[Federal Register Volume 60, Number 207 (Thursday, October 26, 1995)]
[Notices]
[Pages 54893-54895]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-26574]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36401; File No. SR-CHX-95-10]


Self-Regulatory Organizations; Chicago Stock Exchange, 
Incorporated; Order Granting Approval to Proposed Rule Change Relating 
to Permanent Approval of the Pilot Program for Stopped Orders in 
Minimum Variation Markets

October 20, 1995.

I. Introduction

    On March 23, 1995, the Chicago Stock Exchange, Incorporated 
(``CHX'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to approve permanently its 
stopping stock program in minimum variation markets.

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in Securities 
Exchange Act Release No. 35910 (June 28, 1995), 60 FR 34563 (July 3, 
1995). No comments were received on the proposal.\3\ For the reasons 
discussed below, the Commission has decided to approve the CHX's 
proposal.

    \3\ The Commission has received three comment letters opposing 
the New York Stock Exchange's proposal for permanent approval of the 
NYSE's procedures for stopping stock in minimum variation markets, 
two of which were from the same commenter (Junius Peake). See letter 
from Junius W. Peake, Monfort Professor of Finance, University of 
Northern Colorado, to Secretary, SEC, dated March 1, 1995; letter 
from Junius W. Peake, Monfort Professor of Finance, University of 
Northern Colorado, to Secretary, SEC, dated July 21, 1995; letter 
from Morris Mendelson, Professor Emeritus of Finance, the Wharton 
School of the University of Pennsylvania to Jonathan Katz, 
Secretary, SEC, dated August 2, 1995. Although the NYSE's procedures 
differ from those of CHX, certain issues raised in the comment 
letters apply equally to the CHX proposal. The comment letters and 
the NYSE's response thereto are summarized in the Commission's 
order. In addition, the Commission's discussion in the NYSE order is 
applicable to this order. See Securities Exchange Act Release No. 
36399 (Oct. 20, 1995) (permanently approving NYSE's pilot program 
for stopping stock in minimum variation markets); see also letter 
from James Buck, Senior Vice President and Secretary, NYSE, to 
Jonathan Katz, Secretary, SEC, dated July 17, 1995.
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II. Description of Proposal

    Prior to 1992, CHX Rule 37, Article XX, required specialists, upon 
request, to grant a stop for Dual Trading System issues \4\ if an out 
of range \5\ execution would result, regardless of the spread. Under 
this stopping stock policy, the specialists were required to execute 
stopped stock based on the next primary market sale. The Exchange's 
purpose for stopping stock generally was to prevent orders from being 
executed outside the primary market range for the day (i.e., from 
establishing a new high or new low).\6\

    \4\ The Dual Trading System of the Exchange allows the execution 
of both round-lot and odd-lot orders in certain issues assigned to 
specialists on the Exchange and listed on either the New York Stock 
Exchange or the American Stock Exchange.
    \5\ ``Out of range'' means either higher or lower than the range 
in which the security traded on the primary market during a 
particular trading day.
    \6\ For example, assume the market in ABC stock is 20-20\1/8\; 
50 x 50 and that a buy order at \1/8\ would be higher than the range 
in which the security traded on the primary market during the 
trading day. A customer places an order with the Exchange specialist 
to buy 100 shares of ABC at the market and a stop is effected. The 
order is stopped at 20\1/8\ and the Exchange specialist includes the 
order in his quote by bidding the 100 shares at 20. If the next sale 
on the primary market is for 100 shares at 20, the Exchange's 
existing general policy regarding stopping stock would require the 
specialist to execute the stopped market order at 10.
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    This general stopping stock policy, however, produced an anomalous 
result in minimum variation markets.\7\ In a minimum variation market 
because the stopped market order did not have time or price priority, 
its execution triggered the requirement for the Exchange specialist to 
execute all pre-existing orders based on the Exchange's rules of 
priority and precedence.\8\ Therefore, the specialists were required to 
execute the preexisting orders even if such orders were not otherwise 
entitled to be filled.\9\

