[Federal Register Volume 67, Number 173 (Friday, September 6, 2002)]
[Notices]
[Pages 57048-57052]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-22654]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46436; File No. SR-CHX-2002-20]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendment Nos. 1 and 2 Thereto by The Chicago Stock 
Exchange, Incorporated Relating to Automatic Execution of Orders and 
Execution Prices

August 29, 2002.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(the ``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice hereby is given 
that on July 11, 2002, the Chicago Stock Exchange, Incorporated 
(``CHX'' or ``Exchange'') filed with the Securities and Exchange 
Commission (the ``Commission'') the proposed rule change as described 
in Items I, II and III below, which Items have been prepared by the 
self-regulatory organization. On August 12, 2002, the Exchange filed 
Amendment No. 1 to the proposed rule change.\3\ On August 27, 2002, the 
Exchange filed Amendment No. 2 to the proposed rule change.\4\ The 
Commission is publishing this notice to solicit comments on the 
proposed rule change, as amended, 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 Kathleen M. Boege, Associate General 
Counsel, CHX, to Nancy J. Sanow, Assistant Director, Division of 
Market Regulation (``Division''), Commission, dated August 9, 2002 
(``Amendment No. 1'').
    \4\ See letter from Kathleen M. Boege, Assistant General 
Counsel, CHX, to Nancy J. Sanow, Assistant Director, Division, 
Commission, dated August 23, 2002 (``Amendment No. 2'').
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to amend Article XX, Rule 37 of the CHX 
Rules, which governs, among other things, automatic execution of market 
and marketable limit orders. Below is the text of the proposed rule 
change. Proposed new language is italicized; deletions are bracketed.

Article XX

Guaranteed Execution System and Midwest Automated Execution System

RULE 37(a). Guaranteed Executions.
* * * * *
    1. Eligible Orders. Specialists must accept and guarantee execution 
of all agency market and marketable limit orders [in Dual Trading 
System issues] from 100 through [up to and including] 5099 shares in 
accordance with this rule. [Specialists must accept and guarantee 
execution of all agency market orders or marketable limit orders in 
NASDAQ/NM Securities from 100 up to and including 5099 shares in 
accordance with this rule. Specialists must accept all agency limit 
orders in NASDAQ/NM Securities from 100 up to and including 10,000 
shares for placement in the limit order book.]
    2. Market and Marketable Limit Orders. Any market or marketable 
limit order executed automatically shall be executed at the BBO price 
or better. With respect to any market or marketable limit order not 
executed automatically, a specialist shall be obligated to either (a) 
manually execute such order at a price and size equal to or better than 
the NBBO price and size at the time the order was received; or (b) act 
as agent for such order in seeking to obtain the best available price 
for such order on a marketplace other than the Exchange, using order 
routing systems where appropriate. [Subject to the requirements of the 
short sale rule and the limitations of Rule 43(d) of this Article, all 
agency market orders must be filled on the basis of the size and price 
associated with the best bid among the American, Boston, Cincinnati, 
Chicago, New York, Pacific, Philadelphia or the Intermarket Trading 
System/Computer Assisted Execution System (``ITS/CAES'') quote (``ITS 
Best Bid'') on a sell order or the size and price associated with the 
best offer among the American, Boston, Cincinnati, Chicago, New York, 
Pacific, Philadelphia or the ITS/CAES quote (``ITS Best Offer'') on a 
buy order (the ``ITS Best Bid'' and ``ITS Best Offer'' are collectively 
referred to as the ``ITS

[[Page 57049]]

