[Federal Register Volume 67, Number 124 (Thursday, June 27, 2002)]
[Notices]
[Pages 43372-43377]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-16210]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46095; File No. SR-Phlx-2002-04]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendments Nos. 1 through 7 thereto by the Philadelphia 
Stock Exchange, Inc. Relating to Electronic Interface With AUTOM for 
Phlx Specialists and Registered Options Traders

June 20, 2002.
    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 January 15, 2002, the Philadelphia Stock Exchange, Inc. (``Phlx'' 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 Phlx. On March 6, 
2002, the Exchange filed Amendment No. 1 to the proposed rule 
change.\3\ On March 14, 2002, the Exchange filed Amendment No. 2 to the 
proposed rule change.\4\ On March 26, 2002, the Exchange filed 
Amendment No. 3 to the proposed rule change.\5\ On April 2, 2002, the 
Exchange filed Amendment No. 4 to the proposed rule change.\6\ On May 
16, 2002, the Exchange filed Amendment No. 5 to the proposed rule 
change.\7\ On June 12, 2002, the Exchange filed Amendment No. 6 to the 
proposed rule change. On June 19, 2002, the Exchange filed Amendment 
No. 7 to the proposed rule change.\8\ 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\ See letter from Richard S. Rudolph, Director and Counsel, 
Phlx, to Nancy J. Sanow, Assistant Director, Division of Market 
Regulation (``Division''), Commission, dated March 5, 2002 
(``Amendment No. 1''). Amendment No. 1: (1) clarified provisions 
relating to the minimum size of an on-floor order for the 
proprietary account of a Registered Options Traders (``ROTs'') or 
specialist; (2) specified how contracts that remain after Price 
Improving ROTs and specialists have received their entitlement will 
be allocated; and (3) stipulated the timeframe for implementing 
proposed system changes.
    \4\ See letter from Richard S. Rudolph, Director and Counsel, 
Phlx, to Nancy J. Sanow, Assistant Director, Division, Commission, 
dated March 13, 2002 (``Amendment No. 2''). Amendment No. 2 
clarified: (1) the responsibility for allocating incoming orders to 
ROTs pursuant to the proposed rule change; (2) the relationship 
between current Phlx rules pertaining to the precedence of orders 
under the proposed rule change; and (3) plans to make an electronic 
interface available to member firms.
    \5\ See letter from Richard S. Rudolph, Director and Counsel, 
Phlx, to Nancy J. Sanow, Assistant Director, Division, Commission, 
dated March 25, 2002 (``Amendment No. 3''). Amendment No. 3: (1) 
clarified that certain Phlx rules pertaining to the precedence of 
orders would not apply to allocation of orders under the proposed 
rule change; and (2) corrected a typographical error in the proposed 
rule text.
    \6\ See letter from Richard S. Rudolph, Director and Counsel, 
Phlx, to Nancy J. Sanow, Assistant Director, Division, Commission, 
dated April 1, 2002 (``Amendment No. 4''). Amendment no. 4: (1) 
clarified the Exchange's commitment to modify its systems to 
automatically execute eligible incoming orders against price-
improving orders placed on the limit order book pursuant to the 
proposed rule; (2) clarified the proposal's approach to allocating 
remaining contracts after an execution or executions have filled a 
price-improving order or price-improving orders; (3) established 
that a price-improving ROT or specialist shall not be required to 
participate in a trade above its stated size; (4) specified the 
specialist's responsibility to ensure that incoming price-improving 
orders are filled up to their stated size; and (5) eliminated the 
requirement that eligibility for order delivery be subject to 
Options Committee approval.
    \7\ See letter from Richard S. Rudolph, Director and Counsel, 
Phlx, to Nancy J. Sanow, Assistant Director, Division, Commission, 
dated May 15, 2002 (``Amendment No. 5''). Amendment No. 5: (1) 
clarified terminology and definitions; (2) stipulated when and how 
crowd participants may match price-improving orders; and (3) 
established a Special Allocation that provides that a Price 
Improving ROT/Specialist is entitled to receive the largest number 
of contracts among all crowd participants at that price and how long 
such Special Allocation would remain in effect.
    \8\ See letter from Richard S. Rudolph, Director and Counsel, 
Phlx, to Nancy J. Sanow, Assistant Director, Division, Commission, 
dated June 11, 2002 (``Amendment No. 6'') and dated June 18, 2002 
(``Amendment No. 7''). Amendments No. 6 and No. 7 corrected the 
marked changes to the proposed rule text to reflect current Phlx 
rules, reinserted the proposed rule text in the 3rd paragraph of 
Rule 1080 commentary .04, and corrected a typographical error.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Philadelphia Stock Exchange, Inc. (``Phlx'' or ``Exchange''), 
pursuant to Rule 19b-4 of Act, proposes to amend Phlx Rule 1080, 
Philadelphia Stock Exchange Automated Options Market (AUTOM) and 
Automatic Execution