    \7\ CHX Rule 22, Article XX sets forth the minimum variations 
for stocks traded on the Exchange. The rule provides that bids or 
offers in stocks above $1.00 per share shall not be made at a less 
variation than \1/8\ of $1.00 per share; in stocks below $1.00 but 
above $.50 per share, at a less fraction than /1/16 of $1.00 per 
share; in stocks below $.50 per share, at a less variation than \1/
32\ of $1.00 per share; provided that the Committee on Floor 
Procedure may fix variations of less than the above for bids and 
offers in specific securities or classes of securities.
    \8\ See CHX Rule 16, Article XX (Precedence of Bids at Same 
Price).
    \9\ Under CHX Rule 37(a)(3), Article XX, the Exchange 
specialists are required to fill orders at the limit price only if: 
(1) The bid or offering at the limit price has been exhausted in the 
primary market; (2) there has been a price penetration of the limit 
in the primary market; or (3) the issue is trading at the limit 
price on the primary market unless it can be demonstrated that such 
order would not have been executed if it had been transmitted to the 
primary market or the broker and specialist agree to a specific 
volume related or other criteria for requiring a fill.
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    In January 1992, the Commission approved on a pilot basis the 
Exchange's revised procedures for stopping orders in minimum variation 
markets that would prevent the anomalous consequence of requiring the 
execution of pre-existing orders that are not yet due a fill.\10\ The 
Commission subsequently extended the Exchange's pilot program without 
modification.\11\ The most recent extension of the pilot program is 
scheduled to expire on October 21, 1995.

    \10\ See Securities Exchange Act Release No. 30189 (Jan. 14, 
1992), 57 FR 2621 (Jan. 22, 1992) (File No. SR-MSE-91-10) (order 
approving MSE pilot program for stopped orders in minimum variation 
markets) (``1992 Approval Order'').
    \11\ See Securities Exchange Act Release Nos. 31975, (Mar. 10, 
1993), 58 FR 14230 (Mar. 16, 1993) (File No. SR-MSE-93-04) (``March 
1993 Approval Order''); 32457 (June 11, 1993), 58 FR 33681 (June 18, 
1993) (File No. SR-MSE-93-14) (``June 1993 Approval Order''); 33790 
(Mar. 21, 1994), 59 FR 14434 (Mar. 28, 1994) (File No. SR-MSE-93-30) 
(``1994 Approval Order''); 35431 (Mar. 1, 1995), 60 FR 12796 (Mar. 
8, 1995) (File No. SR-CHX-95-04) (``March 1995 Approval Order''); 
36011 (July 21, 1995), 60 FR 38874 (July 28, 1995) (``July 1995 
Approval Order'').
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    The pilot program adds interpretation and policy .03 to Rule 37, 
Article XX, to permit a specialist to delay execution of stopped stock 
in minimum variation markets until a volume equal to the pre-

[[Page 54894]]
existing volume ahead of the stopped order prints in the primary 
market.\12\ Specifically, the specialist would be required to execute 
stopped market orders in minimum variation markets after (1) a 
transaction takes place on the primary market at the bid price 
(offering price) or lower (higher) for a stopped sell order (a stopped 
buy order) or (2) the displayed CHX share volume at the offering (or 
bid) has been exhausted. In no event would a stopped order be executed 
at a price inferior to the stopped price.\13\ All stopped orders must 
be executed by the end of the trading day.

    \12\ A stopped buy (sell) order would be placed behind the 
existing limit orders at the bid (offer) for priority purposes.
    \13\ Exchange Rule 28 (Article XX) states:
    An agreement by a member or member organization to ``stop'' 
securities at a specified price shall constitute a guarantee of the 
purchase or sale by him or it of the securities at the price or its 
equivalent in the amount specified.
    If an order is executed at a less favorable price than that 
agreed upon, the member or member organization which agreed to stop 
the securities shall be liable for an adjustment of the difference 
between the two prices.
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    In the orders approving the pilot procedures, the Commission 
requested that the Exchange study the effects of stopping stock in 
minimum variation markets and collect certain data to allow the 
Commission to evaluate fairly and comprehensively the pilot 
program.\14\ In the Commission's 1994 Approval Order extending the 
pilot program until March 21, 1995, the Commission requested that the 
Exchange submit an additional monitoring report on the stopping stock 
pilot.\15\ CHX subsequently submitted the monitoring report and the 
Commission then approved an extension of the pilot until October 21, 
1995, so that the Commission would have additional time to evaluate the 
information provided by the Exchange and the CHX's use of its pilot 
procedures.

