[Federal Register Volume 62, Number 98 (Wednesday, May 21, 1997)]
[Notices]
[Pages 27814-27816]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-13277]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38634; File No. SR-CBOE-97-02]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Granting Approval to Proposed Rule Change Relating to the 
Use of Proprietary Brokerage Order Routing Terminals on the Floor of 
the Exchange

May 14, 1997.

I. Introduction

    On January 21, 1997, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ And Rule 19b-4 
thereunder,\2\ a proposed rule change to extend from the Standard & 
Poor's 500 index (``SPX options'') to the trading crowd in options on 
the Standard & Poor's 100 index (``OEX options'') its existing policy 
adopted pursuant to Exchange Rule 6.23 whereby members are permitted to 
establish, maintain and use proprietary hand-held, brokerage order 
routing terminals and related systems (``Terminals'') in the trading 
crowd.
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    \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 the Federal 
Register on February 20, 1997.\3\ No comments were received on the 
proposal. This order approves the proposal.
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    \3\ Securities Exchange Act Release No. 38268 (Feb. 11, 1997), 
62 FR 7812 (Feb. 20, 1997).
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II. Background

    On December 16, 1996, the Commission approved a proposal by the 
CBOE to adopt a policy pursuant to its Rule 6.23 \4\ allowing the use 
of proprietary brokerage order routing terminals and their related 
systems in the SPX trading crowd.\5\ Written Exchange approval is 
required prior to a member establishing, maintaining, or using a 
Terminal. The Exchange does not approve a Terminal unless and until the 
member who proposes to establish one on the floor of the Exchange has 
filed with the Exchange an ``Application & Agreement for Brokerage/
Order Routing Terminals in Trading Crowds'' (``Application 
Agreement''). In addition, the original filing limited the use of 
Terminals to the SPX options trading crowd for the routing of orders in 
SPX options.
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    \4\ CBOE Rule 6.23 provides that no member shall establish or 
maintain any telephone or other wire communications between his or 
its office and the Exchange without prior approval by the Exchange. 
The Exchange may direct discontinuance of any communication facility 
terminating on the floor of the Exchange.
    \5\ See Securities Exchange Act Release No. 38054 (December 16, 
1996), 61 FR 67365 (``SPX-Terminal Approval Order'').
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    The Application Agreement approved by the Commission for use in the 
SPX trading crowd addressed several important issues including 
restrictions on the use of Terminals and the information thereon. The 
Application Agreement prohibits the operators of Terminals from trading 
with orders transmitted to the floor through Terminals except when 
certain conditions are met and prohibits the use of Terminals to make 
markets.
    The Application Agreement requires an applicant to agree that it 
will not trade with orders transmitted through the Terminal, except 
when (1) No one else wants to trade with it (i.e., the member is the 
contra-party of last recourse) or (2) an applicant is able to 
participate in the order on the same basis that other market makers who 
do not have priority participate. Under the second exception, the 
member may trade with an order as long as (a) The member in the trading 
crowd who is the first to respond to such order (other than the 
applicant) has priority in taking the other side of such order, and (b) 
the aggregate portion of such order taken by the applicant is not 
greater than the portion of the order taken by every other Exchange 
market maker in the crowd who wishes to participate in the order in the 
same aggregate quantity.
    The Application Agreement also prohibits an applicant from using 
for their own benefit any information contained in any order in the 
Terminal system until that information has been disclosed to the 
trading crowd.
    The Application Agreement also requires an applicant to agree that 
its Terminal will be used to receive brokerage orders only, and that it 
will not be used to perform a market making function. In adopting this 
restriction, the Exchange was concerned that Terminals may enable 
person not subject to Exchange control to perform market making 
functions from off the floor of the Exchange without being burdened by 
the cost of maintaining an Exchange membership, or the obligations 
imposed on Exchange market makers.\6\
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    \6\ In addition, the Application Agreement has provisions 
relating to the installation and use of Terminals. These provisions 
relate to surveillance, audit trails, compliance, physical, 
electrical and communications requirements and termination of 
approval for Terminals.
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III. Description of the Proposal

