[Federal Register Volume 65, Number 115 (Wednesday, June 14, 2000)]
[Notices]
[Pages 37442-37445]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-14931]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42824; File No. SR-CBOE-99-40]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Granting Approval to Proposed Rule Change Relating to 
Operation of Retail Automatic Execution System; Nine-Month Pilot 
Program

May 25, 2000.

I. Introduction

    On July 29, 1999, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``SEC'' or

[[Page 37443]]

``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a 
proposal to permit the appropriate CBOE Floor Procedure Committee 
(``FPC'') to implement a new order assignment procedure for the 
Exchange's Retail Automatic Execution System (``RAES''). The new RAES 
order assignment procedure is called the ``100 Spoke RAES Wheel.'' On 
January 21, 2000, the Exchange filed Amendment No. 1 to the proposed 
rule change.\3\ On February 14, 2000, the Commission published the 
proposed rule change and Amendment No. 1 in the Federal Register.\4\ 
The Commission received no comments on the proposal. This order 
approves the proposed rule change, as amended, for a pilot period of 
nine months through February 28, 2001.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Letter from Timothy Thompson, Director, Regulatory 
Affairs, CBOE, to Nancy Sanow, Assistant Director, Division of 
Market Regulation, SEC, dated January 19, 2000.
    \4\ See Securities Exchange Act Release No. 42396 (February 7, 
2000), 65 FR 7404 (February 14, 2000).
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II. Description of the Proposal