    \14\ See supra notes 10-11.
    \15\ See 1994 approval Order, supra note 11.
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III. Discussion

    After careful consideration, the Commission has determined to 
approve permanently the proposed rule change. For the reasons discussed 
below, the Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, with Section 6(b)(5) \16\ and Section 11(b) \17\ of the 
Act.

    \16\ 15 U.S.C. 78f.
    \17\ 15 U.S.C. 78k.
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    Historically, the Commission has had mixed reactions about the 
practice of stopping stock. The 1963 Report of the Special Study of the 
Securities Markets found that unexecuted customer limit orders on the 
specialist's book might be bypassed by the stopped orders.\18\ The 
Commission, nevertheless, has allowed the practice of stopping stock in 
markets where the spread is at least twice the minimum variation 
because the possible harm to orders on the book is offset by the 
reduced spread that results and the possibility of price improvement.

    \18\ See SEC, Report of the Special Study of Securities Markets 
of the Securities and Exchange Commission, H.R. Doc. No. 95, 88th 
Congress., lst Sess., Pt. 2 (1963).
    When stock is stopped, limit book orders on the opposite side of 
the market do not receive an immediate execution. Consequently, if 
the stopped order then receives an improved price, limit orders at 
the top price are bypassed and, if the market turns away from that 
limit, may never be executed.
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    Although the procedures for stopping stock in minimum variation 
markets do not reduce the spread between the quotes, the Commission has 
allowed, on a pilot basis, the practice on the Exchange in limited 
circumstances. The Exchange's procedures for stopping stock in minimum 
variation markets were intended to assist specialists in providing an 
opportunity for primary market price protection to the customer whose 
order is stopped, without requiring that specialists execute all pre-
existing bids or offers when such executions otherwise would not be 
required under Exchange rules. The CHX pilot procedures allow 
specialists to delay execution of the stopped stock until a volume 
equal to the pre-existing volume ahead of the stopped order prints in 
the primary market. Specifically, the specialist would be required to 
execute stopped market orders in minimum variation markets either (1) 
at the stopped price after a transaction takes place on the primary 
market at the bid price or lower (or the offering price of higher) on 
the primary market or (2) at an improved price after the displayed CHX 
share volume has been exhausted.
    To examine whether specialists have been using the pilot program as 
intended, the Commission had asked the Exchange to provide data on the 
stopping stock program in minimum variation markets. The Exchange has 
submitted to the Commission several monitoring reports regarding the 
stopping stock pilot program. The Commission believes that the 
monitoring reports, especially, the latest monitoring report, provide 
useful information regarding the effectiveness of the program during 
the pilot period.
    Specifically, the Exchange reports that only approximately 2%-6% of 
the stopped orders received an out-of-range execution despite having 
been stopped and, thus, did not benefit from the CHX proposal.\19\ With 
respect to the limit orders on the opposite side of the market from all 
market orders stopped in minimum variation markets, the Exchange 
reports that approximately 52% were executed before the close.\20\ 
Moreover, almost all of the stopped orders were orders for 2000 shares 
or less.\21\ Finally, CHX reports that there has been no compliance 
problems with respect to the pilot program.

    \19\ The Commission notes that this pilot program is intended to 
prevent orders from being executed outside the primary market range 
for the day (i.e., from establishing a new high or new low). 
Consistent with that policy, the CHX requires the specialist to 
execute stopped stock based on the next primary market sale. 
Specifically, if the next sale is at a better price, the stopped 
stock may, depending on the depth of the specialist's limit order 
book at that price, receive price improvement. However, if the next 
primary market sale is at the stop price (or worse), the order would 
receive the stop price.
    Conversely, an order may not benefit from the CHX proposal if, 
despite having been stopped, it ultimately receives an out-of-range 
execution. In a minimum variation market, this can occur if, by the 
close, (1) the primary market has not traded at the stop price and 
(2) all  pre-existing limit orders on the CHX specialist's book at 
the better price have not been executed.
    \20\ The Exchange reports that approximately 48% of the limit 
orders on the opposite side of the market from all market orders 
stopped in minimum variation markets were not executed by the end of 
the day. This percentage, however, overstates the number of limit 
orders that were not executed as a result of the stopped orders 
because it includes all limit orders on the opposite side of the 
market at the time of the stop rather than being limited to the size 
of the stopped order. Therefore, some of these limit orders that 
were not executed by the end of the trading day would not have been 
executed regardless of the stopped orders.
    \21\ This data indicates the pilot program is benefiting small 
public customer orders.
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    The Commission believes that the data on the stopping stock in 
minimum variation markets show that the pilot program has continued to 
help reduce the potential that an order may receive an out-of-range 
execution. Moreover, the procedures enable specialists to offer the 
opportunity for price improvement to small size orders. The Commission 
believes that the reduction in out-of-range executions, coupled with 
price improvement opportunities, sufficiently offset the possible harm 
to the opposite side limit orders on the book. The Commission 
recognizes the unintended consequence that can arise from the interplay 
between a regional exchange's price protection rules and its procedures 
for stopping stock. In the Commission's opinion, the CHX data suggests 
that stopped stock generally has been executed in accordance with 
traditional auction market principles.\22\ The Commission, therefore, 
believes that the data on stopping stock in minimum 

