Notice2023-19728
Self-Regulatory Organizations; The Nasdaq Stock Market LLC; Notice of Filing of Amendment No. 2 and Order Granting Accelerated Approval of a Proposed Rule Change, as Modified by Amendment No. 2, To Amend Rules 4702(b)(14) and (b)(15) Concerning Dynamic M-ELO Holding Period
Primary source
Metadata and text below are from the Federal Register, a public-domain U.S. government work. Always verify the official published version before relying on it for any legal matter.
Published
September 13, 2023
Issuing agencies
Securities and Exchange Commission
Full Text
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<title>Federal Register, Volume 88 Issue 176 (Wednesday, September 13, 2023)</title>
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[Federal Register Volume 88, Number 176 (Wednesday, September 13, 2023)]
[Notices]
[Pages 62850-62863]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2023-19728]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-98321; File No. SR-NASDAQ-2022-079]
Self-Regulatory Organizations; The Nasdaq Stock Market LLC;
Notice of Filing of Amendment No. 2 and Order Granting Accelerated
Approval of a Proposed Rule Change, as Modified by Amendment No. 2, To
Amend Rules 4702(b)(14) and (b)(15) Concerning Dynamic M-ELO Holding
Period
September 7, 2023.
I. Introduction
On December 21, 2022, The Nasdaq Stock Market LLC (``Nasdaq'' or
``Exchange'') filed with the Securities and Exchange Commission
(``Commission''), pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a
proposed rule change to replace the static holding period requirements
for Midpoint Extended Life Orders and Midpoint Extended Life Orders
Plus Continuous Book with dynamic holding periods. The proposed rule
change was published for comment in the Federal Register on January 10,
2023.\3\ On February 22, 2023, pursuant to Section 19(b)(2) of the
Act,\4\ the Commission designated a longer period within which to
approve the proposed rule change, disapprove the proposed rule change,
or institute proceedings to determine whether to disapprove the
proposed rule change.\5\ On March 9, 2023, the Exchange filed Amendment
No. 1 to the proposed rule change, which amended and superseded the
proposed rule change as originally filed. On April 7, 2023, the
Commission provided notice of filing of Amendment No. 1 and instituted
proceedings to determine whether to approve or disapprove the proposed
rule change, as modified by Amendment No. 1.\6\ On July 6, 2023,
pursuant to Section 19(b)(2) of the Act,\7\ the Commission designated a
longer period on proceedings to determine whether to approve or
disapprove the proposed rule change.\8\ On July 18, 2023, the Exchange
filed Amendment No. 2 to the proposed rule change, which amended and
superseded the proposed rule change as amended by Amendment No. 1. The
Commission received comments on the proposed rule change.\9\ The
Commission is publishing this Notice and Order to solicit comment on
Amendment No. 2 in Sections II and III below, which sections are being
published verbatim as filed by the Exchange, and to approve the
proposed rule change, as modified by Amendment No. 2, on an accelerated
basis.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 92844 (January 4,
2023), 88 FR 1438.
\4\ 15 U.S.C. 78s(b)(2).
\5\ See Securities Exchange Act Release No. 96963, 88 FR 12710
(February 28, 2023).
\6\ See Securities Exchange Act Release No. 97263, 88 FR 22498
(April 13, 2023).
\7\ 15 U.S.C. 78s(b)(2).
\8\ See Securities Exchange Act Release No. 97844, 88 FR 44423
(July 12, 2023).
\9\ All comments received by the Commission on the proposed rule
change are available on the Commission's website at: <a href="https://www.sec.gov/comments/sr-nasdaq-2022-079/srnasdaq2022079.htm">https://www.sec.gov/comments/sr-nasdaq-2022-079/srnasdaq2022079.htm</a>.
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II. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The Exchange proposes to amend Rules 4702(b)(14) and (b)(15) of the
Exchange's Rulebook to replace the static holding period requirements
for Midpoint Extended Life Orders and Midpoint Extended Life Orders
Plus Continuous Book with dynamic holding periods. This Amendment No. 2
[[Page 62851]]
supersedes the original filing and Amendment No. 1 \10\ in their
entireties.
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\10\ See SR-Nasdaq-2022-079 Amendment No. 1 (March 9, 2023), at
<a href="https://www.sec.gov/comments/sr-nasdaq2022-079/srnasdaq2022079-20159016-327215.pdf">https://www.sec.gov/comments/sr-nasdaq2022-079/srnasdaq2022079-20159016-327215.pdf</a>.
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The text of the proposed rule change is available on the Exchange's
website at <a href="https://listingcenter.nasdaq.com/rulebook/nasdaq/rules">https://listingcenter.nasdaq.com/rulebook/nasdaq/rules</a>, at
the principal office of the Exchange, and at the Commission's Public
Reference Room.
III. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the Exchange included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. The Exchange has prepared summaries, set forth in
sections A, B, and C below, of the most significant aspects of such
statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
1. Purpose
The Exchange proposes to amend Rules 4702(b)(14) and (15) of the
Exchange's Rulebook to replace the static 10 millisecond holding period
requirements for its Midpoint Extended Life Order (``M-ELO'') and
Midpoint Extended Life Order Plus Continuous Book (``M-ELO+CB'') Order
Types with dynamic holding periods (``Dynamic M-ELO and M-ELO+CB'' or
collectively, ``Dynamic M-ELO'').
Background
In 2018, the Exchange introduced the M-ELO, which is a Non-
Displayed Order priced at the Midpoint between the National Best Bid
and Offer (``NBBO'') and which is eligible for execution only against
other eligible M-ELOs and only after a minimum of one-half second
passes from the time that the System accepts the order (the ``Holding
Period'').\11\ In 2019, the Exchange introduced the M-ELO+CB, which
closely resembles the M-ELO, except that a M-ELO+CB may execute at the
midpoint of the NBBO, not only against other eligible M-ELOs (and M-
ELO+CBs), but also against Non-Displayed Orders with Midpoint Pegging
and Midpoint Peg Post-Only Orders (``Midpoint Orders'') that rest on
the Continuous Book for at least one-half second and have Trade Now
enabled.\12\
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\11\ See Securities Exchange Act Release No. 34-82825 (March 7,
2018), 83 FR 10937 (March 13, 2018) (SR-NASDAQ-2017-074) (``M-ELO
Approval Order'').
\12\ See Securities Exchange Act Release No. 34-86938 (September
11, 2019), 84 FR 48978 (September 17, 2019) (SR-NASDAQ-2019-048)
(``M-ELO+CB Approval Order'').
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When the Exchange designed M-ELO, it originally set the length of
the Holding Period at one-half second because it determined that this
time period would be sufficient to ensure that likeminded investors
would interact only with each other, and with minimal market impacts.
The Exchange believed that the longer length of the M-ELO Holding
Period and its simplicity in design would provide greater protection
for participants than they could achieve through competing delay
mechanisms.
In 2020, however, the Exchange shortened the length of the Holding
Period to 10 milliseconds.\13\ The Exchange did so after studying two
years of actual use and performance of M-ELOs, as well as customer
feedback. That is, the Exchange came to understand that, while users of
M-ELO and M-ELO+CB are less concerned with achieving rapid executions
of their Orders than are other participants, they are not indifferent
about the length of time in which their M-ELOs and M-ELO+CBs must wait
before they are eligible for execution. Indeed, participants informed
the Exchange that in certain circumstances, such as when they sought to
trade symbols that on average had a lower time-to-execution than a
half-second, they were reticent to enter M-ELOs or M-ELO+CBs. They
indicated that the associated Holding Periods for these Order Types
were longer than necessary to achieve the desired protections and that,
during the residual portion of the Holding Periods, they risked losing
out on favorable execution opportunities that would otherwise be
available to them had they placed a non-MELO order.
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\13\ See Securities Exchange Act Release No. 34-88743 (April 24,
2020), 85 FR 24068 (April 30, 2020) (SR-NASDAQ-2020-011) (``M-ELO
Timer Approval Order'').
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Based upon this feedback, the Exchange studied the potential
effects of reducing the length of the Holding Periods for both M-ELOs
and M-ELO+CBs (as well as for Midpoint Orders that would execute
against M-ELO+CBs). Ultimately, the Exchange determined that it could
reduce the Holding Periods to 10 milliseconds without compromising the
protective power that M-ELO and M-ELO+CB are intended to provide to
participants and investors.\14\ Thus, the Exchange determined that
shortening the Holding Periods to 10 milliseconds for M-ELOs and M-
ELO+CBs would increase the efficacy of the mechanism while not
undermining the power of those Order Types to fulfill their underlying
purpose of minimizing market impacts. At the same time, the Exchange
determined that a reduction in the Holding Periods to 10 milliseconds
would dramatically add to the circumstances in which M-ELOs and M-
ELO+CBs would be useful to participants. In its M-ELO Timer Approval
Order, the Commission agreed with the Exchange:
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\14\ The Exchange examined each of its historical M-ELO
executions to determine at what Midpoints of the NBBO the M-ELOs
would have executed if their Holding Periods had been shorter than
one-half second (500 milliseconds). After examining the historical
effects of shorter Holding Periods of between 10 milliseconds and
400 milliseconds, the Exchange determined that a reduction of the M-
ELO Holding Period to as short as 10 milliseconds would have caused
an average impact on mark-outs of only 0.10 basis points (across all
symbols). In other words, compared to the execution price of an
average M-ELO with a one-half second Holding Period, the Exchange
found that a M-ELO with a 10 millisecond Holding Period would have
had an average post-execution impact that was only a tenth of a
basis point per share--a difference in protective effect that is
immaterial. See Nasdaq, ``The Midpoint Extended Life Order (M-ELO);
M-ELO Holding Period,'' available at <a href="https://www.nasdaq.com/articles/the-midpoint-extended-life-order-m-elo%3A-m-elo-holding-period-2020-02-13">https://www.nasdaq.com/articles/the-midpoint-extended-life-order-m-elo%3A-m-elo-holding-period-2020-02-13</a> (analyzing effects of shortened Holding Periods on
M-ELO performance).
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The Commission notes that, with the proposed ten-millisecond
Holding Period and Resting Period, M-ELOs and M-ELO+CBs would continue
to be optional order types that are available to investors with longer
investment time horizons, including institutional investors. The
Commission also believes that the proposal could make M-ELOs and M-
ELO+CBs more attractive for securities that on average have a time-to-
execution of less than one-half second and, for investors who currently
do not use M-ELOs and M-ELO+CBs for these securities, provide optional
order types that could enhance their ability to participate effectively
on the Exchange. The Commission notes that, if market participants
determine that the proposal would make M-ELOs and M-ELO+CBs less
attractive for their particular investment objectives, such market
participants may elect to reduce or eliminate their use of these
optional order types. Moreover, as noted above, the Exchange will
continue to conduct real-time surveillance to monitor the use of M-ELOs
and M-ELO+CBs to ensure that such usage remains appropriately tied to
the intent of the order types. If, as a result of such surveillance,
the Exchange determines that the shortened
[[Page 62852]]
Holding Period does not serve its intended purpose or adversely impacts
market quality, the Exchange would seek to make further
recalibrations.\15\
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\15\ M-ELO Timer Approval Order, supra, at 85 FR 24069.
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For similar reasons and with even better potential results for
participants, the Exchange now proposes to further refine the length of
the Holding Periods for M-ELOs and M-ELO+CBs, this time through the
application of innovative and patent pending machine learning
technology.
