[Federal Register: December 15, 2004 (Volume 69, Number 240)]
[Notices]
[Page 75093-75100]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr15de04-104]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-50819; File No. SR-ISE-2003-06]
Self-Regulatory Organizations; Order Granting Approval of
Proposed Rule Change and Amendment No. 1 Thereto and Notice of Filing
and Order Granting Accelerated Approval to Amendments No. 2 and 3
Thereto by the International Securities Exchange, Inc. To Establish
Rules Implementing a Price Improvement Mechanism
December 8, 2004.
I. Introduction
On February 25, 2003, the International Securities Exchange, Inc.
(``ISE'' 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 establish rules implementing a
Price Improvement Mechanism (``PIM''). On February 25, 2004, the ISE
submitted Amendment No. 1 to the proposed rule change.\3\ The proposed
rule change, as amended, was published for comment in the Federal
Register on March 3, 2004.\4\ The Commission received one comment
letter with respect to the proposal and Amendment No. 1.\5\ On June 24,
2004, the ISE filed Amendment No. 2 to the proposed rule change,\6\ and
a written response to the Comment Letter.\7\ On October 28, 2004, the
ISE
[[Page 75094]]
filed Amendment No. 3 to the proposed rule change.\8\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Letter from Michael Simon, Senior Vice President and
General Counsel, ISE, to Nancy Sanow, Assistant Director, Division
of Market Regulation (``Division''), Commission, dated February 24,
2004 (``Amendment No. 1''). In Amendment No. 1, the ISE replaced the
proposed rule text in its entirety.
\4\ See Securities Exchange Act Release No. 49323 (February 26,
2004), 69 FR 10087 (``Notice'').
\5\ See Letter from Kenneth R. Leibler, Chairman and Chief
Executive Officer, Boston Stock Exchange, Inc. (``BSE'') to Jonathan
G. Katz, Secretary, Securities and Exchange Commission, dated March
24, 2004 (``Comment Letter''). A discussion of the Comment Letter is
provided below in Section IV, Discussion and Commission Findings.
\6\ See Letter from Michael Simon, Senior Vice President and
General Counsel, ISE, to Nancy J. Sanow, Assistant Director,
Division, Commission, dated June 23, 2004 (``Amendment No. 2''). As
noted below, in Amendment No. 2, the ISE proposes to clarify its
rules to address issues raised by the Comment Letter and Commission
staff.
\7\ See Letter from Michael J. Simon, Senior Vice President and
General Counsel, ISE, to Jonathan G. Katz, Secretary, Commission,
dated June 23, 2004 (``Response Letter'').
\8\ See Letter from Michael Simon, Senior Vice President and
General Counsel, ISE, to Nancy J. Sanow, Assistant Director,
Division, Commission, dated October 14, 2004 (``Amendment No. 3'').
In Amendment No. 3, the ISE proposed to add new Supplemental
Material .06 to proposed ISE Rule 723, to clarify that paragraphs
(c)(5), (d)(5), and (d)(6) of ISE Rule 723 will be effective for a
pilot period expiring on July 18, 2005. Supplemental Material .06 to
proposed ISE Rule 723 also would state that during the pilot period,
the Exchange will submit certain data on a confidential basis
relating to the frequency with which the exposure period is
terminated by unrelated orders.
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This order approves the proposed rule change, as amended by
Amendment No. 1, publishes notice of Amendments No. 2 and 3 to the
proposed rule change, and grants accelerated approval of Amendments No.
2 and 3.
II. Description of the Proposal
The ISE proposes to establish an auction, known as the PIM, that
would allow an ISE Electronic Access Member (``EAM'') to enter matched
trades (``Crossing Transactions''). A Crossing Transaction would be
comprised of an order that the EAM represents as agent (``Agency
Order'') and an order that is executable against the Agency Order for
the full size of the Agency Order (the ``Counter-Side Order'').\9\ A
Member must enter the Crossing Transaction at a price at least one cent
better than the national best bid and offer (``NBBO'').\10\
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\9\ See proposed ISE Rule 723(b). The Counter-Side Order may
represent interest for the EAM's own account, or interest the EAM
has solicited from one or more other parties, or a combination of
both. See Amendment No. 2, supra note 6.
\10\ See proposed ISE Rule 723(b)(1). A PIM could not be
initiated unless there are at least three ISE Market Makers quoting
in the series. Moreover, there could be only one PIM ongoing in a
series at any given time. Therefore, a PIM could not be initiated
during an ongoing PIM in the same series. See proposed ISE Rule 723,
Supplementary Material .04.
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The ISE would broadcast the Crossing Transaction to all ISE
Members.\11\ During a three-second auction, all ISE Members could enter
``Improvement Orders,'' in penny increments, to improve the price of
the Agency Order.\12\ Improvement Orders may be for the account of a
Public Customer or for the Member's own account.\13\ During the
exposure period, the aggregate size of the best prices, including the
Counter-Side Order, Improvement Orders, and any change to either, would
continually be updated and broadcast to all Members.\14\
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\11\ The broadcast message would include the series, price, and
size of the Agency Order and whether it is to buy or sell. See
proposed ISE Rule 723(c); see also Amendment No. 2, supra note 6.
\12\ See proposed ISE Rule 723(c)(1). The ISE would broadcast
Improvement Orders to all Members. Crossing Transactions and
Improvement Orders would not be displayed in the ISE BBO and would
not be disseminated to the Options Price Reporting Authority.
\13\ See proposed ISE Rule 723(c)(2).
\14\ See proposed ISE Rule 723(c)(4); see also Amendment No. 2,
supra note 6.
