JPMorgan Edward J. Johnsen Vice President and Assistant General Counsel J.P. Morgan Securities Inc. 60 Wall Street New York, NY 11260-0060 Tel: 212 648-4619 [Attached is an e-mail version of our comment re File No. SR-NASD-98-26, Exchange Act Release No. 39819, 63 FR 16841 (April 6, 1998). Hardcopy & cc's via Federal Express] April 27, 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 Revise Primary Market Maker Standards, File No. SR-NASD-98-26, Exchange Act Release No. 39819, 63 FR 16841 (April 6, 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") and The Nasdaq Stock Market, Inc. ("Nasdaq"), and set forth in the Release. The NASD and Nasdaq are proposing to amend the Primary Nasdaq Market Maker ("PMM") standards that provide market makers in Nasdaq National Market ("NNM") securities with an exemption from the Nasdaq short sale rule (the "Short Sale Rule" or the "Rule"), and to implement these revised PMM standards on a pilot basis beginning on May 1, 1998. (superscript: 1 ) Under the present standards -- suspended since the adoption of the SEC's order handling rules -- a Nasdaq market maker is deemed to be a PMM if it meets two of three criteria:(superscript: 2) 1. It maintains the best bid or offer no less than 35% of the time; 2. Its spread is no greater than 102% of the average spread ("102% test"); and 3. No more than 50% of its quote changes occur without an execution. The SEC's Order Handling Rules made these criteria unreliable gauges of market maker performance. For example, it was impossible to tell when market maker quote changes were driven by customer orders entered and later canceled without any execution, making it difficult for market makers to meet the 102% test. The NASD and Nasdaq therefore suspended the PMM rules and designated all market makers as PMMs. (Release, 63 FR 16844.) In order to limit the number of registered Nasdaq market makers that qualify for the exemption, the NASD and Nasdaq now intend to impose new standards for PMM status that purportedly "reward" market makers that provide "meaningful liquidity" to the market based on their buying and selling activity in up and down markets and their relative buying and selling activity in comparison to other market makers. To determine whether the market maker is a provider of liquidity, Nasdaq will first apply a net liquidity ratio ("NLR") Test wherein the accumulated share-volume of all of a market maker's proprietary purchases in down markets and proprietary sales during up markets will be divided by the total proprietary volume traded during up and down markets. The resulting number provides an NLR with a value between 0 an 1. (Release, 63 FR 16844.) Next, Nasdaq will calculate a market maker's proportionate share of proprietary share-volume ("proportionate volume") and proportionate share of proprietary trades ("proportionate trades") in a stock (the Proportionality Test").(superscript: 3) The threshold for proportionate volume and trades will be 1.0 for each, meaning that a market maker must account for at least one time its proportionate share of all share-volume or its proportionate share of all trades in the stock during the review period.(superscript: 4) (Id. at 16844-16845.) A market maker automatically will qualify as a PMM in a particular stock if it: (1) passes the NLR Test with a ratio of 0.67 or greater; and (2) passes the Proportionality Test by trading either its proportionate volume or proportionate trades (i.e., a ratio of 1) during the review period -- generally one calendar month (Release, 63 FR 16845.)(superscript: 5) The new PMM standards are slated to become effective May 1, 1998. Currently all registered market makers are PMMs due to the suspension of the previous PMM standards, and will continue as such on the proposed start date of May 1, 1998, since there will be no meaningful trading to analyze prior to that date. The NASD and Nasdaq will implement the new standards so that no market maker designated as a PMM when the pilot begins will lose that status for failure to meet the new PMM standards until July 6, 1998. This is intended to give market makers time to adjust their trading activity before they lose their PMM designation, particularly since the old PMM standards have been suspended for more than a year and the new PMM standards are more stringent than the previous standards. (See Release, 63 FR 16845.) While we understand the concerns raised by the SEC and the NASD regarding the need for more meaningful criteria for the designation of PMMs and the concomitant exemption from the Short Sale Rule, we are very uncertain whether the Proposal is the proper way to achieve this goal. Our concerns are based on two factors. First, the relatively complex formulas appear to require market makers to accept significant risks in times of severe market conditions, in order to be deemed PMMs and permitted to sell short on a down-bid when engaging in normal market making activity. While it does not seem particularly improper to expect a market maker to satisfy its proportional share of trading in an up or down market to be deemed a PMM, requiring an arbitrary minimum level of trading against the trend of buying or selling may prove especially harsh in certain circumstances -- potentially imposing significant risk on the market maker. In addition, once the new PMM standards are in place, to become a PMM a market maker must engage in significant levels of such putative "liquidity providing" transactions while being limited in its ability to sell short in a down market. As a result, that market maker, trying to actively buy in a down market, will be forced to do so while unable to first sell short to position itself to buy that stock. Thus, the market maker must buy first and then hope to be able to sell before the market falls much further, potentially making qualifying as a PMM quite difficult and risky in many circumstances. The Proposal is viewed by the NASD and Nasdaq as providing "a meaningful measure of whether a market maker is providing liquidity to the market and thus deserving of an exemption to the NASD's Short Sale Rule" and "protect[ing] investors by limiting the number of market makers that may sell short only to those that regularly effect liquidity-providing and stabilizing transactions." (Release, 63 FR 16848). It also is purportedly designed to reduce some unexplained level of "investor confusion" -- thus promoting "fair and efficient markets." (Id.) Yet there is no discussion in the Release regarding the nature of this "confusion" and little elaboration as to why this