[Federal Register Volume 65, Number 70 (Tuesday, April 11, 2000)]
[Notices]
[Pages 19401-19407]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-8880]


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SECURITIES AND EXCHANGE COMMISSION

(Release No. 34-42615; File No. SR-CBOE-00-03)


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change by the Chicago 
Board Options Exchange, Inc., Relating to Rejecting RAES Orders in 
Certain Limited Situations

April 3, 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 22, 2000, 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. 
In this proposed rule change, CBOE seeks to

[[Page 19402]]

extend a pilot program that was first approved by the Commission on 
November 22, 1999.\3\ On March 22, 2000, CBOE filed Amendment No. 1 to 
the proposed rule change.\4\ The Commission received eight comment 
letters on the pilot program.\5\ The Exchange's response to these 
comment letters can be found in Item IV. The Commission is publishing 
this notice and order to solicit comments on the proposal from 
interested persons and to approve the proposal on an accelerated basis 
for a 6 month pilot that will expire on August 22, 2000.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Release No. 34-42168 (November 22, 1999), 64 FR 66952 
(November 30, 1999) (File No. SR-CBOE-99-61).
    \4\ In Amendment No. 1, the CBOE amended the filing to respond 
to questions from the Commission staff and to incorporate these 
responses into the text of the rule filing. In addition, the CBOE 
proposed to adopt an Interpretation that provides protection for 
orders kicked out of RAES when the prevailing market bid or offer is 
equal to the best bid or offer on the Exchange's book. This 
Interpretation, which was part of CBOE's rules until October 1999, 
would apply to option classes where the Automated Book Priority 
system has not been implemented (Interpretation .04 to CBOE Rule 
6.8). See letter from Timothy Thompson, Director, Regulatory 
Affairs, CBOE, to Elizabeth King, Associate Director, Division of 
Market Regulation, Commission, dated March 21, 2000 (``Amendment No. 
1'').
    \5\ See letters from George Brunelle, Law Offices of George 
Brunelle, to Secretary, Commission, dated December 20, 1999 
(``Brunelle Letter 1''); James I. Gelbort, to Jonathan G. Katz, 
Secretary, Commission, dated December 21, 1999 (``Gelbort Letter''); 
Thomas Peterffy, Chairman, and David M. Battan, Vice President and 
General Counsel, Interactive Brokers, The Timber Hill Group, to 
Jonathan G. Katz, Secretary, Commission, dated December 21, 1999 
(``IB Letter''); Linda S. Tors, to Jonathan G. Katz, Secretary, 
Commission, dated January 6, 2000 (``Tors Letter''); Thomas Coyle, 
to Jonathan G. Katz, Secretary, Commission, dated January 3, 2000 
(``Coyle Letter''); John Rohde, to Jonathan G. Katz, Secretary, 
Commission, dated January 9, 2000 (``Rohde Letter''); Brent Houston, 
Senior Vice President, Capital Markets, Datek Online, to Jonathan G. 
Katz, Secretary, Commission, dated February 1, 2000 (``Datek 
Letter''); George Brunelle, Brunelle & Hadjikow, to Jonathan G. 
Katz, Secretary, Commission, dated March 23, 2000 (``Brunelle Letter 
2''). The Division of Market Regulation received Brunelle Letter 2 
on March 28, 2000. In Brunelle Letter 2, the commenter generally 
reiterates the comments from his previous letter (Brunelle Letter 1) 
and also comments on another CBOE rule filing, SR-CBOE-99-57.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The CBOE proposes to extend, for a 6 month period, a pilot program 
that provides for certain orders to be rejected from RAES for manual 
handling in certain limited situations. The text of the proposed rule 
change is available at the CBOE and at the Commission's public 
reference room.

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. The 
text of these statements may be examined at the places specified in 
Item V 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

