[Federal Register Volume 65, Number 154 (Wednesday, August 9, 2000)]
[Notices]
[Pages 48778-48793]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-20094]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43100; File No. SR-Phlx-00-01]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the Philadelphia Stock Exchange, Inc. To Amend its Current 
Enhanced Specialist Participation Provisions and Adopt Two New Programs 
in Phlx Rule 1014(g); Commission Request for Comment

July 31, 2000.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on January 31, 2000, the Philadelphia Stock Exchange, Inc. (``Phlx'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by the Exchange. On March 
17, 2000, the Phlx filed with the Commission Amendment No. 1 to the 
proposed rule change, and on July 7 and July 18, 2000, the Phlx filed 
Amendment Nos. 2 and 3, respectively, substantively amending its 
proposed rule change.\3\ The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ The substance of these amendments has been incorporated in 
the description of the proposal below.
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Table of Contents

Commission's Introduction
I. Statement of the Terms of Substance of the Proposed Rule Change
II. Statements Concerning the Proposed Rule Change
    A. Statement of the Purpose of, and Statutory Basis for, the 
Proposed Rule Change
    1. Purpose
    a. Current Enhanced Specialist Participation Programs
    (i) Enhanced Specialist Participation of Rule 1014(g)(ii)
    (ii) New Specialist Unit/New Options Enhanced Specialist 
Participation
    (iii) New Products Enhanced Specialist Participation
    b. Proposed 80% Enhanced Specialist Participation
    (i) Parameters
    (ii) Performance Requirement
    c. Proposed 50% Enhanced Specialist Participation
    d. Wheel Trades
    e. Relationship Among the Various Enhanced Participation 
Programs
    2. Statutory Basis
    B. Phlx's Statement on Burden on Competition
    C. Comments on the Proposed Rule Change Received by the Phlx 
from Members, Participants, or Others
III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action
IV. Commission's Solicitation of Comments
    A. Background
    B. Price Discovery on the Options Markets
    1. The General Rules: Priority and Parity
    2. Exceptions to the Rule
    a. Specialist Guarantees
    b. Guarantees to Upstairs Firms: Facilitation and Customer 
Crosses
    c. Automatic Execution Allocations
    C. Special Guarantees as an Exchange's Competitive Strategy
    1. Offering Internalization Opportunities
    2. Payment for Order Flow and Preferencing
    D. Specialist Guarantees and Exchange Act Requirements
    E. The Phlx Proposal
Exhibit A. Text of Proposed Rule Change

Commission's Introduction

    The Commission has serious concerns as to whether the proposed rule 
change is consistent with the Act and the rules and regulations 
thereunder. Accordingly, it is considering whether to approve the 
proposed rule change or to institute proceedings pursuant to Section 
19(b)(2)(B) of the Act \4\ to determine whether the proposed rule 
change should be disapproved. In Section IV below, the Commission 
elaborates on the nature of its concerns, and asks for comment on them.
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    \4\ 15 U.S.C. 78s(b)(2)(B).
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I. Statement of the Terms of Substance of the Proposed Rule Change 
\5\
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    \5\ The Phlx proposal has been condensed and edited for clarity, 
with some changes based on a series of telephone conversations with 
the Exchange, the most substantive of which are annotated below.
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    The Phlx is proposing to amend its current enhanced specialist 
participation provisions as codified in Phlx Rule 1014(g), primarily by 
adopting two new programs that would entitle a specialist to a higher 
participation in ``Top 100 Options.'' \6\ These programs would:

    \6\ As defined below, ``Top 100 Options'' are those equity 
options with the highest total year-to-date option volume across all 
options markets as of the date specified in the proposed rule.

     Entitle a specialist on parity to an enhanced 
participation of 80% in Top 100 Options allocated to a Phlx 
specialist after January 1, 1997. This 80% Enhanced Participation 
would be effective for a six month pilot period.
     Entitle a specialist on parity to an enhanced 
participation of 50% in Top 100 Options allocated to a Phlx 
specialist before January 1, 1997.

    The proposal would establish a ``Performance Requirement'' for 
specialists entitled to the 80% participation. If an average of 10% of 
the daily consolidated Options Clearing Corporation (``OCC'') volume in 
a particular specialist's option is not transacted on the Phlx over a 
six-month period, an Exchange committee would be authorized to 
reallocate the option.
    The proposal would also modify the manner in which orders executed 
through AUTO-X, the Phlx's automatic execution system, are allocated, 
specifically with regard to the application of enhanced specialist 
participations to AUTO-X trades.
    The full text of the proposed rule change appears as Exhibit A 
appended

[[Page 48779]]

to this notice. The Phlx's more detailed statement of the terms of 
substance of the proposed rule change has been incorporated into 
Section II below.

II. Statement of the Purpose of, and Statutory Basis for, the 
Proposed Rule Change

    In its filing with the Commission, the Phlx included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The Exchange has prepared summaries of the most 
significant aspects of such statements, set forth in edited form in 
Sections A, B, and C below.\7\
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    \7\ See supra note 5.
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A. Statement of the Purpose of, and Statutory Basis for, the Proposed 
Rule Change

1. Purpose
    Phlx Rules 119 and 120 and Rule 1014(g) specifically direct members 
in the establishment of parity and priority in the execution of orders 
on the options floor. These rules provide that when bids or offers at 
the same price are made simultaneously, or when it is impossible to 
clearly determine the order of time in which they were made, all such 
bids and offers will be on parity.\8\ Although not specifically stated 
in the Phlx rules, the Phlx represents that member son parity receive 
equal shares of the contra-side participation, except where otherwise 
set forth in the rules.
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    \8\ See infra notes 68-71 and accompanying text for additional 
illustrations of parity.
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    An ``enhanced specialist participation''--sometimes called an 
``enhanced parity split''--is one type of exception to the general 
parity rules, allocating to the specialist a greater than pro-rata 
share of the portion of an order that is divided among the specialist 
and any ``controlled accounts'' \9\--e.g., Registered Options Traders 
(``ROTs'')--that are on parity. The Exchange currently has several 
enhanced participation programs, embodied in Rule 1014(g) and described 
below. These programs establish specified percentages as the 
specialist's enhanced participation, depending on the category of 
option.
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    \9\ A ``controlled account'' for the purpose of Phlx Rule 
1014(g) includes any account controlled by or under common control 
with a member broker-dealer of the Exchange. Phlx Rule 1014(g)(i).
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    When an incoming order arrives on the floor and only the specialist 
and controlled accounts are on parity, the specialist is entitled to 
the specified percentage of the order before the controlled accounts 
divide the rest. However, when a customer order is also being 
represented in the crowd at the same bid or offer as the specialist and 
controlled accounts, other rules must be taken into account. 
Specifically, Phlx Rule 1014(g)(i) provides that orders of controlled 
accounts must yield priority to customer orders, but that specialists 
and ROTs closing in person are not required to yield priority to 
customer orders. Nonetheless, a customer may not receive a smaller 
participation than any trading crowd participant, including the 
specialist and an ROT closing in person.
    Thus, a specialist and an ROT closing in person are considered to 
be on parity with the customer, according to the Phlx, while other 
controlled accounts are not.\10\ As a result, when an incoming order 
arrives on the floor, and a customer order, the specialist, an ROT 
closing in person, and other ROTs are all competing to fill it at the 
same price, the customer order, the specialist, and the ROT closing in 
person are all entitled to equal portions of the order and are 
allocated those portions first. If the size of the incoming order is 
sufficient, each will receive up to the number of contracts sought by 
the customer. Any remaining portion of the order will then be divided 
among the specialist and the other ROTs, with the specialist receiving 
his greater than pro-rata share of that remainder, i.e., the enhanced 
specialist participation.
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    \10\ Telephone conversation between Edith Hallahan, Deputy 
General Counsel, Phlx, Nandita Yagnik, Counsel, Phlx, and Robert H. 
Miller III, KRJ Securities, Phlx on-floor Governor; and Ira L. 
Brandriss, Attorney, the Division of Market Regulation 
(``Division''), the Commission, July 14, 2000 (``Telephone 
conservation with the Phlx, July 14, 2000''). See also Amendment No. 
3 to the proposed rule change.
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    a. Current Enhanced Specialist Participation Programs: (i) Enhanced 
Specialist Participation of Rule 1014(g)(ii): The enhanced specialist 
participation provided under Rule 1014(g)(ii) \11\ currently allocates 
to the specialist 30% of the portion of an order divided among the 
specialist and controlled accounts when three or more controlled 
accounts are on parity and more than five contracts are to be bought or 
sold.\12\ If two controlled accounts are on parity, the specialist is 
allocated 40%, and if only one controlled account is on parity, the 
specialist is allocated 60%.\13\ If a customer order is on parity, the 
customer may not receive a smaller participation than any other crowd 
participant, including the specialist.\14\
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    \11\ Rule 1014(g)(ii) applies to both equity and index options.
    \12\ The 30% enhanced participation when three or more 
controlled accounts are at parity was approved by the Commission on 
April 18, 2000. See Securities Exchange Act Release No. 42700, 65 FR 
24246 (April 25, 2000). The enhanced specialist participation in 
Rule 1014(g)(ii) was originally approved by the Commission as a one-
year pilot program for equity options. See Securities Exchange Act 
Release No. 34606 (August 26, 1994), 59 FR 45741 (September 2, 
1994). It was later expanded to include index options. See 
Securities Exchange Act Release No. 35028 (November 30, 1994), 59 FR 
63151 (December 7, 1994). The pilot rule provided for a ``two-for-
one'' split when the specialist was on parity with any number of 
controlled accounts, allocating to the specialist two contracts for 
every one allocated to a controlled account. The program was later 
revised to provide for the current 40% allocation when two 
controlled accounts are on parity and 60% allocation when one is on 
parity. See Securities Exchange Act Release No. 35429 (March 1, 
1995), 60 FR 12802 (March 8, 1995). The pilot was renewed unaltered 
on three occasions. See Securities Exchange Act Release No. 36122 
(August 18, 1995), 60 FR 44530 (August 28, 1995); 37254 (August 5, 
1996), 61 FR 42080 (August 13, 1996); and 38924 (August 11, 1997), 
62 FR 44160 (August 19, 1997). It was thereafter extended for 
another period with certain modifications. See Securities Exchange 
Act Release No. 39401 (December 4, 1997), 62 FR 65300 (December 11, 
1997). The pilot was approved as a permanent program on July 1, 
1999. See Securities Exchange Act Release No. 41588 (July 1, 1999), 
64 FR 37185 (July 9, 1999).
    \13\ The Commission notes that the enhanced participation 
program of Rule 1014(g)(ii) is mandatory. The specialist may not 
decline the enhanced allocation.
    \14\ As explained above, see supra note 10 and accompanying 
text, when a customer order is on parity, the customer, specialist, 
and any ROT closing in person are first allocated an equal number of 
contracts. Any remaining portion of the order is then allocated 
among the specialist and the controlled accounts, with the 
specialist receiving 30% or 40% or 60% of the remaining contracts, 
depending on the number of controlled accounts on parity.
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    (ii) New Specialist Unit/New Options Enhanced Specialist 
Participation: Another enhanced participation program on the Phlx, 
originally adopted in May 1994 and embodied in current Rule 
1014(g)(iii), is designed to encourage the establishment of new 
specialist units to trade options classes that have never been listed 
on the Exchange.\15\ For a period of six months following the 
commencement of trading in such a new options class, the new specialist 
unit is entitled to 50% of an order when one controlled account is on 
parity, and 40% when two or more controlled accounts are on parity.\16\ 
As in the Phlx's other enhanced participation programs, if a customer 
order is on parity, the customer may not receive a smaller 
participation than any

[[Page 48780]]

other crowd participant, including the specialist.\17\
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    \15\ See Securities Exchange Act Release No. 34109 (May 25, 
1994), 59 FR 28570 (June 2, 1994). See also Securities Exchange Act 
Release No. 35028 (November 30, 1994), 59 FR 63151 (December 7, 
1994) (extending the new specialist unit/new options program to 
index options).
    \16\ The enhanced participation is renewable for one additional 
six-month period.
    \17\ See supra note 10 and accompanying text illustrating 
application of this rule.
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    (iii) New Products Enhanced Specialist Participation: On July 1, 
1999, still another enhanced participation program, the ``New Products 
Split,'' was adopted. \18\ Under Phlx Rule 1014(g)(iv), a specialist 
who develops and trades a new product is entitled to 40% when three or 
more controlled accounts are on parity, and 60% if fewer than three 
controlled accounts are on parity. In either of these situations, if a 
customer is on parity, the customer may not receive a smaller 
participation than any other crowd participant, including the 
specialist. \19\
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    \18\ See Securities Exchange Act Release No. 41588 (July 1, 
1999), 64 FR 37185 (July 9, 1999).
    \19\ See supra note 10 accompanying text illustrating 
application of this rule.
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    b. Proposed 80% Enhanced Specialist participation: (i) Parameters: 
The Phlx is now proposing to adopt Rule 1014(g)(vi) on a six-month 
pilot basis. The proposed rule would entitle a specialist allocated a 
Top 100 Option after January 1, 1997 \20\ to participate in 80% of an 
incoming order where the specialist is on parity with one or more 
controlled accounts and no customer order is present (``80% Enhanced 
participation''). \21\ If a customer order is on parity, the customer 
would not receive a smaller participation than any other crowd 
participant, including the specialist. For example:

