[Federal Register Volume 65, Number 151 (Friday, August 4, 2000)]
[Notices]
[Pages 48023-48032]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-19730]



[[Page 48023]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43086, File No. 4-429]


Joint Industry Plan; Order Approving Options Intermarket Linkage 
Plan Submitted by the American Stock Exchange LLC, Chicago Board 
Options Exchange, Inc., and International Securities Exchange LLC

July 28, 2000.
     

I. Introduction

    On January 19, 2000, pursuant to an order issued by the Securities 
and Exchange Commission (``SEC'' or ``Commission''),\1\ the American 
Stock Exchange LLC (``Amex''), Chicago Board Options Exchange, Inc. 
(``CBOE''), International Securities Exchange LLC (``ISE''),\2\ Pacific 
Exchange, Inc. (``PCX''), and Philadelphia Stock Exchange, Inc. 
(``Phlx'') filed with the Commission proposed plans for the purpose of 
creating and operating an intermarket options market linkage 
(``plans''). In accordance with Rule 11Aa3-2 of the Act,\3\ Amex, CBOE, 
and ISE filed a plan (the ``Amex/CBOE/ISE plan''). Separately, PCX and 
Phlx filed with the Commission proposals for alternative linkage plans. 
Although the three plans are identical with respect to a majority of 
the issues pertaining to a linkage, the exchanges were unable to reach 
agreement--and the plans differ--on several significant matters. 
Specifically, the exchanges failed to agree about whether the linkage 
should require that orders be routed to exchanges based on price/time 
priority,\4\ who should have access to the linkage, and the appropriate 
remedy owed when one market trades at a price inferior to that 
displayed on another market (known as a ``trade-through'').
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    \1\ On October 19, 1999, the Commission issued an order under 
Section 11A(a)(3)(B) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78k-1(a)(3)(B), directing the options exchanges 
to file a national market system plan within 90 days to link the 
options markets. See Securities Exchange Act Release No. 42029, 64 
FR 57674 (October 26, 1999) (``October 19, 1999 Order'').
    \2\ The Commission's October 19, 1999 Order also requested the 
ISE to participate with the options exchanges in the development of 
an intermarket linkage plan. On January 19, 2000, ISE had not been 
approved as a national securities exchange. Therefore, the ISE was 
not able to be a signatory to a linkage plan at that time, even 
though it submitted a plan identical to that filed by Amex and CBOE. 
The ISE was subsequently registered as a national securities 
exchange for options trading on February 24, 2000. See Securities 
Exchange Act Release No. 42455, 65 FR 11387 (March 2, 2000).
    \3\ 17 CFR 240.11Aa3-2.
    \4\ Both PCX and Phlx proposed price/time priority as an element 
of the linkage. In general, a price/time priority rule would require 
an exchange that receives an order, but that was not the first 
exchange to display the best price, to route the order to the 
exchange that was the first to display the best price.
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    On March 2, 2000, a detailed summary of the Amex/CBOE/ISE plan, the 
PCX plan, and the Phlx plan was published for comment in the Federal 
Register.\5\ The Commission received comments on the proposed linkage 
plans from 24 market participants.\6\ This Order approves the Amex/
CBOE/ISE plan, thus authorizing the Amex, CBOE, and ISE \7\ to act 
jointly to implement an intermarket linkage as a means of facilitating 
a national market system in accordance with the requirements of Section 
11A of the Act.\8\
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    \5\ See Securities Exchange Act Release No. 42456 (February 24, 
2000), 65 FR 11402. At the same time, the full text of each of the 
plans was made available to interested persons on the Commission's 
website.
    \6\ Letters to the Commission from Salvatore F. Sodano, Chairman 
and Chief Executive Officer (``CEO''), Amex, dated January 19, 2000 
and May 3, 2000 (``Amex Letter''); William J. Brodsky, CEO, CBOE, 
dated January 19, 2000, and two dated March 31, 2000 (``CBOE 
Letter''); U.S. Department of Justice to Commission (``DOJ 
Letter''); David Krell, President and CEO, ISE, dated January 19, 
2000, and from Michael J. Simon, Senior Vice President and 
Secretary, ISE, dated April 3, 1999 (``ISE Letter''); Philip D. 
DeFeo, Chairman and CEO, PCX, dated April 3, 2000 (``PCX Letter''); 
William C. McGowan, Chairman, Options Committee, Securities Industry 
Association, dated April 11, 2000 (``SIA Letter''); Meyer S. 
Frucher, Chairman and CEO, Phlx, dated January 19, 2000 (``Phlx 
Letter''); Douglas J. Engmann, President and CEO, ABN-AMRO, dated 
March 24, 2000 (``ABN Letter''); Kevin M. Luthringhausen, Executive 
Managing Member, Botta Trading, LLC, dated April 10, 2000 (``Botta 
Letter''); George Brunelle, Brunelle & Hadjikow, dated April 25, 
2000 (``Brunelle Letter''); Lon Gorman, Vice Chairman and President, 
Capital Markets & Trading Group, Charles Schwab & Co., Inc., dated 
April 18, 2000 (``Charles Schwab Letter''); Craig S. Tyle, General 
Counsel, Investment Company Institute, dated April 3, 2000 (``ICI 
Letter''); Thomas Peterffy, Chairman, and David M. Battan, Vice 
President and General Counsel, Interactive Brokers, The Timber Hill 
Group, dated April 3, 2000 and April 10, 2000 (``Interactive 
Letter''); Peter Hajas, CEO, Knight Financial Products LLC, dated 
April 3, 2000 (``Knight Letter''); Samuel F. Lek, CEO, Lek 
Securities Corporation, (``Lek Letter''); Terry Brookshire, 
President, OptiMark Options/Derivatives, OptiMark Technologies, 
Inc., dated April 3, 2000 (``OptiMark Letter''); Richard F. 
Brueckner, Chief Operating Officer, Pershing Division of Donaldson, 
Lufkin & Jenrette Securities Corporation, dated April 5, 2000 
(``Pershing Letter''); Andrew Cader, Senior Managing Director, 
Spear, Leeds & Kellogg, dated April 6, 2000 (``Spear, Leeds 
Letter''); Joel Greenberg, Managing Director, Susquehanna Investment 
Group, dated April 3, 2000 (``Susquehanna Letter''); Judy A. Basham, 
dated April 17, 2000 (``Basham Letter''); F. Steven Donahue, dated 
March 27, 2000 (``Donahue Letter''); P. Robert Fenwick, dated April 
1, 2000 (``Fenwick Letter''); Mike Ianni, dated March 19, 2000, 
March 26, 2000, April 1, 2000, April 3, 2000, and April 4, 2000 
(``Ianni Letter''); and Goldman, Sachs & Co. and Morgan Stanley Dean 
Witter & Co., dated July 20, 2000 (``Goldman/Morgan Letter''). A 
summary of comments received on the proposed linkage plans is 
available in the Commission's Public Reference Room (File No. 4-
429).
    \7\ The Commission's Order does not require those options 
exchanges that are not participants in the plan to become 
participants in the Amex/CBOE/ISE plan. The plan does, however, 
include express provisions pursuant to which other options exchanges 
may become participants by executing the plan, paying a fee 
applicable to new participants, and obtaining the Commission's 
approval of the plan as amended to reflect the new participant. See 
Amex/CBOE/ISE plan, Sections 4(c) and 5(c)(ii).
    \8\ In addition, as described below, the Commission is 
separately proposing for comment a Trade-Through Disclosure Rule and 
modifications to the Commission's Quote Rule to apply to the options 
markets. See infra note 33 and accompanying text.
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II. Background