[[Page 43373]]

System (AUTO-X),\9\ to enable a ROT \10\ or specialist to improve the 
Phlx bid or offer by means of enhanced access to place limit orders on 
the electronic limit order book \11\ through electronic interface with 
AUTOM (``Price Improving ROT/Specialist'').
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    \9\ AUTOM is the Exchange's electronic order delivery and 
reporting system, which provides for the automatic entry and routing 
of equity option and index option orders to the Exchange trading 
floor. Orders delivered through AUTOM may be executed manually, or 
certain orders are eligible for AUTOM's automatic execution feature, 
AUTO-X. Equity option and index option specialists are required by 
the Exchange to participate in AUTOM and its features and 
enhancements. Option orders entered by Exchange members into AUTOM 
are routed to the appropriate specialist unit on the Exchange 
trading floor.
    \10\ A ROT is a regular member or a foreign currency options 
participant of the Exchange located on the trading floor who has 
received permission from the Exchange to trade in options for his 
own account. See Phlx Rule 1014(b).
    \11\ The electronic ``limit order book'' is the Exchange's 
automated specialist limit order book, which automatically routes 
all unexecuted AUTOM orders to the book and displays orders real-
time in order of price-time priority. Orders not delivered through 
AUTOM may also be entered onto the limit order book. See Phlx Rule 
1080, Commentary .02.
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    Under the proposal, on-floor orders for the proprietary accounts of 
specialists and ROTs, up to 1,000 contracts, may be entered for 
delivery through AUTOM, through the use of Exchange approved 
proprietary systems to interface with AUTOM. The following types of 
orders for the proprietary account(s) of specialists and ROTs would be 
eligible for AUTOM: day and simple cancel. By January 2004, the Phlx's 
systems will be capable of automatically executing eligible incoming 
orders against Price-Improving ROT/Specialist orders entered via 
electronic interface with AUTOM. The system change necessary to 
facilitate the automatic execution of these orders will be fully 
deployed over a 15-month period.\12\ Following full implementation of 
this system change, the proposed rule will apply to all series and 
classes of options traded on the exchange.\13\
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    \12\ See Amendments Nos. 3 and 4.
    \13\ Telephone conversation between Richard Rudolph, Director 
and Counsel, Phlx, and Steven Johnston, Special Counsel, Division, 
Commission, March 21, 2002 (``March 21, 2002 Telephone 
Conversation'').
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    In conjunction with the proposed rule change to Phlx Rule 1080, the 
Exchange also proposes to amend Phlx Rule 1014, Obligations and 
Restrictions Applicable to Specialists and Registered Options Traders, 
to provide for special parity and priority rules and procedures 
concerning orders for the account(s) of Phlx ROTs and specialists 
entered through electronic interface with AUTOM, where those orders are 
submitted to either improve the Phlx bid or offer or to match such 
improved bid or offer.\14\
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    \14\ March 21, 2002 Telephone Conversation.
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    The text of the proposed rule change is set forth below. New text 
is italicized; deleted text is bracketed.