Dynamic M-ELO
After receiving feedback from participants that even 10 millisecond
Holding Periods for M-ELO and M-ELO+CB may, at times, exceed what is
necessary to accomplish the underlying intent of these Order Types, the
Exchange began to experiment with making further refinements to the
duration of the Holding Periods. Ultimately, the Exchange concluded
that shorter Holding Periods could achieve the same, if not better
results for participants in terms of mark-outs, but not in all
circumstances. That is, where prices of the underlying securities are
stable, and not subject to imminent unfavorable changes, M-ELOs and M-
ELO+CBs face lower risks of confronting spread-crossing orders, such
that shorter Holding Periods could suffice to protect M-ELOs and M-
ELO+CB from such orders. In periods of heightened price volatility,
however, M-ELOs and M-ELO+CBs also face heightened risks, such that
longer Holding Periods would continue to be beneficial in protecting M-
ELOs and M-ELO+CBs from such risks. Thus, the Exchange determined that
another across-the-board reduction of the static 10 millisecond Holding
Periods would be sub-optimal because it could impact the performance of
the M-ELO and M-ELO+CB Order Types during periods of heightened
volatility.
In light of these observations, the Exchange tasked its artificial
intelligence and machine learning laboratory (the ``AI Core Development
Group'') to explore whether it could employ these innovative
technologies to optimize the length of M-ELO and M-ELO+CB Holding
Periods during various states of price volatility, and then to vary the
lengths of the Holding Periods dynamically during the lifecycles of M-
ELOs and M-ELO+CBs, with the objectives of improving the performance of
these Order Types while also further reducing opportunity costs.
As the Exchange explains in greater depth in the attached White
Paper,\16\ the AI Core Development Group proceeded to develop an
artificial intelligence-based timer control system that will achieve
these objectives.\17\ The AI Core Development Group did so by using
reinforcement learning techniques--machine learning paradigms which
develop optimal solutions to problems over time by taking actions to
solve them, generating feedback on the results of such actions,
applying that feedback to direct and improve the next round of
solutions, and then repeating the feedback loop until the paradigm
achieves optimized solutions.
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\16\ See Diana Kafkes et al., ``Applying Artificial Intelligence
& Reinforcement Learning Methods Towards Improving Execution
Outcomes,'' SSRN, October 19, 2022, available at <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4243985">https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4243985</a> (attached hereto
[sic] without modification from the prior version as Exhibit 3(a))
(the ``White Paper'').
\17\ Although the AI Core Development Group acknowledges that an
optimal Holding Period would update with every incoming order, it
determined that training a reinforcement learning model on every
order would be too difficult to program and too difficult to
implement given the nanosecond latency requirements of the Exchange.
The Group then investigated more feasible update cadences and
determined the point at which optimal outcomes were best balanced
with the level of programming and implementation difficulty to be
between 15 and 30 second updates. Ultimately, the Group chose a 30
second update cadence to give the model the greatest opportunity to
learn between potential actions.
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In this instance, the AI Core Development Group applied
reinforcement learning techniques to a simulation of the M-ELO Book
that it constructed using a representative data set from the first
quarter of 2022 (the ``Training Period''). The Training Period data
consisted of 380 out of the 6,257 symbols on the M-ELO Book (accounting
for approximately 67 percent of M-ELO volume). The symbols chosen
reflect both actively-traded and thinly-traded securities, and both
low-priced and high-priced securities.
The AI Core Development Group then developed a machine learning
model and applied it to the Training Period data. The Group programmed
the model to value the achievement of higher fill rates or lower mark-
outs than that which occurred in a historical simulation of M-ELOs and
M-ELO+CBs involving the Training Period data.\18\ The Group then
programmed the model to seek to achieve its goals by taking one of five
possible actions with respect to the duration of the Holding Periods at
30 second intervals \19\ for each symbol during each trading day of the
Training Period. That is, at each 30 second internal, the model
evaluated market conditions for each symbol over the prior 30 second
period and either kept the Holding Periods the same, increased/
decreased them by 0.25 milliseconds, or increased/decreased them by
0.50 milliseconds.\20\ After each decision-making round, the model
utilized the results to inform its actions at the next 30 second
increment.
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\18\ As the White Paper explains, the Group developed a model to
simulate activity on the Exchange involving M-ELOs and M-ELO+CBs
during the Training Period. See White Paper, supra, at 10.
\19\ See id.
\20\ The AI Core Development Group experimented with a range of
permissible Holding Period durations. Ultimately, it concluded that
it could produce better outcomes for M-ELO and M-ELO+CB participants
than the existing approach using Holding Periods as low as 0.25
milliseconds and as high as 2.5 milliseconds, under normal market
conditions.
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In making its decisions, the model (again, drawing upon a
combination of historical SIP and M-ELO-specific data) considered 142
categories of data points.\21\ A confluence of data points that
correlated with an increase in volatility tended to cause the model to
increase the durations of Holding Periods, including increases in the
standard deviation of NBBO prices, the number of unique participants
placing sell orders on M-ELO and M-ELO+CB, and the volume-weighted
average of the NBBO spread. Conversely, a confluence of data points
that correlated with greater price stability tended to cause the model
to decrease the durations of Holding periods, such as an increase in
the median and max number of shares per trade and the number of resting
bids left in the M-ELO and M-ELO+CB Book.
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\21\ Nasdaq attaches a full list of these data elements
(attached hereto [sic] as ``Exhibit 3(b))'', along with an
observation of the strength of the correlations that currently exist
between changes to those data values and decisions the system makes
to set the duration of Holding Periods at any given time. The
Exchange notes that the version of this list attached to this
Amendment No. 2 supersedes prior versions attached to prior versions
of this filing. This version of the list includes expanded
explanations of the terminology used therein. See also White Paper,
supra, at 31, for a description of these features.
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The AI Core Development Team produced variations of its model that
prioritized achievement of the lowest mark-outs, the highest fill
rates, and a blend of these two objectives.\22\ Through
[[Page 62853]]
a process of learning and experimentation involving a combination of
historical and simulated data, the AI Core Development Group settled on
a Dynamic M-ELO model that achieved substantial simulated performance
improvements for users of M-ELO and M-ELO+CB--both in terms of mark-
outs and fill rates--as compared to the static 10 millisecond Holding
Periods. As the White Paper explains in greater detail, Dynamic M-ELO
yielded an average combined volume-weighted (simulated) improvement of
31.7 percent, including a 20.3 percent increase in fill rates and a
11.4 percent reduction in mark-outs.\23\ The White Paper provides a
more fulsome explanation of these improvements.\24\
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\22\ The AI Core Development Group also applied to the model a
paradigm called ``retraining'' to combat the degradation of model
performance that can otherwise occur as the reference data it uses
for initial comparison becomes stale. Finally, the AI Core
Development group added a stability protection mechanism to the
model to provide maximum production to participants in the event
that the model observes extraordinary levels of instability in the
National Best Bid and Offer during the prior three seconds as
compared to reference data. When the model detects such instability,
it is programmed to increase the length of the Holding Period to 12
milliseconds for a period of 750 milliseconds.
\23\ See White Paper, supra, at 22.
\24\ See id.
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Based upon these exciting results, the Exchange now proposes to
amend Rule 4702(b)(14) and (15) to replace the static 10 millisecond
timers applicable to M-ELO and M-ELO+CB with Dynamic M-ELO Holding
Periods. Using the Exchange's ``proprietary assessment of market
conditions'' \25\ and patent pending technology, the Dynamic M-ELO
system will evaluate and, as it deems necessary, adjust the length of
the Holding Periods for each symbol comprising M-ELOs and M-ELO+CBs
(and Midpoint Orders on the Continuous Book that opt to interact with
M-ELO+CBs after resting on the Book) every 30 seconds throughout the
Market Hours (each such 30 second interval, a ``Change Event''). In so
doing, Dynamic M-ELO will help participants to achieve a more optimized
blend of the underlying purposes of the M-ELO and M-ELO+CB Order Types:
protection against adverse selection (low mark-outs) without
sacrificing opportunities to achieve high-quality executions (high fill
rates).
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\25\ As set forth in the proposed rule text, the phrase
``proprietary assessment of market conditions'' refers to the
Exchange's evaluation of prevailing market conditions for a given
symbol using an algorithm programmed to set a Holding Period
duration which, at each Change Event, achieves an optimal blend of
two objectives: maximization of M-ELO fill rates; and minimization
of M-ELO mark-out rates. As the rule text states and as is discussed
below, the algorithm ingests and analyzes 142 data points, which the
Exchange identifies and describes in Exhibit 3b hereto. The Exchange
derives these data from a combination of public data and M-ELO data
feeds. Furthermore, the Exchange conducts weekly re-trainings of the
algorithm, outside of Market Hours, to improve its performance
relative to the immediately preceding period (in terms of the two
aforementioned objectives). The Exchange deploys a retrained version
of the algorithm only if it determines that doing so will, in fact,
improve its performance relative to the immediately preceding
period. The Exchange provides further information about the
algorithm and the retraining process in a White Paper attached
hereto [sic] as Exhibit 3a.
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A proposed M-ELO or M-ELO+CB with a Dynamic Holding Period will
operate as follows. At the outset of Market Hours (approximately
9:30:00 a.m.), the Exchange will impose initial Holding Periods of 1.25
milliseconds for M-ELOs and M-ELO+CBs in all symbols. Thereafter,
Holding Periods for a given symbol will become eligible to change
dynamically from the initial duration beginning at 9:30:30 a.m. and
then at 30 second intervals thereafter during Market Hours. The
Exchange will then apply to the M-ELO or M-ELO+CB Order a Holding
Period that is of the duration that prevailed at the time of entry. For
example, if participant A enters a M-ELO for symbol XYZ at 9:30:25
a.m., then Holding Period for that M-ELO will be 1.25 milliseconds. If
at 9:30:30:00 a.m., the System decides to lower the duration of the
Holding Period by 0.50 milliseconds, and then participant B enters a M-
ELO for symbol XYZ at 9:30:45 a.m., then the System will assign a 0.75
millisecond Holding Period to participant B's M-ELO. To be clear, the
System will determine Dynamic M-ELO Holding Periods independently for
M-ELOs and M-ELO+CBs in each symbol.
During normal market conditions, the range of potential Holding
Period durations for M-ELOs and M-ELO+CBs will be between 0.25-2.50
milliseconds, with the Holding Period duration being eligible to change
by increments of either 0.25 or 0.50 milliseconds at each Change Event.
Thus, if the Holding Period for a M-ELO in symbol XYZ is set at 0.75
milliseconds at 2:22:11 p.m., and at 2:22:41 p.m., the System
determines to increase the duration of the Holding Period, it may do so
only by 0.25 or 0.50 milliseconds during that event.
When a Change Event occurs, and the System determines to adjust the
duration of a Holding Period for a symbol, that adjustment will apply,
not only to all M-ELOs and M-ELO+CBs for that symbol entered within the
30 second period after the Change Event occurs, but also to M-ELOs and
M-ELO+CBs entered prior to the Change Event with unexpired Holding
Periods (with applicability retroactive to the time of Order
acceptance). Thus, if a participant enters a M-ELO in symbol XYZ at
1:14:299 p.m., and the prevailing Holding Period applicable to that M-
ELO is 2 milliseconds, and at 1:14:30 p.m., the System modifies the
Holding Period to be 1.5 milliseconds, then the M-ELO will become
eligible to execute at 1:14:3005 p.m. This is the case because the M-
ELO will have already expended 1 millisecond of its Holding Period as
of the time of the Change Event; thereafter, the M-ELO will need to
rest only another 0.5 milliseconds to become eligible to execute under
the new 1.5 millisecond Holding Period (as measured from 1:14:299
p.m.). This last feature ensures that the M-ELO Book maintains time
priority among M-ELOs and M-ELO+CBs in a dynamic environment. That is,
it ensures that no M-ELO or M-ELO+CB with an unexpired Holding Period
at the time of a Change Event will end up becoming eligible to execute
later than a M-ELO entered after the Change Event which has a shorter
Holding Period applicable to it.
