[Federal Register Volume 63, Number 208 (Wednesday, October 28, 1998)]
[Notices]
[Pages 57721-57726]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-28850]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40577, File No. SR-PSE-97-02]


Self-Regulatory Organizations; Order Approving a Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval to 
Amendments 1 and 2 to the Proposed Rule Change by the Pacific Exchange, 
Inc., Relating to the Proprietary Hand-Held Terminal Program for Floor 
Brokers

October 20, 1998.

I. Introduction

    On January 17, 1997, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange'') \1\ filed a proposed rule change with the Securities and 
Exchange Commission (``SEC'' or ``Commission''), pursuant to Section 
19(b)(1) of the Securities Exchange Act of 1934 (``Act'') \2\ and Rule 
19b-4 thereunder,\3\ to adopt Rule 6.89 governing the use by PCX 
Members and Member Organizations (``Members'') of proprietary brokerage 
order routing terminals (``Terminals'') on the options floor of the 
Exchange. On March 30, 1998, and June 5, 1998, respectively, the 
Exchange filed Amendments 1 \4\ and 2 \5\ with the Commission.
---------------------------------------------------------------------------

    \1\ The Exchange changed its name from the Pacific Stock 
Exchange to the PCX subsequent to the filing of this proposed rule 
change. For record-keeping purposes the file number will remain SR-
PSE-97-02.
    \2\ 15 U.S.C. 78s(b)(1).
    \3\ 17 CFR 240.19b-4.
    \4\ See Letter from Michael D. Pierson, Senior Attorney, 
Regulatory Policy, PCX, to David Sieradzki, Attorney, Division of 
Market Regulation (``Division''), Commission, dated March 27, 1998 
(``Amendment No. 1''). In Amendment No. 1, the Exchange makes three 
substantive changes to the proposal. First, the Exchange states that 
approval to use Terminals on the floor of the Exchange will not be 
granted on an issue by issue basis. Instead, the Exchange will 
approve the use of any Terminal system that does not interfere with 
any Exchange-sponsored hand-held terminals, POETS, or any other 
equipment on the floor. Subject to those conditions, once the 
Exchange has approved a Member or Member Firm to use a Terminal, the 
approval is not restricted to particular options trading crowds. 
Second, the Exchange amends the market making restriction in Section 
4(d)(3) to make the definition of market making consistent with the 
definition of market making in PCX's Exchange-sponsored hand-held 
terminal filing (SR-PCX-97-28) and Section 3(a)(38) of the Act. See 
Securities Exchange Act Release No. 39970 (May 7, 1998), 63 FR 26662 
(May 13, 1998) and 15 U.S.C. 78c(a)(38). Third, the Exchange removes 
provisions designating the proposal as a pilot program. finally, the 
Exchange modifies the format of the proposal so that it will be a 
change to the text of the Rules of the Exchange, rather than a 
written policy.
    \5\ See Letter from Michael D. Pierson, Senior Attorney, 
Regulatory Policy, PCX, to David Sieradzki, Attorney, Division, 
commission, dated June 3, 1998 (``Amendment No. 2''). Amendment No. 
2 makes one non-substantive change to the text of the Rule, removing 
a reference to the fact that the Exchange intends to roll out its 
own brokerage order routing system. In addition, the Exchange 
clarified, through an internal cross-reference, that any decision to 
terminate approval for a Terminal system under PCX rule 6.89(g) 
would be based on the factors set forth in PCX rule 6.89(b).
---------------------------------------------------------------------------

    Notice of the proposal was published for comment and appeared in 
the Federal Register on February 18, 1997.\6\ Two comment letters were 
received on the proposed rule change.\7\ The PCX responded to IB's 
comment letter.\8\ This order approves the Exchange's proposal, 
including Amendments No. 1 and 2 on an accelerated basis.
---------------------------------------------------------------------------