    The purpose of the proposed rule filing is to extend, for an 
additional 6 month period, the pilot program that provides (where the 
Exchange's Automated Book Priority (``ABP'') system has been 
implemented) for certain orders to be rejected from RAES for manual 
handling in the limited situation where the bid or offer for a series 
of options generated by the Exchange's Autoquote system becomes crossed 
or locked with the best bid or offer for that series as established by 
a booked order. The Exchange believes this limited kick-out situation 
provided by the pilot program is the best alternative currently 
available to the Exchange to address the particular risk presented by 
the unusual situation where the Autoquote crosses or locks with an 
order in the Exchange's book. In fact, as described further below, the 
Exchange has found that only 0.44% of all orders (in those classes 
where the ABP system has been implemented) routed to RAES would be 
rejected pursuant to the pilot program.
1. Background
    The Exchange's ABP system allows an order entered into RAES to 
trade directly with an order on the Exchange's customer limit order 
book in those cases where the prevailing market bid or offer is equal 
to the best bid or offer on the Exchange's book.\6\ The Commission 
approved the Exchange's rules implementing the ABP system in October 
1999,\7\ however, these rule changes do not become operative in a 
particular class until the Exchange implements the ABP system in that 
class.\8\ In those classes in which the ABP system has yet not been 
implemented, orders are still subject to Interpretation .04, which 
requires an order to be rerouted from RAES in the event that an order 
in the book is establishing the prevailing best bid or offer (whichever 
one is relevant to the particular order).\9\ The Exchange is not 
proposing to provide this extra protection to orders that are rejected 
where the ABP system has been implemented for a number of reasons. 
First, as the Exchange noted in its original filing, in most cases 
where the order is kicked out due to an Autoquote inversion, the booked 
order already will have been traded in open outcry before the incoming 
RAES orders are received. In addition, the Exchange's systems have been 
designed such that a rejected order will normally be routed directly to 
the Exchange's electronic brokerage terminal (``PAR'') in the trading 
crowd and will appear on that PAR machine instantaneously. 
Consequently, these rejected orders will routinely be represented in 
the trading crowd within a matter of seconds of being rejected. These 
orders will be entitled, by virtue of the firm quote rule, to be 
executed at the bid or offer displayed when that order reaches the 
trading station.
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    \6\ In the event that the order in the book is for a smaller 
number of contracts than the RAES order, the balance of the RAES 
order would be assigned to participating market makers at the same 
price at which the rest of the order is to be executed
    \7\ See Release No. 34-41995 (October 8, 1999), 64 FR 56547 
(October 20, 1999) (File No. SR-CBOE-99-29).
    \8\ As of February 10, 2000, ABP has been implemented in over 
150 classes of equity options on the Exchange floor, including many 
of the most actively traded option classes. ABP has been implemented 
in options classes at every trading station on the floor. As the 
Exchange has noted to Commission staff, the Exchange will continue 
to roll out ABP to the other option classes on the floor in any 
orderly manner--in a manner designed to ensure the continued 
integrity of the ABP system.
    \9\ In those classes where ABP has not yet been implemented, 
when a RAES order is entered into the Exchange's Order Routing 
System at a time when the prevailing market bid or offer is equal to 
the best bid or offer on the Exchange's book, the order generally is 
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. Until ABP is implemented in the particular class, the 
first such order rerouted from RAES due to a situation in which the 
book touches the market is entitled to be filled at the prevailing 
quote at the time the order was rerouted. See Amendment No. 1.
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    As described in the prior filing, in the course of planning for the 
implementation of the ABP system, the Exchange became aware of an 
unintended consequence of the operation of the ABP system. That is, the 
Exchange realized that in situations where the best bid or offer for 
one or more series of a particular class is established by one or more 
orders in the

[[Page 19403]]

