[Federal Register: April 10, 2003 (Volume 68, Number 69)]
[Notices]
[Page 17697-17712]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr10ap03-143]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-47628; File No. SR-CBOE-00-55]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Notice of Filing and Order Granting Accelerated Approval of
Amendment No. 4 Thereto by the Chicago Board Options Exchange,
Incorporated to Establish Rules for a Screen-Based Trading System Known
as CBOEdirect
April 3, 2003.
On November 9, 2000, the Chicago Board Options Exchange,
Incorporated (``CBOE'' 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 proposal to establish rules for a screen-based trading
system known as CBOEdirect. Subsequently, CBOE submitted three
amendments to the proposed rule change.\3\ On May 8,
[[Page 17698]]
2002, the Commission published the amended proposal in the Federal
Register.\4\ The Commission received no comments on the proposal. On
March 14, 2003, CBOE submitted a fourth amendment to the proposal.\5\
This notice and order solicits comment on Amendment No. 4 and approves
the proposal, as amended, on an accelerated basis.\6\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See letters from Angelo Evangelou, Legal Division, CBOE, to
Nancy Sanow, Division of Market Regulation, Commission, dated
October 25, 2001 (``Amendment No. 1''); April 1, 2002 (``Amendment
No. 2''); and April 18, 2002 (``Amendment No. 3''). Amendment No. 1
superceded the original submission in its entirety and made
substantial changes to the proposed rule text and the accompanying
narrative. In Amendment No. 2, CBOE revised the proposed trade
nullification rule for CBOEdirect. In Amendment No. 3, CBOE further
modified the proposed trade nullification rule.
\4\ See Securities Exchange Act Release No. 45829 (April 25,
2002), 67 FR 31002 (``Notice'').
\5\ See letter from Angelo Evangelou, Legal Division, CBOE, to
Nancy Sanow, Division of Market Regulation, Commission, dated March
13, 2003 (``Amendment No. 4''). For the matters addressed in
Amendment No. 4, see infra section III.
\6\ In addition, CBOE submitted a letter to the Division of
Market Regulation requesting interpretive guidance under section
11(a) of the Act, 15 U.S.C. 78k(a), and rule 11a2-2(T) thereunder,
17 CFR 240.11a2-2(T). See letter from Angelo Evangelou, Legal
Division, CBOE, to Catherine McGuire, Division of Market Regulation,
Commission, dated March 28, 2003. In response to CBOE's request,
staff of the Division of Market Regulation provided interpretive
guidance under section 11(a) of the Act. See letter from Paula R.
Jenson, Division of Market Regulation, Commission, to Angelo
Evangelou, Legal Division, CBOE, dated March 31, 2003.
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I. Description of the Proposal
The Exchange proposed rules governing CBOEdirect, a screen-based
trading system (``SBT System'') that allows market participants to
trade options in a wholly electronic environment. CBOEdirect will
supplement the Exchange's floor-based open outcry auction market. Many
of CBOE's existing rules also will apply to CBOEdirect; CBOE provided a
list of these rules as Appendix A to the proposed rule change.\7\ CBOE
also has proposed a number of new rules that would govern the SBT
System.
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\7\ See notice, supra note 4, 67 FR at 31016-22 (listing the
existing Exchange rules in chapters I through XXVII that would apply
to CBOEdirect and indicating those rules that would be supplemented
by the CBOEdirect rules). In Amendment No. 4, CBOE made several
revisions to Appendix A.
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The Exchange commenced operating CBOEdirect as a pilot trading
system in October 2001 pursuant to rule 19b-5 under the Act \8\ and
currently is used to trade three classes of index options during an
early morning session. CBOEdirect is designed, however, to handle a
full range of products that currently trade on CBOE's floor.
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\8\ 17 CFR 240.19b-5. Rule 19b-5 provides that a self-regulatory
organization (``SRO'') may operate a pilot trading system without
obtaining prior Commission approval for the rules governing such
system, provided that the SRO files a Form PILOT with the Commission
and meets the other criteria set forth in rule 19b-5. On September
7, 2001, CBOE filed with the Commission a Form PILOT with respect to
CBOEdirect. An SRO may commence operation of a pilot trading system
no sooner than 20 days after filing its Form PILOT. See 17 CFR
240.19b-5(e)(1). CBOE commenced operation of the SBT System on
October 26, 2001. Rule 19b-5 requires an SRO, within two years of
commencing operations of the pilot trading system, to file a
proposed rule change pursuant to section 19(b)(2) of the Act, 15
U.S.C. 78s(b)(2), to obtain permanent authority to operate that
system. See 17 CFR 240.19b-5(f)(1). The proposed rule change that is
the subject of this Order was submitted pursuant to that
requirement.
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A. Overview of CBOEdirect
Any CBOE member that chooses to participate on the SBT System must
apply with the Exchange to act as an SBT market maker, SBT broker, or
proprietary trader (collectively, ``SBT traders'').\9\ An SBT trader
may connect to CBOEdirect from any place in the United States where it
has a workstation and communication link to the Exchange.\10\ Orders
may be submitted through the current wire order facility (used to send
orders to the Exchange's open-outcry auction market), an SBT
workstation, or a computer-to-computer link using a new application
program interface (``API''). Any SBT trader may submit an order to
CBOEdirect; only an SBT market maker may enter quotes.\11\ The SBT
System provides SBT traders with the means to electronically hit a bid
or take an offer, resulting in either a full or partial execution of
the existing bid or offer.\12\
A concept central to the operation of CBOEdirect is the ``legal
width market.'' A legal width market would exist in an option series if
the best bid and the best ask available on the SBT System were within a
prescribed width.
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\9\ See CBOE rule 41.2.
\10\ See CBOE rule 41.3.
\11\ Other SBT traders would be prohibited from entering limit
orders in the same options series, for the account or accounts of
the same or related beneficial owners, in such a manner that the
order provider or the beneficial owner(s) effectively would be
operating as a market maker by holding itself out as willing to buy
and sell option contracts on a regular or continuous basis. See CBOE
rule 43.6(c).
\12\ See notice, supra note 4, 67 FR at 31037-38.
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These widths are as follows:
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Maximum
Bid range allowable quote
spread
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Less than $2.00........................................ $0.25
$2.00-$5.00............................................ 0.40
$5.01-$10.00........................................... 0.50
$10.01-$20.00.......................................... 0.80
$20.01-higher.......................................... 1.00
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A legal width market on CBOEdirect may be established by an
unrelated bid and offer. See CBOE rule 44.4(b). The appropriate Market
Performance Committee may widen the legal width market for one or more
option series for a period of time not to exceed the remainder of the
existing expiration cycle. See CBOE rule 44.4(e). If the committee were
to modify the legal width market, an information circular would be
issued to provide notice of such modification. See id.
The legal width market feature is designed to prevent executions
from occurring at unfair or unreasonable prices. For example, a market
order for a particular option series would execute immediately only if
a legal width market existed in that series at the moment the order was
entered. If a legal width market in that series did not exist when the
market order was entered, the SBT System would generate a request for
quote (``RFQ'') 13 14 in an effort to establish a legal
width market.
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\13 14\ See CBOE rule 40.1(m).
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CBOEdirect would send the RFQ to: (1) SBT market makers who are
logged on to the SBT system and who hold an appointment in the subject
option class; and (2) any non-appointed SBT market maker who is quoting
in that class at the time of the RFQ. The market makers' responses
(i.e., quotes) would be submitted to the SBT book and displayed as they
arrived. If the responses were not sufficient to establish a legal
width market, the System would continue to hold the market order,
repeat the RFQ cycle, and send an alert message to the Help Desk, which
then could solicit quotes from the SBT market makers.\15\ The Help Desk
would have the authority to send a Special RFQ to the SBT market makers
that would require a response.\16\ However, assuming that the RFQ
responses created a legal width market, the order being held by the
System would execute in a manner described in section I.H.1. below.
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\15\ See CBOE rule 43.7(b).
\16\ See id.; CBOE rule 40.1(n).
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When the SBT System eventually is so enabled, CBOEdirect would
similarly protect a marketable limit order for an options series for
which a legal width market did not exist at the time of order entry by
running the RFQ cycle before attempting to execute the limit order.
Presently, however, a limit order would execute immediately if the
limit order were marketable on the SBT book, even if a legal width
market did not exist. A fuller description of limit order processing is
contained in section I.H.2. below.
CBOE anticipates that, during regular trading hour (``RTH'')
sessions,\17\
[[Page 17699]]
multiple SBT market makers would continuously quote actively traded
products, while less actively traded products would be quoted through
the RFQ process.\18\ The Exchange indicated, however, that when the SBT
System is used during an extended trading hour (``ETH'') session, most
products likely would be quoted through RFQs.\19\
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\17\ See CBOE rule 40.1(l) (definition of ``regular trading hour
session'').
\18\ See notice, supra note 4, 67 FR at 31038.
\19\ In addition, the appropriate SBT Trading Committee may
determine to limit the kinds of orders that may be traded during an
ETH session, even if such order types may be traded during an RTH
session. See CBOE rule 43.2(b). CBOE has represented that it would
distribute an information circular indicating any committee
determination to limit the order types that may be traded during an
ETH session. Telephone conversation between Angelo Evangelou, Legal
Division, CBOE, and Elizabeth King, Division of Market Regulation,
Commission, on June 21, 2002 (``June 21 conversation'').
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B. Market Participants
1. Market Makers
An SBT market maker is a CBOE member who is either an SBT standard
market maker, an SBT designated primary market maker (``DPM''), or an
SBT lead market maker (``LMM''). An applicant for registration as an
SBT market maker must file an application with the Exchange's
Membership Department; the Exchange's Membership Committee may approve
or disapprove the applicant's registration as an SBT market maker.\20\
A registered SBT market maker may apply for an appointment in one or
more classes of option contracts traded on CBOEdirect. The appropriate
Market Performance Committee may arrange two or more classes of options
into groupings and make appointments to those groupings rather than to
individual classes. The appropriate Market Performance Committee may
suspend or terminate any appointment of an SBT market maker or make
additional appointments whenever, in the Committee's judgment, the
interests of a fair and orderly market would best be served by such
action.\21\
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\20\ See CBOE rule 44.2(a).
\21\ See CBOE rule 44.3(a).
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With respect to each class of options for which it holds an
appointment, an SBT market maker has a continuous obligation to engage,
to a reasonable degree under the existing circumstances, in dealings
for its own account when there exists or it is reasonably anticipated
that there will exist, a lack of price continuity, a temporary
disparity between the supply of and demand for a particular option
contract, or a temporary distortion of the price relationships between
option contracts of the same class. An SBT market maker is expected to
perform the following activities in the course of maintaining a fair
and orderly market:
[sbull] Competing with other SBT market makers to improve markets
in all series of options class in which the SBT market maker holds an
appointment;
[sbull] Making markets which, absent changed market conditions,
will be honored for the number of contracts entered into the SBT System
in all series of options classes in which the SBT market maker holds an
appointment; and
[sbull] Updating market quotations in response to changed market
conditions in all series of options classes in which the SBT market
maker holds an appointment.\22\
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\22\ See CBOE rule 44.4(a)(1). In Amendment No. 4, the Exchange
clarified SBT market makers' obligations by incorporating into CBOE
rule 44.4(a)(1) the provisions of its existing CBOE rule 8.7
(setting forth market makers' obligations on the Exchange floor),
modified to take into account differences between making markets on
a physical floor and on an electronic platform.
In addition, at least 75% of an SBT market maker's total contract
volume on CBOEdirect must be in options classes in which it holds an
appointment.\23\
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\23\ See CBOE rule 44.4(a)(2).
