[Federal Register Volume 65, Number 44 (Monday, March 6, 2000)]
[Notices]
[Pages 11823-11826]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-5381]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42472; File No. SR-ISE-00-01]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the International Securities Exchange LLC Relating to Market 
Maker Allocations

February 29, 2000.
    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 February 25, 2000 the International Securities Exchange LLC (the 
``Exchange'' or the ``ISE'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by the ISE. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I.Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The ISE is proposing commentary to ISE Rule 713(e) regarding 
precedence of non-customer orders and market maker quotes to define its 
trading algorithm. Proposed new language is in italics.
* * * * *
    Rule 713  Priority of Quotes and Orders
    No change to text of Rule

Supplementary Material To Rule 713

    .01  Rule 713(e) (Priority of Quotes and Orders) states that Public 
Customer Orders have priority on the Exchange. That rule further 
provides that the Exchange will determine a procedure for allocating 
executions among Non-Customer Orders and market maker quotes in cases 
where all Public Customer Orders have been executed and there are two 
or more Non-Customer Orders or market maker quotes at the best price. 
This procedure is as follows:
    (a) Subject to the two limitations below, Non-Customer Orders and 
market maker quotes at the best price receive allocations based upon 
the percentage of the total number of contracts available at the best 
price that is represented by the size of the Non-Customer Order or 
quote;
    (c) If the Primary market Maker is quoting at the best price, it 
has participation rights equal to the greater of (i) the proportion of 
the total size at the best price represented by the size of its quote, 
or (ii) sixty percent (60%) of the contracts to be allocated if there 
is only one (1) other Non-Customer Order or market market quotation at 
the best price, forty percent (40%) if there are two (2) other Non-
Customer Orders and/or market maker quotes at the best price, and 
thirty percent (30%) if there are more than two (2) other Non-Customer 
Order and/or market maker quotes at the best price; and
    (c) Orders for five (5) contracts or fewer will be executed first 
by the Primary Market Maker; provided however, that on a semi-annual 
basis the Exchange will evaluate what percentage of the volume executed 
on

[[Page 11824]]

the Exchange is comprised of orders for five (5) contracts or fewer 
executed by Primary Market Makers, and will reduce the size of the 
orders included in this provision if such percentage is over forty 
percent (40%).
    This procedure only applies to the allocation of executions among 
Non-Customer Orders and market maker quotes existing in the Exchange's 
central order book at the time the order is received by the Exchange. 
No market participant is allocated any portion of an execution unless 
it has an existing interest at the execution price. Moreover, no market 
participant can execute a greater number of contracts than is 
associated with the price of its existing interest. Accordingly, the 
Primary Market Maker participation rights and the small order 
preference contained in this allocation procedure are not guarantees; 
the Primary Market Maker (i) must be quoting at the execution price to 
receive an allocation of any size, and (ii) cannot execute a greater 
number of contracts than the size that is associated with its quote.
* * * * *