    \6\ See Securities Exchange Act Release No. 38270 (February 11, 
1997), 62 FR 7286 (February 18, 1997).
    \7\ Letter from Earl H. Nemser, Managing Director, Interactive 
Brokers, LLC (``IB''), to Jonathan G. Katz, Secretary, Commission, 
dated March 11, 1997; letter from Earl H. Nemser, The Timber Hill 
Group, LLC (``Timber Hill''), to Chairman Levitt, Commissioners 
Hunt, Unger, Carey and Johnson, Commission, dated June 8, 1998. In 
further support of its March 11 comment letter, on August 15, 1997, 
IB supplemented its comment letter with a working paper entitled 
``Affirmative Obligations of Market Makers: An Idea Whose Time Has 
Passed?'' Letter from Bradford L. Jacobowitz, General Counsel, IB, 
to Jonathan G. Katz, Secretary, Commission, dated August 14, 1997.
    \8\ Letter from Michael D. Pierson, Senior Attorney, Regulatory 
Policy, PCX, to Jonathan G. Katz, Secretary, Commission, dated April 
21, 1997.
---------------------------------------------------------------------------

II. Description of the Proposal

    The Exchange proposes to adopt rules governing Terminals that 
Members may use on the options floor of the Exchange. The rules include 
specific provisions on Exchange approval of

[[Page 57722]]

Terminals; restrictions on Members' use of Terminals; exchange 
inspection and audit; exchange liability; and termination of exchange 
approval.

Exchange Approval

    Proposed Rule 6.89 specifies that Members must obtain prior 
Exchange approval to use any proprietary brokerage order routing 
terminals on the options floor. Once the Exchange grants approval to a 
Member to use Terminals, the Member may do so in all trading crowds. To 
request such approval, Members must submit a letter of application to 
the Exchange specifying the make, model number, functions, and intended 
use of the equipment, and must also provide additional information upon 
the request of the Exchange. The rule further provides that the format 
of any orders to be transmitted over the Terminals must also be pre-
approved by the Exchange.
    PCX Rule 6.89(b) states that, in considering the approval of an 
application, as well as whether a previously issued approval should be 
withdrawn, the Exchange will take into account such factors as: (1) the 
physical size of the Terminal; (2) space available at the post where 
the Terminal is to be used; (3) telecommunication, electrical and radio 
frequency requirements; (4) Terminal characteristics and capacity; and 
(5) any factors that the Exchange considers relevant in the interest of 
maintaining fair and orderly markets, the orderly and efficient conduct 
of Exchange business, the maintenance and enhancement of competition, 
the ability of the Exchange to conduct surveillance of the use of the 
Terminal and the business transmitted through it, the adequacy of 
applicable audit trails, and the ability of the Terminal to interface 
with other Exchange facilities.
    PCX Rule 6.89(c) provides that Members must report to the Exchange 
every proposed material change in functionality of a Terminal and every 
proposed change in the use of a Terminal. It further provides that 
Members must not implement any such proposed changes unless and until 
they have been approved by the Exchange, and that Members must also 
promptly file with the Exchange supplements to their applications 
whenever the information currently on file becomes inaccurate or 
incomplete for any reason.

Restrictions on Use of Terminals

    PCX Rule 6.89(d) sets forth four restrictions applicable to 
Members' use of Terminals on the options floor. The first restriction 
is that Members may receive brokerage orders in the trading crowd via 
Terminals, but must represent such orders in the trading crowd by open 
outcry in a manner that is consistent with Exchange rules.
    The second restriction states that when a Member executes an order 
that was received over a Terminal, the Member must fill out and time 
stamp a trading ticket within one minute of the execution. Exchange 
rules on record keeping and trade reporting are unchanged.
    The third restriction states that Terminals may be used to receive 
brokerage orders only, and that Terminals may not be used to perform a 
market making function. it states that any system used by a Member to 
operate a Terminal must be separate and distinct from any system that 
may be used by a member or any person associated with a Member in 
connection with market making functions. It further states that, for 
the purpose of this subsection, orders initiated from off the floor of 
the Exchange that are not counted as ``Market Maker transactions'' 
within the meaning of PCX Rule 6.32 and that do not constitute a 
Member, on a regular and continuous basis, simultaneously representing 
orders to buy and sell options contracts in the same series for the 
account of the same beneficial holder shall not be deemed to be a 
market making function.
    The Exchange believes that if Terminals were permitted to be used 
to perform market making functions from off the floor of the Exchange, 
it may become undesirable for Exchange market makers to continue to 
assume the costs and obligations associated with being a registered 
market maker, which in turn could harm the liquidity and quality of the 
Exchange's market. The Exchange is 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. Moreover, the Exchange believes that surveillance of 
market making through the Terminals currently would be particularly 
difficult.
    The Exchange intends 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.\9\ The definition 
of market making would 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 securities.
---------------------------------------------------------------------------