    The CBOE proposes to amend the policy adopted pursuant to its Rule 
6.23 that would extend the use of proprietary brokerage order routing 
terminals and their related systems from the SPX options trading crowd 
to the OEX options trading crowd, Exchange members would still be 
required to obtain written approval from the Exchange to establish, 
maintain, or use a terminal in either of the two trading crowds. The 
Exchange would not approve the use of a Terminal unless and until the 
member who proposes to utilize it on the floor has filed with the 
Exchange an Application Agreement, and Terminals may only be used in 
the crowds trading SPX or OEX options to route orders in SPX or OEX 
options.\7\ To accommodate this change, the application Agreement will 
also be amended to specifically allow for the use of Terminals in the 
OEX options trading crowd. The terms and restrictions of the 
Application Agreement remain unchanged and will be identical to those 
approved in the SPX-Terminal Approval Order as described above.
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    \7\ The Exchange requires applicants wishing to use Terminals in 
both the OEX and SPX options trading crowds to execute separate 
Application Agreements with the Exchange for each trading crowd. 
Telephone conversation between Tim Thompson, CBOE and David 
Sierazki, SEC, on May 13, 1997.
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IV. Discussion

    Section 6(b)(5) of the Act \8\ requires that the rules of an 
exchange be designated to prevent fraudulent and manipulative acts and 
practices, promote just and equitable principles of trade, remove 
impediments to and perfect the mechanism of a free and open market, and 
in general to protect investors and the public interest. Section 
6(b)(7) of the Act \9\ requires that the rules of an Exchange be in 
accordance with Section 6(d) of the Act,\10\ and in general provide a 
fair

[[Page 27815]]

