[Federal Register Volume 67, Number 37 (Monday, February 25, 2002)]
[Notices]
[Pages 8567-8569]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-4344]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45454; File No. SR-NYSE-2001-43]


Self-Regulatory Organizations; Order Approving a Proposed Rule 
Change by the New York Stock Exchange, Inc. Amending Paragraph (1) of 
the Guidelines to Exchange Rule 105 to Permit Approved Persons of 
Specialists To Act as a Specialist With Respect To an Option on a 
Specialty Stock

February 15, 2002.

I. Introduction

    On August 21, 2001, 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 change to amend paragraph (1) of the 
Guidelines to NYSE Rule 105 to permit an approved person of a 
specialist to act as a specialist or primary market maker with respect 
to an option on a stock in which the NYSE specialist is registered as 
such on the Exchange (``specialty stock''), provided that the 
requirements of the NYSE Rule 98 exemption program are met. The 
Exchange filed Amendment No. 1 to the proposed rule change on December 
4, 2001.\3\ The proposed rule change, as amended by Amendment No. 1, 
was published for comment in the Federal Register on December 12, 
2001.\4\ The Commission received two comment letters on the proposed 
rule change.\5\ This order

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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 letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Nancy Sanow, Assistant Director, Division of 
Market Regulation, Commission, dated December 3, 2001 (``Amendment 
No. 1'').
    \4\ See Securities Exchange Act Release No. 45136 (December 6, 
2001), 66 FR 64328.
    \5\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Edward J. Joyce, President and Chief Operating Officer, Chicago 
Board of Options Exchange, Inc. (``CBOE''), dated January 17, 2002 
(``CBOE Letter''); and Mathew D. Wayne, Chief Legal Officer, Knight 
Financial Products LLC (``Knight''), dated December 21, 2001 
(``Knight Letter'').
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II. Description of the Proposal

    Currently, NYSE Rule 105 provides that an ``approved person'' 
(i.e., an affiliate in a control relationship) of a NYSE specialist 
organization may trade options based on a specialty stock only for 
hedging purposes. If the approved person establishes a system of 
internal controls and information barriers pursuant to NYSE Rule 98, 
however, the approved person may engage in proprietary trading of 
options based on the specialist's specialty stock without being 
restricted solely to hedging transactions. In addition, pursuant to 
Guideline (1) to NYSE Rule 105, approved persons of NYSE specialists 
may act as competitive or non-primary market makers in options based on 
a specialty stock if NYSE-approved Rule 98 information barriers have 
been established. An approved person of a specialist may not, however, 
act as a specialist or primary market maker with respect to an option 
based on a specialty stock.
    The Exchange now proposes to amend paragraph (1) of the Guidelines 
to NYSE Rule 105 to permit an approved person of a specialist to act as 
a specialist or primary market maker with respect to an option based on 
a specialty stock, provided that NYSE Rule 98 information barriers are 
established and approved by the Exchange.

III. Summary of Comments

    The Commission received two comment letters on the proposed rule 
change.\6\ Both commenters, CBOE and Knight, support the general 
objective of the proposed rule change, but disagree on whether an 
approved person's ability to act in a market making capacity with 
regards to options based on a specialty stock should be predicated on 
establishing Exchange-approved internal controls and information 
barriers under NYSE Rule 98.
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    \6\ Id.
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    CBOE supports the proposed rule change because it could: (1) enable 
CBOE's designated primary market makers (``DPMs'') to acquire more 
capital through combinations with broker-dealers that own NYSE 
specialists firms; and (2) enable NYSE specialists to become better 
capitalized through combinations with firms containing large options 
specialist firms. CBOE predicates its support for the proposed rule 
change upon the ``strict separation'' between the options specialist 
firm and the NYSE specialist firm. CBOE believes that this strict 
separation between the options specialist firm and the NYSE specialist 
firm should prevent side-by-side trading \7\ in a stock and its 
overlying option.
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    \7\ The Commission notes that side-by-side trading generally 
refers to the practice of trading an equity security and its related 
option at the same physical location. The proposed rule change also 
implicates the practice of integrated market making, which refers to 
the practice of the same person or firm making markets in an equity 
security and its related options.
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    Knight generally supports the proposed rule change and agrees with 
NYSE that ``consolidation within the securities industry makes it 
likely that large, well-capitalized, well-regulated organizations may 
seek to conduct distinct business operations among several affiliated 
entities.'' However, Knight does not believe that (1) information 
barriers between the NYSE specialist and its approved person regarding 
trading and position information; (2) the separation of each entity's 
daily business activities with its own staff; and (3) trade decisions 
independent of the other entity should be preconditions for an approved 
person to act in a primary market maker capacity on options based on 
the specialist's specialty stock. Instead, Knight believes that 
communication between separate but affiliated business units engaged in 
both stock and option market making would grant a firm the ability to 
better risk manage its inventory and thus enable the firms to make 
deeper and more liquid markets. Further, Knight believes that the NYSE 
and the five national options exchanges are equipped with the necessary 
regulatory processes to monitor for any potential wrongdoing that could 
result from an entity's market making in a stock and its option.