    RAES is a part of the CBOE's order routing system that 
automatically executes customer market and marketable limit orders that 
fall within designated order size parameters. The maximum order size 
eligible for entry into RAES is 50 contracts for all classes of equity 
options and most classes of index options.\5\ All designated primary 
market makers (``DPMs'') of a particular option class are required to 
log on RAES for that class; other market makers who trade that class on 
the floor may log on RAES but are not required to do so.\6\ When RAES 
receives an order, the system automatically attaches to the order its 
execution price, generally determined by the prevailing market quote at 
the time of the order's entry to the system, and a participating market 
maker will be designated as the counterparty on the trade.\7\ 
Participating market makers are assigned by RAES on a rotating basis, 
with the first market maker selected at random from the list of logged-
on market makers.\8\
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    \5\ See CBOE Rule 6.8(e).
    \6\ Generally, a market maker may log on RAES in a particular 
equity option class (other than DJX) only in person and may continue 
on the system only so long as he or she is present in that trading 
crowd. Accordingly, a member generally may not remain on the RAES 
system and must log off the system when he or she has left the 
trading crowd, unless the departure is for a brief interval. See 
CBOE Rule 8.16(a)(iii). In option classes designated by the 
appropriate Market Performance Committee, any market maker who has 
logged on RAES at any time during an expiration month must log on 
the RAES system in that option class whenever he or she is present 
in that trading crowd until the next expiration. See CBOE Rule 
8.16(b).
    \7\ See CBOE Rule 6.8(a)(ii).
    \8\ See CBOE Rule 6.8(d)(i).
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    In its filing, the Exchange described that its PFCs currently have 
two options by which to allocate RAES orders: The ``entire order'' 
procedure and ``Variable RAES.'' Under the entire order procedure, RAES 
orders are assigned to market makers participating on RAES one order at 
a time to the market maker next in line on the ``RAES Wheel.'' When a 
particular market reaches his or her turn on the Wheel, the market 
maker is assigned one entire order whether the order is for one 
contract or for the maximum number of contracts eligible for entry into 
RAES for that particular class of options. By contrast, under Variable 
RAES, for each options class in which market makers participates in 
RAES, market makers are permitted to designate the maximum number of 
contracts that they are willing to buy or sell each time it is their 
turn on the RAES Wheel, provided that the number of contracts selected 
is equal to or greater than a minimum number selected by the FPC.\9\ 
CBOE represents that its FPCs now employ Variable RAES for both equity 
options and index options.\10\
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    \9\ CBOE Rule 6.8, Interpretation .06(b). See Securities 
Exchange Act Release No. 41821 (September 1, 1999), 64 FR 50313 
(September 16, 1999) (approving implementation of Variable RAES).
    \10\ Telephone conversation between Timothy Thompson, Director, 
Regulatory Affairs, CBOE, and Gordon Fuller, Special Counsel, 
Division of Market Regulation, SEC (May 16, 2000).
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    The current proposal provides the appropriate FPC with a third 
choice for apportioning RAES trades among participating market makers, 
the ``100 Spoke RAES Wheel.'' Under the 100 Spoke RAES Wheel, RAES 
orders will be assigned to logged-in market makers according to the 
percentage of their in-person agency contracts (excluding RAES 
contracts) traded in that class compared to all of the market maker in-
person agency contracts (excluding RAES contracts) traded during the 
review period. Agency contracts are defined as contracts that are 
represented by an agent and do not include contracts traded between 
market makers in person in the trading crowd. The CBOE represents that 
in-person agency contracts include trades by a market maker against a 
booked order or an order represented by a broker in the trading crowd, 
whether that order is for the account of another broker-dealer or for 
the account of a customer. \11\ Agency contracts do not included 
contracts executed through RAES.
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    \11\ Telephone conversation between Timothy Thompson, Director, 
Regulatory Affairs, and Anthony Montesano, Vice President, Trading 
Operations Department, CBOE; and Nancy Sanow, Assistant Director, 
and Gordon Fuller, Special Counsel, Division of Market Regulation, 
SEC, (May 1, 2000).
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    Under the 100 Spoke RAES Wheel, on each revolution of the Wheel, 
each participating market maker who is logged on RAES at the time will 
be assigned a number of agency contracts that replicates the percentage 
of contracts on RAES that he or she traded in-person in that class 
during the review period, subject to the exceptions described below. 
The appropriate FPC will determine the review period but in no event 
may it set the review period for a period greater than two weeks. At 
the end of each review period, the appropriate FPC will recalculate the 
percentage of RAES orders to be distributed to each market maker 
participating on the 100 Spoke RAES Wheel. The percentage allotted to a 
particular market maker will be the same as the percentage of in-person 
agency contracts traded by that market maker in the Exchange crowd 
during the previous review period.\12\ Any market maker that logs on 
the system during a particular review period will be guaranteed to 
receive an entitlement during that review period of no less than 1 
percent of RAES contracts, or one ``spoke'' as explained below.\13\
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    \12\ All designees of the same DPM unit will have their 
percentage aggregated into a single percentage for the DPM unit. 
Because of this methodology, the DPM unit can still receive its 
entitled percentage even if any particular designee is not logged on 
RAES at the time.
    \13\ The minimum entitlement applies to any market maker in a 
particular option class who logs on RAES during a given review 
period. Thus, new market makers who have not yet had time to acquire 
market share on the trading floor will be allocated a single spoke 
if they log on RAES during the first review period they traded that 
class on the Exchange floor. Similarly, an existing market maker who 
was on vacation for the whole of the previous review period, who 
thus had no trading history during that review period, would receive 
a one-spoke allocation if he or she logged on RAES during the first 
review period immediately following his or her return. Telephone 
conversation between Timothy Thompson, Director, Regulatory Affairs, 
and Anthony Montesano, Vice President, Trading Operations 
Department, CBOE; and Gordon Fuller, Special Counsel, and Michael 
Gaw, Attorney, Division of Market Regulation, SEC (May 19, 2000).
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    The RAES Wheel may be envisioned as having a number of ``spokes,'' 
each generally representing 1 percent of the total participation of all 
market makers in the class. Thus, a market maker generally will be 
assigned one spoke for each 1 percent of his or her market maker 
participation during the review period. If all market makers who traded 
in-person agency contracts in that option class during the review 
period are logged on RAES, no other market makers are logged on, the 
RAES Wheel

