[Federal Register Volume 66, Number 156 (Monday, August 13, 2001)]
[Notices]
[Pages 42575-42578]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-20181]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44659; File No. SR-ISE-2001-18]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the International Securities Exchange LLC, Relating to 
Priority Principles on Complex Orders

August 6, 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 25, 2001, the International Securities Exchange LLC (``ISE'' 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 ISE. On July 11, 
2001, the Exchange filed Amendment No. 1 to the proposed rule 
change.\3\ On July 24, 2001, the Exchange filed Amendment No. 2 to the 
proposed rule change.\4\ On August 2, 2001, the Exchange filed 
Amendment No. 3 to the proposed rule change.\5\ 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\ Amendment No. 1 expanded upon the discussion contained in 
the purpose section of the filing, corrected various typographical 
errors, and added a one-year sunset to the proposed rule that the 
Exchange inadvertently omitted in its original filing. See letter 
from Jennifer M. Lamie, Assistant General Counsel, ISE to Nancy 
Sanow, Assistant Director, Division of Market Regulation 
(``Divison''), Commission, dated July 10, 2001.
    \4\ Amendment No. 2 made a technical change to the text of the 
one-year sunset provision of the proposed rule change. See letter 
from Jennifer M. Lamie, Assistant General Counsel, ISE to Nancy 
Sanow, Assistant Director, Division, Commission, dated July 23, 
2001.
    \5\ In Amendment No. 3, the Exchange added text to the proposed 
rules relating to stock-option orders, and the effect of price 
increments on order priority. The Exchange also amended the purpose 
section of the filing by adding a further description of the 
operation of the proposed allocation procedures. See letter from 
Jennifer M. Lamie, Assistant General Counsel, ISE to Nancy Sanow, 
Assistant Director, Division, Commission, dated August 2, 2001.

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[[Page 42576]]

I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange is proposing to adopt Rule 722 (Complex Orders) to 
establish priority and order handling principles for complex orders, 
such as spreads, straddles, and other multi-legged transactions, 
similar to other options exchanges. Below is the text of the proposed 
rule change. Proposed new language is in italics. Proposed deletions 
are in [brackets].
* * * * *

