|
March 31, 2003 Angelo Evangelou Re: CBOEdirect Screen Based Trading System Dear Mr. Evangelou: In your letter dated March 28, 2003, you request interpretive guidance regarding the application of Rule 11a2-2(T) under the Securities Exchange Act of 1934 ("Exchange Act") to transactions executed via the Chicago Board Options Exchange's ("CBOE") CBOEdirect Screen Based Trading System ("CBOEdirect"). Section 11(a) of the Exchange Act prohibits a member of a national securities exchange from effecting transactions on that exchange for its own account, the account of an associated person, or an account over which it or its associated person exercises investment discretion (collectively, "covered accounts") unless an exception applies. Rule 11a2-2(T) provides exchange members with an exemption, in addition to the exceptions delineated in the statute. Known as the "effect versus execute" rule, Rule 11a2-2(T) permits an exchange member, subject to certain conditions, to effect transactions for covered accounts by arranging for an unaffiliated member to execute the transactions directly on the exchange floor. To comply with the rule's conditions, a member (1) must transmit the order from off the exchange floor, (2) may not participate in the execution of the transaction once it has been transmitted to the member performing the execution,1 (3) may not be affiliated with the executing member, and (4) with respect to an account over which the member or an associated person has investment discretion, neither the member nor its associated person may retain any compensation in connection with effecting the transaction without express written consent from the person authorized to transact business for the account in accordance with the rule. Off-Floor TransmissionThe requirement in Rule 11a2-2(T) for orders to be transmitted from off the exchange floor reflects Congress' intent that Section 11(a) should operate to put member money managers and non-member money managers on the same footing for purposes of their transactions for covered accounts. In considering other automated systems, the Commission and the staff have stated that the off-floor transmission requirement would be met if a covered account order is transmitted from off the floor directly to the exchange floor by electronic means.2 Because all orders sent to CBOEdirect will be electronically submitted directly to the system from remote terminals, the staff believes that orders transmitted for execution on CBOEdirect satisfy the off-floor transmission requirement. Non-Participation in Order Execution and Execution Through Unaffiliated MemberRule 11a2-2(T) further provides that the exchange member and its associated persons may not participate in the execution of a transaction once the order has been transmitted to the exchange floor. This requirement was included to prevent members with their own brokers on the exchange floor from using those persons to influence or guide their orders' execution. This requirement does not preclude members from canceling or modifying orders, or from modifying the instructions for executing orders, after they have been transmitted to the floor. Such cancellations or modifications, however, also must be transmitted from off the exchange floor.3 In a release discussing both the COMEX and the PACE systems, the Commission noted that a member relinquishes any ability to influence or guide the execution of its order at the time the order is transmitted into the systems and, although the execution is automatic, the design of these systems insures that members do not posses any special or unique trading advantages in handling orders after transmission to the trading floor.4 Similarly, orders submitted to CBOEdirect will enter an order processing queue and be executed against the account of one of the market makers who is logged on the CBOEdirect system or an order resident in the system based on an established matching algorithm. To the extent that users of CBOEdirect will relinquish control of their orders upon transmission to CBOEdirect, and will not be able to influence or guide the execution of their orders, the staff believes that this requirement is met with respect to orders that are executed automatically on CBOEdirect. Furthermore, although Rule 11a2-2(T) contemplates having an order executed by an exchange member who is unaffiliated with the member initiating the order, the Commission has recognized that this requirement is not applicable when automated exchange facilities are used. For example, in considering the operation of COMEX and PACE, the Commission noted that while there is no independent executing exchange member, the execution of an order is automatic once it has been transmitted into the systems. Because the design of these systems ensures that members do not possess any special or unique trading advantages in handling their orders after transmitting them to the exchange floors, the Commission has stated that executions obtained through these systems satisfy the independent execution requirement of Rule 11a2-2(T).5 Similarly, to the extent that the design of CBOEdirect ensures that members do not possess any special or unique trading advantages in the handling of their orders after transmission, a member effecting a transaction through CBOEdirect satisfies the requirement for execution through an unaffiliated member. However, the priority rule for CBOEdirect, CBOE Rule 43.1, allows certain members of CBOE's screen based trading committee (the "Committee") to determine which priority provisions of Rule 43.1 will govern options trading on CBOEdirect. To the extent a member firm sought to manipulate CBOEdirect's trading algorithm by causing a Committee member to change the algorithm in order to benefit the firm, its client, or a related entity in the execution of a pending order, neither the requirement for non-participation in order execution not the requirement for execution through an unaffiliated member will be satisfied. To the extent CBOE's surveillance of the matching algorithm ensures that members do not abuse Rule 43.1 in a manner that is inconsistent with Section 11(a) of the Exchange Act, the staff believes that both the requirement for non-participation in order execution and the requirement for execution through an unaffiliated member will be satisfied. Non-Retention of Compensation for Discretionary AccountsThe staff notes that members who intend to rely on Rule 11a2-2(T) in connection with transactions using CBOEdirect must comply with the requirements of Section (a)(2)(iv) of the rule. ConclusionThis interpretive position is based solely on your representations and the facts presented, and is strictly limited to the application of Rule 11a2-2(T) to the CBOEdirect transactions described above. Any different facts or circumstances may require a different response.
