5. The Commission and the NASD should make it part of their continuous agendas to seek further possibilities for strengthening the mechanisms of interdealer markets and the protection of investors in relation therto, particularly in light of the possibilities of automation referred to below. Among other subjects for possible coverage in future rules, interpretations or statements of policy, to be applied either generally or in respect of specified categories of securities or of broker-dealers, would be: rights and obligations of primary market makers in maintaining competitive, fair and orderly markets; the grant of "cheap stock," warrants or options to primary market makers (see ch. IV.B); standards of supervision and methods of compensation of traders; intrafirm responsibility for and supervision of the insertion of quotations in an interdealer quotation system; provisions for the handling of limit orders; and possible special requirements or exemptions for primary market makers in brokerdealer capital rules, including a possible exemption from "haircut" provisions in respect of limited amounts of inventory of securities traded by a primary market maker (see ch. III.D).

6. While a public investor must ultimately rely upon the competence and probity of his broker-dealer for a good execution, under present rules and standards in over-the-couter markets the price paid or realized by an investor on the purchase or sale of a security may depend, to an excessive degree, on the diligence of the broker-dealer and the capacity in which he acts and/or on the identity of the investor. The NASD and/or the Commission should adopt rules and standards requiring all broker-dealers executing retail transactions, whether or not they are primary market makers in the particular security and whether the transaction is on a principal or agency basis, (a) to make reasonable effort, in light of all circumstances including the kind and size of order, to ascertain the best interdealer quotations (and to show in their permanent records the number of markets checked), and (b) to provide an execution as favorable as may reasonably be obtained in light of the kind and amount of securities involved and other pertinent circumstances.

7. Under present rules and standards in over-the-counter markets the disclosure of facts on which the investor may judge the price and quality of an execution depends in part on whether the broker-dealer acts as agent or principal. So-called "riskless" transactions, i.e., those in which a broker-dealer who neither is a primary market maker nor has a bona fide inventory position elects to execute a customer's purchase order by buying from another broker-dealer and reselling to the customer (or the reverse in the case of a customer's sale order) on a "net" basis without disclosure of markup or commission, are inherently susceptible to abuse and (subject to possible defined exceptions) should not be permitted to take that form; that is, a broker-dealer who neither is a primary market maker nor has a bona fide inventory position should be required (subject to defined exceptions) to execute customers' orders on an agency basis.

8. The NASD's markup policy is in need of substantial clarification and strengthening in respect of other than "riskless" transac

tions. In particular, an integrated broker-dealer's obligation and standards of retail pricing in relation to its contemporaneous cost or its current interdealer quotations, especially in the case of securities for which there is no independent market, should be defined, by the Commission and/or the NASD, more clearly and positively than has been done in the interpretations or administration of the present markup policy.

9. As a further basic improvement in retail over-the-counter markets the present retail quotation system of the NASD should be supplanted by a system designed to show generally (with appropriate exceptions to deal with exceptional categories of securities or situations, if any) the best prevailing interdealer bid and asked quotations that can be reasonably ascertained and the number of primary market makers for each security. Any other quotation system designed for public dissemination, including electronic systems, should be required to conform to the same provisions. By appropriate explanatory legends and by NASDsponsored educational efforts the investing public can and should be advised that published quotations in such form are interdealer quotations rather than retail quotations and hence are subject to markups, markdowns, or commissions in retail transactions.

10. The NASD should reexamine and strengthen, in a manner consistent with the above, its methods of handling "local" quotations, the functioning of its local quotations committees, and its procedures for coordinating and supervising the work of such committees.

11. The NASD should also give consideration to ways and means of improving its retail quotation system in other respects, including, but not necessarily limited to, supplying indications of dividends, ex-dividends, insolvency or reorganization proceedings, etc., in the manner of stock exchange quotations.

12. To the extent that space limitations prevent inclusion in any newspaper or similar quotation system of more than a fraction (presently about one-sixth) of all securities quoted in interdealer systems, the privilege of being included in the NASD's "national" or "regional" lists should be limited to the "OTC listed" category (see ch. IX),343 and within that category the selection should be based on appropriate rules of the NASD or other operator of the particular quotation system.

