[Federal Register Volume 67, Number 141 (Tuesday, July 23, 2002)]
[Notices]
[Pages 48232-48236]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-18562]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46213; File No. SR-Amex-2002-21]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendments Nos. 1, 2, 3 and 4 Thereto by the American Stock 
Exchange LLC to Permit Limited Side-by-Side Trading and Integrated 
Market Making

July 16, 2002.

I. Introduction

    On March 18, 2002, the American Stock Exchange LLC (``Amex'' 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 Exchange Rules 174, 175, 
193, 900, and 958 to (1) permit affiliates of Amex specialists in 
securities admitted to dealings on an unlisted basis to act as a 
specialist, Registered Options Trader (``ROT'') or other registered 
market maker in the related options provided there are Exchange-
approved information barriers between the stock specialist and the 
options specialist, ROT or other registered options market maker 
established pursuant to Exchange Rule 193, and (2) provide that 
specified Exchange-Traded Fund Shares (``ETFs'') or Trust Issued 
Receipts (``TIRs'') and their related options may be traded by the same 
specialist, specialist firm, and the approved persons of such 
specialist or specialist firm without information or physical barriers 
or other restrictions. The Exchange filed Amendment No. 1 to the 
proposed rule change on March 22, 2002.\3\ The Exchange filed Amendment 
No. 2 to the proposed rule change on March 27, 2002.\4\ The Exchange 
filed Amendment No. 3 to the

[[Page 48233]]

proposed rule change on April 5, 2002.\5\ The Exchange filed Amendment 
No. 4 to the proposed rule change on June 4, 2002.\6\ The proposed rule 
change, as amended by Amendments Nos. 1, 2, 3, and 4, was published for 
comment in the Federal Register on June 12, 2002.\7\ The Commission 
received one comment letter on the proposed rule change.\8\ This order 
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\ On March 22, 2002, the Exchange filed a Form 19b-4, which 
replaced the original filing in its entirety (``Amendment No. 1'').
    \4\ On March 27, 2002, the Exchange filed a second amended Form 
19b-4 (``Amendment No. 2'').
    \5\ On April 5, 2002, the Exchange filed a third amended Form 
19b-4 (``Amendment No. 3'').
    \6\ On June 4, 2002, the Exchange filed a fourth amended Form 
19b-4 (``Amendment No. 4'').
    \7\ See Securities Exchange Act Release No. 46036 (June 5, 
2002), 67 FR 40357.
    \8\ See letter to Jonathan Katz, Secretary, Commission, from 
Edward J. Joyce, President and Chief Operating Officer, Chicago 
Board Options Exchange, Inc. (``CBOE''), dated July 11, 2002 (``CBOE 
Letter'').
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II. Description of the Proposal

    The Exchange proposes to permit limited side-by-side trading \9\ 
and integrated market making \10\ for certain securities. Specifically, 
Amex proposes to permit limited integrated market making of securities 
admitted to dealings on an unlisted trading privileges (``UTP'') basis 
and their related options so long as information barriers are 
established, approved and maintained. In addition, Amex proposes to 
permit side-by-side trading and integrated market making of certain 
ETFs, TIRs, and options overlying such ETFs and TIRs. These proposals 
are discussed more fully below.
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    \9\ ``Side-by-side trading'' refers to the trading of securities 
and related derivative products at the same location, though not 
necessarily by the same specialist.
    \10\ ``Integrated market making'' refers to the trading of 
securities and related derivative products by the same specialist 
and/or specialist firm.
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A. Securities Admitted to Dealings on an Unlisted Basis