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After three seconds, the ISE would execute the Agency Order against
the best prices as follows: (1) All Public Customer Improvement Orders
and unrelated Public Customer orders on the book at the best price
would be executed first; (2) all unrelated agency orders on the book
for the account of a non-Member broker-dealer would then be executed;
(3) if the entering EAM is at the best price, it would then execute
against the greater of one contract or 40 percent of the Agency Order;
and (4) the remainder of the order would be allocated to all other
interest, which includes Improvement Orders and unrelated orders on the
book for the account of an ISE Member (including ISE market makers), at
the best price based on size.\15\
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\15\ See proposed ISE Rule 723(d). This sized-based allocation
formula for the remainder of the order would be the same formula the
Exchange applies in its regular market, without any special
allocation rights for the ISE Primary Market Maker. See ISE Rule
713, Supplementary Material .01.
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The PIM exposure period would be terminated immediately, prior to
the expiration of the three-second exposure period, upon the receipt of
certain orders in the regular Exchange market (``unrelated orders'').
Specifically, the PIM would terminate when a market or marketable limit
order is received in the same series \16\ or when a non-marketable
limit order on the same side of the market as the Agency Order is
received that would cause the price of the Crossing Transaction to be
outside of the best bid or offer on the Exchange.\17\
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\16\ See proposed ISE Rule 723(c)(5).
\17\ Id. Under such circumstances: (1) the PIM would be
concluded; (2) the Agency Order executed; and (3) the non-marketable
limit order would be displayed on the ISE book.
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Under proposed ISE Rule 723(d)(5), as originally proposed and
published in the Notice, in the case where an unrelated market or
marketable limit order on the opposite side of the market from the
Agency Order is received, the order would execute against the Agency
Order at a price that is mid-way between the best Counter-Side interest
and the bid or offer on the Exchange.\18\ The Exchange proposes to
change this provision to state that when a market order or marketable
limit order on the opposite side of the market from the Agency Order
ends the exposure period, it would participate in the execution of the
Agency Order at the price that is mid-way between the best Counter-Side
interest and the NBBO, so that both the unrelated order and the Agency
Order receive price improvement.\19\
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\18\ See Amendment No. 1, supra note 3.
\19\ See proposed ISE Rule 723(d)(5); see also Amendment No. 2,
supra note 6.
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When a market order or marketable limit order on the same side of
the market from the Agency Order ends the exposure period, the
unrelated order would execute against any unexecuted interest in the
PIM after the Agency Order is executed in full to provide the unrelated
order with the opportunity for price improvement.\20\ In Amendment No.
2, the ISE proposes to clarify that in such instances, executions in
the PIM would be handled such that at a given price, Public Customer
interest is executed in full before any non-Customer interest.\21\
After Public Customer interest at a given price, agency orders for the
account of non-Member broker-dealers would be executed in full before
any proprietary interest of Members.\22\ Finally, Member proprietary
interest would participate in the execution of the Agency Order upon
the percentage of the total number of contracts available at the price
that is represented by the size of the non-Customer's interest.\23\ In
Amendment No. 2, the Exchange also proposes to clarify that when an
unrelated order on the same side of the market from the Agency Order
ends the exposure period, and the Counter-Side Order is at the same
price as Member interest, the Counter-Side Order would not be allocated
the greater of one contract or forty percent of the initial size of the
Agency Order before other Member interest is executed.\24\
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\20\ See proposed ISE Rule 723(d)(6); see also Amendment No. 2,
supra note 6.
\21\ Id.
\22\ Id.
\23\ Id.
\24\ Id.
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As originally proposed, Supple- mentary Material .01 to proposed
ISE Rule 723 provided that it would be considered conduct inconsistent
with just and equitable principles of trade for any Member to enter
orders, quotes, Agency Orders, Counter-Side Orders or Improvement
Orders for the purpose of disrupting or manipulating the PIM. In
Amendment No. 2, the ISE proposes to clarify that such conduct would
include, but not be limited to, engaging in a pattern of conduct where
the Member submitting an Agency Order into the PIM breaks up the Agency
Order into separate orders for two or fewer contracts for the purpose
of gaining a higher allocation percentage than the Member would have
otherwise received in accordance with the allocation procedures
established for the situation in which
[[Page 75095]]
the Counter-Side Order is at the same price as Member interest.\25\
Also, the ISE proposes to clarify that ISE Rule 717(f), which places
limitations on electronic orders, would not apply to transactions
executed pursuant to ISE Rule 723.\26\
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\25\ See proposed ISE Rule 723, Supplementary Material .01; see
also Amendment No. 2, supra note 6.
\26\ See proposed ISE Rule 723, Supplementary Material .05; see
also Amendment No. 2, supra note 6.
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Finally, the ISE proposes in Amendment No. 2 to amend the text of
ISE Rule 400 regarding solicited orders. The proposed addition to ISE
Rule 400 would clarify that nothing in the Supplementary Material .01
to ISE Rule 400 is intended to prohibit a member from soliciting
interest to execute against an order it represents as agent, the
execution of which is governed by ISE Rule 717(e) (Solicitation
Orders), and Supplementary Material .02 to ISE Rule 717.
In Amendment No. 3, the ISE proposes new Supplemental Material .06
to proposed ISE Rule 723 to establish that paragraphs (c)(5), (d)(5),
and (d)(6) of ISE Rule 723 would be effective for a pilot period
expiring on July 18, 2005.\27\ The ISE also proposes in new
Supplemental Material .06 that the Exchange would submit data relating
to the frequency with which the exposure period is terminated by
unrelated orders.\28\
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\27\ See proposed ISE Rule 723, Supplementary Material .06; see
also Amendment No. 3, supra note 8.
\28\ Id.
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III. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendments No. 2 and 3, including whether
Amendments No. 2 and 3 are consistent with the Act. Comments may be
submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or Send e-mail to rule-comments@sec.gov. Please include File
Number SR-ISE-2003-06 on the subject line.
Paper Comments
Send paper comments in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549-0609.
All submissions should refer to File Number SR-ISE-2003-06. This
file number should be included on the subject line if e-mail 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 Web site (http://www.sec.gov/rules/sro.shtml
). 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 inspection
and copying in the Commission's Public Reference Section, 450 Fifth
Street, NW., Washington, DC 20549. Copies of such filing also will be
available for inspection and copying at the principal office of the
ISE. All comments received will be posted without change; the
Commission does not edit personal identifying information from
submissions. You should submit only information that you wish to make
available publicly. All submissions should refer to File Number SR-ISE-
2003-06 and should be submitted on or before January 5, 2005.
