[Federal Register Volume 64, Number 131 (Friday, July 9, 1999)]
[Notices]
[Pages 37185-37187]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-17418]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41588; File No. SR-Phlx-98-56]


Self-Regulatory Organizations; Philadelphia Stock Exchange Inc.; 
Order Approving Proposed Rule Change Relating to the Enhanced Parity 
Split Pilot Program for Equity and Index Option Specialists, and the 
Adoption of an Enhanced Parity Split for Specialists That Develop and 
Trade New Products

July 1, 1999.

I. Introduction

    On December 28, 1998, the Philadelphia Stock Exchange, Inc. 
(``Exchange'' or ``Phlx'') 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 seeking to extend and receive 
permanent approval of the Exchange's enhanced parity split pilot 
program for Exchange specialists in equity and index options (``Pilot 
Program'').\3\ In addition, the Exchange proposed to amend Exchange 
Rule 1014(g), ``Equity Option and Index Option Priority and Parity,'' 
and its corollary Option Floor Procedure Advice B-6 to provide an 
enhanced parity split for Exchange specialists that develop and trade 
new products.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Exchange Rule 1014(g)(ii), ``Two for-one Enhanced 
Specialist Participation.''
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    In the release published for comment in the Federal Register on 
January 12, 1999, the Commission gave accelerated approval to the 
Exchange's request that the Pilot Program be extended for a six-month 
period ending June 30, 1999, or until the Commission approves the 
Exchange's request for permanent approval of the Pilot Program, 
whichever occurred first.\4\ The Commission did not receive any comment 
letters with respect to the proposal. This order permanently approves 
the Pilot Program and the Exchange's proposal to establish an enhanced 
parity split for Exchange specialists that develop and trade new 
products.
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    \4\ Securities Exchange Act Release No. 40876 (Dec. 31, 1998), 
64 FR 1849 (Jan. 12, 1999).
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II. Description of the Proposal

A. Permanent Approval of the Pilot Program

    The Exchange seeks permanent approval of the Pilot Program for 
Exchange specialists in equity and index options. The Commission first 
approved the Pilot Program on August 26, 1994,\5\ to provide Exchange 
specialists in equity options with an enhanced participation in 
``parity trades,'' or trades where orders compete at the same price.\6\ 
While a parity trade is generally divided evenly among the crowd 
participants on parity, the enhanced participation gives the specialist 
a greater share of the trade than he would normally receive.
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    \5\ See Securities Exchange Act Release No. 34606 (Aug. 26, 
1994), 59 FR 45741 (Sep. 2, 1994). The Pilot Program was initially 
approved for a one year period ending August 26, 1995.
    \6\ According to Exchange Rules 119 and 120, when bids and 
offers are made simultaneously, or when it is impossible to 
determine clearly the order of time in which they were made, all 
such bids and offers shall be on parity. For example, suppose that a 
floor broker holding a sell order for 10 Jan XYZ call options 
announces his order to the crowd. In response, three crowd 
participants might simultaneously bid to buy the 10 Jan XYZ call 
options at the same price. Because these three simultaneous bids are 
competing at the same price, the bids are on parity.
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    On November 30, 1994, the Commission approved the Exchange's 
proposal to expand the Pilot Program to include index option 
specialists.\7\ The Pilot Program was later revised on March 1, 1995, 
with respect to situations where less than three controlled accounts 
are on parity with the specialist.\8\ The Pilot Program was 
subsequently renewed without change on three occasions \9\ and later 
was extended and expanded so that the enhanced parity split applies to: 
(i) All index options; (ii) all new option classes allocated to a 
specialist during the year; and (iii) 50% of a specialist's equity 
option issues, which issues are designed by the specialist and approved 
by the Exchange's Allocation, Evaluation, and Securities Committee.\10\ 
In addition, the Pilot Program was revised to permit specialists to 
revise the list of eligible

