Electronic access to SelectNet through member systems is permitted by non-members under certain terms as set forth in the letter.

April 15, 1998


Lloyd H. Feller, Esq.
Morgan, Lewis & Bockius
1800 M Street, NW
Washington, DC 20036-5869


Re: Customer Access To SelectNet Through QuantEX


Dear Mr. Feller:


This letter is in response to your letter, dated March 4, 1998, to Richard G. Ketchum regarding ITG’s use of its QuantEX System to allow its institutional customers to electronically route orders into Nasdaq’s SelectNet system. Mr. Ketchum has asked that I respond to your inquiry. After discussing this matter with officials of The Nasdaq Stock Market, Inc. and NASD Regulation, Inc., I am pleased to inform you that ITG may offer institutional customers of ITG using your QuantEX System a service that allows those customers to electronically and directly routing orders from QuantEX into Nasdaq’s SelectNet System, provided that the conditions set forth below are met. Further, you should be aware that Nasdaq is in the process of formalizing these conditions in a Notice To Members that will be filed as an interpretation of NASD Rules with the Securities and Exchange Commission in the near future. In the course of such filing, specific requirements laid out in this letter may change.


Under NASD interpretations of its rules and its contracts, the NASD believes that NASD members that are Nasdaq Workstation II subscribers may choose to provide an electronic transmission of a non-member’s order through the member’s own system into Nasdaq’s SelectNet system. Nasdaq provides a service known as SelectNet that permits NASD member firms to enter buy or sell orders in Nasdaq securities into the system, directing those orders to a single market maker ("directed orders") or broadcasting the order to market participants ("broadcast orders"). SelectNet facilitates the communication of trading interest between members, the negotiation of orders with the possibility of price improvement, and the dissemination of last sale reports after execution of SelectNet orders. Trades executed through SelectNet are submitted for clearing as locked-in trades. The SelectNet service is available for execution of orders from 9:00 a.m. until 5:15 p.m., Eastern Time.


Nasdaq allows Nasdaq Workstation II subscribers to enter SelectNet orders from a Nasdaq Workstation or through an electronic means known as an Application Programming Interface ("API"). As mentioned above, there are two types of SelectNet orders: (1) directed orders; or (2) broadcast orders. SelectNet orders may be directed to a particular market participant displaying a quotation in the Nasdaq quote montage or the SelectNet order may be generally broadcast to all participants. Orders entered into SelectNet have a minimum life of 10 seconds, that is, they cannot be canceled by the order entry firm until 10 seconds have elapsed. In the case of directed orders, the participant reviewing the order has up to three minutes to respond to the order, unless the party entering the order specified a longer time period. While directed orders generally have a lifespan of three minutes, directed orders sent to a participant at or up to the participant’s quoted price and size impose liability on the recipient’s part on receipt of the SelectNet order pursuant to the SEC’s firm quote rule, unless an exception to the rule applies.1 Traditionally, SelectNet has been used by NASD members, market makers and order entry firms alike, to access the quotations of other market makers and ECNs.


As mentioned above, the NASD staff believe it is permissible under NASD Rules and the Nasdaq Workstation II Subscriber Agreement ("NWII Agreement") for an NASD member to permit its customers to enter orders into the member’s own electronic system and to re-transmit those orders directly and electronically, without the manual entry of such order by a person associated with the member, into the SelectNet system through an API arrangement. In other words, certain NASD members that connect to Nasdaq through an API are permitted to build an electronic access link that the member provides to certain of its customers. The customer is then able to enter orders through this member-provided electronic entry point that flow through the member’s network into the member’s own computer system that electronically connects through the Nasdaq API to the Nasdaq network and the Nasdaq SelectNet application. Such activity is permissible under NASD rules and the Nasdaq Workstation II Subscriber Agreement to the extent that the NASD member undertakes to ensure that all relevant NASD rules and system protections are followed, as described below.


