[Federal Register Volume 64, Number 229 (Tuesday, November 30, 1999)]
[Notices]
[Pages 66952-66954]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-31027]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42168; File No. SR-CBOE-99-61]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change by the Chicago 
Board Options Exchange, Inc. Relating to Non-Automatic Handling of RAES 
Orders

November 22, 1999.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on November 8, 1999, the Chicago Board Options Exchange, Inc. (``CBOE'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I and 
II below, which Items have been prepared by the Exchange. On November 
22, 1999, CBOE submitted Amendment No. 1 to the proposed rule 
change.\3\ The Commission is publishing this notice and order to 
solicit comments on the proposed rule change from interested persons 
and to approve the proposal on an accelerated basis for a ninety day 
pilot to expire on February 21, 2000.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No. 1, CBOE shortened the length of the pilot 
program from one year to ninety days. See letter from Timothy 
Thompson, Director, Regulatory Affairs, CBOE, to Richard Strasser, 
Assistant Director, Division of Market Regulation, Commission, dated 
November 19, 1999.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    CBOE proposes to amend its rule governing the operation of its 
Retail Automatic Execution System (``RAES'') to allow, under certain 
circumstances, orders to be rejected from RAES and routed to the Public 
Automated Routing terminal (``PAR'') for manual handling. The text of 
the proposed rule change is available at the Office of the Secretary, 
CBOE and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the CBOE included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item III below. The CBOE has prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The purpose of the proposal is to allow, under certain 
circumstances, orders to be rejected from RAES for manual handling 
where the bid or offer for a series of options generated by the 
Exchange's Autoquote system becomes crossed or locked with the best 
offer or bid for that series as established by a booked order. The 
proposed rule is intended to correct an unintended consequence of the 
planned implementation of the Automated Book Priority (``ABP'') system 
that could have significant detrimental effects on the operation of the 
RAES as described further below. The CBOE anticipates that the number 
of orders that will be rejected from RAES under this proposed rule 
should represent only a small subset of the orders that have been and 
currently are rejected pending implementation of the ABP system.
    The Exchange's ABP system will allow an order entered into RAES to 
trade directly with an order on the Exchange's customer limit order 
book where the prevailing market bid or offer is equal to the best bid 
or offer on the Exchange's book.\4\ The Commission recently approved 
the Exchange's rules implementing the ABP system,\5\ which has not yet 
been implemented.\6\
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    \4\ In the event the order in the book is for a smaller number 
of contracts than the RAES order, the balance of the RAES order will 
be assigned to participating market-makers at the same price at 
which the rest of the order was executed.
    \5\ See Securities Exchange Act Release No. 41995 (October 8, 
1999), 64 FR 56547 (October 20, 1999) (File No. SR-CBOE-99-29).
    \6\ Currently, with certain exceptions discussed below, when a 
RAES order is entered into the Exchange's Order Routing System when 
the prevailing market bid or offer is equal to the best bid or offer 
on the Exchange's book, the order will be routed electronically to a 
Floor Broker's terminal or work station in the crowd subject to the 
volume parameters of each firm. Today, the orders are routed to the 
Floor Brokers instead of being automatically executed in the crowd 
at the market price, because execution with the crowd would be 
inconsistent with CBOE Rule 6.45, which provides that bids or offers 
displayed on the customer limit order book are entitled to priority 
over other bids or offers at the same price. CBOE permits RAES 
orders in options on IBM, options on the Dow Jones Industrial 
Average (DJX) and options on the Standard & Poor's 100 Stock Index 
(OEX) to be executed on RAES even if the prevailing market bid or 
offer equals the best bid or offer on the Exchange's book. In other 
words, RAES orders in these options classes are currently allowed to 
``trade through'' the book. Upon implementation of the ABP system, 
RAES orders in these option classes, like all other option classes, 
will trade against orders in the book in these circumstances.
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    The Exchange recently became aware of an unintended consequence of 
the operation of the ABP system. That is, in situations where the best 
bid or offer for one or more series of a particular option class is 
established by one or more orders in the book, the market-makers logged 
on to RAES for that class of options could be subject to a substantial 
risk in the event that the market in the underlying stock moves 
significantly and quickly in a direction that makes the booked order 
price substantially better than the price calculated by CBOE's 
Autoquote formula. In that event, while the booked order would quickly 
be executed, CBOE represents that the ABP system may not be able to 
react quickly enough to remove the executed order from the limit order 
book. As a result, once ABP is implemented, orders entered in RAES 
would automatically be executed against the stale bid or offer still 
being shown in the book notwithstanding the booked order having already 
been executed. CBOE contends that this result could cause direct and 
substantial economic disadvantage to the market-makers who are 
obligated to participate in RAES executions. The Exchange believes that 
implementing ABP without addressing this potential risk could cause 
market-makers to avoid participating on RAES (thus, affecting the 
liquidity of lower volume series traded on RAES and endangering the 
viability of RAES), or to widen their quotes to minimize the possible 
adverse consequences of executing orders based on stale quotes and to 
account for the potential losses (thus, affecting the ability of CBOE's 
market-makers to compete with competing specialists or market-makers). 
In the alternative, market-makers might request that the Equity Floor 
Procedure Committee reduce the size of orders eligible for RAES to 
minimize the impact of these orders (thus, eliminating a significant 
advance in automatic execution that CBOE represents its customers have 
requested).