book, the market makers logged into RAES for that class of options 
would be subject to a substantial risk in the event that the market in 
the underlying stock moved significantly and quickly in a direction 
that made the booked order 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.\10\ The Exchange 
believes there is no question that the consequence of implementing ABP 
without addressing this substantial increased risk is that (i) market 
makers may choose not to participate on RAES (thus, affecting the 
liquidity of those lower volume series traded on RAES and endangering 
the viability of RAES itself) and/or (ii) market makers may request the 
Equity Procedure Committee to either reduce the size of orders eligible 
for RAES or to take some series off of RAES (thus, eliminating 
significant advances in automatic execution that our customers have 
requested).
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    \10\ 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 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 
moves, the Exchange's Autoquote system will also update CBOE market 
makers' quotes for the options overlying that stock. Assume with the 
drop in the underlying, the Exchange's Autoquote system establishes 
a bid and offer of 4\3/4\-\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 this 
period, the displayed bid of 5 in the book will be out of line with 
the theoretical bid of 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 now be significantly 
away from the theoretical bid. Of course, the same adverse 
consequences 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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    As mentioned in that prior filing, the Exchange expected the number 
of orders that would be rejected from RAES under this proposed rule 
would represent only a small subset of the orders that were rejected in 
those same classes before ABP was implemented in those classes. In 
fact, the Exchange has found that the number of kick-outs resulting 
from the implementation of this system is a remarkably small percentage 
of the RAES-eligible orders. Of the 150 classes in which ABP had been 
implemented as of February 14, the Exchange found that only 44 of those 
classes had an ABP order on that day. Over the course of that day, 5908 
orders were routed to RAES in those particular 44 classes accounting 
for 41,102 contracts. Of those 5908 orders, 1054 orders (representing 
9017 contracts) were handled by ABP, i.e. they were traded against 
orders in the book and in some cases also against market makers at the 
price of the booked order. In all 44 classes during the course of the 
day, there were only 26 orders (representing 130 contracts) rejected 
from RAES due to the Autoquote bid or offer crossing or locking with 
the price of the booked order.\11\ This is, on average, less than one 
order per day per class that was rejected pursuant to the pilot program 
and amounts to only 0.44% of the orders routed to RAES in those 44 
classes and only 0.31% of all the contracts routed to RAES in those 44 
classes.\12\ It should also be noted that if ABP had not been 
implemented in those classes, all 1054 orders that were handled by ABP 
would have been rejected from RAES for manual handling because of the 
situation in which the book touches the market. With ABP in place along 
with the limited kick-out, only 2.46% of the orders (and 1.44% of the 
contracts) that would have been rejected without ABP are now rejected 
with ABP.
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    \11\ In those 44 classes in which an ABP order was received, 26 
orders were rejected. While there was a limited concentration of the 
kickouts in certain classes, no class had more than 5 kickouts for 
the entire day. Of the 26 rejects, 19 of them occurred in five 
classes as follows: CSCO (Cisco Systems)--5, YHOO (Yahoo! Inc.)--4, 
CMGI (CMGI Inc.)--4, AOL (America Online, Inc.)--3, QCOM (Qualcomm 
Inc.)--3.
    \12\ Of course, a more revealing statistic might be the 
percentage of RAES orders rejected compared to all RAES orders 
received in those 150 classes in which ABP had been implemented, not 
only those classes in which an ABP order was received. The 
percentages for the 150 ABP classes would be significantly lower 
than they are for the 44 classes alone.
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Other Alternatives
    The Exchange believes that the present alternative of rejecting 
RAES orders in the limited situation it has described is the most 
effective way to provide the benefits of the ABP system without 
creating such a great risk to Exchange market makers that they choose 
not to participate on RAES, or that they encourage the appropriate 
Floor Procedure Committee to offer only a few active series on RAES. 
During the 6 month pilot period, the Exchange will continue to seek 
other alternatives to having these orders rejected. Among the 
alternatives the Exchange is presently considering are: (i) Having the 
Autoquote system generate an order that will be traded on RAES in those 
cases where the Autoquote crosses with the book value and (ii) having 
an income order trade against the book order at the book price for the 
volume in the book and then having the balance of the incoming order 
trade at the next best available price whether it is another booked 
order or against the market makers logged onto RAES at the best market 
maker quote whether from Autoquote or verbalized by a market maker. The 
Exchange will continue to search for alternatives to develop its 
systems to provide the best opportunities for its customers. As it is, 
Exchange customers who enter orders in the RAES system in those classes 
where the ABP system has been implemented are much less likely to have 
their orders rejected for manual handling today than they were before 
the implementation of ABP along with the limited kickout provided by 
the pilot program.
Monthly Study
    The Exchange is committing to provide a study each month during the 
pilot program detailing the number of kickouts that the Exchange 
experienced pursuant to the pilot program during the previous month.
2. Statutory Basis
    The CBOE believes the proposed rule change is consistent with and 
furthers the objectives of Section 6(b)(5) \13\ of the Act in that it 
is designed to remove impediments to a free and open market

[[Page 19404]]

and to protect investors and the public interest.
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    \13\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    CBOE does not believe that the proposed rule change will impose a 
burden on competition that is not necessary or appropriate in 
furtherance of purposes of the Act.