IV. Discussion and Commission Findings
After careful review of the amended proposal and consideration of
the Comment Letter and Response Letter, the Commission finds that the
proposed rule change to establish rules for the implementation of the
ISE PIM is consistent with the requirements of the Act and the rules
and regulations thereunder applicable to a national securities exchange
\29\ and, in particular, the requirements of section 6 of the Act.\30\
Specifically, as discussed in greater detail below, the Commission
finds that the proposal is consistent with section 6(b)(5) of the
Act,\31\ which requires, in part, that the rules of an exchange be
designed to prevent fraudulent and manipulative acts and practices; to
promote just and equitable principles of trade; to foster cooperation
and coordination with persons engaged in regulating, clearing,
settling, and processing information with respect to, and facilitating
transactions in securities; 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. Section
6(b)(5) also requires that the rules of an exchange not be designed to
permit unfair discrimination among customers, issuers, brokers, or
dealers.
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\29\ In approving this proposal, the Commission has considered
the proposed rule's impact on efficiency, competition, and capital
formation. 15 U.S.C. 78c(f).
\30\ 15 U.S.C. 78f.
\31\ 15 U.S.C. 78f(b)(5).
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Specifically, the Commission believes that approving the ISE's
proposal to establish the PIM should confer important benefits to the
public by increasing competition between and among the options
exchanges, resulting in better prices and executions for investors. The
Comment Letter argues that because the ISE market structure does not
include many of the elements of the Boston Options Exchange (``BOX'')
market structure, the ISE PIM lacks basic customer protections and will
discourage price competition and aggressive bidding.\32\ The Commission
does not agree with these objections, and notes that market structures
need not be identical to be consistent with the Act; in fact, such a
policy would likely result in less competition between markets and
fewer innovations.
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\32\ See Comment Letter, supra note 5, at pp. 1-6.
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The Commission believes that the proposed ISE PIM provides
limitations on internalization comparable to the other exchanges' rules
that guarantee members the right to internalize their customers'
orders. In particular, as discussed below, the ISE's proposal would
require an EAM seeking to utilize the PIM to expose its Customer Order
before trading with that order and would further require a minimum of
three ISE market makers to be quoting in a particular series before a
PIM could be initiated. The Commission also believes that the access to
the PIM for those who may wish to compete for an Agency Order should be
sufficient to provide opportunities for a meaningful, competitive
auction.
The Commission therefore finds that, for the reasons discussed more
fully below, the ISE's proposal is consistent with the Act.
A. Need for Both PIM and ISE Facilitation Mechanism
In the Comment Letter, BSE argues that the ISE should have only one
facilitation process in its system.\33\ The Comment Letter notes that
ISE Rule 716(d) currently provides for a facilitation mechanism (``ISE
Facilitation Mechanism'') by which an EAM can facilitate block-size
\34\ Public Customer orders. According to the Comment Letter, the
election of a PIM
[[Page 75096]]
by an EAM to facilitate a Customer Order would always be better for the
Customer than the election of the ISE Facilitation Mechanism, whereas
the election of the ISE Facilitation Mechanism would always be better
for the EAM than the election of the PIM. The Comment Letter maintains
that for orders of over 50 contracts, EAMs would have an incentive to
seek first to facilitate an order through the ISE Facilitation
Mechanism and, if it appeared that the EAM would lose its guaranteed
allocation, the EAM would cancel the facilitation order and elect the
PIM.
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\33\ See Comment Letter, supra note 5, at p. 11.
\34\ ``Block''-size is defined under the ISE Rules as orders for
at least 50 contracts. See ISE Rule 716(a).
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The Commission does not agree with the Comment Letter's assertions
for several reasons. First, the ISE rules specifically provide that it
would be a violation of an ISE Member's duty of best execution to its
Customer if the Member were to cancel a facilitation order to avoid
execution of the order at a better price.\35\ Therefore, the BSE's
argument that an EAM could exploit the availability of both the
Facilitation Mechanism and the PIM by simply canceling its facilitation
order after it has been entered into the ISE Facilitation Mechanism to
avoid losing its allocation guarantee is not accurate, as such conduct
would be a violation of Exchange rules.
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\35\ See ISE Rule 716, Supplementary Material .01.
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Second, the Commission notes that ISE Members have an obligation of
best execution with respect to their Customer Orders. The Commission
has long held the view that in satisfying its duty of best
execution,\36\ which requires a broker to seek the most favorable terms
reasonably available under the circumstances for a customer's
transaction, a broker must periodically assess the quality of competing
markets to assure that order flow is directed to markets providing the
most beneficial terms for their customers' orders.\37\ The Commission
believes that this obligation would require an EAM to evaluate whether
the PIM or Facilitation Mechanism would provide better execution to
customers' orders.
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\36\ A broker-dealer's duty of best execution derives from
common law agency principals and fiduciary obligations and is
incorporated both in the rules of the self-regulatory organization,
and through judicial and Commission decisions, in the antifraud
provisions of the federal securities laws. See Securities Exchange
Act Release No. 37619A (September 6, 1996), 61 FR 48290 (September
12, 1996) (``Order Handling Rules Release''), note 348 and
accompanying text.
\37\ See id.
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B. Three Market Maker Requirement
Proposed ISE Rule 723 would require that there be at least three
Market Makers quoting in a relevant series at the time an EAM submits
its Crossing Transaction into the PIM.\38\ The Commission believes that
this requirement will improve the opportunity for an Agency Order to be
exposed to a competitive auction.\39\
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\38\ See proposed ISE Rule 723(b)(1); see also BOX Rules Chapter
V, Sec. 18(e).
\39\ See Securities Exchange Act Release No. 49068 (January 13,
2004), 69 FR 2775 (January 20, 2004) (Order approving the BOX as an
options trading facility of the BOX).