Rule 722. Complex Orders

    (a) Complex Orders Defined. A complex order is any order for the 
same account as defined below:
    (1) Spread Order. A spread order is an order to buy a stated number 
of option contracts and to sell the same number of option contracts, of 
the same class of options.
    (2) Straddle Order. A straddle order is an order to buy (sell) a 
number of call option contracts and the same number of put option 
contracts on the same underlying security which contracts have the same 
exercise price and expiration date (e.g., an order to buy two XYZ July 
50 calls and to buy two XYZ July 50 puts).
    (3) Strangle Order. A strangle order is an order to buy (sell) a 
number of call option contracts and the same number of put option 
contracts in the same underlying security, which contracts have the 
same expiration date (e.g., an order to buy two ABC June 40 calls and 
to buy two ABC June 35 puts).
    (4) Combination Order. A combination order is an order involving a 
number of call option contracts and the same number of put option 
contracts in the same underlying security and representing the same 
number of shares at option.
    (5) Stock-Option Order. A stock-option order is an order to buy or 
sell a stated number of units of an underlying stock or a security 
convertible into the underlying stock (``convertible security'') 
coupled with either (i) the purchase or sale of option contract(s) on 
the opposite side of the market representing either the same number of 
units of the underlying stock or convertible security or the number of 
units of the underlying stock necessary to create a delta neutral 
position; or (ii) the purchase or sale of an equal number of put and 
call option contracts, each having the same exercise price, expiration 
date, and each representing the same number of units of stock, as and 
on the opposite side of the market from, the stock or convertible 
security portion of the order.
    (6) Ration Order. A spread, straddle or combination order may 
consist of a different number of contracts, so long as the number of 
contracts differs by a permissible ratio. For purposes of this 
paragraph, a permissible ratio of contracts is any of the following: 
one-to-one, one-to-two and two-to-three.
    (7) Butterfly Spread Order. A butterfly spread order is an order 
involving three series of either put or call options all having the 
same underlying security and time of expiration and, based on the same 
current underlying value, where the interval between the exercise price 
of each series is equal, which orders are structured as either (i) a 
``long butterfly spread'' in which two short options in the same series 
offset by one long option with a higher exercise price and one long 
option with a lower exercise price or (ii) a ``short butterfly spread'' 
in which two long options in the same series are offset by one short 
option with a higher exercise price and one short option with a lower 
exercise price.
    (8) Box Spread Order. A box spread order is an order involving (a) 
a long call option and a short put option with the same exercise price, 
coupled with (b) a long put option and a short call option with the 
same exercise price; all of which have the same underlying security and 
time of expiration.
    (9) Collar Order. A collar order is an order involving the sale of 
a call option coupled with the purchase of a put option in equivalent 
units of the same underlying security having a lower exercise price 
than, and same expiration dates as, the sold call option.
    (b) Applicability of Exchange Rules. Except as otherwise provided 
in this Rule, complex orders shall be subject to all other Exchange 
Rules that pertain to orders generally.
    (1) Minimum Increments. Bids and offers on complex orders may be 
expressed in any decimal price regardless of the minimum increments 
otherwise appropriate to the individual legs of the order. Complex 
orders expressed in net price increments that are not multiples of the 
minimum increment are not entitled to the same priority under 
subpargarph (b)(2) of this Rule as such orders expressed in increments 
that are multiples of the minimum increment.
    (2) Complex Order Priority. Notwithstanding the provisions of Rule 
713, a complex order, as defined in paragraph (a) of this Rule, may be 
executed at a total credit or debit price with one other member without 
giving priority to bids or offers established in the marketplace that 
are no better than the bids or offers comprising such total credit or 
debit; provided, however, that if any of the bids or offers established 
in the marketplace consist of a Public Customer limit order, the price 
of at least one leg of the complex order must trade at a price that is 
better than the corresponding bid or offer in the marketplace. Under 
the circumstances described above, the option leg of a stock-option 
order, as defined in subparagraph (a)(5)(i) of this Rule, has priority 
over bids and offers established in the marketplace by Non-Customer 
orders and market maker quotes that are no better than the price of the 
options leg, but not over such bids and offers established by Public 
Customer Orders. The option legs of a stock-option order as defined in 
subparagraph (a)(5)(ii), consisting of a combination order with stock, 
may be executed in accordance with the first sentence of this 
subparagraph (b)(2).
    (3) Execution of Orders. Complex orders will be executed without 
consideration of any prices that might be available on other exchanges 
trading the same options contracts.
    (4) Types of Complex Orders. Complex orders may be entered as fill-
or-kill or immediate-or-cancel orders, as defined in Rule 715(b), or as 
all-of-none orders, which are resting limit orders to be executed in 
their entirety or not all.
    (5) Limitations on Complex Orders.
    (i) A member may execute as principal up to forty percent (40%) of 
an order it represents as agent without complying with the thirty (30) 
second exposure requirement contained in Rule 717(d).
    (ii) A member may execute up to forty percent (40%) of an order it 
represents as agent against an order solicited from a Member and non-
member broker-dealer to transact with such order without complying with 
the thirty (3) second exposure requirement contained in Rule 717(e).
    (iii) The restrictions on order entry contained in paragraphs (f) 
and
    (h) of Rule 717 shall not apply to complex orders.
Supplementary Material to Rule 722
    .01  This Rule 722 will be in effect until [INSERT DATE ONE YEAR 
FROM COMMISSION APPROVAL OF SR-ISE-2001-18].
Rule 805. Market Maker Orders
    (a) Options Classes to Which Appointed. Market makers may not place 
principal orders to buy or sell options in the options classes to which 
they are appointed under Rule 802, other than immediate-or-cancel 
orders,

[[Page 42577]]

complex and block-size orders executed through the Block Order 
Mechanism pursuant to Rule 716(c). Competitive Market Makers shall 
comply with the provisions of Rule 804(e)(2)(ii) upon the entry of such 
orders if they were not previously quoting in the series.
    (b) Options Classes Other Than Those to Which Appointed.
    (1)--A market maker may enter all order types permitted to be 
entered by non-customer participants under the Rules [limit orders, and 
immediate-or-cancel orders] to buy or sell options in classes of 
options listed on the Exchange to which the market maker is not 
appointed under Rule 802, provided that:
* * * * *

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 in received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The ISE has prepared summaries, set forth in sections A, 
B, and C below, of the most significant parts of such statements.