[[Page 66953]]

    CBOE explains the potential risk market-makers could be subject to 
by implementing the ABP system without the proposed ``carve out'' by 
way of example. Assume that in a volatile internet stock (where the 
maximum order size for RAES has been established at 50 contracts) small 
customer orders in the book are establishing the best bid in six 
different series. In one particular series, Series A, assume that the 
CBOE market is 5 (bid)--5\1/8\ (offer), with a book order to buy 5 
contracts at $5 (which establishes the best bid). Assume further that 
the price of the underlying internet stock drops precipitously in a 
matter of seconds. When the underlying stock moves, the Exchange's 
Autoquote system will update CBOE market-makers' quotes for the options 
overlying that stock. \7\ Assume with the drop in the underlying stock, 
the Exchange's Autoquote system establishes a bid and offer of 4\3/4\--
4\7/8\ for Series A. (The same scenario would play out with the other 
five series whose best bid is established by an order in the book.) The 
order in the book representing the best bid will likely be immediately 
executed by the crowd in the auction market. For some period of time 
after the trade has been consummated in open outcry, however, the bid 
will still be displayed as CBOE's bid while the Order Book Official 
physically punches the keys to take the bid down from the display. 
During the period, the displayed bid of 5 in the book will be out of 
line with the theoretical bid 4\3/4\ generated by CBOE's Autoquote 
system. In the meantime, traders who have equipped themselves with the 
necessary computer equipment and communications facilities could have 
identified the pricing disparity between the theoretical price of the 
options and the displayed best bids, could automatically generate 
orders to sell the affected options and route those orders to RAES. If 
RAES is allowed to operate as it does under normal circumstances, each 
order to sell that arrives at the Exchange from these investors, for so 
long as the out-of-line book bid continues to be displayed, will be 
assigned to market-makers in the trading crowd who are logged on to 
RAES. These market-makers in turn will be obligated to buy at the $5 
bid, which could be significantly away from the theoretical bid.\8\ Of 
course, the same adverse consequence could be experienced in the other 
five series of the class in which the bid was established by a booked 
order.
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    \7\ In approving this pilot, the Commission takes no position 
with respect to the procedures involved in CBOE's Autoquote system, 
which are the subject of pending proposal SR-CBOE-98-04.
    \8\ If, for example, six different traders use such a system to 
identify pricing disparities and to generate and send orders 
instantly for automatic execution, market-makers in the trading 
crowd could be responsible for trading 295 or 300 contracts of 
Series A options alone, reflecting an aggregate payment of as much 
as $150,000 more than their theoretical value. The maximum number of 
contracts to be purchased in response to six orders for 50 contracts 
each would be 300 contracts, except in the unlikely event that the 
original 5 contract order on the book had not yet been filled, in 
which case 5 contracts of the orders received would trade with the 
booked order, and market makers would be obligated to buy the 
remaining 295 contracts.
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    The Exchange believes that by rejecting orders from RAES in the 
limited situation where the bids or offers generated by Autoquote 
become crossed or locked with the CBOE's best bid or offer as 
established by an order in the Exchange's customer limit order book, 
the problem described above can be resolved without any significant 
disruption in the proper handling of customer orders or to the market 
as a whole. The Exchange will then be able to offer RAES to its 
customers together with the benefit of the ABP system, which will allow 
RAES orders to trade directly with orders on the Exchange's customer 
limit order book. Those orders that are rejected from RAES in the 
limited circumstances when Autoquote crosses or locks the book will be 
immediately and automatically routed to a broker's PAR terminal in the 
trading crowd (absent contrary instructions of the firm), where they 
will be represented by the broker and, if executable, will ordinarily 
be executed in seconds. Because these orders remain RAES eligible, they 
will be entitled to receive firm quote treatment when they are 
represented in the crowd.
    The Exchange represents that during the course of the pilot 
program, the Exchange will monitor those situations in which RAES 
orders are rejected as provided in the rule and will prepare a report 
to the Commission describing its experience with the rule before the 
end of the pilot program.
2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with and furthers the objectives of Section 6(b)(5)\9\ of the Act in 
that it is designed to remove impediments to a free and open market and 
to protect investors and the public interest.
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    \9\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The CBOE does not believe that the proposed rule change will impose 
any burden on competition.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    No written comments were solicited or received with respect to the 
proposed rule change.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. 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 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-99-61 and should be 
submitted by December 21, 1999.