    \20\ An option that was listed on the Phlx before January 1, 
1997, but was reallocated or transferred to a new specialist after 
that date, would be subject to the 80% Enhanced Participation. See 
proposed Rules 1014(g)(vi)(A) and 511(d)(3)(B).
    \21\ Unlike the enhanced participation under Rule 1014(g)(ii), 
the proposed 80% Enhanced Participation would be voluntary, allowing 
the specialist to decline the allocation. In addition, the 
Commission notes that the proposed 80% Enhanced Participation, 
unlike the enhanced specialist split of Rule 1014(g)(ii), is not 
limited to orders for more than five contracts.
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     If there is a market order to sell 500 contracts of XYZ 
option, and the specialist and the ROTs in the trading crowd are at 
the same price on parity, the specialist would be allocated 400 
contracts (80% of 500) and the floor broker would allocate the 
remaining 100 contracts (20% of 500) to the ROTs.
     If however, a customer order to buy 250 contracts is 
also represented in the trading crowd at the same price, the ROTs 
who are not closing in person must yield priority to it. The 
specialist and any ROTs closing in person are not required to yield 
to the customer order, but may not receive a greater participation 
than the customer. Therefore, the customer order would first be 
allocated 250 contracts, and the specialist would receive an equal 
allocation of 250 contracts. The ROTs would receive no 
participation. \22\
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    \22\ The Phlx states, however, that if the customer order was 
not represented in the trading crowd, but was on the specialist's 
limit order book with the specialist acting as agent, the specialist 
could not be considered on parity with the customer order, due to 
various restrictions relating to specialist trading ahead of 
customer orders as well as agency-principal restrictions. In such 
case, the customer order for 250 contracts would first be executed, 
and then the 80% Enhanced participation would apply to the 
remainder, with the specialist entitled to 200 contracts (80% of 
250) and the ROTs dividing the remaining 50 contracts.
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     If, however, there is a market order to sell 525 
contracts, the customer and the specialist would each receive 250 
contracts. Then, the specialist would be entitled to the 80% 
Enhanced Participation in the remaining 25 contracts (i.e., 20 
additional contracts), and the other five contracts would be divided 
among the ROTs. \23\
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    \23\ The Phlx notes that allocating the specialist the same 
number of contracts as the customer and then adding an enhanced 
participation of 80% in the remainder of the order might on first 
impression appear to result in a total specialist participation 
exceeding 80%. However, the Exchange does not believe it to be 
mathematically possible that, in such an allocation scheme, a 
specialist would ever receive more than 80% of the original incoming 
order.

    As defined in proposed Rule 1014(g)(vi)(A), the Top 100 Options for 
the pilot period would be those equity options with the highest total 
year-to-date option volume as of November 30, 1999. \24\ The initial 
list of Top 100 Options would remain in effect for at least the length 
of the pilot period. If the pilot is extended, the options constituting 
the Top 100 Options would be re-determined as of May 30 and November 30 
of each year. The 80% Enhanced Participation would then become 
effective for those options on the following July 1 and January 1, 
respectively.
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    \24\ Volume here refers to the aggregate of trading on all 
options exchanges. Telephone conversation between Nandita Yagnik, 
Counsel, the Phlx, and Ira L. Brandriss, Attorney, Division, the 
Commission, March 15, 2000.
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    Proposed Phlx Rule 1014(g)(vi)(B) provides that a specialist 
eligible for the 80% Enhanced Participation would not be eligible for 
any other enhanced specialist participation program under Rule 1014(g).
    Proposed Rule 1014(g)(vi)(C) provides an exception to the 80% 
Enhanced Participation, stating that it would not apply when an ROT is 
closing in person, provided that the ROT announces to the trading crowd 
that he is doing so. In such case, the proposed 50% Enhanced 
Participation of proposed Rule 1014(g)(v), as described below, would 
apply. The purpose of this exception is to better enable an ROT to 
trade out of a position in its entirety, which could be inhibited by 
the 80% Enhanced Participation. The following examples illustrated how 
the exception in proposed Rule 1014(g)(vi)(C) would apply:

     A market order to sell 500 contracts of XYZ option 
arrives on the floor, and the specialist, a customer order to buy 
100 contracts, an ROT closing for 200 contracts, and other ROTs in 
the trading crowd are at the same price. The customer, the 
specialist, and the ROT closing are on parity. Each is entitled to 
100 contracts. With respect to the remaining 200 contracts, the 80% 
Enhanced Participation does not apply, because there is an ROT 
closing. Instead, the 50% Enhanced Participation would apply. Thus, 
the specialist would be entitled to 100 contracts (50% of 200), and 
the remaining 100 contracts would be allocated among the ROTs in the 
crowd, including the ROT closing.
     However, if, in the above example, the customer order 
was for 300 contracts, the customer would receive 168 contracts, the 
specialist would be entitled to 166 contracts, the ROT closing would 
receive 166 contracts, and the other ROTs would receive no 
participation.

    the Phlx believes that by recognizing the additional 
responsibilities of specialists, the 80% Enhanced Participation would 
help to attract and retain highly capitalized specialists who would be 
able to attract sufficient order flow to the Exchange. Because the 
specialist unit is the key party responsible for marketing to attract 
order flow in particular options, the Exchange seeks to provide the 
appropriate encouragement to specialists to plan, invest in, and effect 
marketing strategies. Therefore, the Exchange believes that an 80% 
Enhanced Participation would provide the specialists with the 
appropriate incentive to create more depth and liquidity in applicable 
options in order to attract greater order flow to the Exchange. The 
Exchange's reasons for the proposal are outlined more fully in Section 
II.A.2 below.
    (ii) Performance Requirement: The Exchange is also proposing to 
adopt new Rule 511(d)(3), which would require the Exchange's 
Allocation, Evaluation and Securities Committee (``Committee'') to 
conduct a ``Special Review'' \25\ of each specialist assigned a Top 100 
Option to which the 80% Enhanced Participation applies. The

[[Page 48781]]

rule would direct the Committee to solicit new specialist applications 
when a defined ``Performance Requirement'' has not been met by the 
current specialist in that option.
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    \25\ Phlx Rule 511, ``Specialist Performance Evaluation,'' 
provides for reviews of specialists on the Exchange based on 
criteria enumerated in Phlx Rule 515. Rule 511(c)(2) provides for 
``Routine Reviews'' of options specialists, while Rule 511(d) 
provides for ``Special Reviews'' addressing specific situations. The 
proposed rule change would add a new category of Special Review 
specifically designed for specialists in the 80% Enhanced 
Participation program. Notwithstanding the Special Review, however, 
specialists in the program would also be subject to Routine Reviews. 
Telephone conversation between Edith Hallahan, Deputy General 
Counsel, and Nandita Yagnik, Counsel, the Phlx; and Ira L. 
Brandriss, Attorney, the Division, the Commission, May 1, 2000 
(``Telephone conversation with the Phlx, May 1, 2000'').
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    Specifically, if the Committee finds that an average of 10% of the 
daily consolidated OCC volume in any Top 100 Option in the 80% Enhanced 
Participation program has not been transacted on the Exchange for each 
six month period commencing with the effective date of the rule, the 
Committee would be authorized to solicit specialist applications to 
reallocate such option pursuant to Phlx Rule 506.
    The intent of this provision, the Phlx states, is to allow a search 
for another specialist. However, a failure to meet the Performance 
Requirement would not mean the automatic loss of the book. The current 
specialist would be permitted to apply and be considered by the 
Committee. As an applicant, the current specialist would be evaluated 
as a whole, using the current allocation criteria, such as staffing and 
expertise.\26\ Thus, the Performance Requirement becomes a factor in 
triggering a process to reevaluate the current specialist's role.
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    \26\ Allocation criteria are set forth in Phlx Rule 511(b).
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    The Exchange is also proposing to amend Rule 515 and Rule 511(e) to 
reflect that Top 100 Options in the 80% Enhanced Participation program 
would be subject to different procedures, and that current reallocation 
and hearing procedures described in Rule 511(e) would not apply to 
reviews conducted pursuant to Rule 511(d)(3).\27\
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    \27\ Because 80% Enhanced Participation would be a pilot 
program, the Phlx proposes to provide for specialist evaluations, 
aside from Routine Reviews, only through the 10% Performance 
Requirement it is proposing as a Special Review under Rule 
511(d)(3). If the current specialist fails the review, the Committee 
would be authorized to solicit applications for a new specialist 
without needing to comply with the relevant procedural requirements 
embodied in Rule 511(e).
    Accordingly, the enhanced specialist participation review of 
Phlx Rule 509 would not apply to specialists in the proposed 80% 
Enhanced Participation program. Rule 509 generally sets a 
performance standard for specialists who receive enhanced 
participations, providing, among other things, that if the Phlx does 
not maintain a minimum of 10% of market share in a multiply-traded 
issue listed on five exchanges (or up to 25%, if the issue is traded 
on fewer exchanges) the specialist may lose the enhanced 
participation for that option. Telephone conversation with the Phlx, 
May 1, 2000.
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    Proposed Rule 511(d)(3)(B) provides that if any Top 100 Option is 
reallocated under this rule, or allocated or transferred after the 
effective date of the rule, the new specialist would be entitled to 80% 
Enhanced Participation. It would also require the new specialist to 
meet the Performance Requirement every six months commencing on the 
business day following allocation, reallocation, or transfer and 
continuing until the end of the current six month test period operating 
for the other options (which originated with the effective date of the 
rule).\28\ If the Performance Requirement is not met, the Committee 
would again solicit specialist applications.
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    \28\ For example, if the effective date of the rule was March 1, 
2000, then the first review date would be September 1, 2000, and the 
following review date would be March 1, 2001. However, if a Top 100 
Option was allocated on June 1, 2000, the first review date for that 
option would be December 1, 2000, and the next review date would be 
March 1, 2001.
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    The Performance Requirement is intended by the Phlx to establish 
volume criteria that will encourage new business and a viable, active 
marketplace in Top 100 Options. The Exchange believes that in order to 
compete, highly capitalized, qualified specialists are needed who are 
willing to attract order flow to the Exchange. Thus, the Phlx believes 
that if a specialist unit cannot attract the order flow to meet the 
Performance Requirement, then its specialist privileges should be 
reevaluated (by comparing other applicants) to seek out the best 
specialist unit--to ensure that it does have the capability to attract 
that order flow. The Exchange believes that Top 100 Options, due to 
their volume, present both the need for a highly capitalized specialist 
as well as the opportunity to attract more of this volume to the 
Exchange.
    c. Proposed 50% Enhanced Specialist Participation: The Exchange 
also proposes to adopt Rule 1014(g)(v), to apply to Top 100 Options 
that were allocated to a Phlx specialist prior to January 1, 1997.\29\ 
The proposed rule change would entitle a specialist in these options to 
50% of an incoming order when the specialist is on parity with more 
than one controlled account (and no customer order is on parity).\30\ 
When one controlled account is on parity, the specialist would be 
entitled to 60% of the incoming order. If a customer order is on 
parity, the customer would not receive a smaller participation than any 
other crowd participant, including the specialist.\31\
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    \29\ This date differentiates those Top 100 Options in which the 
Phlx has already achieved a significant market share, such that it 
believes that an 80% Enhanced Participation incentive is less 
important for them. In addition, the Exchange recognizes with this 
differentiation that ROTs are also responsible for having achieved 
and retained market share in these options.
    \30\ See supra note 10 and accompanying text.
    \31\ Like the 80% Enhanced Participation, the proposed 50% 
Enhanced Participation would be voluntary, allowing the specialist 
to decline the allocation. Similarly, the 50% Enhanced Participation 
would not be limited to orders of more than five contracts.
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    Because the 50% Enhanced Participation would not be a pilot 
program, specialists receiving it would be subject to the enhanced 
specialist participation review of Phlx Rule 509.\32\ The purpose of 
this review is to monitor all specialists benefiting from an enhanced 
split.\33\ Specifically, the Committee would be permitted to reduce the 
50% Enhanced Participation if the specialist performs below any minimum 
standards or fails to satisfy any conditions established pursuant to 
the rule, which also includes provisions for reinstatement.\34\
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    \32\ Thus, the Phlx proposes to amend Rule 509 to refer to the 
50% Enhanced Participation, and Rule 1014(g)(v)(B) to refer to Rule 
509.
    \33\ But see supra note 27.
    \34\ Specialists receiving the 50% Enhanced Participation would 
also be subject to the Routine Reviews of Phlx Rule 511(c)(2) and 
the related provisions of Rule 515. Telephone conversation with 
Phlx, May 1, 2000.
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    Proposed Phlx Rule 1014(g)(v)(D) provides that a specialist 
eligible for the 50% Enhanced Participation would not be eligible for 
any other enhanced specialist participation program under Rule 1014(g).
    The 50% Enhanced Participation is intended by the Phlx to create a 
performance incentive to encourage specialists to attract additional 
order flow. The Exchange believes that this incentive is reasonable in 
light of specialists' added responsibilities in updating and 
disseminating quotations as well as in maintaining the limit order 
book. In addition, the Exchange proposes to increase the specialist 
participation to 50% in order to remain competitive with other 
exchanges.\35\ These reasons are outlined more fully in Section II.A.2 
below.
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    \35\ See, e.g., Pacific Exchange Rule 6.82(d)(2), which provides 
the Lead Market Maker on that exchange with a 50% guaranteed 
participation similar to the enhanced participation proposed by the 
Phlx.
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    d. Wheel Trades: The Exchange proposed to modify Option Floor 
Procedure Advice F-24 (``Advice F-24''), ``AUTO-X Contra-Party 
Participation (the Wheel),'' to give the specialist whatever split the 
specialist would receive pursuant to Rule 1014(g)(ii) (v) or (vi). 
AUTOM is the Exchange's electronic order routing and delivery system 
for option orders.\36\ AUTO-X is the automatic execution feature of 
AUTOM, which provides customers with automatic executions of eligible 
option orders at displayed markets. The Wheel is an automated

