2nd Market, NASDAQ OTC

tamer hamed 1:08:00 AM
NASDAQ OTC
NASDAQ (NASDAQ) stands for the National Association of Securities Dealers Automated Quotation system. What is a "securities dealer"? We're talking about broker-dealers who execute transactions in securities for customers, including well-known firms such as TD Ameritrade, Morgan-Stanley Merrill Lynch, Charles Schwab, and E-Trade. As you may know from working at a broker-dealer yourself, many precise records are involved with executing a buy or sell order for securities, and the process is highly regulated by FINRA, the SEC, and the state securities regulators. When billions of dollars are moving back and forth between investors every day, the potential for fraud or costly mistakes is huge.

The NASDAQ system has three levels of access. Level 1 is for registered representatives and individual investors, and it shows the highest bid and lowest offer price for a security, as well as last sale and volume information. The highest bid and lowest offer is the inside market representing the best prices buyers and sellers can trade at immediately.
If a customer wanted to see what each market maker was quoting, he would need Level 2 access, which shows the two-sided quote, with size, for each market maker in the security. It also shows last-sale and volume information updated in real time. NASDAQ Level 2 is a subscription service for pension funds, mutual funds, and other large institutional investors.

NASDAQ Level 3, unlike the first two levels, is not just a display system. Level 3 is for market makers inputting and updating their quotes on the security in real time. It displays all information the other levels see, and allows a firm's trading desk to update their quotes for the securities in which they make a market.

Securities
The OTC securities that meet the requirements of NASDAQ trade on the NASDAQ Global Select, NASDAQ Global or NASDAQ Capital markets. Requirements for listing on the NASDAQ Global market are stringent, and the requirements for initial and maintained listing on the NASDAQ Global Select market are, according to the NASDAQ website, "the highest standards of any stock market in the world."

To help smaller companies raise capital, the NASDAQ Capital Market exists and has lower listing requirements designed to help less proven companies raise capital from aggressive investors while still maintaining reasonably high listing standards. By "standards" for listing we mean companies that want to list on the Global or Global Select tiers must meet high standards of financial strength and liquidity for their stock, and companies listing on those or even just the NASDAQ Capital Market must maintain high corporate governance standards.

The requirements for initial listing are higher than for continued listing. For example, the national best bid on the stock must be at least $4 to list initially, but the company doesn't get threatened with a de-listing unless the bid falls below $1. NASDAQ explains this approach ensures companies are as strong as possible before their stock starts trading on an exchange, especially the top two tiers (Global, Global Select).

A company can get their stock onto the NASDAQ Capital Market without showing a profit at all or by showing net income/profits of just $750,000 if using one of the other standards for financial strength. Then again, if the net income is only $750,000, the company would still have to have among other things-1 million publicly held shares, 300 round lot shareholders, and at least three broker-dealers acting as market makers for the stock.

We mentioned that companies trading on the NYSE can have their securities de-listed. Similarly, NASDAQ explains:
NASDAQ is entrusted with the authority to preserve and    strengthen the quality of and public confidence in its market.NASDAQ stands for integrity and ethical business practices to enhance investor confidence, thereby contributing to the financial health of the economy and supporting the capital formation process. NASDAQ Companies, from new public Companies    to Companies of international stature, are publicly recognized as sharing these important objectives. NASDAQ, therefore, in addition to applying the enumerated criteria set forth in the Rule 5000 Series, has broad discretionary authority over the initial and continued listing of securities in NASDAQ to maintain the quality of and public confidence in its market, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to protect investors and the public interest. NASDAQ may use such discretion to deny initial listing, apply additional or more stringent criteria for the initial or continued listing of particular securities, or suspend or de-list particular securities based on any event, condition, or circumstance that exists or occurs that makes initial or continued listing of the securities on NASDAQ inadvisable or unwarranted in the opinion of NASDAQ, even though the securities meet all enumerated criteria for initial or continued listing on NASDAQ   

So, NASDAQ mentions the authority of the Listing Qualifications Department to use its discretionary authority to deny or terminate the listing of a security. They then explain how this works in one of their many interpretative materials (IMs). A common reason a company's security gets de-listed from NASDAQ is that one of the officers or directors turns out to be a bad actor. The "IM" mentions that these individuals are usually officers, directors, substantial shareholders, or consultants.

