June 24, 2004

re: Limited Exemption from Rule 11Ac1-1

Mr. Michael J. Simon
Senior Vice President and General Counsel
International Securities Exchange, Inc.
60 Broad Street
New York, NY 10004

Dear Mr. Simon:

In your letter, dated June 14, 2004, you request that the Securities and Exchange Commission ("Commission"), pursuant to Rule 11Ac1-1(e) under the Securities Exchange Act of 1934 ("Exchange Act"),¹ grant the International Securities Exchange, Inc. ("ISE" or "Exchange") a limited exemption from Rule 11Ac1-1 (the "Quote Rule")² that would permit the Exchange to relieve an ISE market maker from its obligation under the Quote Rule to trade with matching quotations from another ISE market maker, provided that the quotations are locked or crossed for no more than one second, and that such ISE market maker is firm to all other customer and broker-dealer orders, including orders for the accounts of other ISE market makers.

Paragraph (c) of Rule 11Ac1-1 requires responsible brokers or dealers on ISE to communicate their best bids, best offers, and quotation sizes to the Exchange and, subject to certain enumerated exceptions in paragraph (c)(3) of the Quote Rule, to execute any order to buy or sell at a price as favorable as their published quotation in an amount up to their published quotation size. You request that the Commission exempt ISE market makers from this provision of the Quote Rule. Specifically, the ISE proposes to maintain its current rule that requires its market makers to be firm for the size disseminated with their quotations for all orders, other than the quotations of other ISE market makers, regardless of whether such orders are for the accounts of other ISE market makers, customers, or broker-dealers. The ISE proposes, however, to establish a rule relieving an ISE market maker from its obligation under the Quote Rule to trade with matching quotations from another ISE market maker, provided that the quotations are locked or crossed for no more than one second, and that such ISE market maker is firm to all other customer and broker-dealer orders, including orders for the accounts of other ISE market makers.

You note that "market makers update quotations in multiple series at the same time" and that "there is invariably a lag between the time the stock price first changes and the time by which [the ISE] can process all the corresponding option quotations changes." During the updating process, one market maker's bid price may be updated to be the same as another market maker's asked price or one market maker's bid price may "cross" another market maker's asked price, resulting in a temporary market "lock" or "cross," respectively. You note that, without an exemption from the Quote Rule, multiple market maker to market maker trades would occur and that these executions, "would not properly reflect the true nature of the market" and would subject market makers, "to multiple execution and clearing fees, with no real economic justification behind the trades." The Exchange's proposed rule change, if approved, would reduce these inefficiencies by relieving an ISE market maker from being obligated to trade with matching quotations from another ISE market maker for no more than one second. Consequently, you request an exemption from the Quote Rule, subject to certain conditions, to allow the ISE to implement this approach.

Response:

The Commission grants ISE market makers an exemption pursuant to paragraph (e) of the Quote Rule from their obligations under paragraph (c)(2) of Rule 11Ac1-1 with respect to interacting quotations of ISE market makers that remain locked or crossed for no more than one second, provided that such ISE market makers continue to be firm for all customer and broker-dealer orders, including orders for the accounts of other ISE market makers.

Because the ISE would continue to require its market makers to be firm for their quotations for the same size to customers and broker-dealer orders, including orders for the account of other ISE market makers, the Commission finds that it is consistent with the public interest, the protection of investors and the removal of impediments to and perfection of the mechanism of a national market system to permit ISE market makers from being obligated to trade with interacting ISE market maker quotations that last for no more than one second. In addition, the Commission notes that the ISE believes that, without such an exemption, pricing inefficiencies would result on the Exchange and ISE market makers would widen their quotations or limit size to avoid multiple executions against other market makers. Therefore, the Commission grants the Exchange's request for a limited exemption from the Quote Rule.

This limited exemption is based on the facts and representations made in your letter. Specifically, this exemption is conditioned on ISE maintaining the rule that requires all ISE market maker quotations to be firm for their quotations at the full disseminated size for all incoming orders, including orders for the accounts of ISE market makers. Facts or circumstances different than those presented in your letter might require a different conclusion.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority,³

¹ Exchange Act Rule 11Ac1-1(e) provides:

The Commission may exempt from the provisions of this section, either unconditionally or on specific terms and conditions, any responsible broker or dealer, electronic communications network, exchange, or association if the Commission determines that such exemption is consistent with the public interest, the protection of investors and the removal of impediments to and perfection of the mechanisms of a national market system.