If at any time, the System detects extraordinary instability in a
symbol, then the System will activate a ``stability protection
mechanism'' to provide an extra layer of protection to M-ELO and M-ELO
users from the heightened risks of adverse selection that exists during
such periods of instability.\26\ The stability protection mechanism
will override the prevailing Holding Periods for M-ELOs and M-ELO+CBs
in a symbol experiencing extraordinary instability and immediately
increase the duration of those Holding Periods to 12 milliseconds for a
period of 750 milliseconds. The System may activate the stability
protection mechanism even between Change Events. The System will
evaluate, at each NBBO update, whether market conditions remain
extraordinarily unstable and, if so, it will restart the 750
millisecond Stability Protected Period and maintain the 12 millisecond
Holding Period until conditions stabilize. Once the System determines
that market conditions have stabilized (i.e., all measurements for the
symbol are at or below the threshold value throughout the duration of
the prevailing Stability Protected Period), the System will revert the
duration of the Holding Periods to that which prevailed as of the
Change Event that
[[Page 62854]]
occurred immediately prior to the activation of the stability
protection mechanism or, if the stability protection mechanism was
active when a Change Event occurred, to the duration selected at the
immediately preceding Change Event. The System will then proceed to
reevaluate the duration of the Holding Periods as per the regular
schedule of Change Events.
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\26\ For purposes of this Rule, the System determines that
``extraordinary instability'' for a symbol exists through
observations it makes following every change in the NBBO for that
symbol that occurs during the trading day. When the NBBO changes,
the System looks back at the prior three seconds of trading and
measures the difference between the highest and the lowest NBBO
midpoint values that occurred during that period, and then it
compares that measurement to a threshold value for the symbol. The
System concludes that extraordinary instability exists for a symbol
if the measurement exceeds the threshold value. The threshold value
for a symbol, in turn, is the difference between the highest and the
lowest NBBO midpoint values for the symbol that, if applied to its
trading activity during the prior trading day, would have caused the
System to deem trading in the symbol to be extraordinarily unstable
for as close to one percent of that day as possible.
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The following is an illustration of the operation of the stability
protection mechanism. At 11:10:04 a.m., the prevailing Holding Period
for M-ELOs in symbol XYZ is 1.5 milliseconds. At the same time, the
NBBO for symbol XYZ updates. The System looks back at the prior three
seconds of trading in symbol XYZ and finds that during that period, the
highest observed NBBO midpoint was $10.05, and the lowest was $10.00,
such that the difference between these two values is a range of $0.05.
The System then looks back at trading behavior for symbol XYZ during
the immediately preceding trading day. In doing so, the System
calculates the value of the threshold that would have caused the symbol
to be deemed extraordinarily unstable for one percent of the trading
day; the System determines that this threshold value is a range of
$0.03. The System then compares the $0.03 threshold to its measurement
of the prior three seconds of NBBO changes ($0.05), and concludes that
over these past three seconds, the symbol is extraordinarily unstable.
Accordingly, the System activates the stability protection mechanism
and the Holding Period for M-ELOs in symbol XYZ immediately increases
to 12 milliseconds for a period of 750 milliseconds. However, 5
milliseconds after the Stability Protection Period commences, the NBBO
updates again, thus prompting the System to repeat its assessment of
the stability of the symbol in light of the update. This reassessment
reveals that the symbol remains unstable, such that a new Stability
Protection Period of 750 milliseconds begins at that time (overriding
the pre-existing Period). Over the course of this new Stability
Protection Period, the NBBO shifts two more times, but each of the
ensuing reassessments indicate that the NBBO ranges for the symbol have
fallen below the $0.03 threshold. The Stability Protection Period
elapses 750 milliseconds after it began with the symbol remaining
stable. Thus, the Holding Period reverts to 1.5 milliseconds.
If the Exchange halts trading in a symbol, then upon resumption of
trading, any new M-ELO or M-ELO+CB in that symbol and any pending M-ELO
or M-ELO+CB in that symbol with an unexpired Holding Period will be
subject to a new 12 milliseconds Holding Period (running from the time
when trading resumes) until the next scheduled Change Event, at which
point the System may determine to adjust that Holding Period to a
duration within the range applicable under normal market
conditions.\27\ If, however, the System determines that extraordinary
instability in the symbol exists, it will instead determine to activate
the stability protection mechanism and maintain the duration of the
Holding Period at 12 milliseconds for another 750 milliseconds. This
design will help to ensure that M-ELOs and M-ELO+CBs receive added
protection coming out of halt conditions.\28\
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\27\ Prior to commencement of a new 12 millisecond Holding
Period for a new or pending M-ELO or M-ELO+CB following a Halt, the
System will first determine whether the M-ELO or M-ELO+CB is or
remains eligible for execution. That is, the Holding Period will
commence only if, upon commencement of trading following the Halt,
the midpoint price for the Order is within the limit set by the
participant. If not, the System will hold the Order until the
midpoint falls within the limit set by the participant, at which
time the 12 millisecond Holding Period will commence.
\28\ Also as a safeguard, the System will apply a default
Holding Period of 12 milliseconds to a M-ELO or M-ELO+CB if ever it
fails to receive a signal during a Change Event as to whether the
System should adjust or maintain the duration of the prevailing
Holding Period. The System will continue to apply the default 12
millisecond Holding Period until the next Change Event where the
signal is restored and the System is able to act dynamically again.
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The Exchange notes that same dynamic process described above will
also apply to and govern the time periods during which Midpoint Orders
on the Continuous Book must rest before they will become eligible to
interact with M-ELO+CBs (provided that participants have opted for
their Midpoint Orders to interact with M-ELO+CBs). Thus, the same
Holding Period duration that the System sets for a M-ELO+CB in a symbol
during Regular Market Hours will also be the length of time that a
Midpoint Order must rest on the Continuous Book must rest before it may
interact with a M-ELO+CB.
Apart from these impacts of Dynamic Holding Periods, M-ELOs and M-
ELO+CBs will continue to behave as they do now in all respects, and as
set forth in Rules 4702(b)(14) and (15).
It is important to note that within the parameters discussed herein
and in the White Paper, the Exchange will continue to re-train Dynamic
M-ELO and M-ELO+CB on a weekly basis (outside of market hours) so that
the model will continue to learn from and act upon the basis of more
recent SIP and M-ELO book data sets, and further improve its
performance over time. The retraining process should not result in
dramatic or unpredictable changes to the behavior of Dynamic M-ELO. The
retraining process will not retrain the model from scratch each week;
rather, it will retain the model's existing data inputs, knowledge
base, and objectives--all without alteration. Retraining will result in
new behaviors only as needed to address new scenarios that the model
did not confront previously, and even then, only in a manner designed
to further optimize outcomes, i.e., reduce mark-outs or increase fill
rates. If the System assesses that a retrained model would be worse
than the existing model in achieving its objectives, then the System
will continue to use the existing model and discard the retrained
model. This retraining process is a standard and accepted practice for
use of deep learning models; it helps to ensure that deep learning
models not only work well, but that they continue to work well in
dynamic circumstances.\29\
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\29\ During periods where the model is not undergoing
retraining, the System will behave predictably from day to day, such
that its decisions when presented with given set of facts and
circumstances in a given security on day 1 should be the same as
they would be on day 2.
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The Exchange will not modify the underlying structure of Dynamic M-
ELO and M-ELO+CB without first obtaining the Commission's approval to
do so, including modifications to the data elements the model considers
in making decisions about Holding Period durations, the conditions
under which the model may adjust the duration of Holding Periods, the
frequency with which the model my adjust the Holding Periods, the range
of Holding Period durations available to M-ELOs and M-ELO+CBs, the
increments by which Holding Periods may change at any given Change
Event, and the procedures for triggering, maintaining, and ending 12
millisecond Holding Periods during times of extraordinary
instability.\30\ Although the Exchange will seek Commission approval
prior to changing any of the data elements that the model considers,
the Exchange will not seek Commission approval prior to retraining
[[Page 62855]]
the model to adjust the weighting it applies to those data elements.
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\30\ In addition to the proposed changes described above, the
Exchange proposes to delete an extraneous reference in Rule
4702(b)(15) to M-ELO+CB being eligible to execute against a Midpoint
Order on the Continuous Book if the Continuous Book order has the
``Midpoint'' Trade Now Attribute enabled. In a prior filing, the
Exchange folded the concept of ``Midpoint Trade Now'' into the
general ``Trade Now'' Attribute. See Securities Exchange Act Release
No. 34-92180 (June 15, 2021), 86 FR 33420 (June 24, 2021)(SR-NASDAQ-
2021-044).
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To aid investors in understanding and evaluating Dynamic M-ELO,
Nasdaq will continue to publish weekly and monthly transparency
statistics on <a href="http://Nasdaqtrader.com">Nasdaqtrader.com</a>, as it does now, about the performance
of its M-ELOs and M-ELO+CBs, including statistics listing the weekly
numbers of shares and trades in M-ELOs by symbol, weekly aggregated M-
ELO share and trade data, and monthly aggregated block data.\31\ Nasdaq
also will continue to disclose monthly data on <a href="http://Nasdaq.com">Nasdaq.com</a>, as it does
now (the M-ELO Monthly Report), about M-ELO and M-ELO+CB mark-outs
(quote stability by time horizon) and fill rates.\32\ Moreover, Nasdaq
will add statistics to the M-ELO Monthly Report about how frequently,
on average, the System changes Holding Period durations for the top
decile, median, and bottom decile of symbols, as measured by monthly M-
ELO and M-ELO+CB trading volumes. Nasdaq will retain copies of each
historical iteration of its models as part of its books and records,
and make them available to the Commission upon request, should it wish
to examine them to understand how the model changes over time.
Furthermore, Nasdaq will publish an equity trader alert in advance of
deploying a retrained version of Dynamic M-ELO whenever Nasdaq has
reason to anticipate that the retrained version will produce results
that differ materially from the prior version, i.e., a projected change
in mark-outs or fill-rates of 10% or more in either direction.
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\31\ See <a href="http://www.nasdaqtrader.com/Trader.aspx?id=MELOSymbolData">http://www.nasdaqtrader.com/Trader.aspx?id=MELOSymbolData</a>.
\32\ See, e.g., <a href="https://www.nasdaq.com/docs/M-ELO-Monthly-Report">https://www.nasdaq.com/docs/M-ELO-Monthly-Report</a>. Nasdaq understands that current users of M-ELO and M-ELO
independently monitor the performance of these Order Types. Nasdaq
often receives feedback from such users about M-ELO and M-ELO+CB
performance, which Nasdaq then factors into decisions about
improvements and enhancements. Nasdaq expects that this feedback
loop will continue after implementation of Dynamic M-ELO.
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The Exchange acknowledges that systems necessary to implement
Dynamic M-ELO, including the systems proposed that include model
development and retraining processes, are ``SCI Systems'' within the
meaning of Regulation Systems Compliance and Integrity (``Reg.
SCI''),\33\ and that the Exchange, as an SCI Entity, remains
responsible for compliance with all requirements of Reg. SCI,
including, without limitation, to have policies and procedures
reasonably designed to ensure that its SCI Systems operate in a manner
that complies with the Act and the rules and regulations thereunder and
Exchange's rules and governing documents, among them a plan for
assessments of the functionality of SCI Systems designed to detect
systems compliance issues, including by responsible SCI personnel and
by personnel familiar with applicable provisions of the Act and the
rules and regulations thereunder and Exchange's rules and governing
documents.
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\33\ 17 CFR 242.1000 et seq. As set forth in Reg. SCI, the term
``SCI Systems'' means ``means all computer, network, electronic,
technical, automated, or similar systems of, or operated by or on
behalf of, an SCI entity that, with respect to securities, directly
support trading, clearance and settlement, order routing, market
data, market regulation, or market surveillance.'' Id. at 242.1000.
An ``SCI Entity'' means ``an SCI self-regulatory organization, SCI
alternative trading system, plan processor, exempt clearing agency
subject to ARP, or SCI competing consolidator.'' Id.
