[Federal Register Volume 66, Number 74 (Tuesday, April 17, 2001)]
[Notices]
[Pages 19825-19828]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-9507]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44175; File No. SR-NYSE-00-62]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the New York Stock Exchange, Inc. Relating to Specialists' 
Specialty Stock Option Transactions

April 11, 2001.

I. Introduction

    On December 22, 2000, the New York Stock Exchange, Inc. (``NYSE'' 
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 to amend paragraph (1) of the Guidelines 
to NYSE Rule 105 and paragraph (a) of NYSE Rule 98. The proposed rule 
change was

[[Page 19826]]

published in the Federal Register on January 26, 2001.\3\ No comments 
were received on the proposal. On January 31, 2001, the NYSE filed 
Amendment No. 1 to the proposed rule change.\4\ 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\ See Securities Exchange Act Release No. 43859 (January 18, 
2001), 66 FR 7945 (``Notice'').
    \4\ See letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Sapna Patel, Attorney, Division of Market 
Regulation (``Division''), SEC, dated January 30, 2001 (``Amendment 
No. 1''). In Amendment No. 1, the NYSE made minor technical changes 
to the rule text that do not need to be published for comment.
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II. Background

    NYSE Rule 105 restricts specialists' transactions in options based 
on the stock for which the specialist is registered as such 
(``specialty stock''). Specifically, NYSE Rule 105(b) prohibits 
specialists from directly or indirectly holding, acquiring, granting or 
having an interest in any options to purchase or sell or to receive or 
deliver shares of the specialist's specialty stock, except as expressly 
permitted in the Guidelines to the rule. Generally, the Guidelines 
permit specialists to engage in certain hedging transactions in options 
based on the specialist's specialty stock. Guideline (1) to NYSE Rule 
105, however, expressly prohibits specialists from acting in any market 
making capacity in any option that is a derivative of the specialist's 
specialty stock.
    The restrictions in NYSE Rule 105 extend to the specialist's member 
organization, other members, allied members, and approved persons in 
such member organization, and any officer or employee thereof. An 
``approved person'' is an individual or entity that controls a member 
organization, or is engaged in the securities business and is either 
controlled by, or is under common control with, a member 
organization.\5\ Approved persons affiliated with a specialist are 
subject to a number of Exchange rules, including NYSE Rule 105, that 
place restrictions on the approved person's ability to trade in the 
specialty stocks and options based on the specialty stock of the 
related specialist. Thus, pursuant to Rule 105, an approved person 
associated with a specialist is prohibited from engaging in 
transactions in options based on the specialist's specialty stock 
except for the limited hedging transactions permitted in the Rule 105 
Guidelines.
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    \5\ NYSE Rule 98 Guideline (a). NYSE Rule 2 defines ``control'' 
as the power to direct or cause the direction of the management or 
policies of a person whether through ownership of securities, by 
contract or otherwise. A presumption of control is made in certain 
circumstances outlined in the rule.
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    NYSE Rule 98 provides exemptions for specialists and approved 
persons from certain NYSE trading restriction rules. NYSE Rule 98 
exempts approved persons associated with a NYSE specialist from the 
Rule 105 trading restrictions as long as the approved person and the 
specialist organize their respective operations in such a way that the 
activities of each entity are clearly separate and distinct. This is 
accomplished by the entities when they establish organizational 
separation and informational barriers that conform to NYSE Rule 98 
Guidelines and have their proposed structure approved by the Exchange. 
NYSE Rule 98, however, does not exempt an approved person from the 
market making restriction set forth in Guideline (1) to NYSE Rule 105. 
Therefore, an approved person associated with a specialist may not act 
as a market maker in any option that is based on the specialist's 
specialty stock.
    In the Notice, the NYSE explained that these prohibitions were 
intended to address potential conflict-of-interest concerns raised by 
side-by-side trading of equity securities and their related options by 
a specialist and a specialist affiliate.\6\ The prohibitions were 
adopted in the early 1980s when options overlying a security were 
traded on one exchange only, unlike today's environment where options 
are frequently traded on more than one exchange.\7\ According to the 
Exchange, conflict-of-interest concerns can be adequately addressed 
through the use of information barriers. Therefore, the NYSE proposes 
to permit, in a limited context, integrated market making involving 
NYSE specialists and approved persons associated with the specialist.
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    \6\ Side-by-side trading refers to the practice of trading an 
equity security and its related options at the same physical 
location. The Commission notes that the NYSE's restrictions also 
address concerns raised by integrated market making, which refers to 
the same person or firm making a market in an equity security and 
its related options. The Commission historically has viewed 
integrated market making and side-by-side trading as implicating 
many of the same regulatory concerns, such as the potential for 
market participants to misuse non-public market information and to 
engage in manipulative and improper trading conduct. In addition, 
the Commission has identified potential conflicts of interest 
inherent in side-by-side trading and integrated market making and 
has questioned the ability of the markets to effectively surveil 
market participants. See Report of the Special Study of the Options 
Markets to the Securities and Exchange Commission, 96th Cong., 1st 
Sess. (Comm. Print No. 96-1FC3), December 22, 1978 (examining the 
major issues of market structure in standardized options markets, 
including integration of stock and options trading) (``Options 
Study'').
    \7\ See Securities Exchange Act Release No. 21710 (February 4, 
1985), 50 FR 5708 (February 11, 1985) (approving SR-NYSE-82-20). The 
Commission notes that at the time the Commission approved these 
restrictions, the NYSE traded standardized options on its floor. 
NYSE subsequently sold its options business to the Chicago Board 
Options Exchange, Inc. in 1997.
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III. Description of the Proposed Rule Change