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C. Solicitation Process
The ISE's proposal would permit an ISE EAM to solicit interest from
other parties to participate in the Counter-Side Order in the PIM.\40\
In its Comment Letter, BSE argues that it is unclear whether ISE market
makers may be solicited to participate in the Counter-Side Order.\41\
The Commission notes, however, that an EAM would be prohibited from
soliciting an order from an ISE Market Maker, pursuant to ISE Rule
717(g).\42\ Furthermore, the Commission emphasizes that a blanket
exemption from ISE Rule 717(g) would not be permitted without
Commission approval of a proposed rule change submitted by the Exchange
under section 19(b) of the Act.\43\
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\40\ See proposed ISE Rule 723(a).
\41\ See Comment Letter, supra note 5.
\42\ ISE Rule 717(g) prohibits an EAM from causing the entry of
orders for the account of an ISE Market Maker.
\43\ 15 U.S.C. 78s(b).
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D. Three-Second PIM
1. Content of Broadcast Message
Under the ISE proposal, upon entry of a Crossing Transaction into
the PIM, a broadcast message would be sent to all ISE members to begin
the exposure period. The BSE suggests that the only information
provided to ISE members in the PIM broadcast would be the aggregate
size of the best-priced Improvement Orders (not improved Counter-Side
Orders) and that this would be insufficient information for market
participants to make fully-informed decisions about how to compete for
the Agency Order.\44\ In response to the Comment Letter, the ISE
proposes in Amendment No. 2 to clarify that the broadcast message would
include the series, price, and size of the Agency Order, and whether
the Agency Order is a buy or sell order. The ISE also proposes to
clarify that during the exposure period, the aggregate size of the best
prices, (including the Counter-Side Order, Improvement Orders, and any
changes to either) would continually be updated and broadcast to all
ISE Members.\45\
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\44\ See Comment Letter, supra note 5, at pp. 11-15.
\45\ See Amendment No. 2, supra note 6; see also proposed ISE
Rule 723(c)(4).
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The Commission believes that the proposed content of the broadcast
message at the initiation of the PIM should provide sufficient
information to permit interested market participants to participate in
the auction. In addition, the Commission does not believe that it is
necessary for the ISE to provide information about prices and sizes
below the best price.
2. Duration of the PIM
The ISE proposes that the duration of each PIM be three
seconds.\46\ The Commission believes that a three-second PIM should
afford electronic crowds sufficient time to compete for Agency Orders
submitted by an EAM. In reaching this conclusion, the Commission
believes that the timeframes necessary for exposure and execution of
orders be adjudged in light of the ISE's market structure. The
Commission reiterates that the critical issue is determining whether
the proposed three-second timeframe gives participants in a fully
automated marketplace sufficient time to respond to a PIM broadcast to
compete and provide price improvement for Agency Orders and whether
electronic systems are available to ISE members that would allow them
to respond to PIM broadcasts in a meaningful way within the proposed
timeframe.\47\ The Commission notes that the ISE is a fully electronic
exchange where crowd members interact by electronic means. The
Commission also notes that electronic systems are readily available to
ISE members--if not already in place--to allow them to respond to PIM
broadcasts.\48\
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\46\ The PIM would end prior to the expiration of the three-
second exposure period under certain circumstances. See proposed ISE
Rule 723(c)(5). See also infra notes 49-57 and accompanying text for
a more detailed discussion.
\47\ See supra note 40.
\48\ The Commission notes that the ISE offers a facilitation
mechanism through which an EAM can facilitate Public Customer orders
of 50 contracts or more. The ISE facilitation mechanism currently
employs an exposure period of ten seconds. See ISE Rule 716(d) and
Supplemental Material .02 to ISE Rule 716.
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3. Premature Termination of the PIM
As proposed, the PIM would end prematurely under certain
circumstances: \49\ (1) Upon the receipt of a market or marketable
limit order on
[[Page 75097]]
the Exchange in the same series on the opposite side of the market from
the Agency Order; \50\ (2) upon the receipt of a market or marketable
limit order on the Exchange in the same series on the same side of the
market as the Agency Order; \51\ (3) upon the receipt of a non-
marketable limit order in the same series on the same side of the
market as the Agency Order that would cause the price of the Crossing
Transaction to be outside of the best bid or offer on the Exchange.\52\
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\49\ With respect to the same series, no PIM will run
simultaneously with another PIM, nor will PIMs be permitted to queue
or overlap in any manner. See proposed ISE Rule 723, Supplementary
Material .04.
\50\ See proposed ISE Rule 723(c)(5)(ii).
\51\ Id.
\52\ See proposed ISE Rule 723(c)(5)(iii).
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The ISE's proposal would provide these unrelated orders with the
opportunity for price improvement.\53\ The Commission, however, is
concerned that this could result in an Agency Order being disadvantaged
by the premature conclusion of a PIM, in that it would not have
received the full three second auction exposure period in which to
receive price improvement.\54\
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\53\ See supra notes 16-23 and accompanying text.
\54\ The Commission notes that under the BOX rules, the BOX
Price Improvement Period (``PIP'') auction can be terminated prior
to the three-second period only in cases where an executable
unrelated order is submitted to BOX on the same side as the customer
order that was initially entered into the PIP. See BOX Rules,
Chapter V, Section 18(i). The BOX rules, unlike the ISE proposal, do
not permit the unrelated order to be executed against unexecuted
interest in the PIP after the facilitated customer order is executed
in full.
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The Commission notes that proposed ISE Rule 723, Supplementary
Material .01 states that it would be considered conduct inconsistent
with just and equitable principles of trade for any ISE Member to enter
orders, quotes, Agency Orders, Counter-Side Orders, or Improvement
Orders for the purposes of disrupting or manipulating the PIM.\55\ The
Commission believes that this proposed rule should help to address its
concern, because ISE Members would be prohibited from deliberately
entering unrelated orders in the ISE system to end the PIM prematurely
to disrupt or manipulate it.\56\
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\55\ See proposed ISE Rule 723, Supplementary Material .01. See
also Amendment No. 2, supra note 6.