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

1. Purpose
    Currently, Exchange members wishing to execute complex orders, such 
as spreads, straddles and other multi-legged transactions, must enter 
at least two separate orders into the trading system. As a result, the 
member is at risk in that one part of the order may be filled, while 
the remainder goes unexecuted. ISE is therefore developing system 
functionality to permit more efficient and effective execution of 
certain defined multi-legged orders through entry of a single complex 
order. The purpose of this proposed rule change is to prescribe the 
priority and order handling principles that will apply to such complex 
orders when priced on the basis of a total credit or debit (``net 
price``). The Exchange believes that these rule changes will facilitate 
the orderly execution of complex orders in our electronic trading 
environment.
    To qualify for special priority and order handling treatment, 
complex orders must meet the requirements of proposed Rule 722. As 
defined in paragraph (a), orders included within the definition of 
complex orders are orders entered for the same account which are spread 
orders, straddle orders, strangle orders, combination orders, stock-
option orders, ratio orders, butterfly spread orders, box spread orders 
and collar orders. When meeting the definitional criteria and entered 
as a net price, these defined orders will be considered complex orders 
and will be accorded priority over the displayed bids and offers of 
members, other broker-dealers and Public Customers on the ISE at the 
same price if the conditions specified in paragraph (b) of the proposed 
rule are met.
    Paragraph (b) of the rule provides that the legs of a complex order 
may not be executed at prices inferior to the displayed best bids and 
offers available in the ISE market. It further provides that a complex 
order entered at a net price may be executed with one other member 
without yielding priority to the displayed bids or offers of members 
and other broker-dealers established in the ISE market provided that 
the bids and offers comprising the net price of the complex order are 
the same as or better than the displayed bids or offers. If the 
displayed bids or offers established in the ISE market consist of a 
Public Customer Order, the price of at least one leg of the complex 
order must trade at a price better than the corresponding best bid or 
offer established in the ISE marketplace. As such, the proposal 
provides that complex orders entered at a net price have priority over 
the displayed bids and offers of members and other broker-dealers, but 
not over Public Customers.\6\ The Exchange believes that this approach 
affords greater protection to Public Customers since one leg of the 
complex order must at least trade at a better price than the displayed 
market (while all remaining legs must still at least touch the other 
bids or offers in the displayed market) before a Public Customer will 
lose priority. In addition, because the proposed rule requires that one 
member must represent all legs of the trade and that the trade may only 
be executed against one other member at a net debit or credit, Public 
Customers are still less likely to lose priority to complex orders. The 
Exchange believes that this approach is a reasonable effort to 
accommodate the ability to price complex orders more competitively 
while at the same time not disadvantaging Public Customers.
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    \6\ This approach of permitting a complex order entered at a net 
price to take priority over Public Customer orders only when at 
least one leg of the transaction trades at a better price and the 
remaining legs at a price at least equivalent to the established 
market, and over the displayed bids and offers of members and other 
broker-dealers when all legs of the complex order trade at a price 
at least equivalent to the displayed market, is similar to that 
adopted by the Chicago Board Options Exchange (``CBOE''). See CBOE 
Rule 6.45. By comparison, the American and Philadelphia Stock 
Exchanges (``Amex'' and ``Phlx,'' respectively) appear to require 
that at least one leg of a complex order trade at a better price to 
take priority over bids and offers established by both Public 
Customers and members; whereas, the Pacific Exchange (``PCX'') 
appears to merely require that a complex order trade (other than 
stock-option orders) at a price at least equivalent to the displayed 
market to take priority over bids and offers established by both 
Public Customers and members. See Amex Rule 950(d), Commentary .01, 
Phlx Rule 1033 and PCX Rule 6.75.
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    The proposed rule specifies that the net price of a complex order 
may be expressed in any decimal price, regardless of the minimum 
increments otherwise applicable to the individual legs of the complex 
order. It also states that complex orders may be entered as fill-or-
kill, immediate-or-cancel, or all-or-none. Further, complex orders are 
not subject to the restrictions on order entry pertaining to the 
electronic generation of orders and multiple orders for the same 
beneficial account contained in rule 717(f) and (h).\7\ The proposal 
further provides that the legs comprising a complex order receive 
neither time-price priority nor away market price protection.\8\
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    \7\ The risks to market maker quotations that the restrictions 
contained in paragraphs (f) and (h) of Rule 717 are designed to 
protect against (i.e., protection against rapid entry of electronic 
orders and multiple order entry, respectively) are not apparent with 
respect to complex order entry as such orders do not receive 
automatic executions.
    \8\ In connection with establishing an intermarket linkage 
between the options exchanges, the ISE and other options exchanges 
are developing rules on which types of orders are and are not 
subject to trade through protection. When these linkage rules are 
adopted, ISE will if necessary amend its complex order rule to be 
consistent with the provisions developed under the intermarket 
linkage plan.
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    In proposing these complex order provisions, the Exchange also 
proposes to allow a firm to execute immediately up to forty percent 
(40%) of a complex order, either as principal or against an order it 
has solicited, as opposed to applying the 30 second exposure rule that 
currently applies to orders in the ``regular'' market under paragraphs 
(d) and (e) of Rule 717. A firm would still be required to expose the 
remaining sixty percent (60%) of the complex order for 30 seconds.
    The exposure of limit orders required by paragraphs (d) and (e) 
does not affect the execution price of the orders. Rather, this 
exposure gives the crowd an opportunity to participate in the execution 
of the orders before the entering member may trade against the orders 
as principal. The Exchange is