Sincerely, Footnotes
Incoming LetterMarch 28, 2003 Ms. Catherine McGuire Re: Proposal to Adopt a Screen Based Trading System - Dear Ms. McGuire: In connection with the above referenced filing, the Chicago Board Options Exchange, Incorporated ("CBOE" or "Exchange") respectfully requests the Division of Market Regulation of the Securities and Exchange Commission ("SEC" or "Commission") to provide interpretive guidance regarding the application of Rule 11a2-2(T)1 to CBOE's proposed rule change SR-CBOE-00-55, which proposes to adopt a screen based trading system known as CBOEdirect®.2 CBOE believes its proposed rule change meets the requirements of Rule 11a2-2(T).3 The Exchange believes the policy concerns Congress sought to address in Section 11(a) of the Act,4 the time and place advantage members on exchange floors have over non-members off the floor and the general public, are not present in the CBOEdirect system. I. Background CBOE has analyzed the Application of Section 11(a) of the Act and Rule 11a2-2(T) thereunder relative to option orders that are executed through CBOEdirect. For the reasons discussed below, CBOE believes the proposed rule change in SR-CBOE-00-55 is consistent with the stated objectives of Section 11(a) of the Act. II. Discussion Effect Versus Execute Rule Section 11(a) of the Exchange Act prohibits a member of a national securities exchange from effecting transactions on that exchange for his own account, the account of an associated person, or an account over which he or his associated person exercises investment discretion (collectively, "covered accounts") unless an exception applies. Rule 11a2-2(T) provides exchange members with an exemption, in addition to the exceptions delineated in the statute. Known as the "effect versus execute" rule, Rule 11a2-2(T) permits an exchange member, subject to certain conditions, to effect transactions for covered accounts by arranging for an unaffiliated member to execute the transactions directly on the exchange floor. To comply with the rule's conditions, a member (1) must transmit the order from off the exchange floor, (2) may not participate in the execution of the transaction once it has been transmitted to the member performing the execution,5 (3) may not be affiliated with the executing member, and (4) with respect to an account over which the member has investment discretion, neither the member nor his associated person may retain any compensation in connection with effecting the transaction without express written consent from the person authorized to transact business for the account in accordance with the rule. The requirements of the "effect versus execute" rule are "designed to put members and non-members on the same footing, to the extent practicable, in light of the purposes of Section 11(a)."6 For the reasons set forth below, CBOE believes the structural and operational characteristics of CBOEdirect places all users, both members and non-members, on the "same footing", as intended by Rule 11a2-2(T).
CBOEdirect's Matching Algorithm/Priority Rules The Exchange notes that the priority rule for CBOEdirect (Rule 43.1) cannot be utilized by Exchange members in a manner that is inconsistent with the objectives of Section 11(a). While Rule 43.1 allows the appropriate SBT Trading Committee to determine which priority provisions of Rule 43.1 will govern options trading on CBOEdirect, the Exchange does not intend to modify the application of the priority rules on an intra-day basis. First, CBOE trading committees commonly consist of twenty or more members who conduct business on different parts of the trading floor (sometimes off of the trading floor) and it would be extremely impracticable to convene a meeting during business hours for any purpose, let alone to effect a change to CBOE's priority algorithms. Also, the Exchange will issue circulars in connection with any change to how the priority rules are applied, and such circulars will be issued in advance of the actual implementation of the change thereby providing members and non-members with notice. The Exchange would also like to emphasize that existing CBOE rules safeguard against members abusing Rule 43.1 to circumvent Section 11(a). For example, Rule 4.18 is designed to prevent the misuse of material non-public information. Thus, to the extent a member firm sought to manipulate CBOE's trading algorithm by directing an affiliated person on CBOE's SBT Trading Committee to request a committee meeting to change the algorithm in order to benefit the firm, its client, or a related entity in the execution of a pending order, the Exchange believes the disclosure of the pending order(s) and/or imminent transaction(s) to the affiliated person would be deemed a violation of Rule 4.18. Additionally, the Exchange believes any effort generally to manipulate the trading algorithm to facilitate a favorable execution for a pending order would be deemed a violation of CBOE Rule 4.1 (Just and Equitable Principles of Trade). Lastly, while these rules should prevent any abuses of Rule 43.1, CBOE will provide for surveillance of the manner in which the matching algorithm is modified (to the extent it is ever modified) to ensure that members do not abuse Rule 43.1 in a manner that is inconsistent with Section 11(a). III. Conclusion The Exchange believes its CBOEdirect system, coupled with the rules described above and appropriate surveillance, satisfies the four requirements of the "effect versus execute" rule as well as the general policy objectives of Section 11(a) of the Act. The proposed rule change to adopt a screen-based options trading platform is beneficial because it will facilitate transactions in securities and will remove impediments to and perfect the mechanism of a free and open market. The proposed rule change will place all CBOEdirect users, members and non-members, on the "same footing," as intended by Rule 11a2-2(T). In light of the aforementioned, CBOE believes, under its proposal, no member will be able to engage in proprietary trading in a manner inconsistent with Section 11(a) of the Act.
Sincerely, cc: Joanne Moffic-Silver
Footnotes
http://www.sec.gov/divisions/marketreg/mr-noaction/cboe033103.htm
|