\56\ In addition, the ISE has provided Commission staff with
details regarding its proposed PIM surveillance procedures. See
Letter to Nancy Sanow, Assistant Director, Division, Commission,
from Michael J. Simon, Senior Vice President & General Counsel, ISE,
dated October 14, 2004. The Commission notes that as a matter of
Commission policy, surveillance programs and procedures are
generally kept confidential. Disclosure of specific surveillance
procedures could provide market participants with information that
could aid attempts at avoiding regulatory detection of inappropriate
trading activity.
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Moreover, the ISE has proposed that those portions of proposed ISE
Rule 723 relating to the premature termination of the PIM be effective
on a pilot basis. The Commission believes that approval of these
provisions on a pilot basis is appropriate and will afford both the
Exchange and the Commission an opportunity to analyze the impact of
unrelated orders on the PIM, as well as the ISE's surveillance
procedures with respect to the PIM.\57\
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\57\ The ISE's surveillance plan and procedures are subject to
inspection by the Commission, to ensure that the ISE adequately
monitors its market and its members, and enforces its rules and the
federal securities laws, including the anti-fraud provisions.
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E. Competition in the PIM
Under the ISE's proposal, all ISE Members would be permitted to
participate in a PIM.\58\ Improvement Orders entered by ISE members may
be for their own account or for the account of a Public Customer.\59\
In addition, unrelated orders could compete in standard increments to
trade with the Agency Order in the PIM. Such unrelated orders could
include agency orders on behalf of Public Customers, market makers on
other exchanges, and non-ISE member broker-dealers, as well as non-
Improvement orders submitted by ISE members.
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\58\ See proposed ISE Rule 723(c).
\59\ Id.
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The BSE questions how Improvement Orders from Public Customers
would be handled by an EAM.\60\ In its Response Letter, the ISE
clarifies that Public Customer orders would be handled as provided
under the current ISE Rules. Specifically, there would be no
limitations on the ability of Public Customers to participate in the
PIM, and ISE members may represent Public Customers in a PIM under any
type of instruction they wish to accept without restriction.\61\ The
Commission believes that the lack of restrictions on the participation
of Public Customers in the PIM should increase the opportunity for them
to participate in the PIM.
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\60\ See Comment Letter, supra note 5, at p. 16.
\61\ See Response Letter, supra note 7, at pp. 4-5.
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The BSE also argues that under ISE Rule 717, which prohibits
customers from creating and transmitting orders electronically unless
such orders are non-marketable limit orders to buy (sell) that are
priced higher (lower) than the best ISE bid or offer, Public Customers
would not be permitted to participate in the PIM.\62\ In response, the
ISE, in Amendment No. 2, proposes that ISE Rule 717(f) would not apply
to transactions executed pursuant to proposed ISE Rule 723.\63\ The
Commission believes that Amendment No. 2 sufficiently clarifies the
application of ISE Rule 717.
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\62\ See Comment Letter, supra note 5, at p. 19.
\63\ See Amendment No. 2, supra note 6. See also proposed ISE
Rule 723, Supplementary Material .05. In its Response Letter, the
ISE stated that ISE Rule 717(f) was not intended to be applied to
orders entered into the PIM. See Response Letter, supra note 7, at
p. 5.
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Finally, the BSE argues that a lack of time priority would
discourage price competition in the PIM.\64\ The Commission disagrees
with this assertion and, instead, continues to believe that allocations
based on price/size priority are consistent with the Act.\65\
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\64\ See Comment Letter, supra note 5, at pp. 6-8.
\65\ See Securities Exchange Act Release Nos. 47959 (May 30,
2003), 68 FR 34441 (June 9, 2003) (Order approving the CBOE Hybrid
System where, pursuant to CBOE Rule 6.45A, the applicable floor
procedure committee could determine to weight the allocation
algorithm so that the entire allocation would be based on size pro
rata); and 46514 (September 18, 2002), 67 FR 60267 (September 25,
2002) (Order approving ISE proposal relating to the allocation of
customer orders on a price/size priority basis).
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F. Improvement Orders
As discussed above, during the PIM, ISE members may submit
Improvement Orders. Improvement Orders would be submitted in penny
increments and would be valid only in the PIM process. The BSE asks
whether an ISE Member that submits an Improvement Order may reduce the
size of the Improvement Order at the same price.\66\ In its Response
Letter, the ISE notes that its proposed rules provide that an
Improvement Order may be modified only to increase the size at the same
price, or improve the price of the Improvement Order for any size up to
the size of the Agency Order.\67\ The Commission believes that the
proposed ISE rules make clear that ISE Members would not be permitted
to reduce the size of an Improvement Order without improving its price.
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\66\ See Comment Letter, supra note 5, at p. 16.
\67\ See Response Letter, supra note 7 p. 5; see also proposed
ISE Rule 723(c)(3).
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G. PIM Trade Allocation
With multiple trading of options, individual options markets are
under significant pressure to attract or retain business. One approach
to increasing business on an exchange is to allow members a preference
in trading with customer orders that they bring to the exchange. The
Commission, however, has expressed its concern that proposals by
options exchanges that guarantee a significant portion of orders to any
market participant could erode the incentive to display aggressively
priced quotes.\68\ Thus, the Commission must weigh whether the proposed
[[Page 75098]]
participation right would so substantially reduce the ability of other
market participants to trade with an order that it would reduce price
competition. As the Commission has noted previously:
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\68\ See, e.g., Securities Exchange Act Release No. 43100 (July
31, 2000), 65 FR 48778 (August 9, 2000).
It is difficult to assess the precise level at which guarantees
may begin to erode competitive market maker participation and
potential price competition within a given market. In the future,
after the Commission has studied the impact of guarantees, the
Commission may need to reassess the level of these guarantees. For
the immediate term, the Commission believes that 40% is not clearly
inconsistent with the statutory standards of competition and free
and open markets.\69\
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\69\ See Securities Exchange Act Release No. 42455 (February 24,
2000), 65 FR 11388 (March 2, 2000) (order approving registration of
the ISE as a national securities exchange).