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Implementation
The Exchange intends to make the proposed change effective for M-
ELOs and M-ELO+CBs in the Second or Third Quarter of 2023, but that
time frame is subject to change. The Exchange will publish a Trader
Alert in advance of making the proposed change effective.
2. Statutory Basis
The Exchange believes that its proposal is consistent with Section
6(b) of the Act,\34\ in general, and furthers the objectives of Section
6(b)(5) of the Act,\35\ in particular, in that it is designed to
promote just and equitable principles of trade, to remove impediments
to and perfect the mechanism of a free and open market and a national
market system, and, in general to protect investors and the public
interest, by allowing for more widespread use of M-ELOs and M-ELO+CBs.
---------------------------------------------------------------------------
\34\ 15 U.S.C. 78f(b).
\35\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------
When the Commission approved the M-ELO and the M-ELO+CB, it
determined that these Order Types are consistent with the Act because
they ``could create additional and more efficient trading opportunities
on the Exchange for investors with longer investment time horizons,
including institutional investors, and could provide these investors
with an ability to limit the information leakage and the market impact
that could result from their orders.'' \36\ Nothing about the
Exchange's proposal should cause the Commission to revisit or rethink
this determination. Indeed, the proposal will not alter the fundamental
design of these Order Types, the manner in which they operate, or their
effects.
---------------------------------------------------------------------------
\36\ M-ELO Approval Order, supra 83 FR at 10938-39; M-ELO+CB
Approval Order, supra, 84 FR at 48980.
---------------------------------------------------------------------------
Even with Dynamic M-ELO Holding Periods, M-ELOs and M-ELO+CBs will
continue to provide their users with protection against information
leakage and adverse selection--and they will do so at levels which are
substantially undiminished from that which they provide now.\37\
---------------------------------------------------------------------------
\37\ See note 6, supra.
---------------------------------------------------------------------------
At the same time, however, the proposal will benefit market
participants and investors by reducing the opportunity costs of
utilizing M-ELOs and M-ELO+CBs. The proposal, in other words, will re-
calibrate the lengths of the Holding Periods so that M-ELOs and M-
ELO+CBs will operate in the ``Goldilocks'' zone--their Holding Periods
will not be so short as to render them unable to provide meaningful
protections against information leakage and adverse selection, but the
Holding Periods also will not be too long so as to cause participants
and investors to miss out on favorable execution opportunities. Nasdaq
believes the proposal will render M-ELOs and M-ELO+CBs more useful and
attractive to market participants and investors, and this increased
utility and attractiveness, in turn, will spur an increase in M-ELO and
M-ELO+CB use cases on the Exchange, both from new and existing users of
M-ELOs and M-ELO+CBs. Ultimately, the proposal should enhance market
quality by increasing opportunities for midpoint executions on the
Exchange.
As Nasdaq explained above, the Proposal will operate within strict,
well-defined, and transparent parameters. Although it will undergo
weekly retraining (outside of market hours),\38\ such retraining will
aim to improve the performance of the model in achieving its twin
objectives; retraining will not alter the inputs, objectives, or basic
design parameters of Dynamic M-ELO without prior Commission
approval.\39\ Moreover, the Exchange will not deploy a retrained model
if it fails to achieve performance improvements. To aid
[[Page 62856]]
investors in evaluating Dynamic M-ELO, the Exchange will publish
statistics about its performance, including as to mark-outs and fill
rates, as well as statistics about how frequently the System changes
Holding Period durations. To further facilitate accountability, the
Exchange will retain each historical iteration of its model as part of
its books and records, and make such information available to the
Commission, upon request. The Exchange will also publish equity trader
alerts whenever retraining will result in a performance change of 10%
or more.
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\38\ To be clear, performance statistics for Dynamic M-ELO cited
herein and in the White Paper are based upon data derived from
weekly, not daily retrainings.
\39\ As discussed above, Nasdaq will not seek Commission
approval prior to allowing the model, as part of its re-training
process, to vary the weighting of the data elements it ingests.
Nasdaq believes this is appropriate because such variance will only
occur to the extent that it will improve the model's performance
with respect to pre-defined objectives. Nasdaq will alert traders if
the retraining process would result in substantial performance
changes, and it will also publish statistics to help participants to
assess performance themselves. Moreover, Nasdaq will retain
historical iterations of its models for the Commission's review,
should it wish to examine how these models have changed over time.
---------------------------------------------------------------------------
Nasdaq notes that the twin objectives it prescribes for the model
involve the absolute values of mark-outs and fill rates; they are not
designed to further the performance of any participant or any category
of participant. Furthermore, Nasdaq performed internal tests of its AI
model to detect indications of harmful bias in its performance results,
and such tests concluded that no such indications exist. That is, the
Exchange reviewed the impact on fill rates and mark-outs of Dynamic M-
ELO, as compared to the ``static'' M-ELO, for those firms that
accounted for more than 95% of M-ELO activity on the Exchange during Q1
2022.\40\ The Exchange analyzed results both in an absolute and a
relative sense. Testing revealed that all participants experienced at
least some improvements in fill rates and mark-outs when using Dynamic
M-ELO versus static M-ELO, with the volume-weighted average improvement
being aligned with the results expressed in the White Paper. We
detected no material variations that might suggest that a particular
participant or category of participant (i.e., nature of firm; size of
firm) benefitted from Dynamic M-ELO functionality to an extent that was
unreasonably disproportionate to the benefits that other participants
experienced. Thus, Nasdaq believes the model is objective, is designed
to, and does avoid bias and discrimination.\41\
---------------------------------------------------------------------------
\40\ Beyond this grouping of participants, the activity levels
of other individual M-ELO participants were so small as to be
insignificant. In many cases, these participants entered only a
handful of M-ELOs during the study period. As such, the Exchange
believes it is reasonable to exclude such participants from its
analysis to avoid their data distorting the results.
\41\ The Exchange will review its AI model periodically to
affirm that it continues to perform in accordance with the
Exchange's rules and has not introduced any harmful bias in favor of
or against any participant or category of participants.
---------------------------------------------------------------------------
The Exchange notes that use of Dynamic M-ELOs and M-ELO+CBs remains
voluntary for all market participants. Accordingly, if any market
participant feels that the dynamic Holding Periods are still too long
or too short or because competing venues offer more attractive delay
mechanisms, then the participants are free to pursue other trading
strategies or utilize other trading venues. They need not utilize
Dynamic M-ELOs or M-ELO+CBs.
Furthermore, the design of Dynamic-MELO would constitute an
``established, non-discretionary'' method that is consistent with the
definition of an exchange, as set forth in SEC Rule 3b-16.\42\ The
Commission stated as follows when it adopted Rule 3b-16:
---------------------------------------------------------------------------
\42\ See 17 CFR 240.3b-16(a)(2) (``(a) An organization,
association, or group of persons shall be considered to constitute,
maintain, or provide `a market place or facilities for bringing
together purchasers and sellers of securities or for otherwise
performing with respect to securities the functions commonly
performed by a stock exchange,' as those terms are used in section
3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if such organization,
association, or group of persons: (1) Brings together the orders for
securities of multiple buyers and sellers; and (2) Uses established,
non-discretionary methods (whether by providing a trading facility
or by setting rules) under which such orders interact with each
other, and the buyers and sellers entering such orders agree to the
terms of a trade.'').
A system uses established non-discretionary methods either by
providing a trading facility or by setting rules governing trading
among subscribers. The Commission intends for ``established, non-
discretionary methods'' to include any methods that dictate the
terms of trading among the multiple buyers and sellers entering
orders into the system. Such methods include those that set
procedures or priorities under which open terms of a trade may be
determined. For example, traditional exchanges' rules of priority,
parity, and precedence are ``established non-discretionary
methods,'' as are the trading algorithms of electronic systems.
Similarly, systems that determine the trading price at some
designated future date on the basis of pre-established criteria
(such as the weighted average trading price for the security on the
specified date in a specified market or markets) are using
established, non-discretionary methods.\43\
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\43\ See Securities Exchange Act Release No. 40760 (December 8,
1998), 63 FR 70844, 70850 (December 22, 1998).
Nothing in the Reg. ATS Adopting Release or in any of its
illustrative examples suggests that Dynamic M-ELO would constitute an
exercise of discretionary behavior. Dynamic M-ELO will handle and
execute Orders according to published, pre-determined rules that are
disclosed to the public and which provide reasonable notice of how the
Order Type will behave.\44\ To the extent that the design of the System
permits variation in the Holding Periods for such Orders, it does so by
design. The range of potential variations, the objectives that such
variations are intended to achieve, and the factors that determine when
such variations may occur are also predetermined and set forth in the
Exchange's Rules or otherwise disclosed to the public. The mere fact
that the System may apply different weights over time to the factors it
uses to determine whether and by how much to vary a Holding Period does
not mean that the System will act with discretion in the same sense
that a human being could be said to be exercise independent judgment
when deciding whether and how to handle an order.\45\ Even when the
System makes decisions about changing the Holding Periods, the System
will operate pursuant to a mathematical algorithm from which it cannot
deviate--an algorithm that is programmed to achieve pre-defined and
pre-disclosed objectives.\46\
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\44\ See id. at 70900 (``an essential indication of the non-
discretionary status of rules and procedures is that those rules and
procedures are communicated to the systems users'' and ``[t]hus,
participants have an expectation regarding the manner of execution--
that is, if an order is entered, it will be executed in accordance
with those procedures and not at the discretion of a counterparty or
intermediary.'').
\45\ Cf. id. at 70851 (explaining that a traditional block
trading desk is an example of a system that does not use
established, non-discretionary methods because the operators of such
desks do not act according to fixed procedures known to their
customers, but instead shop orders around for potential
counterparties and make their own determinations as to whether and
how to execute block orders, including by sometimes deciding to take
a proprietary position in part of the block order).
\46\ See id. at 80755 (describing an example of a system that
would be non-discretionary in nature: ``System I permits
participants to enter a range of ranked contingent buy and sell
orders at which they are willing to trade securities. These orders
are matched based on a mathematical algorithm whose priorities are
designed to achieve the participants' objectives. System I does not
display orders to any participants. System I is included under Rule
3b-16.''); see also Securities Exchange Act Release No. 34-89686
(August 20, 2020), 85 FR 54438, at 54445, n.92 (September 1, 2020)
(Order approving SR-IEX-2019-15) (rejecting argument that IEX's D-
Limit order time is an exercise of discretion because ``D-Limit
orders will not allow IEX to exercise any discretion on any
particular order by deviating from the CQI and D-Limit
functionality, which is hardcoded in the IEX rulebook.''; Securities
Exchange Act Release No. 34-78101 (June 17, 2016), 81 FR 41141, at
41153(June 17, 2016) (Order approving IEX Form 1 and D-Peg Order
Type) (``the Commission does not believe that the hardcoded
conditionality of the IEX proposed ``discretionary'' peg order type
provides IEX with actual discretion or the ability to exercise
individualized judgment when executing an order. Rather, if IEX's
fixed formula determines the quote to be stable, the discretionary
peg order can execute up to the midpoint; if it does not deem the
quote to be stable, then it will hold the order to its pegged price.
As such, IEX would not exercise discretion over the routing and
execution of a resting order''). Nasdaq does not believe that it is
necessary to codify its mathematical formula for Dynamic M-ELO in
its Rules because Nasdaq has disclosed sufficient information in its
Rules and in its filing to inform the public as to the possible and
expected behaviors associated with Dynamic M-ELO, as well as a means
for the Commission and/or investors to verify whether Dynamic M-ELO
is performing appropriately. Much as the Commission does not require
an exchange to codify the source code it uses to effectuate other
behaviors or actions that it explains in its Rules, including the
behaviors of other complex Order Types, there is no basis to require
codification of the Dynamic M-ELO formula in this instance.
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[[Page 62857]]
The Exchange notes that it will continue to conduct real-time
surveillance to monitor the use of M-ELOs and M-ELO+CBs to ensure that
such usage remains appropriately tied to the intent of the Order Types.