    In 1975, Congress directed the Commission to oversee the 
development of a national market system.\9\ One of the principal 
purposes of the national market system is to assure ``the 
practicability of brokers executing investors' orders in the best 
market.'' \10\ In the equity and options market, price transparency and 
the duty of best execution owed by brokers to their customers are 
central to achieving this and other national market system goals. In 
the equity market, the Commission's Quote Rule \11\ and the Intermarket 
Trading System \12\ (which requires exchanges to avoid intentionally 
trading through another exchange's displayed quote) are additional 
components of the national market system that have assisted customers 
in receiving quality executions of their orders. At the time these 
additional national market system mechanisms were developed in the 
equity markets, however, the trading of standardized options was 
relatively new.\13\ As a result, the Commission deferred applying these 
initiatives to the options markets to give options trading an 
opportunity to develop.
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    \9\ Pub. L. No. 94-29 Stat. 97 (1975).
    \10\ 15 U.S.C. 78k-1(a)(1)(C)(iv).
    \11\ Rule 11Ac1-1 under the Act, 17 CFR 240.11Ac1-1.
    \12\ The Intermarket Trading System (``ITS'') Plan is an 
effective national market system linkage plan linking the equity 
markets. The ITS Plan was first approved on an interim basis in 
1978. Securities Exchange Act Release No. 14661 (April 14, 1978), 43 
FR 17419 (April 24, 1978).
    \13\ The trading of standardized options on securities exchanges 
began in 1973, with the organization of CBOE as a national 
securities exchange. See Securities Exchange Act Release No. 9985 
(February 1, 1973), 1 S.E.C. Doc.11 (February 13, 1973). Currently, 
Amex, CBOE, ISE, PCX, and Phlx are the only national securities 
exchanges that trade standardized options.
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    The absence in the options markets of firm quotes and intermarket 
linkages makes it more difficult for broker-dealers to ensure the best 
execution of customer orders for multiply-traded options. The obstacles 
to access between the options exchanges makes reaching any better 
quotes displayed on another market difficult in many cases. Moreover, 
other than exchange rules

[[Page 48024]]

that require members' quotes to be firm for customer orders, market 
makers are not subject to a firm quote obligation. Thus, market makers' 
quotes are not required to be firm for broker-dealers' proprietary 
orders, or for agency orders routed from another exchange. Instead, 
options exchanges have adopted ``trade-or-fade'' rules, requiring 
market makers to move their quote if they are unwilling to trade at 
that price. Accordingly, firms representing customer orders cannot be 
certain that a better price quoted on another exchange is actually 
available to them.
    Since the establishment of the options exchanges, the Commission 
has repeatedly called for market integration facilities for the options 
markets to achieve the national market system goals.\14\ In 1991, in 
response to these calls, four of the five options exchanges\15\ 
submitted a proposal for the development of a linkage.\16\ The plan was 
never adopted, in part, because the exchanges did not agree on the 
feasibility of implementing a single linkage plan. More recently, 
Chairman Levitt wrote to the options exchanges emphasizing the need for 
the options markets to develop mechanisms, such as linkages, firm 
quotes, and trade-through protections, to protect customer orders.\17\ 
Finally, because of the growing practice by the options exchanges of 
multiply trading options classes previously listed on a single 
exchange, the need for measures to ensure that such customer orders are 
not executed at prices inferior to prices quoted on another options 
exchange has become more acute. For this reason, on October 19, 1999, 
the Commission ordered the markets to submit a linkage plan within 90 
days that, at a minimum, included uniform trade-through rules and 
expanded firm quote obligations to cover agency orders presented by 
competing exchanges.\18\ In response to this Order, on January 19, 
2000, Amex, CBOE, and ISE submitted the Amex/CBOE/ISE plan and PCX and 
Phlx each filed separate plans.
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    \14\ See Report of the Special Study of the Options Markets to 
the SEC, 96th Cong., 1st Sess. (Comm. Print No. 96-IFC3, December 
22, 1978) (examining the major issues of market structure in 
standardized options markets, including multiple trading); 
Securities Exchange Act Release No. 16701 (March 26, 1980), 45 FR 
21426 (April 1, 1980) (deferring expansion of multiple trading to 
afford the options exchanges an opportunity to consider the 
development of market integration facilities); Securities Exchange 
Act Release No. 22026 (May 8, 1985), 50 FR 20310 (May 15, 1985) 
(urging options market participants to consider the development of 
market integration facilities); Directorate of Economic and Policy 
Analysis, ``The Effects of Multiple Trading on the Market for OTC 
Options'' (November 1986); Office of the Chief Economist, 
``Potential Competition and Actual Competition in the Options 
Market'' (November 1986); and Securities Exchange Act Release No. 
26871 (May 26, 1989), 54 FR 24058 (June 5, 1989) (requesting comment 
on three measures, including an intermarket linkage). In 1990, then 
Chairman Breeden requested that the options exchanges develop an 
intermarket linkage plan. See letter from Chairman Breeden to the 
registered options exchanges dated January 9, 1990.
    \15\ At that time, the five options exchanges were the CBOE, 
PCX, Amex, Phlx, and the New York Stock Exchange (``NYSE''), which 
later sold its options business to the CBOE. See Securities Exchange 
Act Release No. 38542 (April 23, 1997), 62 FR 23521 (April 30, 
1997).
    \16\ See Securities Exchange Act Release No. 30187 (January 14, 
1992), 57 FR 2612 (January 22, 1992) (soliciting comments on an 
intermarket linkage plan submitted by Amex, CBOE, NYSE, and PCX).
    \17\ See letters from Arthur Levitt, Chairman, SEC, to Richard 
F. Syron, Chairman and CEO, Amex; William J. Brodsky, Chairman and 
CEO, CBOE; Robert M. Greber, Chairman and CEO, PCX; and Meyer S. 
Frucher, Chairman and CEO, Phlx, dated February 10, 1999. See also 
letters from Chairman Levitt, to Salvatore Sodano, Chairman and CEO, 
Amex; William J. Brodsky, Chairman and CEO, CBOE; Philip D. DeFeo, 
Chairman and CEO, PCX; and Meyer S. Frucher, Chairman and CEO, Phlx; 
dated October 1, 1999.
    \18\ See note 1, supra.
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III. Description of the Amex/CBOE/ISE Plan

    The Amex/CBOE/ISE plan proposes an intermarket linkage for the 
following three types of orders:
     Customer orders, where the market maker chooses not to 
``step up'' to match a better price displayed on an away market;
     Principal orders of eligible market makers \19\ and
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    \19\ An ``eligible market maker'' is defined in the Amex/CBOE/
ISE plan as a ``market maker'' that: (1) Is assigned to provide, and 
is providing, two-sided quotations in the eligible option class; (2) 
is participating in its market's automatic execution system in such 
eligible option class; and (3) is not prohibited from sending 
``principal orders'' in such eligible option class through the 
linkage pursuant to the plan.
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     Orders intended to satisfy trade-through liability.
    The means of routing these three types of orders, along with 
certain limitations on their routing, are discussed below.

A. Customer Orders Where Market Makers Choose Not To Step Up

    The Amex/CBOE/ISE plan would permit an eligible market maker 
representing a customer order to transmit through the linkage a new 
type of order--a principal acting as agent order (``P/A Order'').\20\ 
If the size of the P/A Order is no larger than the Firm Customer Quote 
Size,\21\ the Amex/CBOE/ISE plan provides that an eligible market maker 
that chooses to route the order away can send it through the linkage 
for execution in the automatic execution system of a participating 
exchange at the best price (``NBBO'').\22\ The exchange receiving the 
P/A Order through the linkage must execute it in its automatic 
execution system, if its disseminated quote is equal to or better than 
the limit price attached to the P/A Order (``reference price'') \23\ at 
the time the order arrives at the receiving exchange.
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    \20\ A P/A Order is defined as an order for the principal 
account of a market maker authorized to represent customer orders, 
which reflects the terms of a related unexecuted customer order for 
which the market maker is acting as agent.
    \21\ Under the Amex/CBOE/ISE plan, the Firm Customer Quote Size 
is the lesser of: (1) The number of contracts the exchange sending 
the P/A Order guarantees it will automatically execute for customer 
orders that are entered directly in that market; or (2) the number 
of contracts the receiving exchange guarantees it will automatically 
execute for customer orders that are directly entered in that 
market. However, in no event, would a P/A Order be guaranteed fewer 
than 10 contracts.
    \22\ The term ``NBBO'' is defined as the national best bid and 
offer in a series of an eligible option class calculated by a 
participating exchange. Currently, a consolidated NBBO does not 
exist for the option markets. Instead, each options exchange 
separately calculates the best bid or offer for each multiply-traded 
options class.
    \23\ Except with respect to a satisfaction order, the reference 
price is equal to the quotation disseminated by the receiving 
exchange at the time the linkage order is transmitted. With respect 
to a satisfaction order, the reference price is the price to which 
the member in the sending exchange is entitled pursuant to the 
linkage plan. See Section III.C, infra for a discussion of 
satisfaction orders.
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    If the size of the P/A Order is larger than the Firm Customer Quote 
Size, the Amex/CBOE/ISE plan provides two alternatives to an eligible 
market maker that chooses to route the order. First, the eligible 
market maker can send a P/A Order representing the entire customer 
order through the linkage. If the receiving exchange's disseminated 
quote is equal to or better than the reference price of the order, the 
receiving exchange must execute that order for at least the Firm 
Customer Quote Size and, within 15 seconds of receipt of such P/A 
Order, inform the sending exchange of the amount of the order that was 
executed and the amount, if any, that was canceled. Second, an eligible 
market maker can send as a P/A Order that portion of the customer order 
equal to the Firm Customer Quote Size. Then, 15 seconds after reporting 
the execution of this P/A Order, if the receiving exchange continues to 
disseminate the same quote, and that quote is the NBBO, the market 
maker may send a second P/A Order. This second P/A Order must be for 
the lesser of 100 contracts or the entire remainder of the customer 
order the sending eligible market maker is representing. Under either 
alternative, if the receiving exchange does not execute the entire P/A 
Order, it must move its

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quote to a price inferior to the reference price of the P/A Order.
    In addition, an eligible market maker that sends a P/A Order 
through the linkage and who does not receive a reply within 30 seconds 
may reject any response received thereafter purporting to report a 
total or partial execution of that order. The eligible market maker 
that sent the P/A Order must inform such executing exchange within 15 
seconds that it is rejecting the execution.
    Finally, the Amex/CBOE/ISE plan provides that the linkage should 
not be used as an order delivery system through which all or a 
substantial portion of a participant's customer orders are executed 
using P/A Orders routed through the linkage.

