[Federal Register Volume 65, Number 104 (Tuesday, May 30, 2000)]
[Notices]
[Pages 34515-34518]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-13414]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42808; File No. SR-ISE-00-01]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval to 
Amendment No. 1 by the International Securities Exchange LLC Relating 
to Market Maker Allocations

May 22, 2000.

I. Introduction

    On February 25, 2000, the International Securities Exchange LLC 
(``ISE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change relating to its proposed market 
maker allocation algorithm.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in the Federal 
Register on March 6, 2000.\3\ The Commission received three comment 
letters regarding the proposal.\4\ On May 19, 2000, the ISE filed 
Amendment No.

[[Page 34516]]

1 to proposed rule change.\5\ This order approves the proposed rule 
change. In addition, the Commission is publishing this notice to 
solicit comments on Amendment No. 1 and is simultaneously approving 
Amendment No. 1 on an accelerated basis.
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    \3\ Securities Exchange Act Release No. 42473 (February 29, 
2000), 65 FR 11818.
    \4\ See letters to Jonathan G. Katz, Secretary, SEC, from Holly 
H. Smith, Sutherland, Asbill & Brennan LLP, dated March 24, 2000 
(``SA&B Letter''); Peter J. Chepucavage, Fulbright & Jaworski 
L.L.P., dated March 28, 2000 (``Phlx Letter''); and Charles J. 
Henry, President and Chief Operating Officer, Chicago Board Options 
Exchange, dated March 31, 2000 (``CBOE Letter'').
    \5\ See letter from Katherine Simmons, Vice President and 
Associate General Counsel, ISE, to Deborah Flynn, Senior Special 
Counsel, Division of Market Regulation, SEC, dated May 19, 2000 
(``Amendment No. 1''). In Amendment No. 1, the ISE requests that the 
Commission approve its proposal with respect to its proposed five 
contract preference as a one-year pilot program. Consistent with 
this request, the ISE proposes to revise paragraph .01(c) of 
Supplementary Material to ISE Rule 713 to require that the ISE 
provide the following information to the Commission on a quarterly 
basis, with respect to OCC cleared transactions: (1) The percentage 
of volume executed on the Exchange (excluding facilitation orders) 
that results from the execution of orders of five contracts or fewer 
(``Five Contract Volume''); (2) the percentage of Five Contract 
Volume executed by Primary Market Makers (``PMMs''); (3) the ratio 
of PMM trades to the total of PMM and Competitive Market Maker 
(``CMM'') trades; and (4) the ratio of PMM contract volume to the 
total of PMM and CMM contract volume.
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II. Description of the Proposal

    ISE Rule 713(d) provides that public customer orders at a given 
price have priority. ISE Rule 713(e) provides that, if there are two or 
more non-customer 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 PMM is quoting at the Exchange's inside market, it will 
have precedence over non-customer orders and CMM quotes for execution 
of orders that are up to a specified number of contracts. The ISE is 
proposing to establish its allocation procedure for non-customer orders 
and market maker quotations, and to define the size of orders for which 
the PMM has priority.
    According to the ISE, the allocation procedure is a trading 
algorithm programmed in the ISE's electronic auction market system 
(``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 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. The ISE represents that, 
subject to the PMM's participation rights discussed below, the 
allocation of executions to non-customer orders and market maker quotes 
is based on the size associated with the order or quote relative to the 
total size available at the execution price.
    The ISE is also proposing certain participation rights for PMMs. 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 of fewer if it is quoting at the best price. The proposal 
provides that the PMM cannot receive any portion of an allocation 
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.
    The Exchange proposes to implement the PMM five contract preference 
as a one-year pilot program.\6\ During that time, ISE proposes to 
evaluate what percentage of the volume executed on the Exchange, 
excluding volume resulting from the execution of orders in the 
facilitation mechanism, 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.\7\ In 
addition, during this pilot period, ISE proposes to provide certain 
data to the Commission on a quarterly basis, with respect to OCC 
cleared transaction: (1) The percentage of volume executed on the 
Exchange (excluding facilitation orders) that results from the 
execution of orders of five contracts or fewer (``Five Contract 
Volume''); (2) the percentage of Five Contract Volume executed by PMMs; 
(3) the ratio of PMM and CMM trades; and (4) the ratio of the PMM 
contract volume divided by the total of PMM and CMM contract volume.\8\
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    \6\ See Amendment No. 1, supra note 5.
    \7\ Id.
    \8\ Id.
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III. Summary of Comments