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

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

III. Summary of Comments

    The Commission received eight comment letters on the pilot 
program.\14\ All of the commenters disapprove of the pilot program and 
ask the Commission not to extend it. Generally, the commenters assert 
that the pilot program protects CBOE market makers and disadvantages 
retail customers.\15\ A few firms commented on the linking of the 
options exchanges.\16\ The linking issues, however, is not the subject 
of this filing.
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    \14\ See supra note 5.
    \15\ See, e.g., Brunelle Letter 1, Gelbort Letter, Tors Letter, 
Rohde Letter and Datek Letter.
    \16\ See IB Letter, Datek Letter.
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    One commenter argues that the pilot program allows CBOE market 
makers to abandon their firm quote responsibilities.\17\ He states that 
CBOE's Autoquote system does not reflect public bids or offers, but 
only the activity of a CBOE computer. The commenters asserts that, for 
example, when this system locks or crosses CBOE's bid as established by 
a customer limit order, the pilot program will allow market makers to 
abandon the prevailing public quotation, and to reject all incoming 
sell orders which would otherwise be entitled to trade against the best 
published bid. The commenter goes on to state that after these sell 
orders have been redirected to the crowd, these orders will most likely 
be executed at an inferior price.
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    \17\ See Brunelle Letter 1.
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    In addition, this commenter believes that CBOE's arguments 
supporting the pilot program are flawed. He notes that CBOE supports 
the pilot by arguing that without it, market makers might avoid 
participating on RAES or might widen their quotes, both in response to 
the risk created by potential arbitrage situations. He further notes, 
however, that CBOE also states that it does not anticipate that the 
potential arbitrage situation will occur that frequently and therefore, 
the pilot program will have a minimal impact on the market. In sum, he 
argues that CBOE's support of the proposal is flawed because it 
simultaneously argues that makers may be exposed to tremendous risk, 
but the situations creating this risk will occur very infrequently.
    Another commenter also refutes CBOE's arguments supporting the 
pilot program.\18\ In particular, the commenter notes that CBOE's fear 
that market makers may not participate on RAES should be balanced with 
some of CBOE's other RAES initiatives, such as requiring all DPMs to 
participate in automatic execution systems and earlier attempts to 
decrease the number of market makers participating in RAES. Further, 
the commenter addresses CBOE's argument about market makers widening 
their quotes by asserting that CBOE already permits double-width quotes 
in many volatile options classes and also allows market makers to 
specify a RAES size limit that is less than the class maximum.
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    \18\ See Gelbort Letter.
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    In addition, this commenter argues that the changes to various 
exchanges' automatic execution systems may create public confusion and 
unfairly restrict customers' trading opportunities. Before the approval 
of the ABP system and the pilot program, the commenter asserts that 
public customers knew how their orders would be handled when these 
orders reached the CBOE floor. When the ABP system was approved, the 
commenter notes that CBOE deleted Interpretation .04, which provided 
protection for kicked-out RAES orders, because CBOE believed that the 
ABP system would reduce or eliminate kick-outs. However, after approval 
of the ABP system, the commenter points out that CBOE subsequently 
expanded the situations in which RAES orders could be kicked-out 
through a series of rule filings, including the pilot program. 
According to the commenter, the effect of all of these changes is that 
CBOE still has the ability to kick-out orders, but it no longer has a 
rule in place which protects these kicked-out orders.
    Two broker-dealers commented that the pilot program has an adverse 
impact on the trading strategies of their customers.\19\ In particular, 
these firms maintain that they have created order routing systems that 
send customer orders to the market with the best price, and these order 
routing systems rely on firm quotes and automatic execution. They 
assert that the kick-out feature of the pilot program hurts their order 
routing systems because the price displayed by CBOE might not actually 
be the price that their customers receive. Further, they argue that 
once an order is kicked-out, their customers lose the advantages of an 
automatic execution system such as RAES, which according to these 
commenters, include the ability to modify or cancel orders online. 
Three other individuals also share these comments.\20\
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    \19\ See IB Letter, Datek Letter.
    \20\ See Tors Letter, Rohde Letter, Coyle Letter.
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    All of the commenters argue that the pilot program does not allow 
customers to take advantage of certain trading opportunities, including 
arbitrage situations. For example, one commenter asserts that the 
essence of successful options trading, and of successful arbitrage, is 
the identification of a pricing disparity between the theoretical price 
of the option and the displayed best bid or offer.\21\ This commenter 
believes that the pilot program, with its kick-out feature, does not 
allow traders to take advantage of these opportunities.
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    \21\ See Brunelle Letter 1.
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    Two commenters offer suggestions on how to eliminate the need for 
the pilot program. One of these commenters believes that if CBOE 
provides additional staff to help take out the booked order when the 
booked order is locked or crossed by the Autoquote price, the need for 
the pilot program would be eliminated.\22\ The other commenter suggests 
that when an Autoquote price touches the price of a book order, the 
system should automatically execute the book order against a market 
maker.\23\ The commenter believes that this would eliminate the need 
for the pilot program because it would eliminate the possibility of a 
book order being locked or crossed with the Autoquote price.
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    \22\ See Gelbort Letter.
    \23\ See IB Letter.
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    In the alternative, this commenter suggests that if the pilot 
program is to continue, then CBOE should be required to notify broker-
dealers that automatic execution is not available in a particular 
options series. the commenter believes that CBOE should post this 
notification at least three seconds prior to removing the options 
series from the automatic execution system. In addition, this commenter 
believes that the pilot program should not be extended because it gives 
no incentive to CBOE to fix its systems.

