[Federal Register Volume 64, Number 179 (Thursday, September 16, 1999)]
[Notices]
[Pages 50313-50315]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-24115]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41821; File No. SR-CBOE-99-17]


Self-Regulatory Organizations; Order Granting Approval of 
Proposed Rule Change and Notice of Filing and Order Granting 
Accelerated Approval of Amendment No. 3 to Proposed Rule Change by the 
Chicago Board Options Exchange, Inc. Relating to the Operation of the 
Retail Automatic Execution System

September 1, 1999.

I. Introduction

    On April 16, 1999, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') 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 amending the CBOE's rules 
governing the operation of its Retail Automatic Execution System 
(``RAES''). The proposal increases the maximum order sizes of certain 
RAES-eligible options and authorizes the appropriate Floor Procedure 
Committees (``FPCs'') of the Exchange to change current procedures 
governing assignment and price improvement of RAES orders. On May 21, 
1999, the CBOE filed with the Commission Amendment No. 1 to the 
proposal.\3\ Notice of the proposal was published in the Federal 
Register on June 17, 1999.\4\ The Commission received no comments on 
the proposal. On August 23, 1999, the CBOE filed Amendment No. 2 to the 
proposal,\5\ on August 31, 1999, the CBOE filed Amendment No. 3 to the 
proposal.\6\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No. 1, the CBOE clarified issues relating to 
implementation of the new RAES order assignment procedures. See 
letter from Timothy Thompson, Director, Regulatory Affairs, CBEO, to 
Gordon Fuller, Special Counsel, Division of Market Regulation, SEC, 
dated May 20, 1999.
    \4\ See Securities Exchange Act Release No. 41501 (June 9, 
1999), 64 FR 32568.
    \5\ Amendment No. 2 is described below. See letter from 
Christopher R. Hill, Attorney, CBOE, to Michael Walinskas, Associate 
Director, Division of Market Regulation, SEC, dated August 23, 1999.
    \6\ Amendment No. 3 is described below. See letter from Timothy 
Thompson, Director, Regulatory Affairs, CBOE, to Gordon Fuller, 
Special Counsel, Division of Market Regulation, SEC, dated August 
31, 1999.
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II. Description of the Proposal

a. Summary

    This filing does four things. First, it increases from 20 to 50 
contracts the maximum size of orders for equity options and certain 
classes of index options eligible to be executed through RAES.\7\ 
Second, it authorizes the appropriate FPCs to implement a new RAES 
order assignment procedure called ``Variable RAES'' (described below) 
for some or all classes of CBOE options. Third, it allows the 
appropriate FPCs to authorize automatic RAES ``step-ups'' for price 
differentials greater than the one ``tick'' differential currently 
specified in the rules.\8\ Fourth, it makes editorial revisions to 
clarify or update current RAES rules.
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    \7\ The proposal also effects a minor increase (from 99 
contracts to 100 contracts) in the maximum size of RAES orders for 
options on two indices--the S&P 500 Index and the Nasdaq 100 Index--
to bring those size maximums into conformity with size maximums for 
other index options and interest rate options. See infra note 11.
    \8\ ``Step-ups'' refers to the ability to improve the price at 
which an order is executed on RAES to match a better price in 
another market.
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b. Previous Partial Approval

    The Commission previously granted accelerated approval to a portion 
of this rule filing. Specifically, on August 23, 1999, the Commission 
approved Amendment No. 2, which permitted the CBOE to immediately 
implement Variable RAES in five stocks that are dually listed on both 
the Philadelphia stock Exchange (``Phlx'') and the CBOE.\9\ Amendment 
No. 2 was filed in tandem with a related rule proposal, SR-CBOE-99-47, 
which increased the maximum RAES order size from 20 to 50 contracts in 
options on those five stocks only.\10\ SR-CBOE-99-47 became effective 
on August 23, 1999. The Commission granted immediate approval of 
Amendment No. 2 to enable Variable RAES to be used on August 23, when 
the new order size maximum on the five dually traded options went into 
effect.
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    \9\ Those stocks are Dell Computer Corporation (``DLQ''), 
International Business Machines (``IBM''), Johnson & Johnson 
(``JNJ''), Coca-Cola (``KO''), and Ford Motor Company (``F''). 
Securities Exchange Act Release No. 41782 (August 23, 1999), 64 FR 
47881 (September 1, 1999).
    \10\ Securities Exchange Act Release No. 41823 (September 1, 
1999).
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c. Order Size Increase