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Furthermore, SBT market makers are required to respond to a certain
percentage of RFQs that they receive. The appropriate Market
Performance Committee has the authority to determine the percentage of
RFQs to which an SBT standard market maker would be required to
respond, which percentage may not be less than 75%,\24\ and may vary
the RFQ response rate on a series-by-series basis.\25\ SBT DPMs and
LMMs are subject to higher requirements and must respond to 98% of the
RFQs that they receive.\26\ An SBT market maker would be credited for
an RFQ response only if: (1) The SBT market maker responds to the RFQ
with a two-sided market within a number of seconds designated by the
appropriate Market Performance Committee; (2) the quote width is equal
to or narrower than a legal width market; \27\ (3) the quote size is at
least equal to the minimum size specified by the appropriate Market
Performance Committee and in any case is at least five contracts; and
(4) the SBT market maker provides a continuous market for 30 seconds,
or the quote is filled before the 30-second period expires.\28\ The SBT
market maker could change its quote during this period but could not
cancel it to receive credit for the response.\29\
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\24\ See CBOE rule 44.4(b). The response rate would be computed
as the number of times the SBT market maker made a credited
response, divided by the number of RFQs to which the market maker
was obligated to respond. See notice, supra note 4, 67 FR at 31039.
In addition, the appropriate Market Performance Committee could,
depending on the liquidity in any of the underlying markets during
an ETH session, determine not to impose an RFQ response requirement,
or impose an RFQ response rate lesser than the one applicable during
regular trading hours. See CBOE rule 44.4(d).
\25\ See CBOE rule 44.4(e).
\26\ See CBOE rules 44.4, Interpretation .01(a)(4) and
44.14(a)(4).
\27\ See supra note 13.
\28\ See CBOE rule 44.4(b).
\29\ See id.
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On CBOEdirect, a market maker may also be a designated primary
market maker (``DPM'') or a lead market maker (``LMM''). The Exchange's
SBT DPM Committee may assign an SBT DPM to a particular option
class.\30\ Different members could be assigned to be the SBT DPM for
the same option class during different trading sessions.\31\ If the SBT
DPM Committee does not appoint an SBT DPM in a given class, the
appropriate Market Performance Committee could appoint one or more SBT
LMMs.\32\ If more than one SBT LMM is appointed, they would function as
the SBT LMM on a rotating basis in accordance with a schedule set by
the appropriate Market Performance Committee.\33\ SBT LMMs would have
responsibilities similar to SBT DPMs.\34\
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\30\ See CBOE rule 44.12.
\31\ See CBOE rule 44.16.
\32\ See CBOE rule 44.3, Interpretation .01.
\33\ See id.
\34\ See CBOE rule 44.4, Interpretation .01(a).
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The obligations of SBT DPMs and LMMs are greater than those of SBT
standard market makers.\35\ SBT DPMs and LMMs are obligated, for
example, to provide opening quotes for all series in their allocated
classes.\36\ The appropriate Market Performance Committee also could
require that an SBT DPM or LMM provide continuous quotations in some or
all of the series of its appointed classes.\37\ Furthermore, SBT DPMs
and LMMs are required to handle public customer orders that are not
executed on the System due to the fact that there is a better quote on
another exchange, and to accord priority to such public customer orders
over their own principal transactions (unless the customer who placed
the order has consented to not being accorded such priority).\38\
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\35\ See CBOE rule 41.1(a)(2).
\36\ See CBOE rules 44.4, Interpretation .01(a)(2) and
44.14(a)(2).
\37\ See id.
\38\ See CBOE rules 44.14(b)(6) and 44.4, Interpretation
.01(a)(6).
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2. Brokers
An SBT broker is an individual (either a member or a nominee of a
member organization) who is registered with the Exchange for the
purpose of accepting and executing on CBOEdirect orders
[[Page 17700]]
received from members, registered broker-dealers, or public customers.
As with brokers operating in the Exchange's open-outcry auction market,
an SBT broker would not be permitted to accept an order from any source
other than a member or a registered broker-dealer, unless he or she
were approved to transact business with the public in accordance with
CBOE rule 9.1.\39\
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\39\ See CBOE rules 41.1(a)(5) and 45.1.
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SBT brokers would have the same obligations as brokers on the
Exchange's auction market to use due diligence in the representation of
orders for which they act as agent. SBT brokers may use an SBT
workstation or an API to enter, cancel, cancel/replace, and maintain
orders; hit bids and take offers; submit RFQs; and enter cross
notifications and proposed cross orders.
3. Proprietary Traders
A proprietary trader is a CBOE member who enters orders as
principal for a non-market-maker proprietary account.\40\ A proprietary
trader may use an SBT workstation or an API to enter, cancel, cancel/
replace, and maintain orders; hit bids and take offers; and submit
RFQs.
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\40\ See CBOE rule 41.1(a)(6).
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4. Clearing Firm Brokers
A clearing firm broker is an individual who represents the clearing
firm of a particular SBT market maker and has the authority to take
certain actions with respect to that market maker's use of the SBT
System.\41\ A clearing firm broker may request the CBOE Help Desk to
force the logout of an SBT trader when, for example, that trader has
financial difficulty. In addition, the forced logout of an SBT trader
could be necessary if technical difficulties prevented the trader from
logging off on his or her own.
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\41\ See CBOE rule 45.11.
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C. Priority
The proposed CBOEdirect rules do not prescribe a single allocation
methodology. Instead, the rules give the appropriate SBT Trading
Committee authority to apply various allocation priorities. CBOE has
represented that it would issue a regulatory circular specifying the
allocation rules that would govern each option class.\42\
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\42\ See notice, supra note 4, 67 FR at 31026.
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There would be two basic types of trade allocation methodologies:
[sbull] Price-Time Priority. Under this method, resting orders in
the SBT book would be prioritized according to price and time. If two
or more orders were at the best price, priority among these orders
would be afforded in the sequence in which they were received by the
System.\43\
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\43\ See CBOE rule 43.1(a)(1). For examples of how the price-
time allocation method would operate, see notice, supra note 4, 67
FR at 31027-28.
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[sbull] Pro Rata Priority.\44\ Under this method, resting orders in
the SBT book would be prioritized according to price. If there were two
or more orders at the best price, trades would be allocated
proportionally according to their size.\45\ The executable quantity
would be allocated to the nearest whole number, with fractions one-half
or greater rounded up and fractions less than one-half rounded
down.\46\
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\44\ In Amendment No. 4, CBOE changed the name of this
allocation methodology from ``combined price-time and size
priority'' to ``pro rata priority.''
\45\ See CBOE rule 43.1(a)(2). For examples of how this
allocation method would operate, see notice, supra note 4, 67 FR at
31028-31.
\46\ If there were two SBT traders that were both entitled to an
additional one-half contract and there were only one contract
remaining to be distributed, the additional contract would be
distributed to the SBT trader whose quote or order had time
priority. See CBOE rule 43.1(a)(2).
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In addition to these allocation methodologies, the appropriate SBT
Trading Committee could determine to overlay, on a class-by-class basis
and in any order, any or all of the following additional market
participant priorities (``priority overlays''): \47\
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\47\ See CBOE rule 43.1(b).
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1. Public Customer. If this were the only priority overlay in
effect, the highest bid and lowest offer would have priority, except
that a public customer order would have priority over a non-public
customer order at the same price. If other priority overlays were also
in effect, priority would be established in the sequence designated by
the appropriate SBT Trading Committee. In either case, if there were
two or more public customer orders for the same option series at the
same price, priority would be afforded to these orders in the sequence
in which they had been received by the System, even if the pro rata
allocation method were the designated allocation method. For purposes
of this provision, a ``public customer order'' is an order for an
account in which no CBOE member, non-member participant in a joint
venture with a member, or non-member broker-dealer (including a foreign
broker-dealer) has an interest.\48\
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\48\ See CBOE rule 43.1(b)(1).
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2. Market Turner. The ``market turner'' is the SBT trader who is
the first to enter an order or quote at a better price than the
previous best book price, and the order or quote was continuously in
the market until it traded.\49\ If market turner priority were the only
priority overlay in effect, the market turner would have priority at
the highest bid or lowest offer that it had established. If other
priority overlays were also in effect, priority would be established in
the sequence designated by the appropriate SBT Trading Committee. In
either case, market turner priority at a given price would remain with
the order once it had been earned. For example, if the market moved in
the same direction as the marker turner had moved the market, and then
the market moved back to the market turner's original price, the market
turner would retain priority at the original price.
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\49\ See CBOE rule 40.1(i).
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3. Trade Participation Right. SBT DPMs and LMMs may be granted a
trade participation right to trade against up to 40% of an incoming
order,\50\ even though the order and/or quote of the SBT DPM or LMM do
not have the highest priority. If other priority overlays were also in
effect, priority would be established in the sequence designated by the
appropriate SBT Trading Committee. All of the following conditions
would apply to the SBT DPM or LMM trade participation right:
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\50\ See CBOE rules 43.1(b); 44.4, Interpretation .01(b); and
44.15. However, the participation of an SBT DPM or LMM in an order
may exceed 40%, depending on the allocation rules in effect. See id.
Assume, for example, that price-time priority is in effect. An SBT
DPM or LMM could receive up to 40% of an incoming order due to its
trade participation right, then receive an additional portion of the
incoming order if it has an order or quote on the SBT book that has
the highest time priority at the best price. If pro rata priority
were in effect, an SBT DPM or LMM could receive up to 40% of an
incoming order due to its trade participation right, then receive an
additional portion of the incoming order if its percentage of the
total volume being quoted at the best price exceeds 40%.
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[sbull] The order and/or quote of the SBT DPM or LMM must be at the
best price.\51\
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\51\ See CBOE rule 43.1(b)(3)(A).
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[sbull] An SBT DPM or LMM may not be allocated a total quantity
greater than the quantity than it was quoting at that price.\52\
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\52\ See CBOE rule 43.1(b)(3)(B).
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[sbull] If pro rata priority is in effect and the SBT DPM's or
LMM's allocation of an order pursuant to its trade participation right
is greater than its percentage share of the quotes/orders at the best
price at the time that the trade participation right is granted, the
SBT DPM or LMM may not receive any further allocation of that
order.\53\
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\53\ See id.
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[sbull] If the trade participation right priority overlay and the
market turner priority overlay are both in effect and the SBT DPM or
LMM were the market turner, market turner priority would not apply.\54\
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\54\ See CBOE rule 43.1(b)(3)(C).
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[[Page 17701]]
[sbull] If price-time priority were in effect and the SBT DPM or
LMM had a quote and one or more orders at the same price, any contacts
executed as part of the SBT DPM/LMM's trade participation right would
trade with the highest priority quote/order(s) of the SBT DPM or
LMM.\55\
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\55\ See CBOE rule 43.1(b)(3)(D).
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[sbull] The trade participation right may not be in effect unless
the public customer priority overlay is in effect in a priority
sequence ahead of the trade participation right.\56\ Thus, public
customer orders at the best price would be executed before an SBT DPM
or LMM trades by virtue of any trade participation right.
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\56\ See CBOE rule 43.1(b)(3)(E).
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[sbull] If other priority overlays are in effect and designated as
higher priorities than the SBT DPM or LMM trade participation right,
the participation right would apply only to any remaining balance of an
order after all higher priorities were satisfied.\57\
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\57\ See CBOE rule 43.1(b)(3)(F).
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D. States of Trading
1. Pre-Opening
The pre-opening state would last for some period of time (as
determined by the appropriate SBT Committee) before the opening of the
underlying security.\58\ During this state, CBOEdirect would accept
quotes and orders but no trading would take place.\59\ The System would
disseminate information about resting orders in the SBT book that
remained from the prior business day and any orders and quotes sent
before the opening.\60\ After the primary market for the underlying
security disseminates the opening trade or the opening quote for the
underlying security, the System would send a notice to SBT market
makers with an appointment in that class who then may submit their
opening quotes.\61\ The SBT DPM or LMM for that option class would be
required to submit opening quotes.\62\
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\58\ See CBOE rule 42.3(a). CBOE has represented that it would
distribute an information circular indicating the pre-opening period
of time that it establishes. June 21 conversation.
\59\ See CBOE rule 42.2(a). However, spread orders and
contingency orders (except for opening-only orders) would not
participate in the opening or in the determination of the opening
price. See CBOE rule 42.3(a). CBOE has represented that it would
distribute an information circular indicating the pre-opening period
of time that is established by the Exchange. June 21 conversation.