B. Principal Orders of Eligible Market Makers

    The Amex/CBOE/ISE plan would allow eligible market makers to send 
proprietary orders through the linkage. Such orders must be at the 
NBBO. If the principal order is not larger than the Firm Principal 
Quote Size,\24\ the exchange receiving such order through the linkage 
must execute it in its automatic execution system, if its disseminated 
quote is equal to or better than the reference price at the time the 
order arrives. If the principal order is larger than the Firm Principal 
Quote Size, the receiving exchange must execute the order in its 
automatic execution system for at least the Firm Principal Quote Size 
and, within 15 seconds of receipt of such order, inform the sending 
exchange of the amount of the order that was executed and the amount, 
if any, that was canceled. In addition, if the receiving exchange does 
not execute the entire principal order, it must move its quote to a 
price inferior to the reference price of the principal order. An 
eligible market maker may not send a second principal order in the same 
eligible option class for at least 15 seconds after it sent the first 
principal order, unless the receiving exchange changes its quote and 
that quote is the NBBO. If the receiving exchange's disseminated quote 
does not change for one minute after the automatic execution of the 
first principal order, the exchange that initially sent the principal 
order for automatic execution may send only principal orders for 
greater than the Firm Principal Quote Size.
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    \24\ Under the Amex/CBOE/ISE plan, the Firm Principal Quote Size 
means the number of contracts that a receiving exchange guarantees 
it will execute at its disseminated quote for incoming principal 
orders, but in no event shall this number be fewer than 10 
contracts.
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    As with P/A Orders sent through the linkage, an eligible market 
maker that sends a principal order through the linkage and who does not 
receive a reply within 30 seconds may reject any response received 
thereafter purporting to report a total or partial execution of that 
order. The market maker that sent the principal order must inform the 
receiving exchange within 15 seconds that it is rejecting the response.
    As a limitation on eligible market makers' access to the linkage 
for sending principal orders, the Amex/CBOE/ISE plan would impose an 
``80/20 Test.'' Under this test, a market maker that effected 20 
percent or more of its market maker volume by sending principal orders 
through the linkage in a calendar quarter would be prohibited from 
sending principal orders through the linkage for the next calendar 
quarter (i.e., would not be an ``eligible market maker'' for that 
period). Outgoing P/A Orders would not be included in this calculation.

C. Satisfaction of Trade-Through Liability

    The Amex/CBOE/ISE plan provides that members of participant markets 
should avoid initiating trade-throughs, subject to certain exceptions, 
absent reasonable justification and during normal market conditions. 
Any member of a plan participant that does initiate a trade-through 
would be liable to the market maker who complains that its quote was 
traded through. Under the plan, there are a number of proposed 
exceptions to this trade-through liability, which include systems 
malfunction, failure of the receiving market to respond to a P/A or 
principal order within 30 seconds, complex trades, trading rotations, 
and non-firm quotations on the market that was traded through.
    The Amex/CBOE/ISE plan provides that if a market that had its quote 
traded through complains within the specified time period, the member 
that initiated such trade-through would have to satisfy the complaining 
market by adjusting the price or canceling the trade. If customer 
orders constituted either or both sides of the transaction involved in 
the trade-through, each customer order would receive whichever of the 
following is most beneficial to the customer:
     The price of the trade that caused the trade-through;
     The satisfaction price, if the trade-through was 
satisfied; The satisfaction price would equal the bid or offer, unless 
the transaction that constituted the trade-through was a block 
trade,\25\ in which case satisfaction would be the price of the 
transaction that caused the trade-through; or
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    \25\ The term ``block trade'' is defined as a trade that: (i) is 
of block size, defined as 500 or more contracts and a premium value 
of at least $150,000; (ii) is effected at a price outside of the 
NBBO; and (iii) involves either a cross (where a member of the 
exchange represents all or a portion of both sides of the trade) or 
any other transaction that is not the result of an execution at the 
current bid or offer on the exchange.
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     The adjusted price, if there was an adjustment.
    The member initiating the trade-through is responsible for any 
differences.
    With respect to the appropriate size of satisfaction, in the 
absence of disseminated size, the Amex/CBOE/ISE plan would limit the 
satisfaction of a trade-through to the verifiable number of customer 
contracts that were included in the disseminated bid or offer of each 
exchange that was traded through, subject to certain limitations. In 
particular, if the number of contracts to be satisfied in one or more 
exchanges exceeds the size of the transaction that caused the trade-
through, satisfaction will be limited to the size of the transaction 
that caused the trade-through.

IV. Discussion

A. Introduction

    In Section 11A of the Act,\26\ Congress directed the Commission to 
facilitate the development of a national market system consistent with 
the objectives of the Act. In particular, Section 11A(a)(3)(B) of the 
Act \27\ authorizes the Commission ``by rule or order, to authorize or 
require self-regulatory organizations to act jointly with respect to 
matters as to which they share authority under this title in planning, 
developing, operating, or regulating a national market system (or a 
subsystem thereof) or one or more facilities.'' Rule 11Aa3-2 
establishes the procedures for filing, amending, and approving national 
market system plans.\28\ Pursuant to paragraph (c)(2) of Rule 11Aa3-2, 
the Commission's approval of a national market system plan is 
conditioned upon a finding that the proposed plan ``is necessary or 
appropriate in the public interest, for the protection of investors and 
the maintenance of fair and orderly markets, to remove impediments to, 
and perfect the mechanisms of, a national market

[[Page 48026]]