If, as a result of such surveillance, the Exchange determines that the
Dynamic M-ELO Holding Periods do not serve their intended purposes, or
adversely impact market quality, then the Exchange will seek to make
further re-calibrations.
Nasdaq does not believe that the design of Dynamic M-ELO lends
itself to potential manipulation by a single participant or a small
group of participants because the System makes determinations regarding
Holding Periods based upon prevailing market-wide conditions for a
given symbol, rather than the behaviors of particular participants with
respect to that symbol, or the activity of participants in M-ELOs
involving that symbol. Manipulation of the System also would be
difficult to accomplish given the large number of variables that factor
into the System's decisions to change Holding Periods during Change
Events, as well as the different weights that apply to each such
factor, which as described above, the System may vary over time. Any
benefits that a participant might derive from manipulating the duration
of Holding Periods would likely be small and outweighed significantly
by the difficulty and cost of affecting such manipulation.
Nevertheless, the Exchange will surveil for indications of manipulation
and act accordingly if it detects such indications.
B. Self-Regulatory Organization's Statement on Burden on Competition
The Exchange does not believe that the proposed rule change will
impose any burden on competition not necessary or appropriate in
furtherance of the purposes of the Act. To the contrary, the Exchange
believes that this proposal will promote the competitiveness of the
Exchange by rendering its M-ELO and M-ELO+CB Order Types more
attractive to participants.
The Exchange adopted the M-ELO and M-ELO+CB as pro-competitive
measures intended to increase participation on the Exchange by allowing
certain market participants that may currently be underserved on
regulated exchanges to compete based on elements other than speed. The
proposed change continues to achieve this purpose. With Dynamic M-ELO
Holding Periods, both M-ELOs and M-ELO+CBs will afford their users with
a level of protection from information leakage and adverse selection
that is better from what is achievable at present.\47\ At the same
time, the Dynamic Holding Periods will increase opportunities to
interact with other like-minded investors with longer time horizons
while also lowering the opportunity costs for participants that utilize
M-ELOs and M-ELO+CBs, particularly for securities that trade within the
``Goldilocks'' zone. In sum, the proposed changes will not burden
competition, but instead may promote competition for liquidity in M-
ELOs and M-ELO+CBs by broadening the circumstances in which market
participants may find such Orders to be useful. With the proposed
changes, market participants will be more likely to determine that the
benefits of entering M-ELOs and M-ELO+CBs outweigh the risks of doing
so.
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\47\ See White Paper, supra.
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The proposed change will not place a burden on competition among
market venues, as any market may adopt an order type that operates
similarly to a M-ELO or a M-ELO+CB with Dynamic M-ELO Holding Periods.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
No written comments were either solicited or received.
IV. Discussion and Commission Findings
After careful review, the Commission finds that the Exchange's
proposal to adopt Dynamic M-ELO is consistent with the requirements of
the Act and the rules and regulations thereunder applicable to a
national securities exchange.\48\ In particular, the Commission finds
that the proposed rule change, as modified by Amendment No. 2, is
consistent with Sections 6(b)(5) and 6(b)(8) of the Act.\49\ Section
6(b)(5) of the Act requires that the rules of a national securities
exchange be designed, among other things, to prevent fraudulent and
manipulative acts and practices, to promote just and equitable
principles of trade, and, in general, to protect investors and the
public interest, and not be designed to permit unfair discrimination
between customers, issuers, brokers, or dealers.\50\ Section 6(b)(8) of
the Act requires that the rules of a national securities exchange not
impose any burden on competition that is not necessary or appropriate
in furtherance of the purposes of the Act.\51\
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\48\ In approving this proposed rule change, the Commission has
considered the proposed rule's impact on efficiency, competition,
and capital formation. See 15 U.S.C. 78c(f). One commenter
questioned whether Nasdaq's pending patent applications for the
systems it will use to operate Dynamic M-ELO imposes an unnecessary
or inappropriate burden on competition. See Letter from R.T.
Leuchtkafer, dated January 21, 2023 (``Leuchtkafer Letter 1''), at
3. The Commission does not believe that the sole fact that Nasdaq
has a pending patent application for the technology it has developed
to operate the Dynamic M-ELO is indicative that the operation of
Dynamic M-ELO on the Exchange would place an inappropriate burden on
competition. As explained below, Nasdaq has provided sufficient
public disclosure and analysis to explain how Dynamic M-ELO will
operate.
\49\ In addition to providing a statutory analysis in its
filing, Nasdaq also acknowledges, above in Amendment No. 2, that the
systems it will use to implement Dynamic M-ELO, including the
Exchange's model development and retraining processes, are SCI
systems under Regulation SCI, see 17 CFR 242.1000 et seq., and thus,
it will be responsible for compliance with Regulation SCI with
respect to Dynamic M-ELO, including having appropriate policies and
procedures. See supra note 33 and accompanying text.
\50\ 15 U.S.C. 78f(b)(5).
\51\ 15 U.S.C. 78f(b)(8).
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Nasdaq's Obligation To Sufficiently Explain Its Proposed Rule Change
The burden to demonstrate that a proposed rule change is consistent
with the Act and rules and regulations thereunder is on the self-
regulatory organization (``SRO'') proposing a rule change.\52\ Each
proposed SRO rule change must be ``accompanied by a concise general
statement of the basis and purpose of such proposed rule change.'' \53\
As described in more detail below, several commenters argued that the
proposal did not provide sufficient information with respect to the
operation of Dynamic M-ELO, or that the information provided was not
``clear and comprehensible,'' as required by Form 19b-4. For the
reasons articulated below, the Commission believes that Nasdaq has
provided clear and comprehensible information on the overall operation
of Dynamic M-ELO and the role of the machine-learning model and
demonstrated that the proposal is consistent with the Act. Several
related comments addressed this issue; these comments and Nasdaq's
responses are discussed below, followed by the Commission's analysis.
---------------------------------------------------------------------------
\52\ See 17 CFR 201.700(b)(3).
\53\ 15 U.S.C 78s(b)(1).
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One commenter stated that the initial filing would establish ``a
dangerously vague standard for describing how exchange-hosted complex
algorithmic
[[Page 62858]]
order types operate.'' \54\ In response to public comment, Nasdaq added
more details describing the operation of Dynamic M-ELO to both the
filing and public record since this proposed rule change was initially
submitted to the Commission, and Nasdaq also provided additional legal
analysis to support Dynamic M-ELO's consistency with the Act. Prior to
the filing of Amendment No. 1, a commenter stated that although
``Nasdaq shared some of the 142 features of their formula,'' Nasdaq
should reveal all of these features so that prospective users may
evaluate how the model works.\55\ Similarly, another commenter stated
that the public cannot provide meaningful comment on the proposal
without knowing all categories and parameters of the proposed Dynamic
M-ELO.\56\ In its response to these comments, the Exchange, among other
things, provided the specific 142 data elements that will be weighed by
the machine-learning model as both an appendix to its first letter in
response to comments,\57\ and as Exhibit 3B to its Amendment No. 1
filing.
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\54\ See Leuchtkafer Letter 1, supra note 48, at 1-2. See also
Letter from Joseph Saluzzi, Partner, Themis LLC, dated January 25,
2023, at 3 (``Themis Letter'') (questioning whether the complexity
of Dynamic M-ELO is necessary).
\55\ See Themis Letter, supra note 54, at 2.
\56\ See Leuchtkafer Letter 1, supra note 48, at 1.
\57\ See Letter from Brett Kitt, Associate Vice President and
Principal Associate General Counsel, Nasdaq, Inc., dated March 9,
2023, at Appendix A (``Nasdaq First Response to Comments'').
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In response to the Exchange's disclosures in Exhibit 3B of
Amendment No. 1, one of these commenters stated that the list of data
elements was not ``clear and comprehensible'' as is required by the
Form 19-4, but rather ``vague, confusing, and perfunctory.'' \58\ This
commenter also stated that the disclosed data elements included
unexplained terms (e.g., ``baseline simulated,'' ``action simulated,''
and ``synthetic mark-out'').\59\ In a subsequent comment letter, this
commenter reiterated these points; the commenter specified that the
commenter's concern is that Nasdaq's rule text does not disclose
information about its methods for assessing market conditions and that
``Nasdaq should carefully detail its methods in its rulebook, just like
other exchanges have done, and Nasdaq should also thoroughly disclose
its methods in its filing text.'' \60\ In its second response to
comments \61\ and the revised Exhibit 3b to Amendment No. 2, Nasdaq
expanded and ``simplified'' the explanation of these 142 data elements.
The Exchange also added to the proposed rule text a definition of the
term ``proprietary assessment of market conditions'' to explain how the
machine-learning model will evaluate those 142 data elements.\62\
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\58\ See Letter from R.T. Leuchtkafer, dated May 2, 2023, at 8-9
(``Leuchtkafer Letter 2'').
\59\ See id.
\60\ See Letter from R.T. Leuchtkafer dated May 30, 2023, at 3-
5; 8-9 (``Leuchtkafer Letter 3''). This commenter also cites to the
rules governing the Crumbling Quote Indicator and D-Limit order type
on the Investors Exchange (``IEX''), as well as language from the
Commission's approval order for the D-Limit order type. See id. at
4. The commenter notes the level of detail with regard to how and
when the D-Limit order type exercises its discretionary price-
sliding that is set forth in the IEX Rulebook. See id. at 4; see
also Themis Letter, supra note 54, at 2 (``Another exchange, IEX,
operates a smart logic called CQI (Crumbling Quote Indicator) which
aims to protect orders from being adversely selected. IEX has
published detailed notes on how the CQI is calculated.''). Each
proposal must be evaluated based on the specific facts and
circumstances before the Commission. In this case, the Commission is
only reviewing the proposed operation of Dynamic M-ELO and its
machine-learning model. Accordingly, the level of detail provided in
the IEX Rulebook for the D-Limit order type and Crumbling Quote
Indicator--or the rulebooks for order types on other exchanges--does
not determine whether Nasdaq has met its burden in this proposal.
\61\ See Letter from Brett Kitt, Associate Vice President and
Principal Associate General Counsel, Nasdaq, Inc., dated May 18,
2023 at Appendix A (``Nasdaq Second Response to Comments'').
\62\ See supra note 25.
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Furthermore, Nasdaq attached, as Exhibit 3A to its proposed rule
change, the White Paper written by its AI Core Development Team that
explains, among other things, how Dynamic M-ELO's machine-learning
functions were developed and tested. The White Paper includes a general
discussion of the type of model implemented in the proposed system, in
this case a reinforcement learning model,\63\ as well as citations to
academic research behind the Double Deep Q-Network algorithm that is
the basis for the algorithm used in Nasdaq's model.\64\ The White Paper
also describes the ways in which Nasdaq's implementation of the
proposed model differs from the model and training in the academic
research, providing both an English summary and a pseudocode
description of differences in model training implemented by Nasdaq.\65\
---------------------------------------------------------------------------
\63\ See White Paper Section 3.1.
\64\ See White Paper Section 4.1.
\65\ See White Paper, Section 7.2.
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One of the commenters stated that the White Paper is not easily
understood by most market participants and that referencing the White
Paper in the filing is an ``unacceptable substitute'' for a ``plain
English'' explanation of the proposal in Form 19b-4.\66\ In response,
Nasdaq explained that it drafted the filing to provide a general
understanding of Dynamic M-ELO and how it will behave, and the more
detailed information and explanation in the White Paper are meant to
support the filing.\67\
---------------------------------------------------------------------------
\66\ See Leuchtkafer Letter 2, supra note 58, at 3-4;
Leuchtkafer Letter 3, supra note 60, at 4-5; Letter from R.T.
Leuchtkafer, dated August 11, 2023, at 8-10 (``Leuchtkafer Letter
4'').
\67\ See Nasdaq Second Response to Comments, supra note 61, at
3-5.