    \9\ See 15 U.S.C. 78c(a)(38).
---------------------------------------------------------------------------

    The fourth restriction in PCX Rule 6.89(d)(4) states that no Member 
or any person associated with a Member may use for the benefit of such 
Member or any person associated with such Member information about any 
brokerage order in the Terminal system until that information has been 
disclosed to the trading crowd. Accordingly, prior to acting on 
information displayed on a Terminal by placing an order or making or 
changing a bid or offer on the Exchange or in any other securities or 
futures market to the benefit of the Member, the Member must disclose 
information displayed on a Terminal to the trading crowd. The Exchange 
believes that this restriction will help to ensure that Members using 
Terminals trade on the same terms and conditions as other market 
participants and do not receive any trading advantages such as the 
ability to interact with orders transmitted through the Terminals 
without first disclosing those orders to the trading crowd.

Inspection and Audit

    PCX Rule 6.89(e) states that the operation and use of all aspects 
of the Terminal and all orders entered through the Terminal are subject 
to inspection and audit by the Exchange at any time upon reasonable 
notice. It further provides that Members must furnish to the Exchange 
such information concerning the Terminal as the Exchange may from time 
to time request upon reasonable notice, including without limitation an 
audit trail identifying transmission, receipt, entry, execution, and 
reporting of all orders. For the purpose of this subsection, a notice 
of at least twenty-four hours shall be deemed to be reasonable 
(however, shorter periods may be provided in appropriate 
circumstances).

Exchange Liability

    PCX Rule 6.89(f) states that neither the Exchange nor its 
directors, officers, employees or agents shall be liable to a member, a 
Member's employees, a Member's customers or any other person for any 
loss, damage, cost, expense or liability arising from the installation, 
operation, relocation, use of, or inability to use a Terminal on the 
floor of the Exchange (including any failure, malfunction, delay, 
suspension, interruption, or termination).

[[Page 57723]]

Termination of Approval

    PCX Rule 6.89(g) provides that the Exchange may at any time 
determine to terminate approvals for the installation and use by 
Members of Terminals on the floor of the Exchange or at particular 
trading posts, as long as the Exchange gives 30 days notice to such 
Member(s). However, any such decision to terminate its approval of the 
installation or use of Terminals on the floor of the Exchange must be 
based on certain specified factors.\10\ It further provides that a 
Member's approval to use a Terminal may also be summarily terminated by 
the Exchange, once notice has been provided to the affected Member, if: 
(1) any statement by such Member in its application or any supplement 
thereto is inaccurate or incomplete; (2) such Member has failed to 
comply with any provision of this Rule; or (3) the operation of the 
Terminal is causing operational difficulties on the floor of the 
Exchange, and the Member has failed to cure the same within seven 
calendar days following the giving of notice (or such shorter period of 
time as the Exchange may deem appropriate if it determines the 
circumstances have created a situation requiring a shorter period). It 
states that Members must immediately stop using their Terminals and 
must remove such Terminals from the floor of the Exchange upon the 
termination of approval pursuant to this subsection, and that nothing 
in this subsection shall be construed as a waiver of or limitation upon 
whatever right Members may otherwise have to seek appropriate relief 
pursuant to PCX Rule 11.\11\
---------------------------------------------------------------------------

    \10\ These factors include the physical size of the terminal, 
space available at the post where the Terminal is to be used, 
telecommunication, electrical and radio frequency requirements, and 
Terminal characteristics and capacity. See Amendment No. 1, supra 
note 4.
    \11\ PCX Rule 11.7 provides due process protections for persons 
who have been aggrieved by Exchange action. It gives such persons an 
opportunity to be heard and to have the complaint reviewed by the 
Exchange.
---------------------------------------------------------------------------

    In its filing, the Exchange noted that, except in certain minor 
respects, the proposed Rule is similar to an approved rule change of 
the Chicago Board Options Exchange (``CBOE'') relating to the use of 
proprietary brokerage order routing terminals on the CBOE floor.\12\
---------------------------------------------------------------------------