[[Page 48782]]

mechanism for assigning trade participation among specialists and ROTs 
on a rotating basis, as contra-side participants to AUTO-X orders. The 
Exchange's detailed Wheel provisions appear as Advice F-24.\37\ The 
purpose of the Wheel is to increase the efficiency of order execution 
through AUTO-X by including all floor traders, on a voluntary basis, in 
the automated assignment as contra parties to incoming AUTO-X orders.
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    \36\ AUTOM is an acronym for Automated Options Market System.
    \37\ See Securities Exchange Act Release No. 35033 (November 30, 
1994), 59 FR 63152 (December 7, 1994).
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    Currently, as detailed in Advice F-24(e), ``Wheel Rotation/
Assigning Contracts, Exception to the Normal Rotation,'' the Wheel 
operates with a different trade participation and allocation process 
than Rule 1014.\38\ At this time, the Exchange proposes to amend Advice 
F-24(e) so that specialists are allocated the same enhanced 
participation in Wheel trades that they receive under Rule 1014(g)(ii), 
(v) and (vi) for non-Wheel trades. Thus, a specialist that receives a 
30% enhanced participation in the trading crowd under Rule 1014(g)(ii) 
would receive a 30% enhanced participation on the Wheel; a specialist 
that receives a 50% Enhanced Participation under Rule 1014(g)(v) would 
receive a 50% enhanced participation on the Wheel; and a specialist 
that receives a 80% Enhanced Participation under Rule 1014(d)(vi) would 
receive an 80% enhanced participation on the Wheel.\39\ The Exchange 
does not propose, at this time, to extend the new specialist/new option 
enhanced participation of Rule 1014(g)(iii) or the new product enhanced 
participation of Rule 1014(g)(iv) to the Wheel.
---------------------------------------------------------------------------

    \38\ Advice F-24(e) currently entitles the specialist the 
substantial equivalent of a two-for-one split on the Wheel for 
options covered by Rule 1014(g)(ii), provided that Wheel 
participants unanimously consent and the Options Committee Chairman 
or his designee approves. See Securities Exchange Act Release No. 
42699 (April 18, 2000), 65 FR 24248 (April 25, 2000).
    \39\ The size of orders guaranteed execution through AUTO-X 
varies according to the option being traded. Floor Advice F-24 
provides that the Wheel rotates and assigns contracts to 
participants in the system depending on the size of the guarantee 
for that option. When the guarantee is between 1 and 10 contracts, 
the Wheel assigns 2 contracts to the first participant in line, 
rotates and assigns 2 contracts to the next participant in turn, and 
continues rotating and assigning in this manner. For guarantees 
between 11 and 25 contracts, the Wheel rotates every 5 contracts. 
For guarantees of more than 26 contracts the Wheel rotates every 10 
contracts. Under the proposal, if the AUTO-X guarantee is 10 
contracts, and an order for five contracts that is subject to the 
80% Specialist Participation enters the system, the specialist would 
receive four contracts and the Wheel would assign the remaining one 
to the Wheel participant next in the line in the rotation. If the 
next order is again for five, four would be assigned to the 
specialist and the remaining one to the next Wheel participant in 
the rotation. Telephone conversation with the Phlx, May 1, 2000.
---------------------------------------------------------------------------

    e. Relationship Among the Various Enhanced Participation Programs: 
For purposes of clarity, the Phlx is proposing to codify a reference to 
all its enhanced participation programs at the beginning of Rule 
1014(g)(i). The Exchange further makes clear in its proposal that all 
equity and index options that do not qualify under any other enhanced 
participation program of Rule 1014(g)--i.e., the new specialist unit/
new option split, the new product split, or either of the two Top 100 
Option splits--would continue to be eligible under the proposal for the 
enhanced participation of Rule 1014(g)(ii).
    Finally, the Phlx is proposing to amend Rules 1014(g)(ii) (the 
standard 30% enhanced participation) and (iii) (new specialist/new 
options enhanced participation) to make clear that these programs 
exclude options subject to the 50% and 80% Enhanced Participations of 
Rule 1014(g)(v) and (vi),\40\ and to amend Option Floor Procedure 
Advice B-6 (``Advice B-6'') to reflect corresponding modifications.
---------------------------------------------------------------------------

    \40\ The Phlx is also proposing a related amendment to clarify 
that options qualifying for the new products category of Rule 
1014(g)(iv) are also excluded from Rule 1014(g)(ii) and (iii).
---------------------------------------------------------------------------

2. Statutory Basis
    Enhanced participation programs are generally intended to create 
incentives to retain and attract specialist units. The Phlx believes 
that the proposed enhanced specialist participation programs for Top 
100 Options are necessary and important to create such incentives, 
which are reasonable in light of the increasing responsibilities of 
specialists. With respect to prior proposals, the Commission has 
acknowledged the need for well capitalized specialist units, burdens 
and costs borne by specialists, and how enhanced participation is 
intended to compensate specialists for these costs and burdens. For the 
reasons stated below, the Phlx believes the proposal is consistent with 
the Act.
    The Phlx believes that the incentives afforded to specialists by 
this proposal are justified by the particular responsibilities, 
burdens, and costs borne by specialists as compared with other market 
participants. Although both specialists and ROTs perform market making 
functions, specialists, as the principal market maker, have more 
responsibilities than ROTs. For instance, various Exchange rules impose 
higher affirmative and negative market making obligations on 
specialists.\41\ In addition, Rule 11b-1(a)(2)(iii) under the Act, 
provides that ``the rules of a national securities exchange permitting 
a member to act as specialist shall include provisions restricting his 
dealings so far as practicable to permit him to maintain a fair and 
orderly market.'' \42\ Thus, the Phlx states, the specialist is 
considered the market maker of last resort who must not only step in 
when no other market participant will, but must refrain from trading 
when others are willing to do so. ROTs, it states, are required to make 
markets only when called upon by either the specialist, floor broker, 
or a floor official.
---------------------------------------------------------------------------

    \41\ See Phlx Rule 1020(d), which states that it is ordinarily 
expected that the specialist will engage, to a reasonable degree 
under existing circumstances, in dealings for his own account in 
options when lack of price continuity or lack of depth in the 
options market exists or is to be reasonably anticipated.
    \42\ See 17 CFR 240.11b-1(a)(2)(iii).
---------------------------------------------------------------------------

    The Phlx notes that in addition to these responsibilities, 
specialists are faced with certain unique costs associated with being a 
specialist, including higher capital requirements,\43\ staff and risk 
related costs associated with continually updating and disseminating 
quotes, as well as reflecting all markets in the displayed quote.\44\ 
Further, specialists market to upstairs firms in order to attract order 
flow to the Exchange, entailing efforts that require expenditures for 
appropriate staff to plan and implement strategies. In addition, 
specialists must also monitor markets on other exchanges. These costs 
and burdens are exacerbated by today's current increases in options 
volume, the number of options traded by each specialist, quotation 
activity, and market volatility. Although specialists might address 
some of these burdens directly or the Exchange might attempt to offset 
them differently, the Phlx has determined that it is again appropriate 
to address these increasing burdens and costs with enhanced trade 
participation in order to attract and retain specialist units.
---------------------------------------------------------------------------

    \43\ Specialists are subject to a minimum net capital 
requirement of $100,000; ROTs, on the other hand, must meet an 
initial net capital requirement of $25,000 and thereafter must 
maintain positive net assets. See Rule 15c3-1 under the Act and Phlx 
Rule 703(a)(iii).
    \44\ See Phlx Rule 1080. See also Securities Exchange Act 
Release No. 34606 at 13 (August 24, 1994), 59 FR 45741 (September 2, 
1994).
---------------------------------------------------------------------------

    The Exchange believes that this proposal should not unreasonably 
burden competition, and should, in fact, serve as an incentive for 
market performance. Currently, in Top 100 Options, the Exchange has not 
benefited

[[Page 48783]]

from significant order flow.\45\ To the extent that the proposed 
enhanced participant programs should provide incentives for specialists 
to provide tighter markets and attract order flow to the Exchange, all 
market participants in the crowd, including ROTs, should benefit. This 
benefit would come in the form of increased depth of markets as well as 
increased liquidity, both of which are important market performance 
elements. The Phlx expects that specialist efforts to reach the 10 
Performance Requirement should also result in deeper, more liquid 
markets and tighter spreads. Thus, the Phlx believes that competition 
should be enhanced, and important auction market principles preserved.
---------------------------------------------------------------------------

    \45\ The Phlx represents that its share of volume across the 
options markets in the Top 100 Options that would be eligible for 
the 80% Enhanced Participation was approximately 5% in November 
1999. Also, for top 100 Options traded on the Phlx in November 
1999--69 issues--trading volume was 1,463,477 contracts out of a 
total Phlx trading volume of 2,368,300 contracts, a percentage of 
61.79%.
---------------------------------------------------------------------------

    The Exchange believes that the proposal should not materially 
disadvantage ROTs and other controlled accounts. Specifically, because 
these accounts have not historically transacted significant volume in 
Top 100 Options, based on Exchange analysis of certain data, the 
Exchange believes that if it is successful in attracting order flow to 
these options, ROTs and controlled accounts should benefit in absolute 
terms from that enhanced flow. The Phlx notes that, in the past, the 
Commission has refuted assertions that the enhanced specialist 
participation programs may harm ROTs by noting that the ``ROTs may in 
fact benefit from the enhanced parity split, if the specialists are 
successful in attracting order flow to the Exchange.'' \46\ 
Specifically, more order flow may benefit ROTs, even if they receive a 
lesser percentage of such order flow when they are on parity. The 
Exchange believes that this reasoning is still applicable whether the 
enhanced participation is 80% or 50%.
---------------------------------------------------------------------------

    \46\ See Securities Exchange Act Release No. 34109 at note 19 
(May 25, 1994) 59 FR 28570 (June 2, 1994). The Commission notes that 
the quotation is cited from an order approving the 40% participation 
right granted to new specialist units trading new options classes 
when two or more controlled accounts are on parity, and 50% when one 
is on parity.
---------------------------------------------------------------------------

    The Phlx believes that the proposal is narrowly crafted to apply to 
certain options in certain situations, minimizing the potential 
negative impact and preserving opportunities in other options. For 
instance, both the 80% and the 50% Enhanced Participation would only 
apply when the specialist is on parity with a least one controlled 
account.\47\ Because the specialist must be on parity with another 
controlled account, that controlled account, such as an ROT, can either 
establish a better price (improve the market) or establish a market 
first. In either case, the enhanced participation would not apply. The 
Phlx notes that an ROT's ability to quote a better price may soon be 
enhanced by the advent of decimalization, which reduces the cost of 
improving markets by narrowing minimum increments. In the Phlx's view, 
the proposal provides an incentive for ROTs to better markets and thus 
should promote competition. Therefore, the Exchange believes that this 
proposal should encourage tighter markets and attract order flow to the 
Exchange.
---------------------------------------------------------------------------

    \47\ See Options Floor Procedure Advice A-10. The Phlx 
represents that the specialist may establish his market and be on 
parity either verbally or by electronic means.
---------------------------------------------------------------------------

    In addition, the proposal is limited to certain Top 100 Options, in 
which the Exchange has not received significant order flow. 
Furthermore, the 80% Enhanced Participant program is being proposed as 
a six-month pilot program which the Exchange believes should enable 
both the Exchange and the Commission to evaluate its actual impact and 
whether is purposes were achieved.
    The Exchange also believes that the proposal protects investors and 
the public interest, because it specifically addresses the situation of 
a customer order on parity with any other crowd participant. Under the 
80% Enhanced Participation, no customer order on parity may received a 
smaller participation than any other crowd participant including the 
specialist. If the proposal is successful in attracting order flow, 
customers should benefit from the additional liquidity and tighter 
markets. Thus, the proposal contains safeguards to ensure that 
customers are protected.
    The Exchange has also analyzed whether specialists could be 
encouraged by the proposal to pay for order flow (as opposed to 
tightening spreads) to meet the Performance Requirement. The Phlx notes 
that following extensive public policy debate and Commission study of 
the practice in the equities markets, payment for order flow was not 
banned, but rather was addressed with enhanced disclosure requirements 
for broker-dealers and reliance on the duty of best execution. The 
Exchange does not believe that the proposal would be inconsistent with 
the Act or that it is necessary for payment for order flow in the 
options markets to be addressed in the proposal's current, limited 
context.
    For these reasons, the Phlx believes that the proposed rule change 
is consistent with Section 6 of the Act \48\ in general, and with 
Section 6(b)(5) \49\ in particular, because it is designed to promote 
just and equitable principles of trade and protect investors and the 
public interest, by rewarding specialist units for their cost and 
responsibilities which, in turn, should attract and retain highly 
capitalized specialist units, thereby attracting additional order flow 
and resulting in increased competition and tighter markets. The 
Exchange believes that in crafting its proposal and presenting its 
justification, it has addressed and remained consistent with certain 
principles on which the Commission has focused in approving past 
enhanced participation programs, including the belief that such 
incentives encourage specialists to make deep, tight markets, enhance 
their ability to compete for order flow, address their heightened 
responsibilities, protect investors, and enhance competition.
---------------------------------------------------------------------------

    \48\ 15 U.S.C. 78f.
    \49\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

B. Phlx's Statement on Burden on Competition

    The Phlx does not believe that the proposed rule change will impose 
any inappropriate burden on competition.

