the Nasdaq marketplace. (See Release, 63 FR at 13896.) The NASD is also correct in stating that eliminating the artificial minimum quote sizes would remove a disincentive for market makers to quote certain stocks, which would attract additional liquidity and again enhance pricing efficiency in the Nasdaq market. (See id.) Indeed, in approving the Pilot Program, the SEC pointed out that "the 1,000 share minimum quote size represents a barrier to entry for market making. Lowering this barrier to entry could attract more market makers, thereby increasing liquidity and competition across the market." (Exchange Act Release No. 38156, 62 FR 2415, 2425 (January 16, 1997)). This can only have a positive effect on the Nasdaq marketplace. III. The NASD's Economic Studies Indicate That The Actual Size Rule Will Have No Adverse Impact On Market Quality The NASD has performed detailed studies on the effects of the Actual Size Rule, including analysis of each of the first 50 securities subject to the Order Handling Rules -- later expanded to 100 more securities[4] -- and comparison to stocks not subject to the Actual Size Rule. In approving the Pilot Program, the SEC noted its preliminary view that the Actual Size Rule "will not adversely affect market quality and liquidity" (Exchange Act Release No. 38156, 62 FR 2415, 2425), and that "there are substantial reasons . . . to expect that reducing market makers' proprietary quotation size requirements in light of the shift to a more order-driven market would be beneficial to investors." (Id. at 2423.) It was also noted that "[t]he Commission, based on its experience with the markets and discussions with market participants, believes that decreasing the required quote size will not result in a reduction in liquidity that will hurt investors." (Id. at 2424.) The NASD's studies appear to have proven these predictions correct. The NASD found that implementation of the Order Handling Rules significantly improved the quality of the Nasdaq market by creating a market structure where customer limit orders provide liquidity and compete effectively with market maker quotations, and that the regulatory necessity for the mandatory quote size requirements no longer exists. A. The Actual Size Rule Has No Material Effect On Nasdaq Market Quality The NASD studies published in June 1997 and January 1998 indicate that the Actual Size Rule has no material effect on market quality. Several measures of market quality were analyzed in the January 1998 Study: spread, volatility, depth, and liquidity, leading to the following conclusions. 1. Spreads: There was no significant evidence of a differential change in quoted or effective spreads associated with the Actual Size Rule.[5] 2. Volatility: While volatility in the Pilot stocks fell slightly more than for non-Pilot stocks, the differential cannot be attributed to the Actual Size Rule. 3. Depth: The Actual Size Rule was not associated with a change in aggregate quoted depth.[6] Furthermore, neither the mean number of market makers, nor the mean number of market makers at the inside quote, changed significantly for either group. 4. Liquidity: The study found no significant association between effective depth (a measure of liquidity) and the Actual Size Rule. (Release, 63 FR 13898.) B. The Actual Size Rule Does Not Impair SOES Access To Market Maker Capital The NASD's analysis of market maker accessibility via Nasdaq's SOES system and dealer proprietary systems demonstrated that the Actual Size Rule did not impact the operation of these systems, and that the Actual Size Rule had minimal effect on investors' ability to obtain SOES executions. Even under the extreme market conditions of October 27 and 28, 1997, the NASD found no significant evidence that the Actual Size Rule had any impact on market quality or SOES accessibility. (Release, 63 FR 13898.) IV. Conclusion: The Actual Size Rule Should Be Approved For All Stocks The Order Handling Rules have transformed Nasdaq into an order-driven market by integrating customer limit and ECN orders into the marketplace, making it unnecessary, and indeed inappropriate, to require market makers to enter proprietary quotations in artificial minimum sizes. No other equity market requires such artificial minimum quote sizes. Moreover, the NASD has demonstrated that the Actual Size Rule will likely have a positive impact on market quality, possibly leading to narrower spreads and reduced costs for investors, since market makers will have more flexibility to manage risk and quote prices more favorable for small orders. Moreover, permitting market makers to quote according to their actual trading interest should enhance the efficiency of Nasdaq pricing and the competitiveness of dealer quotations. Eliminating artificial minimum quotation sizes should also facilitate greater variation in quotation sizes, rendering market maker quotes more informative since dealers having a real interest in a stock at any particular time will likely quote differently than those who do not. Actual Size quotations may also eliminate a barrier to entry for smaller market making firms, increasing price competition and liquidity. Finally, requiring market makers to commit artificially established minimum levels of capital, while allowing customer and ECN orders to be entered without a similar commitment, results in inequitable treatment of market makers versus other market participants. There is no justification for such treatment, since, as shown above, there may be long term benefits from the removal of minimum quotation sizes, and, according to the NASD's empirical research, there will be no adverse impact on investors or the Nasdaq market. Given that Section 15A(b)(9) of the Securities Exchange Act of 1934, as amended, prohibits rules that "impose any burden on competition not necessary or appropriate" to further the purposes of that Act, artificial minimum quote sizes should be eliminated and the Actual Size Rule approved for all Nasdaq securities on a permanent basis. We appreciate the opportunity to present our views on this subject. Please do not hesitate to contact the undersigned if you have any questions or comments regarding this letter or the matters discussed therein. Sincerely, s/ Edward J. Johnsen Edward J. Johnsen Vice President and Assistant General Counsel cc: Dr. Richard R. Lindsey Director, Division of Market Regulation, Securities Exchange Commission Alfred R. Berkeley, III President, The Nasdaq Stock Market, Inc. J. Patrick Campbell Executive Vice President -- Market Services, The Nasdaq Stock Market, Inc. [Footnotes] 1. See Exchange Act Release No. 37619A, 61 FR 48290 (September 12, 1996). 2. In approving the Pilot Program, the SEC noted that "[n]either the [Securities Exchange] Act nor the Commission's rules require a quote size larger than 100 shares. Historically, because customer trading interest was not displayed in the Nasdaq market, the NASD determined that it was appropriate that market makers display at least a minimum size in their quotes . . . ." Exchange Act Release No. 38156, 62 FR 2415, 2424 (January 16, 1997). 3. The Actual Size Rule would not affect a market maker's obligation to display the full size of a customer limit order. Thus, if a market maker is required to display a customer limit order that is for 200 shares, it would be required to display a quote size of at least 200 shares. 4. In expanding the original Pilot Program, the NASD attempted to avoid skewing the results toward larger, more active issues, by selecting a more representative sample of the Nasdaq market. The expanded Pilot Program provided additional data across a broad range of securities, allowing a more accurate evaluation of the rule's effects. In approving continuation and expansion of the Pilot Program, the SEC noted that the data compiled to that point preliminarily indicated that the Pilot Program "has not resulted in harm to the Nasdaq Market. Indeed, . . . , the Actual Size Rule appears to be a reasonable means to provide market making obligations that reflect the new market dynamics produced by the Order Execution Rules." (Exchange Act Release No. 39285, 62 FR 59932, 59936 (November 5, 1997). 5. Quoted spread is the difference between the inside bid and offer. Individual spreads are weighted by their duration, that is, the amount of time each was in effect for the day. Effective spread is twice the absolute difference between the trade price and the bid-ask midpoint, accounting for trades at prices inside the spread. 6. Quoted depth is the size of a market maker quote, or the number of shares at the quote that a market maker is required to transact under the Firm Quote Rule. Aggregated quoted depth is the sum of the quoted depths of all market makers quoting at the prevailing inside market.