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The Commission agrees with comments and the Exchange that there is
an extent to which the proposed changes will introduce an unavoidable
degree of uncertainty with respect to the use of these order types. The
deep reinforcement learning model that will determine the dynamic
holding periods for each symbol for M-ELO and M-ELO+CB orders will be
implemented through established, non-discretionary methods,\68\ but it
is so complex that its complete details are, for most intents and
purposes, not readily intelligible, and it would be immensely difficult
for the Exchange or any market participant to precisely predict the
holding periods that will be generated by the model for any given
symbol at any particular time. Nevertheless, as further discussed
below, the Commission believes that the Exchange has provided
information sufficient for the Commission and public to understand the
design, operation, and limits of the proposed changes to these order
types, and the role of the machine-learning model therein.
---------------------------------------------------------------------------
\68\ See infra notes 91-92 and accompanying text.
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While the holding periods under the proposal would be dynamic,
Nasdaq has precisely articulated both the nature of changes that would
be permissible under the proposal, and the limits to those changes.
Nasdaq described when changes might occur (every thirty seconds
throughout the trading day), the initial default holding period for all
symbols (1.25 milliseconds), the permissible increments by which a
holding period might change in each symbol (0.25 or 0.50 milliseconds),
and the outer bounds of permissible holding period lengths (0.25
milliseconds at the short end, and 2.50 milliseconds at the long end).
Nasdaq also described the conditions of ``extraordinary instability''
in a symbol when these holding periods would not apply, and when the
holding periods would be overridden by the proposed ``stability
protection mechanism'' (with a holding period of 12 milliseconds for at
least 750 milliseconds). The Commission believes that these details
provide sufficient information to understand the range of potential
holding periods that may be applied when M-ELO or M-ELO+CB orders are
entered or resting on the order book, the changes that may occur, and
the limits to those changes.
[[Page 62859]]
Nasdaq has also described the role of the machine-learning model in
its proposal. The model will determine whether, by which increment, and
in which direction to adjust the holding period for each symbol
throughout the trading day.\69\ In its Form 19b-4, White Paper, and
response letters, Nasdaq described the goals towards which the model is
optimized: reducing mark-outs and increasing fill rates.\70\ Nasdaq's
White Paper includes a detailed discussion of model choice,
development, and training, including citations to relevant other
research.\71\ Nasdaq also provided several iterations of a list of data
elements that the model will ingest and use, including a glossary
defining terms used in the descriptions.\72\ Nasdaq affirmed that in
operation during market hours, the data used would be calculated based
on intraday market data.\73\ One version of these lists included
Nasdaq's estimates of the tendencies of data elements to affect model
outcomes.\74\ Nasdaq's White Paper also included an ``explainability
study'' that assessed both the effects of individual data elements on
model performance and the effects of interactions between individual
data elements.\75\ Across its filing and incorporated exhibits, aspects
of the model's operations and design are described in different formats
and with different levels of specificity--for example, the filing and
exhibits include ``plain English'' descriptions, mathematical
definitions, and pseudocode. Together, this set of information allows
the Commission to understand the type of decision the model will
implement, the goals the model aims to achieve, which model type is
implemented and how it was developed, the range of data types and data
sources used by the model, and estimates of the manner in which those
data may affect model outcomes.
---------------------------------------------------------------------------
\69\ See supra notes 16-24 and accompanying text.
\70\ See, e.g., Form 19b-4 at 9, White Paper Section 5, and
Nasdaq First Response to Comments at 2. In its White Paper, Nasdaq
provides mathematical definitions of fill rate for a period of time
and mark-out by trade (White Paper at 5, Equations 1 and 2), as well
as of the assessment made by the agent in the model's reinforcement
learning process (White Paper at 11, Equation 3).
\71\ See White Paper Sections 3-5.
\72\ See Exhibit 3B. As described below, these data elements are
also those used in training and retraining the model.
\73\ See Letter from Brett Kitt, Associate Vice President and
Principal Associate General Counsel, Nasdaq, Inc., dated September
6, 2023 (``Nasdaq Third Response to Comments'').
\74\ Nasdaq affirmed that, while this information was not
included in all versions of the list of data elements, it remains
accurate and valid. See id. at 3.
\75\ See White Paper Section 5.3.
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Nasdaq also explains how and when the machine-learning model will
be retrained. Nasdaq will retrain the model weekly, outside of market
hours. Retraining will incorporate market data obtained during the week
from the equity consolidated data feeds and M-ELO order book. A
retrained model will only be promoted to production if it improves upon
the model objectives compared to the prevailing model.\76\ Furthermore,
the Exchange explained that the machine-learning model is consistent in
its behavior from day-to-day during periods when it is not undergoing
retraining, ``such that its decisions when presented with given set of
facts and circumstances in a given security on day 1 should be the same
as they would be on day 2.'' \77\ The Exchange also stated in its
initial response to comments that ``[e]ven after the system undergoes
retraining, which will occur on a weekly basis (and not during market
hours), system behavior should not change dramatically or in unexpected
ways from week-to-week.'' \78\ As noted above as well, the Exchange
also represents that outside of set retraining periods, ``the System
will operate pursuant to a mathematical algorithm from which it cannot
deviate--an algorithm that is programmed to achieve pre-defined and
pre-disclosed objectives.'' \79\ Nasdaq also will publish equity trader
alerts when it anticipates that a model update may change mark-outs or
fill rate by 10% or more in either direction.\80\ By including this set
of information, Nasdaq has provided the Commission and public with
information that allows them to understand how frequently the model
will be retrained, the data used for retraining, and the criteria that
will be used to determine whether to update the production model based
on retraining. This information allows the Commission to understand
when the proposed model may change and when it will remain constant,
the circumstances under which a change would be implemented, and
circumstances under which the public will receive notice of significant
changes in the model's anticipated outcomes.
---------------------------------------------------------------------------
\76\ For example, Nasdaq affirmatively states that if ``a
retrained model would be worse than the existing model in achieving
its objectives, then the System will continue to use the existing
model and discard the retrained model.'' See Section III.A.1.,
supra.
\77\ See Nasdaq First Response to Comments, supra note 57, at 2-
3. See also supra note 30.
\78\ See Nasdaq First Response to Comments, supra note 57, at 2-
3. A commenter also noted that it was initially unclear when and how
frequently the machine-learning model would retrain, stating that
the White Paper set forth an analysis based on daily retraining, but
the rule filing proposes weekly retraining. See Leuchtkafer Letter
2, supra note 58, at 4; Leuchtkafer Letter 3, supra note 60, at 2;
Leuchtkafer Letter 4, supra note 66, at 9. In Amendment No. 2, the
Exchange affirmatively represents that ``the performance statistics
for Dynamic M-ELO cited herein and in the White Paper are based upon
data derived from weekly, not daily retrainings.'' See supra note
38.
\79\ See supra note 46 and accompanying text.
\80\ See, e.g., Amendment No. 2 at 19-20.
---------------------------------------------------------------------------
In addition, a commenter stated their belief that the Exchange's
proposal for Dynamic M-ELO would result in the exercise of discretion
by a national securities exchange because the machine-learning model's
decisions would vary over time based on the following: (1) varying
parameter values; and (2) results of retraining cycles.\81\ The
commenter stated that by making it possible for Dynamic M-ELO to behave
differently when confronted by the same market conditions before and
after the model is retrained, Nasdaq's model would be exercising
discretion that is more akin to a broker than an exchange.\82\
---------------------------------------------------------------------------
\81\ See Leuchtkafer Letter 1, supra note 48, at 2; Leuchtkafer
Letter 2, supra note 58, at 4-6; Leuchtkafer Letter 3, supra note
60, at 5-7; Leuchtkafer Letter 4, supra note 66, at 4-8.
\82\ See Leuchtkafer Letter 1, supra note 48, at 2. See also
Leuchtkafer Letter 3, supra note 60, at 5-7. For example, the
commenter believes that Dynamic M-ELO will ``exercise individualized
judgment'' such that it can set a different time-in-force for the
very same order presented in the very same market conditions on, for
example, August 21 than it set on May 15, depending on the system's
undisclosed individualized judgments of market conditions and
participant behavior from even days or weeks in the past. See
Leuchtkafer Letter 4, supra note 66, at 6.
---------------------------------------------------------------------------
The commenter claimed that Dynamic M-ELO would operate outside of
established non-discretionary methods, which require ``fully disclosed
procedures operating in a strictly linear, invariant, and deterministic
fashion.'' \83\ Additionally, the commenter stated that Nasdaq would be
exercising discretion with Dynamic M-ELO to alter a participant's
material order terms.\84\ The commenter claimed that Nasdaq would be
using undisclosed data such as the
[[Page 62860]]
buyer and seller counts and recent trade sizes.\85\ Further, the
commenter stated:
---------------------------------------------------------------------------
\83\ See Leuchtkafer Letter 2, supra note 58, at 5-6. See also
Leuchtkafer Letter 3, supra note 60, at 5-7. See also Leuchtkafer
Letter 4, supra note 66, at 6-9 ('' . . . . Nasdaq's rulebook won't
set out the `totality of the discretionary feature' (I believe it
can't, because the totality changes week-to-week and even minute-to-
minute) and it won't define the `hardcoded conditionality' of its
feature (again, I believe it can't), and a market participant won't
be able to `recreate on its own' what Dynamic M-ELO has done
(participants can't--it's not even clear anyone will be able to, as
discussed below) . . . . Dynamic M-ELO departs from decades of this
progress. Its behavior will not be deterministic or invariant over
time, and purposefully so.'').
\84\ See Leuchtkafer Letter 2, supra note 58, at 8. See also
Leuchtkafer Letter 3, supra note 60, at 5-7.
\85\ See Leuchtkafer Letter 2, supra note 58, at 8. See also
Leuchtkafer Letter 3, supra note 60, at 5-7; Leuchtkafer Letter 4,
supra note 66, at 5-7.
that (a) by determining the universe of data the system consumes,
(b) by programming how the system thinks, (c) by controlling and
supplying the information with which it thinks, and (d) by setting
the goals and programming the nature and extent of its actions, and
when it does all this to determine (e) when and in which prescribed
intervals to set an ever variable time-in-force term for an order, a
term which (f) dictates when to expose an order to the market to
find contra-side interest, then without question Nasdaq is
exercising control, judgment, and discretion over its customer
---------------------------------------------------------------------------
orders.
In Amendment No. 1, Nasdaq added language to address these
concerns.\86\ Among other things, Nasdaq stated that to the extent that
the design of Dynamic M-ELO permits variation in the Holding Periods
for such orders, it does so by design, and the ``mere fact that the
System may apply different weights over time to the factors it uses to
determine whether and by how much to vary a Holding Period does not
mean that the System will act with discretion in the same sense that a
human being could be said to be exercise independent judgment when
deciding whether and how to handle an order.'' \87\ Additionally,
Nasdaq stated the following in its second response to comments:
---------------------------------------------------------------------------
\86\ See supra notes 42-46.
\87\ See supra note 45 and accompanying text.
It is also worth noting that presently, exchanges like Nasdaq
already employ non-linear, non-deterministic functionalities, like
the randomized timers it uses to resolve certain unavoidable race
conditions that arise in the order handling process. Nasdaq employs
these functionalities with the knowledge of the SEC, and without any
suggestion that they somehow transform Nasdaq into a broker.\88\
---------------------------------------------------------------------------
\88\ See Nasdaq Second Response to Comments, supra note 61, at
5-9. See also Nasdaq First Response to Comments, supra note 57, at
5-7.
Furthermore, as noted above, the Exchange represents that outside of
set retraining periods, ``the System will operate pursuant to a
mathematical algorithm from which it cannot deviate--an algorithm that
is programmed to achieve pre-defined and pre-disclosed objectives.''