Rule 1080. Philadelphia Stock Exchange Automated Options Market (AUTOM) 
and Automatic Execution System (AUTO-X)

    (a) General--AUTOM is the Exchange's electronic order delivery and 
reporting system, which provides for the automatic entry and routing of 
Exchange-listed equity options and index options orders to the Exchange 
trading floor. Orders delivered through AUTOM may be executed manually, 
or certain orders are eligible for AUTOM's automatic execution feature, 
AUTO-X, in accordance with the provisions of this Rule. Equity option 
and index option specialists are required by the Exchange to 
participate in AUTOM and its features and enhancements. Option orders 
entered by Exchange member organizations into AUTOM are routed to the 
appropriate specialist unit on the Exchange trading floor.
    This Rule shall govern the orders, execution reports and 
administrative messages (``order messages'') transmitted between the 
offices of member organizations and the trading floors of the Exchange 
through AUTOM.
    All references to ``ROTs'' in this Rule 1080 are to Phlx Registered 
Options Traders as defined in Exchange Rule 1014(b).
    (b) Eligible Orders [-]
    (i) The following types of orders are eligible for entry into 
AUTOM: [(i) Generally, only agency orders may be entered.]
    (A) Agency orders up to the maximum number of contracts permitted 
by the Exchange. Agency orders up to 1000 contracts, depending on the 
option, are eligible for AUTOM order delivery, subject to the approval 
of the Options Committee. The following types of agency orders are 
eligible for AUTOM: day, GTC, market, limit, stop, stop limit, all or 
none, or better, simple cancel, simple cancel to reduce size (cancel 
leaves), cancel to change price, cancel with replacement order, market 
close, market on opening, limit on opening, limit close, and possible 
duplicate orders.
    (B) On-floor orders for the proprietary account(s) of ROTs and 
specialists via electronic interface with AUTOM, up to the maximum 
number of contracts permitted by the Exchange, subject to the 
restrictions on order entry set forth in Commentary .04 of this Rule. 
Orders up to 1,000 contracts, depending on the option, are eligible for 
AUTOM order delivery. The following types of orders for the proprietary 
account(s) of ROTs and specialists are eligible for entry via 
electronic interface with AUTOM: day limit and simple cancel.
* * * * *
    (ii) The Exchange's Options Committee may determine to accept 
additional types of orders as well as to discontinue accepting certain 
types of orders.
    (iii) Orders may not be unbundled for the purposes of eligibility 
for AUTOM and AUTO-X, nor may a firm solicit a customer to unbundle an 
order for this purpose.
* * * * *

Commentary

* * * * *
    .04  Price-improving ROT and specialist price-improving orders via 
electronic interface with AUTOM. On-floor orders for the proprietary 
accounts of ROTs or specialists that result in an improvement in the 
then prevailing market disseminated by the Exchange (i.e., raise the 
bid or lower the offer) may be entered for delivery through AUTOM, 
through the use of Exchange approved proprietary systems to interface 
with AUTOM to be placed on the specialist's limit order book. In order 
to be displayed, on-floor price improving orders for the proprietary 
accounts of ROTs or specialists delivered via electronic interface with 
AUTOM shall be for a minimum size of at least the lesser of the AUTO-X 
guarantee for the option that is the subject of such an order, or 20 
contracts. Inbound orders eligible for execution against price-
improving ROT or specialist price-improving orders entered into AUTOM 
via electronic interface and orders that match such price-improving 
orders via electronic interface with AUTOM, shall be executed by the 
specialist and shall be allocated by the person required to do so 
pursuant to Exchange rules. The Exchange will make electronic interface 
with AUTOM available to member firms, and will notify all members on 
the Options Floor when it has completed the development of appropriate 
interfaces for such proprietary systems on the Options Floor, and when 
the use of such electronic interfaces may commence. Thereafter, ROTs 
and specialists must connect with these interfaces with their own 
proprietary devices.
    The Exchange shall modify its AUTO-X system not later than January 
2004, so that it shall automatically execute

[[Page 43374]]

eligible incoming orders against Phlx Price Improving ROT and 
specialist price improving orders and orders matching such price-
improving orders entered via electronic interface with AUTOM resting on 
the limit order book. The Exchange will deploy the modified system over 
a 15-month period.
    An ROT or specialist that posts a bid or offer through electronic 
interface with AUTOM and elects to cancel such a bid or offer must 
cancel such bid or offer through the electronic interface.