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.\8\ 
In particular, the Commission believes that the proposed rule change is 
consistent with Section 6(b)(5) of the Act,\9\ 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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    \8\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \9\ 15 U.S.C. 78f(b)(5).
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    Last year, the Commission approved an NYSE proposal to permit NYSE 
specialists to act as competitive or non-primary market makers in 
options based on the NYSE specialist's specialty stock so long as NYSE 
Rule 98 information barriers were established and approved.\10\ In that 
order, the Commission noted the regulatory concerns that arise with 
integrated market making. Specifically, the Commission noted that 
integrated market making raises 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.\11\ Further, the Commission noted concerns 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. 
Finally, the Commission noted its concern about an exchange's ability 
to effectively surveil the trading practices of integrated entities.
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    \10\ Securities Exchange Act Release No. 44175 (April 11, 2001), 
66 FR 19825 (April 17, 2001).
    \11\ Previously, Commission staff has noted that substantial 
profits could be made from options positions as a result of small 
movements in the price of the underlying stock. Further, the staff 
has 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. SEC, Report of 
the Special Study of the Options Markets, H.R. Rep. No. IFC 3, 96th 
Cong. 1st sess. (Comm. Print 1978) (``Options Study'').
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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.\12\ In this regard, the 
Commission must consider whether an integrated market making proposal 
would permit the integrated entities to possess undetectable, material 
non-public market information, which could give either the stock 
specialist or the related options specialist or 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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    \12\ See Options Study, supra note 11. See also Securities 
Exchange Act Release No. 22026 (May 8, 1985), 50 FR 20310 (May 15, 
1985).
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    In the present proposed rule change, the Exchange seeks to permit 
its

[[Page 8569]]

specialists to be affiliated with specialists and market makers that 
act as such with regards to options based on the NYSE specialist's 
specialty stock. The NYSE's proposal seeks to permit a more extensive 
form of integrated market making. The NYSE, however, seeks to limit the 
concerns raised by integrated market making by requiring the affiliated 
entities to establish strict information barriers designed to prevent 
the flow of non-public information. These information barriers must be 
approved by the NYSE and are subject to annual review by the NYSE.
    Specifically, the related entities must organize their respective 
operations in such a way that the activities of each entity are clearly 
separate and distinct. The Guidelines to Exchange 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 freestanding 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 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 raised by 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, NYSE 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 its Rule 98's 
organizational requirements and information barriers and thus should be 
able to ensure that the integrated entities do not improperly use their 
affiliations to their advantage. In addition, the Exchange has verified 
that organizational separation and information barriers must be 
established and maintained between an Exchange specialist, any approved 
person of the specialist that acts as a market maker in an option based 
on the specialist's specialty stock, and any other persons affiliated 
with them.\13\
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    \13\ 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 acts as a specialist or 
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. See Securities Exchange Act Release 
No. 44175 (April 11, 2001), 66 FR 19825, 19827, n. 14 (April 17, 
2001).
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    The Commission continues to expect the Exchange to assess, as it 
gains experience with integrated market making, whether any other 
informational barriers are necessary to 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 continue to surveil the integrated entities to ensure that the 
information barriers and organizational structure continue to prevent 
the flow of non-public market information.
    In the previous order, the Commission noted that because the NYSE 
is the primary market for many equity securities underlying options, 
concerns were 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 specialists in a stock and its related options could 
control the pricing and liquidity of both markets. The Commission 
believes the requirement that the related entities maintain complete 
organizational separation and prohibit the sharing of market 
information should prevent either entity from using its affiliation to 
control the pricing and liquidity of either market.
    The Commission believes that the proposal should provide benefits 
to the markets. For example, the number of entities that may act as 
specialists or primary 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 primary options 
market makers because of the restrictions in Paragraph (1) of NYSE Rule 
105 would 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.\14\
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    \14\ 15 U.S.C. 78f(b)(5).
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V. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule change, as amended, is consistent with the requirements of the Act 
and rules and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\15\ that the proposed rule change (SR-NYSE-2001-43), as amended, 
is approved.
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    \15\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-4344 Filed 2-22-02; 8:45 am]
BILLING CODE 8010-01-P