\89\ The Exchange explains that outside of the set retraining periods
``the System will behave predictably from day to day, such that its
decisions when presented with given set of facts and circumstances in a
given security on day 1 should be the same as they would be on day 2.''
\90\
---------------------------------------------------------------------------
\89\ See supra note 46 and accompanying text.
\90\ See supra note 29.
---------------------------------------------------------------------------
Based on Nasdaq's representations described above, Dynamic M-ELO
would operate pursuant to pre-determined, programmed procedures that
would dictate order interaction and the terms for trading for each
Dynamic M-ELO order entered on the Nasdaq trading facility. While the
Exchange's procedures include conditions that, if satisfied under
certain circumstances, might result in different outcomes for different
M-ELO orders, such conditions and circumstances, if pre-determined,
pre-defined, and programmed into the Exchange's trading facility, would
be considered established and not discretionary. For example, according
to the Exchange, Dynamic M-ELO may apply different pre-determined
weights over time to pre-determined factors it uses to determine
whether and by how much to vary a Holding Period.\91\ In such an event,
Dynamic M-ELO will operate pursuant to pre-determined procedures and
programmed mathematical algorithm from which it cannot deviate to
``achieve pre-defined and pre-disclosed objectives.'' \92\ Further, the
procedures governing Dynamic M-ELO and use of M-ELO orders will be
established before the beginning of each trading day. For example,
Dynamic M-ELO will use preset methods to evaluate and weigh specific
data elements to determine the dynamic holding periods. Such pre-set
methods will be established during the prior retraining period, and
outside regular trading hours, and will not vary intra-day until
adjusted at the next retraining period.
---------------------------------------------------------------------------
\91\ See supra note 45 and accompanying text.
\92\ See supra note 46 and accompanying text.
---------------------------------------------------------------------------
Given the pre-determined, programmed procedures and rules that
Nasdaq has proposed to dictate trading for Dynamic M-ELO, the
Commission does not believe that Dynamic M-ELO is designed to provide
Nasdaq with judgement and flexibility, and therefore, discretion over
the handling or execution of a M-ELO order entered on the Exchange.
Unfair Discrimination
Section 6(b)(5) of the Act requires that the rules of a national
securities exchange not be designed to permit unfair discrimination
between customers, issuers, brokers, or dealers. In several letters,
one commenter stated that Nasdaq inadequately explains how it will
monitor and, if necessary, adjust Dynamic M-ELO to ensure no unfair
discrimination.\93\ Initially, this commenter emphasized what they
perceived to be silence on the part of Nasdaq with regard to whether
Dynamic M-ELO will discriminate among categories of participant
types.\94\ In its response to these comments, Nasdaq initially added a
new representation to the filing in Amendment No. 1, stating that that
Dynamic M-ELO is not designed to further the performance of any
participant or any category of participant, but instead has twin
objectives--the absolute values of mark-outs and fill rates. In
Amendment No. 2, Nasdaq expanded on this representation by adding the
following:
---------------------------------------------------------------------------
\93\ See Leuchtkafer Letter 3, supra note 60, at 7-8;
Leuchtkafer Letter 2, supra note 58, at 5; Leuchtkafer Letter 1,
supra note 48, at 3. Nasdaq's White Paper includes a ``firm-level
analysis'' that ``tried to identify patterns and trends that could
potentially signify a systematic bias towards specific firms.''
White Paper at 24. This analysis concluded that ``Dynamic M-ELO will
not result in systematic-biased execution towards any one firm.''
Id. at 26.
\94\ See Leuchtkafer Letter 3, supra note 60, at 7-8.
Furthermore, Nasdaq performed internal tests of its AI model to
detect indications of harmful bias in its performance results, and
such tests concluded that no such indications exist. That is, the
Exchange reviewed the impact on fill rates and mark-outs of Dynamic
M-ELO, as compared to the ``static'' M-ELO, for those firms that
accounted for more than 95% of M-ELO activity on the Exchange during
Q1 2022 . . . . The Exchange analyzed results both in an absolute
and a relative sense. Testing revealed that all participants
experienced at least some improvements in fill rates and mark-outs
when using Dynamic M-ELO versus static M-ELO, with the volume-
weighted average improvement being aligned with the results
expressed in the White Paper. We detected no material variations
that might suggest that a particular participant or category of
participant (i.e., nature of firm; size of firm) benefitted from
Dynamic M-ELO functionality to an extent that was unreasonably
disproportionate to the benefits that other participants
experienced. Thus, Nasdaq believes the model is objective, is
---------------------------------------------------------------------------
designed to, and does avoid bias and discrimination.
In Amendment No. 2, Nasdaq also affirmed that it will periodically
review its model to ensure that it continues to perform in accordance
with the Exchange's rules and that it has not introduced any harmful
bias in favor of or against any participant or class of
participants.\95\
---------------------------------------------------------------------------
\95\ See Amendment No. 2 at fn. 34.
---------------------------------------------------------------------------
In response to the above, the commenter submitted a fourth comment
letter, in which they questioned the approach Nasdaq took to
demonstrate that there is not bias against any one
[[Page 62861]]
participant or class of participants.\96\ The commenter, among other
things, expressed concern about Nasdaq conducting its analysis using
data for firms that accounted for 95% of M-ELO activity during Q1 of
2022 rather than all M-ELO activity. The commenter states that Nasdaq
did not describe how it determined the 5% of activity during that
period to exclude from its analysis.\97\ For example, the commenter
states that it is not clear whether Nasdaq excluded firms with large
orders and trades, and the commenter opines that discarding any data
could exclude activity that has qualitative or quantitative differences
from the rest.\98\
---------------------------------------------------------------------------
\96\ See Leuchtkafer Letter 4, supra note 66, at 1-4.
\97\ See id. at 2-3 (``It seems Nasdaq trimmed its data before
analyzing it for bias and constrained its analysis to `those firms
that accounted for more than 95% of M-ELO activity on the Exchange
during Q1 2022.' (I assume Nasdaq used the same data defined in the
Filing as the `Training Period' for its analysis. Nasdaq doesn't say
so, however.) Nasdaq doesn't describe the kind of M-ELO `activity'
it filtered the data for, and specifically whether it filtered on
order or trade counts or order or trade volume or some combination
of two or more of these categories, or on some other factor, before
removing firms from its analysis.'')
\98\ See id. at 2-3.
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In response to this comment, Nasdaq represented that it conducted a
supplemental analysis of the initially-excluded data--which were the
activity of the least-active M-ELO firms from the control period of its
initial analysis--to confirm whether its initial conclusions held for
those participants.\99\ Nasdaq explains that the individual variations
among the previously excluded participants was higher than that for the
original batch of data, but that, based on simulated data, each of
these participants would have experienced the same or better fill rates
during the testing period if they had utilized Dynamic M-ELO.\100\
Based on this supplemental data analysis, Nasdaq concluded that there
is no apparent biases for the Dynamic M-ELO, even among the least
active M-ELO participants.\101\
---------------------------------------------------------------------------
\99\ See id. at 5-6.
\100\ See id.
\101\ See id.
---------------------------------------------------------------------------
The Commission concludes that Nasdaq has adequately demonstrated
that the proposal is not designed to permit unfair discrimination
consistent with Section 6(b)(5) of the Act. Through the White Paper,
amendments, and response letters, Nasdaq has demonstrated that it has
analyzed the anticipated or simulated effects of the proposed change on
all current M-ELO users, and that this work did not indicate that
particular firms or classes of firms are anticipated to unfairly
benefit from or be harmed by the proposed Dynamic M-ELO functionality.
Prevention of Fraudulent and Manipulative Acts and Practices, Just and
Equitable Principles of Trade, and the Protection of Investors and the
Public Interest
Section 6(b)(5) of the Act also requires that the rules of a
national securities exchange be designed to prevent fraudulent and
manipulative acts and practices, to promote just and equitable
principles of trade, and, in general, to protect investors and the
public interest. In Amendment No. 2, Nasdaq addressed whether the
Dynamic M-ELO is designed to prevent fraudulent and manipulative acts
and practices. Nasdaq states that the design of Dynamic M-ELO does not
lend itself to potential manipulation by a single participant or a
small group of participants because the machine-learning model makes
determinations regarding Holding Periods based upon prevailing market-
wide conditions for a given symbol, rather than the behaviors of
particular participants with respect to that symbol, or the activity of
participants in M-ELOs involving that symbol. Nasdaq further states
that manipulation of the machine-learning model would be difficult to
accomplish given the large number of variables that factor into the
machine-learning model's decisions to change Holding Periods during
Change Events, as well as the different weights that apply to each such
factor, which as described above, may vary over time. Furthermore,
Nasdaq states that any benefits that a participant might derive from
manipulating the duration of Holding Periods would likely be small and
outweighed significantly by the difficulty and cost of effecting such
manipulation.
The Exchange, in Amendment No. 2, also sets forth representations
regarding how it will surveil its market after Dynamic M-ELO is
implemented. First, Nasdaq represents that it will review the machine-
learning functionality and operation periodically to affirm that it
continues to perform in accordance with the Exchange's rules and has
not introduced any harmful bias in favor of or against any participant
or category of participants.\102\ Nasdaq also represents above that it
will surveil for indications of manipulation and act accordingly if it
detects such indications.
---------------------------------------------------------------------------
\102\ See supra note 41.
---------------------------------------------------------------------------
The Commission finds that the proposed rule change is designed to
prevent fraudulent and manipulative acts and practices consistent with
Section 6(b)(5) of the Act. The Commission agrees that aspects of the
Dynamic M-ELO design reduce opportunities for manipulation or are
likely to make manipulation costly or difficult. The model's operation
depends on 142 data elements, which are each likely to have effects on
model outcomes of differing magnitudes and in different directions.
Many of these data elements are also based on market-wide data, in some
cases spanning periods of days,\103\ which are likely themselves
difficult for market participants to manipulate. Given these design
features, it appears likely that manipulating the duration of Dynamic
M-ELO holding periods in any given symbol or group of symbols would be
an extremely complex undertaking. In light of this complexity, and the
size of M-ELO activity relative to the market for NMS stocks,\104\
Nasdaq's assertion that the potential benefits of manipulating the
dynamic holding periods for these order types would be outweighed by
the cost and complexity of manipulation also appears reasonable. Nasdaq
has also represented that it intends to surveil the proposed order
types for manipulation. This ongoing surveillance, to ensure the
appropriate use of Dynamic M-ELO by Exchange Members and behavior by
the machine-learning model, is important to the successful
implementation of Dynamic M-ELO and appears appropriately tailored to
the accomplish the intent of the M-ELO and M-ELO+CB order types.
---------------------------------------------------------------------------
\103\ See, e.g., Exhibit 3b.
\104\ According to the ``M-ELO Monthly Report'' published by
Nasdaq for July 2023 (available at: <a href="https://www.nasdaq.com/docs/M-ELO-Monthly-Report">https://www.nasdaq.com/docs/M-ELO-Monthly-Report</a> (accessed September 2, 2023)), the average daily
notional volume executed in M-ELO was $624,556,748. The average
daily notional volume executed in July 2023 across the market for
NMS stocks was about $523,769,246,196. See, e.g., Cboe, Historical
Market Volume Data, available at: <a href="https://www.cboe.com/us/equities/market_statistics/historical_market_volume/">https://www.cboe.com/us/equities/market_statistics/historical_market_volume/</a>. The average daily
notional volume in M-ELO for that month was approximately 0.12%
(just over one-tenth of one percent) of the average daily notional
volume across the entire NMS stock market.