Rule 1014. Obligations and Restrictions Applicable to Specialists and 
Registered Options Traders

* * * * *
    (g) Equity Option and Index Option Priority and Parity
    (i) (A) Exchange Rules 119 and 120 direct members in the 
establishment of priority of orders on the floor. In addition, equity 
option and index option orders of controlled accounts are required to 
yield priority to customer orders when competing at the same price, as 
described below.
    For the purpose of paragraph (g) of this Rule, an account type is 
either a controlled account or a customer account. A controlled account 
includes any account controlled by or under common control with a 
broker-dealer. Specialist accounts of PHLX Option Specialists, however, 
are not subject to yielding requirements placed upon controlled 
accounts by this Rule. Customer accounts are all other accounts.
    Orders of controlled accounts must yield priority to customer 
orders, except that PHLX ROTs closing in-person are not required to 
yield priority to orders of customer accounts.
    Orders of controlled accounts are not required to yield priority to 
other controlled account orders, except that when both an order of a 
PHLX ROT closing in-person and some other order of a controlled account 
are established in the crowd at the same price, and then a customer 
order is established at that price, the order of the controlled account 
must yield to the customer order while the order of the PHLX ROT 
closing in-person does not have to so yield.
    (B) ROT Access--Pursuant to Rule 1080(b)(i)(B) and Commentary .04 
thereto, a Phlx ROT or specialist may enter an order that results in 
the improvement of the prevailing bid and/or offer disseminated by the 
Exchange through an electronic interface with AUTOM (``price improving 
order'') and must announce, loudly and audibly in the crowd, that he 
has improved the displayed market. Such ROT or specialist is referred 
to, in this rule, as a Price Improving ROT/Specialist.
    Matching--The other crowd participants, including ROTs and/or the 
specialist, may match such price improving order via electronic 
interface with AUTOM and by loudly and audibly announcing their 
intention to do so, and indicating their size, at any time. If Auto-
Quote or Specialized Quote Feed matches the price associated with a 
price improving order, the specialist and crowd participants shall be 
deemed to be matching the price improving order under this paragraph.
    Further Improvement--the other crowd participants may improve the 
price improving order by entering an order via an electronic interface 
with AUTOM.
    Trade Allocation--Among the Price Improving ROT/Specialist and 
matching crowd participants, trades shall be allocated as follows:
    (1) Special Allocation: a Price Improving ROT/Specialist shall be 
entitled to receive the largest number of contracts among all crowd 
participants that have matched such price improving order, subject to 
size, as follows:
    (a) When a price improving order is matched by one single crowd 
participant via electronic interface with AUTOM, the Price Improving 
ROT/Specialist shall be entitled to receive 60% of an incoming order, 
and the matching crowd participant shall be entitled to receive 40% of 
an incoming order.
    (b) When a price improving order is matched via electronic 
interface with AUTOM by two or more crowd participants, the Price-
Improving ROT/Specialist shall be entitled to receive 40% of an 
incoming order. If one of the matching crowd participants is the 
specialist, the specialist shall be entitled to receive of 30% of an 
incoming order, and any other ROT(s) that matched the Price Improving 
ROT's order shall be entitled to receive 30% of an incoming order, in 
the aggregate.
    (c) When a Price Improving ROT/Specialist's price improving order 
is matched via electronic interface with AUTOM by two or more other 
ROTs in the crowd, the Price Improving ROT/Specialist shall be entitled 
to receive 40% of an incoming order, and any other ROT(s) that matched 
the Price Improving ROT's order shall be entitled to receive 60% of an 
incoming order, in the aggregate.
    (d) Any partial contracts shall be rounded up in favor of the Price 
Improving ROT/Specialist.
    (2) The Special Allocation set forth in (a)-(c) above shall remain 
in effect until:
    (a) the price improving order has been executed up to the minimum 
number of contracts required under Rule 1080, Commentary .04;
    (b) the Price Improving ROT/Specialist cancels the price improving 
order;
    (c) the original price improving order is superceded by a new price 
improving order, unless that new price improving order is cancelled 
before at least one contract executes at that price (in which case the 
original price improving order remains subject to special allocation 
until one of these three conditions occur).
    (3) Once the Special Allocation is no longer in effect, all 
contracts remaining to be executed at the originally improved price 
(including those remaining of the price improving order) shall be 
considered on parity and allocated in accordance with Exchange Rule 
1014(g)(ii)-(iv). Thus, if the specialist is among the crowd 
participants remaining on parity, the specialist shall be entitled to 
receive an Enhanced Specialist Participation in eligible options. The 
Special Allocation may apply to part of an incoming order (up to the 
minimum number permitted by Rule 1080, Commentary .04 i.e., 20 
contracts), with the rest of an incoming order subject to allocation 
under Rules 1014(g)(ii)-(iv).
    (4) In no event shall a Price Improving ROT/Specialist or crowd 
participant that matches a price improving order be required to 
participate in a trade above such Price Improving ROT or crowd 
participant's stated size.
    (5) Notwithstanding the first sentence of Rule 1014(g)(i), neither 
Rule 119(a)-(d) and (f), nor Rule 120 (insofar as it incorporates those 
provisions by reference) shall apply to the allocation of trades 
executed against price-improving orders and orders matching such price 
improving orders. The Special Allocation set forth above shall apply 
only to price improving orders and orders matching such price improving 
orders. No other rule relating to the allocation of contracts shall 
apply to price improving orders until the Special Allocation ends, 
which is determined above. The person responsible for allocation of 
orders shall use best efforts to ensure that price improving orders and 
crowd participants that match such price improving orders are allocated 
contracts in accordance with this Rule.