[[Page 37444]]

would consist of 100 spokes, representing 100 percent of all market 
maker activity during the review period. Normally, one spoke on the 
Wheel would be equivalent to one contract, except that the appropriate 
FPC may establish a larger spoke size. For example, setting the spoke 
size to five contracts would redefine the RAES Wheel for a particular 
option class as a Wheel of 500 contracts. Changing the spoke size (and 
thus, the Wheel size) would not change the participation percentages of 
the individual market makers.\14\
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    \14\ The CBOE has stated that Variable RAES and the 100 Spoke 
RAES Wheel cannot operate concurrently for trading in a given option 
class. Similarly, the ``entire order'' allocation procedure and the 
100 Spoke RAES Wheel cannot operate concurrently for trading in a 
given option class. Telephone conversation between Timothy Thompson, 
Director, Regulatory Affairs, and Anthony Montesano, Vice President, 
Trading Operations Department. CBOE; and Gordon Fuller, Special 
Counsel, and Michael Gaw, Attorney, Division of Market Regulation, 
SEC (May 19, 2000).
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    For example, if there are twelve market in a crowd, consisting of 
ten veteran market makers each of whom accounted for 10 percent of 
total market maker trading (exclusive of RAES trades) during the review 
period, and two new market makers, and if nine of the veteran makers 
and both of the new market makers are logged on RAES, the RAES Wheel 
would consist of 92 spokes (ten spokes for each of the nine veteran 
market makers, and one spoke for each of the two new market 
makers),\15\ accounting for 92 contracts in a complete revolution of 
the Wheel. In this case, each of the veteran market makers would 
participate in ten out of every 92 contracts traded on RAES, and the 
two new market makers would each receive one out of every 92 contracts.
    A wedge is the maximum number of spokes that may be assigned to a 
market maker in any one ``hit'' during a rotation of the RAES Wheel. 
The purpose of the wedge is to break up the distribution of contracts 
into smaller groupings to reduce the exposure of any one market maker 
to market risk. If the size of the wedge is smaller than the number of 
spokes to which a particular market maker may be entitled based on his 
or her participation percentage, that market maker would receive one or 
more additional assignments during one revolution of the RAES Wheel. 
For example, in the case where one spoke is equal to one contract and 
the market maker's participation percentage is 15 percent (entitling it 
to 15 contracts on one RAES Wheel revolution, i.e., 15 percent of 100) 
and the wedge size is ten, that market maker first would be assigned 
ten contracts on the RAES Wheel and then five contracts at a different 
place on the RAES Wheel during that same revolution. Thus, in one 
complete revolution of the RAES Wheel, the market market would be 
assigned two times for a total of 15 contracts (assuming one contract 
per spoke), consisting of ten-contract assignment and one five-contract 
assignment. The wedge size would be variable at the discretion of the 
appropriate FPC and may be established at different levels for 
different classes, or at the same level for all classes.
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    \15\ The one-spoke allocation for each of the two new market 
makers would apply only during their initial review period. See 
supra note 13. After that initial review period, each of the two new 
market makers would be entitled to the number of spokes they had 
earned during the applicable review period.
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III. Discussion

A. General

    After careful review, the Commission finds that implementation of 
the proposed rule change on a pilot basis is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities exchange and, in particular, with 
Sections 6(b)(5) and 6(b)(8) of the Act.\16\ Section 6(b)(5) requires, 
among other things, that the rules of an exchange be designed to 
prevent fraudulent and manipulative acts and practices, to promote just 
and equitable principles of trade, to facilitate transactions in 
securities, to remove impediments to and perfect the mechanisms of a 
free and open market and a national market system, and, in general, to 
protect investors and the public interest.\17\ Section 6(b)(5) also 
requires that those rules not be designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers. 
Finally, Section 6(b)(8) of the Act requires that the rules of an 
exchange not impose any burden on competition not necessary or 
appropriate in furtherance of the purposes of the Act.
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    \16\ 15 U.S.C. 78f(b)(5) and 78f(b)(8).
    \17\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiently, competition, 
and capital formation. See 15 U.S.C. 78c(f).
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B. An Important Step Forward