C. Comments on the Proposed Rule Change Received by the Phlx from 
Members, Participants, or Others

    No written comments were solicited with respect to the proposed 
rule change. The Phlx received one letter commenting on the proposal, 
which it has submitted to the Commission and is available for 
inspection in the Commission's Public Reference Room.\50\
---------------------------------------------------------------------------

    \50\ See Letter from Tim D. Lobach, General Partner, Keystone 
Trading Partners, to Members of the Board, Phlx, dated December 22, 
1999.
---------------------------------------------------------------------------

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Section 19(b)(2) of the Act\51\ provides that within 35 days of the 
date of publication of notice of a proposed rule change in the Federal 
Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization that filed the proposal 
consents, the Commission will:

    \51\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    (A) By order approve such proposed rule change, or

[[Page 48784]]

    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

    The Commission finds it appropriate to designate a period of 90 
days from the date of publication of this notice within which to 
approve the Phlx proposal or institute proceedings to determine whether 
to disapprove it. As detailed below, the proposed rule change raises 
several complex issues on which the Commission is seeking public 
comment to assist it in its decision whether to institute disapproval 
proceedings.

IV. Commission's Solicitation of Comments

    The Commission believes the proposed rule change could result in a 
significant alteration to the current structure of the options markets 
and, as noted in the introduction, has serious concerns as to whether 
such changes are consistent with the Act and the rules and regulations 
thereunder. The Commission is concerned specifically about the 
potential impact that specialist guarantees of up to 80% could have 
upon competition in the options markets and, consequently, upon the 
quality of prices that investors receive in those markets.
    Section 6(b)(8) of the Act\52\ requires that the rules of a 
national securities exchange ``not impose any burden on competition not 
necessary or appropriate'' in furtherance of the Act. Section 6(b)(5) 
of the Act,\53\ moreover, requires that the rules of a national 
securities exchange be designed to, among other things, ``remove 
impediments to and perfect the mechanism of a free and open market and 
a national market system, and, in general, to protect investors and the 
public interest.'' Assuring that price competition remains vigorous is 
crucial in ensuring that investors receive the best execution possible. 
Finally, in considering whether any proposed rule change of a national 
securities exchange is in the public interest, the Commission is 
required by Section 3(f) of the Act\54\ to consider whether the change 
will ``promote efficiency, competition, and capital formation.''
---------------------------------------------------------------------------

    \52\ 15 U.S.C. 78f(b)(8).
    \53\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    The Commission believes it will be helpful to provide some 
background regarding the context of the proposal and the issues it 
raises, and to pose a number of specific questions concerning its 
potential ramifications, so that commenters will better be able to 
assist the Commission in deciding whether to approve the proposed rule 
change or to institute proceedings to determine whether it should be 
disapproved.
---------------------------------------------------------------------------

    \54\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

A. Background

    The proposed rule change arises against a backdrop of increasingly 
intense completion over the past year among the options exchange--the 
American Stock Exchange (``Amex''), the Chicago Board Options Exchange 
(``CBOE''), the Pacific Exchange (``PCX''), and the Phlx--to attract 
the flow of options business to their respective markets.
    Prior to August 1999, the great majority of the most actively 
traded options in this country was listed on only one exchange. Thus, 
broker-dealers receiving orders from customers to buy or sell these 
options had only one place to send them for execution. Since then, the 
number of options that are ``multiply traded''--i.e., traded on more 
than one exchange--has vastly expanded.\55\ In addition, the 
anticipated entry of the International Securities Exchanges (``ISE'') 
into the arena as the first fully electronic options exchange \56\ 
increased the demand upon the existing exchanges to compete vigorously 
for order flow. The ISE, which began operating on May 26, 2000, by 
trading three options classes, plans to list standardized equity 
options on 600 of the most actively traded stocks, and is widely 
considered to be a catalyst for the increase of multiple trading among 
the existing exchanges. As a result of these ongoing changes in the 
options market, the exchanges have felt intense pressure to compete 
with each other for the flow of customer orders that are represented by 
brokerage firms.
---------------------------------------------------------------------------

    \55\ Between mid-August and mid-September 1999, for instance, 
131 equity options classes that were previously listed on only one 
market became multiply-listed. Although in number these options 
represent a small percentage of the approximately 3000 options 
classes that trade, as a result of their addition to the multiple 
trading category, the volume of trading in multiply-listed options 
across the markets rose in the same period from 39% to 76% of all 
options trading.
    \56\ The ISE's application to become a registered national 
securities exchange was submitted in February 1999 and was approved 
in February 2000. See Securities Exchange Act Release Nos. 41439 
(May 24, 1999), 64 FR 29367 (June 1, 1999) and 42455 (February 24, 
2000), 65 FR 11388 (March 2, 2000).
---------------------------------------------------------------------------

    Investors have benefited measurably from the increased competition. 
Since multiple trading began in earnest, bid-ask spreads have narrowed 
significantly.\57\ The options exchanges have also reduced their 
transaction fees.\58\ The Phlx proposal is another response to these 
developments. By proposing changes to the Exchange's priority rules, 
the Phlx believes it would be able to better attract or retain business 
in the new competitive environment.
---------------------------------------------------------------------------

    \57\ See, e.g., ``Best Execution: Promise of Integrity, Guardian 
of Competition,'' Remarks of Commission Chairman Arthur Levitt to 
the Securities Industry Association, Boca Raton, FL, November 4, 
1999, citing an analysis of trading in 81 options that had recently 
become multiply listed, which found that spreads had been narrowed 
by 15% or more in 76% of the cases.
    \58\ See Exchange Act Release Nos. 41270 (April 9, 1999), 64 FR 
19395 (April 20, 1999) (SR-CBOE-99-08); 41307 (April 16, 1999), 64 
FR 20349 (April 26, 1999) (SR-PCX-99-09); 41317 (April 24, 1999), 64 
FR 23144 (April 29, 1999) (SR-Phlx-99-09); 41370 (May 5, 1999), 64 
FR 25931 (May 13, 1999) (SR-Amex-99-12) (reducing options 
transactions fees).
---------------------------------------------------------------------------

    To evaluate the proposal's potential impact and determine whether 
it is consistent with the Act, we must consider it in the context of 
how options are traded today and the impact on the markets if similar 
proposals were implemented on all options exchanges.\59\
---------------------------------------------------------------------------

    \59\ The Commission notes that in many cases options exchanges 
adopt similar rules when a rule proposal has been approved by the 
Commission. Particularly when rules are designed to provide benefits 
to order flow providers, and therefore create incentives for order 
flow providers to send their customers' orders to a particular 
exchange, other exchanges frequently adopt similar rules to compete. 
The Commission, of course, does not approve or disapprove rules 
based on which exchange submits them, but instead must base approval 
or disapproval on the statutory standards.
---------------------------------------------------------------------------

B. Price Discovery on the Options Markets

    An options exchange, like any exchange, is a marketplace where 
buyers and sellers of a product--in this case, standardized options 
contracts--come together in the hope of finding a party ready to take 
part on the opposite side of the transaction at a favorable price.
    The buyers and sellers include: (a) Floor brokers, who represent 
orders to buy and sell sent to the exchange by broker-dealers (``order 
entry firms'' or ``upstairs firms'') on behalf of customers; (b) market 
makers, i.e., dealers trading for their own accounts who stand ready to 
buy and sell contracts on a continuous basis\60\ and (c) in many 
markets, the specialist, who is a market maker that assumes additional 
leadership responsibilities in assuring fair and orderly markets, is 
authorized to represent certain types of customer orders as a broker, 
and may manage the public customer limit order book. On the CBOE and 
the PCX, market participants serving in a role similar to that of the 
specialist are called ``Designated Primary Market Makers'' (``DPMs'') 
and ``Lead Market Makers'' (``LMMs''), respectively.\61\ On the ISE, 
the role is filled by ``Primary Market Makers'' (``PMMs''). These 
various participants all congregate at a designated ``trading 
station,'' an

[[Page 48785]]

assigned spot on the exchange floor, to buy and sell options contracts 
in each particular options class.\62\
---------------------------------------------------------------------------

    \60\ Market makers are known as ``Registered Traders'' on the 
Amex and ``ROTs'' on the Phlx.
    \61\ Thus the term ``specialist'' is intended hereinafter to 
include DPMs and LMMs, unless otherwise indicated. The Commission 
notes that the specialist-like system led by DPMs and LMMs on the 
CBOE and PCX, respectively, is not mandated for all options trading 
on these exchanges. See CBOE Rule 8.80 and PCX Rule 6.82.
    \62\ This description applies, of course, to a floor-based 
exchange. The Amex, CBOE, PCX, and Phlx, operating on this floor-
based model, have installed various systems to route many orders 
electronically to the trading station. However, the essential 
process of trading at these exchanges is conducted through open 
auction outcry of bids and offers and the finalization of 
transactions by brokers and market makers in person on the floor of 
the exchange. The ISE substantially replicates the auction process 
of the floor-based exchange in a fully electronic format.
---------------------------------------------------------------------------

1. The General Rules: Priority and Parity
    When a customer order arrives at the trading station and the floor 
broker representing it asks for the current price (i.e., calls for a 
market), members of the crowd respond with their bids and offers in 
public outcry.\63\ The trade is executed at the best price that emerges 
from the auction to meet the customer order.\64\ To participate in the 
trade, therefore, market participants at the station compete with each 
other to provide the best price for the customer order. Among the 
competitors may be floor brokers representing customer orders to fill, 
as well as the specialist and the market makers, who must always be 
prepared to buy and sell at prices reasonably close to the last sale.
---------------------------------------------------------------------------

    \63\ Often, the trade takes place at the disseminated quotation, 
which is a posting by the exchange of the best bid and offer 
currently being quoted on its market. Frequently--in the absence of 
better-priced customer orders or market maker quotes--the 
disseminated quotation will be generated by an exchange's 
``autoquote'' system, which calculates the price for an option based 
on variables, including the price of the underlying stock.
    \64\ Order routed to an exchange's automatic execution system, 
which is discussed in Section IV.C.2.c below, are executed pursuant 
to different rules.
---------------------------------------------------------------------------

    In addition, the floor broker who brought the order to the floor 
may compete to fill the order he is holding. He may, on behalf of the 
firm that sent it to the floor, propose to cross it at a superior price 
with the order of another of the firm's customers. Alternatively, he 
may propose to cross it with an order submitted by the firm itself, 
seeking to trade with the firm's customer as principal at a better 
price than that offered by others--in what is called a ``facilitation 
cross.'' \65\
---------------------------------------------------------------------------

    \65\ See, e.g., Amex Rule 950(d), Commentary .02; CBOE Rule 
6.74; PCX Rule 6.47; Phlx Rule 1064.
---------------------------------------------------------------------------

    When more than one market participant is bidding or offering the 
best price, depending on the circumstance, in general the rules of the 
exchange grant any one of several different participants the right to 
fill the order--either entirely, or a certain percentage of it--before 
anyone else.
    As a general rule, the first person to quote the price at which the 
option is ultimately traded is entitled to ``priority''--the right to 
fill the order before anyone else.\66\
---------------------------------------------------------------------------

    \66\ The rule is not absolute, however. The order of a public 
customer on the limit order book, on some exchanges, takes priority 
over the quote of any member of the crowd. See CBOE Rule 6.45(a); 
PCX Rule 6.75(a). Market makers in the trading crowd, for their 
part, generally have a degree of priority over a bid or offer 
submitted on behalf of the proprietary account of an upstairs 
broker-dealer firm. See Amex Rule 950(d), Commentary .02; CBOE Rule 
6.74; PCX Rule 6.47; Phlx Rule 1064. But see also infra Section 
IV.C.2.b.
---------------------------------------------------------------------------

    ``Parity,'' by contrast, means that none of the market participants 
competing to fill the order has rights over any other based on quoting 
the best price first. Parity is established on the Phlx, for example, 
when an order arrives on the floor to sell 100 contracts, and three 
market makers--A, B, and C--all bid to fill it at $3 per contract, but, 
in the public outcry, no one can determine which of A, B, or C called 
out the $3 bid first. Generally, in a situation of this kind, 
participation in the order must be divided up equitably among the crowd 
participants who simultaneously bid to fill the order at the best 
price.\67\
---------------------------------------------------------------------------

    \67\ See Phlx Rule 119(b). See also Amex Rule 126(e), applied to 
options trading by Amex Rule 950(d).
---------------------------------------------------------------------------

    According to the Phlx, as a practical matter, in the pace of 
trading on its options floor today, it is often difficult to determine 
who cried out the best price first, and therefore crowd participants 
are frequently on parity on this basis.\68\ Moreover, it is common for 
the members of a trading crowd to be all simultaneously committed to 
the bid and offer of the Exchange's publicly disseminated 
quotation,\69\ and thereby considered at parity.\70\
---------------------------------------------------------------------------

    \68\ Telephone conversation with the Phlx, May 1, 2000.
    \69\ See supra note 63.
    \70\ Telephone conversation with the Phlx, July 14, 2000.
---------------------------------------------------------------------------

    In addition, even if one member of the trading crowd is the first 
to bid or offer at a particular price, if others indicate their 
willingness to trade at that price, too, then the first member bidding 
or offering at the price has priority only for the first trade executed 
at that price. Afterward, all who remain willing to trade at the same 
price are considered to be at parity for subsequent trades.\71\
---------------------------------------------------------------------------

    \71\ Telephone conversation with the Phlx, July 14, 2000.
---------------------------------------------------------------------------

    In practice, a large majority of trades on the Phlx take place 
where all participants are at parity.\72\
---------------------------------------------------------------------------

    \72\ Telephone conversation with the Phlx, July 14, 2000.
---------------------------------------------------------------------------

    Although, in its purest form, an auction should treat all 
participants equally, to create incentives for various market 
participants, the exchanges have enacted rules that in certain 
circumstances guarantee a portion of an order to a particular 
participant even when that participant is on parity.
    In a similar vein, but for a different purpose, the exchanges have 
established automatic execution (``auto-ex'') systems, discussed below, 
to fill smaller customer orders quickly and efficiently, but without 
the benefit of an auction on the trading floor. Each of the floor-based 
options exchanges' auto-ex systems allocate orders to market makers on 
a rotational basis to execute at the exchange's disseminated 
quotation.\73\
---------------------------------------------------------------------------

    \73\ See supra note 63.
---------------------------------------------------------------------------

    Allocations of this kind represent exceptions from pure competitive 
principles. The Commission has approved them when it has believed that 
vigorous competition would be preserved and the overall price-discovery 
mechanism of the market would not be substantially affected.
2. Exceptions to the Rule
    a. Specialist Guarantees: Historically, most of the options 
exchanges have adopted rules that under certain circumstances guarantee 
a specialist the right to trade ahead of others in the crowd with a 
certain percentage of every order, even when the specialist has not 
otherwise established priority. Of course, the specialist must also be 
quoting the best price available to the customer to receive such a 
guarantee. When the specialist is entitled to these special guarantees 
varies somewhat among the exchanges.
    More specifically, a DPM on the CBOE and an LMM on the PCX is 
entitled to a percentage of each order only when the trade takes place 
at its previously established ``principal bid or offer'' \74\ or 
``previously disseminated'' quote.\75\ The DPM does not receive its 
guaranteed portion of the fill if the auction improves the price.
---------------------------------------------------------------------------

    \74\ See Securities Exchange Act Release No. 42190 (December 1, 
1999) 64 FR 68706 (December 8, 1999) (concerning CBOE Rule 
8.80(c)(7)(ii)).
    \75\ PCX Rule 6.82(d).
---------------------------------------------------------------------------

    The Phlx's version of the specialist guarantee, the ``enhanced 
parity split,'' applies, by contrast, when the specialist is ``on 
parity'' as defined and illustrated above.\76\
---------------------------------------------------------------------------

    \76\ See supra notes 8 and 67-71 and accompanying text.
---------------------------------------------------------------------------

    These exceptions to the general priority and parity rules, which 
would otherwise require the equitable division of an order among market 
makers on a par with the specialist, are intended to provide an 
incentive for market makers to assume the extra responsibilities 
assigned to the specialist to supply liquidity and attract order flow 
to the market.