procedure for the disciplining of members and the prohibition or 
limitation by an exchange of a person's access to services offered by 
the exchange. Section 6(b)(7) of the Act \11\ requires that the rules 
of an exchange not impose any burden on competition not necessary or 
appropriate in furtherance of the purposes of the Act. Section 
11A(a)(1)(C)(ii) of the Act \12\ states that it is in the public 
interest and appropriate for the protection of investors and the 
maintenance of fair and orderly markets to assure fair competition 
among brokers and dealers. For the reasons set forth 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, the 
requirements of Sections 6(b)(5), 6(b)(7), 6(b)(8), and 11A(a)(1)(C) of 
the Act.\13\
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    \8\ 15 U.S.C. 78f(b)(5).
    \9\ 15 U.S.C. 78f(b)(7).
    \10\ 15 U.S.C. 78f(d). Section 6(d) of the Act, among other 
things, requires that an exchange, in any proceeding to determine 
whether a member should be disciplined, bring specific charges, 
notify such member of and provide him with an opportunity to defend 
himself against such charges, and keep a record.
    \11\ 15 U.S.C. 78f(b)(8).
    \12\ 15 U.S.C. 78k-1(a)(1)(C)(ii).
    \13\ In approving this rule, the Commission has considered the 
proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
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    The Commission believes that the CBOE's proposal should foster 
coordination with persons engaged in facilitating transactions in 
securities, remove impediments to and perfect the mechanism of a free 
and open market, and protect investors and the public interest by 
expediting and making more efficient the process by which members can 
receive OEX orders to be executed on the floor of the Exchange. The 
proposal also will promote fair competition among brokers and dealers 
and facilitate transactions in options on the Exchange. Finally, the 
Commission believes that the requirement that an applicant file the 
Application Agreement with the Exchange and comply with it is 
reasonable and ensures adequate surveillance and compliance with CBOE 
Rules.
    The Commission notes that the substantive provisions set forth in 
the Application Agreement submitted with this proposal, are identical 
to those approved in the SPX-FLoor Broker Terminal Approval Order.\14\ 
The Commission believes that the Exchange's policy regarding the use of 
Terminals and the Application Agreement provide a reasonable framework 
in which to introduce the use of Terminals to the OEX options trading 
crowd. The Commission also believes that the requirement that an 
applicant file the Application Agreement with the Exchange and comply 
with it is reasonable and ensures adequate surveillance and compliance 
with CBOE rules. The Commission notes, however, that the Exchange is 
required to submit a proposed rule change with the Commission pursuant 
to Section 19(b) of the Act, if it wants to extend the use of Terminals 
beyond the SPX and OEX options trading crowds.
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    \14\ See SPX-Terminal Approval Order, supra note 5. The 
discussion and findings in the SPX-Terminal Approval Order are 
incorporated herein.
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    The Commission also believes that the termination procedures in the 
Application Agreement are consistent with the Act, including Sections 
6(b)(7) and 6(d) of the Act,\15\ and are designed to provide affected 
members with adequate due process. The Commission notes that a member 
so affected could seek relief pursuant to the Hearings and Review 
provisions of Chapter XIX of the Exchange's Rules. These provisions 
provide specific procedures to seek Exchange hearing and review for 
persons aggrieved by action of the Exchange in terminating or enforcing 
the terms of the Application Agreement.\16\
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    \15\ See supra notes 9-10 and accompanying text.
    \16\ See CBOE Rules 19.4, Hearing and 19.5 Review.
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    As noted above, the Application Agreement prohibits a member or an 
associated person from trading with orders transmitted through a 
Terminal, unless no other member were to trade with the order, or the 
applicant were to trade on the same basis as other members who do not 
have priority. In addition, the Application Agreement prevents a member 
from using for its benefit information transmitted through a Terminal, 
before that information is disclosed to the trading crowd. The 
Commission believes that these restrictions are an appropriate measure 
to ensure that an applicant or one if its associated persons does not: 
(1) Interact with an order prior to information relating to such order 
becoming known to the trading crowd, which would be inconsistent with 
the open auction market principles governing the Exchange's trading 
system; or (2) effect transactions or change quotes in the Exchange's 
market or in the markets for the underlying interest or related 
interests before the information were available in the market. The 
Commission also believes that the two exceptions to the general 
restriction on trading with orders in the Terminal system are 
consistent with these concerns, and ensure that members using Terminals 
trade on the same terms and conditions as other market participants and 
do not receive any trading advantages to interact with orders 
transmitted through the Terminals.
    For the same reasons set forth in the Commission's findings in the 
SPX-Terminal Approval Order,\17\ the Commission believes that the 
market making prohibition on the use of Terminals in OEX options 
adequately balances the potential benefits to be derived from Terminals 
with the important regulatory issues that are raised in connection with 
the potential use of Terminals for off-floor market making in CBOE-
listed options. Because off-floor market makers potentially would enjoy 
the benefits of other ``public customers,'' while not having the 
concomitant obligations and responsibilities of CBOE market makers, the 
Commission does not believe it is unreasonable for the CBOE to 
determine that the introduction of unregulated market making through 
Terminals in OEX options could undermine its market maker system. 
Indeed, the CBOE's proposal will allow the expansion of an innovative 
technology into another extremely active trading crowd, while doing so 
in a manner designed to ensure the continued viability of its market 
maker system.\18\
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    \17\ See SPX-Terminal Approval Order, supra note 5.
    \18\ See infra note 22.
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    The Commission also believes that the CBOE restriction on market 
making through the use of Terminals in OEX options has been effected in 
a clear and reasonable manner that is not ambiguous nor overbroad, and 
that takes into account regulatory and market impact concerns, 
including those relating to quote competition and price discovery.\19\ 
Notably, the CBOE's proposal does not bar all two-sided limit orders. 
Instead it only restricts the acceptance of orders placed in the 
performance of a market making function. The distinction between market 
making and brokerage activity is well established among market 
participants. Moreover, the language of the market making restriction 
expressly restricts only an aggregate pattern of orders, which 
indicates whether an investor is performing a market making function, 
not the occasional entry of two-sided limit orders. Thus, the 
restriction on Terminal use for routing limit orders is the minimum 
necessary