    The NYSE proposes to amend paragraph (1) of the Guidelines to NYSE 
Rule 105 and paragraph (a) of NYSE Rule 98 to permit an approved person 
of a specialist to act as a competitive market maker or perform other 
similar non-primary/supplemental market-making activities \8\ in any 
option that is a derivative of the related specialist's specialty 
stock. The proposal would permit this limited form of integrated market 
making as long as the entities are organized as clearly separate and 
distinct entities with informational barriers, approved by the 
Exchange, established between them.
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    \8\ The NYSE distinguishes primary market makers and competitive 
(or non-primary) market makers based on their differing obligations. 
Generally, primary market makers (``PMMs''), also called Designated 
Primary Market Makers (``DPMs''), Lead Market Makers (``LMMs''), and 
Registered Equity Market Makers, are market makers with significant 
responsibilities, similar to specialists on the Exchange, including 
overseeing the opening and closing of trading in option classes, and 
providing continuous, two-sided quotations in all of their assigned 
options. Competitive Market Makers (``CMMs''), also called 
competitive options traders, registered options traders, and non-
primary market makers, however, are market makers who quote 
independently and add depth and liquidity to the market, but do not 
have the primary responsibility to maintain a fair and orderly 
market.
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    While NYSE Rule 105, Guideline (1) would permit an approved person 
associated with a specialist to act as a competitive market maker or 
perform other similar non-primary/supplemental market-making activities 
in any option based on the specialist's specialty stock, it would 
continue to prohibit a specialist, its member organization, other 
members, allied members, or other approved persons of such specialist 
from acting as a primary market maker in any option based on the 
specialist's specialty stock.
    Under the proposed rule change, if an approved person acts as a 
competitive market maker in an option overlying a specialty stock of 
its associated specialist, neither it, nor any other approved person 
associated with the specialist, may act as a market maker in any equity 
stock in which the associated specialist is registered as such and 
which underlies an option as to which the approved person acts as a 
market maker. The Exchange proposed the additional restriction to 
prevent a non-primary market maker in the options

[[Page 19827]]

market from relaying information obtained on the floor (due to time and 
place advantage) to an approved person of the specialist who trades the 
stock underlying the option on a regional exchange or in another 
market.
    As described above, NYSE Rule 98 exempts approved persons of 
specialists from the trading restrictions of NYSE Rule 105 if the 
approved person and the specialist organize their operations in such a 
manner that each entity is clearly separate and distinct. In addition, 
the entities must establish information barriers that prevent the 
possibility that privileged information would be made available for use 
in any way to influence a particular trading decision by a specialist 
or the approved person. Accordingly, the Guidelines require, among 
other things, confidentiality of trading information including 
information about the specialist's book, separate books and records, 
separate financial accounting, and separate capital requirements. The 
approved person and the specialist must submit a written statement to 
the Exchange describing the internal controls they intend to adopt for 
the establishment of procedures sufficient to restrict the flow of 
privileged market information and the Exchange must approve the 
structure to enable the entities to enjoy the Rule 98 exemption.