[[Page 48786]]

    The following specialist guarantees are operative on the options 
exchanges today:

     On the Amex, a specialist is not currently entitled by 
rule to a participation guarantee. However, the Amex recently filed 
a proposal to codify the specialist allocation practices that have 
developed on its trading floor.\77\ The proposal would guarantee the 
specialist approximate 60% of an order when one registered trader is 
on parity, 40% when two to four are on parity, 30% when five to 
seven are on parity, 25% when eight to fifteen are on parity, and 
20% when 16 or more are on parity. Amex rules provide that a 
customer will not receive a lesser amount than the market makers or 
specialist.\78\
---------------------------------------------------------------------------

    \77\ See Securities Exchange Act Release No. 42964 (June 20, 
2000), 65 FR 39972 (June 28, 2000).
    \78\ A specialist cannot be on parity with a customer order for 
which he is acting as agent, however, and a registered trader cannot 
be on parity with a customer when either establishing or increasing 
his position in the option. See id.
---------------------------------------------------------------------------

     On the CBOE, after all public customer orders in the 
book have been filled, a DPM is guaranteed to trade with 30% of each 
order filled at its principal bid or offer.\79\
---------------------------------------------------------------------------

    \79\ See Securities Exchange Act Release No. 42190 (December 1, 
1999), 64 FR 68706 (December 8, 1999) (establishing pro-rata 
percentage pursuant to CBOE Rule 8.80(c)(7)(ii)).
---------------------------------------------------------------------------

     On the ISE, after all public customer orders have been 
filled, a PMM is allocated 60% of an order if only one other 
participant is quoting at the best price, 40% if two other 
participants are at the best price, and 30% if more than two other 
participants are at the best price. A PMM also has precedence to 
execute orders of five contracts or fewer.\80\
---------------------------------------------------------------------------

    \80\ See Securities Exchange Act Release No. 42808 (May 22, 
2000), 65 FR 34515 (May 30, 2000) (establishing allocation 
procedures pursuant to ISE Rule 713(e)). The PMM is entitled to a 
larger allocation if its quotation size in proportion to the total 
size of quotations on the market is greater than these percentages. 
This larger allocation recognizes the superiority of larger sized 
quotes, and is not based merely on the PMM's status as PMM.
---------------------------------------------------------------------------

     On the PCX, after all public customer orders in the 
book have been filled, an LMM is generally guaranteed the right to 
participate in 50% of each transaction occurring at its disseminated 
quote.\81\ However, the Commission understands that with the 
expansion of multiple exchange trading of options last summer, LMM 
guarantees have been reduced on the PCX to between 25% and 35% of 
each trade in some of the most actively traded issues.
---------------------------------------------------------------------------

    \81\ See PCX Rule 6.82(d). For more heavily traded options, this 
guarantee may be reduced based on LMM performance to 40% under 
certain conditions when PCX market share falls in the case of 
multiple-traded issues; and to 25% in the case of non-multiple-
traded issues.
---------------------------------------------------------------------------

     On the Phlx, as discussed in Section II of this Notice, 
a specialist is currently allocated 30% of an order when three or 
more controlled accounts are on parity, 40% when two are on parity, 
and 60% when one is on parity.\82\ A specialist on the Phlx is not 
required to yield to a customer order on parity, but a customer 
order may not receive a smaller participation than the 
specialist.\83\
---------------------------------------------------------------------------

    \82\ New specialist units introducing new options and 
specialists developing and trading new products receive different 
percentages, as discussed in Section II.
    \83\ However, orders of controlled accounts--except for orders 
of ROTs closing inperson--must yield priority to customer orders. 
Phlx Rule 1014(g)(i).

    Specialist guarantees, generally, have been found by the Commission 
to be consistent with the Act as a reasonable means for an exchange to 
attract and retain well capitalized specialists who will attract order 
flow to the exchange, as long as the granting of such guarantees does 
not unreasonably restrain competition and harm investors.\84\
---------------------------------------------------------------------------

    \84\ See, e.g., Securities Exchange Act Release Nos. 34109 (May 
25, 1994), 59 FR 28570 (June 2, 1994); 34606 (August 26, 1994), 59 
FR 45741 (September 2, 1994). These orders, approving specialist 
guarantees, are cited above by the Phlx in support of the current 
proposed rule change.
---------------------------------------------------------------------------

    b. Guarantees to Upstairs Firms: Facilitation and Customer Crosses: 
Until recently, upstairs--or order-entry--firms seeking to cross the 
order of one customer with that of another, or to trade as principal 
with a customer order, were required to yield priority to members of 
the trading crowd for the full size of the order.\85\ Even if the cross 
were proposed at a better price than that given by the crowd in its 
response to a floor broker's call for a market, if members of the crowd 
then decided they wanted to trade with the original customer order at 
the new best price, they could do so, and thus ``break up the cross.''
---------------------------------------------------------------------------

    \85\ See, e.g., Amex Rule 950(d), Commentary .02; CBOE Rule 
6.74; PCX Rule 6.47; Phlx Rule 1064.
---------------------------------------------------------------------------

    The options exchanges have made exceptions to this general rule, 
however. As an incentive to improve market liquidity in FLEX options, 
for instance, the exchanges guarantee upstairs firms the right to cross 
or trade with a certain percentage of each order they bring to the 
floor when the firm improves or matches the best bid or offer supplied 
by the crowd in response to the floor broker's call for a market.\86\
---------------------------------------------------------------------------

    \86\ See Amex Rule 904G(e)(iii); CBOE Rule 24A.5(e)(iii); PCX 
Rule 8.103(c)(3); Phlx Rule 1079(f)(6).
---------------------------------------------------------------------------

    In addition, most of the options exchanges have adopted rules to 
permit such crossing and/or facilitation guarantees in the case of 
standardized options. A trading mechanism on the ISE, for instance, 
guarantees an Electronic Access Member the right to trade with 40% of 
its own customer order.\87\ New Amex, CBOE, and PCX rules, approved by 
the Commission in May and June, 2000, similarly give order entry firms 
the right to trade as principal with up to 40% of each of their 
customers' orders above a certain size.\88\ These rules provides, 
however, that if the trade takes place at a price at which the 
specialist too, is entitled to a guarantee, the combined total 
percentage of an order allocated to the upstairs firm and the 
specialist may not exceed 40%.
---------------------------------------------------------------------------

    \87\ ISE Rule 716(c). See also Securities Exchange Act Release 
No. 42455 (February 24, 2000), 65 FR 11388 (March 2, 2000).
    \80\ See Securities Exchange Act Release Nos. 42894 (June 2, 
2000) (File No. SR-Amex-99-36), 65 FR 36850 (June 12, 2000); 42835 
(May 26, 2000), 65 FR 35683 (June 5, 2000) (File No. SR-CBOE-99-10); 
42848 (May 26, 2000), 65 FR 36206 (June 7, 2000) (File No. SR-PCX-
99-18).
---------------------------------------------------------------------------

    The Commission believes that these new rules and proposals reflect, 
in part, the increased competition among the options exchanges to 
attract the flow of customer orders to their respective markets since 
August 1999, when multiple trading was vastly expanded. By guaranteeing 
order entry firms the right to participate in the execution of their 
customers' orders, exchanges allow these firms to profit from the 
spread. Effectively, these types of guarantees allow order entry firms 
to internalize a portion of their own customers' order flow through the 
facilities of the exchange. Multiple trading has meant that order entry 
firms have more leverage to demand that exchanges provide them these 
participation rights because they now have more of a choice where to 
execute their customer orders.
    c. Automatic Execution Allocations: All the exchanges have systems 
that automatically execute orders of public customers below a certain 
size--currently up to 50 contracts \89\ without exposing them to the 
auction on the floor. Auto-ex systems are designed to give investors 
speed, efficiency, and accuracy in the execution of their small orders. 
These orders are executed at the exchange's disseminated quotation on a 
rotational basis against the accounts of specialists and market makers 
who sign up for the system.
---------------------------------------------------------------------------

    \89\ See Securities Exchange Act Release Nos. 36601 (December 
18, 1995), 60 FR 66817 (December 26, 1995) (SR-Phlx-99-35); 41821 
(September 1, 1999), 64 FR 50313 (September 16, 1999) (SR-CBOE-99-
17); 41823 (September 1, 1999), 64 FR 49265 (September 10, 1999) 
(SR-PCX-99-04); and 42094 (November 3, 1999), 64 FR 61675) (November 
12, 1999) (SR-Amex-99-43). Proposals by the exchanges to increase 
the maximum size of orders eligible for auto-ex to 75 or 100 
contracts are currently pending before the Commission. See 
Securities Exchange Act Release Nos. 42930 (June 13, 2000), 65 FR 
38618 (June 21, 2000) (SR-CBOE-99-51); 42931 (June 13, 2000), 65 FR 
38615 (June 21, 2000) (SR-Amex-99-45); 42932 (June 13, 2000) 65 FR 
38621 (June 21, 2000) (SR-Phlx-99-32); and File Nos. SR-PCX-00-18 
and 99-19.
---------------------------------------------------------------------------

    Auto-ex orders are thus not executed according to auction 
principles and priority rules, but are allocated to market makers on 
the system by turn, regardless of who was first to bid or offer the 
disseminated price. Although a

[[Page 48787]]

market maker can change the disseminated quote and thereby directly 
affect the price at which orders will be automatically executed, that 
market maker will receive no larger an allocation of auto-ex orders as 
a result, and hence has no incentive to better prices for this purpose. 
On the other hand, auto-ex prices are not totally isolated from 
competitive forces. The disseminated quote may be narrowed or widened 
by the specialist or the market makers to compete with other exchanges 
in atracting customer orders.
    Some exchanges' rules governing their auto-ex systems incorporate a 
specialist guarantee. On the PCX, the LMM is required to either 
participate in every other auto-ex trade, or participate in every trade 
to the extent of the LMM's guaranteed percentage for non-auto-ex 
orders.\90\ On the Phlx, as discussed above in this Notice, the Wheel 
currently assigns specialists in certain options approximately twice 
the number of contracts as it assigns every ROT with the unanimous 
consent of Wheel participants.\91\ Under the proposed rule change, Phlx 
specialists would be guaranteed 30% of each auto-ex order in non-Top 
100 options covered by Rule 1014(g)(ii), 50% of each auto-ex order for 
Top 100 Options assigned to a Phlx specialist before January 1, 1997, 
and 80% of each auto-ex order for Top 100 options assigned to a Phlx 
specialist before that date.\92\
---------------------------------------------------------------------------

    \90\ See Securities Exchange Act Release No. 41823 (September 1, 
1999), 64 FR 49265 (September 10, 1999).
    \91\ See supra note 38.
    \92\ See supra Section II.A.1.d.
---------------------------------------------------------------------------

C. Special Guarantees as an Exchange's Competitive Strategy

    Paradoxically, while the special allocations raise concerns about 
inhibiting price competition within an exchange, they are often 
conceived--from the perspective of the exchange and its members--as 
necessary strategies to compete with other exchanges.
    For any market center to survive, it must compete with other, 
similar centers to attract the flow of customer orders to buy and sell 
through its own facility. Many of these competitive efforts are 
designed to appeal to brokers, who play a critical role in deciding 
where to route their customer orders. \93\ These efforts can take many 
forms, such as providing faster and more reliable execution of orders, 
lowering transaction fees, initiating innovative trading services, and 
providing economic inducement to brokers to send their customer order 
flow to the market center.
---------------------------------------------------------------------------

    \93\ For amplification on this theme, see Securities Exchange 
Act Release No. 42450 (February 23, 2000), 65 FR 10577 (February 28, 
2000) (notice of filing of SR-NYSE-99-48, including Commission 
request for comment on issues relating to market fragmentation) 
(``Market Fragmentation Release'').
---------------------------------------------------------------------------