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 self-regulatory organization 
included

[[Page 43375]]

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 IV below. The Exchange 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 and Overview
    The purpose of the proposed rule change is to permit Phlx ROTs to 
place orders directly on the specialist's limit order book, and to 
encourage Phlx ROTs and specialists to quote competitively in options 
in which they are registered,\15\ by allowing such ROTs to interface 
electronically with, and to submit proprietary orders through, AUTOM.
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    \15\ The Exchange notes that the Commission has directed that 
the options markets adopt new, or amend existing, rules concerning 
its automated quotation and execution systems which substantially 
enhance incentives to quote competitively and reduce disincentives 
for market participants to act competitively. See Securities 
Exchange Act Release No. 43268 (September 11, 2000), Administrative 
Proceeding File No. 3-10282.
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    Currently, Phlx Rule 1080 provides that, generally, only agency 
orders may be entered into AUTOM.\16\ The proposal would provide that 
on-floor orders for the proprietary account(s) of ROTs, up to the 
maximum number of contracts permitted by the Exchange, are eligible for 
delivery via AUTOM. This is intended to provide ROTs with additional 
means to enter orders while on the floor of the Exchange other than 
through open outcry while physically present in the trading crowd, or 
through a floor broker.
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    \16\ The Exchange has defined an agency order as any order 
entered on behalf of a public customer, and does not include any 
order entered for the account of a broker-dealer, or any account in 
which a broker-dealer or an associated person of a broker-dealer has 
any direct or indirect interest. See, e.g., Phlx Rule 229.02. See 
also, Securities Exchange Act Release No. 40970 (January 25, 1999), 
64 FR 4922 (February 1, 1999) (File No. SR-Phlx-98-44).
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    Currently, only Exchange options specialists may access the limit 
order book electronically. The Exchange believes that allowing Phlx 
ROTs to place orders directly on the limit order book via electronic 
interface with AUTOM should level the playing field by eliminating any 
actual or perceived technological advantage the specialist may have 
respecting the ability to place orders directly on the limit order 
book, and thus would provide incentives for all crowd participants to 
quote competitively.
    The proposal would also allow specialists to improve the prevailing 
market by placing price-improving orders via a similar electronic 
interface with AUTOM as that used by ROTs. The use of a specific 
electronic interface is intended to distinguish the specialists' price 
improving orders under the instant proposed rule from their general 
two-sided quoting, including by Auto-Quote or specialized quote 
feed.\17\ The Exchange believes that this provision substantially 
enhances the incentives for all crowd participants engaged as options 
market-makers, including specialists, to quote competitively.
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    \17\ A specialist may establish a specialized connection with 
AUTOM, known as a specialized quote feed, which enables the 
specialist to provide quotations based on a proprietary pricing 
model, by-passing the Exchange's Auto-Quote System. See Phlx Rule 
1080, Commentary .01(c).
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    Under existing Phlx rules, Phlx ROTs are able to improve the Phlx 
market with respect to a given option series by verbally announcing 
their trading interest in a loud and audible fashion. A Phlx ROT (or a 
floor broker on the ROT's behalf) may also ask the specialist to place 
an order for an ROT's account on the limit order book maintained by the 
specialist. In either case, the Phlx ROT may establish priority with 
respect to an incoming order if the ROT's quote or order is first in 
time.\18\
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    \18\ See Securities Exchange Act Release No. 35033 (November 30, 
1994), 59 FR 63152 (December 7, 1994) (File No. SR-Phlx-94-32).
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    Inbound orders eligible for execution against ROT or specialist 
orders entered into AUTOM via electronic interface would be executed by 
the specialist and allocated initially by the individual responsible 
for allocating trades under existing Exchange rules. Currently, under 
the Exchange's Option Floor Procedure Advice (``OFPA'') F-2, the 
largest participant in a trade is responsible for allocating contracts 
to crowd participants. In a separate rule proposal, the Exchange has 
proposed amendments to OFPA F-2 and Rule 1014(g)(iv) that the Phlx 
represents would further delineate this responsibility.\19\ The person 
responsible for allocating orders would be required to use his or her 
best efforts to ensure that price-improving orders and orders that 
match price-improving orders are allocated contracts pursuant to the 
allocation formula in the proposed rule.\20\ No later than January 
2004, the Exchange will modify the AUTO-X system and will automatically 
execute incoming orders against ROT and specialist orders that improve 
the disseminated price, as well as orders that match such price-
improving orders.\21\
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    \19\ Under the separate rule proposal, if a trade involved a 
floor broker, the floor broker would be responsible for allocating 
contracts among crowd participants but could delegate the 
responsibility to the specialist or an assistant to the specialist 
under the specialist's supervision (``Assistant''), provided that 
the specialist (or Assistant) would be responsible for allocating 
trades. If neither the specialist nor floor broker is involved, but 
there is more than one buyer or seller, the largest participant 
would be responsible for allocating trades. If neither the 
specialist nor floor broker is involved, and there is only one buyer 
and seller, the seller would be responsible for allocating trades. 
See File No. SR-Phlx-2001-28.
    \20\ See Amendments Nos. 4 and 5.
    \21\ See Amendment No. 1. March 21, 2002 Telephone Conversation.
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    It is inherent in the specialist system (the Phlx uses the 
specialist system) that the specialist controls the limit order book 
and also the operation of the Auto-Quote.\22\ Currently, Phlx ROTs 
cannot directly place orders on the electronic limit order book or 
cause the displayed market to reflect a price-improving bid, offer or 
booked order of the ROT, except by asking the specialist to do so. 
Thus, specialists could be perceived to have a major technological 
advantage over ROTs, which could be seen as a competitive advantage. 
Because of the ROT's dependence on the hearing and reactions of the 
specialist, the absence of electronic interface with AUTOM for ROTs 
might be regarded as an impediment to vigorous quoting by ROTs, 
especially in busy trading crowds, where ROTs might be concerned that 
specialists might not hear them or properly recognize the time sequence 
in which an ROT has vocalized a quote. Moreover, this might be seen as 
an opportunity for a specialist who did not wish an ROT to better the 
market through price competition to consciously ignore an ROT's quote 
or order, even if properly verbalized.
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    \22\ Auto-Quote is the Exchange's electronic options pricing 
system, which enables specialists to automatically monitor and 
instantly update quotations, based on incremental changes in the 
price of the security underlying the option. See Phlx Rule 1080, 
Commentary .01(a).
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    The Exchange believes that the enhanced ROT access to the AUTOM 
system contemplated in this proposal would substantially enhance the 
incentives of ROTs to quote competitively because they will be able to 
improve the Phlx market electronically, and thereby increase their 
prospects for trade participation, rather than merely passively staying 
on the disseminated market and waiting to receive their allocated 
participation in AUTO-X trades on the ``Wheel.'' \23\ By