[[Page 54895]]
variation markets show that the pilot has operated as intended and 
should be approved permanently.

    \22\ See infra note 27.
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    For all of the above reasons, the Commission believes that the CHX 
proposal is consistent with Section 6(b)(5) of the Act. Moreover, the 
Commission also believes that the proposal is consistent with the Rule 
11b-1(a)(2)(ii) of the Act.\23\ Rule 11b-1(a)(2)(ii) requires that a 
specialist engage in a course of dealings for his own account that 
assist in the maintenance, so far as practicable, of a fair and orderly 
market. As previously noted in the 1992 Approval Order, the Commission 
believes that the proposal is consistent with the objectives of this 
Rule because the implementation of the proposal should help the 
specialist to provide an opportunity for price improvement to the 
customer whose stop order is granted, without placing a burden on 
specialists by requiring that specialists execute other pre-existing 
bids or offers when such executions would not be otherwise required 
under Exchange rules.

    \23\ 17 CFR 240.11b-1(a)(2)(ii).
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    The Commission also believes that the proposal is consistent with 
the prohibition in Section 11(b) against providing discretion to a 
specialist in the handling of an order.\24\ Section 11(b) was designed, 
in part, to address potential conflicts of interest that may arise as a 
result of the specialist's dual role as agent and principal in 
executing stock transactions. In particular, Congress intended to 
prevent specialists from unduly influencing market trends through their 
knowledge of market interest from the specialist's book and their 
handling of discretionary agency orders.\25\ The Commission has stated 
that, pursuant to Section 11(b), all orders other than market or limit 
orders are discretionary and therefore cannot be accepted by 
specialists.\26\

    \24\ Section 11(b) permits a specialist to accept only market or 
limit orders.
    \25\ See H. Rep. No. 1383, 73d Cong. 2d Sess. 22, S. Rep. 792, 
73d Cong. 2d Sess. 18 (1934).
    \26\ See Special Study, supra note 18.
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    As previously noted in the 1992 Approval Order, the Commission 
believes that it is appropriate to treat stopped orders, even those 
under the pilot procedures, as equivalent to limit orders. A limit 
order is an order to buy or sell a stated amount of security at a 
specified price, or better if obtainable. The Commission believes that 
stopped orders are equivalent to limit orders, in this instance, 
because the orders would be automatically elected after a transaction 
takes place on the primary market at the stopped price. The Commission, 
therefore, believes that the requirements imposed on the specialist for 
granting stops in minimum variation markets provide sufficiently 
stringent guidelines to ensure that the specialist will implement the 
proposed rule change in a manner consistent with his market making 
duties and Section 11(b).\27\

    \27\ Moreover, stopped orders as ``limit orders'' would not 
bypass pre-existing limit orders on the same side of the market. 
Under CHX's procedures, specialists may not execute a stopped order 
before the limit order interest on the Exchange (at the same price 
as the stopped order) is exhausted.
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    In permanently approving the Exchange's proposal, the Commission 
expects the Exchange to continue monitoring the practice of stopping 
stock in minimum variation markets and to take appropriate action in 
the event CHX identifies any instances of specialist non-compliance 
with the program's procedures.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\28\ that the proposed rule change (SR-CHX-95-10) is approved.

    \28\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\29\

    \29\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-26574 Filed 10-25-95; 8:45 am]
BILLING CODE 8010-01-M