July 12, 2004
Ms. Joanne Moffic-Silver
General Counsel
Chicago Board Options Exchange, Inc.
400 South LaSalle Street
Chicago, IL 60605
Re: Limited Exemption from Rule 11Ac1-1
Dear Ms. Moffic-Silver:
In your letter, dated July 9, 2004, you request that the Securities and Exchange Commission ("Commission"), pursuant to Rule 11Ac1-1(e) under the Securities Exchange Act of 1934 ("Exchange Act"),1 grant the Chicago Board Options Exchange, Inc. ("CBOE" or "Exchange") a limited exemption from Rule 11Ac1-1 (the "Quote Rule")2 that would permit the Exchange to relieve a CBOE market maker on the Hybrid trading platform from its obligation under the Quote Rule to trade with matching quotations from another CBOE market maker, provided that the quotations are locked for no more than one second and such CBOE market maker is firm to all other incoming customer and broker-dealer orders, including orders for the accounts of other options market makers.
Paragraph (c) of Rule 11Ac1-1 requires a responsible broker or dealer on CBOE to communicate its best bid, best offer, and quotation size to the Exchange and, subject to certain enumerated exceptions in paragraph (c)(3) of the Quote Rule, to execute any order to buy or sell at a price as favorable as its published quotation in an amount up to its published quotation size. You request that the Commission exempt CBOE market makers on the Exchange's Hybrid trading platform from their obligations under this provision of the Quote Rule in limited circumstances. Specifically, the CBOE proposes to maintain its current rule that requires CBOE market makers in Hybrid to be firm for the size disseminated with their quotations for all incoming orders eligible for automatic execution (whether from customers or broker-dealers), other than the quotations of other CBOE market makers. The CBOE proposes, however, to modify its existing rule to relieve a CBOE market maker on the Hybrid trading platform from its obligation under the Quote Rule to trade with matching quotations from another CBOE market maker, provided that the quotations are locked for no more than one second and such CBOE market maker is firm to all other incoming customer and broker-dealer orders eligible for automatic execution, including orders for the accounts of other options market makers.
You note that under the Hybrid trading platform, CBOE market makers generally must honor the full size of their quotations, except for trades involving the interaction of CBOE market maker quotes. In this regard, you note that CBOE market makers, "use quotations to input and update prices on multiple series of options at the same time" and that market makers inadvertently interact with each other, because some market makers' quote update systems are faster than those of other market makers. In addition, you note that the CBOE's current rules provide that, in the event of a locked market, CBOE market makers must be firm for the size disseminated with their quotations for all orders (whether from customers or broker-dealers) eligible for automatic execution, other than the quotations of CBOE market makers. You also note that, during a locked market, the current rules provide that CBOE market makers are obligated for one contract in open outcry.
In connection with the proposed introduction of remote electronic market making in Hybrid, you propose to eliminate the obligation of CBOE market makers to trade with other CBOE market makers for one contract in open outcry during a locked market, because the remote market makers may not have an open outcry presence. Because remote market makers would not necessarily have a presence in open outcry, their quotations would be accessible only electronically under current CBOE rules. To provide access to such remote market maker quotations, CBOE proposes to allow orders for the accounts of options market makers to be eligible for execution automatically in Hybrid.
In support of your proposal, you note that the CBOE has monitored the effects of its current quote lock provisions and determined that approximately 52% of the locks exist for less than one second. You then conclude that, "[t]he brevity of most of the locks supports [the CBOE's] belief that these fleeting 'locks' are a result of technology disparities and not an intention by the Market-Makers to trade with one another at that price." You also believe that, "it is inappropriate for small but noticeable technology disparities to cause the Quote Rule to attach to a Market-Maker quote that is 'clipped' by another Market-Maker's faster quote when both are moving in the same direction." Consequently, you request a limited exemption from the Quote Rule, subject to certain conditions, to allow CBOE to implement this approach for its Hybrid trading platform.
Response:
The Commission grants CBOE market makers trading on the Exchange's Hybrid trading platform a limited exemption pursuant to paragraph (e) of the Quote Rule from their obligations under paragraph (c)(2) of Rule 11Ac1-1 with respect to interacting quotations of CBOE market makers on the Exchange's Hybrid trading platform that remain locked for no more than one second, provided that such CBOE market makers continue to be firm for all incoming customer and broker-dealer orders, including orders for the accounts of other options market makers, including CBOE Market-Makers, and that orders for the accounts of options market makers are eligible for automatic execution through the Hybrid trading platform.
Because the CBOE would require its market makers to be firm for their quotations in Hybrid for their full disseminated size to incoming customers and broker-dealer orders, including orders for the accounts of other options market makers, the Commission finds that it is consistent with the public interest, the protection of investors and the removal of impediments to and perfection of the mechanism of a national market system to relieve CBOE market makers trading on the Hybrid trading platform from their obligation to trade with interacting CBOE market maker quotations that last for no more than one second. In addition, the Commission notes that the CBOE believes that an exemption would eliminate "trades that are both unwanted, the result of technological disparities between Market-Makers that are not beneficial to customers, and that impede certain liquidity providers' ability to competitively quote" and "increase the liquidity available in [its] market and will enhance competition because Market-Makers will be better able to quote aggressively with fewer concerns over quoting technological disparities." Therefore, the Commission grants the Exchange's request for a limited exemption from the Quote Rule for interacting quotes occurring on the Exchange's Hybrid trading platform.