The explanation then continues with: Based on this review, NASDAQ may determine that the regulatory history rises to the level of a public interest concern, but may also consider whether remedial measures proposed by the Company, if taken, would allay that concern. Examples of such remedial measures could include any or all the following, as appropriate:
•    the individual's resignation from officer and director positions, and/or other employment with the Company
•    divestiture of stock holdings
•    terminations of contractual arrangements between the Company and the individual
•    the establishment of a voting trust surrounding the individual's shares in the issuer

NASDAQ explains they are willing to discuss with companies, on a case-by-case basis, what type of remedial measures can be taken to put out the fire. Or, if they conclude the public interest concern is so serious nothing can remediate it, staff can deny an initial or continued listing on NASDAQ, If that happens, the issuer of the security can seek a review of this decision by a panel of people independent of NASDAQ, The panel may end up accepting, rejecting, or modifying NASDAQs decision to deny or de-list the company's security.

It isn't just bad behavior that can lead to a de-listing. If the issuer files for bankruptcy protection, or if their auditing accountants issue a disclaimer opinion or refuse to certify the financial statements contained in filings such as the annual 10-K report, the stock can be de-listed. Remember that stocks trading on NASDAQ are issued by companies with solid financials and current reporting, so if the issuer is facing bankruptcy or their accountants won't certify its financial statements, it makes sense that NASDAQ would start to show this issuer the exit to protect investors.

Market Makers
To enter quotes through the NASDAQ system, broker-dealers who want to act as market makers must get access to the system and get their registration accepted by NASDAQ They also must meet certain requirements:
•    Execution of all applicable agreements with NASDAQ
•    Membership in or an arrangement with a participant of a clearing agency registered with the SEC
•    Compliance with all NASDAQ and SEC rules concerning the system
•    Maintenance of the physical security of the equipment located on the premises of the NASDAQ Market Maker, NASDAQ ECN or Order Entry Firm to prevent the improper use or access to NASDAQ systems
•    Acceptance and settlement of each NASDAQ trade identified as belonging to the participant
•    Input of accurate information into the System, including, but not limited to, whether the member acted in a principal, agent, or risk less principal capacity.

The Market Maker Registration Form is short and sweet, NASDAQ is asking for basic information: full name of member and CRD (Central Registration Depository) number, MPID (if adding securities to existing market making activities), clearing arrangement and NSCC account #, and list of stock symbols to be quoted. As NASDAQ explains the process of becoming a NASDAQ market maker involves these steps:

  • Complete the Market Maker Registration Form (PDF) and fax it to NASDAQ Subscriber Services. If new services are required, also complete the NASDAQ Port Request Form (PDF) or the NASDAQ Front-End Access Form (PDF).
  • Have your clearing agency call the National Securities Clearing Corporation (NSCC) to ensure a clearing arrangement.
  • Contact the local FINRA District Office to express an interest in becoming a NASDAQ market maker. The District Office will write to you requesting information.
  • Compile all information, and send it to the local FINRA District Office for review. (If all information is completed properly, the District Office will interview you and determine if you are qualified to be a NASDAQ market maker.)
  • The FINRA District Office will forward an approval form to NASDAQ's Subscriber Services department. (If your firm is not a FINRA member, the approval will be made by The NASDAQ Stock Market LLC.)
  • A NASDAQ Subscriber Services representative will notify you if you are permitted to make markets and will activate all your services.
If the firm is going through this process, they must be sure they are ready to start making markets. NASDAQ rules state the firm's status as a market maker in that security would automatically terminate if the market maker failed to enter a quote on it within 5 business days after their registration became effective.

When a market maker becomes registered with NASDAQ, NASDAQ assigns an MPID (Market Participant Identifier).

So, if this is the first time a firm has acted as a NASDAQ market maker, an MPID would have to be assigned. For existing market makers adding stocks to their market making activities, the MPID would already have been assigned. Many market makers, including some in the chart above, have several MPIDs, so the first MPID issued by NASDAQ to the market maker is called the Primary MPID. Market makers with multiple trading centers would then request Supplemental MPIDs from NASDAQ
NASDAQ rules state that if a market maker ceases to live up to its obligations relating to the primary MPID in any security, it will not be able to use any of the supplemental MPIDs to trade in that security, either. Quotes entered by the other trading centers using the Supplemental MPIDs are referred to as "attributable quotes/orders."

Whether it's the Primary MPID or one of the Supplemental MPID trading centers, the name of the system into which quotes are entered is currently known as the "NASDAQ Quotation Montage." All quotes entered by NASDAQ market makers, ECNs, and NASDAQ order entry firms are firm quotes and are immediately executable. 

All quotes are firm; all orders ready to go. As NASDAQ rules state:
For each security in which a member is registered as a NASDAQ Market Maker; the member shall be willing to buy and sell such security for its own account on a continuous basis and shall enter and maintain a two-sided quotation ("Principal Quote"), which is attributed to the market maker by a special market participant identifier ("MPID") and is displayed in the NASDAQ Market Center at all times, subject to the procedures for excused withdrawal.   