system, or otherwise in furtherance of the purposes of the Act.''\29\
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    \26\ 15 U.S.C. 78k-1.
    \27\ 15 U.S.C. 78k-1(a)(3)(B).
    \28\ 17 CFR 240.11Aa3-2.
    \29\ 17 CFR 240.11Aa3-2(c)(2).
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    After carefully considering the proposed linkage plans and the 
issues raised by the comment letters, the Commission has determined to 
approve, pursuant to Section 11A(a)(3)(B) of the Act,\30\ and Rule 
11Aa3-2 thereunder,\31\ the Amex/CBOE/ISE plan, thus authorizing the 
Amex, CBOE and ISE to act jointly to implement the plan's intermarket 
linkage.\32\ In approving the Amex/CBOE/ISE plan, the Commission finds 
that, as discussed in greater detail below, the Amex/CBOE/ISE plan is 
consistent with the Act in that it provides, among other things, a 
mechanism for assuring price priority for published quotes and 
obtaining the quoted price for customer orders, and therefore, would 
enhance investor protections and the maintenance of fair and orderly 
markets.
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    \30\ 15 U.S.C. 78k-1(a)(3)(B).
    \31\ Pursuant to paragraph (c)(2) of Rule 11Aa3-2 under the Act, 
the Commission designates up to 180 days from the date of 
publication of notice of the filing of a national market system plan 
for its approval of the Amex/CBOE/ISE plan. The Commission finds 
that, due to the complexity of issues relating to an intermarket 
linkage between the options markets, it is necessary and appropriate 
in the public interest, for the protection of investors, and the 
maintenance of fair and orderly markets to designate this longer 
period. 17 CFR 240.11Aa3-2.
    \32\ The Commission's approval of the Amex/CBOE/ISE plan should 
not be construed as a rejection on the merits of either the Phlx or 
the PCX submissions. Neither of those submissions could be approved 
as a national market system plan pursuant to Rule 11Aa3-2 under the 
Act, 17 CFR 240.11Aa3-2, because neither was filed by two or more 
sponsors, as required by the Rule. In fact, the Commission would 
consider approving other national market system plans relating to 
intermarket linkages between the options markets, submitted by two 
or more markets.
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    Specifically, the Commission believes that the continuing growth in 
the number of options classes traded on more than one exchange has 
significantly increased the need for a vehicle to assure price priority 
for published options quotes. Without an efficient linkage between the 
options markets, it is difficult for one options exchange to access 
better prices on another exchange. Given the recent increase in 
multiply-traded options classes, the absence of an efficient mechanism 
allowing one market to access a better price displayed by another 
exchange heightens the Commission's concern that better priced quotes 
may not be honored and that investors may not receive the best price 
available for their orders. The Commission believes that the Amex/CBOE/
ISE plan, if implemented, would help reduce the frequency of 
intermarket trade-throughs of published quotations.
    The Commission recognizes the limited scope of the Amex/CBOE/ISE 
plan. Notably, the Amex/CBOE/ISE plan does not attempt, among other 
things, to give priority to customer limit orders across markets or to 
encourage quote competition by rewarding market makers who establish 
the NBBO. The Commission, however, believes that it would be premature 
at this time to require the inclusion of either customer limit order 
protection or price/time priority as elements of a linkage between the 
options markets.
    Moreover, while the Commission has determined at this time to 
approve the Amex/CBOE/ISE plan, the Commission recognizes that there 
may be a number of equally acceptable means of achieving the 
Commission's goal of encouraging price priority by limiting intermarket 
trade-throughs of customer orders. To that end, the Commission has 
separately proposed modifications to its Quote Rule to apply to the 
options exchanges and options market makers the same obligations, with 
certain modifications, currently imposed on equity markets and market 
makers. The Commission is also proposing a rule that would require a 
broker-dealer to disclose to customers when the customer's order is 
executed at a price inferior to the best available quote, unless the 
order is routed only to options exchanges that participate in a plan 
that limits trade-throughs.\33\ The Commission believes that its 
approval of the Amex/CBOE/ISE plan, coupled with the rulemaking 
separately proposed, should minimize the probability of intermarket 
trade-throughs involving customer orders.
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    \33\ See Securities Exchange Act Release No. 43085 (July 28, 
2000) (Firm Quote and Trade-Through Disclosure for Options 
Proposal). The Commission's proposal would require a broker-dealer 
to disclose to its customer when a transaction in listed options was 
effected at a price that trades through a better published price, 
and the better published price. The broker-dealer would be excepted 
from the disclosure requirement of the proposed rule if the 
transaction is effected on an options exchange that is a participant 
in an effective national market system options linkage plan that 
includes provisions to limit customer orders from being executed at 
a price that trades through a better published price, including 
prices published other than by a linkage plan participant. In 
addition, the Commission is proposing amendments to its Quote Rule, 
17 CFR 240.11Ac1-1, to require quotes for listed options to be firm.
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B. Price/Time Priority

    One way to encourage market makers to quote competitively is 
through a rule that gives priority to quotes based on price and time. 
Generally, priority among orders and quotes within an exchange is based 
on price and time.\34\ A requirement that priority across markets be 
based on price and time has also been suggested as a way to reward 
market makers who are the first in time at the best quote. In general, 
an intermarket requirement of price/time priority would require an 
exchange that receives an order, but that was not the first exchange to 
display the best price, to route the order to the exchange that was 
first at the best price. The PCX\35\ and Phlx\36\ each incorporated 
price/time priority as an element of their proposed linkage plans. As 
discussed above, the Amex/CBOE/ISE plan does not include price/time 
priority and instead, would allow the exchange initially receiving an 
order to step up to match the better price being disseminated by 
another market.
---------------------------------------------------------------------------

    \34\ The exchanges, however, have rules that grant certain 
market participants priority based on other factors. For example, 
exchanges' rules permit specialists, under certain circumstances, to 
trade ahead of others in a trading crowd with a certain percentage 
of every order, known as specialist guarantees. See CBOE Rule 8.87; 
ISE Rule 713(e); PCX Rule 6.82(d); Phlx Rule 1014(g); see also 
Securities Exchange Act Release No. 42964 (June 20, 2000), 65 FR 
39972 (June 28, 2000) (File No. SR-Amex-00-30). In addition, some 
exchanges' rules, subject to certain requirements, grant order entry 
firms priority over members of the trading crowd to trade as 
principal with up to 40% of each of their customers' orders above a 
certain size, known as facilitation guarantees. See Securities 
Exchange Act Release Nos. 42894 (June 2, 2000), 65 FR 36850 (June 
12, 2000) (File No. SR-Amex-99-36); 42835 (May 26, 2000), 65 FR 
35683 (June 5, 2000) (File No. SR-CBOE-99-10); and 42848 (May 26, 
2000), 65 FR 36206 (June 7, 2000) (File No. SR-PCX-99-18). Finally, 
all of the exchanges have automatic execution systems for small 
public customer orders that execute such orders against the accounts 
of market makers at each exchange's disseminated quote on a 
rotational basis without exposing such orders to the auction on the 
floor and its price/time priority rules.
    \35\ The PCX proposed that customer orders of 20 contracts or 
less would be automatically executed by the exchange that initially 
received the order only if that exchange was disseminating a quote 
with price/time priority, or if the exchange was at the NBBO 
(although not first in time) and provided price improvement for the 
order. If the exchange was not quoting at the NBBO at the time it 
initially received the order, it would be required to automatically 
generate a P/A Order and send it to the away market that was 
disseminating a quote with price/time priority, so long as the away 
exchange provided a firm customer quote of at least 20 contracts in 
the particular options class.
    \36\ The Phlx proposed a linkage plan that incorporated a strict 
price/time priority feature. The Phlx plan would require each 
exchange to build a front-end system to route all customer orders 
that would be eligible for automatic execution, as P/A Orders, 
either directly through the linkage or to the facilities manager if 
the exchange that initially received the order was not the first to 
disseminate the best price.
---------------------------------------------------------------------------

    In addition to the PCX and Phlx, several commenters supported the 
notion of price/time priority as an element of an intermarket linkage 
plan. One commenter noted that without price/time priority, there is no 
incentive

[[Page 48027]]

for market makers to show their best markets, thus making bid-ask 
spreads wider.\37\ Other commenters argued that the best linkage plan 
would limit the imposition of price/time priority to small, non-
contingent orders.\38\
---------------------------------------------------------------------------

    \37\ Ianni Letter.
    \38\ DOJ Letter and Goldman/Morgan Letter.
---------------------------------------------------------------------------

    A number of commenters stated, however, that strict price/time 
priority would undermine market competition by eliminating the ability 
of the exchanges to compete with each other on service factors, 
including: quick turnaround on fills, low costs, superior order 
handling systems, low-error rates, investor education, and enhanced 
liquidity and depth of the markets.\39\ One commenter asserted that the 
price/time priority proposals were intended more to advance the 
perceived competitive positions of the exchanges supporting the 
proposals, than to benefit investors.\40\ Another commenter suggested 
that the price/time priority proposals were actually anticompetitive 
because they would eliminate all forms of competition except one--the 
race to the quote.\41\
---------------------------------------------------------------------------

    \39\ Amex Letter; Susquehanna Letter; Spear, Leeds Letter; 
Pershing Letter; SIA Letter; Charles Schwab Letter; and CBOE Letter.
    \40\ ISE Letter; see also Charles Schwab Letter.
    \41\ ISE Letter.
---------------------------------------------------------------------------

    Other commenters contended that imposing an intermarket price/time 
priority rule would require the creation of a routing switch or 
consolidated limit order book (``CLOB'') that would consist of a single 
execution facility, with a single point of failure, and that such a 
development would reduce incentives for the markets to innovate.\42\
---------------------------------------------------------------------------

    \42\ Botta Letter; Charles Schwab Letter; and Knight Letter.
---------------------------------------------------------------------------

    Several commenters argued that decimalization, which may create 
pricing increments as small as a penny, would undermine a price/time 
priority requirement.\43\ These commenters suggested that if a price/
time priority requirement were imposed, an exchange could easily step 
ahead of another exchange or customer limit order by improving the NBBO 
by just a penny. This ability to improve the NBBO by as little as a 
penny could lead to competition based on which computer could update 
its quotes faster.\44 \
---------------------------------------------------------------------------