This limited exemption is based on the facts and representations made in your letter. Specifically, this exemption is conditioned on CBOE maintaining the requirement for its Hybrid trading platform that all CBOE market maker quotations must be firm for their full disseminated size for all incoming orders, including orders for the accounts of other options market makers, including CBOE Market-Makers, and that orders for the accounts of options market makers are eligible for automatic execution through the Hybrid trading platform. Facts or circumstances different than those presented in your letter might require a different conclusion.
For the Commission, by the
Division of Market Regulation,
pursuant to delegated authority,3
David S. Shillman
Associate Director
Endnotes
The Commission may exempt from the provisions of this section, either unconditionally or on specific terms and conditions, any responsible broker or dealer, electronic communications network, exchange, or association if the Commission determines that such exemption is consistent with the public interest, the protection of investors and the removal of impediments to and perfection of the mechanisms of a national market system.
17 CFR 240.11Ac1-1(e). The Director of the Division of Market Regulation has delegated authority to grant an exemption under this provision pursuant to 17 CFR 200.30-3(a)(28). See Securities Exchange Release No. 44079 (March 15, 2001), 66 FR 15791 (March 21, 2001).
Incoming Letter:
July 9, 2004
Ms. Annette Nazareth
Director
Division of Market Regulation
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Exemption from SEC Rule 11Ac1-1 ("Quote Rule")
Dear Ms. Nazareth:
The Chicago Board Options Exchange, Incorporated ("Exchange" or "CBOE") requests an exemption from Rule 11Ac1-1 ("Quote Rule") under the Securities Exchange Act of 1934, as amended ("Act"). We request this exemption in conjunction with pending proposed rule change SR-CBOE-2004-24, in which the Exchange proposes to adopt a new category of Designated Primary Market-Maker ("DPM"), to be called e-DPMs.
Relevant Provisions of the Firm Quote Rule
The Quote Rule requires an exchange to collect and disseminate quotations from responsible broker-dealer members of the exchange. Responsible broker-dealers who provide such quotations generally must be firm up to the size of their quotations. However, the Quote Rule allows options exchanges the ability to adopt rules creating different firm quotation sizes for customers and for broker-dealers. Specifically, subparagraph (d)(1)(iii) of the Quote Rule permits options exchanges: (1) to collect and disseminate quotation sizes that responsible broker-dealers must be firm for customer orders; and (2) to establish by rule the size for which responsible broker-dealers must be firm for orders of other broker-dealers, as long as such size is for at least one contract. CBOE implements this provision in CBOE Rule 8.51(c)(1) by establishing a one-contract minimum size for broker-dealer orders.
Paragraph (e) of the Quote Rule grants the Commission authority to provide an exemption from the Quote Rule "if the Commission determines that such exemption is consistent with the public interest, the protection of investors and the removal of impediments to and perfection of the mechanism of a national market system." CBOE requests an exemption pursuant to this paragraph.
Background
Under CBOE's Hybrid trading platform structure, each Market-Maker is considered the responsible broker-dealer for each quote it causes to be disseminated. As such, each Market-Maker must honor its quote for up to the firm quote size. Under the Hybrid trading platform, orders submitted for automatic execution generally are entitled to an execution for up to the disseminated size, however, Hybrid provides one area in which CBOE quotations may not be electronically available for the full disseminated size: trades involving the interaction of Market-Maker quotations. Underpinning this distinction is the difference between quotations and orders in Hybrid. Only Market-Makers (including DPMs) may enter quotations in Hybrid. Market-Makers use quotations to input and update prices on multiple series of options at the same time. Quotations generally are based on pricing models that rely on various factors, including the price of the underlying security and that security's volatility. As these variables change, a Market-Maker's pricing model automatically will enter quotation updates for some or all of an option's series. In contrast, an order is an interest to buy or sell a stated number of contracts of one specific options series. All CBOE members have the ability to enter orders.1
Because Market-Makers update quotations in multiple series at the same time (e.g. in response to movement in the underlying stock), there can be a multitude of instances in which their quotes inadvertently interact with each other (i.e., fleeting locked quotes), which can lead to significant risk and exposure. This will occur where one Market-Maker's quote update system is faster than systems used by other Market-Makers. In this respect, a system that updates options prices milliseconds faster than another system will lock the quotes of those other systems every time its bid (offer) adjusts to the offer (bid) of the second quote even if the second Market-Maker's system was also in the process of updating. For example, assume that Market-Makers A and B are both quoting $1.10-1.20, when the underlying moves causing both quotes to update to $1.20-1.30. By being milliseconds faster, A's quotation system will send a quote that locks B's quote even though B's system also was in the process of updating. This could happen simultaneously in a large number of series within the class such that instead of locking one quote, A locks twenty of B's quotes.