    The special allocations for specialists, for example, enable an 
exchange to recruit market makers to serve in the specialist role, 
which is critical to operating an effective marketplace. Specialists 
provide the liquidity and offer the services that assure the smooth 
functioning of today's exchanges. Some exchange rules and policies 
explicitly oblige the specialist to promote the exchange's standing as 
a marketplace.\94\
---------------------------------------------------------------------------

    \94\ See, e.g., PCX Rule 6.82(c)(8); CBOE Rule 8.80(b)(2), 
Interpretations and Policies. 01.
---------------------------------------------------------------------------

    In addition, through their automatic execution systems, exchanges 
assure brokers that their smaller customer orders will be executed with 
certainty, speed, and efficiency. The exchanges can provide this 
assurance only when market makers agree to execute those orders. 
Exchanges provide market makers with an incentive to participate in 
these auto-ex systems through rotational allocation.
    In addition to competing for orders solely on the strength of their 
specialists' services, automatic execution facilities, and other 
services, the exchanges also increasingly rely on providing order entry 
firms with economic inducements to attract order flow.
1. Offering Internalization Opportunities
    One such type of inducement is allowing members to 
``internalize''--i.e., trade on a proprietary basis with--at least a 
portion of the customer order flow they control. Internalization allows 
the member who brought the customer's order to the exchange to make 
profit as a dealer, rather than simply act as agent and change the 
customer a brokerage commission. One way in which an exchange allows 
its members to internalize is by adopting the kind of facilitation 
guarantee described above, whereby a broker-dealer is entitled to trade 
ahead of the crowd with a certain percentage of any customer order it 
sends to the floor.
    A second way in which exchange rules may set the stage for firms to 
internalize is through the specialist guarantee. When a broker-dealer 
is affiliated with the specialist in a particular option at a 
particular exchange, it has the incentive to route its customer orders 
to that exchange, knowing that its affiliated specialist will have 
priority, by virtue of the specialist guarantee, to trade with a 
significant portion of them.
2. Payment for Order Flow and Preferencing
    Another economic inducement used by market centers to attract 
business is ``payment for order flow,'' an arrangement in which a 
market center or one of its members pays brokers who agree to route 
their orders to it for execution--in other words, to preference their 
order flow.\95\ For example, the specialist firm in a given option, 
responsible for attracting order flow in that option to the exchange, 
may consider paying, or in some other form compensating brokerage firms 
who choose to send their customer orders to its own market over 
another. The specialist firm can earn extra profits when those orders 
are executed, by virtue of its guaranteed right to participate in a 
significant portion of every transaction at the disseminated price. The 
higher the specialist firm's percentage, the more contracts it can 
trade with and the more it can afford to pay for order flow. In this 
way, the rules by which exchanges provide guarantees can directly 
impact their specialists' ability to implement this strategy.
---------------------------------------------------------------------------

    \95\ Payment for order flow, a common practice in the equities 
markets, began to appear in the options markets as a result of the 
competition for order flow engendered by multiple trading. See, 
e.g., ``Payment for Order Flow has Entered the Options Markets,'' 
Dow Jones Business News, November 4, 1999. In a recent development 
in this area, the CBOE, followed by the Amex, submitted rule changes 
to the Commission--which became effective upon filing--that allow 
them to collect a fee of 40 cents per contract from their market 
makers for certain transactions on the exchange. The collected 
monies are then given to the DPM or specialist in each options class 
to use, among other things, to pay for options order flow. See File 
Nos. SR-CBOE-00-28 and SR-Amex-0038.
---------------------------------------------------------------------------

    The Commission has expressed the views that internalization and 
payment for order flow, while not unlawful in themselves, can present 
conflicts between the interests of brokers and the investors they 
represent. Moreover, internalization and payment for order flow 
agreements diminish the need for exchange participants to quote 
competitively. The latter concern is discussed further in Part D below.

D. Specialist Guarantees and Exchange Act Requirements

    As discussed above, the Exchange Act requires the Commission to 
consider the impact on competition in evaluating proposed rules of 
self-regulatory organizations.\96\
---------------------------------------------------------------------------

    \96\ See supra notes 52-54 and accompanying text.
---------------------------------------------------------------------------

    Thus, in approving exchange rules that provide for special 
guarantees--be they guarantees to specialists, market makers on the 
automatic execution Wheel, or firms seeking to cross or facilitate 
customer orders--the

[[Page 48788]]

Commission has been always mindful that, if too great, guarantees will 
negatively impact the competitive auction process that lies at the 
heart of exchange trading.\97\ This is because, while such strategies 
are a competitive response by markets to attract order flow, if a 
guarantee becomes too large it could significantly discourage another 
type of competition: Price competition.
---------------------------------------------------------------------------

    \97\ See e.g., Securities Exchange Act Release Nos. 34109 (May 
25, 1994) 59 FR 28570 (June 2, 1994); 41588 (July 1, 1999), 64 FR 
37185 (July 9, 1999); 42455 (February 24, 2000), 65 FR 11388; 42845 
(May 26, 2000), 65 FR 35683 (June 5, 2000).
---------------------------------------------------------------------------

    Because these guarantees ``lock up'' a certain portion of each 
affected order, they reduce the number of contracts for which the 
market making crowd can compete. The concern is that locking up a 
percentage or the order--for whatever the purpose--may so tilt the 
playing field that the opportunities available to the crowd are reduced 
and its members are unable to compete in some or all options.\98\
---------------------------------------------------------------------------

    \98\ For a discussion of the role dealers and market makers play 
in the overall structure of the securities markets, see Market 
Fragmentation Release.
---------------------------------------------------------------------------

    In its recent approval of the ISE's application for registration as 
a national securities exchange, the Commission discussed this concern 
with respect to the ISE's proposed ``facilitation mechanism,'' a system 
designed to effect a form of facilitation guarantee in an electronic 
context. The Commission wrote:

    It is difficult to assess the precise level at which guarantees 
may begin to erode competitive market maker participation and 
potential price competition within a given market. In the future, 
after the Commission has studied the impact of guarantees, the 
Commission may need to reassess the level of these guarantees. For 
the immediate term, the Commission believes that 40% is not clearly 
inconsistent with the statutory standards of competition and free 
and open markets.\99\

    \99\ See Securities Exchange Act Release No. 42455 (February 24, 
2000), 65 FR 11388 (March 2, 2000).
---------------------------------------------------------------------------

    With respect to specialist guarantees, it is similarly difficult to 
predict the potential effects on the market of a particular proposed 
rule change. At some certain point it becomes clear, however, that if 
the percentage of each order allocated to the specialist rises too 
high, the members of the trading crowd will be left with too little 
with which to trade to sustain their competitive market making 
activity.
    When only a small percentage of each order is left to the market 
makers to trade with, not only are their potential profits reduced, 
their costs of doing business on a per-unit basis--e.g., their clearing 
expenses--also rise. This is particularly true when the remaining 
portion of an order must be divided among several market makers. By the 
same token, the specialist firm is in a better position to lower its 
clearing costs, enabling it to compete even more aggressively against 
the crowd.
    If market makers cannot make sufficient profits by trading, for 
instance, at the spread determined by auto-quote-- normally an 
approximation of the realistic best price, at which the specialist will 
also be quoting--they will scarcely be able to compete by offering 
still better prices. Although any market maker can capture an order 
entirely anytime he chooses if he alone improves the specialist's 
quote, it is likely that he will not be able to long sustain his 
business by constantly reducing the spread. Moreover, the specialist 
firm can use its position and its greater economies of scale to match 
or continuously best the improving market maker at the auction.
    The Phlx argues that a large specialist percentage will encourage 
the specialist to draw more order flow to the Phlx, so that the 
absolute amount of volume received by the competing market makers will 
grow, even though their percentage volume may decrease. But this 
assumes that other markets do not imitate the Phlx and offer similar 
specialist guarantees. If they do, the Phlx may not attract any greater 
volume, while the competing market makers' share will have been 
reduced.
    If the market makers leave the market, the specialist firm will be 
left as the only one determining the spread. Even if some market makers 
remain, they may be forced to recognize the specialist firm as the 
price leader, enabling it to establish the best bid and offer on its 
own. In either case, the spread is likely to widen, to the detriment of 
customers.
    In addition to the concern over price competition dwindling or 
disappearing on one market, if other exchanges adopt similar 
guarantees, the end result could be one price-setter left on each 
exchange.
    Theoretically, the absence of competition on one exchange need not 
mean that customer orders sent to that exchange will receive inferior 
prices. In order to attract customer orders, a specialist firm left as 
the sole price-setter on an exchange would still need to compete with 
other exchanges to provide the best price. At a minimum it would need 
to at least match the best price available elsewhere--the national best 
bid or offer (``NBBO'')--or, if it cannot match that price, agree to 
send it to another exchange that will.
    Several concerns remain, however. Because there is currently no 
prohibition against trade-throughs,\100\ the specialist who is not 
prepared to match the NBBO can execute an order at an inferior price. 
Moreover, even the adoption of a rule prohibiting trade-throughs would 
not necessarily inspire intermarket competition to improve prices if 
the market makers on one market can match a better price quoted by 
another market. Such competition might be fostered by a system of 
``peer/time priority,'' which would reward the first exchange to offer 
the best price by requiring that any order received across the country 
be sent to that exchange for execution, and possibly strengthen the 
incentives to display competitive quotes. The Commission, however, 
recently concluded that it does not have sufficient information, at 
this time, to satisfy itself that the potential benefits of a mandatory 
price/time priority requirement justify the potential drawbacks.\101\
---------------------------------------------------------------------------

    \100\ A ``trade-through'' occurs where a customer's order is 
executed on one exchange at a price inferior to that available on 
another exchange.
    \101\ See Securities Exchange Act Release No. 43086 (July 28, 
2000) (Order approving options intermarket linkage plan submitted by 
the Amex, CBOE, and ISE). See also Securities Exchange Act Release 
No. 43084 (July 28, 2000) (proposing new rules under the Act 
concerning disclosure of order routing and execution practices).
---------------------------------------------------------------------------

    Further, with one price-setter left on each exchange, the potential 
grows for payment for order flow and internalization arrangements to 
interfere with order interaction and discourage the display of 
aggressively-priced quotations. The preferencing of orders based on 
factors unrelated to the quality of the market to which they are sent, 
raises the concern that price spreads may not remain narrow over time. 
At least one academic study has concluded, for example, that while 
preferencing to some market centers may not have significant negative 
effect when competition reigns in the market as a whole, ``once 
preferencing becomes the norm in a market, there is little question 
that market performance can deteriorate.'' The authors observe: ``The 
results [of the study] that shows that the scale of preferencing can be 
detrimental suggest an active role for regulators in limiting the 
dominance of preferencing in markets.'' \101\ The Commission must 
consider the potential impact of any proposed rule change in light of 
these concerns.
---------------------------------------------------------------------------

    \101\ Robert Bloomfield and Maureen O'Hara, Does Order 
Preferencing Matter?, 50 Journal of Financial Economics 3, 35 
(1998). The study, which conducted experiments based on a market 
design patterned after the Nasdaq, related to the debate over the 
potential effects of preferencing in the securities markets.
---------------------------------------------------------------------------

    In evaluating proposals that increase specialist guarantees, the 
Commission

[[Page 48789]]

must consider the provisions of Section 6(b)(5) of the Act that 
require, in addition to the standards cited above that exchange rules 
be designed to ``promote just and equitable principles of trade'' and 
not to permit ``unfair discrimination between customers, issuers, 
brokers, or dealers.'' \103\ It must further consider Section 11A(a) of 
the Act,\104\ which sets as one of its objectives ``fair competition 
among brokers and dealers and among exchange markets.'' \105\
---------------------------------------------------------------------------

    \103\ 15 U.S.C. 78f(b)(5).
    \104\ 15 U.S.C. 78k-1(a). Section 11A(a) sets forth findings and 
objectives that are intended to guide the Commission in its 
oversight of the national market system. As the Commission has 
recently noted, these findings and objectives can be summed up in 
two fundamental principles: (1) the interests of investors (both 
large and small) are preeminent, especially the efficient execution 
of their securities transactions at prices established by vigorous 
competition; and (2) investor interests are best served by a market 
structure that, to the greatest extent possible, maintains the 
benefits of both an opportunity for interaction of all buying and 
selling interest in individual securities and fair competition among 
all types of market centers seeking to provide a forum for the 
execution of securities transactions. See Market Fragmentation 
Release.
    \105\ Section 11A(a)(1)(C)(ii), 15 U.S.C. 78k-1(a)(1)(C)(ii).
---------------------------------------------------------------------------

    Specialist guarantees, which afford specialists the ability to 
attract increased order flow to an exchange, may, on the one hand, 
benefit market markers in the exchange's trading crowd by enabling them 
to interact with a larger number of customer orders. On the other hand, 
the larger the specialist guarantee, the less of each order the crowd 
in left to trade with, raising the question of whether the guarantee is 
too high and thus unfairly discriminatory.

