[Federal Register Volume 63, Number 176 (Friday, September 11, 1998)]
[Notices]
[Pages 48775-48777]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-24373]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40397; File No. SR-PCX-98-19]


Self-Regulatory Organizations; Pacific Exchange, Inc.; Order 
Approving Proposed Rule Change Relating to Capital Requirements and 
Guaranteed Participation of Lead Market Makers

September 3, 1998.

I. Introduction

    On April 16, 1998, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange''), pursuant to Section 19(b)(1) of the Securities Exchange 
Act of 1934 (``Act'') \1\ and Rule 19b-4 \2\ thereunder, filed with the 
Securities and Exchange Commission (``Commission''), a proposed rule 
change to amend PCX Rule 6.82 concerning Lead Market Makers. The 
Exchange filed Amendment No. 1 to the proposed rule change with the 
Commission on June 4, 1998.\3\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 1 clarified the text of the proposed rule 
change. See letter from Michael D. Pierson, Senior Attorney, to 
Heidi Pilpel, Special Counsel, Division of Market Regulation, SEC 
(June 4, 1998).
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    The proposed rule change was published for comment in the Federal 
Register on June 15, 1998.\4\ No comments were received on the 
proposal. This order approves the proposal.
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    \4\ See Securities Exchange Act Release No. 40070 (June 4, 
1998), 63 FR 32691.
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II. Description of the Proposal

    PCX Rule 6.82 sets forth the basic rules and procedures applicable 
to Lead Market Makers (``LMMs'') and the PCX's LMM Program.\5\ PCX 
seeks to amend PCX Rule 6.82 by modifying the capital requirements for 
LMMs on the exchange and clarifying the procedures applicable to LMM's 
guaranteed participation. The text of the proposed rule change is 
available at the offices of the Commission and the Exchange.
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    \5\ The LMM Program is governed by PCX Rules 6.82 and 6.83, 
which rules apply strictly to options trading. The PCX's LMM Program 
was granted permanent approval on September 22, 1997. See Securities 
Exchange Act Release No. 39111, 62 FR 51710 (October 2, 1997).
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A. LLM Capital

    PCX Rule 6.82(c)(11) currently provides that each LMM on the 
Exchange must maintain a cash or liquid asset position in the amount of 
$100,000 or in an amount sufficient to assume a position of twenty 
trading units of the security underlying the option the LMM has been 
allocated, whichever amount is greater. The term ``trading unit'' 
means, in the case of stocks, 100 shares.\6\ Therefore, LMMs are 
currently required to maintain a cash or liquid asset position in the 
amount of $100,000 or in an amount sufficient to assume a position of 
2000 shares of stock in each option issue allocated to the LMM.
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    \6\ See PCX Rule 5.3(a).
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    The proposed rule change would eliminate the current LMM capital 
requirement and replace it with another one providing that each LMM 
must maintain a cash or liquid asset position of at least $350,000, 
plus $25,000 for each issue over eight issues that have been allocated 
to the LMM.\7\ Under the proposal, PCX Rule 6.82(c)(11) will continue 
to provide that in the event that two or more LMMs are associated with 
each other and deal for the same LMM account, the LMM capital 
requirement will apply to such LMMs collectively, rather than to each 
LMM individually.\8\
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    \7\ Like the current rule, the proposed rule would not apply to 
issues traded by an LMM in connection with the Exchange's LMM Book 
Pilot Program, as provided in PCX Rule 6.82)h).
    \8\ Cf. CBOE Rule 8.80, Interp. and Policy .02.
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    The Exchange believes that the current LMM capital requirement, 
which generally fluctuates as the price of the underlying stock 
fluctuates, is unduly complicated and difficult to calculate, both for 
the exchange and for individual LMMs.\9\ Additionally, the Exchange 
believes that all of its LMMs should have cash or liquid asset 
positions of at least $350,000 and that the current minimum amount of 
$100,000 is insufficient.
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    \9\ In that regard, the Exchange noted in its filing that the 
Commission's net capital rule also establishes fixed dollar amounts 
applicable to broker-dealers.
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B. Guaranteed Participation

