[Federal Register Volume 66, Number 133 (Wednesday, July 11, 2001)]
[Notices]
[Pages 36353-36355]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-17305]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44508; File No. SR-ISE-2001-17]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the International Securities Exchange LLC Relating to 
Permanent Approval of its Allocation Algorithm Pilot

July 3, 2001.
    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 May 23, 2001, the International Securities Exchange LLC (the 
``Exchange'' or the ``ISE'') 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 ISE. 
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.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange is proposing to amend Supplementary Material .01 to 
Rule 713 to adopt the Exchange's current allocation algorithm pilot 
program on a permanent basis. The Exchange's allocation algorithm pilot 
was approved by the Commission on May 22, 2000,\3\ and recently was 
extended until August 1, 2001.\4\ The text of the proposed rule change 
is available at the ISE and the Commission.
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    \3\ See Securities Exchange Act Release No. 42808 (May 22, 
2000), 65 FR 34515 (May 30, 2000)(``Release No. 42808'').
    \4\ See Securities Exchange Act Release No. 44340 (May 22, 
2001), 66 FR 29373 (May 30, 2001)(``Release No. 44340'').
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II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the ISE 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 III below. The ISE has prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    ISE Rule 713 provides that, at a given price, customer orders have 
priority, based on the time priority of such orders. ISE Rule 713(e) 
provides that if there are two or more non-customer orders or market 
maker quotations at the Exchange's inside market, after filling all 
customers at that price, executions will be allocated between the non-
customer orders and market maker quotations ``pursuant to an allocation 
procedure to be determined by the Exchange from time to time * * *.'' 
ISE Rule 713(e) also states that, if the primary market maker (``PMM'') 
is quoting at the Exchange's inside market, it will have precedence 
over non-

[[Page 36354]]