[[Page 43376]]

providing a means of quote improvement that is not dependent on the 
hearing, reaction time, and perhaps ``good will'' of the specialist, 
the Exchange believes that the proposed rule change substantially 
reduces ROTs' actual or perceived disincentives to act competitively.
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    \23\ The ``Wheel'' is a feature of AUTOM that provides an 
automated mechanism for assigning specialists and ROTs signed on the 
Wheel for a given listed option, on a rotating basis, as contra-side 
participants to trades executed via AUTO-X. See Phlx Rule 1080(g) 
and Options Floor Procedure Advice F-24.
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    Nothing in this proposal would eliminate the current ability of 
Phlx ROTs to price improve through the customary method of open outcry 
(or to submit orders through Phlx floor brokers) or alter the priority 
of Phlx ROT bids/offers verbalized in the crowd or submitted through 
floor brokers. Rather, the proposal offers Phlx ROTs an additional 
method of price competition, by means of order entry via electronic 
interfaces.
2. Procedural Requirements
    The proposal provides for some procedural requirements and 
limitations applicable to orders entered via the electronic interface. 
The proposal also includes a rule pertaining to priority, parity, and 
precedence of orders, applicable solely to Phlx specialist and ROT 
orders that are entered via electronic interface and either improve the 
displayed Phlx marker or match another order that has improved the 
displayed market.\24\
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    \24\ March 21, 2002 Telephone Conversation.
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    In order to be displayed, on-floor orders for the proprietary 
accounts of ROTs delivered via AUTOM must be for a minimum size of at 
least the lesser of the AUTO-X guarantee for the option that is the 
subject of such an order, or 20 contracts.\25\ This is to reduce the 
potential logjam of orders entered electronically on the specialist's 
limit order book. The Exchange believes that this requirement would 
enable specialists to continue to meet their obligation to make fair 
and orderly markets.
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    \25\ See Amendment No. 1. This requirement applies only to Phlx 
ROT and specialist orders entered via electronic interface. This 
requirement is distinguished from the display requirement for all 
other orders set forth in Options Floor Procedure Advice A-1.
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    Paragraph (g) of Phlx Rule 1014 provides that a Price-Improving 
ROT/Specialist that enters an order through an electronic interface 
with AUTOM that results in an improvement in the then prevailing market 
disseminated by the Exchange (i.e., raises the bid or lowers the offer) 
must announce, loudly and audibly in the crowd, that he has improved 
the displayed market. The purpose of this provision is to ensure that 
other crowd participants (including the specialist) are alerted to the 
fact that the specialist or an ROT in the crowd has improved the 
market, thus enabling such other crowd participants to quote 
competitively by entering matching orders through electronic interface 
with AUTOM and verbalizing their intention to join in such an improved 
market, or to better the price (see Section 3.C., below).
    The proposal would require that an ROT or specialist that posts a 
bid or offer through electronic interface with AUTOM, and subsequently 
elects to cancel such a bid or offer, must cancel such bid or offer 
through the electronic interface. The purpose of this provision is to 
eliminate the necessity for a specialist to cancel such an order 
manually upon verbal notification of the cancellation, thereby freeing 
the specialist to continue maintaining fair and orderly markets.
3. Price-Improving, ``Matching'' and Special Parity Rule
    The other crowd participants (including the specialist) may match a 
price-improving order through an electronic interface with AUTOM, but 
must loudly and audibly announce their intention to do so, as well as 
their size. If Auto-Quote or Specialized Quote Feed matches a price-
improving order, the specialist and crowd participants on that quote 