---------------------------------------------------------------------------
Furthermore, the Commission finds that overall structure of Dynamic
M-ELO--particularly, the static numerical constraints set forth in the
proposed rule text--is designed in general, to protect investors and
the public interest and promote just and equitable principles of trade
pursuant to Section 6(b)(5) of the Act. As described above, the model
will continuously engage in dynamic analysis of current market
conditions during trading hours, and outside of market hours, it will
retrain with the goal of improving the overall performance of Dynamic
M-ELO. These dynamic aspects of the proposal,
[[Page 62862]]
however, are constrained by the static numerical thresholds set forth
in the proposed rule text. For example, the initial Holding Periods for
each trading day will be 1.25 milliseconds, the overall range for any
Holding Period must be between 0.25 and 2.50 milliseconds during normal
market conditions, and the Holding Period can only change by either
0.25 or 0.50 milliseconds at each Change Event during normal market
conditions. Regardless of how the model analyzes the current market or
changes the weighting of the data elements as a result of its
retraining, Dynamic M-ELO cannot operate outside of the static
numerical ranges and limitations or minimums set forth in the rule
text. As such, the Commission finds that Nasdaq has designed Dynamic M-
ELO to operate in a manner that in general protects investors and the
public interest and promotes just and equitable principles of trade in
accordance with Section 6(b)(5) of the Act.
Compliance With SRO Recordkeeping and Reporting Obligations
One commenter queried whether Nasdaq could maintain an adequate
audit trail given the potential for frequently shifting Holding Periods
for Dynamic M-ELO.\105\ In response, Nasdaq states that it will retain
copies of each iteration of its system as part of its books and records
and will disclose publicly statistics relating to Dynamic M-ELO
performance.\106\ Nasdaq additionally represented that it will publish
weekly and monthly Dynamic M-ELO performance statistics, which would
include the weekly numbers of shares and trades in M-ELOs by symbol,
weekly aggregated M-ELO share and trade data, and monthly aggregated
block data, on <a href="http://Nasdaqtrader.com">Nasdaqtrader.com</a>.\107\ Nasdaq also indicated it would
add statistics to its existing M-ELO Monthly Report, which discloses
quote stability by time horizon, about how frequently, on average, its
system changes Holding Period durations for the top decile, median, and
bottom decile of symbols, as measured by monthly M-ELO and M-ELO+CB
trading volumes.\108\
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\105\ See Leuchtkafer Letter 1, supra note 48, at 1.
\106\ See Nasdaq First Response to Comments, supra note 57, at
3.
\107\ See Section III.A.1., supra.
\108\ See id.
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Nasdaq also added a representation to the filing, addressing how it
would comply with its recordkeeping obligations.\109\ Nasdaq states
that it will retain copies of each historical iteration of its models
as part of its books and records, and make them available to the
Commission upon request, should it wish to examine them to understand
how the model changes over time.\110\ Nasdaq also states that it will
publish an equity trader alert in advance of deploying a retrained
version of Dynamic M-ELO when Nasdaq anticipates the retrained version
will produce results that differ materially from the prior
version.\111\ Based on these representations, the Commission finds that
Nasdaq has met its burden to demonstrate that it will comply with all
relevant exchange recordkeeping requirements and obligations when it
implements Dynamic M-ELO. In addition, the Commission notes that Nasdaq
must comply with its reporting obligations under Rule 613 of Regulation
NMS \112\ and the National Market System Plan Governing the
Consolidated Audited Trail (``CAT NMS Plan'') \113\ with respect to
Dynamic M-ELO, which requires it to record and electronically report to
the central repository the material terms of each order and each
reportable event.\114\
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\109\ See id.
\110\ See id.
\111\ See id.
\112\ See 17 CFR 242.613.
\113\ The CAT NMS Plan was approved by the Commission, as
modified, on November 15, 2016. See Securities Exchange Act Release
No. 79318 (November 15, 2016), 81 FR 84696 (November 23, 2016).
\114\ See 17 CFR 242.613(c)(7).
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Nasdaq's Obligation To File Proposed Rule Changes Relating to Dynamic
M-ELO
Prior to the filing of Amendment No. 1, a commenter stated that it
was unclear what types of changes to the model would lead Nasdaq to
seek approval from the Commission via an SRO rule filing.\115\ As
explained above,\116\ Nasdaq represents that it will not modify the
underlying structure of Dynamic M-ELO without first obtaining the
Commission's approval to do so, including modifications to the data
elements the model considers in making decisions about Holding Period
durations, the conditions under which the model may adjust the duration
of Holding Periods, the frequency with which the model may adjust the
Holding Periods, the range of Holding Period durations available to M-
ELOs and M-ELO+CBs, the increments by which Holding Periods may change
at any given Change Event, and the procedures for triggering,
maintaining, and ending 12 millisecond Holding Periods during times of
extraordinary instability. In contrast, the Exchange states that it
will not seek Commission approval prior to retraining the model to
adjust the weighting it applies to those data elements pursuant to the
weekly retraining process.
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\115\ See Leuchtkafer Letter 1, supra note 48, at 2.
\116\ See Section II.A.1., supra.
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Section 19(b)(1) of the Act \117\ and Rule 19b-4 thereunder \118\
require an SRO to file a proposed rule change with the Commission
whenever it seeks any proposed change in, addition to, or deletion from
the rules governing the SRO and its members' activities on the SRO. As
discussed above, the proposal sets forth the specific data elements
that Dynamic M-ELO will use during the trading day. Furthermore, the
proposed rule change sets forth when the machine-learning model will
retrain and the extent to which the retraining can and cannot cause the
machine-learning model to update Dynamic M-ELO's operation during
subsequent trading days.\119\ In addition, the proposal sets forth the
operation of Dynamic M-ELO, such as the potential range for a Holding
Period, how often Dynamic M-ELO reevaluates market conditions for a
given security to adjust a Holding Period, and the increment by which a
Holding Period may be changed. Nasdaq represents that it will not
change any of these aspects of the proposal or any other function of
Dynamic M-ELO without first filing a proposed rule change.\120\ Nasdaq
does, however, state that it would not file a proposed rule change in
connection with the operation of the machine-learning model's weekly
retraining and the results of that process.
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\117\ 15 U.S.C. 78s(b)(1).
\118\ 17 CFR 240.19b-4.
\119\ See Section III.A.1., supra.
\120\ See supra note 30 and accompanying text.
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Based on the foregoing, the Commission believes that Nasdaq has
adequately responded to the commenter's concern. Nasdaq will need to
file a proposed rule to make any changes, additions, or deletions to
the operation of Dynamic M-ELO as approved herein. Nasdaq has
delineated when it would file a proposed rule change to alter the
operation of Dynamic M-ELO, and when the machine-learning model would
retrain and adjust the weighting it applies to the data elements
without it filing a proposed rule change. Specifically, Nasdaq's
proposed rule change and rule text reflect the 142 data elements
Dynamic M-ELO will consider when determining the Holding Period for a
security and the goals Nasdaq will consider when weighing those data
elements (i.e., reducing mark-outs and increasing fill rates) but does
not set forth the relative weighting of each those individual data
elements. Though
[[Page 62863]]
the structure of the proposal does not disclose of the exact weighting
for each of the 142 data elements, it does set forth the two goals
Nasdaq will consider when weighing those data elements initially and
during each weekly retraining, which provides information as to how
those 142 factors will be used in determining the Holding Period for a
security. Based on how the proposed rule sets forth the goals that will
govern each retraining, the Commission believes that Nasdaq's
delineation of when it would and would not file a proposed rule change
to alter the operation of Dynamic M-ELO is consistent with Nasdaq's
rule filing obligation. The Commission agrees that the weekly
retraining to optimize the weighting of the 142 data elements
considered by Dynamic M-ELO to best achieve those goals within the
rule's parameters would not necessitate the filing of a proposed rule
change with the Commission because those adjustments would be
reasonably and fairly implied by the proposed rule. However, to the
extent Nasdaq seeks to change, add to, or delete from the rule's
construct in connection with the weekly retraining, it would first be
required to file a proposed rule change with the Commission.
V. Solicitation of Comments on Amendment No. 2 to the Proposed Rule
Change
Interested persons are invited to submit written data, views, and
arguments concerning whether Amendment No. 2 is consistent with the
Act. Comments may be submitted by any of the following methods:
Electronic Comments
<bullet> Use the Commission's internet comment form (<a href="https://www.sec.gov/rules/sro.shtml">https://www.sec.gov/rules/sro.shtml</a>); or
<bullet> Send an email to <a href="/cdn-cgi/l/email-protection#f684839a93db95999b9b93988285b6859395d8919980"><span class="__cf_email__" data-cfemail="3a484f565f17595557575f544e497a495f59145d554c">[email protected]</span></a>. Please include
file number SR-NASDAQ-2022-079 on the subject line.
Paper Comments
<bullet> Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to file number SR-NASDAQ-2022-079. This
file number should be included on the subject line if email is used. To
help the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's internet website (<a href="https://www.sec.gov/rules/sro.shtml">https://www.sec.gov/rules/sro.shtml</a>). Copies of the submission, all subsequent amendments, all
written statements with respect to the proposed rule change that are
filed with the Commission, and all written communications relating to
the proposed rule change between the Commission and any person, other
than those that may be withheld from the public in accordance with the
provisions of 5 U.S.C. 552, will be available for website viewing and
printing in the Commission's Public Reference Room, 100 F Street NE,
Washington, DC 20549 on official business days between the hours of
10:00 a.m. and 3:00 p.m. Copies of the filing also will be available
for inspection and copying at the principal office of the Exchange. Do
not include personal identifiable information in submissions; you
should submit only information that you wish to make available
publicly. We may redact in part or withhold entirely from publication
submitted material that is obscene or subject to copyright protection.
All submissions should refer to File Number SR-NASDAQ-2022-079, and
should be submitted on or before October 4, 2023.
VI. Accelerated Approval of Proposed Rule Change, as Modified by
Amendment No. 2
The Commission finds good cause to approve the proposed rule change
prior to the 30th day after the date of publication of Amendment No. 2
in the Federal Register. Amendment No. 2 does not include any material
changes to the operation of the proposed Dynamic M-ELO and its machine-
learning model. In Amendment No. 2, the Exchange: (1) adds the defined
term ``proprietary assessment of market conditions'' to the proposed
rule text, which consolidates certain details and explanations about
how the machine-learning model would operate from prior versions into a
single defined term; (2) revises the list of factors provided in
Exhibit 3b to include expanded and ``simplified'' explanations of the
terminology used therein; (3) adds a representation that the systems
used to operate Dynamic M-ELO and machine-learning model are ``SCI
Systems'' and thus subject to compliance with Regulation SCI; and (4)
expands the legal analysis to address comments regarding unfair
discrimination and the exercise of impermissible discretion by the
Exchange.
The Commission finds that Amendment No. 2 raises no novel
regulatory issues that have not previously been subject to comment and
is reasonably designed to prevent fraudulent and manipulative acts and
practices, to promote just and equitable principles of trade, and, in
general, to protect investors and the public interest, and not be
unfairly discriminatory, or impose an unnecessary or inappropriate
burden on competition. Amendment No. 2 does not alter the proposed
operation or any material features of Dynamic M-ELO, which operation
and features have been subject to two rounds of public comment. In
response to public comment, the revisions to the proposal contained
within Amendment No. 2 provide additional clarification and details
regarding how Dynamic M-ELO and the machine-learning model will
operate, as well as additional legal analysis to support the Exchange's
position that the proposal is consistent with the Act. Accordingly,
pursuant to Section 19(b)(2) of the Act,\121\ the Commission finds good
cause to approve the proposed rule change on an accelerated basis prior
to the 30th day after publication of notice of the filing of Amendment
No. 2 in the Federal Register.
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\121\ 15 U.S.C. 78s(b)(2).
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VII. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\122\ that the proposed rule change (SR-NASDAQ-2022-079), as
modified by Amendment No. 2, be, and it hereby is, approved on an
accelerated basis.
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\122\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\123\
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\123\ 17 CFR 200.30-3(a)(12).
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Sherry R. Haywood,
Assistant Secretary.
[FR Doc. 2023-19728 Filed 9-12-23; 8:45 am]
BILLING CODE 8011-01-P
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