[[Page 37186]]

options (i.e., the designated equity options for which the specialist 
is entitled to receive the enhanced parity split) on a quarterly basis, 
rather than annually.
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    \7\ Securities Exchange Act Release No. 35028 (Nov. 30, 1994), 
59 FR 63151 (Dec. 7, 1994).
    \8\ Securities Exchange Act Release No. 35429 (Mar. 1, 1995), 60 
FR 12802 (Mar. 8, 1995).
    \9\ Securities Exchange Act Release Nos. 36122 (Aug. 18, 1995), 
60 FR 44530 (Aug. 28, 1995); 37524 (Aug. 5, 1996), 61 FR 42080 (Aug. 
13, 1996); and 38924 (Aug. 11, 1997), 62 FR 44160 (Aug. 19, 1997).
    \10\ Securities Exchange Act Release No. 39401 (Dec. 4, 1997), 
62 FR 65300 (Dec. 11, 1997). The Exchange maintains a separate, 
permanent enhanced parity split program for new specialist units 
that trade newly listed options. See Exchange Rule 1014(g)(iii), 
``New Unit/New Option Enhanced Specialist Participation,'' and 
Securities Exchange Act Release No. 34109 (May 25, 1994), 59 FR 
28570 (June 2, 1994).
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    The Exchange now seeks permanent approval of the Pilot Program. The 
Pilot Program works as follows: when an equity or index option 
specialist is on parity with one controlled account \11\ and an order 
for more than five contracts comes into the crowd, the specialist will 
receive 60% of the contracts and the controlled account will receive 
40%. When the specialist is on parity with two controlled accounts and 
the order is for more than five contracts, the specialist will receive 
40% of the contracts and each controlled account will receive 30%. When 
the specialist is on parity with three or more controlled accounts and 
the order is for more than five contracts, the specialist will be 
counted as two crowd participants when allocating the contracts. In any 
of these situations, if a customer order is on parity, the customer 
will not be disadvantaged by receiving a lesser allotment than any 
other crowd participant, including the specialist. Thus, a customer on 
parity is assured a minimum participation that is equal to the 
participation of the specialist.\12\
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    \11\ A controlled account is defined as ``any account controlled 
by or under common control with a member broker-dealer.'' Customer 
accounts, which include discretionary accounts, as defined as all 
accounts other than controlled accounts. See Exchange Rule 
1014(g)(i).
    \12\ For example, if a customer is on parity with a specialist 
and two controlled accounts for a 10 contract order, the 
specialist--and therefore the customer also--would be entitled to 
receive 4 contracts (40%).
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    The application of this enhanced parity split is mandatory. 
Therefore, with respect to any equity or index option transaction that 
implicates the enhanced parity split, the specialist is required to 
accept the preferential allocation and may not decline the enhancement. 
If an equity or index option trade is on parity, but not subject to the 
enhanced parity split (i.e., the trade is for five or less contracts), 
the Exchange specialist is required to allocate the contracts according 
to the Exchange's priority and parity rules.\13\
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    \13\ See Exchange Rule 119, ``Precedence of Highest Bid,'' and 
Exchange Rule 120, ``Precedence of Offers at Same Price.''
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    At the request of the Commission, the Exchange prepared a report 
(``Report'') discussing whether the: (i) Pilot Program has generated 
any evidence of any adverse effect on competition or investors, in 
particular, or the market for equity or index options, in general; (ii) 
Exchange has received any complaints, either written or otherwise, 
concerning the operation of the Pilot Program; and (iii) Exchange has 
taken any disciplinary action against, or commenced any investigations, 
examinations, or inquires concerning the operation of the Pilot 
Program, as well as the outcome of any such matter.
    The Exchange incorporated the findings of its Report into the 
proposed rule change filing. According to the Exchange, its regulatory 
personnel have not observed during the past year evidence of any 
adverse effects on competition, investors, or the market for equity or 
index options. As to the second issue, the Exchange has not received 
any complaints, either orally or in writing, from investors or Exchange 
members regarding the Pilot Program. Finally, regarding disciplinary 
actions, investigations, examinations or inquires, the Exchange reports 
that it did not commence any investigations relating to the Pilot 
Program this past year.