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The ISE PIM proposal would provide that at the conclusion of the
PIM exposure period, the Agency Order would be executed in full against
the best-priced orders, including orders and quotes in the Exchange
market, Improvement Orders, and the Counter-Side Order.\70\ The ISE
would execute the Agency Order against the best prices as follows: (1)
All Public Customer Improvement Orders and unrelated Public Customer
orders on the book at the best price would be executed first; (2) all
unrelated agency orders on the book for the Account of a non-Member
broker-dealer would then be executed; (3) if the Counter-Side Order is
at the best price, it would then be executed against the greater of one
contract or 40% percent of the Agency Order; and (4) the remainder of
the order would be allocated to all other interest, which includes
Improvement Orders and unrelated orders on the book for the account of
an ISE Member (including ISE market makers), at the best price pro-rata
based on size.\71\
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\70\ See proposed ISE Rule 723(d).
\71\ See proposed ISE Rule 723(d)(1)-(4).
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The BSE argues that the ISE's proposal to allow a 40% guarantee to
the Counter-Side Order based on the size of the original order is
inconsistent with facilitation rules for BOX's PIP auction.\72\
However, the Commission believes that the ISE's proposal, which
entitles (subject to certain exceptions) an EAM who submits the
Counter-Side Order to 40% of the Agency Order, is not inconsistent with
the Act. In addition, the Commission notes that the guarantee for the
EAM bringing an Agency Order to the PIM is consistent with the
facilitation guarantees in place at other options exchanges.\73\
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\72\ See Comment Letter, supra note 5, at p. 9. See also BOX
Rules, Chapter V, Sec. 18 (f).
\73\ See Securities Exchange Act Release No. 47628 (April 3,
2003), 68 FR 17697 (April 10, 2003) (approving proposal by the
Chicago Board Options Exchange, Inc. to establish rules for
CBOEdirect trading system). See also ISE Rule 716(d) (ISE
Facilitation Mechanism).
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The Commission believes that the ISE PIM proposal should promote
price competition within the PIM by providing ISE Members with a
reasonable opportunity to compete for a significant percentage of the
incoming order and, therefore, should protect investors and the public
interest. The Commission continues to believe that a 40% allocation is
consistent with the statutory standards for competition and free and
open markets.
On a related note, the BSE points out that the proposal does not
describe the order of priority among the excess Improvement Orders in
the situation where an unrelated marketable order on the same side of
the market as the Agency Order terminates the PIM.\74\ In response, the
ISE proposes in Amendment No. 2 to clarify that these executions would
follow the same execution priority rules described in proposed ISE Rule
723(d)(1)-(4).
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\74\ See Comment Letter, supra note 5, at p. 18.
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H. Section 11(a) of the Act
Section 11(a) of the Exchange Act \75\ prohibits a member of a
national securities exchange from effecting transactions on that
exchange for its own account, the account of an associated person, or
an account over which it or its associated person exercises discretion
(collectively, ``covered accounts'') unless an exception applies.
Section 11(a)(1)(G) \76\ and Rule 11a1-1(T) \77\ under the Act provide
an exception to the general prohibition in Section 11(a) on an exchange
member effecting transactions for its own account. Specifically, a
member that ``is primarily engaged in the business of underwriting and
distributing securities issued by other persons, selling securities to
customers, and acting as broker, or any one or more of such activities,
and whose gross income normally is derived principally from such
business and related activities'' \78\ and effects a transaction in
compliance with the requirements in Rule 11a1-1(T)(a) \79\ may effect a
transaction for its own account. Among other things, Rule 11a1-1(T)(a)
requires that an exchange member presenting a bid or offer for its own
account or the account of another member shall grant priority to any
bid or offer at the same price for the account of a non-member of the
exchange.\80\ Because proposed ISE Rule 723 would require EAMs and
Exchange Market Makers to yield priority in the PIM to all non-Member
orders, the Commission believes that the proposal is consistent with
the requirements in section 11(a) and Rule 11a1-1(T) under the Act.
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\75\ 15 U.S.C. 78k(a).
\76\ 15 U.S.C. 78k(a)(1)(G).
\77\ 17 CFR 240.11a1-1(T).
\78\ 15 U.S.C. 78k(a)(1)(G)(i). Paragraph (b) of Rule 11a1-1(T)
under the Act provides that a member shall be deemed to meet the
requirements of Section 11(a)(1)(G)(i) of the Act if during its
preceding fiscal year more than 50% of its gross revenues was
derived from one or more of the sources specified in that section.
In addition to any revenue which independently meets the
requirements of Section 11(a)(1)(G)(i), revenue derived from any
transaction specified in paragraph (A), (B), or (D) of Section
11(a)(1) of the Act or specified in Rule 11a1-4(T) shall be deemed
to be revenue derived from one or more of the sources specified in
Section 11(a)(1)(G)(i).
\79\ 15 U.S.C. 78k(a)(1)(G)(ii).
\80\ 17 CFR 240.11a1-1(T)(a)(3).
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Under the proposal, Public Customer interest in the PIM would be
executed in full before orders for the account of non-Member broker-
dealers could be executed. The BSE argues that section 11(a) does not
require Public Customers to be treated preferentially to other non-
Members.\81\ The Commission notes, however, that section 11(a)(1)(G) of
the Act and the rules thereunder do not prohibit Public Customers from
being treated preferentially relative to other non-Members. Instead,
the statute and the rules require only that non-Member orders receive
priority over Member orders. Under the ISE's proposed rules, Public
Customer and non-Member broker-dealer orders would receive first
priority. Therefore, the Commission believes that the proposed ISE PIM
priority execution rules would comply with section 11(a) of the
Act.\82\
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\81\ See Comment Letter, supra note 5, at p. 19.
\82\ 15 U.S.C. 78k(a).