    The Commission received three comment letters on the proposal.\9\ 
These commenters opposed ISE's proposed rule change, as originally 
proposed. The commenters argued that the ISE's proposed allocation 
algorithm would discourage competition among market participants by 
requiring that other market makers and non-customers be quoting at the 
best bid or offer on ISE to participate in the execution of an incoming 
order. Thus, ISE Rule 713 would allow a PMM to trade with 100 percent 
of an incoming order when it was along at the ISE's best bid or 
offer.\10\ In addition, commenters asserted that the algorithm would 
permit a PMM to internalize order flow by giving PMMs at the best bid 
or offer an absolute right to trade against all orders of five 
contracts or fewer.\11\ Commenters characterize this proposed guarantee 
as essentially a small order referencing rule giving PMMs a distinct 
economic advantage over all other non-customer trading interest entered 
into the ISE. In connection with the proposed allocation procedure, the 
commenters argued that these rules build an infrastructure for 
percentage and crossing, and guarantee that the orders routed to ISE 
will not be exposed to the level of price competition necessary to 
protect the public interest.\12\
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    \9\ See note 4, supra.
    \10\ See CBOE Letter.
    \11\ See SA&B Letter, Phlx Letter; CBOE Letter.
    \12\ Id.
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    Commenters also disagreed with ISE's characterization of five 
contracts as an ``odd lot,'' noting that five contracts represent 500 
shares of underlying stock and that orders of five contracts or fewer 
constitute a significant portion of all portion of all options order 
flow.\13\ According to commenters, the proposed five contract 
precedence for PMMs will result in referencing arrangements, 
internalization, and payment for order flow to attract these low-risk 
orders, and is anticompetitive because it reduces incentives for other 
market makers to quote aggressively due to their inability to attract 
these smaller orders.\14\
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    \13\ See CBOE Letter.
    \14\ Id.
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    In response to commenters' objections, the ISE notes that the 
percentage of an order that a PMM executes is uncertain from the 
outset, and far from a ``guarantee.'' \15\ Instead, the allocation is 
dependent on the number of public customer orders, the price and size 
of the PMM's quote, and

[[Page 34517]]

the number of non-customers competing with the PMM at the same price. 
The ISE argues that, contrary to the commenters' characterization of an 
absolute ``guarantee,'' the algorithm provides only that if an order is 
not completely executed after public customer orders are executed, the 
PMM has preference as to the balance, but only if quoting at the best 
price and only if it has displayed sufficient size. Thus, according to 
the ISE, a PMM must be competitive on price in order to receive any 
allocation, and must be competitive on size--otherwise its allocation 
is limited by the size associated with its quote.\16\
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    \15\ See letter to Jonathan G. Katz, Secretary, SEC, from 
Katherine Simmons, Vice President and Associate General Counsel, 
ISE, dated May 19, 2000 (``ISE Response Letter'').
    \16\ See ISE Response Letter.
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    Similarly, the ISE argues that the commenters' assertions that the 
PMM preference as to orders of five contracts or fewer will lead to 
decreased competition for small orders, preferencing, internalization, 
and payment for order flow is erroneous because it is based on the 
flawed premise that this preference is an ``exclusive right'' and 
absolute ``guarantee.'' \17\ The ISE further claims that preferencing 
and payment for order flow arrangements are unlikely because orders for 
five contracts or fewer are expected to constitute only a small 
percentage of order flow.\18\ Moreover, the ISE maintains that because 
its market is based on intramarket price and size competition and 
incoming orders are executed automatically, market participants, 
including the PMM, would not have the opportunity to know the size of 
an incoming order, nor would market participants know whether the PMM 
would be quoting at the best with sufficient size.\19\
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    \17\ Id.
    \18\ Id.
    \19\ Id.
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1, including whether the proposed 
amendment 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. 
SR-ISE-00-01 and should be submitted by June 20, 2000.