    Currently, Amex Rule 175(c) prohibits approved persons \11\ and 
other affiliates (``specialist affiliates'') of an Amex equity 
specialist from acting as an options specialist or functioning in any 
capacity involving market making responsibilities in any option as to 
which the underlying security is a stock in which the specialist is 
registered as such. The Amex proposes to amend Exchange Rule 175 to 
permit Amex specialists in stocks admitted to dealings on an unlisted 
basis to act as options specialists, ROTs and registered market makers 
with respect to the related options provided there are Exchange-
approved procedures restricting the flow of material, non-public 
corporate or market information established pursuant to Amex Rule 193. 
In addition, stocks admitted to dealings on an unlisted basis and their 
related options would be traded in areas of the Exchange Floor that are 
separated from each other so that no side-by-side trading would be 
permitted.\12\
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    \11\ The Exchange defines an ``approved person'' as an 
individual or corporation, partnership or other entity which 
controls a member or member organization, or which is engaged in the 
securities business and is under common control with, or controlled 
by, a member or member organization or which is the owner of a 
membership held subject to a special transfer agreement. See Article 
I, Section 3(g) of the Exchange Constitution. The term ``control'' 
is defined in Exchange Definitional Rule 13.
    \12\ See Amex Rules 900(b)(38), (40) and (41). See also Amex 
Rule 958(f), which prohibits an ROT from executing a trade in an 
option if he or she has been in the ``Designated Stock Area'' for 
the related option within the previous 60 minutes.
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B. ETFs and TIRs

    The Exchange proposes to amend Amex Rules 174, 175, 900, and 958 to 
allow side-by-side trading and integrated market making of certain ETFs 
and TIRs and their related options so long as the ETF or TIR meets the 
criteria set forth in Commentary .03(a) to Amex Rule 1000 and 
Commentary .02(a) to Amex Rule 1000A.\13\ Specifically, the Exchange 
proposes to amend Amex Rule 175(c) to permit specialists registered in 
ETFs or TIRs that meet the criteria in Commentary .03(a) of Amex Rule 
1000 or Commentary .02(a) of Amex Rule 1000A to also act as 
specialists, ROTs or other registered market makers in the related 
options without information barriers or physical barriers. In addition, 
the Exchange proposes to amend Amex Rule 175(c) to provide that 
specialists of these ETFs and TIRs, their member organizations, and 
their approved persons may trade the related options without the 
limitations of Amex Rule 175(b) and the Guidelines to Amex Rule 
175.\14\ The Exchange also proposes to amend Amex Rule 958 to permit 
ETF and TIR specialists to act as ROTs.
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    \13\ The criteria set forth in Commentary .03(a) to Amex Rule 
1000 and Commentary .02(a) to Amex Rule 1000A is as follows:
     Component securities that in the aggregate account for 
at least 90% of the weight of the portfolio must have a minimum 
market value of at least $75 million.
     The component securities representing 90% of the weight 
of the portfolio each have a minimum monthly trading volume during 
each of the last six months of at least 250,000 shares.
     The most heavily weighted component security cannot 
exceed 25% of the weight of the portfolio and the five most heavily 
weighted component securities cannot exceed 65% of the weight of the 
portfolio.
     The underlying portfolio must include a minimum of 13 
securities.
     All securities in the portfolio must be listed on a 
national securities exchange or the Nasdaq Stock Market.
    \14\ Generally, Amex Rule 175(b) only permits a specialist to 
trade options on its specialty stock for the purpose of offsetting 
the risk of making a market in the underlying specialty security. 
The Guidelines to Amex Rule 175 provide the conditions for opening 
options transactions to hedge existing specialty stock positions.
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    The Exchange also proposes to amend Amex Rule 174 to require an ETF 
or TIR specialist that is also the specialist in the related option in 
a side-by-side environment to disclose on request to participants in 
the ETF, TIR, and option trading crowds information about aggregate 
buying and selling interest at different price points represented by 
limit orders on the ETF, TIR or option limit order books.
    Finally, the Exchange proposes to amend the definition of ``Paired 
Security'' in Amex Rule 900 to provide that ETFs and TIRs that meet the 
criteria of Commentary .03(a) to Amex Rule 1000 and Commentary .02(a) 
to Amex Rule 1000A may trade side-by-side with their related options.

III. Summary of Comments

    The Commission received one comment letter on the proposed rule 
change.\15\ In general, CBOE supported Amex's proposal to permit 
integrated market making of securities admitted to dealings on an 
unlisted basis and the related options as long as information barriers 
are established. CBOE did, however, raise concerns about the 
sufficiency of Amex's Rule 193 information barriers and whether they 
are as comprehensive as those required by the New York Stock Exchange, 
Inc. (``NYSE'') under NYSE Rule 98. As discussed further below, the 
Commission believes that the information barriers required under Amex 
Rule 193 are sufficient to prevent the flow of material non-public 
information between affiliates engaged in integrated market making.
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    \15\ See CBOE Letter, supra note 8.
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    In addition, CBOE expressed concerns about Amex's proposal to 
permit side-by-side trading and integrated market making in certain 
ETFs and TIRs and their related options without any information or 
physical barriers or other restrictions. As discussed further below, 
the Commission believes that Amex has limited its proposal to address 
regulatory concerns.