would be deemed to be matching the price-improving order. In such a 
situation, the ``Special Allocation'' in proposed Phlx Rule 
1014(g)(i)(B)(1) would apply until terminated as set forth in Rule 
1014(g)(i)(B)(2). Specifically, a ``Special Allocation'' entitles the 
Price Improving ROT/Specialist to receive the largest number of 
contracts among all crowd participants that have matched a price-
improving order, subject to size.\26\ Any partial contracts would be 
rounded up in favor of the Price Improving ROT/Specialist. In no event 
shall a Price Improving ROT/Specialist or crowd participant that 
matches a price-improving order be required to participate in a trade 
above that Price Improving ROT/Specialist's crowd or participant's 
size.\27\
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    \26\ The proposal would entitle a Price Improving ROT/Specialist 
to participate in at least 60% of the contracts in the transaction 
if his or her order is matched by one single crowd participant. If 
the Price Improving ROT/Specialist's order is matched by two or more 
crowd participants (including the specialist), the Price Improving 
ROT/Specialist would be entitled to participate in at least 40% of 
the contracts in the transaction; a matching specialist would be 
entitled to participate in 30%, and other crowd participants on 
parity with the Price Improving ROT/Specialist would be entitled to 
participate in 60% of the contracts in the transaction, in the 
aggregate. If a Price Improving ROT/Specialist order is matched by 
two or more crowd participants (but not the specialist), the Price 
Improving ROT/Specialist would be entitled to participate in 60% of 
the contracts in the transaction, in the aggregate.
    \27\ See Amendment No. 4.
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    The Special Allocation would remain in effect until one of the 
following takes place: (1) the lesser of 20 contracts or the AUTO-X 
guarantee for the option that is the subject of the price-improving 
quote, have been executed against the price-improving quotes eligible 
to receive an allocation; (2) the ROT or specialist who improved the 
price cancels the price-improving order; or (3) the original price-
improving order is superseded by a new price-improving order.\28\ If 
any of those conditions are satisfied, the special allocation formula 
would no longer be in effect, and crowd members with orders that have 
not been filled would be considered to be on parity. If the specialist 
were one of the crowd members, the specialist would, consistent with 
applicable exchange rules, be entitled to receive an Enhanced 
Specialist Participation in eligible options.\29\
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    \28\ Unless the new price-improving order is cancelled before at 
least one contract executes at the price of the new price-improving 
order. See proposed Phlx Rule 1014(g)(B)(2). The Exchange represents 
that the purpose of this third condition is to eliminate the 
possibility that a crowd participant could, by placing and then 
immediately canceling a price-improving order, cause a Price 
Improving ROT/Specialist to lose their entitlement under the Special 
Allocation.
    \29\ See Amendment No. 5.
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    Further, proposed Commentary .04 to Phlx Rule 1080 provides that 
the Exchange will notify all members on the Options Floor when it has 
completed the development of appropriate interfaces for such 
proprietary systems and/or deployed such terminals on the Options 
Floor, and when the use of such electronic interfaces and/or terminals 
may commence. This provision is included in the proposed rule change 
because, in the event that the Commission approves this proposal, the 
Exchange's ability to deploy such interfaces may not coincide with the 
effective date of the rule. The Exchange believes that the interfaces 
should be able to be deployed in or around the third quarter 2002.
    Finally, the Exchange has determined to work towards the 
development of a proposal for an alternative model for ROT access, 
which would involve giving ROTs the ability to electronically post 
their own quotations in competition with the specialist and to have 
their own quotation generation models (which might be supplied by the 
Exchange or third parties, or be independently developed), as opposed