B. Adoption of Enhanced Parity Split for Specialists That Develop and 
Trade New Products

    The Exchange separately proposes to adopt an enhanced parity split 
for Exchange specialists that develop and trade new products (``New 
Products Split''). The Exchange stated that the New Products Split is 
intended to encourage specialist units to develop and trade new 
products, and to provide liquidity in such products, thereby attracting 
order flow to the Exchange. The exchange believes that the proposal 
balances the competing interests of specialists and Registered Option 
Traders (``ROTs''), while encouraging specialists to take an active 
role in supporting and marketing a new product, both important 
activities in a competitive environment.
    Under the proposed New Products Split, when the specialist is on 
parity with three or more controlled accounts in the crowd, the 
specialist will receive 40% of the contracts and the controlled 
accounts will receive the remaining 60%. When the specialist is on 
parity with less than three controlled accounts in the crowd, the 
specialist will receive 60% of the contracts and the controlled 
accounts will receive 40%. In either of these situations, if a customer 
order is on parity, the customer may not receive a lesser allotment 
than any other crowd participant, including the specialist.
    The Exchange indicated that the New Products Split would be limited 
to new products developed and traded by the same specialist unit. 
Therefore, if one specialist unit develops a new product but another 
specialist unit is allocated specialist privileges in that same new 
product,\14\ the specialist unit trading the new product would not be 
entitled to the New Products Split. The Exchange's Options Committee 
will be responsible for determining whether a specialist ``developed'' 
a new product.
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    \14\Allocation determinations are governed by Exchange Rules 
500-526.
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III. Discussion

    For the reasons discussed below, the Commission finds that the 
proposed rule change is consistent with the Act and the rules and 
regulations under the Act applicable to a national securities exchange. 
In particular, the Commission believes the proposed rule change is 
consistent with the Section 6(b)(5)\15\ requirements that the rules of 
an exchange be designed to promote just and equitable principles of 
trade, prevent fraudulent and manipulative acts and practices, and 
protect investors and the public interest.\16\ The Commission also 
finds that the proposal may serve to remove impediments to and perfect 
the mechanism of a free and open market by helping the Exchange to 
attract and retain specialist units, and offer new products to the 
investing public.
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    \15\ 15 U.S.C. 78f(b)(5).
    \16\ In approving this proposed rule change, the Commission has 
considered the proposal's impact on efficiency, competition, and 
capital formation. 15 U.S.C. 78c(f).
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    Generally, a parity trade is divided evenly among the crowd 
participants on parity. However, the Pilot Program and the New Products 
Split would provide Exchange specialists with an enhanced participation 
in parity trades. The enhancement would give the specialist a greater 
share of the trade than he would normally receive.
    The Pilot Program gives an equity or index option specialist 60% of 
the contracts when he is on parity with one controlled accounts and the 
order is for more than five contracts. When the specialist is on parity 
with two controlled accounts and the order is for more than five 
contracts, the specialist will receive 40% of the contracts. When the 
specialist is on parity with three or more controlled accounts and the 
order is for more than five contracts, the specialist will be counted 
as two crowd participants when allocating the contracts.
    The New Products Split would give an eligible specialist (i.e., a 
specialist who developed a new product and to whom the new product is 
allocated) 40% of the contracts in the new product when the specialist 
is on parity with three or more controlled accounts in the crowd. When 
the specialist is on parity with less than three controlled accounts

