[Federal Register Volume 65, Number 108 (Monday, June 5, 2000)]
[Notices]
[Pages 35688-35690]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-13959]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42825; File No. SR-ISE-00-04]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendment No. 1 by the International Securities Exchange LLC 
Relating to the Exposure of Orders on the Exchange

May 25, 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

[[Page 35689]]

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 the 
exposure of orders on the Exchange.
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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 March 30, 2000, the ISE amended 
the proposed rule change.\5\ This order approves the proposed rule 
change, as amended.
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    \3\ Securities Exchange Act Release No. 42475 (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 March 28, 2000 
(``Amendment No. 1''). In Amendment No. 1, the ISE made minor 
technical changes to ISE Rule 717, replacing section headings 
``(a)'' and ``(b)'' with ``(d)'' and ``(e),'' respectively. Because 
Amendment No. 1 did not change the substance of the proposal, there 
was no need to publish it in the Federal Register.
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II. Description of the Proposal

    The ISE proposes to amend ISE Rule 717 to reduce from two minutes 
to 30 seconds the amount of time that Electronic Access Members 
(``EAMs'') are required to expose agency orders on the Exchange before 
executing them as principal or executing them against a solicited 
order. According to the ISE, its order exposure requirements are 
intended to assure that agency orders have an opportunity to interact 
on the Exchange before they are executed. The Exchange proposes to 
reduce the exposure time because it believes that the objective of the 
exposure rule can be satisfied by a 30 second exposure period.

III. Summary of Comments

    The Commission received three comment letters on the proposal.\6\ 
These commenters opposed ISE's proposal to reduce the order exposure 
time from two minutes to 30 seconds.\7\ Commenters argued that the 
proposed reduction in response time would make it easier for ISE 
members to execute as principal orders for less than 50 contracts 
without meaningful opportunity for price improvement by competitors.\8\ 
The commenters contend that this would undermine the intended purpose 
of having customers' orders reasonably exposed to other trading 
interest before being executed by the facilitating ISE member.\9\ Two 
commenters agreed that two minutes is an appropriate time frame for 
this purpose, but that a 30 second exposure time would make it unlikely 
that interested market participants would have sufficient time to gauge 
their risk exposure in other markets and related positions, and reveal 
on the ISE their true ``best'' price.\10\
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    \6\ See note 4, supra.
    \7\ The Commission notes that commenters also raised issues 
related to ISE's system that were outside of the scope of the 
current ISE proposal, several of which were addressed in the 
Commission's order approving ISE's registration as a national 
securities exchange. See Securities Exchange Act Release No. 42455 
(February 24, 2000), 65 FR 11388 (March 2, 2000). Consequently, this 
order addresses only comments regarding those issues presented by 
the current proposal.
    \8\ See SA&B Letter; Phlx Letter; CBOE Letter.
    \9\ Id.
    \10\ See SA&B Letter; Phlx Letter.
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    Commenters stated that this proposal encourages internalization 
because it allows an EAM to execute orders as principal if it utilizes 
the facilitation mechanism of ISE Rule 716(d) or has been bidding or 
offering on the ISE for 30 seconds. Commenters noted that an EAM could 
easily internalize orders by, upon receiving a customer order, holding 
that order until the EAM has posted a bid or offer at this intended 
crossing price for 30 seconds, then executing the order as principal, 
effectively subverting the intent of the exposure period.\11\
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    \11\ See SA&B Letter; Phlx Letter; CBOE Letter.
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    In response to commenters' objections to the proposed reduction in 
the exposure period from two minutes to 30 seconds, the ISE states that 
it believes 30 seconds is a sufficient time for participants in the ISE 
market to respond to an order, noting that the Commission has approved 
exposure times of as few as 15 seconds for certain equity 
exchanges.\12\ With regard to the sufficiency of the proposed 30 second 
exposure time, the ISE contends that a 30 second order exposure time is 
especially appropriate in light of the fact that floor-based exchanges 
have no limitation on how long a crowd must interact with a proposed 
crossing of orders, nor do floor-based exchanges have safeguards 
preventing a firm from negotiating with the crowd to execute against 
any and all of its customer orders, regardless of size.\13\ ISE states 
that, because it is an electronic marketplace, it must define some 
order exposure time period.\14\
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    \12\ 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'').
    \13\ See ISE Response Letter.
    \14\ Id.
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    In response to the commenters' claim that members can subvert the 
30 second requirement, ISE argues that the only exception to the 30 
second exposure rule is the situation in which an EAM had disseminated 
proprietary trading interest on the ISE for at least 30 seconds prior 
to the customer order. In this case, according to ISE, the firm has 
disseminated trading interest, available to all customer orders, at the 
stated price, thus putting itself at risk to the public. Accordingly, 
ISE believes that execution of the EAM's own customer orders would not 
deprive the public of the opportunity to trade at the same prices.\15\ 
Moreover, ISE notes that a broker would not be permitted, under its 
rules, to simply delay entering an order into the system in order to 
circumvent the exposure rule.\16\
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    \15\ Id.
    \16\ Id.
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    In response to the commenters' internalization claims, ISE notes 
that that there is little opportunity for an EAM to be assured of 
executing against its own customer orders. Once customer orders are 
entered into the system, those limit orders that do not improve upon 
the ISE best bid or offer are placed into the ISE's electronic limit 
order book last in time priority behind any existing customer orders at 
the same price. Thus, the ISE argues, a given EAM would have no way of 
knowing whether the resulting increase in the best bid or offer 
(assuming the order matched the ISE best bid or offer) was due to its' 
customer's order, as opposed to other customer orders or interest from 
non-customers.\17\ In addition, the ISE maintains that its proposed 
amendment to ISE Rule 717(d) addresses the only real opportunity for 
internalization in its system: The narrow case where an EAM has a limit 
order that improves upon the ISE best bid or offer or a market order 
that it is willing to execute at an improved price. The ISE argues that 
the proposed 30 second delay required by its amendment will remove the 
informational advantage that makes internalization profitable and will 
provide other market participants an opportunity to compete for such 
orders.\18\
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    \17\ Id.
    \18\ Id.
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Discussion