    \43\ Optimark Letter and Charles Schwab Letter.
    \44\ See also Spear, Leeds Letter.
---------------------------------------------------------------------------

    At this time, the Commission believes that the proposed options 
intermarket linkage, even without a price/time priority component, is 
consistent with the requirements of the Act. The Commission does not, 
however, currently have sufficient information to satisfy itself that 
the potential benefits of a mandatory price/time priority requirement 
justify the potential drawbacks.
    For example, the implementation of decimals is expected to have a 
dramatic impact on the minimum pricing increments in the options 
markets and may affect the behavior of market participants. At this 
point, however, before the U.S. securities markets have actually begun 
trading in decimals, it is impossible to gauge the impact of 
decimalization on the options markets. Because the Commission cannot 
reliably predict the effect of decimals on the quoting practices in the 
options markets, it would be premature to mandate a requirement that 
dictates order execution practices based on quoting practices that have 
not yet developed. Further, the Commission believes that it is prudent 
to wait until decimals are implemented to consider whether, in a 
decimals environment, an intermarket price/time priority requirement 
would or would not reduce competition among the exchanges.
    Finally, the issue of whether price/time priority could negatively 
impact liquidity in a given market by requiring the routing of orders 
based on price alone, without consideration of the size demands of the 
order or an exchange's ability to execute the full size of the order, 
should be considered. For these reasons, the Commission believes that a 
price/time priority requirement is not a prerequisite to approval of an 
intermarket linkage plan in the options market. The Commission, 
nevertheless, continues to consider further ways to strengthen price 
competition and price priority within existing market structures.\45\ 
In addition, the Commission is concerned about the impact on quote 
competition of payment for order flow and other non-price competition 
practices. To better inform the Commission about the nature, scope, and 
prevalence of payment for order flow and internalization arrangements 
and their influence on order routing patterns, the Commission's Office 
of Economic Analysis along with the Office of Compliance Inspections 
and Examinations plans to conduct a study of the development of these 
practices in the options markets since multiple listing.\46 \
---------------------------------------------------------------------------

    \45\ See Securities Exchange Act Release No. 43084 (July 28, 
2000) (Disclosure of Order Routing and Execution Practices Proposal) 
and supra note 33.
    \46\ SEC Press Release No. 2000-97 (July 19, 2000) (Commission 
To Study Effect of Payment for Order Flow and Internalization in the 
Options Markets).
---------------------------------------------------------------------------

C. Customer Limit Order Protection

    In its transmittal letter, the ISE proposed an alternative approach 
for handling P/A Orders that would provide a means of protecting 
customer limit orders. Under this alternative approach, if one market 
executes an order at another market's quoted price without quoting at 
that price, and if the other market's quote was for a customer limit 
order, the other market can require the first market to honor its 
displayed customer limit order. Also, under this alternative approach, 
if the exchange receiving an order decides to route an order to another 
market instead of stepping up to match the better quote, it would be 
required to route the order through the linkage based on price/time 
priority.
    The Commission received three comments in support of a customer 
limit order protection component to a linkage.\47\ One of these 
commenters believed that the Commission should not approve a linkage 
unless customer limit orders have the opportunity to interact with the 
flow of orders on other markets.\48\ In addition, two commenters 
supported a customer limit order protection rule that would protect 
customer limit orders while continuing to allow a market maker to step 
up to match the NBBO.\49 \
---------------------------------------------------------------------------

    \47\ Optimark Letter; Ianni Letter; and Pershing Letter.
    \48\ Optimark Letter.
    \49\ Ianni Letter and Pershing Letter.
---------------------------------------------------------------------------

    On the other hand, seven commenters either opposed or expressed 
serious reservations about the potential competitive impact, cost, 
feasibility, or utility of a customer limit order protection rule.\50\ 
These commenters believed that such a rule would be tantamount to a 
CLOB, which could eventually turn the options markets into a single 
execution facility, with a potential single point of failure, rather 
than a system of competing markets.\51\ Several commenters believed 
that this would create a disincentive for dealers to commit capital, 
disrupt trading, stifle innovation, and discourage firms from offering 
new services.\52\
---------------------------------------------------------------------------

    \50\ CBOE Letter; Botta Letter; Susquehanna Letter; Knight 
Letter; Spear, Leeds Letter; and Charles Schwab Letter; see also 
Amex Letter.
    \51\ CBOE Letter; Susquehanna Letter; and Charles Schwab Letter.
    \52\ Susquehanna Letter; Botta Letter; and Charles Schwab 
Letter.
---------------------------------------------------------------------------

    In addition, two commenters expressed concern that a customer limit 
order protection rule could expose market makers who step up to match 
the NBBO to increased risk because such market makers could have to 
satisfy customer limit orders on another

[[Page 48028]]

market.\53\ Therefore, one commenter stated, there would be less 
incentive for a market maker to provide liquidity, which could result 
in wider spreads or in market makers leaving the options exchanges' 
floors.\54\ In addition, one commenter believed that for a customer 
limit order protection rule to be feasible, size would have to be 
disseminated to allow market makers to make informed decisions about 
whether to price match or route an order.\55\
---------------------------------------------------------------------------

    \53\ Susquehanna Letter and Botta Letter.
    \54\ Susquehanna Letter.
    \55\ Spear, Leeds Letter. The Commission notes that, at this 
time, only the ISE displays customer limit orders with size.
---------------------------------------------------------------------------

    Several commenters believed that the issue of limit order 
protection could be addressed by the exchanges imposing a customer 
limit order protection rule on their own members or allowing each 
specialist to determine the level of intermarket limit order protection 
it wishes to provide to limit orders sent to its market.\56\ Commenters 
believed that, as a result of competitive pressures and exchanges' 
concerns about assisting firms in satisfying their best execution 
responsibilities, the markets would achieve the appropriate level of 
limit order protection without the Commission mandating it as part of a 
linkage.\57\
---------------------------------------------------------------------------

    \56\ CBOE Letter; Susquehanna Letter; and Botta Letter; see also 
Charles Schwab Letter.
    \57\ CBOE Letter; Susquehanna Letter; and Charles Schwab Letter; 
see also SIA Letter and Amex Letter.
---------------------------------------------------------------------------

    Finally, several commenters noted that adopting a customer limit 
order protection rule should not be allowed to delay an options market 
linkage.\58\ In addition, some commenters believed that a customer 
limit order protection rule should be addressed in the context of the 
broader market structure debate.\59\ In that regard, at least three 
exchanges committed to studying the idea of incorporating a customer 
limit order protection rule into an intermarket linkage plan.\60\
---------------------------------------------------------------------------

    \58\ Pershing Letter; ISE Letter; and Amex Letter; see also SIA 
Letter and CBOE Letter.
    \59\ SIA Letter and ISE Letter.
    \60\ CBOE Letter; Amex Letter; and ISE Letter.
---------------------------------------------------------------------------

    As discussed above, the Commission has determined, at this time, 
that a customer limit order protection requirement is not a 
prerequisite to approval of an options market linkage plan. While the 
Commission believes that such a rule could enhance limit order 
protections, the Commission believes that it is important not to delay 
the implementation of a linkage while resolving the issues raised by 
protecting limit orders across markets.

D. Access to the Linkage

1. General Limitations
    The Amex/CBOE/ISE plan provides access \61\ to the linkage to 
eligible market makers on behalf of customer orders and by market 
makers and specialists on behalf of their principal accounts. Non-
market maker broker-dealers would not have access to the linkage.
---------------------------------------------------------------------------

    \61\ Access would include, up to a specified size, automatic 
execution and firm quote treatment.
---------------------------------------------------------------------------

    Several commenters supported limiting access to the linkage.\62 \ 
One commenter stated simply that access must be limited to the orders 
of retail customers.\63\ Two commenters believed, however, that the 
proposed restrictions on proprietary access are not consistent with an 
open, accessible, and efficient marketplace and would perpetuate the 
current two-tiered market. These commenters noted that non-market maker 
broker-dealers would not have an efficient mechanism to execute orders 
for their proprietary accounts,\64\ resulting in the use of slower, 
manual execution methods, which ultimately would decrease liquidity and 
pricing efficiency.\65\ Finally, one commenter stated that the proposed 
distinction between broker-dealer and non-broker-dealer customers is 
unfair and unsupportable.\66\
---------------------------------------------------------------------------