    \12\ See Securities Exchange Act Release No. 38054 (December 16, 
1996), 61 FR 67365 (December 20, 1996). The Commission notes that 
the CBOE proposal authorized the use of hand-held order routing 
terminals in the S&P 500 (``SPX'') crowd to trade SPX options only. 
The current PCX filing concernsthe use of Terminals on a floor-wide 
basis.
---------------------------------------------------------------------------

III. Summary of Comments

A. IB Comment Letter

    In its comment letter, IB expressed support for the proposal's aim 
to introduce Terminals to the options floor, but objected for several 
reasons to the Exchange prohibiting a Terminal from being used to 
transmit two-sided orders. IB requested that the Commission, pursuant 
to the National Securities Markets Improvement Act of 1996 (``NSMIA''), 
``use its * * * exemptive powers and supervisory authority over the 
[Exchange] to * * * modify the proposed rule to eliminate unreasonable 
restrictions * * * and then to direct its implementation forthwith.''
    First, IB argued that Section 105 of NSMIA permits the Commission 
to provide an exemption in order to permit the immediate use of hand-
held technology on the PCX options floor, without imposing the 
restrictions suggested by the PCX proposal. Second, IB argued that the 
Exchange's proposal must be rejected because it does not sufficiently 
analyze the proposal's impact on efficiency and competition as required 
by Section 106 of NSMIA. Third, IB argued that a floor-wide prohibition 
on the use of Terminals for two-sided orders would place an 
unreasonable burden on competition. IB noted that, in proposing its 
market making restriction, the Exchange improperly relied on the 
Commission's approval of the CBOE proposal relating to Terminals used 
by the SPX options trading crowd. IB believes that approval of the 
restriction for that one options class should not act as a precedent 
for a floor-wide policy as proposed by PCX, and should be re-examined 
by the Commission. In particular, IB noted the important differences in 
the liquidity of the SPX option and the various PCX products. Fourth, 
IB argued that the proposed restrictions on two-sided orders must be 
rejected because the Exchange did not appropriately assess whether the 
restriction's resulting burden on competition was justified as 
reasonable and appropriate, and whether the public interest could 
otherwise be protected by a more competitive alternative. Fifth, IB 
argued that the use of Terminals for two-sided orders would not deprive 
market makers of the advantages afforded to them and would not 
discourage them from meeting their market making obligations. IB noted 
that it believes that as new products are listed on the various 
exchanges, market makers will have the financial incentive to continue 
to make markets. In addition, IB noted that if the Exchange restricts 
the use of Terminals to transmit two-sided orders to the trading floor, 
the liquidity of the markets and the investing public will suffer 
during periods of market stress. Sixth, IB argued that the Exchange 
should have considered less restrictive alternatives such as requiring 
non-market makers who use Terminals for the submission of two-sided 
orders to assume market maker obligations through the use of Terminals. 
Seventh, IB argued that the Exchange should not be (1) permitted to 
limit the use of proprietary Terminals when it implements its own 
brokerage order routing system; or (2) deny the use of Terminals 
summarily,\13\ or on an ``issue-by-issue'' basis without setting out an 
objective standard.\14\ IB noted that to develop a proprietary order 
routing system requires a large capital investment. Further, IB 
believes that by denying the use of Terminals in this manner, the 
Exchange discourages development of better systems, deprives the public 
of the benefits of market efficiencies created by new technology, is 
inconsistent with Commission policy to encourage development of 
innovative trading systems and services, and has not been shown to 
justify the resulting burdens on competition. Finally, IB argued that 
the PCX proposal unnecessarily mandates the manual writing and time 
stamping of paper tickets. IB noted that it believes that an electronic 
audit trail is more accurate and more efficient than paper tickets and 
more consistent with Commission policy and NSMIA.
---------------------------------------------------------------------------

    \13\ The Commission notes that a member would have the right to 
appeal any decision to deny approval to use a Terminal or suspend a 
member from using a Terminal pursuant to PCX Rule 11.7, Hearings and 
Review of Committee Action.
    \14\ See infra note 31.
---------------------------------------------------------------------------