\60\ See id. CBOE could determine to disseminate this
information for free to any SBT trader interested in trading the
product. Alternately, CBOE could determine to impose a fee for such
information. In the latter case, the fee proposal would have to be
filed with the Commission pursuant to section 19(b) of the Act, 15
U.S.C. 78s(b). Telephone conversation between Angelo Evangelou,
Legal Division, CBOE, and Nancy Sanow and Michael Gaw, Division of
Market Regulation, Commission, on October 23, 2002 (``October 23
conversation'').
\61\ See CBOE rule 42.3(a).
\62\ See id. SBT standard market makers generally would not be
required to provide opening quotes, except in the circumstances
described in proposed CBOE rule 42.3(b).
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2. Opening
The SBT System would begin the opening procedure at a randomly
selected time within a number of seconds after receiving the underlying
security's opening price.\63\ For some time after the notice of the
underlying security's opening price is sent, the System would calculate
and provide the expected opening price (``EOP'') based on the current
resting orders and quotes during an EOP period.\64\ The length of the
EOP period would be established by the appropriate SBT Trading
Committee and would be no less than five seconds and no more than one
minute.\65\ After the EOP period, the System would enter a lock
interval during which quotes and orders could be submitted but would
not be included in the opening trade. The lock interval would be a
period of time not to exceed four seconds. At this time, the SBT System
would establish the opening price, which would be the ``market
clearing'' price that would leave bids and offers that could not trade
with each other.
---------------------------------------------------------------------------
\63\ See CBOE rule 42.3(a). In the case of trading during an ETH
session, the System could open the class without having received the
underlying security's opening price. See id.
\64\ See CBOE rule 42.3(c).
\65\ See id. CBOE has represented that it would distribute an
information circular indicating the period that is established by
the Committee. June 21 conversation.
---------------------------------------------------------------------------
The System would process the series of a class in random order.\66\
The series of a class may not open all at the same time. The System
would not open a series if: (1) There were no legal width market; (2)
the opening price were not within a range determined by the appropriate
SBT Trading Committee (e.g., the upper boundary of the acceptable range
may be 125% of the highest quote offer and the lower boundary may be
75% of the lowest quote bid); \67\ or (3) the opening trade would leave
a market order imbalance.\68\ If a series does not open, the System
would commence the RFQ process in an effort to alleviate the conditions
that caused the series not to open.\69\
---------------------------------------------------------------------------
\66\ See CBOE rule 42.3(d).
\67\ CBOE has stated that this provision is designed to prevent
orders that rest on the SBT book between sessions from being
executed at a price far from the prevailing quote at the opening of
the next session. Telephone call between Angelo Evangelou, Legal
Division, CBOE, and Michael Gaw, Division of Market Regulation,
Commission, on December 9, 2002. CBOE has represented that it would
publicize the range set by the committee in an information circular.
Id.
\68\ See CBOE rule 42.3(f).
\69\ See CBOE rule 42.3(g). The RFQ generated by the SBT System
in this case would include size. The RFQs generated by the System in
market and limit order processing also would include size. October
23 conversation.
---------------------------------------------------------------------------
As the opening price is determined by series, the System would
change the product state of the series to ``trading'' and disseminate
to OPRA and the SBT participants the opening quote and the opening
trade price, if any.\70\
---------------------------------------------------------------------------
\70\ See CBOE rule 42.3(e).
---------------------------------------------------------------------------
3. Trading
During this state, the series would trade freely. All order types
and quotes would be accepted, except for opening-only contingency
orders.\71\
---------------------------------------------------------------------------
\71\ See CBOE rule 42.2(c).
---------------------------------------------------------------------------
4. Trading Halts
CBOE will use the same criteria to halt trading on CBOEdirect that
they use to halt trading on CBOE's floor.\72\ In addition, the SBT
System may be programmed (as determined by the appropriate SBT Trading
Committee) to automatically halt trading with respect to an equity
option if a trading halt has been declared for the underlying security
in the primary market.\73\ However, when the System is operated during
an ETH session, there may not be a primary market trading the
underlying security. In such cases, the appropriate SBT Trading
Committee would determine in advance whether to have the System
automatically halt trading with respect to the options if there is no
primary market for the underlying security in the ETH session and if
trading in the underlying security has been halted in another market
trading the underlying security during an ETH session.\74\ Whenever
trading has been halted, trading may be resumed whenever two trading
officials determine that a fair and orderly market may be
maintained.\75\
---------------------------------------------------------------------------
\72\ Specifically, CBOE rules 6.3, 6.3B, or 24.7 will apply to
trading on CBOEdirect. See Appendix A. Originally, CBOE proposed
that new, different provisions would govern trading halts on the SBT
System. In Amendment No. 4, CBOE deleted most of these proposed
provisions and instead proposed to apply existing CBOE rule 24.7 to
trading halts on CBOEdirect.
\73\ See CBOE rule 43.4(b). The System would send status alerts
to OPRA for a product that is halted. See notice, supra note 4, 67
FR at 31025.
\74\ See CBOE rule 43.4(b).
\75\ See id.
---------------------------------------------------------------------------
5. Closed
CBOEdirect would change the state to ``closed'' at a pre-determined
time depending on the closing time of the
[[Page 17702]]
underlying security. Trading would cease but the System would continue
to accept certain order types (such as market orders, which would be
held by the System for participation in the opening of the next SBT
session).\76\ At some designated time, as determined by the Exchange,
the System would stop accepting orders and would enter into end-of-
session procedures as described in CBOE rule 42.4.\77\
---------------------------------------------------------------------------
\76\ See CBOE rule 42.2(e).
\77\ See id. CBOE has represented that it would issue an
information circular regarding the designated time that the SBT
System would stop accepting orders and enter into end-of-session
procedures. December 5 conversation.
---------------------------------------------------------------------------
6. Fast Markets and Non-Firm Markets
A fast market may be declared in one or more option classes. A fast
market may be declared by the System automatically if the System loses
an underlying security feed.\78\ A fast market also may be declared by
two trading officials whenever, in their judgment, an influx of orders
or other conditions or circumstances would impair the operation of a
fair and orderly market. In determining whether to declare a fast
market, the trading officials may consider, among other things,
impending news, increases in trading volume that threaten the capacity
of the System, and the loss of an underlying security feed.\79\ Regular
trading conditions may be resumed when two trading officials believe
that such action is warranted or, if the System had made the fast
market declaration, if the underlying security feed has been
restored.\80\
---------------------------------------------------------------------------
\78\ See CBOE rule 43.4(a)(1).
\79\ See CBOE rule 43.4(a)(2).
\80\ See CBOE rule 43.4(a)(1)-(2).
---------------------------------------------------------------------------
CBOE may designate the market in an option to be ``non-firm'' if
two trading officials determine that the level of trading activities or
the existence of unusual market conditions is such that the Exchange is
incapable of collecting, processing, and making available to quotation
vendors the data for the option in a manner that accurately reflects
the current state of the market on CBOEdirect. If a market is declared
non-firm, the Exchange would provide notice that its quotations are not
firm by appending an appropriate indicator to such quotations, and two
trading officials would have the authority to direct that one or more
trading rotations be employed or to take such other actions as are
deemed necessary in the interest of maintaining a fair and orderly
market. The Exchange would monitor the activity or conditions that
caused the declaration of a non-firm market, and two trading officials
would be required to review the condition of such market at least every
30 minutes. Regular trading procedures would be resumed by the Exchange
when two trading officials determined that the conditions supporting a
non-firm market declaration no longer existed. The Exchange would
provide notice that its quotations were once again firm by removing the
indicator from its quotations. However, if the conditions supporting a
non-firm market declaration could not be managed utilizing the
prescribed procedures, two trading officials would halt trading in the
class or classes so affected.\81\
---------------------------------------------------------------------------
\81\ See CBOE rule 43.14(b).
---------------------------------------------------------------------------
There is a significant difference between a ``non-firm'' market and
a fast market: Only in a non-firm market would responsible brokers and
dealers be relieved of their obligations under the Exchange's firm
quote rule, as applicable to CBOEdirect,\82\ and the Commission's firm
quote rule.\83\ In a fast market that is not also a non-firm market,
the firm quote obligations would continue to apply.
---------------------------------------------------------------------------
\82\ CBOE rule 43.14(a).
\83\ 17 CFR 240.11Ac1-1.
---------------------------------------------------------------------------
E. Firm Quote Obligations on CBOEdirect
Each responsible broker or dealer, as defined in rule 11Ac1-1 under
the Act,\84\ must communicate to the Exchange its bids and offers in
accordance with rule 11Ac1-1, and a bid or offer submitted by a
responsible broker or dealer must be firm pursuant to rule 11Ac1-1 for
the number of contracts specified in such bid or offer, subject to
certain exceptions.\85\ A responsible broker or dealer would be
relieved of its firm quote obligations under rule 11Ac1-1 and Exchange
rules if any of the following conditions existed: \86\
---------------------------------------------------------------------------
\84\ 17 CFR 240.11Ac1-1.
\85\ See CBOE rule 43.14(a). The Commission notes that an SBT
market maker is permitted to display a single quote and one or more
orders at the same time. All orders and quotes of a responsible
broker or dealer that are displayed on CBOEdirect will be subject to
the Commission's Firm Quote rule.
\86\ See CBOE rule 43.14(c)(1).
---------------------------------------------------------------------------
[sbull] The level of trading activities or the existence of unusual
market conditions is such that the Exchange is incapable of collecting,
processing, and making available to quotation vendors the data for the
option in a manner that accurately reflects the current state of the
market on the Exchange and, as a result, the market in the option is
declared to be ``non-firm'' pursuant to CBOE rule 43.14(b);
[sbull] A system malfunction or other circumstance impairs the
Exchange's ability to disseminate or update market quotes in a timely
and accurate manner;
[sbull] A trading rotation is in progress; or
[sbull] Any of the circumstances set forth in paragraph (c)(3) of
rule 11Ac1-1 \87\ exists.
Within 30 seconds of receipt of an order to buy or sell an option
series in an amount greater than the size associated with the
responsible broker's or dealer's bid or offer, that portion of the
order equal to the size associated with the responsible broker's or
dealer's bid or offer will be executed, and the bid or offer price will
be revised.\88\
---------------------------------------------------------------------------
\87\ 17 CFR 240.11Ac1-1(c)(3)
\88\ See CBOE rule 43.14(c)(2).
---------------------------------------------------------------------------
F. Trade Nullification
The SBT System rules provide for the ability to nullify a trade
through a negotiated or mandated trade nullification procedure.
1. Negotiated Trade Nullification
A CBOEdirect trade could be nullified if both parties to the
transaction agreed to the nullification.\89\ Negotiation could be
conducted through the SBT System's messaging facility that would allow
a party to exchange messages with its contraparty of a particular
trade. The System would preserve the anonymity of the parties, although
one party could voluntarily disclose its identity to the other party.
When both parties to a trade have agreed to a trade nullification, one
party must contact the Help Desk. The Help Desk then would confirm the
agreement and promptly nullify the trade, notify the parties involved,
disseminate cancellation information in prescribed OPRA format, and re-
establish orders and their priorities in the SBT book on a best-efforts
basis.
---------------------------------------------------------------------------
\89\ See CBOE rule 43.5(a).
---------------------------------------------------------------------------
2. Mandated Trade Nullification
An SBT trader may have a trade nullified by two trading officials
if a documented request is made within five minutes of execution (or 15
minutes if the request is on behalf of a public customer) and one of
five following conditions is met:
[sbull] The trade resulted from a verifiable disruption or
malfunction of an Exchange execution, dissemination, or communication
system that caused a quote/order to trade in excess of its disseminated
size (e.g., a quote/order that is frozen, because of an Exchange system
error, and traded repeatedly); \90\
---------------------------------------------------------------------------
\90\ See CBOE rule 43.5(b)(1). For example, assume that an SBT
market maker enters a quote of 4.00-4.30, 20x20. Another SBT trader
hits the market maker's bid at 4.00 for the full size of 20
contracts. Also assume that the SBT System fails to remove the
market maker's bid from the SBT book, even though it has been taken
out completely. A second SBT trader sees the ``frozen'' bid for 20
at 4.00 and also trades against it. In this case, the second trade
could be nullified under CBOE rule 43.5(b)(1). Telephone
conversation between Angelo Evangelou, Legal Division, CBOE, and
Nancy Sanow, Division of Market Regulation, Commission, on February
20, 2003 (``February 20 conversation'').