13. The NASD and/or the Commission should reexamine present requirements with a view to improving disclosures, at the time of soliciting a retail purchase or in confirmations, of essential information relevant to particular types of retail transactions. Among other possibilities that should receive early consideration in this connection would be rules of the following kinds: (a) A brokerdealer soliciting a customer's purchase of any security for which there is no independent market other than its own, or any security out of its own inventory, or any security in which there is a spread of, say, 20 percent or more in prevailing interdealer bids and offers, should be required to disclose such fact or facts at the time of solicitation. (b) The confirmation of a customer's purchase or sale involving 100 shares or less (or, in the case of securities priced

343 See note 338, p. 669, above.

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at $5 per share or less, involving say, $1,500 or less), if handled on a principal basis, should be required to show the best interdealer quotation on the opposite side of the customer's transaction (i.e., the interdealer bid in the case of a customer's sale or the interdealer offer in the case of a customer's purchase) reasonably ascertainable at time of execution. (c) The confirmation of a customer's purchase (but not sale), whether handled on a principal or agency basis, should provide an indication of the prevailing spread between interdealer bids and offers by showing a representative bid quotation.

14. With an already strong communications network, there is on the horizon the likelihood of a computer system that would assemble all interdealer quotations and instantaneously determine and communicate best quotations for particular securities at any time. If such a system were established, the further possibility of using it in connection with executions and to compile actual price and volume data for over-the-counter transactions would exist. Any such automated system would clearly be affected with a public interest and should be under regulatory supervision. The NASD is the natural source of leadership and initiative in dealing with matters of automation in respect of over-the-counter markets. It should actively carry forward the very limited study of automation possibilities applicable to over-the-counter markets that the Special Study has been able to undertake and should report to the Commission from time to time as to the progress and programs of the industry in this area. The Commission and the NASD should jointly consider possibilities for developing and coordinating automation programs in such manner as to fulfill their respective regulatory needs, as well as operational needs of the markets, with maximum effectiveness and minimum duplication and expense.

15. In the absence of a completely automated system for recording transaction data, consideration should be given by the Commission and the NASD to the feasibility of establishing a reporting system designed to obtain maximum price and volume data, without undue burden, for actual transactions in over-the-counter securities or for specified categories of transactions and/or securities.

16. Interdealer or retail over-the-counter transactions in exchange-listed securities present special problems because of their actual or potential interaction with auction markets. In implementing the recommendations in this chapter for over-the-counter markets generally, appropriate exceptions and/or special requirements should be provided for over-the-counter transactions in exchange-listed securities. Other recommendations on this subject appear in chapter VIII.D.

TABLES

TABLE VII-1.-Distribution of number of markets made in over-the-counter stocks by registered broker-dealers (as of Feb. 28, 1962)

1 Broker-dealer firm reported that it made markets but did not give the number of stocks in which markets were made.

TABLE VII-2.—Transactions as principal in over-the-counter stocks by 25 largest wholesale dealers with other broker-dealers and with the public (Jan. 18, 1962) [Value of transactions in thousands of dollars]

NOTE. Broker-dealers were selected on the basis of their principal purchases from and sales to other broker-dealers on Jan. 18, 1962.

TABLE VII-3.-Spread between inside bid and offer classified by number of dealers listed and price of stock (212 selected stocks1 on Oct. 31, 1961)

1 Sample of 212 stocks, beginning with the letter "A," which appeared in National Quotation Bureau, Inc., the National Quotation Service, Eastern Stock Section, which were quoted on Oct. 31, 1961, and which had at least 1 dealer quoting a 2-way market.

2 Based on the 1st 2-way quotation for each selected stock. Percent spread was computed as the difference between the bid and offer expressed as a percent of the offer.

Includes all dealers listed for each stock in National Quotation Bureau, Inc., the National Quotation Service, Oct. 31, 1961, irrespective of type of quotation inserted.