The quotes are not just firm, but must be for a minimum size one normal unit of trading.
Market makers provide liquidity to the markets. If the market maker wants to withdraw temporarily for a legitimate reason, they request an excused withdrawal from FINRA.

Why would a market maker want to do that? Maybe the security trades in a volatile market and the one experienced trader the firm has is suddenly unavailable. Or, there could be an equipment malfunction, or maybe they lost their clearing agreement. Or, if they somehow come into possession of material, inside information, they must excuse themselves from making a market, no matter how tempting it would be to just keep on trading.

Reasons that a market maker may not use to request an excused withdrawal include: a sudden influx of orders, sudden price changes, or a news release. In other words, if you sign up as a market maker, don't complain about volatility. It's your job to deal with it, keeping the markets functioning as smoothly as possible.
If, on the other hand, a market maker wants to terminate its activities on NASDAQ, it simply withdraws its quotes from the system, which gives FINRA the heads up that the firm is terminating its registration for that security. If the firm wants to jump back into making a market in that security, the firm must wait at least 20 business days before registering once again. And, if a market maker fails to follow the rules and obligations of FINRA, they can be suspended or even terminated as a market maker.
An excused withdrawal indicates the market maker wants to take a break from trading activities entirely. But, if the firm wants to remain in the system, they can agree to fill orders at another member's quotations being disseminated through the NASDAQ system.
Getting registered to act as a market maker takes much more effort than adding securities to the list of stocks in which the firm trades. In fact, for a newly authorized security, a registered market maker's registration for that security is effective immediately if the request was made within five business days (after) of the security's inclusion in the system. Even if the request is made more than five business days after the security starts trading on NASDAQ, the registration would be effective on the next business day.
Normal business hours for the NASDAQ system are from 9:30 AM – 4:00 PM Eastern, and market makers are required to be open for business during those times. Firms can voluntarily trade either before or after the normal trading session. The early session runs from 7:00 AM to 9:30 AM Eastern, and the late session from 4:00 PM to 8:00 PM. Trading that occurs before or after normal business hours carries certain risks, which is why firms must provide their customers with an extended hours trading risk disclosure before allowing them to trade outside the "regular trading hours" of 9:30 AM – 4:00 PM. Such risks pointed out to customers include:
•    Lower liquidity
•    Higher volatility
•    Risk of news announcements (which are usually made after normal trad¬ing hours)

Order-Entry Firms
Market makers buy and sell securities for their own account. Order-entry firms enter orders into the NASDAQ system. They do not buy and sell for their own account the way a market making firm does. As the SEC explains, "Order entry firms route orders to the NASDAQ Market Center for execution against displayed orders and quotations, and for display under the anonymous SIZE MPID. Order entry firms may not display trading interest under an attributable MPID."
So, some broker-dealers make markets. Some broker-dealers merely enter orders to buy and sell NASDAQ stocks on behalf of their customers, routing such orders to the market maker with the best quote for the security.
Order-entry firms use the NASDAQ subscription service called ACES (Advanced Computerized Execution System) to quickly route their orders to their preferred market makers' internal trading systems for execution. The order-entry firm sends the order through the ACES system from its NASDAQ terminal. The system sends a confirmation back to the order-entry firm once the trade has been executed by the market maker.
There is no maximum size for orders entered through the system, and it is used for NASDAQ stocks trading on any of the three tiers (Global Select, Global, Capital Market). The ACES system also provides automatic ACT reporting, a reporting system explored in more detail up ahead.

Non-NASDAQ OTC
Companies such as Oracle, Cisco, Microsoft, and Google are NASDAQ OTC stocks. Non-NASDAQ OTC stocks include companies many have never heard of:
 
Auburn Bancorp, Inc.    ABBB
Applied Enrgetics Preferred    AERGP
Dakota Gold Corporation    DAKO
Global Stevia Corp    GSTV
China Ginseng Holdings    CSNG
The above companies' stocks trade through the Over-the-Counter Bulletin Board (OTCBB), where there are over 3,300 securities trading by way of more than 200 market makers. The OTCBB (Over-the-Counter Bulletin Board) is a trading system that is both over-the-counter and Non-NASDAQ, As FINRA points out: any reference to the OTC Bulletin Board should never include the word "listed" and should not be associated with "NASDAQ®."