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.\16\ In particular, the

[[Page 48234]]

Commission believes that the proposed rule change is consistent with 
section 6(b)(5) of the Act,\17\ 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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    \16\ 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).
    \17\ 15 U.S.C. 78f(b)(5).
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    When considering a side-by-side trading or integrated market making 
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.\18\ In this 
regard, the Commission must consider whether a side-by-side trading or 
integrated market making proposal would permit market participants to 
possess undetectable, material non-public market information, which 
could give certain market participants a trading advantage over other 
market participants. Thus, the Commission must evaluate the extent of 
the proposed side-by-side trading or integrated market making, as well 
as the characteristics of the market center putting forth the proposal.
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    \18\ See Securities Exchange Act Release No. 22026 (May 8, 
1985), 50 FR 20310 (May 15, 1985). See also Report of the Special 
Study of the Options Markets to the Securities and Exchange 
Commission, H.R. Rep. No. IFC 3, 96th Cong. 1st sess. (Comm. Print 
1978) (``Options Study'').
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    Historically, the Commission has had concerns regarding side-by-
side trading and integrated market making.\19\ The Commission staff 
also discussed the regulatory issues raised by side-by-side trading and 
integrated market making in the Options Study. More specifically, the 
Commission staff noted that side-by-side trading and integrated market 
making raise the concern that participants engaging in such trading 
practices could unfairly use non-public market information to their 
advantage because such participants have access to non-public market 
information about both a stock and its related option. In addition, 
side-by-side trading and integrated market making could result in 
certain market participants gaining an unfair competitive advantage 
over other market participants because of their access to and ability 
to use non-public market information. For example, in a side-by-side 
trading environment or integrated market making environment on a single 
exchange floor, floor members, by virtue of their positions on the 
floor of an exchange, are able to react instantaneously to market 
information by executing orders before the information is publicly 
disseminated. Similarly, because an integrated entity that operates on 
two different floors may also have access to non-public market 
information regarding a stock and its related option, it too could 
execute orders before information is publicly disseminated. 
Accordingly, in evaluating whether Amex's proposal is consistent with 
the Act, the Commission considered the extent to which additional non-
public market information and competitive advantages would accrue to 
stock and options market makers on the Exchange, and their affiliates 
off the exchange.
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    \19\ See, e.g., Securities Exchange Act Release Nos. 22026, 
supra note 18; 21759 (February 14, 1985), 50 FR 7250 (February 21, 
1985)(approving SR-NYSE-84-3 and SR-NYSE-84-10); 26147 (October 3, 
1988), 53 FR 39556 (October 7, 1988)(approving SR-Amex-88-16); and 
28556 (October 19, 1990), 55 FR 43233 (October 26, 1990)(approving 
SR-CBOE-90-08).
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    In addition, in the Options Study, the staff expressed concerns 
about the potential for manipulation and other improper trading 
practices that could result from side-by-side trading and integrated 
market making, and that such improper conduct would be hard, if not 
impossible, to surveil.\20\ For example, much of the market information 
that may be used in a side-by-side trading or integrated market making 
environment may never be publicly disseminated, and thus may never be 
available for surveillance purposes. In addition, a side-by-side 
trading environment may increase a specialist's or market maker's 
ability to observe and utilize information regarding orders, 
transactions, and patterns of trading and quoting and may permit such 
specialist or market maker to continuously and accurately assess risks 
that could be associated with improper trading conduct. For example, in 
the Options Study, the staff noted that manipulations of stock prices 
to benefit options positions may be undertaken with greater precision 
if a market participant on an exchange floor is able to evaluate 
accurately the supply of, and demand for, a security by observing the 
buying and selling interest in the crowd, the depth of orders in the 
book and the trading patterns of market participants at the trading 
post. This concern may be present in an integrated market making 
situation when a firm acts as a specialist in a stock on one exchange 
and as a specialist in the option on another exchange because of its 
ability to observe transactions, order flow, and trading and quoting 
patterns on both floors.
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    \20\ The Commission staff 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 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. See Options Study, supra note 18.
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    Finally, the Commission staff noted concerns about the potential 
conflicts of interest that may arise when an integrated entity, whether 
on the same or different exchange floors, has an obligation to make 
markets in both an option and its underlying equity.