1. Notice to Nasdaq Acknowledging Responsibility for Orders: NASD members providing a SelectNet electronic pass-through service to customers must provide a letter to Nasdaq that acknowledges that the NASD member is acting as agent for the non-member in submitting the order through the member’s facilities and that the member is responsible for the order sent through SelectNet. Any NASD member providing this service must submit all such orders as agent on behalf of the customer inputting the order. All orders submitted by customers into SelectNet will have the NASD member’s MMID identifier attached to them, and the NASD member (market maker or ECN) receiving the order through SelectNet will know only that another member has attempted to access its Nasdaq-published price.


Further, the NASD member should provide a system description of its facility that provides non-members with SelectNet access. Such system description must provide details on the manner in which orders are received and re-transmitted, including the security and capacity of the member’s system, the manner in which the member’s system connects to Nasdaq’s service, and any internal system protocols designed to fulfill a member’s "know your customer" obligations and other regulatory obligations. The letter and system description should be submitted to me. On receipt of such documentation, I will forward a copy of such information to appropriate personnel in Nasdaq and NASD Regulation.


2. Compliance With NASD Rules


Any NASD member that chooses to offer this service to a customer must ensure that orders submitted through this member-provided service comply with SEC and NASD rules. For example, the NASD member must ensure that rules related to the short sale rule, including the affirmative determination rule, are complied with. Similarly, the NASD member must ensure that any obligations regarding limit order protection and display and the electronic communications network ("ECN") rule are met. In particular, if customers use this mechanism to broadcast SelectNet orders, a market maker allowing customers to do so must be cognizant that SelectNet Broadcast is an ECN that is not linked to Nasdaq’s quote montage, and accordingly requires the market maker to reflect such price in its quote.


Further, in permitting priced orders to be entered by customers, market makers will need to review the effect that such activity may have with respect to the firm’s best execution obligations, including the ability of a firm to match market orders against undisplayed customer limit orders. Members must also be able to continue to meet their obligations to comply with the SEC’s confirmation rule, Rule 10b-10.


3. Internal System Controls Regarding A Member’s Procedures for Supervision of Submission of Orders: NASD Members that provide non-members with SelectNet access should have in place at the time they offer such access to customers and other non-member broker-dealers adequate written procedures and controls that permit the member to effectively monitor and supervise the entry of electronic orders. Among the items that should be found in such written controls and procedures are controls to monitor for: (1) the entry of erroneous or unauthorized orders; (2) orders that exceed or attempt to exceed credit and other parameters, such as order size, that the member has established for a particular customer; (3) activity by a customer that could be considered manipulative or an attempt to improperly affect the price of the security or related products; (4) activity that would give rise to potential inquiries by a regulatory authority; (5) activity that appears to be generated by an automated order entry system; (6) orders that expose the member to significant financial risk; (7) violations of the affirmative determination and short sale rules.


In addition to written procedures and controls, the NASD member’s electronic system that transmits these non-member orders from the member’s network to Nasdaq’s system must have system-driven internal control features that, for example: (1) establish controls regarding the unauthorized use of the system; (2) perform basic order validation checks, such as size of an order for the type of customer entering the order and compliance with the short sale rule requirements; and (3) measure orders against pre-determined credit and trading risk limit established by the member for each individual, non-member user.


An NASD member providing SelectNet access to non-members should have a signed agreement with the non-member customer that outlines the responsibilities of the member and the customer with respect to the use of this means of access.


4. Acknowledgment of Responsibility for Orders: Any NASD member that provides its customers with access to SelectNet should understand that the member remains responsible for any and all activity that occurs through the connection into Nasdaq, as if the member itself had entered such order. Consequently, any NASD member that chooses to provide such service must make appropriate determinations under NASD Rules prior to providing the service to a particular customer that the customer is capable of using the means of access being provided by the firm. Further, a member’s customer agreement that permits the customer to access SelectNet should inform the user that the user is subject to potential prosecution under the federal securities laws for illegal activity conducted by means of such connection and that the NASD will monitor all such trading activity so as to detect any such improper activity. Further, the member should inform the customer that if the NASD detects improper activity through the customer’s use of SelectNet, the member’s link to Nasdaq may be terminated if at any time, activity harmful to the integrity of the Nasdaq Stock Market or its system is detected.