IV. The Exchange's Response to the Commenters

    Seven comment letters were submitted on the original proposed rule 
change: one by Interactive Brokers; one by James Gelbort; one by George

[[Page 19405]]

Brunelle on behalf of a private investment firm client; one by Thomas 
Coyle; one by Linda S. Tors; one by John Rohde; and one from Datek 
Online.\24\ It should be noted that all but three of the letters--the 
IB Letter, the Gelbort Letter, and the Brunelle Letter 1--were sent to 
the Commission after the public comment period had expired; the Datek 
letter was sent more than one month after the comment period ended. 
Nevertheless, the Exchange is addressing the arguments raised in each 
of the letters.
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    \24\ CBOE did not receive a copy of Brunelle Letter 2.
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    Stripped of their rhetoric and inaccuracies, these letters all 
essentially argue that the Exchange's proposed rule should be 
disapproved because it does not allow, in their opinion, for the smooth 
operation of a certain business model of which they presumably want to 
take advantage. A central theme of many of the letters is that the type 
of kick-out provided for by this rule (and other procedures at other 
exchanges) is a step backward in a technological world that is 
providing quicker and better access for customers to automatic 
execution systems. What these letters ignore is that the Exchange has 
continually expanded access to RAES over the last few years by 
increasing the eligible RAES order size, and that with this new kick-
out there are actually fewer orders rejected from RAES today (not more 
as these letters suggest) than there were just a few months ago before 
the ABP system was put in place.\25\ Before the implementation of ABP 
in a particular class, every incoming RAES-eligible order would be 
rejected from RAES in those cases in which a booked order was 
establishing the best price on that side of the market against which 
the order would be traded. In those classes where ABP is in place, an 
incoming RAES-eligible order is only rejected from RAES if the booked 
order is establishing the best price on the side of the market against 
which the order would be traded and if the Autoquote bid or offer (as 
appropriate) crosses or locks with that book price.
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    \25\ As described above, only 2.46% of the orders (1.44% of the 
contracts) rejected before the implementation of ABP are rejected 
pursuant to the pilot program. If the number of rejected orders were 
compared to all RAES orders in those classes in which ABP had been 
implemented these percentages would be even smaller.
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    The letters also wrongly assume that there is no public benefit to 
this kick-out \26\ and that the proposal was established merely to 
protect the Exchange's market makers from suffering losses or to 
protect the market makers' ``advantages.'' \27\ Again, these letters 
ignore the fact that, unlike the professional traders who commented on 
the pilot program, market makers have become subject to ever greater 
obligations that have been imposed by Exchange rules. In fact, the ABP 
system obligates the Exchange's market makers to trade up to fifty (50) 
contracts (the maximum RAES order size) at a price that was established 
by a public customer and not by the market makers.
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    \26\ See Brunelle Letter 1 at 1, ``Without any countervailing 
benefit to the public markets. * * *''
    \27\ Id.
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    One of the commenters suggested that the book staff have an 
incentive to continue to display a book price that is crossed or locked 
with the Autoquote system.\28\ Of course, it should be apparent from 
everything the Exchange has explained why the DPM book staff has an 
incentive to take down the already traded book price as soon as 
possible. The longer the book price remains, the more orders that will 
be sent to the Exchange trying to trade at the erroneous price and the 
more orders that will subsequently be rejected due to the pilot 
program. The Exchange's DPMs have an incentive from a customer service 
standpoint and for the sake of running an efficient business to ensure 
the displayed prices are accurate and that the prices of orders that 
are traded are taken down as soon as possible.
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    \28\ See IB Letter.
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    While the above discussion addresses the arguments presented in all 
of the comment letters, the Exchange wanted to address individually 
some of the letters which raise some issues that are particularly 
troubling because they state inaccuracies and/or misrepresent the 
Exchange's intentions.