    \62\ Amex Letter; Susquehanna Letter; Botta Letter; and CBOE 
Letter.
    \63\ Knight Letter.
    \64\ Interactive Letter and Lek Letter.
    \65\ Spear, Leeds Letter. This commenter also opposed the 
limitation on market makers routing orders more frequently than 
every 15 seconds and routing orders for automatic execution more 
frequently than every minute. The commenter believed this would put 
competing market makers at a significant disadvantage when 
attempting to provide price equilibrium between markets.
    \66\ SIA Letter.
---------------------------------------------------------------------------

    Instead of implementing a new system for the linkage, one commenter 
proposed using existing routing systems to allow members of one 
exchange to access other exchanges, and permitting the exchange being 
accessed to charge a small fee to eliminate the concern that the 
linkage would allow unlimited free access to other exchanges. The same 
commenter argued that unlimited and unrestricted access should be 
available to anyone for publicly displayed bids and offers.\67\ 
Finally, one commenter proposed that the exchanges grant access to each 
other's order routing systems either through private vendors or through 
direct linkages between markets, pursuant to accessibility standards 
established by the Commission.\68\
---------------------------------------------------------------------------

    \67\ Lek Letter.
    \68\ Charles Schwab Letter.
---------------------------------------------------------------------------

    At this time, while the Commission would support broader access 
between options markets, the Commission does not believe it is 
essential that an options linkage plan provide broader access for 
proprietary traders. The Amex/CBOE/ISE plan eliminates barriers to 
routing customer orders between markets, helping to ensure that 
customer orders have an opportunity to access the best price available 
in the options market. To achieve this goal, the plan provides for 
routing customer orders to other markets through the linkage. The 
plan's approach of permitting eligible market makers, acting as agents 
for customer orders, to access the linkage provides customer orders 
with access to other markets.
    The Amex/CBOE/ISE plan also allows eligible market makers to use 
the linkage to hit quotes on an away market, thus helping to protect 
the priority of the better displayed price. As discussed below, the 
Commission also recognizes the validity of concerns with respect to 
unlimited principal access.
    Finally, the Commission finds that, at this time, the proposed 
exclusion of non-market maker broker-dealers from the linkage is not 
unreasonable. The Amex/CBOE/ISE plan limits access to the linkage to 
eligible market makers due to their affirmative obligations to the 
markets. The Commission believes that, by limiting who has access to 
the linkage, the Amex/CBOE/ISE plan reasonably attempts to address the 
concern that allowing broader access to the linkage could dilute the 
value of exchange memberships.
2. Limitation on Principal Access
    As previously noted, the Amex/CBOE/ISE plan proposed to limit 
eligible market maker access to the linkage for sending principal 
orders to less than 20 percent of each market makers total volume (the 
80/20 Test). A market maker effecting more than 20 percent of its 
volume in a calendar quarter through the linkage would be prohibited 
from sending principal orders through the linkage in the subsequent 
quarter. The PCX plan proposed to prohibit the transmission of 
principal orders, except to unlock or uncross markets or to satisfy 
trade-through liability. Under the Phlx plan, eligible market makers 
would be permitted to send principal orders through the linkage without 
limitation.
    Commenters generally maintained that limited principal access 
should be permitted to the extent it facilitates the operation of the 
linkage, but that it should not become a surrogate for exchange 
membership.\69\ Several

[[Page 48029]]

commenters supported the Amex/CBOE/ISE plan's proposed 80/20 Test for 
volume restriction.\70\ Another commenter argued, however, that each 
exchange should be permitted to independently adopt its own limitation, 
if any, on principal access.\71\
---------------------------------------------------------------------------

    \69\ Amex Letter; Susquehanna Letter; Botta Letter; and CBOE 
Letter.
    \70\ Amex Letter; Susquehanna Letter; CBOE Letter; Ianni Letter; 
and SIA Letter.
    \71\ Knight Letter.
---------------------------------------------------------------------------

    One commenter believed the 80/20 Test would put smaller market 
participants at a competitive disadvantage. This commenter preferred 
the PCX plan to the Amex/CBOE/ISE plan because it would allow for 
essentially unlimited principal trading to unlock or uncross a 
market.\72\ Another commenter noted that the Commission and the 
exchanges should be mindful of the potential, practical difficulties 
associated with requiring a participant to unlock or uncross a market 
it has locked or crossed.\73\
---------------------------------------------------------------------------

    \72\ Interactive Letter.
    \73\ SIA Letter.
---------------------------------------------------------------------------

    The plan's limitation on principal access is designed to prevent 
the linkage from becoming a means of wide scale proprietary trading by 
broker-dealers on markets in which they are not members. The Commission 
finds that the 80/20 Test is a reasonable means to ensure that market 
makers use the linkage to prevent trade-throughs and honor other 
markets' quotes, as the plan intends, and not as a substitute for 
exchange membership. Otherwise, a trader on one exchange could gain 
virtually free access to another exchange through use of the linkage, 
without having to satisfy the exchange's membership requirements. The 
plan is not intended to displace membership in exchanges, or replace 
direct broker-dealer order routing connections to the exchanges. Thus, 
the plan does not preclude a market maker from obtaining direct access 
to a particular exchange by sending orders to such exchange through a 
member of that exchange or by becoming an exchange member itself.
    The Commission recognizes that the 20 percent limitation on a 
market maker's principal activity in the Amex/CBOE/ISE plan is based on 
judgment, rather than practical experience with a linkage. The 
Commission believes that the 20 percent limitation is reasonable. If 
experience indicates that a different limit would be preferable, the 
percentages can be altered at a future date.

E. Trade-Through Provisions

    As discussed above, the Amex/CBOE/ISE plan proposes that members in 
their markets should, absent reasonable justification and during normal 
market conditions, avoid initiating trade-throughs, subject to certain 
exceptions. Generally, commenters supported the trade-through 
protections provided for in the proposed plans.\74\ One commenter noted 
that a linkage would enhance execution quality of customer orders by 
providing trade-through protection.\75\ Another commenter specifically 
supported the Amex/CBOE/ISE plan's treatment of trade-throughs, which 
would limit satisfaction of a trade-through up to the verifiable number 
of customer contracts in the markets that were traded through, subject 
to the size of the transaction that caused the trade-through.\76\ That 
commenter specifically opposed the Phlx's proposal, which would allow 
the total number of verifiable contracts to be satisfied to exceed the 
size of the transactions that caused the trade-through.\77\
---------------------------------------------------------------------------

    \74\ SIA Letter; ISE Letter; Ianni Letter; and Botta Letter.
    \75\ Knight Letter.
    \76\ SIA Letter.
    \77\ Id.
---------------------------------------------------------------------------

    One commenter believed that the trade-through provisions of the 
plans needed to be clarified.\78\ First, this commenter noted that the 
proposed plans do not specify what time (i.e., receipt or execution) 
would be used when evaluating whether a trade-through had occurred. 
Second, this commenter questioned whether a specialist would have to 
step up or send an order to a better market if the specialist had 
already sent that order and it had been rejected by a market that was 
previously at the NBBO.
---------------------------------------------------------------------------

    \78\ Botta Letter.
---------------------------------------------------------------------------

    One commenter noted that the plans do not provide any deterrent for 
initiating trade-throughs or ignoring linkage orders, other than the 
risk of a complaint by another market. The commenter believed that 
because the plans require the aggrieved party to complain about a 
trade-through within three minutes of the trade-through being reported 
by the Options Price Reporting Authority (``OPRA'') and because damages 
are limited to making the aggrieved party whole, violators initiating 
trade-throughs will reap the benefits of doing so, while only 
occasionally having to return any gains. The commenter encouraged the 
Commission to include a penalty, in addition to making aggrieved 
parties whole, extend the time during which complaints could be lodged 
to thirty minutes, and require the exchanges to bear the responsibility 
for detecting trade-throughs. The commenter also recommended exchange 
surveillance to deter participants from ignoring orders routed through 
the linkage.\79\
---------------------------------------------------------------------------

    \79\ Interactive Letter.
---------------------------------------------------------------------------

    The Commission notes that trade-throughs currently can occur in the 
options market because there is no efficient means for accessing quotes 
across those markets. The Commission believes that approval of the 
Amex/CBOE/ISE plan will improve execution of orders and promote best 
execution opportunities by providing not only a linkage to send 
customer orders to markets if they have a better quote, but also 
remedies in the event that a better bid or offer is traded through. 
Generally, under the Amex/CBOE/ISE plan, a trade-through would be 
determined at the time the order is executed to avoid having an 
exchange become liable for a quote that did not exist in its market at 
the time of execution.
    The rule proposed in the Amex/CBOE/ISE plan does not flatly 
prohibit trade-throughs and does not provide a remedy to the quotes or 
orders traded through unless the aggrieved party complains.\80\ Because 
the trade-through provision depends upon the aggrieved party 
complaining of the trade-through within an allotted period of time, the 
Commission concurs with one commenter's opinion that the Amex/CBOE/ISE 
plan may not eliminate trade-throughs in all instances. The plan is 
beneficial nevertheless because it provides an efficient means, and 
some incentive, to avoid trade-throughs. The exchanges also have 
competitive incentives to avoid trade-throughs to attract broker-
dealers seeking to satisfy their obligation to assess the various 
markets in determining how to achieve best execution of their 
customers' orders.\81\ Moreover, the Trade-Through Disclosure Rule, 
proposed today in a separate release, would also give broker-dealers 
and exchanges a substantial