B. PCX Response Letter

    The PCX response to IB's comment letter stated that without the 
market making restriction, an off-floor market maker could avoid all 
affirmative market making obligations and have significant trading 
advantages over on-floor market makers. Among other things, on-floor 
market makers are required to: (1) trade with public customers at the 
disseminated best bid or offer,\15\ (2) maintain fair and orderly 
markets,\16\ (3) maintain price continuity by dealing from their own 
accounts under certain circumstances,\17\ and (4) log on to the 
Exchange's Auto-Ex system when circumstances warrant it. In this 
context, the Exchange notes that if a market maker had the freedom to 
leave

[[Page 57724]]

the floor and perform market making through a Terminal, many would do 
so to avoid the obligations of being a market maker. This could 
ultimately result in a significant reduction of liquidity on the 
Exchange's options trading floor. Accordingly, the Exchange believe 
IB's proposal would compromise the continued viability of its markets.
---------------------------------------------------------------------------

    \15\ See PCX Rule 6.86.
    \16\ See PCX Rule 6.37(a).
    \17\ See PCX Rule 6.37(b).
---------------------------------------------------------------------------

    Next, the Exchange contends that allowing off-floor market making 
would, in effect, create an entirely new category of floor trader. The 
Exchange notes that the IB proposal to allow off-floor market making 
was never presented to the Options Floor Trading Committee for 
approval. The Exchange also requests that, if the Commission does 
approve IB's proposal, that the Commission do so uniformly across 
options exchanges to prevent one exchange from being at a competitive 
disadvantage to another.
    The Exchange also addresses IB's contention that the Exchange 
unjustifiably relies on the Commission's prior approval of a similar 
CBOE filing that included a market making restriction because the prior 
proposal dealt with heavily traded issues while the trading volume on 
the PCX is considerably smaller. The Exchange states that ``the 
question of whether Terminals should initially be permitted in trading 
crowds with low volume or trading crowds with high volume should be 
left to the discretion of the [Options Floor Trading Committee], which 
is in the best position to make such a determination because of its 
diverse composition of industry representatives.''
    The Exchange makes several arguments in response to IB's request 
that the Commission ``uses its * * * exemptive powers and supervisory 
authority over the [Exchange] to * * * modify the proposed rule to 
eliminate unreasonable restrictions. First, the Exchange argues that 
Congress has not indicated that Section 105 of NSMIA should be used in 
the manner that IB suggests. The Exchange believes that Congress 
intended that Section 105 be used to allow the exchanges to use 
automated trading systems without filing a proposed rule change or that 
the exemption refers to the Commission's ability to exempt certain 
electronic trading systems from having to be registered under the Act 
as national securities exchanges. Second, the Exchange argues that even 
if Section 105 were to apply, IB has failed to meet the statutory 
requirements that the exemption be ``necessary or appropriate in the 
public interest'' and ``consistent with the protection of investors'' 
because, among other things, it could undermine the Exchange's market 
making system and result in less deep and liquid markets. The Exchange 
also believes that surveillance would be particularly difficult and 
that IB has not met the burden under NSMIA that the exemption be 
necessary or appropriate because IB still has the choice of putting a 
market maker in the trading crowd. Third, the Exchange notes that the 
Commission has yet to use its exemptive authority under Section 105 and 
recommends that the Commission use caution before doing so. Fourth, the 
Exchange believes that the Commission has previously engaged in a 
``rigorous'' analysis of the issues in this matter. Specifically, the 
Commission has previously considered comment letters and responses in 
connection with similar rule filings of the American Stock Exchange and 
the CBOE. Fifth, in response to IB's argument that the Exchange should 
not be permitted to limit the use of proprietary Terminals when it 
implements its own brokerage order routing system, the Exchange states 
that ``as long as an applicant's proprietary trading system does not 
cause operational problems on the trading floor, the applicant will not 
be arbitrarily denied the privilege of operating its Terminals on the 
floor[.]'' Finally, with regard to IB's objection that written, time-
stamped tickets would be required under the rules relating to 
Terminals, the Exchange notes that such tickets are needed, at this 
time, not only for audit trail purposes, but also for purposes of 
verifying compared trades and reconciling uncompared trades.

