[Federal Register Volume 65, Number 183 (Wednesday, September 20, 2000)]
[Notices]
[Pages 56972-56974]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-24128]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43285; File No. SR-CBOE-00-01]


Self-Regulatory Organizations; Order Approving a Proposed Rule 
Change by the Chicago Board Options Exchange, Inc. Relating to the 
Prohibition on the Entry of Certain Electronically Generated Orders 
Into the Exchange's Order Routing System

September 12, 2000.

I. Introduction

    On February 9, 2000, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change governing certain electronically 
generated orders. On March 6, 2000, April 28, 2000, and July 10, 2000, 
the CBOE filed Amendment Nos, 1, 2, and 3, respectively to the 
proposal.\3\ Notice of the proposal was published in the Federal 
Register on August 4, 2000.\4\ The Commission received one comment 
letter regarding the proposal.\5\ This order approves the proposed rule 
change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No, 2, the Exchange proposed to create new Rule 
6.8A, Electronically Generated and Communicated Orders, rather than 
including the proposed rule language as a subsection of CBOE Rule 
6.8, RAES Operations. In Amendment No. 2, the Exchange proposed to 
prohibit electronically generated orders only if they were eligible 
for execution on the Exchange's Retail Automatic Execution System 
(``RAES''). In Amendment No. 3, the Exchange revised the proposed 
rule language to clarify that electronically created orders will be 
prohibited from entry into the Order Routing System (``ORS'') if 
they are eligible for execution on RAES at the time they are sent to 
the Exchange. Amendment No. 3 also clarified the types of orders 
that are considered to be eligible for execution on RAES at the time 
they are sent. See letters from Timothy Thompson, Assistant General 
Counsel, Legal Department, CBOE, to Nancy J. Sanow, Assistant 
Director, Division, Commission, dated March 3, 2000, April 27, 2000, 
and July 6, 2000. The modifications made by these amendments are 
incorporated in the description of the proposal in Section II below.
    \4\ Securities Exchange Act Release No. 43087 (July 28, 2000), 
65 FR 48033.
    \5\ See Section III below for a description of the comment 
letter.
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II. Description of the Proposal

    New Rule 6.8A (``Rule'') restricts the entry of certain options 
orders that are created and communicated electronically, without manual 
input, into the CBOE's Order Routing System (``ORS''). ORS is the 
Exchange's automated order trading and routing system comprised of the 
options order routing system, the Retail Automatic Execution System 
(``RAES''),\6\ the electronic limit order book, and other electronic 
delivery and acceptance systems and terminals.
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    \6\ RAES automatically executes customer market and marketable 
limit orders that fall within designated order size parameters. All 
designated primary market makers (``DPMs'') of a particular option 
class are required to log on RAES for that class; other market 
makers who trade that class on the floor may log on RAES but are not 
required to do so. When RAES receives an order, the system 
automatically attaches to the order its execution price, generally 
determined by the prevailing market quote at the time of the order's 
entry to the system, and a participating market maker will be 
designated as the counterparty on the trade. See CBOE Rule 
6.8(a)(ii).
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    The Rule provides that members may not enter nor permit the entry 
of, orders into ORS if those orders are created and communicated 
electronically without manual input and if such orders are eligible for 
execution on RAES at the time that they are sent. To be permitted under 
the Rule, order entry by public customers or associated persons of 
members must involve manual input, such as entering the terms of an 
order into an order-entry screen or manually selecting a displayed 
order against which an off-setting order should be sent. Members are 
permitted to communicate to the Exchange orders manually entered by 
customers into front-end communication systems such as Internet gateway 
and online networks.
    The Rule clarifies that an order is eligible for execution on RAES 
if: (1) its size is equal to or less than the maximum RAES order size 
for the particular option series; (2) the order is marketable or is 
tradable pursuant to the RAES auto step-up feature at the time it is 
sent; and (3) the order has either no contingency or has a contingency 
that is accepted for execution by RAES. As defined in the Rule, a 
marketable order is a market order or a limit order in which the 
specified price to sell is below or at the current bid, or the 
specified price to buy is above or at the current offer. An order is 
tradable pursuant to the RAES auto step-up feature if the appropriate 
CBOE Floor Procedure Committee (``FPC'') has designated the class as an 
auto step-up class and if the National Best Bid or Offer (``NBBO'') for 
the particular series is reflected by the current best bid or offer in 
another market by no more than the step-up amount as defined in 
Interpretation .02 of CBOE Rule 6.8.
    The proposal is designed to permit CBOE market makers who 
participate in RAES to compete more effectively with customers who are 
equipped with electronic systems. Specifically, the Exchange represents 
that its business model depends upon market makers for competition and 
liquidity. If further represents that public customer orders submitted 
to the CBOE are provided with certain benefits pursuant to various 
rules of the Exchange, including Rule 6.8 (RAES Operations), Rule 6.45 
(Priority of Bids and Offers), Rule 7.4 (Obligations for Orders), and 
Rule 8.51 (Trading Crowd Firm Disseminated Market Quotes). The Exchange 
represents that allowing electronically generated and communicated 
customer orders to be routed directly to ORS and RAES would give 
customers with such electronic systems a significant advantage over 
market makers. The Exchange believes that this could undercut its 
business model. The Exchange notes that under the proposed rule change, 
computer generated orders can still be sent for execution on the 
Exchange; however, they may not be sent for execution through ORS.

