[Federal Register Volume 67, Number 77 (Monday, April 22, 2002)]
[Notices]
[Pages 19605-19607]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-9779]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45757; File No. SR-CBOE-99-45]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Granting Partial Approval of Proposed Rule Change and 
Amendment No. 2 Thereto To Clarify Certain Aspects of Interpretation 
and Policy .02 to CBOE Rule 6.8

April 15, 2002.
    On August 19, 1999, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``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 clarify certain aspects of 
Interpretation and Policy .02 to CBOE Rule 6.8. On December 28, 1999, 
the proposed rule change was published for comment in the Federal 
Register.\3\ On November 19, 2001, the Exchange amended the proposal to 
establish criteria to describe the circumstances in which Exchange 
Floor Officials may determine that quotes from one or more markets in 
one or more particular classes of options are not reliable, and, thus, 
may be excluded from CBOE's Retail Automatic Execution System 
(``RAES'') determination of the National Best Bid and Offer 
(``NBBO'').\4\ The proposed rule change, as amended, was published for 
comment in the Federal Register on January 8, 2002.\5\ The Commission 
received one comment letter on the amended proposal from the 
International Securities Exchange LLC (``ISE'').\6\ The Commission is 
granting approval to that portion of the proposal that: (i) Allows two 
Floor Official to determine that quotes in one or more particular 
options classes in a market are not reliable and thus may be excluded 
from the NBBO under the following two circumstances: (a) where a market 
confirms that its quotes are not firm based upon direct communication 
to CBOE from the market or the dissemination through OPRA of a message 
indicating that disseminated quotes are not firm; or (b) where a market 
directly communicates to CBOE or otherwise confirms that it is 
experiencing systems or other problems affecting the reliability of its 
disseminated quotes; (ii) sets forth the procedures to be followed once 
a determination of unreliability has been made; (iii) sets forth when 
such determination will expire; (iv) sets forth the documentation and 
reporting requirements as a result of such determination; and (v) 
relabels a portion of the current Interpretation .02(a) text as .02(b) 
and relabels the current Interpretation .02(b) text as .02(c) 
(together, the ``Confirmed Unreliable Quote and Related Procedures 
Portion'').
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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. 42256 (December 20, 
1999), 64 FR 72707 (December 28, 1999).
    \4\ See letter from Joanne Moffic-Silver, General Counsel and 
Corporate Secretary, Legal Department, CBOE to Stephen M. Cutler, 
Director, Division of Enforcement, Commission, Annette L. Nazareth, 
Director, Division of Market Regulation, Commission, and Lori A. 
Richards, Director, Office of Compliance, Inspections and 
Examination, Commission, dated November 19, 2001 (``Amendment No. 
2'').
    \5\ See Securities Exchange Act Release No. 45221 (January 2, 
2002), 67 FR 947.
    \6\ See letter from Michael J. Simon, Senior Vice President and 
Secretary, ISE, to Mr. Jonathan G. Katz, Secretary, Commission, 
dated January 23, 2002.
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I. Description of Proposal

    The CBOE proposed that two Floor Officials could determine that 
quotes in one or more particular option classes in a market were not 
reliable and thus could be excluded from the NBBO determination under 
any of the following circumstances: (a) Receipt of direct communication 
from the market or dissemination through OPRA of a message indicating 
that the exchange's disseminated quotes are not firm; (b) direct 
communication or confirmation from another market that it is 
experiencing systems or other problems affecting the reliability of its 
disseminated quotes; (c) one or more Floor Officials observe that six 
or more option series in a particular options class are crossed or 
locked with the disseminated quotes of two or more other markets, and 
continue to be crossed or locked for 30 seconds or more (and are 
crossed or locked at the time Floor Officials determine to exclude the 
quote from the determination of the NBBO); or (d) a Floor Official 
observes any of the following: (1) One or more orders originating from 
an exchange's designated market maker or market maker for a particular 
options class that are filled by the market at a worse price than its 
disseminated quote without a required quote change; (2) one or more 
market orders or marketable limit orders originating from an exchange's 
designated market maker or market maker for a particular options class 
that are confirmed to be unfilled or partially unfilled by the market 
without a required quote change; or (3) one or more market orders or 
marketable limit

[[Page 19606]]