FINRA explains:            
Exchanges (such as NASDAQ and the NYSE) have specific quantitative and qualitative listing and maintenance standards, which are stringently monitored and enforced Companies listed on an exchange have reporting obligations to the market, and an on-going regulatory relationship exists between the market and its listed companies. OTC quotation services (OTCBB, OTC Markets) facilitate quotation of unlisted securities. As such, any regulatory relationship between an OTC quotation service and the issuers may be relatively limited or non-existent. 
  
A stock such as MSFT or IBM must meet the listing and maintenance standards of the NASDAQ or NYSE, "which are stringently monitored and enforced" by those exchanges. On the other hand, the OTCBB and OTC Markets only facilitate quota¬tions for those who want to trade in securities that trade over-the-counter but not on NASDAQ
NASDAQ defines the Over the Counter Bulletin Board (OTCBB) as:               
An electronic quotation medium for subscribing members to reflect market making interest in OTCBB-eligible securities. Subscribing market makers can utilize the Service to enter, update, and display their proprietary quotations in individual securities on a real-time basis. 
  
Regardless of how much or how little the OTCBB monitors the issuers whose securities trade there, FINRA monitors and regulates the broker-dealers who trade securities through the system as market makers. In other words, the issuer known as China Ginseng Holdings do not have to meet rigid criteria to have its stock trade through the OTCBB system; however, the broker-dealers making markets in that stock are regulated by FINRA, the SEC, etc.
Many investors think the OTCBB is all about matching their orders with other buyers or sellers. No, in the OTCBB market, a market maker sets the market price. He buys from a seller and then decides how much to charge a buyer.
Securities eligible to trade through the OTCBB system meet the following criteria:
•    security is not listed on a national securities exchange in the US, and
•    issuer is subject to SEC reporting requirements and is current in filing those reports or the issuer is a banking institution/bank holding company not subject to SEC reporting and is current in its filings with its appropriate banking/financial regulator
If the issuer is not current in its SEC regulatory filings, the modifier E will appear next to the stock symbol, e.g., ABCDE. At that point, the issuer has 30 days to get right with the regulators at the SEC (or 60 days if it reports to a banking regulator only). If not, the issuer's securities will be removed from the OTCBB until they get their regulatory filings in order.
Does that mean the securities can no longer trade anywhere? No, as we'll see, there are areas of the OTC Markets where such outcast securities are welcomed. The OTCBB is the part of the Non-NASDAQ OTC where issuers are current in their filings with the SEC. The OTC Markets/Pink Quote, on the other hand, is the part of the Non-NASDAQ OTC market where issuers may or may not be current in their SEC filings.
Either way, this is the Non-NASDAQ Over-the-Counter market, meaning the issuers do not have to meet stringent requirements in terms of financial strength and are not monitored and regulated by an exchange. The Non-NASDAQ part of the Over-the-Counter market also isn't subject to the rigorous oversight of trading that insists on transparency and best execution and that sort of thing.
OTC-eligible securities include domestic equities not trading on a national exchange in the US, ADRs not trading on a national exchange in the US that are registered with the SEC and current in their reporting, stocks undergoing the de-listing process from NYSE, NYSE Amex, or NASDAQ, and direct participation programs not listed on a national exchange that are current in their reports. As the FINRA rule relating to the OTCBB system indicates:

Notwithstanding the foregoing paragraphs, a member shall not be permitted to quote a security
  • The issuer of the security has failed to file a complete required annual or quarterly report by the due date for such report three times in the prior two-year period
  • The security has been removed from the OTCBB due to the issuer's failure to satisfy [the requirements] above, two times in the prior two-year period.
In other words, if the issuer is not going to report on time to the SEC, it is not going to be quoted long through the OTCBB.

A security removed from the OTCBB system might start trading through the OTC Markets Group.

There are three different tiers for this electronic trading facility. As their website indicates, "Due to the wide range of OTC companies, OTC Markets Group developed the OTC Market Tiers to help bring increased clarity, transparency and disclosure to the OTC Market. Securities are assigned a Market Tier based on their reporting method (SEC Reporting, Alternative Reporting Standard) and disclos¬ure category Current, Limited or No Information." From the highest to lowest tier, we have the:
  • OTCQX - best OTC companies with the highest financial standards and superior information availability
  • OTCQB - current in their reporting with a U.S. regulator. There are no financial or qualitative standards to be in this tier
  • OTC Pink - includes shell or development stage companies with little or no operations as well as companies without audited financials and as such should be considered extremely speculative by investors.
Not long ago non-NASDAQ securities were traded so infrequently there was a "three-quote rule" or "contact rule" that required broker-dealers to get three estimates before filling a customer order. Now that the electronic trading systems above are available, the requirement to get quotes from different market makers is waived if there are at least two priced quotations displayed in the OTCBB or OTC Pink marketplace

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