[[Page 48030]]

incentive to avoid trade-throughs involving customer orders, because 
the proposed rule would require such trade-throughs to be disclosed to 
customers.\82\ The proposed Trade-Through Disclosure Rule would except 
broker-dealers from the requirement to disclose trade-throughs to 
customers if such customers' orders are executed on markets that are 
participants in an effective national market system options linkage 
plan that includes provisions reasonably designed to limit the 
execution of customer orders at prices inferior to any published price, 
including prices published by exchanges that are not linkage plan 
participants. Finally, if the Commission were to apply to the options 
markets the execution quality disclosure rules proposed today for the 
equity markets, \83\ the exchanges would have additional incentives to 
avoid trade-throughs that would impair the quality of the executions 
the markets would be required to disclose.
---------------------------------------------------------------------------

    \80\ The Commission notes that its approval of the trade-through 
provision in the Amex/CBOE/ISE plan should not be interpreted to 
mean that unless a party initiating a trade-through is required to 
satisfy, cancel or adjust a trade, a trade-through has not occurred. 
Generally, if an order is executed in one market center at a price 
inferior to that available in another market center, a trade-through 
has occurred, regardless of whether the aggrieved party complains of 
the trade-through. By approving the Amex/CBOE/ISE trade-through 
provision, the Commission is merely approving a means to limit 
potential trade-throughs.
    \81\ In accepting orders and routing them to a market center for 
execution, brokers act as agents for their customers and owe them a 
duty of best execution. This duty requires a broker to seek the most 
favorable terms reasonably available under the circumstances for a 
customer's transaction. As a result, broker-dealers must 
periodically assess the quality of competing markets. See Securities 
Exchange Act Release No. 37619A (September 6, 1996), 61 FR 48290 
(September 12, 1996).
    \82\ See supra note 33.
    \83\ See supra note 45.
---------------------------------------------------------------------------

    The Commission does not believe that it is appropriate to require 
an exchange trading through the quote or quotes on another market to 
satisfy such quote or quotes for a greater number of contracts than the 
trade causing the trade-through. The Commission believes that such a 
requirement may impose an excessive penalty on a market maker that may 
have inadvertently traded through more than one market, and could be an 
unjustified windfall to a market that would not have received the order 
because another market had priority and could have executed the order 
in full.

F. Governance and Voting Requirements

    An Operating Committee, composed of one representative of each 
participating exchange, is proposed to administer the Amex/CBOE/ISE 
plan. The majority of commenters expressing views about the Operating 
Committee supported the Operating Committee's discretion to develop and 
implement the linkage, and to advise participants regarding 
deficiencies, problems, or recommendations.\84\ Further, commenters 
agreed that this authority should include defining plan terms, such as 
whether a ``complex trade'' should be excepted from trade-through 
liability at least during the initial stages of the linkage 
implementation.\85\ One commenter stated that the representatives of 
the participants would have the most familiarity with the linkage and 
should be able to address issues regarding the functionality and 
specifications of the linkage.\86\ Two commenters suggested that the 
Operating Committee should include representatives from member firms in 
addition to the participating exchanges.\87\
---------------------------------------------------------------------------

    \84\ Amex Letter; CBOE Letter; and SIA Letter.
    \85\ Amex Letter; Ianni Letter; and SIA Letter.
    \86\ CBOE Letter.
    \87\ Pershing Letter and Goldman/Morgan Letter. The Commission 
notes that exchange members will be represented on the Member 
Advisory Committee.
---------------------------------------------------------------------------

    The commenters disagreed as to whether a unanimous vote was 
appropriate to amend the plan. Two commenters believed that plan 
amendments should require a unanimous vote, while a simple-majority 
would be appropriate for other actions, such as plan 
administration.\88\ The commenters opposing the unanimous vote proposal 
feared that improvements and innovations could be blocked by the 
interests of a single entity,\89\ reminiscent of problems with the ITS 
Plan.\90\ Two commenters stated their belief that only a super-majority 
should be required to amend the plan.\91\
---------------------------------------------------------------------------

    \88\ Amex Letter and CBOE Letter.
    \89\ Pershing Letter; Goldman/Morgan; and SIA Letter.
    \90\ Interactive Letter and Charles Schwab Letter.
    \91\ SIA Letter; and Ianni Letter.
    \91\ SIA Letter, and Ianni Letter.
---------------------------------------------------------------------------

    The Commission finds that the governance and voting requirements 
proposed in the Amex/CBOE/ISE plan are consistent with the Act. The 
Commission concludes that the proposed discretion and authority that is 
granted to the Operating Committee to implement and operate the linkage 
is reasonable. In addition, the Commission finds that the plan 
provisions requiring that a Member Advisory Committee be established 
should enhance the operation of the linkage and the administration of 
the plan.
    Further, the Commission finds that the unanimous voting requirement 
for plan amendments is consistent with the requirements of the Act. The 
Amex/CBOE/ISE plan differs significantly from the ITS plan because it 
limits the issues subject to a unanimous vote under the plan.\92\ While 
the Commission recognizes that a unanimous voting requirement could 
potentially be used by one participant to block innovations that could 
enhance the linkage, such a provision also encourages participation in 
the plan by preventing the majority from forcing changes to the markets 
of dissenting participants.\93\
---------------------------------------------------------------------------

    \92\ The proposed Amex/CBOE/ISE plan has many provisions that 
distinguish it from the ITS plan. The Commission believes those 
differences should prevent the ITS plan's shortcomings from becoming 
a problem in the options linkage. In particular, the ITS plan 
requires the unanimous consent of all participants to amend the plan 
to permit exchanges to become new participants, while the Amex/CBOE/
ISE plan allows exchanges to become participants without any action 
by the then-current participants. The ITS plan is also a highly 
detailed document that, in many ways, limits the manner in which 
participants can innovate. The Commission believes that the Amex/
CBOE/ISE plan has been drafted in a less restrictive manner that 
should allow participants to independently innovate without 
violating plan terms.
    \93\ The Commission has the authority, pursuant to Rule 11Aa3-2, 
to initiate a national market system plan amendment. See 17 CFR 
240.11Aa3-2(b)(2).
---------------------------------------------------------------------------

G. Dissemination of Quotations With Size

    Currently, the options exchanges do not disseminate the number of 
contracts their quote represents. The Commission specifically requested 
comment on whether a linkage plan should require the options markets to 
disseminate quotes with size \94\ and, if so, what a reasonable time 
frame would be for implementation. Further, the Commission asked how a 
quote size requirement should be balanced against concerns about 
options systems capacity constraints.
---------------------------------------------------------------------------

    \94\ Currently, the options exchanges generally do not 
disseminate quotes with size. Rather, options quotes that are 
disseminated by OPRA reflect only the best bid and offer from each 
options exchange. Each exchange has rules establishing minimum firm 
quote requirements. Quotes that are disseminated over OPRA, however, 
do not indicate the actual depth of a given market. Thus, if the 
best displayed quote is based on a customer limit order that has a 
size greater than an exchange's firm quote requirement, its size is 
not communicated to the public.
---------------------------------------------------------------------------

    The majority of commenters favored the development of a system to 
provide the dissemination of quotes with size.\95\ Some of those 
commenters, however, stated that quotations with size should not be 
required at this time or as part of the linkage plan.\96\ Two of these 
commenters noted the desirability of disseminating quotes with size but 
questioned whether such modifications would ever be warranted because 
of the many variables associated with such an action, such as whether 
existing options quotation systems would be able to handle quotes with 
size in the near future.\97\ Finally, one commenter suggested that the 
issue be addressed by an amendment to the OPRA plan, rather than as 
part of the linkage.\98\
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    \95\ Donahue Letter; Ianni Letter; Amex Letter; Susquehanna 
Letter; Pershing Letter; SIA Letter; CBOE Letter; and Charles Schwab 
Letter.
    \96\ Amex Letter; Susquehanna Letter; Pershing Letter; SIA 
Letter; and CBOE Letter.
    \97\ Susquehanna Letter and SIA Letter.
    \98\ CBOE Letter.
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    The Commission agrees that the dissemination of quotes with size 
would increase transparency in the options market. The Commission notes 
that OPRA has already begun studying the feasibility of disseminating 
quotes with size. Implementing the systems changes