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I. Quote Rule
The BSE argues that the proposed ISE PIM rules violate Rule 11Ac1-1
under the Act (the ``Quote Rule''),\83\ because inbound unrelated
market or marketable limit orders on the same side of the market as the
Agency Order would be permitted to execute against any unexecuted
interest in the PIM after the Agency Order is executed in full on a
pilot basis until July 18, 2005.\84\ In response, the ISE has requested
an exemption from the Quote Rule for unexecuted interest in the PIM
auction after the Agency Order has been executed in full.\85\ Under
separate cover,
[[Page 75099]]
the Commission granted the ISE a limited exemption pursuant to
paragraph (e) of the Quote Rule from its obligations under paragraph
(b) of the Quote Rule that permits the Exchange to collect from its
members the quotation sizes and aggregate quotation sizes communicated
to the Exchange by responsible brokers or dealers with respect to
Counter-Side Orders in connection with the PIM without making such
quotation sizes available to quotation vendors.\86\ The Commission
believes that the 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 because it
would permit the ISE to execute unrelated orders against trading
interest priced better than the NBBO.\87\
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\83\ 17 CFR 240.11Ac1-1.
\84\ See Comment Letter, supra note 5, at p. 19.
\85\ See Letter from Michael J. Simon, Senior Vice President and
General Counsel, ISE, to Annette Nazareth, Director, Division,
Commission, dated November 15, 2004.
\86\ See Letter from Robert L.D. Colby, Deputy Director,
Division, Commission, to Michael J. Simon, Senior Vice President and
General Counsel, ISE, dated December 8, 2004.
\87\ Id.
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J. Trade-Through Issues
As noted above, the PIM would automatically terminate under certain
circumstances, including upon the receipt of a non-marketable limit
order in the same series on the opposite side of the market as the
Agency Order that would cause the price of the Crossing Transaction to
be outside of the best bid or offer on the Exchange.\88\ The BSE argues
that the proposed PIM is inconsistent with the options intermarket
linkage plan,\89\ because a PIM execution could ``trade through'' \90\
another exchange's market in such a case.\91\ In Amendment No. 2, the
ISE proposes to amend its proposal to state that when a market order or
marketable limit order on the opposite side of the market from the
Agency Order ends the exposure period, it would participate in the
execution of the Agency Order at the price that is mid-way between the
best counter-side interest and the NBBO.\92\
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\88\ Under such circumstances, (1) the PIM would be concluded;
(2) the Agency Order executed; and (3) the non-marketable limit
order would be displayed on the ISE book.
\89\ See Securities Exchange Act Release No. 43086 (July 28,
2000), 65 FR 48023 (August 4, 2000) (Order approving the Plan for
the Purpose of Creating and Operating an Intermarket Option Linkage
or ``Linkage Plan'').
\90\ A trade-through means a transaction in an options series at
a price that is inferior to the NBBO. See Linkage Plan, Section
2(29).
\91\ See Comment Letter, supra note 5, at p. 18.
\92\ See Response Letter, supra note 7, at p. 5; see also
Amendment No. 2, supra note 6.
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The Commission notes that all orders executed in the PIM are
``guaranteed'' at a better price than the NBBO at the initiation of the
PIM. The Commission believes that the trade should be considered to
have occurred at the time the order is guaranteed at a price at least a
penny better than the NBBO. Accordingly, the Commission does not
believe that it should be considered a trade-through if a trade is
executed through the PIM at a price that is better than the NBBO at the
commencement of the PIM, but because of a change in the NBBO--inferior
to the NBBO at the conclusion of the PIM. Therefore, the Commission
finds that ISE's proposed PIM is consistent with the Linkage Plan. The
Commission reminds brokers, however, that they must always consider
their best execution obligations.
K. No Minimum Size Requirement for PIM
One of the principal differences between the ISE's proposed PIM and
most other exchanges' rules that guarantee members the right to trade
with their customer orders is that the PIM would be available for
orders of fewer than 50 contracts. Under the ISE's proposal, there
would be no minimum size requirement for orders entered into the PIM,
for a pilot period expiring on July 18, 2005.\93\
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\93\ The July 18, 2005, pilot expiration date corresponds to the
expiration of a similar pilot program for the BOX's PIP, which
provided that there is no minimum size requirement for orders
entered into the PIP, encompassing a period of 18 months from
commencement of the BOX. See BOX Rules, Chapter V, Sect. 18,
Supplementary Material .01.
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The Commission believes that the ISE's proposal may provide small
customer orders with benefits not available under the rules of most
other exchanges, and is consistent with the Act. In particular, any
Agency Order entered into the PIM is guaranteed an execution at the end
of the auction at a price at least a penny better than the NBBO. In
addition, the Commission believes that the ISE's proposal provides the
opportunity for more market participants to compete in its auction. For
example, the ISE would permit all members and Public Customers to
participate in the PIM.
