[Federal Register Volume 66, Number 153 (Wednesday, August 8, 2001)]
[Notices]
[Pages 41643-41645]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-19857]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44641; File No. SR-ISE-2001-17]


Self-Regulatory Organizations; Order Granting Accelerated 
Approval of Proposed Rule Change by the International Securities 
Exchange LLC Relating to Permanent Approval of Its Allocation Algorithm 
Pilot

August 2, 2001.

I. Introduction

    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''), a proposed rule change requesting 
permanent approval of its allocation algorithm pilot.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in the Federal 
Register on July 11, 2001.\3\ No comments were received on the 
proposal. This order approves the proposal on an accelerated basis.
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    \3\ Securities Exchange Act Release No. 44508 (July 3, 2001), 66 
FR 36353.
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II. Description of the Proposal

    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,\4\ and recently was 
extended until August 1, 2001.\5\
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    \4\ See Securities Exchange Act Release No. 42808 (May 22, 
2000), 65 FR 34515 (May 30, 2000) (``Release No. 42808'').
    \5\ See Securities Exchange Act Release No. 44340 (May 22, 
2001), 66 FR 29373 (May 30, 2001) (``Release No. 44340'').
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    ISE Rule 713 provides that 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

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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-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 at the best price 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 tot he ISE market,\6\ they are 
provided with certain participation rights. If the PMM is one of the 
participants with a quote at the best price,\7\ 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.\8\ This 
allocation procedure has been approved by the Commission on a permanent 
basis, and the Exchange did not propose any changes to the procedure at 
this time.\9\
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    \6\ For example, PMMs are responsible for: (1) Ensuring that all 
ISE disseminated quotations are for at least 10 contracts; (2) 
addressing customer orders that cannot be automatically executed 
when another market is disseminating a better quotation; and (3) 
opening the market. See ISE Rule 803(c).
    \7\ 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 tot he participation rights. For example, if a PMM 
would be allocated 30 contracts according to its 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.
    \8\ According to the participation rights, a PMM quoting at the 
inside market generally is allocated the plurality of an order. For 
example, if a 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.
    \9\ See Release No. 42808, supra note 4.
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    The allocation procedure further 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.\10\ 
In its temporary approval of this PMM preference for the pilot period, 
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 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 of facilitation orders).
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    \10\ Id. The Commission extended the pilot to August 1, 2001 in 
order to consider this proposed rule change requesting permanent 
approval. See Release No. 44340, supra note 5.
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III. Commission's Findings and Order Granting Accelerated Approval 
of Proposed Rule Change

    The Commission has reviewed the ISE's proposed rule change and 
finds, for the reasons set forth below, that the proposal is consistent 
with the requirements of section 6 of the Act \11\ and the rules and 
regulations thereunder applicable to a national securities 
exchange.\12\ Specifically, the Commission believes that the proposal 
to provide PMMs with the preference for orders of five contracts or 
fewer is consistent with Section 6(b)(5) of the Act.\13\ Section 
6(b)(5) requires that the rules of a national securities exchange be 
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.
    \12\ In approving this rule, the Commission notes that it has 
also considered the proposed rule's impact on efficiency, 
competition, and capital formation. 15 U.S.C. 78c(f).
    \13\ 15 U.S.C. 78f(b)(5).
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    In its original approval order for the ISE's allocation algorithm, 
the Commission, responding to various issues raised by commenters, 
stated that it intended to use the one-year pilot period to monitor the 
rule's impact on competition by reviewing the four types of specific 
data that ISE provided to the Commission on a quarterly basis.\14\ 
During the pilot period and the pilot extension period, the Exchange 
has provided the statistics required under the terms of the pilot and 
has monitored the percentage of total ISE volume resulting from 
execution of orders of five contracts of fewer by the PMMs. The 
Commission notes that the 40% threshold was not reached during the 
pilot program and pilot extension period; indeed, the total percentage 
was substantially lower than 40%. In particular, the Commission notes 
that throughout the pilot program and pilot extension, a large 
percentage or orders of five contracts or fewer were executed by 
participants other than the PMM, and a large percentage of all the 
volume on

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the Exchange were executed by participants other than the PMM.
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    \14\ See Release No. 42808, supra note 4.
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    The Commission does not believe that the small order participation 
right for PMMs (i.e., five contracts of fewer preference) will 
necessarily result in a significant portion of the Exchange's volume 
being executed by the PMM, especially in light of the fact that the PMM 
executes against such orders only if it is quoting at the best price, 
and only for the number of contracts associated with its quotation. In 
order to provide a safeguard against the potential for increased PMM 
executions in the future in excess of the proposed 40% threshold, 
however, the ISE agrees to continue to maintain the technological 
capability to compile the sort of data it provided to the Commission 
during the pilot period and pilot extension, and agrees to compile and 
provide such data to the Commission at its request.\15\ The Commission 
further notes that the Exchange will continue to evaluate periodically 
the percentage of the volume executed on the Exchange that 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. Given the existence of 
these continued safeguards, as well as the lack of anticompetitive 
statistical trends observed by the Commission during the pilot period 
and pilot extension, the Commission finds that the proposed rule change 
is consistent with Section 6(b)(5).
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    \15\ Telephone conversation between Katherine Simmons, Vice 
President and Associate General Counsel, ISE, Deborah Flynn, 
Assistant Director, Division of Market Regulation, Commission and 
Geoffrey, Pemble, Attorney, Division of Market Regulation, 
Commission, on July 25, 2001.
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    The Commission finds good cause for approving the proposed rule 
change prior to the thirtieth day after the date of publication of 
notice of filing thereof in the Federal Register. The original filing 
proposing the ISE's pilot program for small order participation right 
for PMMs was subject to a full notice and comment period.\16\ In 
addition, this proposal requesting permanent approval of the same 
provision will, as of the date of this order, have been subject to a 
full notice and comment period and no comment letters were received by 
the Commission. Moreover, the one-year pilot period and related 
reporting obligations by ISE were responsive to the issues raised by 
commenters to ISE's earlier filing regarding its allocation 
algorithm.\17\ Accordingly, the Commission finds good cause for 
approving the proposed rule change (SR-ISE-2001-17) prior to the 
thirtieth day after the date of publication of notice thereof in the 
Federal Register.
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    \16\ See Release No. 42808, Supra note 4.
    \17\ Id.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\18\ that the proposed rule change (SR-ISE-2001-17) is approved on 
an accelerated basis.
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    \18\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-19857 Filed 8-7-01; 8:45 am]
BILLING CODE 8010-01-M