Brunelle Letter 1

    The Brunelle Letter 1, which was sent on behalf of a ``private 
investment firm'' who chose to remain anonymous, states that the CBOE 
is arguing that ``the public can have RAES, or they can have the Firm 
Quote Rule * * * but not both.'' This statement is contrary to the 
Exchange's rules and to Exchange practice. In fact, the Exchange's firm 
quote rule, CBOE Rule 8.51, states in paragraph (a)(2) that ``the 
appropriate Floor Procedure Committee * * * may establish a different 
firm quote requirement for a particular class of options that is not 
less than the RAES contract limit and no more than 50 contracts.'' By 
virtue of this rule, every order entered for the maximum RAES eligible 
size or less is entitled to firm quote treatment. This means that every 
RAES-eligible order, including those that are rejected in the limited 
circumstance permitted by the pilot program, will absolutely receive 
firm quote treatment whether through RAES or after having been rejected 
from RAES. Because the Exchange has developed systems that route those 
rejected orders instantaneously to electronic PAR terminals in the 
trading crowd, in most cases these orders will be executed at the 
prevailing quotes within a few seconds of when they were entered.

Gelbort Letter

    The Gelbort Letter states that the ``CBOE does not propose to 
expand the ABP system to insure that booked bids or offers are, in 
fact, rapidly executed by crossed or locked Autoquotes.'' As the 
Exchange has stated herein, the Exchange has in fact considered and 
continues to consider expanding the ABP system to have the Autoquotes 
trade against the booked orders. It was simply not possible at the time 
ABP was implemented to change the system to allow for this to happen 
and so the method chosen for dealing with the problem was the one with 
the Exchange determined was the least disruptive of those feasible 
alternatives.
    Mr. Gelbort continues by arguing that ``[e]ven in an electronic 
world, on-floor traders continue to enjoy significant advantages.'' In 
fact, what Mr. Gelbort completely neglects to point out is that any 
``advantages'' that on floor traders may have once enjoyed have been 
eroded over the years as customers have gained access to computers that 
allow them to identify opportunities for trading and have allowed them 
to transit orders nearly instantaneously to the floor. In fact, the 
Exchange has facilitated the erosion of these ``advantages'' by 
remaining at the forefront of developing systems that allow for quick 
access, by increasing the order size eligible for automatic execution, 
and by guaranteeing that RAES orders will be filled at the NBBO if the 
NBBO is no more than the step-up amount better than the CBOE best 
quote. What Mr. Gelbort also conveniently neglects to mention is that 
in spite of the instantaneous access to the Exchange's markets, high 
speed computers, and a wealth of information at their fingertips, the 
professional traders enjoy one enormous advantage over Exchange market 
makers. They have absolutely no obligation to trade at a particular 
price, unlike Exchange market makers. CBOE market makers who are logged 
onto RAES, however, are obligated to trade incoming RAES orders at the 
disseminated price or better when they are assigned the trade even if 
that price was established by a

[[Page 19406]]