    PCX Rule 6.82(d)(2) currently provides that LMMS are guaranteed 50% 
participation in transactions

[[Page 48776]]

occurring on their disseminated bids or offers in their allocated 
issues. The rule also provides, however, that an LMM's guaranteed 
participation may be reduced from 50% to 40% in a multiply-traded 
issue, and maybe reduced from 50% to 25% in a non-multiply traded 
issue, if trading in the issue rises to certain levels (and other 
events occur).
    The applicable trading volume requirement, for both multiply-traded 
and non-multiply traded issues, is an average daily trading volume of 
3,000 contracts at the Exchange for three consecutive months. The 
Exchange believes that the current formulation of this provision is 
ambiguous and proposes to clarify it by replacing the words ``for three 
consecutive months'' with the words ``during any three-calendar-month 
period (measured on a `rolling' three-calendar-month basis).'' \10\
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    \10\ Thus, for example, if trading volume in an issue reached an 
average of 2,000 contracts per day in the first month, 4,000 per day 
in the second month, and 4,000 per day in the third month, the 
condition would have been met under the proposed formulation, but 
not under the current formulation.
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    For multiply-traded issues, PCX Rule 6.82(d)(2)(A) also requires 
that the Exchange's share of multi-exchange customer trading volume 
drop below a certain level before an LMM's guaranteed participation 
will be reduced. The proposal clarifies that the applicable customer 
trading volume levels are to be determined on a monthly basis.\11\
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    \11\ The proposal states that in the case of an issue traded by 
two options exchanges, the Exchange's monthly share of the total 
multi-exchange customer trading volume must drop from above 70% to 
below 70%. In the case of an issue traded by three or more options 
exchanges, the Exchange's monthly share of the total multi-exchange 
customer trading volume must drop from above 45% to below 45%.
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    The Exchange is also proposing to adopt Rule 6.82(d)(2)(C) to 
specify the circumstances under which an LMM may return to receiving a 
guaranteed 50% participation after having had it reduced to 40% or to 
25%. Specifically, the proposal states that ``[i]f the Options 
Allocation Committee has reduced an LMM's guaranteed participation in 
an issue pursuant to subsections (A) or (B) * * * and average daily 
trading volume in an issue falls below 3,000 contracts at the Exchange 
during any three-calendar-month period (measured on a `rolling' three-
calendar-month basis), the Options Allocation Committee will evaluate 
the LMM's performance in that issue and, based on that evaluation, may 
raise the LMM's guaranteed participation in that issue from 40% to 50% 
(in a multiply-traded issue) or from 25% to 50% (in a non-multiply 
traded issue).'' The proposal codifies the Exchange's existing policy 
on when an LMM's guaranteed participation may return to 50%.

III. Discussion

    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 with the provisions of Section 6(b) \12\ of 
the Act, in general, and furthers the objectives of Section 
6(b)(5),\13\ in particular, in that it is designed to promote just and 
equitable principles of trade and to protect investors and the public 
interest.
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    \12\ 15 U.S.C. 78f(b).
    \13\ 15 U.S.C. 78f(b)(5).
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A. LMM Capital