    The Commission must also consider in this context whether an 
increased guarantee is consistent with Rule 11b-1(a)(2)(iii) under the 
Act, which requires that the rules of a national securities exchange 
include provisions restricting the dealings of a specialist ``so far as 
practicable to those reasonably necessary to permit him to maintain a 
fair and orderly market * * *'' \106\
---------------------------------------------------------------------------

    \106\ 17 CFR 240.11b-1(a)(2)(iii).
---------------------------------------------------------------------------

E. The Phlx Proposal

    The proposed rule change would dramatically increase guarantees on 
the Phlx, to 80% for active options allocated to specialists after 
January 1, 1997. Among the purposes cited by the Exchange for the 
proposals is that this enhanced guarantee would provide added incentive 
for specialists to attract order to flow to the Exchange.
    As indicated above, specialist guarantees on the options markets 
currently rise to more than 40% of an order in only several instances. 
One exception is on the PCX, where 50% is the general rule, but the 
trend has been downward since the advent of multiple exchange 
trading.\107\ Otherwise, specialist allocations on the options 
exchanges generally are 40% or less.\108\ Thus, the proposed rule 
change by the Phlx to establish an 80% specialist guarantee represents 
a significant increase in the amount of order flow that would be 
guaranteed to one market participant.
---------------------------------------------------------------------------

    \107\ On the Phlx itself, the specialist is entitled in one case 
to more than half the fill (60%) when only one other controlled 
account is parity. Also, 50% guarantees are allowed for new products 
and new specialist units on the Phlx.
    \108\ The 60% specialist guarantees on some exchanges, described 
above, apply when only one market besides the specialist is on 
parity. In this case, as one of two participants, the specialist 
would receive 50% of the order even without an enhanced allocation. 
Thus, the 60% allocation entitles the specialist to only 10% more 
than he would otherwise have received. Moreover, if additional 
market makers choose to compete, the specialists guarantee is 
reduced to 40% or less.
---------------------------------------------------------------------------

    The Phlx believes that allocating this large percentage is 
warranted as an incentive for specialists in view of the particular 
responsibilities, burdens, and costs they bear compared to other market 
participants. The Commission is concerned, one the other hand, with the 
effect that such a high specialist guarantee will have on the ability 
of market makers in the crowd to quote competitively or even to 
continue making markets at all.
    In its rule filing, Phlx argues that because the Exchange until now 
has not benefited from significant order flow in the Top 100 Options in 
question, its ROTs in these options will not be disadvantaged. To the 
contrary, the Phlx maintains, the ROTs will benefit by the depth and 
liquidity the specialists in these options will being to the Exchange. 
``Specifically,'' the Phlx writes, ``more order flow may benefit ROTs, 
even if they receive a lesser percentage of such order flow * * *'' 
\109\
---------------------------------------------------------------------------

    \109\ While the Phlx cites a statement by the Commission itself 
to this effect, we note that this statement appeared in the approval 
order for a rule change instituted by the Phlx in 1994 that provided 
for only a 40% guarantee when two or more ROTs were on parity with 
the specialist and 50% when only one ROT was on parity.
---------------------------------------------------------------------------

    The Phlx further argues that ROTs indeed will have an incentive to 
improve prices under the proposed rule change, because by its 
provisions, the specialist's enhanced participation applies only when 
the specialist is on parity. If an ROT or other controlled account 
improves the market or establishes a market first, the specialist's 
enhanced participation does not apply. ``Thus,'' the Phlx maintains, 
``the proposal provides an incentive ROTs to better markets and thus 
should promote competition.'' It adds: ``Therefore, the Exchange 
believes that this proposal should encourage tighter markets and 
attract order flow to the Exchange.''
    The Commission is concerned, however, that because the market 
makers are reduced to so small a percentage of the spread when they are 
at the best bid or offer in parity with the specialist, they will not 
be able to continue market making and compete to establish better 
prices at all. The Commission notes in this regard that the proposal 
would entitle the specialist to an 80% participation in all eligible 
trades executed through the Exchange's auto-ex system.
    Moreover, the Commission is concerned that under the proposed rule 
change, a specialist could, for the short term, tighten its quote to 
the extent that no potential competitor could afford to improve prices 
any further. Unable to make profits on the 20% left to them, the 
potential competitors would be forced to follow the specialist's lead, 
allowing the specialist to widen spreads again.\110\
---------------------------------------------------------------------------

    \110\ The Commission notes that the proposal includes no 
limitation on the number of option classes that could be allocated 
to a specialist under the 80% Enhanced Participation program. The 
Commission also notes that allocations of options classes to 
specialists as mandated by Phlx Rule 511(b) may be based on, in 
addition to specialist evaluation results, ``such other factors as 
the Committee deems appropriate,'' among them capital resources and 
order flow commitments. The Commission is thus concerned about the 
proposal's potential to strengthen the position of specialists still 
further.
---------------------------------------------------------------------------

    Further, the Commission believes it is reasonable to expect that, 
if the Phlx proposal is approved, other exchanges will also propose 
specialist guarantees of 80% in order to remain competitive. Thus, the 
increased order flow and benefits for its ROTs that the Phlx 
anticipates as the result of a higher specialist guarantee may not, in 
the end, be sustainable.
    The Commission is requesting therefore that commenters address the 
merit of the Phlx's arguments, in addition to any other comments they 
may wish to submit on the potential impact of the proposed rule on 
competition. Specifically, the Commission is requesting comments on the 
following questions:
     Will enhanced specialist entitlements of up to 80% 
discourage competition and price improvement on the part of market 
makers in the crowds of individual options exchanges, such as the Phlx, 
that choose to adopt them?
     If enhanced specialist entitlements of these sizes were 
approved by the Commission, and other exchanges also adopted them, what 
would be the

[[Page 48790]]

ultimate effect, if any, on price competition and the width of bid-asks 
spreads across the options markets as a whole?
     Would enhanced specialist entitlements of up to 80% be 
unfairly discriminatory and induce the exit of market makers?
     How have existing specialist entitlements on the options 
exchanges affected competition and market quality?
     What is the likelihood of the Phlx proposal leading to 
preferencing as a norm and in turn creating a risk to overall market 
quality?
     The Commission has elsewhere asked for comment on the 
alternative of requiring greater disclosure by market centers and 
brokers concerning their trade executions and order routing as a means 
of addressing market fragmentation. Would this alternative impact any 
of the concerns raised above? If so, how?
    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing questions and other issues raised by 
this notice, including whether the proposed rule change is consistent 
with the Act or whether the Commission should institute proceedings to 
determine if it should be disapproved as inconsistent with the Act. 
Persons making written submissions should file six copies thereof with 
the Secretary, Securities and Exchange Commission, 450 Fifth Street, 
N.W., Washington, D.C. 20549-0609. Copies of the submission, all 
subsequent amendments, all written statements with respect to the 
proposed rule change that are filed with the Commission, and all 
written communications relating to the proposed rule change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. 552, will be 
available for inspection and copying in the Commission's Public 
Reference Room. Copies of the filing will also be available for 
inspection and copying at the principal offices of the Phlx. All 
submissions should refer to File No. SR-Phlx-00-01 and should be 
submitted by August 30, 2000.

For the Commission, by the Division of Market Regulation, pursuant 
to delegated authority. \111\
---------------------------------------------------------------------------

    \111\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Jonathan G. Katz,
Secretary.

Exhibit A

Text of Proposed Rule Change

    Additions are italicized and deletions are in brackets.

Rules

Obligations And Restrictions Applicable To Specialists And 
Registered Options Traders

Rule 1014

    (a)-(f) No change.
(g) Equity Option and Index Option Priority and Parity
    (i) Exchange Rules 119 and 120 direct members in the establishment 
of priority of orders on the floor. In addition, equity option and 
index option orders of controlled accounts are required to yield 
priority to customers orders when competing at the same price, as 
described below.
    For the purpose of paragraph (g) of this Rule, an account type is 
either a controlled account or a customer account. A controlled account 
includes any account controlled by or under common control with a 
member broker-dealer. Specialist accounts of PHLX Option Specialists, 
however, are not subject to yielding requirements placed upon 
controlled accounts by this Rule. Customer accounts are all other 
accounts.
    Orders of controlled accounts must yield priority to customer 
orders, except that PHLX ROTs closing in-person are not required to 
yield priority to orders of customer accounts.
    Orders of controlled accounts are not required to yield priority to 
other controlled account orders, except that when both an order of a 
PHLX ROT closing in-person and some other order of a controlled account 
are established in the crowd at the same price, and then a customer 
order is established at that price, the order of the controlled account 
must yield to the customer order while the order of the PHLX ROT 
closing in-person does not have to so yield.
    Orders of controlled accounts, other than ROT's and Specialists 
market making in person, must be:
    (1) verbally communicated as for a controlled account when placed 
on the floor and when represented to the trading crowd and
    (2) recorded as for a controlled account by appropriately circling 
the ``yield'' field on the floor ticket of any such order.
    Several programs described below provide an enhanced participation 
(or split) to specialists, which refer to the portion of an options 
trade available for allocation to the specialist on parity, including a 
30% enhanced specialist participation, new unit/new option enhanced 
specialist participation, new product enhanced specialist 
participation, 50% enhanced participation, and 80% enhanced 
participation.
    (ii) Enhanced Specialist Participation--Except as provided in 
(g)(iv), (g)(v) and (g)(vi) below, i[I]n equity and index option 
classes, when the registered specialist is on parity with a controlled 
account as defined in subparagraph (i) above, in accordance with 
Exchange Rules 119 and 120 and the number of contracts to be bought or 
sold is greater than five, the specialist is entitled to receive an 
enhanced participation of 30% when there are three or more controlled 
accounts on parity (``Enhanced Specialist Participation''), except in 
the following circumstances: (1) Where there is one controlled account 
on parity, the specialist is entitled to 60%; or (2) where there are 
two controlled accounts on parity, in which case the specialist is 
entitled to 40%. Further, no customer order which is on parity may 
receive a smaller participation than any other crowd participant 
including the specialist. Enhanced Specialist Participation will be 
effective for: (a) All newly listed issues and issues, (b) all index 
options and (c) such issues selected by the specialist and approved by 
the Allocation, Evaluation and Securities Committee pursuant to section 
(A) below.
(A)-(C) No change.
    (iii) New Unit/New Option Enhanced Specialist Participation--Except 
as provided in (g)(iv), (g)(v) and (g)(vi) below, t[T]o encourage the 
establishment of new specialist units to trade equity and index option 
classes that heretofore have never been listed on the Exchange (``New 
Options Classes''), when such units are on parity with controlled 
accounts in such classes, the new specialist units will be entitled, 
for a period of six months following commencement of trading in New 
Option Classes, to the following enhanced specialist participation in a 
any such parity trade: (1) Fifty percent (50%) where there is one 
controlled account on parity; and (2) Forty percent (40%) where there 
are two or more

[[Page 48791]]

controlled accounts on parity, except that no customer order which is 
on parity may receive a smaller participation than any other crowd 
participant including the specialist. The Allocation, Evaluation and 
Securities Committee may extend such enhanced parity split for each 
applicable option beyond the initial six month period for one 
additional six month period upon petition by the specialist unit and a 
determination by the Committee that such extension is consistent with 
the promotion of just and equitable principles of trade and the public 
interest. Additionally, the Committee after granting such extension may 
at any time terminate with enhanced parity split for any particular 
options class if the Committee determines that such action is 
consistent with the promotion of just and equitable principles of trade 
and the public interest.
(A)-(D) No change.
(iv) No Change.
    (v) 50% Enhanced Participation--in 50% Enhanced Participation 
Options (defined in (A) below), when the registered specialist is on 
parity with more than one controlled account as defined in subparagraph 
(i) above, in accordance with Exchange Rules 119 and 120, the 
specialist is entitled to 50% when there are two or more controlled 
accounts on parity (``50% Enhanced Participation''. Why there is one 
controlled account on parity, the specialist is entitled to 60% 
participation. No customer order which is on parity may receive a 
smaller participation than any other crowd participation including the 
specialist.
    (A) 50% Enhanced Participation Options are the Top 100 Options, 
defined in Rule 1014(g)(vi)(A) below, which were allocated to Phix 
specialist before January 1, 1997.
    (B) Pursuant to Exchange Rule 509, the Allocation, Evaluation and 
Securities Committee may reduce the 50% Enhanced Participation 
authorized under this Rule to a parity level in accordance with Rules 
119 and 120. The reduction shall be in accordance with the provisions 
of this rule if the specialist in such class is determined to be 
performing below any minimum standards or not satisfying any conditions 
that the Exchange may establish with respect to any 50% Enhanced 
Participation Options. The Committee may reinstate the 50% Enhanced 
Participation for a particular option if it determines that the 
specialist in such class is performing at or above all established 
minimum standards and is satisfying all established conditions.
    (C) 50% Enhanced Participation Options that are reallocated or 
transferred to a Phlx specialist after January 1, 1997, are eligible to 
be 80% Enhanced Participation Options, as defined in Rule 
1014(g)(vi)(A) below.
    (D) A 50% Enhanced Participation Option is not eligible for any 
other enhanced specialist participation programs provided in Rule 
1014(g).
    (vi) 80% Enhanced Participation--When the registered specialist in 
80% Enhanced Participation Options (as defined in (A) below) is on 
parity with a controlled account(s) (as defined in subparagraph (i) 
above), the specialist is entitled to 80% participation (``80% Enhanced 
Participation''). No customer order which is on parity may receive a 
smaller participation than any other crowd participant including the 
specialist. This 80% Enhanced Participation will be in effect for a 
six-month pilot period commencing on a date determined by the Exchange 
(``Effective Date'').
    (A) Initially, Top 100 Options are those equity options with the 
highest total year-to-date option volume as of November 30, 1999. The 
initial Top 100 Options will remain in effect for at least the length 
of the initial pilot period and until the next evaluation date as 
follows: subsequent Top 100 Options will be evaluated and established 
on May 30 and November 30 of each year; the 80% Enhanced Participation 
will become effective for those options on July 1 and January 1 of each 
year.
    Top 100 Options allocated, reallocated or transferred to a Phlx 
specialist after January 1, 1997 are eligible to be an 80% Enhanced 
Participation Option.
    (B) An 80% Enhanced Participation Option is not eligible for any 
other enhanced specialist participation programs provided in Rule 
1014(g).
    (C) Exception: The 80% Enhanced Participation does not apply to 
orders when there is a Phlx ROT closing in-person on parity, provided 
that the ROT must announce to the trading crowd that he is closing. 50% 
Enhanced Participation, as defined in subparagraph (g)(v) of this Rule, 
may be applicable to such order.
    (D) The volume requirement for 80% Enhanced Participation Options 
appears in Rule 511(d)(3).