customer orders and competitive market maker (``CMM'') quotes for 
execution of orders that are up to a specified number of contracts. 
Supplementary Material .01 to ISE Rule 713 specifies the ISE's 
allocation procedure for non-customer orders and market maker 
quotations and defines the size of orders for which the PMM has 
priority to be those of five contracts or fewer.
    The allocation procedure is a trading algorithm programmed in the 
ISE's electronic auction market system (the ``System'') that determines 
how to split the execution of incoming orders among professional 
trading interests at the same price. All public customer orders at a 
given price are always executed fully before the trading algorithm is 
applied. Moreover, because the algorithm is applied automatically by 
the System upon the receipt of an executable order, only those non-
customer orders and market maker quotes that are in the System 
participate in the algorithm. Thus, there is no opportunity for a 
market participant to receive an allocation unless it had an order or 
quote in the System at the execution price at the time the incoming 
order was received by the System.
    Subject to the PMM's participation rights discussed below, 
allocation of executions to non-customer orders and market maker quotes 
is based on the size associated with the order or quote relative to the 
total size available at the execution price. According to the Exchange, 
because PMMs have unique obligations to the ISE market,\5\ they are 
provided with certain participation rights. If the PMM is one of the 
participants with a quote at the best price,\6\ it has participation 
rights equal to the greater of (1) the proportion of the total size at 
the best price represented by the size of its quote, or (2) 60 percent 
of the contracts to be allocated if there is only one other non-
customer order or market maker quotation at the best price, 40 percent 
if there are two other non-customer orders and/or market maker quotes 
at the best price, and 30 percent if there are more than two other non-
customer orders and/or market maker quotes at the best price.\7\ This 
allocation procedure has been approved by the Commission on a permanent 
basis, and the Exchange is not proposing any changes to the procedure 
at this time.\8\
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    \5\ For example, PMMs are responsible for ensuring that all ISE 
disseminated quotations are for at least 10 contracts, addressing 
customer orders that cannot be automatically executed when another 
market is disseminating a better quotation, and opening the market. 
See ISE Rule 803(c).
    \6\ The participation rights are programmed into the trading 
algorithm, so that they are applied automatically by the System when 
splitting executions among non-customer orders and market maker 
quotes after public customer orders at the same price are fully 
executed as described above. Consequently, like any other market 
participant, the PMM cannot receive any portion of an allocation, 
regardless of its participation rights, unless it is quoting at the 
best price at the time the executable order is received by the 
System. Moreover, the size associated with the PMMs quote must be 
sufficient to fill the portion of the order that would be allocated 
to it according to the participation rights, but the size of its 
quote is only 20 contracts, the PMM would receive an allocation of 
only 20 contracts. If the size associated with a PMM's quote is only 
three contracts when an executable order for five contracts is 
received (assuming there are no public customer orders), the PMM 
would execute only three contracts.
    \7\ According to the participation rights, a PMM quoting at the 
inside market generally is allocated the plurality of an order. For 
example, if both a PMM and CMM are quoting at the inside market for 
50 contracts each, an incoming order for 10 contracts will be 
allocated between the two for six and four contracts respectively (a 
60% allocation to the PMM). If the PMM is quoting for 50 contracts 
and there are two CMMs each quoting for 50 contracts, the PMM is 
allocated four contracts and the two CMMs are allocated three each 
(40 percent for the PMM, and the remaining 60 percent split equally 
between the CMMs because they are quoting an equal size). At a 
minimum, a PMM will be allocated 30 percent of an order, regardless 
of the number of other quotes or orders at that price.
    \8\ See Release No. 42808, supra note 3.
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    In addition, to the above preference, the allocation procedure 
provides that the PMM has precedence to execute orders of five 
contracts or fewer. This means that such orders will be executed first 
by the primary market maker if it is quoting at the best price. This 
aspect of the allocation procedure was approved by the Commission on a 
one-year pilot basis.\9\ In its temporary approval of this PMM 
preference, the Commission stated its intent to monitor the rule's 
impact on competition during the pilot period and the ISE agreed to 
provide four types of specific confidential data to the Commission on a 
quarterly basis. The Commission stated that these statistics would 
enable it to adequately assess the operation of the small-order 
preference and determine the merit of the competitive issues raised by 
commenters at the time the pilot was adopted. The ISE also committed to 
lowering the size of the orders to which the PMM is given a preference 
if the execution of orders for five contracts or fewer by PMMs exceeded 
40 percent of total exchange volume (excluding volume from the 
execution facilitation orders).
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    \9\ Id. The pilot has been extended to August 1, 2001 while the 
Commission considers this proposed rule change requesting permanent 
approval. See Release No. 44340, supra note 4.
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    During the pilot period, the Exchange has provided the statistics 
required under the pilot and has carefully monitored the percentage of 
total ISE volume resulting from execution of orders of five contracts 
or fewer by the PMMs. The Exchange notes that the 40% threshold was not 
reached during the pilot program, and in fact, that the total 
percentage was substantially lower than 40%. Moreover, the statistics 
indicated that the five contract precedence for PMMs did not result in 
reduced incentives for other market makers to quote aggressively. Large 
percentages of orders of five contracts or fewer were executed by 
participants other than the PMM, and large percentages of all the 
volume on the Exchange were executed by participants other than the 
PMM. Overall, the Exchange believes the confidential statistics showed 
that there is very active quote competition on the ISE for all orders, 
both large and small.
    Going forward, the Exchange believes that the small order 
participation right for PMMs will not necessarily result in a 
significant portion of the Exchange's volume being executed by the PMM. 
As stated above, the PMM executed against such orders only if it is 
quoting at the best price, and only for the number of contracts 
associated with its quotation. Nevertheless, on a semi-annual basis, 
the Exchange will continue to evaluate what percentage of the volume 
executed on the Exchange is comprised of orders for five contracts or 
fewer executed by primary market makers, and will reduce the size of 
the orders included in this provision if such percentage is over 40 
percent.
    The small order participation rights for PMMs described above is 
part of the ISE's careful balancing of the rewards and obligations that 
pertain to each of the Exchange's classes of memberships. This 
balancing is part of the overall market structure that is designed to 
encourage vigorous price competition between market makers on the 
Exchange, as well as maximize the benefits of price competition 
resulting from the entry of customer and non-customer orders, while 
encouraging participants to provide market depth.\10\
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    \10\ The other options exchanges also have participation rights 
for their specialists, designated primary market makers and lead 
market makers. See Amex Rules 950(d) and 126(e); CBOE Rule 
8.80(c)(7); PCX Rule 6.82(d)(2); and Phlx Rule 1014(g).
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    The ISE is the first exchange in the United States to attempt to 
combine all of the elements of an auction market in an electronic 
environment. The Exchange believes the proposed trading algorithm, 
which includes participation rights for PMMs only when they are quoting 
at the best price, strikes the appropriate balance within its market 
and maximizes the benefits of an electronic auction market for all 
participants. The ISE's experience to

[[Page 36355]]

date has been consistent with this belief and the Exchange has provided 
the Commission with execution data to this effect. Accordingly, the 
Exchange requests that the Commission now approve the pilot on a 
permanent basis.
2. Statutory Basis
    The ISE believes that the proposed rule change is consistent with 
the provisions of Section 6(b)(5) of the Act,\11\ which requires that 
an exchange have rules that are designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to 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.
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    \11\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The ISE does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    Written comments on the proposed rule change were neither solicited 
nor received.

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

    Within 35 days of the date of publication of this notice 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 ISE consents, the Commission will:
    (A) By order approve the proposed rule change, as amended, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 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 at the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
ISE. All submissions should refer to File No. SR-ISE-2001-17 and should 
be submitted by August 1, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\12\
Margaret H. McFarland,
Deputy Secretary.
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    \12\ 17 CFR 200.30-3(a)(12).
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[FR Doc. 01-17305 Filed 7-10-01; 8:45 am]
BILLING CODE 8010-01-M