    Formerly, the maximum size of RAES-eligible orders was 20 contracts 
for all classes of equity options (other than the five dually traded 
classes noted above), all classes of sector index options and all other 
classes of index options (except options on the S&P 500 Index, the 
Nasdaq 100 Index, the Dow Jones Industrial Average, and interest rate 
options).\11\ This proposed rule change

[[Page 50314]]

increases the maximum order size for these options classes to 50 
contracts. Increasing the RAES eligibility maximum to 50 contracts for 
these classes of options does not, however, automatically permit orders 
up to this size to be entered into RAES. Instead, the actual maximum 
RAES eligibility size will be established by the appropriate FPC of the 
CBOE, which may maintain the maximum for particular classes at levels 
below the 50-contract maximum.
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    \11\ The RAES eligibility maximum was formerly 99 contracts for 
options on the S&P 500 Index and the Nasdaq 100 Index, and 100 
contracts for options on the DJIA and interest rate options. To 
simplify the administration of RAES and eliminate confusion, this 
proposal makes the RAES eligibility maximums 100 contracts for these 
four classes of options. See Rule 6.8(e). One hundred contracts is 
also the RAES eligibility maximum for options on the Dow Jones High 
Yield Select 10 Index. See Securities Exchange Act Release No. 41509 
(June 10, 1999), 64 FR 32906 (June 18, 1999) (approving increase in 
RAES order size limit from 20 contracts to 100 contracts).
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    Under existing Interpretation and Policy .01 under Rule 6.8, the 
appropriate FPC may increase the size of RAES-eligible orders for 
multiply-traded equity options to match the size of orders in options 
of the same class that are eligible for entry into the automated 
execution system of any other options exchange, subject to filing 
notice of the increase under Section 19(b)(3)(A) of the Act.\12\ The 
CBOE nonetheless believes the FPC should be able to permit up to 50 
contracts to be eligible for RAES in response to the perceived needs of 
the market without regard to automatic execution limits on other 
exchanges. The CBOE also seeks greater flexibility in competing for 
order flow with other exchanges that have 50-contract maximum 
eligibility levels for their own automatic execution systems, since the 
CBOE will not be limited to responding to increases in automatic 
execution eligibility levels initiated by the other exchanges. CBOE 
represents that its systems capacity is sufficient to accommodate the 
increased number of automatic executions anticipated to result from 
implementation of the proposal.
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    \12\ 15 U.S.C. 78s(b)(3)(A).
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d. Variable RAES

    The proposed rule change authorizes the appropriate FPCs to 
implement Variable RAES for some or all classes of CBOE options. Under 
former procedures, RAES orders were randomly assigned to market makers, 
and each market maker had to buy or sell the entire order assigned to 
him or her. By contrast, Variable RAES will enable each market marker 
to designate a maximum number of contracts he or she is willing to buy 
or sell when a RAES order is assigned to that market maker. No market 
maker, however, will be able to designate a maximum that is less than a 
stated minimum number of contracts per assignment established by the 
appropriate FPC. In determining appropriate minimum execution levels, 
the FPC must take into account whether market makers have sufficient 
capital to fill an order that size.
    If the number of contracts in a RAES order is less than or equal to 
the market maker's specified limit, the market maker will be obligated 
to buy or sell all of the contracts in the order, and the next RAES 
order will be assigned to the next market maker on the RAES assignment 
rotation. If the number of contracts in an order exceeds the specified 
limit, the market maker will be obligated to buy or sell the number of 
contracts equal to the specified limit. The remainder of the order will 
be assigned to the next market maker on the RAES assignment rotation, 
who will likewise be obligated to buy or sell the number of remaining 
unassigned contracts in the order up to that market maker's limit. The 
assignment rotation will continue in this manner until all of the 
contracts in the order have been assigned to one or more market makers, 
even if this requires more than one assignment to the same market maker 
as the assignment rotation continues.
    Variable RAES will apply to all classes of options eligible for 
entry into RAES. CBOE represents that Variable RAES will be implemented 
following the effectiveness of this proposed rule change, and will be 
described in a circular to be distributed to the membership prior to 
that time. If the appropriate FPC decides to implement a different RAES 
order assignment procedure, CBOE will file a proposed rule change with 
the Commission pursuant to Section 19(b)(1) of the Act and Rule 19b-4 
thereunder.