[[Page 37187]]

in the crowed, the specialist will receive 60% of the contracts. Under 
the Pilot Program and the New Products Split, if a customer order also 
is on parity, the customer may not receive a lesser allotment than any 
other crowd participant, including the specialist.
    The Commission recognizes that the purpose of the enhanced parity 
split is to encourage specialists to make deep and liquid markets in 
order to attract order flow to the Exchange. The Commission has 
previously noted that specialists have responsibilities that other 
crowd participants do not share, such as the staff costs associated 
with continually updating and disseminating quotes.\17\ As a result, 
the Commission believes it is reasonable for the Exchange to grant 
certain advantages to specialists, such as the enhanced parity split, 
to attract and retain well capitalized specialists at the Exchange. As 
long as these advantages do not unreasonably restrain competition and 
do not harm investors, the Commission believes that the granting of 
such benefits to specialists, in general, is within the business 
judgment of the Exchange.
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    \17\ See, e.g. Securities Exchange Act Release No. 35177 (Dec. 
29, 1994), 60 FR 2419 (Jan. 9, 1995).
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    The Commission believes that the proposal will encourage 
specialists to make deep and liquid markets to attract order flow to 
the Exchange. The Commission also believes that the Pilot Program and 
New Products Split provide reasonable benefits to specialists, given 
the heightened responsibilities and costs of specialist. Because it 
appears that these that these benefits do not unreasonably restrain 
competition and do not harm investors, the Commission believes that the 
approval of the Pilot Program and New Products Split is consistent with 
the Act.
    The Pilot Program and the New Products Split specify that the 
application of the enhanced parity split cannot cause a customer order 
on parity to received a smaller participation than any other crowd 
participant, including the specialist. The Commission believes this 
provision adequately protects customers orders from any negative impact 
that might flow from application of the enhanced parity split. As a 
result, customer orders on parity are ensured a participation that, at 
a minimum, is equal to that given any other crowd participant on 
parity.
    The Commission notes that the Pilot Program has been operative, 
albeit in differing forms, since 1994. During that period, the 
Commission has required the Exchange to submit Reports discussing: (i) 
The Pilot Program's impact on competition and investors; (ii) 
complaints regarding the Pilot Program; and (iii) inquiries, 
investigations, or disciplinary actions taken regarding the Pilot 
Program. The Reports have indicated that the Pilot Program operates 
well and does not adversely impact competition or investors.\18\ 
Furthermore, the Exchange has not received complaints regarding the 
Pilot Program and has brought only one disciplinary action concerning 
the Pilot Program.\19\ The Commission believes that the absence of 
significant problems over the past five years demonstrates that the 
Pilot Program is a reasonable benefit for the Exchange to offer to its 
equity and index option specialists.
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    \18\ The Exchange found that the enhanced parity split, as first 
proposed in 1994, was overly burdensome when only one or two 
controlled accounts were on parity with the specialist. Therefore, 
the Exchange amended the Pilot Program in 1995 to make the enhanced 
parity split more equitable in those situations. See Securities 
Exchange Act Release No. 35429 (Mar. 1, 1995), 60 FR 12802 (Mar. 8, 
1995). The Exchange also formed a subcommittee to analyze the Pilot 
Program and its effect on competition, investors, and the market in 
general. The subcommittee members concluded that there is no 
evidence of any adverse effects on competition, investors, or the 
market for equity or index options.
    \19\ In 1995, the Exchange brought one disciplinary case against 
an equity option specialist for making an inequitable split among 
himself and the ROTs in the crowd. The specialist was censured and 
suspended for one week as part of a settlement. See Exchange 
Enforcement Matter No. 95-12.
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    Based on the Exchange's five year experience with the Pilot 
Program, and the similarity between the Pilot Program and the New 
Products Split, the Commission believes that the New Products Split is 
a reasonable measure to attract new products to the Exchange. Like the 
Pilot Program, the New Products Split should be an incentive for 
Exchange specialists to generate more business by developing and 
training new products. The Commission supports the Exchange's attempts 
to attract new business. The Commission also believes that because the 
enhanced parity split will be available only to a specialist unit that 
develops and trades a new product, the benefit is reasonably limited in 
scope to those specialist units that put forth significant effort. 
Therefore, the Commission believes it is appropriate to approve the New 
Products Split.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\20\ that the proposed rule change (SR-Phlx-98-56) is approved.

    \20\ U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\21\
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    \21\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-17418 Filed 7-8-99; 8:45 am]
BILLING CODE 8010-01-M