orders originating from an exchange's designated market maker or market 
maker for a particular options class partially filled by a responsible 
broker or dealer at a worse price than its disseminated quote, followed 
by a quote change and a redisplay of the previously disseminated quote 
by the same responsible broker or dealer in less than 30 seconds.
    CBOE proposed that in all instances where Floor Officials exclude a 
market or any of its quotes from the determination of the NBBO due to 
quote unreliability, the Exchange Control Room would promptly notify 
the market of the action and continue to actively monitor the 
reliability of the excluded quotes in consultation with Floor 
Officials. Any determination to exclude a market or any of its quotes 
pursuant to (a) or (b) would expire at the end of the trading day, or 
at such time as the quotes were confirmed by the market to be reliable 
again `` whichever occurs first. Any determination to exclude a market 
or any of its quotes pursuant to (c) and (d) would expire not later 
than 30 minutes after the initial determination, unless two Floor 
Officials determine that the excluded quotes continue to be unreliable, 
in which case the quotes would continue to be excluded for an 
additional period of time, not to exceed 30 minutes pending further 
Floor Official review.
    Pursuant to CBOE's proposal, exclusion of a market or its quotes 
from the determination of the NBBO would be reported to Exchange member 
firms.
    In addition, CBOE stated that pursuant to CBOE Rule 8.51(e), CBOE 
is required to document in its Control Room log any action taken to 
disengage RAES or to operate RAES in a manner other than normal, the 
option classes affected by such action, the time such action was taken, 
the Exchange officials who undertook such action, and the reasons why 
such action was taken. Therefore, any determination by Floor Officials 
to exclude unreliable quotes from the NBBO would be documented in the 
Exchange's Control Room log.
    CBOE's proposal also relabeled a portion of the current 
Interpretation .02(a) text as .02(b) and relabeled the current 
Interpretation .02(b) text as .02(c).

II. Summary of ISE Comment Letter and CBOE Response

A. ISE Comment Letter

    In its comment letter, ISE stated that it believed CBOE's proposal 
was motivated by CBOE's frustration with its inability to ``clear'' the 
superior quotes on other markets due to the bifurcated application of 
the Commission's Quote Rule \7\ on the options exchanges: a responsible 
broker or dealer has to be firm for its disseminated quotation up to 
its stated size only for customers and may be firm for non-customers at 
the disseminated quotation for only one contract. As a result, a 
designated primary market maker (``DPM'') on the CBOE floor cannot 
access a superior quote on another exchange's floor for more than one 
contract, and therefore, cannot ``clear'' that superior quote to 
execute a customer order at the inferior price disseminated by the 
CBOE.
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    \7\ Rule 11Ac1-1 under the Act, 17 CFR 240.11Ac1-1.
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    However, ISE also stated that excluding quotations from an 
exchange's NBBO is appropriate in the first three instances proposed by 
the CBOE: When an exchange designates a quotation as ``non-firm'' 
through OPRA; when an exchange specifically confirms to the CBOE that 
it is experiencing systems or other problems; and when there are 
widespread locked or crossed markets. ISE stated that in those limited 
circumstances there is clear, objective evidence that an exchange's 
disseminated quotation is suspect and that a customer may not receive 
an execution at that quotation if the customer's order were routed 
directly to that exchange. ISE also stated that excluding quotations 
from the NBBO in these three situations would be consistent with the 
intermarket options linkage plan approved by the Commission in July 
2000 (``Linkage Plan'').\8\ The Linkage Plan exempts an exchange member 
from liability for trading through the quote of another market if the 
quote is non-firm or if there is a systems or equipment failure. The 
Linkage Plan also provides procedures requiring an exchange to unlock 
or uncross a market, which the ISE believes indicates that the 
dissemination of a locked or crossed market will be fleeting and likely 
will not be accessible for any length of time.
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    \8\ See Securities Exchange Act Release No. 43086 (July 28, 
2000), 65 FR 48023 (August 4, 2000).
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    However, the ISE also expressed its concern that CBOE might abuse 
the application of these provisions. Specifically, ISE was concerned 
with CBOE removing the entire ISE market from its NBBO, instead of only 
removing unreliable quotes, due to CBOE's technical limitations. In 
addition, ISE stated that the remainder of CBOE's proposal raised 
serious legal and policy questions. ISE believes that although the 
proposed exclusions from the NBBO based on documented firm quote issues 
would not affect the ISE, they are contrary to the requirements of the 
Act and are inconsistent with the Linkage Plan. If a member of any 
exchange fails to honor its quotation, or does not properly fade its 
quotation under the rules of the member's exchange, ISE believes that a 
customer of another exchange should not suffer an inferior execution. 
Rather, that member is violating the rules of the exchange and is 
subject to disciplinary action. ISE expects that the CBOE staff would 
call such action to the attention of the offending exchange, and that 
exchange would take prompt regulatory action. In addition, ISE pointed 
out that the Linkage Plan does not except from liability a CBOE member 
that trades-through a quotation on another exchange due to previous 
instances of an exchange member failing to honor or fade its quotation.
    The ISE also explained its anonymous, auction-based, electronic 
competitive market maker system, in which if an ISE market maker does 
not execute an order to the full size of the market maker's quotation 
available to customers, the ISE system automatically fades the reminder 
of the market maker's quotation. Absent a change in the price of the 
underlying security, the market maker is prohibited from reinstating 
that quotation for 30 seconds. However, ISE explained that its quote 
could stay the same for three permitted reasons: (i) A market maker 
other than the market maker that executed the original trade could 
quote at the price of the previous execution; (ii) an Electronic Access 
Member could enter a limit order on the book at the price of the 
previous execution; or (iii) the price of the underlying security could 
change and the market maker that executed the original trade could 
change its quotation to its previous price. ISE noted that whether a 
new ISE quote at the price of a previous execution is a permitted quote 
change or the result of an ISE market maker inappropriately requoting 
at that price cannot be accurately ascertained outside of ISE's market. 
Therefore, ISE is concerned that CBOE floor officials will wrongfully 
assume that ISE members are reentering quotations within 30 seconds, 
and will inappropriately exclude ISE quotations from the CBOE NBBO, 
which will deny customers the opportunity to achieve the best execution 
of their orders.
    Finally, ISE stated that the intermarket linkage will permit CBOE 
market makers to access superior quotations of other markets, which 
will eliminate any need for CBOE's proposal. ISE further stated that 
the delay in implementation of the linkage should not be used to 
justify CBOE's proposal

[[Page 19607]]

since the delay is due to CBOE and the interim linkage currently 
operating provides CBOE with much the same protection as CBOE's 
proposal.