In recognition of this, CBOE structured its Hybrid rules pertaining to internal quote locks as follows:
- The Exchange disseminates the "locked" market.
- The Market-Makers whose quotes are locked receive a quote update notification advising that their quotes are locked.
- A "counting period" begins during which Market-Makers whose quotes are locked will have an opportunity to revise their quotes to eliminate the locked market. Provided, however, that unless and until a Market-Maker revises its disseminated quote it will be obligated to execute any customer or broker-dealer order eligible for automatic execution pursuant to Rule 6.13 at its disseminated quote in accordance with applicable CBOE rules.2 Further, during the counting period Market-Makers will continue to be obligated for one contract in open outcry to other Market-Makers in accordance with Rules 8.51 and 6.48. Currently, in no option class does the counting period exceed four seconds, and in the top 200 option classes (based on volume), the counting period is one second.
- If the quotes remain locked at the end of the counting period, then the locked quotes will execute against each other in accordance with the allocation algorithm described in Rule 6.45A(a).
The Hybrid platform has been in operation for approximately one year. During that time CBOE has monitored the effects of the quote lock provisions described above. Our statistics indicate that roughly 52% of the "locks" exist for less than one second.
The brevity of most of the locks supports our belief that these fleeting "locks" are a result of technology disparities and not an intention by the Market-Makers to trade with one another at that price. We also believe it is inappropriate for small but noticeable technology disparities to cause the Quote Rule to attach to a Market-Maker quote that is "clipped" by another Market-Maker's faster quote when both are moving in the same direction. Of course, quotes that remain locked for a meaningful amount of time should cause the Quote Rule to attach.
As CBOE introduces remote electronic market-making in the form of e-DPMs and Remote Market-Makers, concerns over this internal quote "clipping" will only be exacerbated because (i) there will be more electronic quoters; and (ii) there will be no practical means to assert a one-contract firm quote obligation in open outcry (these remote quoters may not have an open outcry presence). Therefore, CBOE proposes to address these concerns by changing our Hybrid quote lock rules to provide the following:
- The Market-Makers whose quotes are locked would receive a quote update notification advising that their quotes are locked.
- As is currently the case, until a Market-Maker revises its disseminated quote it will be obligated to execute any customer or broker-dealer order eligible for automatic execution pursuant to Rule 6.13 at its disseminated quote in accordance with applicable CBOE rules. However, during the counting period Market-Makers would not be obligated for one contract in open outcry to other Market-Makers that are party to the quote lock in accordance with Rules 8.51 and 6.48.
- If the quotes remain locked after one second, then the locked quotes will execute against each other in accordance with the allocation algorithm described in Rule 6.45A(a).
We believe one second is sufficient time to account for any technology disparities between Market-Makers.
Requested Exemption from the Firm Quote Rule
As discussed, the Quote Rule permits a responsible broker-dealer to establish different quotation sizes for public customers and broker-dealers. CBOE Rule 8.51(c) complies with the Quote Rule by establishing a one-contract minimum for broker-dealer orders. In connection with CBOE Market-Maker quote locks, the Quote Rule attaches anytime one Market-Maker's quote "touches" another Market-Maker's quote, and currently, the one-contract trade is obtainable in open-outcry. Nevertheless, it is rare that such open outcry trades occur. We believe this indicates that the Market-Makers did not intend or desire to trade with one another. Further, more than half of such locks last for less than one second (even though these locks have been permitted to last for as long as 4-10 seconds pursuant to Rule 6.45A(d)). We believe the vast majority of those locks are a result of technology disparities where both Market-Maker quotes were moving in the same direction, just not at the same speed. Accordingly, CBOE believes the Quote Rule should not attach in such instances and that the Commission should grant an exemption from the Quote Rule for any quote locks that do not last for more than one-second.
Paragraph (e) of the Rule grants the Commission authority to provide an exemption from the Quote Rule. An exemption would assist in the removal of impediments to and perfection of the mechanism of a national market system by eliminating trades that are both unwanted, the result of technological disparities between Market-Makers that are not beneficial to customers, and that impede certain liquidity providers' ability to competitively quote. We believe this requested exemption falls squarely within the Commission's exemptive authority. An exemption will increase the liquidity available in our market and will enhance competition because Market-Makers will be better able to quote aggressively with fewer concerns over quoting technological disparities.
We thus request that the Commission process this request in conjunction with the SR-CBOE-2004-24 so that the Exchange will not need to implement system changes to effect an electronic one-contract trade anytime two Market-Maker quotes lock for one second or less (since remote Market-Makers will not be able to effect the one-contract trade in open outcry). If you have any questions on this matter, or if you need any other information, please do not hesitate to call Angelo Evangelou at 312-786-7464.
Sincerely,
Joanne Moffic-Silver
cc: |
Robert L.D. Colby
Elizabeth King
Deborah Flynn
|
Endnotes
http://www.sec.gov/divisions/marketreg/mr-noaction/cboe071204.htm