5. Nasdaq’s Liability: In allowing members to provide the member’s customers access to SelectNet, Nasdaq, pursuant to its NWII Subscriber Agreement, assumes no liability for any order entered into the member’s system, or through the API, into Nasdaq’s system.


6. Nasdaq’s Right To Terminate: In the event that the member’s use of the API to allow the entry of SelectNet orders by non-members threatens the integrity of Nasdaq’s systems, Nasdaq continues to reserve the right under the NW II Subscriber Agreement to unilaterally and immediately terminate the member’s access.


7. NASD’s Right To Examine: The member acknowledges that, as an SRO responsible for examining the activity of a member, NASD Regulation may examine the member's books, records and facilities to determine whether a violation of NASD Rules and/or the federal securities laws, rules and regulations may have occurred. Such examination may include an examination of the electronic system itself, as well as the member’s records regarding its customers and their activity.


8. Clearing Responsibility: The member providing the electronic connection must be a member of a clearing agency registered with the SEC through which system-compared trades may be settled; or the member must have a correspondent clearing arrangement with an NASD member that can do so. The member providing access must accept and settle each trade executed through this connection or, if settlement is to be made through another clearing member, the clearing member must guarantee the acceptance and settlement of such trades.


9. Fees For Execution of SelectNet Orders: All orders entered by customers into SelectNet are subject to the same fee schedule that Nasdaq has established for the entry of orders by members. For example, Nasdaq currently charges $1.00 per order executed to the member entering a SelectNet order. As long as that fee is in place, Nasdaq will bill the member entering the customer pass-through order that amount for an execution that the customer receives. Similarly, if a customer using a member’s pass-through service enters a broadcast order that is executed, Nasdaq will bill the member $2.50 for the execution. Under the SEC’s Order Handling Rules, the SEC has permitted ECNs the right to charge NASD members that use SelectNet to access the ECN’s priced orders displayed in the Nasdaq. NASD members should be aware that if they provide customers with SelectNet access and a customer accesses the order of an ECN that charges for such access, the ECN will bill the member for such access.


10. System Setup: NASD members providing an electronic pass-through of SelectNet orders must use the Nasdaq API between the member’s system and Nasdaq’s system. NASD members may use service bureaus to develop and operate the electronic access capability. All such API connections must be set up on an eight presentation device to one service delivery platform ratio. If a member chooses to use a service bureau to develop the service, the NASD member is nonetheless responsible for ensuring that all NASD Rules and NWII Subscriber Agreement requirements are complied with. No service bureau is permitted to operate a service on behalf of a member unless the service bureau has entered into an agreement with Nasdaq.


This letter provides you with an understanding of the manner in which the NASD believes non-members can be provided with electronic access to SelectNet. Provided that ITG acts consistently with these conditions, the QuantEX service that you discussed may be offered to ITG’s customers. Of course, any different facts or conditions regarding the QuantEX System might require a different response. This is a staff opinion based on the representations made in your letter. Further, as this access capability is to be filed as a proposed rule with the SEC, some requirements may change in the course of the approval process. Finally, any determination with respect to ITG’s compliance with NASD Rules regarding this access service will be made based on NASD Regulation’s examination of the firm. If you have any questions or comments regarding this letter, please do not hesitate to contact me at (202) 728-6998.






Eugene A. Lopez
Vice President
Trading and Market Services


cc: Timothy H. Hosking, ITG, Inc.
Richard G. Ketchum, NASD
J. Patrick Campbell, Nasdaq
Robert Aber, Nasdaq
Alden Adkins, NASD Regulation
Thomas Gira, NASD Regulation


1 See Rule 11Ac1-19(c).