Enhanced Specialist Participation Review

Rule 509

    (a) A Quality of Markets Subcommittee shall be established as a 
permanently standing subcommittee of the Committee. The purpose of the 
Subcommittee will be to monitor and evaluate the performance of equity 
and index option specialists to determine if they will retain an 
enhanced participation as defined in Rule 1014(g)(ii) and Rule 
1014(g)(v), to strengthen the equity option floor, and to oversee the 
specialists' performance respecting multiply traded issues. The 
Chairman of the Subcommittee will be a floor broker who shall be a 
member of the Committee. The Other members of the Subcommittee may be 
anyone that the Chairman of the Committee finds to be qualified and 
there must be an equal number of specialists and ROTs on the 
Subcommittee. The Subcommittee also may assist the Committee in 
conducting informal reviews of specialist units which do not meet 
minimum standards on specialist evaluations pursuant to Rule 515.
    (b)-(e) No change.

Specialist Performance Evaluation

Rule 511

    (a)-(c) No change.
    (d) Special Reviews.
    (1)-(2) No change.
    (3) 80% Enhanced Participation Options. The Committee will conduct 
special reviews for 80% Enhanced Participation Options. Specifically, 
if the volume transacted on the Exchange for each 80% Enhanced 
Participation Option does not exceed an average of 10% of the daily 
consolidated volume compiled by The Options Clearing Corporation 
(``Performance Requirement'') in each such option for the six month 
period commencing on the Effective Date or any six month period 
thereafter, the Committee, pursuant to rule 506, will solicit 
specialist applications to reallocate such option. This subparagraph 
(3) will be in effect for a six-month pilot period commencing on a date 
determined by the Exchange (``Effective Date'').
    (A) Initially, Top 100 Options are those equity options with the 
highest total year-to-date option volume as of November 30, 1999. The 
initial Top 100 Options will remain in effect for at least the length 
of the initial pilot period and until the next evaluation date as 
follows: subsequent Top 100 Options will be evaluated and established 
on May 30 and November 30 of each year; and will become effective for 
those options on July 1 and January 1 of each year.
    (B) For each Top 100 Option reallocated to a new specialist 
pursuant to Section (A) above, or transferred or allocated after the 
Effective Date (which now qualifies as an 80% Enhanced Participation 
Option), the new specialist

[[Page 48792]]

is entitled to receive the 80% Enhanced Participation as described in 
Rule 1014(g)(vi), and the Performance Requirement must be met with the 
initial six month period commencing on the next business day following 
allocation, reallocation or transfer and continuing until the end of 
the next six month period operating for the other options in (A) above 
(that originated with the Effective Date.).
    (C) Reviews conducted pursuant to this subsection (3) will not be 
subject to the hearing procedures described in Section (e) below.
    (e) Hearing Procedures. Prior to a final determination with respect 
to any proceedings instituted under Sections (c) and (d) (1) and (2) 
above,  the Committee shall notify the Registrant in writing of the 
Committee's preliminary evaluation and proposed action and inform the 
Registrant of its right to a hearing on this matter. If the Registrant 
elects to receive a hearing, the information supporting the Committee's 
evaluation of the Registrant's performance shall be presented. The 
Registrant shall have the opportunity to comment on the Committee's 
evaluation and present any information that it believes is relevant. 
The Registrant may question members of the Committee and Exchange staff 
with respect to the evaluation of its performance. Formal rules of 
evidence shall not apply. The Registrant and the Committee shall have 
the right to have present at the hearing one or more technical 
consultants for the purpose of answering questions about trading 
techniques and procedures and shall not otherwise participate in the 
Committee's final evaluation of the Registrant's performance. The 
Registrant may be represented by legal or other counsel. A transcript 
shall be kept of the hearing and copies will be furnished to the 
Registrant upon request and payment of the costs of reproduction. Based 
on the entire hearing record, the Committee shall prepare and deliver 
to the Registrant a written decision setting forth its conclusions 
regarding the Registrant's performance and the action, if any, to be 
taken with respect to removing and reallocating securities and the 
basis therefore. The decision also shall describe the Registrant's 
appeal rights. In the event of such appeal, the Committee's action 
shall be stayed pending the conclusion of the Registrant's appeal. If, 
after receiving notice of the Committee's preliminary evaluation and 
right to a hearing, the Registrant refuses to appear at a scheduled 
hearing or otherwise fails without reasonable justification or excuse 
to attend a scheduled hearing, he shall have waived his rights to such 
hearing.
    Supplementary Material:
    .01-.04 No change.

Specialist Evaluations

Rule 515

    (a) No Change.
    (b) Review Frequency and Weight of Evaluations. Routine reviews 
will be conducted quarterly for equity specialist units and every six 
months for option specialist units. Special reviews shall be commenced 
where a specialist unit's performance in a particular market situation 
was so egregiously deficient as to call into question the Exchange's 
integrity or impair the Exchange's reputation for maintaining 
efficient, fair and orderly markets, where a material change in the 
specialist unit has occurred, within 760 days after a transfer of one 
or more equity books or option classes has become effective pursuant to 
Rule 511(d0(2) or within 90 days after a new allocation and will cover 
such time periods as are deemed appropriate. Special reviews may 
incorporate the same review methodology and procedures as established 
for routine reviews, although special reviews may instead or in 
addition, examine such other matters related to a Registrant's 
performance as the Committee deems necessary and appropriate. The 
Committee may seek input from members, customers and Exchange staff and 
consider any other information the Committee deems relevant in making a 
final determination to initiate a reallocation proceeding pursuant to 
Rule 511(c). The reallocation proceedings described in Rule 511(c) do 
not apply to the 80% Enhanced Participation Review described in Rule 
511(d)(3).

Option Floor Procedure Advice F-24

AUTO-X Contra-Party Participation (The Wheel)

    (a)-(d) No change.
    (e) Wheel Rotation/Assigning Contracts--The AUTO-X participation 
shall be assigned to Wheel Participants on a rotating basis, beginning 
at a random place on the rotational Wheel each day, from those 
participants signed-on in that listed option at that time. The Wheel 
shall rotate and assign contracts depending upon the size of the AUTO-X 
guarantee, as follows:
    1-10 contracts every 2 contracts;
    11-25 contracts ever 5 contracts
    26 and more every 10 contracts
    The Options Committee, or its designees, may approve a Wheel 
rotation in a size larger than the minimum stated above, if requested 
by the specialist and Wheel participants. However, the Wheel may not 
rotate in a size larger than ten contracts. Each remaining portion 
shall be successively assigned to individual Wheel Participants on that 
same basis. The specialist shall receive the first execution of the 
day; thereafter, if four or less ROTs are participating on the Wheel, 
the specialist shall participate in a normal rotation. However, if an 
average of five to 15 ROTs have signed-on the Wheel, the specialist 
shall receive every fifth execution; of an average of 16 or more ROTs 
have signed-on the Wheel, the specialist shall receive every tenth 
execution, unless Wheel participation falls below ten participants at 
any time, then the specialist shall automatically participate in a 
normal rotation.
    Execution to the normal rotation: [With the unanimous consent of 
Wheel participants in an option and approval of the Options Committee 
Chairman or his designee, t] The specialist shall receive [an enhanced 
participation substantially equivalent to twice the number of contracts 
as other crowd participants where the Enhanced Specialist Participation 
of Rule 1014(g)(ii) applies.] the same enhanced participation on the 
Wheel as such specialist should receive under the enhanced specialist 
participation programs of Rule 1014(g)(ii), the 30% Enhanced Specialist 
Participation, Rule 1014(g)(v), 50% Enhanced Participation, or Rule 
1014(g)(vi), 80% Enhanced Participation.
    (f) The provisions of section (e) above will be reviewed and 
evaluated by the Options Committee, on a six-month basis.

FINE SCHEDULE

    F-24 Fine not applicable, except paragraph (c). Matters subject to 
review by the Business Conduct Committee.

Option Floor Procedure Advice B-6

Priority of Options Orders for Equity Options and Index Options by 
Account Type

    Exchange Rules 119 and 120 direct members in the establishment of 
priority of orders on the floor. In addition, equity option and index 
option orders of controlled accounts are required to yield priority to 
customer orders when competing at the same price, as described.
    For the purpose of this Advice, an account type is either a 
controlled account or a customer account. A controlled account includes 
any account controlled by or under common control with a member broker-
dealer. Specialist

[[Page 48793]]

accounts of PHLX Option Specialists, however, are not subject to 
yielding requirements placed controlled accounts by this Advice. 
Customer accounts are all other accounts.

Section A

    No change.

Section B

    Orders of controlled accounts, other than ROTs and Specialists 
market making in-person, must be
    (1) verbally communicated as for a controlled account when placed 
on the floor and when represented to the trading crowd, and
    (2) recorded as for a controlled account by appropriately circling 
the ``yield'' field on the floor ticket of any such order.
    In any instance where an order is misrepresented in this fashion 
due to factors which give rise to the concern that it was the result of 
anything other than an inadvertent error, the Exchange may determine to 
bypass the fine schedule below and refer the incident to the Business 
Conduct Committee for possible disciplinary proceedings in accordance 
with those procedures set forth under the Exchange's Disciplinary Rule 
960.
    Several programs described below provide an enhanced participation 
(or split) to specialists, which refers to the portion of an options 
trade allocated to the specialist on parity, including a 30% enhanced 
specialist participation, new unit/new option enhanced specialist 
participation, new product enhanced specialist participation, 50% 
enhanced participation, and 80% enhanced participation.

Section C

    Enhanced Specialist Participation--Except as provided sections D-F, 
[i[I]n equity and index option classes, when the registered specialist 
is on parity with a controlled account, as defined above, in accordance 
with exchange Rules 119 and 120 and the number of contracts to be 
bought or sold is grater than five, the specialist is entitled to 
received an enhanced participation of 30% when there are three or more 
controlled accounts on parity (``Enhanced Specialist Participation''), 
except in the following circumstances:
    (1) where there is one controlled account on parity, in which case 
the specialist is entitled to 60%; or
    (2) where there are two controlled accounts on parity, in which 
case the specialist is entitled to 40%.
    Further, no customer order which is on parity may receive a smaller 
participation than any other crowd participant including the 
specialist. Enhanced Specialist Participation will be effective for:
    (a) all newly listed issues,
    (b) all index options, and
    (c) such issues selected by the specialist and approved by the 
Allocation, Evaluation and Securities Committee.

Section D

    No change.

Section E

    50% Enhanced Participation--In 50% Enhanced Participation Options 
(defined in (a) below), when the registered specialist is on parity 
with more than one controlled account as defined in subparagraph (i) 
above, in accordance with exchange Rules 119 and 120, the specialist is 
entitled to 50% participation when there are two or more controlled 
accounts on parity. When there is one controlled account on parity, the 
specialist is entitled to 60% participation. No customer order which is 
on parity may receive a smaller participation than any other crowd 
participant including the specialist.
    (a) 50% Enhanced Participation Options are the Top 100 Options, 
defined in Section F below, which were allocated to a Phlx specialist 
before January 1, 1997.
    (b) Pursuant to Exchange Rule 509, the Allocation, Evaluation and 
Securities Committee may reduce the 50% Enhanced Participation 
authorized under Rule 1014(g)(v) to a parity level in accordance with 
Rules 119 and 120. The reduction shall be in accordance with the 
provisions of this rule if the specialist in such class is determined 
to be performing below any minimum standards or not satisfying any 
conditions that the Exchange may establish with respect to any 50% 
Enhanced Participation Options. The Committee may reinstate the 50% 
Enhanced Participation for a particular option if it determines that 
the specialist in such class is performing at or above all established 
minimum standards and is satisfying all established conditions.

Section F

    80% Enhanced Participation--When the registered specialist in 80% 
Enhanced Participation Options (as defined in (a) below) is on parity 
with a controlled account(s), the specialist is entitled to 80% 
participation (``80% Enhanced Participation''). No customer order which 
is on parity may receive a smaller participation than any other crowd 
participant including the specialist. The 80% Enhanced Participation 
will be in effect for a six-month pilot period commencing on a date 
determined by the Exchange (Effective Date).
    (a) Initially, the Top 100 Options are those equity options with 
the highest total year-to-date option volume as of November 30, 1999. 
The initial Top 100 Options will remain in effect for at least the 
length of the initial pilot period and until the next evaluation date 
as follows: subsequent Top 100 Options will be evaluated and 
established on May 30 and November 30 of each year; the 80% Enhanced 
Participation will become effective for those options on July 1 and 
January 1 of each year.
    Top 100 Options allocated, reallocated or transferred to a Phlx 
specialist after January 1, 1997 are eligible to be 80% Enhanced 
Participation Options.
    (b) An 80% Enhanced Participation Option is not eligible for any 
other enhanced specialist participation programs provided in Rule 
1014(g).
    (c) Exception: The 80% Enhanced Participation does not apply to 
orders when there is a Phlx ROT closing in-person on parity, provided 
that the ROT must announce to the trading crowd that he is closing. 50% 
Enhanced Participation, as defined in subparagraph (g)(v) of Rule 
1014(g), may be applicable to such order.
    (d) The volume requirement for 80% Enhanced Participation Options 
appears in Rule 511(d)(3).

FINE SCHEDULE (Implemented on a one year running calendar basis)

    No change.

 [FR Doc. 00-20094 Filed 8-8-00; 8:45 am]
BILLING CODE 8010-01-M