A. Securities Admitted to Dealings on an Unlisted Basis and Related 
Options

    Amex proposes to permit limited integrated market making by 
allowing affiliates of Amex specialists registered as such in 
securities admitted to dealings on an unlisted basis to act as a 
specialist, ROT or other registered market maker in the related options 
provided there are Exchange-approved information barriers between the 
stock specialist and the options specialist, ROT or other registered 
options market maker established pursuant to Amex Rule 193. These 
information barriers must be approved by the Amex and are subject to 
annual review by the Amex. By requiring strict information barriers 
designed to prevent the flow of non-public information, the Amex seeks 
to limit the concerns raised by integrated market making.
    Specifically, the related entities must establish procedures that 
are sufficient to restrict the flow of non-public information. The 
Guidelines to Amex Rule 193 set forth the conditions to be met by the 
related entities in order to satisfy this requirement. For example, 
Guideline (b)(i) requires organizational separation of the specialist 
and approved person such that each entity is a separate and distinct 
organization. Guideline (b)(i) further requires that while the 
affiliates may be under common management, the management of the 
approved person may not exercise influence over or control the stock 
specialist's conduct or vice versa. In addition, any general management 
oversight must not conflict or compromise in any way the specialist's 
market making responsibilities. Guideline (b)(ii) requires the 
establishment of procedures to preserve confidentiality of trading 
information of both the specialist and the affiliate. Specifically, 
Guideline (b)(ii) requires the establishment of procedures to prevent 
the use of material, non-public corporate or market information in the 
possession of the affiliate to influence the specialist's conduct and 
avoid the misuse of the specialist's market information to influence 
the affiliate's

[[Page 48235]]

conduct. These procedures must also include means to prevent the 
disclosure of trading positions and each 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 these procedures set forth in the 
Guidelines address the regulatory issues raised by the proposed rule 
change regarding integrated market making of securities admitted to 
dealings on an unlisted basis and their related options.\21\ The 
requirement of clearly separate and distinct organizations, along with 
the other informational barriers and restrictions, should prevent 
Exchange specialists and their related options specialists or market 
makers from sharing restricted, non-public market information. Further, 
Amex Rule 193 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 193's organizational requirements and 
information barriers and thus should be able to ensure that the 
integrated entities do not improperly use their affiliations. In 
addition, organizational separation and information barriers must be 
established and maintained between an Exchange specialist, any approved 
person of the specialist that acts as a specialist, ROT, or registered 
market maker in an option based on the specialist's specialty stock, 
and any other persons affiliated with them.
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    \21\ The Commission notes that it approved a similar NYSE 
proposal to permit NYSE specialists to be affiliated with 
specialists and primary market makers in options related to the NYSE 
specialist's specialty stock so long as information barriers are 
established, approved, and maintained. See Securities Exchange Act 
Release No. 45454 (February 15, 2002), 67 FR 8567 (February 25, 
2002).
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    The Commission expects 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 surveil the integrated entities to ensure that the information 
barriers and organizational structure prevent the flow of non-public 
market information.
    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.\22\ Therefore, the Commission believes that the 
potential improvements to liquidity and quality of the markets by the 
Amex's proposal outweigh the regulatory concerns.
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    \22\ The Commission notes that side-by-side trading of UTP 
stocks and their related options will not be permitted. Accordingly, 
the UTP stocks and their related options must trade at physically 
separate trading locations on the Exchange's floor. See Amex Rule 
900(b)(38), (40), and (41).
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B. ETFs, TIRs and Related Options