[[Page 56973]]

    CBOE member firms and customers who are not located on the trading 
floor may send option orders to the trading floor in various ways. 
First, a customer in some option classes may telephone an order 
directly to a floor broker in the trading crowd, provided the firm 
taking the order complies with all applicable rules for handling the 
customer order. In other trading crowd, a member firm representative or 
a customer may telephone an order into a member firm booth on the 
trading floor. From here the order may be taken manually into the 
proper trading crowd and represented; alternatively, it may be sent 
electronically from the booth to a floor broker in the trading crowd 
who will represent it. A member firm representative may also send an 
order to the floor of the Exchange pursuant to that firm's proprietary 
order routing network. The order would then be routed to the trading 
crowd in one of the two ways described above. Finally, a member firm 
may send an order to the Exchange through its interface with ORS. 
Eligible orders sent through ORS may be: (1) automatically executed 
against orders in the limit order book; (2) placed in the limit order 
book; (3) automatically executed via RAES; or (4) routed to a Public 
Access Routing (``PAR'') terminal in the trading crowd.
    Prior to adoption of the new Rule, electronically generated orders 
could be sent to the CBOE in any of the ways described above. 
Electronically generated orders sent to ORS would be routed to RAES for 
automatic execution if those orders were otherwise eligible for 
execution on RAES. Under the new Rule, however, electronically 
generated orders that are eligible for execution on RAES at the time 
they are sent may not be routed to ORS. These orders, however, may be 
sent to the trading floor for execution as otherwise described above, 
i.e., by telephone or through a member firm's proprietary order routing 
system.

III. Summary of Comments

    The Commission received one comment letter regarding the proposed 
rule change.\7\ That letter, from Susquehanna Investment Group 
(``Susquehanna''), strongly supported approval of the proposal. 
Susquehanna stated that the Rule will enable CBOE market makers to 
compete more effectively by reducing their exposure to electronically 
generated orders. Susquehanna also stated that the Rule will promote a 
level playing field with the International Stock Exchange LLC (``ISE'') 
because of its similarly to Rule 717(f) of the ISE. Finally, 
Susquehanna asked the Commission to clarify that orders entered with a 
single keystroke are subject to the prohibition against entry into ORS. 
Susquehanna expressed concern that professional traders may attempt to 
circumvent the Rule by ``having a person enter a keystroke to send an 
electronically generated order * * * so that the order can be denied 
`manual'.'' \8\ Susquehanna believes that such a practice could 
undermine the intent of the proposal.