B. CBOE's Response

    On February 28, 2002, CBOE submitted a letter responding to ISE's 
comment letter.\9\ In its letter, CBOE disagreed with ISE's assertions 
that CBOE's proposal was motivated by CBOE's inability to ``clear'' 
superior quotations on other exchanges. CBOE explained that its 
proposal was designed to eliminate unreliable quotes that result in an 
inaccurate NBBO because an unreliable NBBO distorts marketplace pricing 
and can lead to missed executions. CBOE noted that it has refined its 
systems and no longer removes all ISE quotations for an occurrence of 
non-firm quotes occurring in just one options class.
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    \9\ See letter from Joanne Moffic-Silver, General Counsel and 
Corporate Secretary, Legal Department, CBOE, to Jonathan G. Katz, 
Secretary, Commission, dated February 25, 2002.
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    With respect to ISE's argument that CBOE's proposal conflicts with 
the Linkage Plan, CBOE noted that the Linkage Plan is not operational 
yet and will not be in place until next year. Until the permanent 
linkage is implemented, CBOE believes it would be unreasonable to apply 
strictly the provisions of the Linkage Plan to the operation of the 
options market because without the permanent linkage, it is very 
difficult for a market maker to test the reliability of a quote in an 
away market in a quick and efficient manner. Once the permanent linkage 
is operational, CBOE agrees that the fourth group of exclusions in its 
proposal need not be broader than the allowable trade-through 
circumstance in the Linkage Plan. CBOE also stated that the interim 
linkage is insufficient to address unreliable quotes because such 
arrangements do not allow DPMs to submit proprietary orders to the 
auto-execution systems of the linked exchange and thus, do not enable 
DPMs to efficiently probe the reliability of the quote in the away 
market. In addition, the interim linkage only covers a small minority 
of options.
    With respect to ISE's objections to the portion of CBOE's proposal 
relating to firm quote circumstances, CBOE argues that the proposal is 
designed to prevent a customer from receiving an inferior execution 
because the alleged ``superior'' quote is not obtainable. With respect 
to ISE's objection to the part of CBOE's proposal relating to the 
redisplay of a quote within 30 seconds, CBOE believes ISE wants to be 
held to a different standard from the other options exchanges merely 
because it is electronic. CBOE notes that although ISE market makers 
each enter their own quotes, the ISE publishes a collective quote. CBOE 
states that ISE's collective quote should be held accountable for 
adherence to trade or fade because individual market makers on ISE do 
not have to interact with a DPM order. CBOE believes that if the entire 
DPM order were exposed to all market makers on ISE it might receive a 
complete fill, thus obviating the need to fade a quote, or not, in 
which case the quote should be faded.

III. Discussion

    The Commission finds that the Confirmed Unreliable and Related 
Procedures Portion of the proposed rule change is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities exchange \10\ and, in particular, 
the requirements of section 6 of the Act \11\ and the rules and 
regulations thereunder. The Commission finds that the proposed rule 
change is consistent with section 6(b)(5) of the Act \12\ because it 
provides objective criteria and well-defined procedures for excluding 
an unreliable quote from CBOE's determination of the NBBO, which should 
increase the likelihood that only unreliable quotes will be excluded 
from the CBOE's determination of the NBBO. Specifically, the Commission 
notes that the floor officials' determination to exclude unreliable 
quotes contained in the Confirmed Unreliable Quote and Related 
Procedures Portion of the proposal is limited to circumstances in which 
the away market has either directly communicated or confirmed that its 
quotes are unreliable. In this way, the discretion afforded to CBOE 
floor officials to determine that another market's options quotes are 
unreliable is appropriately limited. Moreover, the recordkeeping 
requirements and other procedures proposed in the Confirmed Unreliable 
Quote and Related Procedures Portion of the proposal are not 
unreasonable.
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    \10\ In approving this proposed rule change, the Commission 
notes that it has considered its impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \11\ 15 U.S.C. 78f.
    \12\ 15 U.S.C. 78f(b)(5).
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    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\13\ that the portion of the amended proposed rule change set forth 
above as the Confirmed Unreliable Quote and Related Procedures Portion 
of the proposal (SR-CBOE-99-45) be, and hereby is, approved.
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    \13\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
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    \14\ 17 CFR 200.30-2(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-9779 Filed 4-19-02; 8:45 am]
BILLING CODE 8010-01-P