V. 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.\20\ In particular, the Commission finds that the proposal is 
consistent with Section 6(b)(5) of the Act.\21\
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    \20\ In approving this rule, the Commission has considered its 
impact on efficiency, competition, and capital formation. 15 U.S.C. 
78c(f).
    \21\ 15 U.S.C. 78f(b)(5).
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    Under Section 6(b)(5) of the Act, a registered national securities 
exchange must have rules that are designed 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 is 
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.
    The Commission finds that ISE's proposed amendments to 
Supplementary Material .01 to ISE Rule 713 are consistent with Sections 
6(b)(5) of the Act.\22\ The Commission believes that ISE's proposed 
amendment to the commentary to ISE Rule 713 establishing its algorithm 
governing the allocation of orders to market participants, including 
PMMs, is reasonable. Moreover, because PMMs, like specialists on floor-
based options exchanges, perform important functions and undertake 
responsibilities greater than those of other market makers, the 
Commission believes it is reasonable for the ISE to choose to offer its 
PMMs an elevated level of participation rights like other options 
exchanges currently provide to their specialists.
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    \22\ Id.
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    Although the Commission recognizes that intramarket competition, as 
well as protection of public customers, could be compromised if such a 
participation right constituted an absolute guarantee or if it consumed 
too great a percentage of order flow, the Commission believes that the 
ISE's proposal sets forth reasonable safeguards against such potential 
harms. The ISE's proposal prioritizes public customer limit orders on 
the book. Indeed, if sufficient existing customer interest exists, a 
PMM might not receive any allocation of a given incoming order. 
Moreover, a PMM's participation is directly dependent on the 
competitiveness of the PMM's quote as well as the number of non-
customers who have entered competitive quotes at the same price at the 
time an order is received by the market. In addition, the size of a 
PMM's quote is important, because a PMM's execution is limited by the 
size of its quote, regardless of any participation right that ISE's 
allocation algorithm would otherwise prescribe. The Commission believes 
that these limits on a PMM's participation right should assure 
reasonable protection for public customers and prevent impediments to a 
free and open market that might otherwise result from an absolute 
specialist guarantee.
    The Commission further finds that the ISE's proposal to provide on 
a one-year pilot basis PMMs with a preference for orders of five 
contracts or fewer is consistent with Section 6(b)(5) of the Act.\23\ 
The Commission acknowledges the potential competitive issues noted by 
commenters, and intends to use the one-year pilot period to monitor the 
rule's impact on competition. To assist the Commission in evaluating 
the pilot program, the ISE will provide four types of specific data to 
the Commission, on a quarterly basis and should allow the ISE to 
achieve its stated goal of limiting execution for five contracts or 
fewer by PMMs to 40 percent or less of total exchange volume (excluding 
facilitation orders).\24\
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    \23\ Id.
    \24\ See Amendment No. 1, supra note 5.
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    The Commission finds good cause for approving proposed Amendment 
No. 1 prior to the thirtieth day after the date of publication of 
notice of filing thereof in the Federal Register. The Commission notes 
that Amendment No. 1 clarifies the proposed rule change and is 
responsive to the issues raised by commenters. By approving this 
proposal as a one-year pilot program and requesting certain statistics 
from the ISE on a quarterly basis regarding the volume of orders for 
five contracts or fewer executed by PMMs, the Commission should be able 
to adequately assess the operation of this proposal and determine 
whether the competitive issues raised by commenters pose a concern. 
Because Amendment No. 1 does not significantly

[[Page 34518]]

alter the original proposal, which was subject to a full notice and 
comment period, and addresses the issues raised by commenters, the 
Commission finds that granting accelerated approval to Amendment No. 1 
is consistent with Section 19(b)(2) of the Act.\25\
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    \25\ 15 U.S.C. 78f(b)(2).
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VI. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\26\ that the proposed rule change (SR-ISE-00-01), including 
Amendment No. 1, is approved, and that PMM five contract preference 
proposal contained in Amendment No. 1 is approved as a one-year pilot 
to expire on May 22, 2001.
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    \26\ Id.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\27\
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    \27\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-13414 Filed 5-26-00; 8:45 am]
BILLING CODE 8010-01-M