[[Page 48031]]

necessary to add size to disseminated quotes, however, is a substantial 
undertaking and a variety of factors, including systems capacity, \99\ 
must be considered. Therefore, the Commission has determined that the 
dissemination of quotes with size should not be mandated as part of the 
linkage plan.\100\
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    \99\ The Commission notes that the level of quote message 
traffic generated by the options exchanges has been straining OPRA's 
systems capacity recently. OPRA, along with its processor, 
Securities Industry Automation Corporation, and the exchanges have 
been working to address the capacity limitations so that the systems 
will be able to accept and disseminate the quotes generated by the 
options markets in real-time. The Commission believes that, due to 
systems capacity limitations, it would be inappropriate to mandate 
size at this time because burdening the current OPRA system with 
modifications to add size could result in a further deterioration of 
options quote integrity.
    \100\ The amendments to the Quote Rule for options proposed 
today include two alternative provisions allowing markets to 
specify, rather than individually publish, options quote size. See 
supra note 33.
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H. Firm Quote Size Requirements

    The Amex/CBOE/ISE plan has provisions for designating the size for 
which a participant will be firm for its quotes. For customer orders, 
the Firm Customer Quote Size will be the lesser of: (1) The number of 
contracts the exchange sending the P/A Order guarantees it will 
automatically execute for customer orders that are entered directly in 
that market; or (2) the number of contracts the receiving exchange 
guarantees it will automatically execute for customer orders that are 
directly entered into that market. However, in no event, would a P/A 
Order be guaranteed for fewer than 10 contracts. For principal orders, 
the Firm Principal Quote Size will be the size guaranteed by a 
participant for incoming principal orders, but in no event, fewer than 
10 contracts.
    Several commenters suggested that these criteria were appropriate 
because: (1) They assure customer orders receive minimum guarantee 
execution sizes similar to those that would be in effect had the order 
initially been routed through the automatic execution facilities of the 
market displaying the best bid/offer; and (2) principal orders receive 
a minimum firm quote.\101\ One commenter specified that the 10 contract 
minimum proposed in the Amex/CBOE/ISE plan was acceptable for P/A 
Orders executed in automatic execution systems, but the 20 contract 
minimum proposed in the PCX plan was unacceptable. That commenter 
supported the Amex/CBOE/ISE proposal to allow an exchange to elect 
whether to route all or part of an order through the linkage when the 
size of the order is larger than automatic execution eligible 
size.\102\
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    \101\ Amex Letter; Susquehanna Letter; SIA Letter; and CBOE 
Letter.
    \102\ SIA Letter.
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    Other commenters stated that all quotes displayed by an exchange 
should be firm and subject to automatic execution of public orders up 
to the size displayed.\103\ The commenters further stated that 
electronic access should not be halted unless a bona fide reason exists 
to halt all electronic trading.\104\ One commenter asserted that an 
order that exceeds the minimum guarantee size should be filled based on 
the number of contracts available on the receiving exchange at receipt 
of the order. This commenter also stated that quotes should be firm to 
all market participants.\105\ Finally, one commenter stated that 
exchanges do not currently comply with the firm quote rule and that by 
enforcing current firm quote obligations and eliminating rules 
permitting this noncompliance, the existing system would suffice to 
guarantee firm quote obligations.\106\
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    \103\ Fenwick Letter and Interactive Letter.
    \104\ Donahue Letter and Interactive Letter.
    \105\ Charles Schwab Letter.
    \106\ Lek Letter.
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    Another commenter proposed that the linkage be limited to small 
orders of 20 contracts or less because 20 contracts is the prevailing 
minimum size guarantee for automatic execution of orders. The commenter 
noted that this amount could be reasonably and uniformly 
increased.\107\ Another commenter agreed with the notion of firm quote 
size for 20 contracts for each exchange.\108\ Finally, one commenter 
recommended that the linkage initially be available for orders of ten 
contracts or fewer, but that it should over time be increased to fifty 
contracts or more.\109\
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    \107\ DOJ Letter.
    \108\ Ianni Letter.
    \109\ Goldman/Morgan Letter.
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    The Commission believes that it is important to have a firm 
customer quote requirement as an element of the plan to facilitate and 
ensure the efficient execution of customer orders.\110\ The Amex/CBOE/
ISE plan should ensure that a P/A Order would be treated comparably to 
customer orders received directly by the exchange showing the 
NBBO.\111\ Moreover, the Commission believes that the Amex/CBOE/ISE 
plan allows the exchanges to continue to compete based on automatic 
execution size guarantees because the plan does not limit a 
participant's ability to increase its guarantee size.
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    \110\ In a separate release, the Commission today proposed 
applying the firm quote requirements of Exchange Act Rule 11Ac1-1 to 
the options markets. See supra note 33.
    \111\ Customer orders routed to another exchange may not receive 
the same guaranteed size as customer orders originating on the 
exchange showing the NBBO.
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    The Commission notes that several commenters believed that quotes 
should be firm for greater size. The Commission believes that the plan 
adequately addresses this concern because there is sufficient 
flexibility in the Amex/CBOE/ISE plan to allow exchanges to execute 
orders that are greater than the firm quote customer size. For example, 
the Amex/CBOE/ISE plan allows an originating exchange to route an order 
for greater than the firm customer quote size to another exchange and 
permits the other exchange to execute the order in full.

I. Trade-or-Fade Provisions

    Currently, options' exchanges rules do not require members' quotes 
to be firm for all orders. Instead, the exchanges have what are 
commonly known as trade-or-fade rules.\112\ Generally, under the trade-
or-fade rules, an order must be executed at the currently disseminated 
bid or offer, either by satisfying the full size of the order or by 
updating the disseminated quote to reflect that the previously 
disseminated quote is no longer available.\113\ The Amex/CBOE/ISE plan 
continues to apply the exchanges' trade-or-fade rules in limited 
circumstances to both P/A Orders and principal orders.
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    \112\ See generally Amex Rule 958A, Commentary .01; CBOE Rule 
8.51(b); PCX Rule 6.37(d); and Phlx Rule 1015(b).
    \113\ Generally, if a market maker changes its quote instead of 
executing an order, and then immediately re-displays its previously 
disseminated quote when there is no change in market conditions 
warranting such an action, the market maker is considered to be 
engaging in conduct inconsistent with just and equitable principles 
of trade.
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    Several commenters expressed concern that the plan did not 
expressly provide for the repeal of trade-or-fade rules by the options 
exchanges.\114\ Commenters also asserted that the exchanges should 
provide firm quotes.\115\ One commenter noted that without firm quotes, 
it would be difficult to determine the depth of trading interest, or 
the best execution price, or the best venue.\116\
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    \114\ Ianni Letter and Interactive Letter.
    \115\ Donahue Letter; ISE Letter; Interactive Letter; PCX 
Letter; Fenwick Letter; Lek Letter; and Charles Schwab Letter.
    \116\ Charles Schwab Letter.
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    The Commission has determined at this time to approve the Amex/
CBOE/ISE plan, including the proposed trade-or-fade provisions. 
Although no exchange should be permitted to ``back away'' from its 
displayed quote, the Commission recognizes that there should be a 
mechanism that requires a

[[Page 48032]]

market to change its quote if it refuses to trade at its published (or 
implied) quote with an order for a size that exceeds its firm quote 
requirement. Consequently, the Commission supports the retention of 
trade-or-fade rules to the extent that such rules prevent markets from 
refusing to trade at their disseminated prices and then continuing to 
disseminate the same quotes.

V. Conclusion

    It is hereby ordered, pursuant to Section 11A(a)(3)(B) of the 
Act,\117\ and Rule 11Aa3-2,\118\ that the intermarket linkage plan 
submitted by Amex, CBOE, and ISE is approved and the Amex, CBOE, and 
ISE are authorized to act jointly in planning, developing, operating, 
or regulating the intermarket linkage plan as a means of facilitating a 
national market system.
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    \117\ 15 U.S.C. 78k-1(a)(3)(B).
    \118\ 17 CFR 240.11Aa3-2.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-19730 Filed 8-3-00; 8:45 am]
BILLING CODE 8010-01-U