IV. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the provisions of the Act applicable to a 
national securities exchange, particularly Section 6(b)(5) \9\ and 
Section 6(b)(8) \10\ of the Act, and the rules and regulations 
thereunder. \11\
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    \7\ Letter from Joel Greenberg, Managing Director, Susquehanna 
Investment Group, to Jonathan G. Katz, Secretary, Commission, dated 
August 29, 2000.
    \8\ Id. at 4.
    \9\ 15 U.S.C. 78f(b)(5). Section 6(b)(5) requires that the rules 
of a national securities exchange be designed to, among other 
things, promote just and equitable principles of trade, remove 
impediments to and perfect the mechanism of a free and open market, 
and, in general, to protect investors and the public interest. It 
also requires that those rules not be designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers.
    \10\ 15 U.S.C. 78f(b)(8). Section 6(b)(8) requires that the 
rules of the exchange do not impose any burden on competition not 
necessary or appropriate in furtherance of the purposes of the Act.
    \11\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
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    The Commission has carefully considered whether the Rule inhibits 
competition between the CBOE's automated customers and those who do not 
employ automated means of order entry. The Commission notes that in the 
equity markets, for example, limit orders from active customers have 
been a valuable source of quote competition. Nonetheless, the 
Commission recognizes that the CBOE's business model depends on market 
makers for competition and liquidity. Allowing electronic order entry 
into ORS could give automated customers a significant advantage over 
market makers. This could undercut the CBOE's business model. Moreover, 
the CBOE's prohibition against entry of electronically entered orders 
that are eligible for execution on RAES still allows non-marketable 
limit orders that improve the CBOE's displayed bid and offer to be 
entered into ORS.
    The Commission believes that it is not inconsistent with the 
purposes of the Act for the CBOE to address the risk to its market 
makers posed by rapid entry of electronically generated orders that are 
designed to take advantage of temporary anomalies between current 
options prices and the value of the underlying stock or index. In this 
regard, the Commission notes that it has approved a similar rule for 
the first fully automated options exchanges, the ISE. In approving the 
application of the ISE for registration as a national securities 
exchange, the Commission explicitly recognized that the ISE's business 
model ``depends on market makers for competition and liquidity.'' \12\ 
Recognizing that allowing electronic order entry into the ISE could 
``give automated customers a significant advantage over [the ISE's] 
market makers,'' the Commission stated that it was unable to conclude 
that the limitation violated the statutory requirements.\13\
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    \12\ Securities Exchange Act Release No. 42455 (February 24, 
2000), 65 FR 11401 (March 2, 2000). In approving the ISE's 
application for exchange registration, the Commission also approved 
several ISE rules, including Rule 717(f) regarding entry of 
computer-generated orders.
    \13\ Id.
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    ISE Rule 717(f) regarding computer-generated orders specifically 
permits the entry of computer-generated non-marketable limit orders 
that improve the best price available on the ISE. This provision is 
designed to accommodate non-marketable limit orders because these 
orders serve to increase competition and improve quotes. Similarly, 
non-marketable limit orders that improve the best price on the CBOE 
will not be subject to the Rule's prohibition against entry of 
computer-generated orders into ORS because that prohibition applies 
only to orders that are eligible for execution on RAES at the time they 
are sent. Under the Rule, an order is eligible for execution on RAES if 
(among other criteria) ``the order is marketable or is tradable 
pursuant to the RAES auto step-up feature at the time it is sent.'' The 
Rule defines ``marketable order'' as a market order or a limit order in 
which the specified price to sell is below or at the current bid, or 
the specified price to buy is above or at the current offer. Non-
marketable limit orders that improve the CBOE market, on the other 
hand, are orders priced above the correct bid and below the current 
offer. These non-marketable limit orders will not be excluded from ORS 
under the rule, but will instead be eligible for entry into ORS. Once 
entered into ORS, they will be routed to a member firm booth on the 
trading floor or to a PAR terminal in the trading crowd. Once the order 
arrives at the crowd, a market maker will execute the order or route it 
to the limit order book.

[[Page 56974]]

    Although the ISE and CBOE rules are not identical, both ISE Rule 
717(f) and CBOE Rule 6.8A permit non-marketable limit orders that 
improve the price to be sent to the exchange and routed to the relevant 
trading mechanism for execution. As it stated with respect to its 
approval of ISE Rule 717(f), the Commission is unable to conclude that 
the new CBOE Rule violates any statutory requirements.
    In its comment letter, Susquehanna asked the Commission to clarify 
that orders entered with a single keystroke are subject to the 
Rule.\14\ Susquehanna expressed concern that professional traders may 
attempt to circumvent the Rule by ``having a person enter a keystroke 
to send an electronically generated order . . . so that the order can 
be deemed ``manual'.'' \15\ In response, the CBOE stated that it agrees 
with Susquehanna that this practice could potentially undermine the 
purpose of the Rule. In such a case, the CBOE believes that it can 
effectively address the issue by adding an Interpretation to Rule 6.8A 
that clarifies the scope of the Rule.\16\ Such an Interpretation would 
be subject to the filing requirements of Section 19(b) of the Act.
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    \14\ Supra note 7, at 4.
    \15\ Id.
    \16\ Telephone conversation between Timothy Thompson, Assistant 
General Counsel, Legal Department, CBOE, and Gordon Fuller, Special 
Counsel, Division of Market Regulation, Commission (September 10, 
2000).
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    In sum, the Commission notes that the Rule does not prohibit 
electronically generated orders from being sent to the CBOE; rather, it 
merely prevents them from being entered into ORS. Thus, electronically 
generated orders will be routed to the trading crowd and represented in 
open outcry. Once the order arrives at the trading crown, CBOE rules 
require that the order be executed at the CBOE's displayed bid or offer 
at the time the order is represented in the crowd.\17\ Depending upon 
the circumstances, the order may be filled at a price better than the 
CBOE's displayed bid or offer. Therefore, although electrically 
generated orders will not be eligible for automatic execution on RAES 
under the Rule, they will still be entitled to receive an execution 
price that is as good as or better than the CBOE's displayed bid or 
offer.
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    \17\ See CBOE Rule 8.51.
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V. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act and the rules and regulations 
thereunder.
    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (SR-CBOE-00-01), as amended, adopting 
Rule 6.8A, is approved.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\18\
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    \18\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland
Deputy Secretary.
[FR Doc. 00-24128 Filed 9-19-00; 8:45 am]
BILLING CODE 8010-01-M