[[Page 42578]]

proposing to permit a member to execute up to 40% of a complex order 
(which is a limit order by definition because it must be entered with a 
total debit or credit price) as principal immediately because the 
Exchange's Facilitation Mechanism contained in Rule 716(d), which 
guarantees a facilitating firm an execution of at least forty percent 
(40%) of the original size of a facilitation order in the ``regular'' 
market, will not be available for complex orders. Under the proposal, a 
member that wants to facilitate a complex order will be permitted to 
enter a proprietary counter-order to trade against up to forty percent 
(40%) of the initial complex order size prior to the expiration of 30 
seconds. Thus, the trading crowd will be given an opportunity to 
participate in the execution of at least 60% of each complex order. Any 
portion of an order that remains unexecuted after 30 seconds may be 
executed by the member by entering another proprietary order.
    The Exchange believes that the proposed rule changes strike an 
appropriate balance because they will not permit trades at prices 
inferior to the displayed bids and offers available in the ISE market, 
while providing the added protection that a complex order will not 
trade ahead of Public Customer orders at the same price unless the net 
price is better than what is available in the market. In those 
circumstances where an order meets the criteria contained in proposed 
Rule 722, the Exchange believes it is fair to give complex orders 
entered at a net price the prescribed special priority and order 
handling treatment.
    This proposal permits ISE members to execute orders in a manner 
that is similar to how such orders are executed on the floor-based 
exchanges today. The Exchange proposes to adopt these rules for one 
year only, while the Exchange develops technology that might improve 
upon the existing execution practices of the industry today. The 
Exchange will file a new proposal with the Commission prior to the 
expiration of the rule.
    Finally, the Exchange is proposing to amend Rule 805 (Market Maker 
Orders) to permit the entry of complex orders by market makers. In lieu 
of individually listing the types of orders that a market maker is 
permitted to enter outside of its appointed classes, the Exchange also 
proposes to amend the language in paragraph (b) of Rule 805 to clarify 
that market makers can enter any type of order outside their assigned 
classes that other non-customers are permitted to enter as all such 
order types were listed in the rule.
2. Statutory Basis
    The basis under the act for this proposed rule change is the 
requirement under Section 6(b)(5) \9\ that an exchange have rules that 
are designed to prevent fraudulent and manipulative acts and practices, 
to promote just and equitable principles of trade, and, in general, to 
protect investors and the public interest.
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    \9\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The proposed rule change does not impose any burden on competition 
that is not necessary or appropriate in furtherance of the purposes of 
the Exchange Act.

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

    The Exchange has not solicited, and does not intend to solicit, 
comments on this proposed rule change. The Exchange has not received 
any unsolicited written comments from members or other interested 
parties.

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 self-regulatory organization consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

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, 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 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-2001-18 and should 
be submitted by September 4, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\10\
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    \10\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-20181 Filed 8-10-01; 8:45 am]
BILLING CODE 8010-01-M