The Commission will evaluate the PIM during the pilot period to
determine whether it would be beneficial to customers and to the
options market as a whole to approve any proposal requesting permanent
approval to permit orders of fewer than 50 contracts to be submitted to
the PIM. In addition, the Commission will examine the data submitted by
the ISE with respect to situations in which the PIM is terminated
prematurely by an unrelated order. To aid the Commission in its
evaluation, the ISE represents that it will provide the following
information each month:
(1) The number of orders of fewer than 50 contracts entered into
the PIM;
(2) The percentage of all orders of fewer than 50 contracts sent to
ISE that are entered into ISE's PIM;
(3) The percentage of all ISE trades represented by orders of fewer
than 50 contracts;
(4) The percentage of all ISE trades effected through the PIM
represented by orders of fewer than 50 contracts;
(5) The percentage of all contracts traded on ISE represented by
orders of fewer than 50 contracts;
(6) The percentage of all contracts effected through the PIM
represented by orders of fewer than 50 contracts;
(7) The spread in the option, at the time an order of fewer than 50
contracts is submitted to the PIM;
(8) Of PIM trades, the percentage done at the NBBO plus $.01, plus
$.02, plus $.03, etc.;
(9) The number of orders submitted by EAMs when the spread was
$.05, $.10, $.15, etc. For each spread, specify the percentage of
contracts in orders of fewer than 50 contracts submitted to ISE's PIM
that were traded by: (a) The EAM that submitted the order to the PIM;
(b) ISE Market Makers assigned to the class; (c) other ISE members; (d)
Public Customer Orders; and (e) unrelated orders (orders in standard
increments entered during PIM);
(10) The number of times that a market or marketable limit order in
the same series on the same side of the market as the Agency Order
prematurely ended the PIM auction, and the number of times such orders
were entered by the same (or affiliated) firm that initiated the PIM
that was terminated;
(11) The percentage of PIM early terminations due to the receipt of
a market or marketable limit order in the same series on the same side
of the market that occurred within a \1/2\ second of the start of the
PIM auction; the percentage that occurred within one second of the
start of the PIM auction; the percentage that occurred within one and
\1/2\ second of the start of the PIM auction; the percentage that
occurred within 2 seconds of the start of the PIM auction; the
percentage that occurred within 2 and \1/2\ seconds of the PIM auction;
and the average amount of price improvement provided to the Agency
Order where the PIM is terminated early at each of these time periods;
(12) The number of times that a market or marketable limit order in
the same series on the opposite side of the
[[Page 75100]]
market as the Agency Order prematurely ended the PIM auction and at
what time the unrelated order ended the PIM auction, and the number of
times such orders were entered by the same (or affiliated) firm that
initiated the PIM that was terminated;
(13) The percentage of PIM early terminations due to the receipt of
a market or marketable limit order in the same series on the opposite
side of the market that occurred within a \1/2\ second of the start of
the PIM auction; the percentage that occurred within one second of the
start of the PIM auction; the percentage that occurred within one and
\1/2\ second of the start of the PIM auction; the percentage that
occurred within 2 seconds of the start of the PIM auction; the
percentage that occurred within 2 and \1/2\ seconds of the PIM auction;
and the average amount of price improvement provided to the Agency
Order where the PIM is terminated early at each of these time periods;
(14) The number of times that a non-marketable limit order in the
same series on the same side of the market as the Agency Order that
would cause the price of the Crossing Transaction to be outside of the
best bid or offer on the Exchange prematurely ended the PIM auction and
at what time the unrelated order ended the PIM auction, and the number
of times such orders were entered by the same (or affiliated) firm that
initiated the PIM that was terminated;
(15) The percentage of PIM early terminations due to the receipt of
a market or marketable limit order in the same series on the same side
of the market as the Agency Order that would cause the price of the
Crossing Transaction to be outside of the best bid or offer on the
Exchange that occurred within a \1/2\ second of the start of the PIM
auction; the percentage that occurred within one second of the start of
the PIM auction; the percentage that occurred within one and \1/2\
second of the start of the PIM auction; the percentage that occurred
within 2 seconds of the start of the PIM auction; the percentage that
occurred within 2 and \1/2\ seconds of the PIM auction; and the average
amount of price improvement provided to the Agency Order where the PIM
is terminated early at each of these time periods; and
(16) The average amount of price improvement provided to the Agency
Order when the PIM auction is not terminated early (i.e., runs the full
three seconds).
VI. Accelerated Approval of Amendments No. 2 and 3
Pursuant to section 19(b)(2) of the Act,\94\ the Commission may not
approve any proposed rule change, or amendment thereto, prior to the
30th day after the date of publication of notice of the filing thereof,
unless the Commission finds good cause for so doing and publishes its
reasons for so finding. The Commission hereby finds good cause for
approving Amendments No. 2 and 3 to the proposal, prior to the 30th day
after publishing notice of Amendments No. 2 and 3 in the Federal
Register. The revisions made to the proposal in the ISE's Amendment No.
2 clarify the operation of the PIM and were provided in response to
issues raised in the Comment Letter and by Commission staff. In
addition, the ISE in Amendment No. 3 established that paragraphs
(c)(5), (d)(5), and (d)(6) of proposed ISE Rule 723 would be effective
for a pilot period expiring on July 18, 2005. The Commission believes
that the proposed changes in Amendments No. 2 and 3 are necessary to
the proper functioning and implementation of the ISE PIM. The
Commission further believes that Amendments No. 2 and 3 do not raise
issues of regulatory concern that warrant further delay. Therefore, the
Commission believes that accelerated approval of Amendments No. 2 and 3
is appropriate. Accordingly, pursuant to section 19(b)(2) of the
Act,\95\ the Commission finds good cause to approve Amendments No. 2
and 3 prior to the 30th day after notice of the Amendment is published
in the Federal Register.
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\94\ 15 U.S.C. 78s(b)(2).
\95\ 15 U.S.C. 78s(b)(2).
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VII. Conclusion
For the foregoing reasons, the Commission finds that the proposed
rule change, as amended, is consistent with the Act and the rules and
regulations thereunder applicable to a national securities exchange,
and, in particular, with section 6(b)(5) of the Act.\96\
It is therefore ordered, pursuant to section 19(b)(2) of the
Act,\97\ that the proposed rule change (SR-ISE-2003-06) and Amendment
No. 1 are approved; and that Amendments No. 2 and 3 thereto are
approved on an accelerated basis, except that provisions relating to
paragraphs (c)(5), (d)(5), and (d)(6) of ISE Rule 723 are approved on a
pilot basis until July 18, 2005.
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\96\ 15 U.S.C. 78f(b)(5). In connection with the issuance of
this approval order, neither the Commission or its staff is granting
any exemptive or no-action relief from the requirements of Rule 10b-
10. Accordingly, a broker-dealer executing a customer order through
the PIM will need to comply with all applicable requirements of that
Rule.
\97\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\98\
J. Lynn Taylor,
Assistant Secretary.
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\98\ 17 CFR 200.30-3(a)(12).
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[FR Doc. 04-27395 Filed 12-14-04; 8:45 am]
BILLING CODE 8010-01-P