    After careful review, the Commission find that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations

[[Page 35690]]

thereunder applicable to a national securities exchange.\19\ In 
particular, the Commission finds the proposal is consistent with 
Section 6(b)(5) of the Act.\20\
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    \19\ In approving this rule, the Commission has considered its 
impact on efficiency, competition, and capital formation. 15 U.S.C. 
78c(f).
    \20\ 15 U.S.C. 78f(b)(5).
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    Under Section 6(b)(5) of the Act,\21\ 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 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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    \21\ Id.
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    The Commission finds that ISE's proposed amendments to ISE Rule 
717(d) and (e) reducing the exposure time (i.e., the amount of time 
EAMs are required to expose agency orders on the Exchange before 
executing them as principal or against a solicited order) from two 
minutes to 30 seconds are consistent with Section 6(b)(5) of the 
Act.\22\ The Commission recognizes that, on floor-based exchanges, 
there are no rules that govern the extent to which a given trading 
crowd has an opportunity to interact with a proposed crossing of 
orders. Because the ISE operates a unique electronic options market, it 
must define an order exposure time period. The Commission finds that a 
30 second exposure period is a reasonable time frame for participants 
in ISE's market to assess market conditions and their own trading 
interest, and to allow a reasonable opportunity for price improvement 
from interested participants. The Commission finds that a 30 second 
exposure period strikes a reasonable balance between maintaining 
liquidity and efficiency in the ISE market and preventing impediments 
to a free and open market, while providing the appropriate safeguards 
for investors and the public.
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    \22\ Id.
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    In determining that a 30-second exposure period is reasonable, the 
Commission has considered carefully the commenters' concern that market 
makers might be able to subvert the 30 second exposure period by 
posting bids or offers for a very short period of time, and arranging 
to receive agency orders simultaneously when they are executable 
against the market maker as principal, or against other agency orders 
held by the market maker.\23\ In such a scenario, EAMs allegedly would 
pre-screen order flow, and hold orders until they can be internalized, 
denying the order any exposure in the market and the opportunity for 
price improvement. The Commission is not persuaded by this argument. 
The ISE allows for only one exception to the 30 second exposure period, 
in the scenario where an EAM has previously disseminated proprietary 
trading interest on the ISE for at least 30 seconds prior to receipt of 
a customer order. Under this limited exception, a firm will have placed 
itself ``at risk'' to the public by having disseminated trading 
interest available to all customer orders at a stated price. ISE Rule 
717(d) states that a member must have been bidding or offering on the 
Exchange for at least 30 seconds prior to receiving an agency order 
that is executable against such bid or offer. The Commission finds that 
an EAM's execution of its own customer order under this particular 
scenario would not deprive the public of the opportunity to trade at 
the same price.
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    \23\ See SA&B Letter at 8.
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    The Commission also has considered carefully the commenters' 
concerns about the potential for internalization of order flow where 
there is a 30 second exposure period, and finds that the proposal 
provides sufficient safeguards against such activity. The ISE's system 
is designed to ensure that, once customer orders are entered into the 
system, any limit orders that do not improve upon the ISE best bid or 
offer automatically are placed into the ISE's electronic limit order 
book last in time priority behind any existing customer orders at the 
same price. Therefore, an EAM has no guarantee that it will be able to 
trade against its agency orders. Because ISE's system automatically 
provides reasonable safeguards to prevent EAMs from executing against 
their own customer orders, the Commission finds that a 30 second 
exposure period does not pose an unreasonable risk of increasing the 
internalization of order flow. For these reasons, the Commission finds 
that ISE's proposal is consistent with Section 6(b)(5) of the Act.\24\
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    \24\ 15 U.S.C. 78f(b)(5).
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V. Conclusion

    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the 
Act,\25\ that the proposed rule change (SR-ISE-00-04), as amended, is 
approved.

    \25\ 15 U.S.C. 78s(b)(2).
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Margaret H. McFarland.
Deputy Secretary.
    For the Commission, by the Division of Market Regulation, pursuant 
to delegated authorty.\26\
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    \26\ 17 CFR 200.30-3(a)(12).
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[FR Doc. 00-13959 Filed 6-2-00; 8:45 am]
BILLING CODE 8010-01-M