    In addition, the Exchange proposes to permit specified ETFs and 
TIRs and their related options to be traded by the same specialist, 
specialist firm, and the approved persons of such specialist or 
specialist firm without information or physical barriers or other 
restrictions, i.e., side-by-side trading and integrated market making. 
The Commission believes that Amex's side-by-side trading and integrated 
market making proposal regarding certain ETFs, TIRs and their related 
options is consistent with the Act and is sufficiently limited to 
address regulatory concerns.\23\ Specifically, the Commission notes 
that ETFs and TIRs are securities that are based on groups of stocks. 
ETF and TIR prices are based on the prices of their component 
securities. Accordingly, the Commission believes that a market 
participant's ability to manipulate the price of the ETF, TIR or 
related option is limited.
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    \23\ The Commission notes that it has previously approved side-
by-side trading and integrated market making of related derivative 
products. See Securities Exchange Act Release No. 27383 (October 26, 
1989), 54 FR 45846 (October 31, 1989).
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    In addition, Amex has limited its proposal to permit side-by-side 
trading and integrated market making only in broad-based ETFs and TIRs. 
Specifically, each ETF and TIR must have a minimum of 13 securities in 
its underlying portfolio, the most heavily weighted component 
securities cannot exceed 25% of the weight of the portfolio, and the 
five most heavily weighted component securities cannot exceed 65% of 
the weight of the portfolio. By limiting the proposal to broad-based 
ETFs and TIRs, concerns regarding informational advantages about 
individual securities are lessened.
    In addition, Amex has sought to ensure that the ETFs and TIRs that 
may be traded side-by-side or by integrated market makers are composed 
of highly capitalized and liquid component securities and that the 
component securities are listed on an exchange or the Nasdaq Stock 
Market. For example, the component securities that in the aggregate 
account for at least 90% of the weight of the portfolio must have a 
minimum market value of at least $75 million. In addition, the 
component securities representing 90% of the weight of the portfolio 
each must have a minimum trading volume during each of the last six 
month of at least 250,000 shares. The Commission believes that these 
capitalization and liquidity requirements should reduce the likelihood 
that any market participant has an unfair information advantage about 
the ETF, TIR, its related options, or its component securities, or that 
a market participant would not be able to manipulate the prices of the 
ETFs, TIRs, or their related options.
    Moreover, to mitigate the potential information advantages, Amex 
has proposed to require integrated specialists in a side-by-side 
trading environment to disclose trading interest in both the ETF or TIR 
and related options limit order books upon request. By providing all 
market participants with market information in the limit order books, 
no market participant should have an unfair competitive advantage over 
others in the crowd.
    Finally, Amex has proposed to permit specialists in ETFs and TIRs 
and approved persons of such specialists to trade options on such ETFs 
and TIRs without the limitations set forth in Amex Rule 175(b). 
Generally, Amex Rule 175(b) only permits a specialist to trade options 
on its specialty stock for the purpose of offsetting the risk of making 
a market in the underlying security. The Commission believes that it is 
consistent with the Act to permit ETF and TIR specialists to trade 
options based on their specialty ETF or TIR because integrated 
specialists in ETFs and TIRs would not be able to perform their market 
making responsibilities in the related options if they were limited to 
only executing hedging transactions.
    The Commission expects the Exchange to assess its surveillance 
procedures to determine whether they are adequate for the new trading 
arrangements to ensure that market participants do not engage in 
manipulative or improper trading practices. Further, the Commission 
expects Amex to consider whether any additional surveillance procedures 
or trading restrictions are necessary to prevent manipulative or other 
improper trading practices. Of course, any new trading restrictions 
proposed would have to be submitted to the Commission for approval.
    The Commission believes that trading efficiencies may be realized 
as a result of these new trading arrangements for

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ETFs and TIRs and their related options. For example, operational 
efficiencies may be realized because orders in ETFs and TIRs and their 
related options may receive faster executions. In addition, combination 
orders may be executed in a more efficient and timely fashion. 
Therefore, the Commission believes that the potential improvements to 
liquidity and quality of the markets in ETFs and TIRs and their related 
options by the Amex's proposal outweigh the regulatory concerns.
    For these reasons, the Commission finds that the proposed rule 
change permitting side-by-side trading and integrated market making of 
certain ETFs and TIRs and their related options is consistent with 
section 6(b)(5) of the Act.\24\
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    \24\ 15 U.S.C. 78f(b)(5).
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IV. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\25\ that the proposed rule change (SR-Amex-2002-21), as amended, 
is approved.
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    \25\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\26\
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    \26\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-18562 Filed 7-22-02; 8:45 am]
BILLING CODE 8010-01-P