[[Page 43377]]

to having their electronic access be limited to sending limit orders on 
a strike-by-strike basis (the ``Independent Quoting Model'').\30\
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    \30\ See Amendment No. 5.
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    This Independent Quoting Model would involve the Exchange adopting 
a new trade allocation rule similar to that International Securities 
Exchange (``ISE'') Rule 713. Subject to approval under the governance 
requirements set forth in the Exchange's rules and in the Act, the 
Exchange would, if so approved, submit the same to the Commission as 
the ultimate solution to compliance with Section IV.B.h.(aa) of the 
Order.\31\
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    \31\ Id.
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4. Statutory Basis
    For these reasons, the proposed rule change is consistent with 
Section 6 of the Act in general, and with Section 6(b)(5) of the Act 
specifically, in that it is designed to perfect the mechanisms of a 
free and open market and the national market system, protect investors 
and the public interest and promote just and equitable principles of 
trade by providing Phlx ROTs with increased electronic access to the 
specialist's limit order book, which should provide incentive for Phlx 
ROTs to quote competitively, and which in turn should result in 
competitive pricing and enhanced liquidity on the Exchange 
specifically, and in the options markets in general.

B. Self-Regulatory Organization's Statement on Burden on Competition

    The Phlx does not believe that the proposed rule change will impose 
any inappropriate burden on competition.

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

    No written comments were either solicited or 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 or such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the Phlx 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.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the proposed rule change and Amendments Nos. 1-7 
thereto. Persons making written submissions should file six copies 
thereof with the Secretary, Securities and Exchange Commission, 450 
Fifth Street, NW, Washington, DC 20549. 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 Section, 450 Fifth Street, NW, Washington, DC 20549. Copies 
of such filing will also be available for inspection and copying at the 
principal office of the Phlx. All submissions should refer to File No. 
SR-Phlx-2002-04 and should be submitted by July 18, 2002.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\32\
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    \32\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-16210 Filed 6-26-02; 8:45 am]
BILLING CODE 8010-01-P