17 CFR 240.11Ac1-1(e). The Director of the Division of Market Regulation has delegated authority to grant an exemption under this provision pursuant to 17 CFR 200.30-3(a)(28). See Securities Exchange Release No. 44079 (March 15, 2001), 66 FR 15791 (March 21, 2001).

² 17 CFR 240.11Ac1-1.

³ 17 CFR 200.30-3(a)(28).

Incoming Letter

June 14, 2004

Ms. Annette Nazareth
Director
Division of Market Regulation
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re: Exemption from Rule 11Ac1-1, the "Firm Quote Rule"

Dear Ms. Nazareth:

The International Securities Exchange, Inc. ("ISE") hereby requests an exemption from Rule 11Ac1-1 (the "Rule") under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). We are requesting this exemption to provide limited relief to market makers when their quotations interact in our electronic trading system.

Relevant Provisions of the Firm Quote Rule

The Rule requires an exchange to collect and disseminate quotations from broker-dealer members of that exchange. Broker-dealers who provide such quotations generally must be firm up to the size of their quotations. However, the Rule provides more flexibility for options exchanges, including the ability of an options exchange to adopt rules creating different quotation sizes for customers and for broker-dealers. Specifically, subparagraph (d)(1)(iii) of the Rule permits us: (1) to collect and to disseminate quotation sizes that must be firm for customer orders; and (2) to establish by rule, the size for which our broker-dealer members must be firm for orders of other broker-dealers, as long as such size is at least one contract.

Interaction of ISE Market Marker Quotations

The ISE treats orders and quotations differently, with ISE Rule 804(a) stating that only market makers may enter quotations on the ISE. Market makers use quotations to input and update prices on multiple series of options at the same time. Quotations generally are based on pricing models that rely on various factors, including the price and volatility of the underlying security. As these variables change, a market maker's pricing model automatically update quotations for some or all of an option's series. In contrast, an order is an interest to buy a stated number of contracts of one specific options series. All ISE members, including ISE market makers, can enter orders.¹

When stock prices change, ISE market makers update quotations in multiple series at the same time. We promptly process such quotation changes when we receive them. However, there is invariably a lag between the time the stock price first changes and the time by which we can process all the corresponding option quotation changes. During this short period, we may update one market maker's bid price to be the same as another market maker's asked price, resulting in a temporary market "lock"; quotations may also "cross" each other. If we were to permit executions at such prices, they would not properly reflect the true nature of the market. Rather, they would result in executions against quotations that simply were in the processing queue awaiting updating. Without there being some protection against this happening, we would execute multiple market-maker-to-market-maker trades, subjecting them to multiple execution and clearing fees, with no real economic justification behind the trades. To avoid such executions and the attendant costs, market makers would widen their quotations or limit their size, to the detriment of customers and other market participants.

In order to address this concern, the ISE has established a "timer" pursuant to which locked or crossed market maker quotations will not trade against each other for a specified amount of time. We propose to set this timer at one second. During this brief period, market maker quotations remain firm for all orders the ISE may receive. That is, all orders will be executed at the "locked" or "crossed" price up to the full size of the quotations, effectively resulting in a "zero spread" (or, for crossed markets, a "negative spread") during this time period. This includes orders from customers, broker-dealers and even other market makers. The only exclusion is for executions against other market maker quotes.

The timer allows (1) market makers to update their quotations and (2) the ISE to process these updates, without effecting multiple executions during the update process. If a market maker has not entered a new quotation price during this brief period, once the timer expires trades will occur in all locked or crossed series up to the full size of the quotations. This brief timer allows market prices to reach true pricing equilibrium without the execution of trades lacking economic substance.

Requested Exemption from the Firm Quote Rule

Paragraph (e) of the Rule grants the Commission authority to provide an exemption from the Rule "if the Commission determines that such exemption is consistent with the public interest, the protection of investors and the removal of impediments to and perfection of the mechanism of a national market system." We believe that our requested exemption falls squarely within this exemptive authority. Specifically, we request that the Commission grant an exemption from the Rule to permit market maker quotations at the same price not to trade against each other for no more than one second, provided that such quotations remain firm, for up to their full size, during this short time period. As discussed above, we believe that this exemption would permit market makers to disseminate narrower quotations of greater size, and thus provide all market participants with better prices and greater liquidity.

Sincerely,

Michael J. Simon
Senior Vice President and General Counsel

cc: John Roeser

¹ ISE Rule 717 imposes various limitations on orders that Electronic Access Members may enter on the ISE, while ISE Rule 805 governs market maker orders.

http://www.sec.gov/divisions/marketreg/mr-noaction/ise062404.htm