---------------------------------------------------------------------------
[[Page 17703]]
[sbull] The trade resulted from a verifiable disruption or
malfunction of an Exchange dissemination or communication system that
prevented an SBT trader from updating or canceling a quote/order for
which the SBT trader is responsible, where there is Exchange
documentation providing that the SBT trader sought to update or cancel
the quote/order; \91\
[sbull] The trade resulted from an erroneous print disseminated by
the underlying market that is later canceled or corrected by that
underlying market, where the erroneous print resulted in a trade higher
or lower than the average trade in the underlying security during the
two-minute time period before and after the erroneous print by an
amount at least five times greater than the average quote width for the
underlying security during the time period encompassing two minutes
before and after the erroneous print;\92\
---------------------------------------------------------------------------
\91\ See CBOE rule 43.5(b)(2).
\92\ See CBOE rule 43.5(b)(3).
---------------------------------------------------------------------------
[sbull] The trade resulted from an erroneous quote in the primary
market for the underlying security that has a spread of at least $1.00
and at least five times greater than the average quote width for the
underlying security during the time period encompassing two minutes
before and after the dissemination of such quote; \93\ or
---------------------------------------------------------------------------
\93\ See CBOE rule 43.5(b)(4).
---------------------------------------------------------------------------
[sbull] The execution price of the trade is higher or lower than
the theoretical price for the series by an amount equal to at least two
times the maximum bid/ask spread allowed for the option under proposed
CBOE rule 44.4, so long as such amount is $0.50 or more (or $0.25 or
more for options priced under $3.00).\94\
---------------------------------------------------------------------------
\94\ See CBOE rule 43.5(b)(5). The theoretical price of an
option would be defined as the last bid/offer price, just prior to
the trade, from the exchange providing the most volume in the option
or, if there are no quotes for comparison, the theoretical price
would be determined by two trading officials. See id.
---------------------------------------------------------------------------
Upon nullification, the Help Desk promptly would notify the
parties, disseminate cancellation information in prescribed OPRA
format, and re-establish orders and their respective priorities on the
SBT book on a best-efforts basis.\95\
---------------------------------------------------------------------------
\95\ See CBOE rule 43.5(b).
---------------------------------------------------------------------------
Any determinations made under the trade nullification rule could be
appealed pursuant to chapter 19 of the Exchange's rules.\96\
---------------------------------------------------------------------------
\96\ See id.
---------------------------------------------------------------------------
G. How Trades Are Executed on CBOEdirect
1. Market Orders
a. Market Order Processing
Non broker-dealer market orders to buy or sell options on
CBOEdirect will not be automatically executed by the System at prices
inferior to the best bid or offer on another national securities
exchange, as those best prices are identified by the System.\97\ In
addition, the SBT System would protect a market order for a given
option series by executing it against the best bid or offer only if
there were a legal width market in that series.\98\ The System would
match market orders against orders at the best price in the SBT book
and against the other orders behind the best price at varying prices
until the order is fully executed or a legal width market no longer
exists.\99\ CBOE expects that there would be a legal width market for
most series at most times--at least during an RTH session--and thus
that most market orders on CBOEdirect would execute immediately.\100\
---------------------------------------------------------------------------
\97\ See CBOE rule 43.7.
\98\ See CBOE rule 43.7(a)(1).
\99\ See id.
\100\ See notice, supra note 4, 67 FR at 31033 n.26.
---------------------------------------------------------------------------
If there is no legal width market when the order is entered--or if
the market order is not executed in full because a legal width market
no longer exists--the System would hold the order (or any remaining
portion thereof) in queue, send an RFQ,\101\ and inform the originator
of the market order about the order's status.\102\ In this case, the
RFQ would include the market order quantity but not whether the order
was a buy or a sell.\103\ RFQ responses would be sent to the SBT
book.\104\ The System then would execute the market order if:
---------------------------------------------------------------------------
\101\ The RFQ would be sent to any SBT market maker who held an
appointment in that option class and to any non-appointed SBT market
maker who is quoting in that option class at the time the RFQ is
sent. See CBOE rule 40.1(m).
\102\ See CBOE rule 43.7(a)(2).
\103\ See CBOE rule 43.7(a)(3). The only instance that an RFQ
would disclose whether the intended transaction is a buy or a sell
is if the SBT System generated an RFQ to remedy an order imbalance.
October 23 conversation.
\104\ See CBOE rule 43.7(a)(3). Also, market orders generally
have execution priority over limit orders. However, a limit order
may be executed ahead of the market order if, during the pendency of
an RFQ, an order is entered on the other side of the market that
satisfies the order's limit price. See CBOE rule 43.1(g).
---------------------------------------------------------------------------
[sbull] During the RFQ response time, the best quote becomes a
certain prescribed percentage (as set by the appropriate SBT Trading
Committee) of a legal width market; \105\
---------------------------------------------------------------------------
\105\ See CBOE rule 43.7(a)(3)(A). CBOE has represented that it
would issue an information circular regarding the designated
percentage that would trigger this provision. December 5
conversation. The market order would trade with the best-priced
quote or order on the SBT book.
---------------------------------------------------------------------------
[sbull] The System receives a limit order on the same side of the
market as the market order that could match the best bid or offer and
at least one legal width quote has been received; \106\ or
---------------------------------------------------------------------------
\106\ See CBOE rule 43.7(a)(3)(B). The market order would trade
with the best priced quote or order on the SBT book. However, if no
legal width market existed at the time the limit order were
received, the incoming limit order would execute ahead of the market
order. See id.; CBOE rule 43.1(g).
---------------------------------------------------------------------------
[sbull] A certain prescribed percentage of the SBT market makers
currently providing quotes in the class (the percentage to be set by
the appropriate SBT Trading Committee) respond to the RFQ with legal
width markets.\107\
---------------------------------------------------------------------------
\107\ See CBOE rule 43.7(a)(3)(C).
---------------------------------------------------------------------------
If the market order could be executed under any of the three
conditions above and there is a market order on the opposite side, the
System would execute the market orders with each other.\108\
---------------------------------------------------------------------------
\108\ See CBOE rule 43.7(a)(4).
---------------------------------------------------------------------------
If none of the three conditions noted above were satisfied but a
legal width market existed at the end of the RFQ period, the market
order would execute against the booked order with the highest
priority.\109\ However, if the System were holding a market order and
the RFQ process did not yield a legal width market, the Exchange's Help
Desk could solicit quotes and require a response from SBT market
makers.\110\
---------------------------------------------------------------------------
\109\ Telephone conversation between Angelo Evangelou, Legal
Division, CBOE, and Michael Gaw, Division of Market Regulation,
Commission, on September 25, 2002.
\110\ See CBOE rule 43.7(b).
---------------------------------------------------------------------------
b. Market Order Price
If a market order is executed before the RFQ process is completed
under any of the three conditions set forth above, it would trade at
the price of the highest priority contraside quote or order in the SBT
book. However, if a market order could be executed pursuant to any of
the three conditions and there were one or more market orders on the
opposite side, the System would execute the market orders against each
other at a price determined as follows: \111\
---------------------------------------------------------------------------
\111\ See CBOE rule 43.7(a)(4).
---------------------------------------------------------------------------
[sbull] At the middle of the best bid/offer in the SBT book, if the
middle price is a price that may be entered on the System; or
[sbull] If the middle price is not a price that could be entered on
the System, at the next such price that is closer to the last trade
price for the series.
[[Page 17704]]
If one or more incoming RFQ responses could execute against a
market order as well as any limit orders that were already on the SBT
book at a particular price and the incoming responses are of large
enough quantity to fill all of the older limit orders, all of those
orders would be filled at the price of the older limit orders.\112\ If
the responses could execute against a market order and one or more
older limit orders, but the responses are not of large enough quantity
to fill all of the older limit orders, the market order would be filled
at the minimum price interval ahead of the older limit orders.\113\
---------------------------------------------------------------------------
\112\ See CBOE rule 43.7(a)(3)(B)(ii)(aa).
\113\ See CBOE rule 43.7(a)(3)(B)(ii)(bb).
---------------------------------------------------------------------------
c. Market Orders During Trading Halts
If trading were halted in a series while a market order for an
option in that series were on hold waiting for RFQ responses,
CBOEdirect would operate as follows:
[sbull] If the market order were a good-'til-canceled order, the
System would hold and execute it at the next opening (whether on the
same day or the next day).
[sbull] If the market order were a day order, the System would
execute it at re-opening if trading resumed on the same day.
[sbull] If trading did not resume on the same day, the System would
purge the market order as part of the end-of-day procedures.\114\
---------------------------------------------------------------------------
\114\ See CBOE rule 43.7(d).
---------------------------------------------------------------------------
2. Limit Order Processing
Non-broker-dealer marketable limit orders to buy or sell options on
CBOEdirect will not be automatically executed by the System at prices
inferior to the best bid or offer on another national securities
exchange, as those best prices are identified in the System.\115\
Broker-dealer limit orders, non-broker-dealer limit orders that are not
marketable, and limit orders in options that are not traded on another
national securities exchange will be processed as follows.
---------------------------------------------------------------------------
\115\ See CBOE rule 43.8.
---------------------------------------------------------------------------
As presently configured, CBOEdirect will process limit orders by
matching them against the best prices available in the SBT book under
the priority rules set forth in CBOE rule 43.1. If no booked order
matched the incoming limit order, the limit order would be held in the
SBT book and could trade against later-submitted orders.\116\
---------------------------------------------------------------------------
\116\ See id.
---------------------------------------------------------------------------
In the future, CBOEdirect will be enabled to provide additional
protection for limit orders by allowing a limit order to be executed
only if there is a legal width market in that series.\117\ If a legal
width market did not exist but the limit order could otherwise execute
against the best bid or offer, the System would put the order in queue
and send an RFQ.\118\ The RFQ would include the order quantity but not
whether the order was a buy or sell. Quote responses would be exposed
in the SBT book as they were received. The System would execute the
limit order if:
---------------------------------------------------------------------------
\117\ See CBOE rule 43.8A(a).
\118\ See CBOE rule 43.8A(b). The SBT trader that submitted the
limit order could override the RFQ and enter the limit order into
the SBT book. See id.
---------------------------------------------------------------------------
[sbull] During the RFQ response time, the best quote becomes a
certain prescribed percentage (e.g., 75%, as set by the appropriate SBT
Trading Committee \119\ of a legal width market; \120\
---------------------------------------------------------------------------
\119\ CBOE has represented that it would announce the percentage
set by the committee in an information circular. December 5
conversation.
\120\ See CBOE rule 43.8A(d)(1). The original limit order then
would trade with the best priced quote or order on the SBT book. See
id.
---------------------------------------------------------------------------
[sbull] The System receives a market or limit order (independent of
the RFQ responses) on the opposite side that would match the original
limit order, and a legal width market exists; \121\
---------------------------------------------------------------------------
\121\ See CBOE rule 43.8A(d)(2). The original limit order then
would trade with the incoming market or limit order. See id.
---------------------------------------------------------------------------
[sbull] A certain prescribed percentage of the SBT market makers
that currently are receiving RFQs (the percentage to be set by the
appropriate SBT Trading Committee \122\) respond to the RFQ, or when
the RFQ period expires and there is at least one quote response.\123\
---------------------------------------------------------------------------
\122\ CBOE has represented that it would announce the prescribed
percentage that would trigger this provision in an information
circular. December 5 conversation.
\123\ See CBOE rule 43.8A(d)(3). The original order then would
trade with the best priced quote or order on the SBT book. See id.