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 ISE 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 IV below. The ISE 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
    ISE Rule 713(d) provides that customer orders at a given price have 
priority based on the time priority of such orders. ISE Rule 713(e) 
provides that, if there are two or more noncustomer orders or market 
maker quotations at the Exchange's inside market, after filling all 
customer orders at that price, executions will be allocated between the 
non-customer orders and market maker quotations ``pursuant to an 
allocation procedure to be determined by the Exchange from time to time 
* * *.'' ISE Rule 713(e) also states that, if the Primary Market Maker 
(``PMM'') is quoting at the Exchange's inside market, it will have 
precedence over non-customer orders and Competitive Market Maker 
(``CMM'') quotes for execution of orders that are up to a specified 
number of contracts. The purpose of the proposed rule change is to 
establish the ISE's allocation procedure for non-customer orders and 
market maker quotations, and to define the size of orders for which the 
PMM has priority.
    The allocation procedure is a trading algorithm programmed in the 
ISE's electronic auction market system (the ``System'') that determines 
how to split the execution of incoming orders among professional 
trading interests at the same price. All public customer orders at a 
given price are always executed fully before the trading algorithm is 
applied. Moreover, because the algorithm is applied automatically by 
the System upon the receipt of an executable order, only those non-
customer orders and market maker quotes that are in the System 
participate in the algorithm. Thus, there is no opportunity for a 
market participant to receive an allocation unless it had an order or 
quote in the System at the execution price at the time the System 
received the incoming order.
    Subject to the PMM's participation rights discussed below, the 
allocation of executions to non-customer orders and market marker 
quotes is based on the size associated with the order or quote relative 
to the total size available at the execution price. For example, assume 
there is a public customer order for 10 contracts, a non-customer order 
for 60 contracts and a CMM quotation for 40 contacts in the System at 
the best bid price, so that there is a total of 110 contracts available 
at the best bid. If a market order to sell 30 contracts is received, 
the customer order to buy 10 contracts will be executed first. The 
trading algorithm is then applied to allocate the remaining 20 
contracts to sell between the non-customer order and CMM quote. The 
non-customer order is 60 percent of the available size at the best bid 
(60 out of 100) and the CMM quote is 40 percent of the size available 
at the best bid (40 out of 100). Therefore, twelve contracts will be 
allocated to the non-customer order (60 percent of 20 is 12) and eight 
contracts will be allocated to the CMM (40 percent of 20 is 8). The 
size associated with the non-customer order and CMM quote are then 
reduced by twelve and eight respectively, so that there is a total of 
80 contracts available at the best bid following the execution of the 
market order. This entire process will be completed by the System in a 
fraction of a second.
    The Exchange believes that priority for non-customer orders and 
market maker quotes based on size at the execution price, rather than 
on strict time priority, is beneficial because size priority encourages 
market participants to provide deeper, more liquid markets.\3\ 
Participants with larger size receive a proportionately larger share of 
the execution, and participants that have small trading interests are 
not ``sized-out'' because all participants share in the executions. In 
contrast, the Exchange believes that time priority creates a race to 
enter trading interest first and does not give all participants an 
opportunity to trade. This is especially problematic in an electronic 
market, where entering an order or quote one micro-second (1/100 of a 
second) ahead of another order or quote is possible and would provide 
absolute priority for the first order that arrives. It also is 
problematic in a derivative market, where the price of a quote or order 
is based, in large part, on the price of the underlying instrument. In 
the Exchange's view, a time priority system would disadvantage less 
technologically advanced market participants and encourage competition 
based upon the speed of auto-quoting mechanisms. The Exchange does not 
believe that this type of competition would encourage participants to 
provide accessible and liquid markets.
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    \3\ Orders at the same price with the same size receive 
allocations in time priority.
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    Because PMMs have unique obligations to ISE's market,\4\ they are 
provided with certain participation rights. If the PMM is one of the 
participants with a quote at the best price, it has participation 
rights equal to the greater of (1) the proportion of the total size at 
the best price represented by the size of its quote, or (2) 60 percent 
of the contracts to be allocated if there is only one other non-
customer order or market maker quotation at the best price, 40 percent 
if there are two other non-customer orders and/or market maker quotes 
at the best price, and 30 percent if there are more than two other non-
customer orders and/or market maker quotes at the best price. In 
addition, the PMM has precedence to execute orders of five contracts or 
fewer. This means that such ``odd-lot'' orders will be executed first 
by the PMM if it is quoting at the best price.
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    \4\ For example, PMMs are responsible for: ensuring that all ISE 
disseminated quotations are for at least 10 contracts; addressing 
customer orders that cannot be automatically executed when another 
market is disseminating a better quotation; and opening the market. 
See ISE Rule 803(c).
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    These participation rights are programmed into the trading 
algorithm,