e. Increase in Automation Step-Up Increment

    Finally, the proposed rule change authorizes the appropriate FPC to 
establish a ``step-up amount'' for purposes of the automatic step-up 
procedure of Interpretation and Policy .02 under Rule 6.8 that is 
greater than the minimum quote interval (``tick'') for that class of 
option under rule 6.42. The automatic step-up procedure formerly stated 
that in designated classes of multiple-traded options, if the 
Exchange's best bid or offer is inferior to the bid or offer in another 
market by no more than one tick, an order in RAES will be automatically 
excluded at the better bid or offer. The proposal enables the 
appropriate FPC to establish price differentials greater than one tick 
at which orders will be automatically executed in RAES in order to 
match better bids or offers in other markets.

f. Amendment No. 3

    Amendment No. 3 changes the language of the RAES rules to more 
clearly define the limits of the FPC's discretion to implement Variable 
RAES and increase automatic step-up increments. Amendment No. 3 also 
clarifies language in the RAES rules. Specifically, Amendment No. 3:

    (1) Requires the appropriate FPCs to provide at least three 
days' advance notice to Exchange members of the FPC's intention to 
discuss an issue relating to the RAES allocation method, and to 
provide members with the opportunity to give written comments, or 
appear at the meeting, or both. To prevent delay the FPCs may 
initially implement Variable RAES without notice and comment; 
however, that initial implementation will be subject to review at 
the next FPC meeting, pursuant to notice and comment procedures;
    (2) Describes the criteria the FPCs will consider in setting a 
minimum contract limit under Variable RAES. The Amendment explains 
that the appropriate FPC will select a minimum that is not so high 
as to discourage market makers from participating on RAES. On the 
other hand, the appropriate FPC will choose a level high enough that 
the market-makers retain the incentive to pay attention to and 
update their quotes;
    (3) Clarifies language that orders routed over RAES ``may be 
subject to such contingencies as the appropriate [FPC] shall 
approve.'' The Amendment revises this language to make clear that 
the FPC may approve certain ``contingency orders'' for routing to 
RAES. The FPC may consider whether the order can be easily 
accommodated by RAES without substantial system changes, whether the 
nature of the contingency makes it reasonable to include the order 
in RAES, and whether there is customer interest in including the 
order in RAES;
    (4) Clarifies the term ``group'' in revised Interpretation .04 
to Rule 6.8 which states that ``that first order in any group of 
rerouted orders'' will be entitled to be filled at the offer (bid) 
which existed at the time of the order's entry into the RAES system. 
The Amendment states that ``group'' refers to orders kicked out as 
the result of an instance where the prevailing market bid or offer 
is equal to the best bid or offer on the Exchange's book. When the 
market bid or offer changes or the booked order is traded such that 
the market no longer equals the book, then the instance by which an 
order will be kicked out in a particular group will have ended; and
    (5) Describes the factors that would be considered by the 
appropriate FPC in determining whether to increase the ``step-up'' 
amount beyond the minimum increment for the particular class of 
options. RAES will execute orders in designated classes at the 
National Best Bid or Offer (``NBBO'') if the NBBO is better than the 
CBOE's best bid or offer by no more than the ``step-up amount.'' In 
determining the ``step-up amount,'' the

[[Page 50315]]

appropriate FPC will consider the impact of such decision in 
attracting order flow to the Exchange, the desire or need to reduce 
the amount of orders rejected for manual handling to provide for a 
more orderly market, and any other relevant factors.