---------------------------------------------------------------------------
If a limit order for a certain series were queued, subsequent limit
orders for the same series and side would be queued behind the first
order to ensure that they were processed in time sequence.\124\
Subsequent market orders for the same series and side also would be
queued.\125\ If a legal width market remained upon completion of the
limit order processing, the market order would be executed against
orders resting in the SBT book.\126\ If a legal width market did not
exist, market order processing would begin in accordance with market
order processing rules, discussed above.\127\
---------------------------------------------------------------------------
\124\ See CBOE rule 43.8A(e).
\125\ See id.
\126\ See id.
\127\ See id.
---------------------------------------------------------------------------
3. Contingency Orders
CBOEdirect currently can handle all-or-none, fill-or-kill,
immediate-or-cancel, stop, and stop limit orders. The System is not yet
ready to process opening-only, minimum volume, and market-on-close
orders,\128\ although such orders are contemplated by the proposed
CBOEdirect rules, once the System is enabled to handle them.\129\
Contingency orders (except for opening-only orders) would not
participate in the opening trade or in the determination of the opening
price.\130\
---------------------------------------------------------------------------
\128\ See Amendment No. 4.
\129\ See CBOE rule 43.9.
\130\ See CBOE rule 42.3(a).
---------------------------------------------------------------------------
A contingency order (except for an immediate-or-cancel order or a
stop limit order the stop price of which has been hit) would be placed
last in priority order, regardless of when it was entered into the SBT
System.\131\ If customer priority were afforded to a particular option
class, a public customer contingency order would have priority over a
non-public-customer contingency order but would be behind all other
orders.\132\
---------------------------------------------------------------------------
\131\ See CBOE rules 43.1(c) and 43.9.
\132\ See CBOE rule 43.1(c).
---------------------------------------------------------------------------
4. Spread Orders
Once the SBT System has been so enabled and the Commission has
approved the necessary rules, SBT traders would have the ability to
enter spread orders, the legs of which are options of the same
underlying security.\133\ However, spread orders may not be entered on
the System at this time.
---------------------------------------------------------------------------
\133\ See CBOE rule 43.6(a).
---------------------------------------------------------------------------
H. Facilitation and Solicitation of Orders by SBT Brokers
On the SBT System, an SBT broker would not be permitted to execute
as principal an order that it represents as agent unless the agency
order were first exposed on the System for at least 30 seconds, or the
broker utilizes the applicable crossing procedure described below.\134\
In addition, an SBT broker would be required to expose on the System an
order that it represented as agent for at least 30 seconds before such
order could be executed in whole or in part by orders solicited from
members or non-member broker-dealers to transact with such order.\135\
Described below are an interim crossing procedure and a permanent
crossing procedure, which would replace the interim procedure at some
time in the future.\136\
---------------------------------------------------------------------------
\134\ See CBOE rule 43.12(a).
\135\ See CBOE rule 43.12(b).
\136\ See CBOE rules 43.12A and 43.12B. CBOE rule 43.12C(a)
provides that it would be a violation of CBOE rules 43.12, 43.12A,
and 43.12B for an SBT broker to be a party to any arrangement
designed to circumvent CBOE rule 43.12A or rule 43.12B by providing
an opportunity for a customer, member, or non-member broker-dealer
to execute against agency orders handled by the SBT broker
immediately upon their entry into the System.
---------------------------------------------------------------------------
[[Page 17705]]
1. Interim Crossing Procedure
Under CBOEdirect's interim crossing procedure, an SBT broker that
wishes to cross two original orders of at least 50 contracts or to
facilitate an original order of at least 50 contracts must first send
an RFQ with the size of the orders to be crossed.\137\ The RFQ response
period will be established by the SBT Trading Committee and will not be
less than ten seconds.\138\
---------------------------------------------------------------------------
\137\ See CBOE rule 43.12B(a).
\138\ See id. CBOE has represented that it would announce the
length of the response period set by the committee in an information
circular. December 5 conversation.
---------------------------------------------------------------------------
Within a time period after the RFQ response period has expired
(such time period to be established by the SBT Trading Committee and
not to exceed ten seconds \139\, the SBT broker must expose one of the
orders to the SBT book.\140\ If the exposed order is not completely
taken out by other SBT traders by the end of the exposure period, the
SBT broker could enter the opposite order to cross the balance of the
exposed order.\141\
---------------------------------------------------------------------------
\139\ CBOE has represented that it would announce the length of
the exposure period set by the committee in an information circular.
December 5 conversation.
\140\ See proposed CBOE rule 43.12B(b).
\141\ See CBOE rule 43.12B(c).
---------------------------------------------------------------------------
2. Permanent Crossing Mechanism
In the future, CBOEdirect will provide for a participation right
for SBT brokers who wish to cross orders. As with the interim
procedure, an SBT broker first would have to submit an RFQ for a size
equal to the quantity to be crossed.\142\ The SBT market makers
receiving the RFQ would have a response period for a length of time
(such time period to be established by the SBT Trading Committee, but
no less than ten seconds \143\ to enter orders or quotes that matched
or improved upon the existing quotations on the System.\144\ Within a
time period after the RFQ response period expires (such time period to
be established by the SBT Trading Committee and which may be no longer
than 20 seconds \145\), the SBT broker would enter the terms of the
proposed cross transaction.\146\ The required terms would include the
terms of the original order and the proposed facilitation order (or two
original orders), a proposed crossing price, the quantity of the
original order that the SBT broker would be willing to facilitate (in
the case of a facilitation cross), and a designation of which order (in
the case of a cross of two customer orders) is to be exposed to the
market after the SBT broker received the guaranteed crossing
percentage.\147\ The customer order would be the exposed order in a
facilitation cross.\148\
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\142\ See CBOE rule 43.12A(a)(1).
\143\ CBOE has represented that it would issue an information
circular to publicize the time period established by the appropriate
SBT Trading Committee. June 21 conversation.
\144\ See CBOE rule 43.12A(a)(2).
\145\ CBOE has represented that it would issue an information
circular to publicize the time period established by the appropriate
SBT Trading Committee. June 21 conversation.
\146\ See CBOE rule 43.12A(a)(3).
\147\ See id.
\148\ See id.
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At the time the cross transaction is entered or the System:
[sbull] A legal width market would have to exist for the particular
series to be crossed; and
[sbull] The proposed cross price would have to be between the best
bid and offer displayed by the System.\149\
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\149\ See CBOE rule 43.12A(a)(4). An SBT DPM or LMM would not be
entitled to receive its participation right because a crossing
transaction would occur at a price between the best bid and offer
previously established. See CBOE rule 44.15(b).
---------------------------------------------------------------------------
After accepting the cross transaction, the System would immediately
cross 40% of the two orders. The System would expose in the SBT book
the contracts remaining in the designated order for a period of ten
seconds. The order's price and the remaining quantity would be
disclosed but there would be no indication that the order was part of
an impending cross. The System would place the opposite order on hold
as a shadow order that would not be visible except to the
submitter.\150\ As long as the exposed order is the highest priority
order at the best price, other SBT traders could trade against it
during the ten-second exposure period.\151\
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\150\ See CBOE rule 43.12A(a)(5).
\151\ See CBOE rule 43.12A(a)(6).
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If, at the end of the ten-second exposure period the order has not
yet been fully traded, and the exposed order is at the best price and
has the highest priority, the System would execute the remainder of the
order against the shadow order.\152\ If, however, the exposed order is
not the highest priority order at the market, the System automatically
would cancel the remainder of the exposed order and the shadow order
and send the SBT broker a message that the crossing transaction is
completed. If the exposed order has a quantity remaining after the
crossing transaction is completed and is the highest priority order at
the market, it would remain in the SBT book.
---------------------------------------------------------------------------
\152\ See CBOE rule 43.12A(a)(7).
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3. Interpretation Relating to Crossing Procedure
The availability of the crossing mechanism would not alter a
member's best execution duty to obtain the best price for its customer.
Moreover, CBOE proposes to make it explicit in its rules that it would
be a violation of an Exchange member's duty of best execution to its
customer if it were to cancel or withhold a customer order to avoid
execution of the order a better price.\153\ Accordingly, if a member
were to cancel or withhold a customer order when there was a superior
price available on the System, and subsequently enter the order at an
inferior price after the better price were no longer available without
attempting to obtain that better price for its customer, there would be
a presumption that the member did so to avoid execution of the customer
order in whole or in part at the better price.\154\
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\153\ See CBOE rule 43.12A, Interpretation .01.
\154\ See id.
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I. Additional System Functionality
1. Entry and Maintenance of Orders and Quotes
All SBT traders, including SBT market makers, may enter orders into
the System for any option class. However, only SBT market makers may
enter quotes. An SBT market maker may have only a single quote for any
particular option series but may enter multiple orders in the same
series, regardless of whether it has a quote in that series displayed
on the System. However, the SBT System would distinguish between an SBT
market maker's quotes and orders and credit only the quotes towards the
market maker's quoting obligations.\155\
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\155\ However, an SBT market maker would receive credit for an
RFQ response only by submitting a quote and not two unrelated
orders. Telephone conversation between Angelo Evangelou, Legal
Division, CBOE, and Nancy Sanow and Michael Gaw, Division of Market
Regulation, Commission, on September 30, 2002.
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An SBT market maker may enter a quote in one of two ways: manually
or through an autoquote facility.\156\ Unlike in the open-outcry
system, the Exchange will not provide an autoquote facility to SBT
market makers. However, SBT market makers may use their proprietary
autoquote systems to submit quotes through the API.
---------------------------------------------------------------------------
\156\ See notice, supra note 4, 67 FR at 31039.
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[[Page 17706]]
Depending on how a quote or order is modified, the quote or order
could change priority position as follows: \157\
---------------------------------------------------------------------------
\157\ See CBOE rule 43.1(f).
---------------------------------------------------------------------------
[sbull] If the price is changed, the changed side would lose
priority position and would be placed behind all orders of the same
type at the same price.
[sbull] If quantity of one side is changed, the unchanged side
would retain its priority position.
[sbull] If the quantity of one side is decreased, that side would
retain its priority position.
[sbull] If the quantity of one side is increased, that side would
lose its priority position and would be placed behind all orders of the
same type at the same price.
2. Time in Force of Orders/Quotes
The appropriate SBT Trading Committee would have the authority to
determine which order types may be accepted at the various product
states and session states.\158\ Once the System is so enabled,
customers would be able to specify that their day orders or good-'til-
canceled orders are to be transferred between one CBOE trading session
and the next, and they could determine to have their orders represented
only during ETH sessions, only during RTH sessions, or carry over from
one session to the next.\159\
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\158\ See CBOE rule 43.3(a). At the discretion of the
appropriate SBT Trading Committee, and once the System is so
enabled, any of the following order types may be accommodated on
CBOEdirect: market orders, limit orders, cancel orders, cancel
replace orders, day orders, good-for-session orders, good-'til-
canceled orders, and contingency orders. See CBOE rule 43.2(a). See
also supra notes 128 to 129 and accompanying text. CBOE has
represented that it would issue an information circular regarding
the types of orders that will be accommodated on CBOEdirect.
February 20 conversation.
\159\ See CBOE rule 43.3(b).
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3. Automatic Quote Regeneration
CBOEdirect eventually will allow an SBT market maker to regenerate
its quote where the bid or offer to be regenerated is a defined number
of ticks worse than the bid or offer that had been hit.\160\ The market
maker would pre-set the System with the number of ticks worse by which
its quote would regenerate.\161\
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\160\ See CBOE rule 44.5(b). The Exchange would determine the
number of ticks below the original price at which the quote may be
regenerated and publicize this determination in an information
circular. December 5 conversation.
\161\ See id.