IV. Commission's Findings and Order Granting Accelerated Approval 
of Proposed Rule Change

    After careful review, the Commission finds that the proposed pilot 
is consistent with the requirements of the Act.\10\ In particular, the 
Commission finds the proposal is consistent with Section 6(b)(5) \11\ 
of the Act. Section 6(b)(5) requires, among other things, that the 
rules of an exchange be designed to promote just and equitable 
principles of trade and to protect investors and the public interest.
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    \10\ In addition, pursuant to Section 3(f) of the Act, the 
Commission has considered the proposed rule's impact on efficiency, 
competition, and capital formation. 15 U.S.C. 78c(f).
    \11\ 15 U.S.C. 78f(b)(5).
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    The Commission believes that it is imperative that CBOE implement 
the ABP system as expeditiously as possible to ensure that all customer 
limit orders on CBOE are, where appropriate, given priority over other 
interest on the Exchange. After the ABP system is implemented, RAES 
orders will be able to trade against orders in the book when the 
prevailing market bid or offer equals the best bid or offer in the 
Exchange's

[[Page 66954]]

limit order book. Implementation of the ABP system should provide for 
more efficient execution of both RAES and booked orders. The proposed 
rule change, which would result in RAES orders being routed to the 
trading crowd when the Exchange's Autoquote system locks or crosses 
CBOE's best bid or offer as established by the book, limits market-
maker risk where CBOE is unable to remove a quote based on a customer 
limit order that has already been executed. The Exchange has 
represented that this exception should occur very infrequently.
    In light of the likely benefits to customer limit orders expected 
to be gained by implementation of the ABP system, particularly in those 
classes, discussed above, where CBOE currently permits RAES orders to 
trade through orders on the limit order book, the Commission finds good 
cause for approving the proposed rule change prior to the thirtieth day 
after the date of publication of notice thereof in the Federal 
Register. The Commission hereby requests that CBOE provide monthly 
reports to the Commission regarding the number of times the exception 
that is the subject of this pilot is used to allow the Commission to 
determine whether to approve the proposal permanently.\12\
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    \12\ The approval of the pilot should not be interpreted as 
suggesting that the Commission is predisposed to approving the 
proposal permanently.
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\13\ that the proposed rule change (SR-CBOE-99-61) is hereby 
approved through February 21, 2000.
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    \13\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
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    \14\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-31027 Filed 11-29-99; 8:45 am]
BILLING CODE 8010-01-M