    Currently, RAES assigns orders randomly to market makers who are 
logged on the system. The Commission believes that the 100 Spoke RAES 
Wheel takes an important step forward by rewarding those market makers 
who consistently execute a greater portion of agency orders in the 
trading crowd, rather than randomly assigning contracts to all market 
makers logged on RAES. Although the 100 Spoke RAES Wheel does not 
reward a market maker for improving the Exchange's displayed quotation, 
it does reward the market maker for providing liquidity to orders in 
the trading crowd by linking the market maker's percentage of RAES 
contracts to the percentage of agency contracts it executed in the 
trading crowd. The Commission finds that it is consistent with the 
Act's purpose for the CBOE to take this step.
    Under the two existing means of allocation, the size of the order 
assigned to a particular market maker is determined randomly.\18\ Under 
the entire order procedure, it is theoretically possible for a market 
maker who accounts for a significant percentage of in-person agency 
contracts in a given class of options to be randomly assigned only a 
minimal number of contracts with each turn of the Wheel. Conversely, a 
market maker who accounts for only a small percentage of the in-person 
agency contracts traded in the same option class could be randomly 
allocated on RAES the maximum number of contracts possible. The 100 
Spoke RAES Wheel, however, will more closely allocate the percentage of 
contracts that a particular market maker can receive on a single 
revolution of the Wheel to the percentage of in-person agency contacts 
(excluding RAES contracts) traded on CBOE by that market maker. With 
the 100 Spoke RAES Wheel, market makers will have a greater incentive 
to compete effectively for orders in the crowd, and this, in turn, 
should benefit investors and promote the public interest.
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    \18\ However, under Variable RAES, the market maker has some 
flexibility in limiting the extent of its exposure during each 
revolution of the Wheel.
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    The Commission also views the ``wedge'' system, which limits the 
number of ``spokes'' each market maker may be assigned consecutively, 
not to impose any unnecessary burden on competition, consistent with 
Section 6(b)(8) of the Act. The wedge system will not effect the number 
of contracts to which each market maker is entitled for each revolution 
of the Wheel, but only the timing of the assignment of contracts to 
each market maker. The wedge system ensures that each market maker 
eligible to participate during a particular review period will be 
assigned at least some contracts before market makers entitled to a 
greater number of spokes are assigned all of their contracts in a given 
revolution. The wedge system also reduces the exposure of market makers 
to market risk by breaking up the distribution of contracts into 
smaller groupings.

[[Page 37445]]

    It is important to stress that implementation of the 100 Spoke RAES 
Wheel will have no effect on the prices offered to customers. Under 
CBOE Rule 6.8(a)(ii), RAES automatically provides to each retail 
customer order its execution price, generally determined by the 
prevailing market quote at the time of the order's entry into the 
system. The 100 Spoke RAES Wheel merely provides for a different 
contract allocation system than currently exists for automatic 
execution of small retail orders.

C. Pilot Program

    The Commission is approving this proposal on a nine-month pilot 
basis, through February 28, 2001. As indicated above, the Commission 
anticipates that the 100 Spoke RAES Wheel will encourage market makers 
to compete effectively for order flow in the trading crowds, thus 
benefiting investors and serving the public interest. The Commission, 
however, intends to review the Exchange's experience with the 100 Spoke 
RAES Wheel during the course of the pilot program.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\19\ that the proposed rule change (SR-CBOE-99-40) is approved on a 
pilot basis, through February 28, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \19\ 15 U.S.C. 78s(b)(2).
    \20\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-14931 Filed 6-13-00; 8:45 am]
BILLING CODE 8010-01-M