    The proposed new capital requirement provides that each LMM must 
maintain a cash or liquid asset position of at least $350,000, plus 
$25,000 for each issue over eight issues that have been allocated to 
the LMM. The proposal increases the minimum capital requirement for a 
substantial majority of the LMMs currently subject to PCX Rule 6.82.
    The Commission finds that the proposed new capital requirement is 
reasonably designed to assure that LMMs are capable of making deep, 
liquid, and competitive markets. For LMMs whose minimum capital 
requirement is increased, the rule change will ensure not only their 
greater financial stability, but also will enhance their ability to 
fill large customer orders and compete vigorously with other exchanges 
in multiply-traded issues. With respect to LMMs whose minimum capital 
requirement is either decreased or unchanged, the Commission finds, 
based on the representations of the Exchange, that there are sufficient 
safeguards (in addition to the proposed minimum capital requirement) to 
assure that such LMMs are adequately capitalized.\14\
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    \14\ See letter from Michael D. Pierson, Senior Attorney, 
Pacific Exchange Inc., to Heidi Pilpel Special Counsel, Division of 
Market Regulation, SEC (August 31, 1998), representing, among other 
things that (i) as a business matter, the proposed capital 
requirement will assure that LMMs are capable of making deep, liquid 
and competitive markets; (ii) PCX Rule 6.36 requires each LMM to 
have a letter of guarantee from a clearing firm providing that the 
clearing firm accepts financial responsibility for all Exchange 
transactions made by the LMM, and (iii) it is the practice by the 
Exchange to evaluate the performance of each LMM every six months to 
identify any LMMs who may be trading too many issues to provide 
deep, liquid, and competitive markets.
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    Moreover, the Commission believes that the proposed minimum capital 
requirement is reasonable related to the capital requirement for LMMs 
that are participating in the Book Pilot Program which the Commission 
recently approved.\15\ Like the capital requirement for participants in 
the Book Pilot Program, the amount of capital an LMM is required to 
maintain in excess of the $350,000 minimum will be determined base don 
the number of issues an LMM trades rather than on the constantly 
fluctuating price of the stock underlying an allocated issue. This 
method of determining the minimum capital required has the advantages 
of simplying the capital calculations and preventing stock splits from 
significant reducing LMM capital requirements.\16\
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    \15\ LMMs participating in the Book Pilot Program (who are 
responsible for the operation of the public limit order book and the 
resolution of trading errors committed in the course of operating 
the Book) are required to have minimum capital of $500,000, plus 
$25,000 for each issue over 5 issues included in the Book Pilot 
Program. The Commission recently approved this capital requirement. 
See Securities Exchange Act Release 39875 (April 15, 1998), 63 FR 
19994 (April 22, 1998).
    \16\ See letter from Michael D. Pierson, Senior Attorney, 
Pacific Exchange Inc., to Heidi Pilpel Special Counsel, Division of 
Market Regulation, SEC (August 31, 1998), offering additional 
justifications for the proposed rule change.
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B. Guaranteed Participation

    The proposal amends PCX Rule 6.82(d)(2) to clarify the 
circumstances in which the Exchange may modify an LMM's guaranteed 
participation. Currently, an LMM's guaranteed participation may be 
reduced from 50% to 40% in a multiply-traded issue, and may be reduced 
from 50% to 25% in a non-multiply traded issue, if average daily 
trading volume in the issue reaches 2,000 contracts at the Exchange for 
``three consecutive months'' (and other events occur). The proposal 
replaces the words ``for three consecutive months'' with the words 
``during any three-calendar-month period (measured on a `rolling' 
three-calendar-month basis)'' to clarify that the average daily trading 
volume requirement of 3,000 contracts is determined on an aggregate 
basis, and that 3,000 contracts need not be the average daily trading 
volume for every month in the applicable three-calendar-month 
period.\17\
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    \17\ See footnote 10 supra.
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    For multiply-traded issues, PCX Rule 6.82(d)(2)(A) also requires 
that the Exchange's share of multi-exchange customer trading volume 
drop below a certain level before an LMM's guaranteed participation 
will be reduced. The proposal clarifies that the applicable customer 
trading volume

[[Page 48777]]

levels are to be determined on a monthly basis.\18\
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    \18\ See footnote 11 supra.
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    Additionally, the proposal codifies the Exchange's existing policy 
on when an LMM's guaranteed participation may return to 50% after 
having been reduced. The proposal provides that the Options Allocation 
Committee may in its discretion return an LMM to receiving a guaranteed 
50% participation, after having had it reduced to 40% or 25%, if 
average daily trading volume in an issue falls below 3,000 contracts at 
the Exchange during any three-calendar-month period (measured on a 
`rolling' three-calendar-month basis).
    The Commission finds that the proposed rule changes relating to 
guaranteed participation are appropriate in that they reduce ambiguity 
and provide LMMs and the marketplace with clearer notice as to how an 
LMM's guaranteed participation will be determined.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the Act 
\19\ that the proposed rule change (SR-PCX-98-19) is approved.

    \19\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-24373 Filed 9-10-98; 8:45 am]
BILLING CODE 8010-01-M