small order in the Exchange's book that was better than the price any 
CBOE market maker was willing to pay for that particular series.
    Mr. Gelbort also argues that the result of these rules is to lead 
to ``needless public confusion.'' As stated earlier, however, the 
Exchange has already pointed out that it has gone to great lengths to 
inform the public of those limited circumstances where an order may be 
rejected from RAES pursuant to the pilot program both by filing the 
proposal for pubic comment and by issuing regulatory circulars on the 
matter. The reasons why an order may be rejected from RAES pursuant to 
this proposal are clearly defined and have been clearly stated. Mr. 
Gelbort's final paragraph on the subject rule filing, at the bottom of 
page 4, is a series of inaccuracies and self-serving statements. Mr. 
Gelbort argues that if the keystrokes have not been made to trade a 
booked order it is due to ``inattention rather than some inherent 
systems delay.'' In fact, at most trading stations there are traders 
who specifically look for situations where the Autoquotes become 
crossed with a booked order and trade them immediately. However, even 
though it takes only ``a few quick keystrokes'' to trade the order, 
this is all the time it takes for the RAES system to be flooded with 
orders from multiple customers. This is particularly true when the DPM 
staff has to trade more than one booked order at the same time.\29\ As 
far as Mr. Gelbort's assertion that the CBOE has been willing to 
provide additional book terminals and trained personnel DPMs that 
request them (presumably to suggest that this could solve the problem 
without the need for rejecting RAES orders), while this is true and 
remains true, this is not a solution to the particular problem. The 
Autoquote system may become crossed with a booked order at any time in 
any options class across the floor and by the time the situation arises 
it will be too late to transfer staff as Mr. Gelbort no doubt knows.
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    \29\ The Exchange estimates that for one series it will 
generally take the DPM book staff 1 to 4 seconds to complete the 
transaction. Of course, there are some instances where more than one 
booked order may be traded at the same time. As soon as the booked 
order is traded, the book-Autoquote inversion will generally cease 
to exist and all incoming RAES orders after that point will be 
automatically traded and not rejected from RAES.
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    Mr. Gelbort continues by correctly stating that DPMs have been 
assigned to all equity option classes and argues that this should 
eliminate any concern about market makers not participating on RAES if 
this particular kick-out were not employed because DPMs, at least, are 
required to participate on RAES at all times. Mr. Gelbort's conclusion 
is flawed for a number of reasons. First, the Exchange does not believe 
it is ideal in most instances for DPMs alone to participate on RAESs. 
Non-DPM market makers, however, are not required to log onto RAES 
unless they are present in the trading pit and they have logged on at a 
prior time in the particular expiration cycle. In fact, to the extent 
market makers are logged onto the RAES system, these market makers will 
have an incentive to ensure that the quotes are updated and accurate. 
In addition, regardless of whether a DPM is logged onto RAES, if the 
risk involved in trading over RAES becomes so great, the DPM will 
likely request the Floor Procedure Committee to remove all but the most 
active series from RAES.

IB Letter

    Like the Gelbort Letter, the IB Letter draws faulty conclusions 
from failing to have access to a number of facts. Like the Gelbort 
Letter, the IB Letter suggests there are better alternatives than 
rejecting orders from RAES when the Autoquotes cross with the price of 
a booked order. Interactive Brokers makes this statement without 
knowing what alternatives the Exchange considered (and continues to 
consider) and without knowing what time and effort might be involved in 
instituting Interactive Brokers' preferred solution to deal with the 
issue. The simple fact of the matter is that the Exchange, Interactive 
Brokers and Mr. Gelbort all share the same ultimate goal, to have the 
CBOE's systems operate in the most efficient manner with the fewest 
disruptions. However, the Exchange is also concerned about providing 
market makers with the proper incentives to provide the best and 
tightest markets for the benefit of all customers. Until the Exchange 
is confident that the quality of its markets will not be compromised by 
subjecting market makers to undue risk for which they cannot reasonably 
account, it should not be forced to adopt any particular methodology 
for dealing with the issue at hand merely because it happens to more 
easily accommodate the particular system designed by one firm.
    Interactive Brokers' entire first argument on pages 2-4 of the IB 
Letter is predicated on the notion that the number of exceptions to 
automatic execution is growing on the options exchanges. However, as 
discussed previously, the number of kick-outs that result from the 
current pilot program is only a very small subset of the orders that 
have been kicked out in situations before ABP was implemented on the 
Exchange. It is the Exchange's judgment, however, that although it is 
not ideal, it would prefer the limited number of kick-outs provided for 
by the pilot program than to risk losing liquidity on RAES or having 
series taken off of RAES.
    Interactive Brokers, in fact, suggests an alternative solution on 
page 5 to deal with the Exchange's particular concern that the Exchange 
is already considering. Namely, Interactive Brokers suggests that when 
an Autoquote price touches the price of a booked order, the system 
should automatically execute the booked order against a market maker. 
The CBOE agrees that this may well be a longer term solution to the 
particular issue. In light of the complexities of the RAES system and 
the Exchange's other current system priorities (including a 
conversation to decimalization), ``fixing'' the problem would entail 
more than ``a few of programming work'' as Interactive Brokers 
suggests.
    Finally, Interactive Brokers argues that in lieu of disapproving 
the proposed rule that the Exchange be required to post in electronic 
form, accessible to broker-dealer routing systems, a notification that 
automatic execution is not available for a particular option series. 
Interactive Brokers argues this notice should be accessible at least 
three seconds prior to such options series being removed from the 
automatic execution system. The Exchange is, in fact, exploring having 
a code placed next to its disseminated quotes that indicates when the 
best quote for a particular series is being established by a booked 
order. The Exchange believes it may be able to provide such notice in 
the near future and this would undoubtedly benefit Interactive Brokers' 
system. It would not be feasible to wait three seconds to remove the 
series from automatic execution, however, because the instant that a 
booked order becomes the CBOE's best bid or offer, the market makers 
become subject to the risk that the pilot program was designed to 
manage.