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for the CBOE to bar Terminal use for off-floor market making.
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    \19\ Cf., Securities Exchange Act Release No. 25842 (June 23, 
1988), 53 FR 24539 (approving certain restrictions on the use of 
telephones on the floor of the New York Stock Exchange), aff'd per 
curiam, 866 F.2d 47 (2d Cir. 1989).
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    The Commission also emphasizes that it expects the CBOE to 
interpret the term ``market making'' in accordance with its traditional 
definition as defined under the Act, i.e., holding one's self out as 
being willing to buy and sell a particular security on a regular or 
continuous basis.\20\ The definition of market making should not 
capture parties who enter orders on one side of the market; nor would 
it capture parties who enter two-sided limit orders on occasion. A 
party would not be deemed to be engaging in market making unless it 
regularly or continuously holds itself out as willing to buy and sell 
the security.\21\
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    \20\ See, e.g., 15 U.S.C. 78c(a)(38); Securities Exchange Act 
Release No. 36719A (Sept. 6, 1996), 61 FR 48290, 48316 (Sept. 12, 
1996).
    \21\ Securities Exchange Act Release No. 36719A (Sept. 6, 1996), 
61 FR 48290, 48316 (Sept. 12, 1996). The Commission notes that a 
broker using a Terminal may receive numerous orders from multiple 
customers, some of which are on the bid side and others on the offer 
side of an SPX series. This is consistent with a brokerage function, 
not a market making function. If, however, a particular customer of 
a broker regularly or continuously places two-sided limit orders, 
then the CBOE might, under certain circumstances, reach a different 
conclusion as to the nature of the function being performed by the 
broker and the customer.
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    By approving this proposed rule change, the Commission is not 
stating that it is impermissible for an options exchange to permit 
users of Terminals or other similar devices to make two-sided markets. 
Indeed, the CBOE may determine to reconsider its decision not to permit 
users of Terminals to engage in market making at some future time. 
Nevertheless, while it is not illegal to permit off-floor market 
making, the Commission believes that it is within the CBOE's 
prerogative as an exchange to prohibit it. In approving the market 
making restriction in the SPX-Terminal Approval Order the Commission 
noted that the CBOE was particularly concerned that off-floor market 
making effectively would establish a market making structure devoid of 
affirmative market making obligations that could result in less deep 
and liquid markets during periods of market stress, when off-floor 
Terminal market makers would not be required to continue making 
markets. The Commission believes that these concerns are reasonable. 
The Commission's approval of the proposed rule change reflects the 
Commission's belief that the CBOE may act incrementally in approving 
the use of Terminals for transactions in SPX, and now OEX options, 
given that the CBOE is still learning about the possible impact of 
Terminals upon its market.\22\
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    \22\ The Commission recognizes that markets for certain equity 
options can be less deep and liquid than the OEX market. However, 
the rule change approved today concerns the use of Terminals only in 
the OEX crowd. The Commission will consider the merits of permitting 
the use of Terminals to represent two-sided limit orders that 
effectively create regular two-sided markets in less liquid options 
crowds when it is presented with that issue.
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    In summary, while the CBOE's restrictions on the use of Terminals 
raise regulatory issues, the Commission believes that, within the 
context of the OEX options trading crowd, the market making restriction 
is an acceptable exercise of the Exchange's rulemaking authority. While 
the Commission recognizes that there may be different ways to address 
the regulatory issues presented by off-floor market making through the 
use of Terminals, the Act does not dictate that any particular approach 
be taken. The Commission believes that the manner in which the Exchange 
has chosen to address the regulatory issues presented by off-floor 
market making reflects the considered judgment of the CBOE regarding 
the attributes of Exchange membership and the organization of its 
trading floor, and is a fair exercise of its powers as a national 
securities exchange.
    For the reasons stated above, and the findings set forth in the 
SPX-Terminal Approval Order,\23\ the Commission believes that the 
Exchange's proposal to extend the policy regarding the use of Terminals 
to the OEX options trading crowd is consistent with the Act.
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    \23\ See SPX-Terminal Approval Order, supra note 5.
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\24\ that the proposed rule change (SR-CBOE-97-02) is approved.

    \24\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\25\
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    \25\ 17 C.F.R. 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-13277 Filed 5-20-97; 8:45 am]
BILLING CODE 8010-01-M