[[Page 11825]]

so that they are applied automatically by the System when splitting 
executions among non-customer orders and market maker quotes after 
public customer orders at the same price are fully executed as 
described above. Consequently, like any other market participant, the 
PMM cannot receive any portion of an allocation, regardless of its 
participation rights, unless it is quoting at the best price at the 
time the System receives the executable order. Moreover, the size 
associated with the PMM's quote must be sufficient to fill the portion 
of the order that would be allocated to it according to the 
participation rights. For example, if a PMM would be allocated 30 
contracts according to its participation rights, but the size of its 
quote is only 20 contracts, the PMM would receive an allocation of only 
20 contracts. If the size associated with a PMM's quote is only three 
contracts when an executable order for five contracts is received 
(assuming there are no public customer orders), the PMM would execute 
only three contracts.
    According to the participation rights, a PMM quoting at the inside 
market generally is allocated the plurality of an order. For example, 
if both a PMM and CMM are quoting at the inside market for 50 contracts 
each, an incoming order for 10 contracts will be allocated between the 
two for six and four contracts respectively (a 60% allocation to the 
PMM). If the PMM is quoting for 50 contracts and there are two CMMs 
each quoting for 50 contracts, the PMM is allocated four contracts and 
the two CMMs are allocated three each (40 percent for the PMM, and the 
remaining 60 percent split equally between the CMMs because they are 
quoting an equal size). At a minimum, a PMM will be allocated 30 
percent of an order, regardless of the number of other quotes or orders 
at that price.\5\
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    \5\ The size associated with the PMM's quote, however, must be 
sufficient to fill the 30 percent allocation. Under no 
circumstsances may the PMM execute more than the size associated 
with its displayed quote.
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    PMMs quoting at the ISE's inside market will trade against all 
incoming orders of five contracts or less first. The size of an ISE 
``odd lot'' is roughly equivalent to the similar concept in the equity 
markets. Specifically, the average options contract premium is 
approximately $542.\6\ Thus, the premium for the average options five-
lot is approximately $2,710. This is equivalent to the purchase price 
of an odd-lot of 63 shares of stock traded on the New York Stock 
Exchange (``NYSE'') \7\ or 49 shares of the 600 securities that likely 
will underlie options traded on the ISE.\8\ The Exchange believes that 
this participation right will not necessarily result in a significant 
portion of the Exchange's volume being executed by a PMM. As stated 
above, a PMM only will execute against such orders if it is quoting at 
the best price, and only for the number of contracts associated with 
its quotation. Nevertheless, on a semi-annual basis, the Exchange will 
evaluate what percentage of the volume executed on the Exchange is 
comprised of orders for five contracts or fewer executed by PMMs, and 
will reduce the size of the orders included in this provision if such 
percentage is over 40 percent.
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    \6\ See Options News Network Internet web site (http://onn.theocc.com).
    \7\ The average price of a share of stock traded on the NYSE in 
1998 was $43.10. NYSE 1998 Fact Book at 11.
    \8\ The average price of a share of these 600 stocks was $55.41 
as of January 2000.
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    The proposed participation rights for PMMs described above is part 
of the ISE's balancing of the rewards and obligations that pertain to 
each of the Exchange's classes of memberships. This balancing is part 
of the overall market structure that is designed to encourage vigorous 
price competition between market makers on the Exchange, as well as 
maximize the benefits of price competition resulting from the entry of 
customers and non-customer orders, while encouraging participants to 
provide market depth.\9\
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    \9\ The other options exchanges also have participation rights 
for their specialists, designated primary market makers and lead 
market makers. See Amex Rule 950(d) and 126(e); CBOE Rule 
8.80(c)(7); PCX Rule 6.82(d)(2); PHLX Rule 1014(g).
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    The ISE is the first exchange in the United States to attempt to 
combine all of the elements of an auction market in an electronic 
environment. The Exchange believes the proposed trading algorithm, 
which includes participation rights for PMMs only when they are quoting 
at the best price, strikes the appropriate balance within its market 
and will maximize the benefits of an electronic auction market for all 
participants.
2. Statutory Basis
    The ISE believes that the proposed rule change is consistent with 
the provisions of Section 6(b)(5) of the Act,\10\ which requires that 
an exchange have rules that are designated to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system, and, in general, to 
protect investors and the public interest.
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    \10\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The ISE does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

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

    Written comments on the proposed rule change were neither solicited 
nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the ISE consents, the Commission will:
    (A) By order approve the proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change 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 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 
ISE. All submissions should refer to File No.

[[Page 11826]]

SR-ISE-00-01 and should be submitted by March 27, 2000,

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\11\
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    \11\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-5381 Filed 3-3-00; 8:45 am]
BILLING CODE 8010-01-M