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If an SBT market maker has the System regenerate its quote and the
regenerated quote could immediately execute against the same incoming
order that traded against the original quote, that portion of the
regenerated quote equal to the original size executed against the
market maker's original bid or offer would take priority over all other
interest at the regenerated price, with respect to the balance of the
incoming order, except in one circumstance. That circumstance would be
if public customer priority was applicable to that option class and
there were a public customer order at the same price as the regenerated
bid or offer. The portion of a regenerated quote that is not executed
would be placed in a priority position consistent with the time that
the quote was regenerated.\162\
---------------------------------------------------------------------------
\162\ See CBOE rule 43.1(e).
---------------------------------------------------------------------------
In Amendment No. 4, CBOE provided the following example to
demonstrate the operation of the quote regeneration function:
Assume that price-time priority is in effect, with the public
customer priority overlaid. The System receives a market order to
sell 50 contracts (``Incoming Order''). The best bid is MM A's $3
bid for 20 contracts. The Incoming Order exhausts the $3 bid. The
next best bid is $2.90 for 100 contracts consisting of MM B for 70
contracts, Customer A for 5 contracts, and MM A's regenerated quote
for 25 contracts (its pre-determined regeneration size). The
remaining 30 contracts of the Incoming Order would be filled as
follows: 5 to the Customer, 20 to MM A, and 5 to MM B. After the
Incoming Order is filled, the best bid would be 2.90 for 70
contracts with the following priority: MM B for 65 contracts and MM
A for 5 contracts.
4. Quote Risk Monitor Function
CBOE indicated that SBT market makers are exposed to certain risks
not present in an open-outcry trading environment: an SBT market maker
could have a large number of its quotes hit by a set of incoming orders
within a few seconds. Thus, the SBT market maker could find itself
taking on a large position before it had an opportunity to assess this
position and possibly change its quotes.\163\ CBOEdirect's quote risk
monitor feature is intended to permit an SBT market maker to manage its
risk by automatically deleting the market maker's quotes in a class
when the System determines that trades against the market maker's
quotes have reached a defined number of contracts within a defined
period of time. An SBT market maker may configure the System to set
these limits with respect to its own quotes. In determining whether to
delete quotes pursuant to this feature, the System would consider only
trades against the SBT market maker's resting quotes, not trades that
the SBT market maker itself initiates by hitting a bid or taking an
offer.\164\
---------------------------------------------------------------------------
\163\ See Notice, supra note 4, 67 FR at 31040.
\164\ See CBOE rule 44.5(c).
---------------------------------------------------------------------------
5. Managing Message Traffic
The Exchange may set limits on the quote traffic that is sent to
the SBT System to prevent the System from becoming overloaded. However,
CBOE has noted that, to the extent that the Exchange allows for varying
quote traffic limits by SBT traders, such limits shall be objectively
determined and submitted to the Commission for approval pursuant to
section 19(b) of the Exchange Act.\165\
---------------------------------------------------------------------------
\165\ See CBOE rule 44.5(d).
---------------------------------------------------------------------------
In addition, the Exchange may limit the number of SBT market makers
that may access the SBT System through an API (or the number of
messages sent by market makers accessing the System through an API) to
protect the integrity of the System.\166\ Furthermore, the Exchange may
impose restrictions on the use of a computer connected through an API
if it believed that such restrictions were necessary to ensure the
proper performance of the System.\167\ CBOE has represented that these
limitations would be solely for the purpose of protecting the integrity
of the System and would not be used in a discriminatory or arbitrary
fashion.\168\
---------------------------------------------------------------------------
\166\ See CBOE rule 44.6.
\167\ See id.
\168\ See notice, supra note 4, 67 FR at 31040-41.
---------------------------------------------------------------------------
CBOE has represented that it does not intend to allocate bandwidth
to each SBT trader, and that the System would not programmatically
limit the number of messages that an SBT trader may send.\169\ To
minimize the potential of a particular SBT trader to burden the System
unnecessarily, CBOE has stated that it wishes to be able to: (1)
specify the number of quotes over a certain time period that may be
sent free by an SBT trader, or (2) impose a fee per message for sending
a number that is clearly above the free number and for producing a
ratio of quotes to trades over a certain time period that is higher
than what would be considered a reasonable ratio.\170\
---------------------------------------------------------------------------
\169\ See notice, supra note 4, 67 FR at 31040.
\170\ See id. Any proposal to charge such a fee would have filed
with the Commission pursuant to section 19(b) of the Act, 15 U.S.C.
78s(b). See infra note to and accompanying text.
---------------------------------------------------------------------------
J. Intermarket Price Protection
Non-broker-dealer market and marketable limit orders would not be
automatically executed on CBOEdirect at prices inferior to the best bid
or offer on another national securities exchange, as those best prices
are identified in the System.\171\ If there is a better quote on
[[Page 17707]]
another exchange, the SBT DPM or LMM would be required to handle the
order manually.\172\ CBOE represented its view that the SBT DPM or SBT
LMM handling public customer orders under these circumstances would be
acting as agent for such orders.\173\ Accordingly, the SBT DPM or LMM
would be required to accord priority to such public customer order over
its own orders as principal, unless the customer who placed the order
has consented to not being accorded such priority.\174\ Finally, to
comply with its obligations under the Options Linkage Plan, CBOE rules
6.80 through 6.85 \175\ would apply to trading on the SBT System.
---------------------------------------------------------------------------
\171\ See CBOE rules 43.7 and 43.8. The System would have access
to the OPRA quote stream and be programmed not to automatically
execute a trade in an options series if the System identifies a
better price for that series in another market that participates in
the OPRA plan. Telephone conversation between Angelo Evangelou,
CBOE, and Michael Gaw, Division of Market Regulation, Commission, on
August 16, 2002. Current CBOE rules would not permit another
exchange's quotes to be excluded from the best prices identified by
the System. Telephone conversation between Angelo Evangelou, Legal
Division, CBOE, and Elizabeth King, Division of Market Regulation,
Commission, on February 21, 2003.
\172\ See CBOE rules 44.4, Interpretation .01(a)(6) and
44.14(b)(6).
\173\ See Amendment No. 4. The Commission notes that the
Exchange committed to file in the near future a proposed rule change
under section 19(b) of the Act to expressly state that the SBT DPM
and LMM act as agent when handling customer orders manually.
\174\ See id.
\175\ See Securities Exchange Act Release No. 47294 (January 31,
2003), 68 FR 6527 (February 7, 2003) (approving SR-CBOE-2002-61).
---------------------------------------------------------------------------
K. Trade Reporting and Data Dissemination
1. Executed Orders
The System would send executed orders to the Exchange's Trade Match
System as matched trades. The System would send fill reports for
executed orders to the SBT workstations for display to SBT
traders.\176\
---------------------------------------------------------------------------
\176\ See notice, supra note 4, 67 FR at 31026.
---------------------------------------------------------------------------
2. Internal Dissemination of Quote and Best Bid/Offer
Any subscriber to CBOEdirect would be able to view the System's
best bid and offer for any options series traded on the System.\177\
The System would send quote/order information--i.e., series, price, and
size--to the SBT workstations that are trading a given class.
---------------------------------------------------------------------------
\177\ See CBOE rule 46.1(a).
---------------------------------------------------------------------------
3. Dissemination of Quotes to OPRA
The series and price of an option would be disseminated for each
quote; the size of the quote also would be disseminated. Every change
to CBOEdirect's best bid or ask would generate a quote report to OPRA
and/or some other network that has been approved by the
Commission.\178\ Changes in best quote and size due to all-or-none or
fill-or-kill contingency orders would not result in a message to OPRA
to update the CBOEdirect quote.\179\
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\178\ The Commission notes that the OPRA plan does not presently
permit an options exchange to disseminate quotes to another network
without also disseminating such quotes to OPRA.
\179\ See notice, supra note 4, 67 FR at 31041.
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4. Last Sale Information
CBOEdirect would internally disseminate last sale information--
including series, price, and size--to subscribers that have indicated
interest in a given class.\180\ All SBT market makers assigned to a
given class would be provided this information, but other individuals
and firms could subscribe to this information as well.\181\ CBOEdirect
also would disseminate last sale information externally to OPRA and/or
another distribution network to the extent permitted by agreement or by
rule.
---------------------------------------------------------------------------
\180\ See CBOE rule 46.1(b).
\181\ See id.
---------------------------------------------------------------------------
5. Booked Order Dissemination
When an SBT trader requests information for an option class, the
System would provide the information that presents the SBT book's best
bids and asks and the aggregate size for each series of the class
requested.\182\ CBOE could add or delete categories of disseminated
information as it deemed appropriate.\183\ Although CBOE believes that
such information generally would be available, it may determine not to
provide such information if the System were nearing its message
capacity and degradation of the System could result. CBOE may charge
fees for such information; different fees may be charged to different
categories of SBT traders.\184\
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\182\ See CBOE rule 46.1(c).
\183\ See id. For example, CBOE could determine to provide book
depth to a certain number of levels, but later determine to reduce
the number of levels provided as circumstances warranted. Telephone
conversation between Angelo Evangelou and Andy Lowenthal, CBOE, and
Nancy Sanow and Michael Gaw, Division of Market Regulation,
Commission, on November 7, 2002.
\184\ Any proposal to charge such a fee would have to filed with
the Commission pursuant to section 19(b) of the Act, 15 U.S.C.
78s(b).
---------------------------------------------------------------------------
II. Amendment No. 4
The foregoing discussion incorporated revisions proposed in
Amendment No. 4 to the proposed rule change. Specifically, in Amendment
No. 4, CBOE:
[sbull] Revised the definitions of ``fill-or-kill'' and
``immediate-or-cancel'' orders to clarify that such orders must be
filled immediately upon receipt or canceled;
[sbull] Clarified the definitions of ``RFQ'' and ``Special RFQ''
and explained why RFQs would be sent only to SBT market makers;
[sbull] Added a provision that SBT DPMs and LMMs will not receive
any trade participation right until public customers' orders at the
best price have been executed, and clarified that an SBT DPM's or LMM's
trade participation right will apply only to the portion of an order
remaining after all higher priorities are satisfied;
[sbull] Substantially revised the trade nullification procedures to
include specific objective criteria as to when a trade may be broken;
[sbull] Specified that non-broker dealer market orders and
marketable limit orders will not be automatically executed at prices
inferior to the best bid or offer on another exchange, as those best
prices are identified in the System;
[sbull] Added provisions requiring SBT brokers to expose orders
that they represent as agent for at least 30 seconds or, if
appropriate, to use the crossing mechanism;
[sbull] Revised the crossing procedures to require orders to be for
at least 50 contracts to be eligible for the crossing mechanism, to
establish minimum time periods for which such proposed crosses must be
exposed, and to specify that cross transactions may be effected only in
increments equal to or greater than the Exchange's minimum quoting
increments;
[sbull] Added an interpretation regarding a member's duty of best
execution, prohibited circumvention of the rules on crossing orders,
and represented that CBOE will surveil for violations of the crossing
rules;
[sbull] Added a rule relating to responsible brokers' and dealers'
firm quotation obligations in CBOEdirect and eliminated the application
of CBOE rule 8.51, the firm quote requirements of trading crowds on the
floor, to SBT market makers;
[sbull] Revised the obligations of SBT standard market makers and
SBT DPMs and LMMs, including adding requirements relating to RFQ
response rates;
[sbull] Eliminated the special rules relating to the processing of
spread orders;
[sbull] Deleted a rule relating to the Exchange's position that
information sent over the SBT System is the Exchange's proprietary
information;
[sbull] Represented that CBOE rule 4.18 requires SBT market makers
to maintain information barriers with any affiliates that may act as a
specialist or market
[[Page 17708]]
maker in any security underlying the options for this the CBOE member
acts as an SBT market maker;
[sbull] Represented that CBOE believes that, when an SBT DPM or LMM
is required to handle customer orders under rules 44.14(b)(6) or
44.4.01(a)(6), the DPM or LMM is acting as an agent with respect to
those public customer orders;
[sbull] Explained the priority accorded to regenerated quotes;
[sbull] Clarified that trading officials will use the same criteria
to halt trading on the SBT System as is used for CBOE's trading floor;
[sbull] Revised Appendix A, which sets forth the existing CBOE
rules that also will apply to CBOEdirect, by including, among others,
CBOE rule 3.22, Temporary Access; CBOE rule 4.19, Prohibition Against
Harassment, and the rules in section E to chapter VI, Intermarket
Linkage; and
[sbull] Made other minor, technical changes to the proposed
CBOEdirect rules and to certain existing CBOE rules to accommodate the
establishment of the SBT System.