C. Timber Hill Comment Letter

    In its comment letter, Timber Hill urges the Commission to consider 
the issue of prohibiting the use of Terminals to perform a market 
making function. Timber Hill asserts that, due to the impact of the 
proposed market making restriction on competition and the use of 
technology, NSMIA requires that the restriction must be supported by an 
actual basis in fact, and not merely by possibilities derived from an 
outdated theoretical construct. Further, Timber Hill argues that the 
Commission should not rely on its prior approval of a similar market 
making restriction in a proposal by the CBOE without reanalyzing the 
issue in light of NSMIA.

IV. Commission Finding and Conclusions

    Section 6(b)(5) of the Act \18\ requires that the rules of an 
exchange be designed to prevent fraudulent and manipulative acts and 
practices, promote just and equitable principals 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 \19\ requires that the rules of an Exchange be in 
accordance with Section 6(d) of the Act,\20\ and in general provide a 
fair 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)(8) of the Act \21\ 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 \22\ 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.\23\
---------------------------------------------------------------------------

    \18\ 15 U.S.C. 78f(b)(5).
    \19\ 15 U.S.C. 78f(b)(7).
    \20\ 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. Id.
    \21\ 15 U.S.C. 78f(b)(8).
    \22\ 15 U.S.C. 78k-1(a)(1)(C).
    \23\ In approving the proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78f(b). As discussed below, the 
proposed rule will likely expedite and make more efficient the 
process by which members can receive and execute options orders on 
the floor of the Exchange. In addition, the Commission discusses the 
proposed rule's effect on competition below.
---------------------------------------------------------------------------

    The Commission believes that the PCX'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 and execute options orders on the floor of the Exchange. 
Because Terminals will be allowed to be used by all brokers and dealers 
in all trading crowds, provided that they comply with the terms and 
conditions as set forth in the proposal, the proposal also will promote 
fair competition among brokers and dealers and facilitate transactions 
in

[[Page 57725]]

options on the Exchange. Finally, although IB and Timber Hill have set 
forth a number of objections to the market making restriction, for the 
reasons discussed below, the Commission believes that these objections 
have been adequately addressed and finds that the market making 
restriction is consistent with the Act.
    As described above, PCX Rule 6.89(d)(3) provides that no floor 
broker may knowingly use a Terminal, on a regular and continuous basis, 
to simultaneously represent orders to buy and sell options contracts in 
the same series for the account of the same beneficial holder. The Rule 
further provides that if the Exchange determines that a person or 
entity has been sending, on a regular and continuous basis, orders to 
simultaneously buy and sell option contracts in the same series for the 
account of the same beneficial holder, the Exchange may prohibit orders 
for the account of such person or entity from being sent through the 
Exchange's Member Firm Interface (``MFI'') \24\ for such period of time 
as the Exchange deems appropriate.
---------------------------------------------------------------------------

    \24\ The MFI is an electronic order delivery and reporting 
system that allows member firms to route orders for execution by the 
automatic execution feature of POETS as well as to route limit 
orders to the Options Public Limit Order Book. Orders that do not 
reach those two destinations are defaulted to a member firm booth. 
MFI also provides member firms with instant confirmation of 
transactions to their systems. Member firms may access POETS by 
establishing an MFI mainframe-to-mainframe connection.
---------------------------------------------------------------------------

    The Commission finds that the market making restriction is 
consistent with the Act for the following reasons. The Commission 
believes that the PCX's restriction on market making through the use of 
Terminals has been effected in a clear and reasonable manner that is 
not ambiguous or overbroad, and that takes into account regulatory and 
market impact concerns, including those relating to quote competition 
and price discovery.\25\ Notably, the Exchange's proposal does not bar 
all two-sided limit orders. Instead it only restricts the acceptance of 
two-sided limit orders placed by the same beneficial holder 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 PCX Rule 6.89(d)(3) expressly 
restricts a floor broker from, on a regular and continuous basis, 
simultaneously representing orders to buy and sell options contracts in 
the same series for the account of the same beneficial holder, not the 
occasional entry of two-sided limit orders. This definition of market 
making activity is consistent with the definition of market maker under 
the Act, which states that a market maker ``holds himself out as being 
willing to buy and sell [a] security for his own account on a regular 
or continuous basis.''\26\ Thus, the market making restriction on 
Terminal use for routing limit orders is the minimum necessary for the 
Exchange to ensure that Terminals are not used for off-floor market 
making.
---------------------------------------------------------------------------