III. Discussion

    After careful review, 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.\13\ 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 Section 6 of the Act.\14\ 
Section 6(b)(5) \15\ of the Act that the rules of an exchange must be 
designed to foster cooperation and coordination with persons engaged in 
regulating, clearing, settling, processing information with respect to, 
and facilitating securities transactions. These rules also must help to 
remove impediments to and perfect the mechanism of a free and open 
market.
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    \13\ The Commission has considered to proposed rule's impact on 
efficiency, competition and capital formation. 15 U.S.C. 78c(f).
    \14\ 15 U.S.C. 78c(f).
    \15\ 15 U.S.C. 78f(b)(5).
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    Moreover, the Commission finds good cause for approving Amendment 
No. 3 prior to the 30th day after the date the Amendment is published 
for comment in the Federal Register pursuant to Section 19(b)(2) of the 
Act.\16\ Amendment No. 3 addresses the discretion of the FPCs to 
implement Variable RAES and expand the automatic step-up increment, but 
does not otherwise affect the operation of RAES. In view of the 
immediate need of RAES market makers to limit their risk to compensate 
for increased exposure to the larger RAES order sizes, the Commission 
finds that acceleration of Amendment No. 3 is appropriate.
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    \16\ 15 U.S.C. 78s(b)(2).
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    The Commission does not object at this time to extending the 
benefits available through RAES to larger-size customer orders up to 50 
contracts. The Commission believes that increasing to 50 the number of 
option contracts executable through RAES will enable the Exchange to 
more effectively and efficiently manage increased order flow in 
actively traded option classes consistent with its obligations under 
the Act. In addition, this increase should bring the speed and 
efficiency of automated execution to a greater number of retail orders. 
The Commission also believes that the CBOE should have flexibility to 
compete for order flow with other exchanges without being limited to 
responding to increases in automatic execution eligibility levels 
initiated by those other exchanges. The Commission notes that it has 
approved similar proposals by other exchanges increasing to fifty the 
maximum size of orders that may be executed automatically.\17\
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    \17\ See Securities Exchange Act Release No. 36601 (December 18, 
1995), 60 FR 66817 (December 26, 1995); see also Securities Exchange 
Act Release No. 41823 (September 1, 1999) (SR-PCS-99-04).
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    The Commission believes, based on representations by the Exchange, 
that the increase will not expose RAES to risk of failure or 
operational breakdown. Our approval of this increase is expressly 
conditioned on CBOE's representation that its systems capacity is 
sufficient to accommodate the increased number of automatic executions 
anticipated to result from implementation of this proposal.
    Although the Commission has a degree of comfort with respect to the 
proposed increase, the Commission notes that any proposed increases 
above fifty contracts may raise additional issues, including such 
matters as market maker financial exposure, price improvement, and 
quote dissemination. Because of these concerns, the Commission welcomes 
the opportunity to review the Exchange's experience with any increase 
in maximum order size to fifty contracts. If, in the future, exchanges 
seek to increase order size levels above fifty contracts, this 
examination will help the Commission assess whether such increases are 
appropriate and, if so, whether the Commission should seek additional 
assurances regarding such increases.
    In addition, the Commission is persuaded that permitting the CBOE 
to implement Variable RAES is appropriate. Variable RAES allows RAES 
market makers to choose the level of risk they are comfortable with 
(subject to minimum size requirements set by the (FPCs). Allowing 
market makers to limit their risk in this way is particularly important 
because the CBOE may increase the maximum size of orders eligible for 
RAES from 20 to 50 contracts in many options classes, thus increasing 
the potential exposure of RAES market makers to risk in those options. 
In approving Variable RAES, however, the Commission emphasizes that its 
approval is expressly conditioned on the CBOE's representation that the 
FPCs will take market maker capitalization into account in setting the 
RAES order size minimums, thus further reducing the risk market makers 
and exposed to. Accordingly, the Commission finds that increasing the 
maximum size of RAES orders, in conjunction with implementation of 
Variable RAES, will serve to remove impediments to a free and open 
market while fostering investor protection, consistent with section 
6(b)(5) of the Act.
    Finally, the Commission finds that allowing the FPCs to expand the 
step-up limit beyond one tick for multiply traded options removes 
impediments to a free and open market and protects investors consistent 
with Section 6(b)(5) of the Act, by increasing the likelihood that RAES 
investors will gain to superior bids and offers available in another 
market.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 3, including whether it is 
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, DC 20549-0609. Copies 
of the submission, all subsequent amendments, all written statements 
with respect to the Amendment that are filed with the Commission, and 
all written communications relating to the Amendment 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 in the Commission's Public 
Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the CBOE. All 
submissions should refer to File No. SR-CBOE-99-17 and should be 
submitted by October 7, 1999.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\18\ that the proposed rule change (SR-CBOE-99-17) be, and hereby 
is, approved; and that Amendment No. 3 is approved on an accelerated 
basis.
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    \18\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-24115 Filed 9-15-99; 8:45 am]
BILLING CODE 8010-01-M