V. 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, N.W., Washington D.C. 20549-0609. Copies 
of submission, all subsequent amendments, all written statements with 
respect to the proposed rule change that are filed with the

[[Page 19407]]

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-00-03 and should 
be submitted by May 2, 2000.

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

    After careful review, the Commission finds that the proposal is 
consistent with the requirements of the Act.\30\ In particular, the 
Commission finds the proposal is consistent with Section 6(b)(5) \31\ 
of the Act. Section 6(b)(5) requires, among other things, that the 
rules of an exchange be designed to remove impediments to a free and 
open market and to protect investors and the public interest.
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    \30\ 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).
    \31\ 15 U.S.C. 78f(b)(5).
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    In extending this pilot, the Commission has balanced the commenters 
concerns with those expressed by CBOE. The Commission notes that CBOE 
has provided figures the show that kick-outs under this pilot program 
occur infrequently. Specifically, on February 14, 2000, CBOE conducted 
a study to determine how often kick-outs from RAES occurred as a result 
of this pilot program. On that date, CBOE found that out of the 150 
classes for which the ABP system had been implemented, only 44 of those 
classes had an order executed through the ABP system, i.e., the RAES 
order interacted with an order on the limit order book. In those 44 
classes, 1054 orders (representing 9017 contracts) were executed 
through the ABP system. In those same 44 classes, only 26 orders 
(representing 130 contracts) were rejected from RAES due to the 
Autoquote system locking or crossing CBOE's best bid or offer as 
established by the book. Moreover, the orders rejected from RAES as a 
result of this pilot represent a small percentage of the total amount 
of orders routed to RAES in these 44 options classes on February 14 
(5908 orders representing 41,102 contracts). These figures support 
CBOE's position that kick-outs under this pilot program occur 
infrequently.
    Nevertheless, the Commission is mindful of the commenters concerns. 
In particular, the Commission agrees with the commenters that there are 
other solutions than the one employed by CBOE in this pilot program. In 
this filing, CBOE listed two alternative solutions. One of these 
alternatives involves having an incoming order trade against the book 
order at the book price for the volume in the book and then having the 
balance of the incoming order trade at the next best available price--
whether it is with another booked order or with a market makers logged 
onto RAES. This alternative would allow customer orders to interact 
with orders on the limit order book, but would eliminate the risk to 
market makers of executing a RAES order for the maximum eligible size 
when the limit order is for a smaller number of contracts. In this 
regard, the CBOE has represented that it will continue work on systems 
changes to address the situation when the Autoquote system locks or 
crosses CBOE's best bid or offer as established by the book and has 
assigned a high priority these systems changes. CBOE stated that it is 
confident that these changes could be implemented by the end of this 
calendar year, after it has completed the projects needed for it to 
convert to decimal trading.\32\
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    \32\ See Amendment No. 1 at 2.
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    In the meantime, the Commission agrees with one of the commenters 
that CBOE should provide protection to kicked-out orders in options 
classes where the ABP system has not yet been implemented. When the ABP 
system was originally proposed, CBOE represented that the ABP system, 
by allowing RAES orders to interact directly with orders in the 
exchange's limit order book, would reduce or eliminate the need for 
kick-outs. Because of this representation, CBOE eliminated 
Interpretation .04, which provided protection for orders that had been 
kicked-out. As of the date of this filing, CBOE has not implemented the 
ABP system on a floor-wide basis. The Commission therefore believes 
that Amendment No. 1, which re-adopts Interpretation .04, should help 
provide protection to orders kicked-out in those classes in which the 
ABP system has not been implemented. CBOE also stated that it would 
continue to roll out the ABP system in those classes in which it had 
not yet been implemented.
    In light of the likely benefits to customer limit orders expected 
to be gained by the continued implementation of the ABP system, 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. Further, the Commission notes that the 
CBOE has agreed to provide monthly reports to the Commission regarding 
the number of times an incoming RAES order is rejected pursuant to this 
pilot.\33\
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    \33\ The extension of this 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,\34\ that the proposed rule change (SR-CBOE-00-03) is hereby 
approved through August 22, 2000.
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    \34\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\35\
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    \35\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-8880 Filed 4-10-00; 8:45 am]
BILLING CODE 8010-01-M