    \25\ 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).
    \26\ 15 U.S.C. 78c(a)(38).
---------------------------------------------------------------------------

    IB alleges that the market making restriction places an 
unreasonable burden on competition. As the Commission has previously 
stated in approving market making restrictions similar to that being 
adopted by PCX, the Commission does not believe it unreasonable for a 
market to determine that the introduction of unregulated market making 
through Terminals may undermine its market maker system and potentially 
create disincentives for market makers to remain on an exchange trading 
floor.\27\ Accordingly, any burden on competition that arguably exists 
from PCX's restriction on using Terminals for market making is, in the 
Commission's view, justified as reasonable and appropriate to ensure 
adequate regulation of the PCX market.\28\
---------------------------------------------------------------------------

    \27\ See Securities Exchange Act Release No. 38054 (December 16, 
1996), 61 FR 67365 (December 20, 1996)(order approving SR-CBOE-95-
48).
    \28\ While the Commission recognizes that, as IB contends, there 
may be ways to address the regulatory issues presented by off-floor 
market making through the use of floor broker hand-held 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 PCX 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.
---------------------------------------------------------------------------

    The Commission also does not believe that restricting market making 
activity through Terminals constitutes an unreasonable restriction on 
the introduction of new technology onto the floor of the Exchange in 
violation of NSMIA, as alleged in the IB and Timber Hill Comment 
Letters. The Commission believes that it is within the business 
judgment of an Exchange to determine the manner in which new 
technologies are introduced onto its trading floor provided that the 
limitations do not constitute an unreasonable burden on competition and 
are otherwise consistent with the Act.
    In addition, the Commission has considered the impact of the 
Exchange's market making restriction on efficiency and competition. 
While the proposal may impose a burden on competition by limiting how 
Terminals may be used on the floor, the Commission does not believe 
such burden to be unreasonable. As discussed above, the Commission 
believes that the PCX's restriction on market making through the use of 
Terminals has been effected in a clear and reasonable manner that is 
neither ambiguous nor overbroad, and that takes into account regulatory 
and market impact concerns. Further, the Commission notes that the 
impact on competition of the current proposal is limited by the fact 
that the Exchange's own hand-held order routing terminal program was 
approved by the Commission with an identical market making 
restriction.\29\ In response to IB's request that the Commission use 
its exemptive authority under Section 105 of NSMIA to permit the use of 
Terminals for market making, the Commission agrees with the Exchange 
that Congress did not intend that Section 105 be used in the manner 
that IB suggests. Section 105 of NSMIA states that the Commission ``by 
rule, regulation, or order may conditionally or unconditionally exempt 
any person, security, or transaction, * * * from any provision or 
provisions of this title or of any rule or regulation thereunder[.]'' 
\30\ The rules IB requests relief from are the rules of the PCX, not 
the Act or rules or regulations under the Act. Accordingly, the 
Commission does not believe that it is appropriate to grant the relief 
IB requests under Section 105 of NSMIA.
---------------------------------------------------------------------------

    \29\ See Securities Exchange Act Release No. 39970 (May 7, 
1998), 63 FR 26662 (May 13, 1998) (order approving SR-PCX-97-28).
    \30\ P.L. 104-290; 110 Stat. 3416.
---------------------------------------------------------------------------

    Further, the Commission believes the PCX has adequately addressed 
the other issues raised by IB. First, PCX has amended its proposal so 
that under PCX Rule 6.89(g), termination of the Exchange's approval of 
Terminals can only occur under certain specified circumstances, rather 
than without cause.\31\ In addition, while the Exchange has retained 
the right to summarily terminate its approval of a member's Terminal 
use, such summary action can also only be taken under certain