IV. Discussion

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities exchange.\9\ 
In particular, the Commission believes that the proposal is consistent 
with section 6(b)(5) of the Act,\10\ which requires, among other 
things, that the rules of an exchange be designed to promote just and 
equitable principles of trade, to remove impediments to and perfect the 
mechanism of a free and open market, and to protect investors and the 
public interest.
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    \9\ 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).
    \10\ 15 U.S.C. 78f(b)(5).
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    The Exchange has proposed to permit limited integrated market 
making of stocks listed on the Exchange and the options released to 
such Exchange-listed stocks by affiliated entities. Historically, the 
Commission has been concerned about permitting such practices.\11\ 
Integrated market making raises numerous regulatory issues, such as the 
concern that an integrated entity could unfairly use non-public market 
information to its advantage, or that an integrated entity could easily 
engage in improper conduct, such as manipulating the price of either 
the stock or the option to create unfair advantages that would be hard, 
if not impossible, to surveil.\12\ The Commission has also been 
concerned about the potential conflicts of interest that may arise when 
an integrated entity has an obligation to make markets in both an 
option and its underlying equity. In addition, the Commission has 
expressed concern about an exchange's ability to effectively surveil 
the trading practices of integrated entities.
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    \11\ See Options Study, supra note 6.
    \12\ In the Options Study, the staff noted that substantial 
profits could be made from options positions as a result of small 
movements in the price of the underlying. Further, the staff noted 
the relative ease by which the price of the underlying security 
could be moved and the difficulty in detecting improprieties 
associated with small price movements.
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    When considering an integration proposal, the Commission must 
balance the potential improvements in the quality of the markets for 
the stocks and their related options against the competitive, 
regulatory, and surveillance concerns.\13\ In this regard, the 
Commission must consider whether an integration proposal would permit 
the integrated entities to possess undetectable, material non-public 
market information, which could give either the specialist or the 
related options market maker a trading advantage over other market 
participants. Thus, the Commission must evaluate the extent of the 
proposed integration, as well as the characteristics of the market 
center putting forth the proposal.
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    \13\ See Options Study, supra note 6k, See also Securities 
Exchange Act Release No. 22026 (May 8, 1985), 50 FR 20310 (May 15, 
1985).
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    In the proposed rule change, the Exchange seeks to permit a limited 
kind of integrated market making. Approved persons of Exchange 
specialists will be permitted to act as competitive market makers in 
options based on the specialist's specialty stock. However, these 
integrated entities as well as any other approved persons affiliated 
with the specialist will be required to organize their respective 
operations in such a way that the activities of each entity are clearly 
separate and distinct. The Guidelines to Rule 98 set forth the 
requirements to be followed by the related entities to be considered 
clearly separate and distinct. For example, Guideline (b)(i) requires 
organizational separation of the specialist and approved person and 
that the specialist must function as an entirely free standing entity 
responsible for its own trading decisions. Guideline (b)(ii) requires 
the respective management structures of the specialist and the approved 
person to be organized in such a manner as to prevent the management of 
the approved person from exerting any influence on a particular trading 
decision of the specialist. Guidelines (b)(iii) and (b)(iv) require the 
establishment of procedures to preserve confidentiality of trading 
information. In addition, Guideline (b)(iii) specifically requires the 
establishment of procedures to ensure the confidentiality of the 
specialist's book. Finally, the Guidelines require that the specialist 
and approved person maintain, among other things, separate books and 
records, financial accounting and capital requirements.
    The Commission believes that the Exchange has established 
appropriate procedures in the Guidelines to address the regulatory 
issues related to the proposed rule change. The requirement of clearly 
separate and distinct organizations, along with the other informational 
barriers and restrictions, should prevent Exchange specialists and 
their related options market makers from sharing restricted, non-public 
market information. Further, Rule 98 requires the Exchange to review 
and approve the organizational structure and information barriers of 
the integrated entities. The Commission notes that the Exchange has had 
extensive experience reviewing Rule 98's organizational requirements 
and information barriers and thus should be able to ensure that the 
integrated entities are sufficiently separate and distinct. In 
addition, the Exchange has verified that organizational separation and 
information barriers will be maintained between the Exchange 
specialist, the approved person of the specialist acting as a 
competitive market marker in the overlying option, and any other 
persons affiliated with them.\14\
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    \14\ The Commission notes that a specialist may be associated 
with more than one approved person. For example, a specialist may be 
controlled by a parent organization, which may also control other 
organizations. If any other organization controlled by the parent 
engages in market making activities in options based on the 
specialist's specialty stock, organizational separation and 
information barriers would have to be established between all 
entities, i.e., the specialist, the parent company and the related 
options market making entities. Telephone conversation between Jeff 
Rosenstrock, Senior Project Specialist, Rule Development, NYSE, and 
Kelly Riley, Special Counsel, Division, SEC, on March 28, 2001.
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    The Commission expects that the Exchange will assess, as it gains 
experience with the limited form of integrated market making permitted 
by this proposal, whether any other informational barriers are 
necessary to