III. Discussion
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.\185\ In particular, the
Commission finds that the proposal is consistent with section 6(b)(5)
of the Act,\186\ which requires, among other things, that the rules of
an exchange be designed to promote just and equitable principles of
trade; to facilitate transactions in securities; to remove impediments
to and perfect the mechanisms of a free and open market and a national
market system; and, in general, to protect investors and the public
interest. Although the Commission did not receive any comments on the
proposed rule change, it believes that several aspects of the proposed
rules governing CBOEdirect merit greater discussion.
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\185\ In approving the proposed rule change, the Commission
notes that it has considered the proposed rule's impact on
efficiency, competition, and capital formation. See 15 U.S.C.
78c(f).
\186\ 15 U.S.C. 78f(b)(5).
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A. RFQs and Market Maker Quoting Obligations
For each options series traded on CBOE's floor today, a single
quotation is disseminated that reflects the aggregate trading interest
of one or more customers and/or crowd participants, including the DPM
and market makers. DPMs generally are required to make continuous
markets in the option classes for which they serve as DPM. By contrast,
the CBOEdirect rules do not require SBT DPMs and LMMs to make
continuous markets.\187\ Therefore, it is possible that, at a
particular point in time, CBOE will not have a disseminated market for
a particular option. Instead, the current market for a particular
product may be available only through the RFQ process. The Commission
believes that CBOEdirect's reliance on RFQs as a means of price
discovery when the orders and quotes on the SBT book are not sufficient
to satisfy trading demand is consistent with the Act.
---------------------------------------------------------------------------
\187\ See CBOE rules 44.4, Interpretation .01(a)(4) and
44.14(a)(4). The appropriate Market Performance Committee may, but
is not required to, require an SBT DPM or LMM to provide continuous
quotes in some or all of its appointed option series. See id.
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CBOE's rules require SBT market makers to fulfill certain
requirements as market makers. Specifically, SBT market makers, among
other things, are required to have at least 75% of their total contract
volume on the SBT System in options classes to which they are
appointed. In addition, SBT standard market makers are required to
respond to at least 75% of the RFQs that they receive, and SBT DPMs and
LMMs are required to respond to at least 98% of the RFQs that they
receive. Moreover, RFQ responses must meet certain parameters for them
to count toward the SBT market maker's quote response obligations.\188\
---------------------------------------------------------------------------
\188\ See supra notes 27 to 29 and accompanying text.
---------------------------------------------------------------------------
Market makers receive certain benefits for carrying out their
duties. For example, a lender may extend credit to a broker-dealer
without regard to the restrictions in Regulation T if the credit is to
be used to finance the broker-dealer's activities as a specialist or
market maker on a national securities exchange.\189\ The Commission
believes that an SBT market maker must have an affirmative obligation
to hold itself out as willing to buy and sell options for its own
account on a regular or continuous basis to justify this favorable
treatment. In this regard, the Commission believes that CBOE's rules
impose such affirmative obligations on SBT market makers.
---------------------------------------------------------------------------
\189\ See 12 CFR 221.5(c)(6).
---------------------------------------------------------------------------
B. Trade Participation Right for SBT DPMs and LMMs
The CBOEdirect rules allow the Exchange to award SBT DPMs and LMMs
a participation right of up to 40% of the portion of an order remaining
after orders and quotes of other market participants with higher
priority have been satisfied, provided that the DPM or LMM has a quote
or order at the best price. The Commission continues to believe that it
is consistent with the Act to guarantee a DPM or LMM the right to trade
ahead of other market makers, even when the DPM or LMM has not
otherwise established priority. These guarantees are intended to
provide an incentive for market makers to assume the extra
responsibilities assigned to DPMs and LMMs, such as the obligation to
provide opening quotes in assigned classes, to respond to a greater
percentage of RFQs than SBT standard market makers, and to handle
public customer orders when there is a better price on another market.
The Commission recognizes that a large guaranteed participation
right will erode the incentive of other market makers to make
competitive markets. Thus, the Commission must weigh whether a proposed
participation right adequately balances the aim of rewarding the
specialist or primary market maker with the aim of leaving a sizeable
enough portion of the incoming order for the other market makers
quoting at the same price.\190\ The Commission has previously taken the
position that a trade participation right that does not exceed 40%,
including any guaranteed percentage of the trade to be accorded to any
other trade participant, is not inconsistent with the Act.\191\
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\190\ See Securities Exchange Act Release No. 43100 (July 31,
2000), 65 FR 48778, 48787-90 (August 9, 2000) (``Phlx 80/20
Proposal'') (Commission requested comment on whether the proposal by
the Philadelphia Stock Exchange to establish an 80% specialist
guarantee would be consistent with the Act).
\191\ See, e.g., Securities Exchange Act Release No. 45936 (May
15, 2002), 67 FR 36279, 26280 (May 23, 2002); Securities Exchange
Act Release No. 42835 (May 26, 2000), 65 FR 35683, 35685-66 (June 5,
2000); Securities Exchange Act Release No. 42455 (February 24,
2000), 65 FR 11388, 11398 (March 2, 2000); Phlx 80/20 Proposal, 67
FR at 48787-88.
---------------------------------------------------------------------------
Finally, CBOE proposed that public customer orders at the best
price be filled before an SBT DPM or LMM receives its trade
participation right.\192\ Although, as discussed below, the Commission
does not believe that customers who may electronically generate orders
must be accorded priority over market makers who are not acting as
agent with respect to these customers, the Commission does believe it
is appropriate for customer orders to have priority over a specialist's
trade participation right.
---------------------------------------------------------------------------
\192\ See CBOE rule 43.1(b)(3)(E).
---------------------------------------------------------------------------
C. Priority and Trade Allocation Methodology
The Commission considers each of the priority and trade allocation
rules
[[Page 17709]]
(i.e., price-time priority or pro rata priority) proposed for
CBOEdirect to be consistent with the Act. In addition, the Commission
believes that each of the priority overlays (i.e., public customer,
marker turner, and SBT DPM and LMM trade participation right) is
consistent with the Act. In making its determination that these
priority rules are consistent with the Act, the Commission considered
it critical that an SBT DPM or LMM cannot receive its trade
participation right before any public customer orders at the same price
are executed in full.
The SBT Trading Committee has the ability, but is not required, to
grant customers the highest priority at a particular price level.
Currently, in the rules governing trades on CBOE's floor, customer
orders displayed on the limit order book are given priority over
broker-dealer orders and market maker quotes.\193\ This is essential
under CBOE's rules because the DPM is the agent for orders resting in
the limit order book and, therefore, consistent with general agency law
principles, CBOE's rules accord priority to those resting limit orders.
In contrast, an SBT market maker is not required to act as agent with
respect to a limit order entered into CBOE direct.\194\ Moreover, the
CBOE's rules do not prohibit customers from electronically generating
orders for entry into the CBOEdirect book as they do for orders
eligible for the Exchange's Retail Automatic Execution System.\195\ The
Commission, therefore, believes that it is consistent with the Act for
the CBOEdirect rules not to provide in all approaches that public
customer orders have priority over market maker quotes and orders.
---------------------------------------------------------------------------
\193\ See CBOE rule 6.45(a)(i) and (b). See also CBOE rule
6.74(d)(ii) (giving public customer orders represented in the
trading crowd priority over other participants in the context of
crossing transactions).
\194\ The SBT DPM or LMM, however, would act as agent when
handling an order when there is a better price on another market.
\195\ See CBOE rule 6.8A(a). CBOE has confirmed in its cover
letter to Amendment No. 4 that CBOE rule 6.8A does not apply to
CBOEdirect.
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D. Obligations Under the Linkage Plan
SBT DPMs and LMMs will be required to handle public customer orders
when there is a better quote on another exchange. In addition, to
comply with its obligations under the Options Linkage Plan,\196\ CBOE
rules 6.80 through 6.85 will apply to the SBT System.\197\ It appears
that these provisions satisfy CBOE's obligations under the Options
Linkage Plan.
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\196\ Because of concerns about the increasing likelihood of
intermarket trade-throughs of customer orders in the options markets
following the widespread expansion of multiple trading, the
Commission in October 1999 ordered the options exchanges to work
together to file a national market system plan for linking the
options markets (``Options Linkage Plan''). See Securities Exchange
Act Release No. 42029 (October 19, 1999), 64 FR 57674 (October 26,
1999). The Commission approved an initial Options Linkage Plan in
July 2000. See Securities Exchange Act Release No. 43086 (July 28,
2000), 65 FR 48023 (August 4, 2000). The Commission subsequently
approved amendments to that plan in May 2002 that set forth phase
one of the plan's implementation, providing for automatic execution
of orders routed to from one options exchange to another, and phase
two, to implement all other linkage functionality. See Securities
Exchange Act Release No. 46001 (May 30, 2002), 67 FR 38687 (June 5,
2002). Implementation of phase one began on January 31, 2003, and
implementation of phase two must occur no later than April 30, 2003.
See id., 67 FR at 38688.
\197\ See Securities Exchange Act Release No. 47294 (January 31,
2003), 68 FR 6527 (February 7, 2003) (adopting rules for CBOE
relating to the Options Linkage Plan).
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E. Internalization and Crossing Transactions
As the Commission has noted,\198\ 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. These preferences can have the effect of
reducing intramarket price competition when a right to receive a
portion of the trade is guaranteed to a member based on its status as
an order provider rather than to reward market makers for providing the
best quotes. If exchange rules do not provide a fair opportunity for
market participants to compete for orders based on price, there is a
disincentive to provide competitive quotes on the exchange and thus
price competition may suffer. Eventually, if execution guarantees to
particular exchange members become too great, the number of competitive
market makers could diminish, thereby impeding intramarket price
competition. As a result, the prices available on a market could
deteriorate--ultimately harming investors.
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\198\ See Securities Exchange Act Release No. 42455 (February
24, 2000), 65 FR 11388, 11395 (March 2, 2000) (Order approving
registration of International Securities Exchange LLC as a national
securities exchange) (``ISE Order'').
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The CBOEdirect rules include an interim crossing procedure, which
does not provide for any guarantee to the SBT broker facilitating the
order, and a regular crossing procedure, which will provide for a
guarantee to the SBT broker facilitating the order. The eligible order
size for using either crossing procedure is 50 contracts. The crossing
procedures require the SBT broker to initiate the process by submitting
an RFQ with size to SBT market makers who are registered in that class.
Both the interim and regular crossing procedures set forth minimum time
periods that these SBT market makers are given to respond to the RFQ.
The RFQ will be anonymous; no SBT trader will be able to learn the
identity of the SBT broker who is crossing the order. The Commission
believes that this anonymity is an important difference between
CBOEdirect and floor-based auction markets. The automated, non-personal
nature of the SBT System provides no opportunity for agreements between
the facilitating firm and the trading crowd whereby, for example, the
trading crowd agrees not to break up a firm's proposed facilitations in
exchange for the firm's agreement to bring order flow to the exchange.
In the regular crossing procedure, an SBT broker seeking to
facilitate an order is guaranteed a participation right if, at the end
of the RFQ response period, the broker improves the price that the
customer would receive by entering a proposed cross at a price between
the best bid and offer. The participation right of the SBT broker
seeking to internalize the order when using the regular crossing
procedure would be set at 40%.\199\ The remaining 60% of the order
would be entered on the SBT book as a limit order at the proposed
crossing price. All participants in the SBT System would be able to
trade with this limit order at the proposed price or at an improved
price. The Commission believes that the time periods required by the
regular CBOEdirect crossing procedure would afford SBT market makers an
adequate amount of time in which to respond to the RFQ during the
initial response period and for all participants in CBOEdirect to
compete for 60% of the order during the exposure period that followed.