[[Page 57726]]

circumstances.\32\ Further, upon either type of termination action, the 
PCX proposal provides certain appeal rights of the termination 
decision. The Commission believes that the appeal procedures ensure 
adequate due process for termination under PCX Rule 6.89, consistent 
with Sections 6(b)(7) \33\ and 6(d) \34\ of the Act. In this regard, we 
note that a member aggrieved by an Exchange decision to terminate its 
prior terminal approval could seek relief pursuant to PCX Rule 11. 
These provisions provide specific procedures to seek Exchange hearing 
and review for persons aggrieved by actions of the Exchange including 
terminating or enforcing the terms of PCX Rule 6.89.\35\
---------------------------------------------------------------------------

    \31\ The Commission notes that the Exchange, in Amendment No. 1 
to the proposed rule change, sets forth objective standards on which 
the decision to terminate an approval to use Terminals would be 
based and stating that approval to use Terminals would be given on a 
floor-wide, rather than on an issue-by-issue basis. See Amendment 
No. 1, supra note 4.
    \32\ Under PCX Rule 6.89(g), the Exchange can summarily 
terminate approval of the use of Terminals when (1) a statement in 
the Member's application is inaccurate or incomplete; (2) such 
Member has failed to comply with any provision of PCX Rule 6.89; and 
(3) the operation of the Terminal causes operational difficulties on 
the floor of the Exchange. See Amendment No. 1, supra note 4.
    \33\ 15 U.S.C. 78f(b)(7).
    \34\ 15 U.S.C. 78f(d).
    \35\ See supra note 13.
---------------------------------------------------------------------------

    With respect to the use of written order tickets, the Exchange has 
represented that such tickets are needed, at this time, not only for 
audit trail purposes, but also for purposes of verifying compared 
trades and reconciling uncompared trades. The Commission believes that 
it is reasonable for the Exchange to require the use of written order 
tickets for those purposes.
    In conclusion, the Commission believes that the proposed rule will 
make the process by which members can receive approval for using 
Terminals more transparent and fair. In addition, the use of Terminals 
should also make options trading on the floor of the Exchange more 
efficient. Finally, for the reasons stated above, the Commission 
believes that the market making prohibition on the use of the Terminals 
adequately balances the potential benefits to be derived from the use 
of Terminals with the regulatory issues that are raised in connection 
with the potential use of Terminals for market making.
    The Commission finds good cause for approving Amendments 1 and 2 to 
the proposed rule change prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Amendment No. 1 changes the language in proposed Commentary .02 to Rule 
6.67 to indicate that orders received through proprietary hand held 
terminals will be considered to be in writing for the purposes of PCX 
Rule 6.67. Commentary .02, as originally proposed, applied only to 
Exchange-Sponsored Terminals. Amendment No. 1 ensures that all hand-
held terminal systems, regardless of whether they are Exchange 
sponsored or proprietary will have the same regulatory requirements. 
Amendment No. 2 clarifies the proposal to indicate, through an internal 
cross-reference, what factors the Exchange will consider when 
determining whether or not to revoke approval for the use of a 
terminal. As a result, the Commission does not believe that Amendments 
1 and 2 raise any new regulatory issues. Accordingly, the Commission 
believes there is good cause, consistent with Sections 6(b)(5) and 
19(b)(2) \36\ of the Act, to approve Amendments 1 and 2 to the 
Exchange's proposal on an accelerated basis.
---------------------------------------------------------------------------

    \36\ 15 U.S.C. 78f(b)(5) and 78s(b)(2).
---------------------------------------------------------------------------

V. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendments 1 and 2 including whether the 
amendments are consistent with the Act. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 20549. Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying at the Commission's Public Reference Room. Copies of such 
filing will also be available for inspection and copying at the 
principal office of the above-mentioned self-regulatory organization. 
All submissions should refer to File No. SR-PSE-97-02 and should be 
submitted by November 18, 1998.
    In view of the above, the Commission finds that the proposal is 
reasonable and is consistent with the Act, and, in particular, Sections 
6(b)(5), 6(b)(7), 6(b)(8), and 11A(a)(1)(C)(ii) of the Act.

VI. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\36\ that the proposed rule change (File No. SR-PSE-97-02) is 
approved.
---------------------------------------------------------------------------

    \36\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\37\
---------------------------------------------------------------------------

    \37\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

[FR Doc. 98-28850 Filed 10-27-98; 8:45 am]
BILLING CODE 8010-01-M