[[Page 19828]]

prevent the flow of market information between the related entities. Of 
course, any new information barriers proposed would have to be 
submitted to the Commission for approval. The Commission also expects 
that the Exchange will surveil the integrated entities to ensure that 
the information barriers and organizational structure continue to 
prevent the flow of non-public market information.
    The Commission notes that because the NYSE is the primary market 
for many equity securities underlying options, concerns are raised 
about an integrated organization being able to dominate the markets of 
both the specialty stock and its related options. Specifically, an 
integrated entity may by virtue of its positions as specialist and 
market maker in related securities could control the pricing and 
liquidity of both markets. The Commission, however, believes that the 
instant proposal is sufficiently limited to prevent an integrated 
entity from becoming dominant. For example, the instant integration 
proposal would permit approved persons to act only as competitive 
options market makers. Thus, while the approved person acting as a 
competitive options market maker may receive order flow in the 
specialty stock option, it most likely would not receive order flow or 
participate in trades to the same extent as a primary market maker. 
Further, a competitive market maker is required to compete, on price 
and size, with other market makers on the options floor for order flow. 
By having to compete on both price and size for orders, a competitive 
market maker should not be able to dominate the price or liquidity of a 
specialty stock option. Thus, the Commission believes that concerns 
that an integrated entity may become dominant in options and its 
underlying specialty stock are minimal in this case.
    The Commission believes that the proposal should provide benefits 
to the markets. For example, the number of entities that may act as 
competitive market makers in options based on a specialist's specialty 
stock may increase as a result of this proposal. Now, entities that 
have been prohibited from acting as competitive options market maker 
because of the restrictions in NYSE Rule 105(l) will be permitted to 
act in this capacity. This could lead to increased competition and 
liquidity in the options market.
    In conclusion, the Commission believes that the Exchange has 
sufficiently minimized the potential for manipulative and improper 
trading conduct by requiring strict organizational separation and 
information barriers. Therefore, the Commission believes that the 
potential improvements to liquidity and quality of the markets outweigh 
the potential regulatory concerns. For these reasons, the Commission 
finds that the proposed rule change is consistent with section 6(b)(5) 
of the Act.\15\
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    \15\ 15 U.S.C. 78f(b)(5).
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V. Conclusion

    It Is Therefore Ordered, pursuant to section 19(b)(2) of the 
Act,\16\ that the proposed rule change (SR-NYSE-00-62), is approved.
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    \16\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\17\
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    \17\ 17 C.F.R. 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-9507 Filed 4-16-01; 8:45 am]
BILLING CODE 8010-07-M