particular methodology is the appropriate measure of those market makers that should be entitled to an exemption from the Short Sale Rule. We are also concerned with the relative haste with which market makers are supposed to review and rationally comment on new PMM standards that are, in the words of the Release, "more stringent than the previous standards." (Release, 63 FR 16845.) As the Release points out, in developing these standards, the NASD neither solicited nor received comments, and the minimum 21-day comment period is all that has been provided here. And, curiously, the new standards are slated to become effective only four days after comments are due. This is hardly enough time for market makers to properly evaluate either the general appropriateness of the proposed standards or how they will affect their particular firm, and provide meaningful input to the development of these standards. It also leaves little time for the NASD and Nasdaq to evaluate the points set forth in any comments that may be submitted, leading to the appearance that little weight will be given to the views expressed in such comments. Moreover, market makers are only given general examples of how the new process would operate, rather than specific information on how they would stand if the new PMM standards were in effect. This is in stark contrast to the approach taken in developing the original PMM standards, where market makers, before the standards were imposed, were given the opportunity to obtain data from the NASD showing specifically how their firm would stand if the standards were in place, so that they could provide meaningful evaluation and comment regarding the then-proposed standards. (See NASD Notice to Members 92-8.) We are also concerned that imposing the new PMM standards on an untested basis may have negative effects on market quality, since, as stated in the Release, "the number of market makers qualifying for PMM status will be reduced significantly from the levels under previous PMM standards." (63 FR 16847). We have always understood the market maker exemption from the Short Sale Rule to be "fundamental to avoid disrupting traditional dealer activity . . . so that dealer activities that provide liquidity and continuity to the Nasdaq market will continue uninterrupted." (NASD Notice to Members 92-8.) Imposition of standards that may have the effect of overly restricting such activities, in an effort to induce and reward the provision of certain levels of liquidity, is a step that should only be taken after very careful testing and evaluation. We therefore believe it would be far more beneficial for all market participants if the new standards were imposed on a true "test basis," that is, market makers would continue under the current regime (i.e., all market makers would continue to be deemed PMMs) while the NASD monitored their performance under the new criteria for a period of six months, and made available to them statistics showing how they would have fared if the new PMM standards had been in place. This would give the NASD and market makers a truer picture of the potential effects of the new PMM standards and the ability to provide informed commentary before those standards are actually imposed. It would also reduce the risk of market disruption in the event the PMM standards are found to be either a poor determinant of market maker performance or simply too strict. It may turn out that the new PMM standards prove to be an appropriate method for determining PMM status, and one that operates without undue market interruption. However, without a reasonable opportunity to first test and evaluate the new PMM standards prior to their actual implementation, market makers are being placed at potentially considerable market risk in order to achieve PMM status and thereby be able to provide proper levels of liquidity to the markets and properly facilitate their customers.(superscript: 6) We appreciate the opportunity to present our views on this topic. Please do not hesitate to contact the undersigned at (212) 648-4619 if any further information or comment is needed. 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. The SEC has approved on an accelerated basis another part of the Proposal that extends the application of the Short Sale Rule until November 1, 1998. The NASD and Nasdaq also plan to submit amendments to the Rule that would exempt certain customer facilitating, liquidity-providing transactions, regardless of whether the firm is a PMM. However, the terms and conditions of this exemption are presently unclear. 2. In addition, if a registered market maker meets only one of the above criteria, it still qualifies if it accounts for volume at least 1 1/2 times its proportionate share of overall volume in the stock. 3. Proportionate volume will be determined by dividing the market maker's total proprietary share-volume by all market maker proprietary share-volume for the stock, then multiplying the ratio by the total number of registered market makers in the stock. A market maker's proportionate trades will be determined by dividing its total number of proprietary trades by the total number of proprietary trades by all market makers in the stock, and then multiplying that ratio by the total number of registered market makers in the stock. (Release, 63 FR 16844, n.17.) 4. If a stock had 10 market makers, a share-volume of 1,000,000 shares and 15,000 trades, a market maker would have to transact 1/10 of all share-volume or trades--100,000 in share-volume or 1,500 trades. (Id., n.18.) 5. There will be a one-month "look-back" under which Nasdaq will consider the previous month and the current month to determine continued PMM eligibility if the market maker attained PMM status in the security during the previous month, but fails to meet the applicable thresholds for the current month. Where fewer than 50% of market makers qualify as PMMs, after the application of the NGR and Proportionality Tests, Nasdaq will augment the number of PMMs using a special formula. For securities with eight or fewer market makers, PMM status will require satisfying the NGR threshold only. (Release, 63 FR 16845.) 6. As stated in footnote 1, above, the NASD and Nasdaq are also planning to amend the Short Sale Rule to exempt certain customer facilitating, liquidity-providing transactions. However, the terms of those exemptions are not clear from the Release. A better approach to this entire matter would have been to propose both the new PMM standards and the new exemptions together in a single release.