In the interim crossing procedure, the exposure period would give
CBOEdirect participants an opportunity to compete for 100% of the order
before the SBT broker could participate.
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\199\ See CBOE Rule 43.12(a)(5). The Commission notes that in
this context the SBT DPM or LMM would not be entitled to a trade
participation right because the crossing transaction must occur at
an improved price, which by its terms must be a better price than
the previously established bid or offer of the SBT DPM or LMM.
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In addition, with respect to orders that do not qualify for, or for
which the SBT broker has chosen not to use, the interim or regular
crossing procedures, an SBT broker would have to expose such orders on
the System for at least 30 seconds before executing any part of the
order as principal. Similarly, orders
[[Page 17710]]
must be exposed on the System for at least 30 seconds before they may
be executed by orders solicited from members and non-member broker-
dealers. These rules ensure that the crossing procedures and the
limitations on facilitation described above are not circumvented.
The CBOEdirect rules also would prevent an SBT broker from being
party to any arrangement designed to circumvent the proposed crossing
rules by providing an opportunity for another party to execute against
an agency order immediately after the broker had entered the order in
the SBT System.\200\ The Commission believes that the prohibition on
such arrangements is important, because an SBT broker and a third party
could otherwise use CBOEdirect to execute their orders with each other,
without exposing these orders to other trading interest. The Commission
believes that this prohibition should prove helpful in curbing a firm's
ability to internalize order flow.\201\
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\200\ See CBOE rule 43.12C(a).
\201\ The Commission previously approved a similar provision as
part of the ISE's rules. See ISE rule 400, Supplementary Material;
ISE Order, 65 FR at 11400.
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Finally, the proposed rules also include an interpretation stating
that a violation of a member's duty of best execution would be presumed
if the member were to cancel or withhold a facilitation order to avoid
execution of the order at a better price.\202\ Use of the crossing
mechanism would not modify a member's best execution duty to its
customer. The Commission believes that this interpretation is important
to ensure that SBT brokers who propose to facilitate orders as
principal fulfill their duty of best execution. In the Commission's
view, withholding or withdrawing an order to be facilitated--that could
benefit from price improvement available from other market
participants--simply to avoid executing the order at the superior price
would be a violation of the broker's best execution duty.\203\
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\202\ See CBOE rule 43.12A, Interpretation .01.
\203\ See ISE Order, 65 FR at 11398 (discussing a similar
provision in the ISE rules).
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As a national securities exchange, CBOE is required to enforce its
members' compliance with their best execution obligations. The
Commission notes that when a SBT broker enters a facilitation
transaction into the crossing mechanism and then cancels the remainder
of the customer order after the 40% of the order is executed, this
could indicate--depending on the circumstances--that the broker
originally overstated the size of the customer order and, with the 40%
execution, effectively internalized 100% of the customer order. This
situation would not be consistent with the SBT system's crossing rules.
CBOE has committed to surveil for instances when a SBT broker
immediately cancels the crossing transaction once 40% of the order is
executed. The Commission notes that if, after receiving the responses
to an RFQ, the SBT broker elects not to enter the transaction into the
crossing mechanism because he or she is unwilling to facilitate the
customer order at the requisite price between the best bid and offer
displayed by the System, depending on the circumstances, the SBT broker
may have a best execution obligation to enter the customer order into
the System to execute against the appropriate best response to the RFQ.
The Commission finds that the rules proposed by CBOE relating to
crossing and internalization of orders on the SBT System are consistent
with the Act. The Commission believes that these rules will promote
intramarket price competition by providing SBT traders with a
reasonable opportunity to compete for a significant percentage of the
incoming order and, therefore, will protect investors and the public
interest.
F. Simultaneous Trading of the Same Security on CBOEdirect and the
Exchange Floor
CBOE has not proposed any rules that would govern order handling
and order priority if the same option were traded simultaneously on
CBOEdirect and on CBOE's floor-based market. Accordingly, the
Commission is not approving the use of CBOEdirect to trade any security
during a trading session in which such security is trading on CBOE's
floor-based market.\204\ The Commission believes that trading the same
option classes on the floor and on the SBT System at the same time
raises several issues under the Act that CBOE must address--by filing
one or more proposed rule changes pursuant to section 19(b) of the
Exchange Act \205\--before the Commission could approve concurrent
trading of the same option classes.
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\204\ In Amendment No. 4, the Exchange eliminated the text of
its proposed rule 43.10 regarding the trading of spread orders on
CBOEdirect.
\205\ 15 U.S.C. 78s(b).
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G. Trade Nullification Procedures and the Firm Quote Rule
The rules governing CBOEdirect provide for the ability of one or
both parties to a transaction to nullify the trade. Both parties to the
trade can agree to have a trade nullified and, in that case, the
CBOEdirect rules prescribe that certain procedures be followed for
negotiated trade nullification.
The rules also provide for a procedure whereby an SBT trader may
request two trading officials to nullify a trade. Specifically, a trade
may be nullified by one party to the transaction if a documented
request is made within five minutes or, in the case of a public
customer order, within 15 minutes of execution, and one of the
following conditions is satisfied: (1) There is a verifiable disruption
or malfunction in Exchange systems that cause a quote/order to trade in
excess of its disseminated size or that prevent an SBT trader from
updating or canceling its quote/order; (2) the trade resulted from an
erroneous print in the underlying security that resulted in a trade
higher or lower than the average trade in the underlying security by a
specified factor; (3) the trade resulted from an erroneous quote in the
primary market for the underlying when certain other conditions are
met; or (4) the execution price of the trade is higher or lower than
the theoretical price for the series by a specified factor. A party to
the trade that disagrees with the trade nullification can appeal the
determination under Chapter XIX of the Exchange's rules.
The Commission considers that in most circumstances trades that are
executed between parties should be honored. On rare occasions, the
price or other terms of the executed trade are such that they are
``clearly erroneous,'' suggesting that it is unrealistic to expect that
the parties to the trade had come to a meeting of the minds regarding
the terms of the transaction. In the Commission's view, abrogating a
trade should occur under specific and objective circumstances only. The
trade nullification rule for CBOEdirect contains specific and objective
criteria with respect to the circumstances when a trade can be
nullified, which helps to ensure that the rule would be applied in a
fair and non-discriminatory manner. In addition, the conditions under
which a trade can be nullified indicate that the error would be
``clearly erroneous,'' i.e., the terms of the trade clearly were
outside of the norm for other trades that were executed within a
proximate time frame. In addition, the CBOEdirect rule on trade
nullification contains clear procedures on how the trade would be
nullified and provides a time frame within which a request to nullify a
trade must be made. Finally, the trade nullification rule specifies the
procedures to be followed for an appeal by a party who disagrees with
the result.
[[Page 17711]]
In light of the foregoing, the Commission believes that the trade
nullification rule for CBOEdirect is appropriate.
H. Integrated Market Making and Side-by-Side Market Making
Under the Commodity Futures Modernization Act of 2000,\206\ futures
contracts on single securities and narrow-based security indexes may
now be traded under the joint jurisdiction of the Securities and
Exchange Commission and the Commodity Futures Trading Commission. The
Commission understands that SBT traders who may make markets in options
on CBOEdirect also may make markets in security futures that are based
on the same underlying security or may have an affiliate that engages
in such trading. In addition, SBT traders who effect transactions in a
particular option may be affiliated with market makers or specialists
who trade the underlying security (i.e., ``integrated market making'').
The Exchange has indicated that CBOE Rule 4.18, which governs the use
of material, non-public information, would apply to members trading on
CBOEdirect. The Exchange represented that this rule would require a SBT
market maker to maintain information barriers--that are reasonably
designed to prevent the misuse of material, non-public information by
such member--with any affiliates that may act as a specialist or market
maker in any security underlying the options for which the CBOE member
acts as a SBT market maker. The Commission believes that the
requirement that there be an information barrier between the SBT market
maker and its affiliates with respect to transactions in the option and
the underlying security serve to reduce the opportunity for unfair
trading advantages or misuse of material, non-public information.
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\206\ Pub. L. No. 106-554, Appendix E, 114 Stat. 2763.
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I. Managing Message Traffic
CBOE has indicated that it may, in the future, be necessary to set
limits on the message traffic on the SBT System to prevent it from
becoming overloaded. For example, CBOE has stated that it may have to
limit the number of SBT market makers that may access the SBT System
through an API, or limit the number of messages sent by market makers
accessing the System through an API, to protect the integrity of the
System.\207\ Furthermore, CBOE has indicated that it may have to impose
restrictions on the use of a computer connected through an API if it
believed that such restrictions were necessary to ensure the proper
performance of the System.\208\ In addition, CBOE has stated that it
wishes to be able to: (1) Specify the number of quotes over a certain
time period that may be sent free by an SBT trader, or (2) impose a fee
per message for sending a number that is clearly above the free number
and for producing a ratio of quotes to trades over a certain time
period that is higher than what would be considered a reasonable
ratio.\209\ Finally, CBOE has indicated that it intends to charge fees
for RFQs that exceed a certain ratio of requests-to-trades.\210\
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\207\ See CBOE rule 44.6.
\208\ See id.
\209\ See notice, supra note 4, 67 FR at 31040.
\210\ See notice, supra note 4, 67 FR at 31039.
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Trading options in an electronic environment presents greater
capacity burdens than does the electronic trading of equity securities.
For every equity security, there potentially exists dozens of overlying
options, each series having a different expiration date or strike
price. The continuous quoting of options, therefore, generates far more
message traffic than the continuous quoting of equity securities. The
Commission acknowledges that an electronic options exchange has a
legitimate interest in ensuring that the amount of message traffic
passing through the facilities of that exchange does not become so
great as to compromise system performance. However, the Commission
expects CBOE to file with the Commission, in accordance with the
procedural requirements of section 19(b) of the Act \211\ and the
substantive requirements of section 6(b) of the Act,\212\ any proposal
to throttle message traffic. The Commission notes in particular that
any such proposal by the Exchange must not permit unfair discrimination
between CBOEdirect participants.\213\ Section 6(b) also requires that
any dues, fees, or other charges imposed by a national securities
exchange must be fair and reasonable and allocated equitably.\214\
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\211\ 15 U.S.C. 78s(b).
\212\ 15 U.S.C. 78f(b).
\213\ See 15 U.S.C. 78f(b)(5).
\214\ See 15 U.S.C. 78f(b)(4).
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J. Accelerated Approval
Pursuant to section 19(b)(2) of the Act,\215\ 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 the proposal, as amended by Amendment No. 4, prior
to the 30th day after publishing notice of the amended proposal in the
Federal Register. Many of the revisions made to the proposal in CBOE's
Amendment No. 4 are modeled on existing CBOE floor rules or the rules
of the ISE. The Commission previously approved these CBOE rules and ISE
rules and therefore believes that accelerating such rules for
CBOEdirect is appropriate because these revisions do not raise new
regulatory issues. Other revisions, although not based on existing ISE
or CBOE rules, were not material to the overall proposal. The
Commission believes that no purpose would be served by delaying
approval of the proposal until those additional revisions had been
published for comment, particularly in light of the fact that no
comments were received in response to the notice. Therefore, the
Commission finds that good cause exists to accelerate approval of the
amended proposal.
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\215\ 15 U.S.C. 78s(b)(2).
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IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendment No. 4, including whether the amendment
is consistent with the Act. Persons making written submissions should
file six copies thereof with the Secretary, Securities and Exchange
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. 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 Room. Copies of such filings will also be available
for inspection and copying at the principal office of the Exchange. All
submissions should refer to File No. SR-CBOE-00-55 and should be
submitted by May 1, 2003.
V. Conclusion
It is therefore ordered, pursuant to section 19(b)(2) of the
Act,\216\ that the proposed rule change (SR-CBOE-00-55), as amended, is
approved on an accelerated basis.
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\216\ 15 U.S.C. 78s(b)(2).
[[Page 17712]]
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\217\
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-8730 Filed 4-9-03; 8:45 am]
BILLING CODE 8010-01-P