BBO''); provided, however, for NASDAQ/NM Securities, all agency market 
orders must be filled on the basis of the price and size associated 
with the best bid disseminated pursuant to SEC Rule 11Ac1-1 on a sell 
order or price and size associated with the best offer disseminated 
pursuant to SEC Rule 11Ac1-1 on a buy order (collectively, the 
``NBBO''); or, if the specialist is quoting at the NBBO, based on the 
size associated with the specialist's bid or offer and the auto-
execution threshold designated by the specialist.]
    3-7. No change to text.
    (b) Automated Executions. The Exchange's Midwest Automated 
Execution System (the MAX System) may be used to provide an automated 
delivery and execution facility for orders that are eligible for 
automatic execution on the Exchange. [under the Exchange's BEST Rule 
(Article XX, Rule 37(a)) and certain other orders. In the event that an 
order that is subject to the BEST Rule is sent through MAX, it shall be 
executed in accordance with the parameters of the BEST Rule and the 
following. In the event that an order that is not subject to the BEST 
Rule is sent through MAX, it shall be executed in accordance with the 
parameters of the following:]
    (1) Size. The MAX System has two size parameters which must be 
designated by the specialist on a stock-by-stock basis. These 
parameters are the auto-execution threshold and the auto-acceptance 
threshold. For both Dual Trading System issues and NASDAQ/NM 
Securities, the auto-execution threshold must be set at 300 shares or 
greater and the auto-acceptance threshold must be set at 1000 shares or 
greater. In no event may the auto-acceptance threshold be less than the 
auto-execution threshold. If the order sending firm sends an agency 
market order in a Dual Trading System issue through MAX, such order 
will be executed in accordance with paragraph (b)(6) of this Rule. If 
the order sending firm sends an agency market order in a Nasdaq/NM 
Security through MAX, such order shall be executed in accordance with 
paragraph (b)(7) of this Rule. Notwithstanding the subsequent 
provisions of Rule 37(b) regarding automatic execution of orders, a 
specialist may elect, on an issue-by-issue basis, to limit the 
specialist's automatic execution exposure during a designated time 
period to a number of shares aggregated from multiple orders (the 
``Aggregate Share Threshold''). If a specialist makes this election, 
the MAX system will automatically execute orders in such issue until 
the Aggregate Share Threshold is reached and subsequent orders will be 
directed to the specialist's book for manual execution during the 
remainder of the designated time period.
* * * * *

Interpretations and Policies:

    .01--.09 No change in text.
    .10 For purposes of this Rule 37, ``BBO price'' shall mean the best 
bid or offer disseminated by a national market participant and 
reasonably accessible by the Exchange. ``NBBO price'' shall mean (a) 
for Dual Trading System issues, the best bid among the American, 
Boston, Cincinnati, Chicago, New York, Pacific, Philadelphia or the 
Intermarket Trading System/Computer Assisted Execution System (``ITS/
CAES'') quote (``ITS Best Bid'') on a sell order or the best offer 
among the American, Boston, Cincinnati, Chicago, New York, Pacific, 
Philadelphia or the ITS/CAES quote (``ITS Best Offer'') on a buy order 
(the ``ITS Best Bid'' and ``ITS Best Offer'' are collectively referred 
to as the ``ITS BBO''); and (b) for NASDAQ/NM Securities, the price 
associated with the best bid disseminated pursuant to SEC Rule 11Ac1-1 
on a sell order or price associated with the best offer disseminated 
pursuant to SEC Rule 11Ac1-1 on a buy order.
* * * * *
RULE 43.
* * * * *
[(d) Manual Executions.
    With respect to MAX System agency market or marketable limit orders 
in NASDAQ?NM Securities which have a size equal to or less than the 
auto-execution threshold but which are not auto-executed under the 
provisions of Rule 37(b)(7) of this article, a specialist shall be 
obligated to either (i) manually executed such orders at the NBBO in 
existence when the order is received or better, or (ii) act as agent 
for such orders in seeking to obtain the best available price for such 
orders on a marketplace other than the Exchange. A specialist acting as 
agent pursuant to subparagraph (ii) above shall use order routing 
systems where appropriate.]
* * * * *

ARTICLE XXX

Specialists

* * * * *
Precedence to Orders in the Book
RULE 2.
* * * * *

Interpretations and Policies:

    .05 Interaction between professional limit orders and agency limit 
orders that are not professional orders (``Agency Orders'').
    In the event that a professional order ``has the post,'' i.e., is 
the highest priority order in the specialist's book at a given price, 
the professional order is not required to yield precedence to an Agency 
Order at the same price that has not established time priority over the 
professional order. [Notwithstanding anything in the previous sentence 
to the contrary, in the event that such Agency Order is due a fill 
under the Exchange's Best Rule, that Agency Order shall be filled even 
though the professional order which had a higher priority on the book 
is not filled.]
* * * * *

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 Exchange included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received regarding 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
    The Exchange proposes to amend Article XX, Rule 37 and Rule 43 of 
the CHX Rules, which governs, among other things, automatic execution 
of market and marketable limit orders and execution prices due orders. 
The proposed amendments to Rules 37 and 43 are intended to modify a CHX 
specialist's order execution obligations to address post-decimalization 
market conditions, specifically the significant reduction in liquidity 
at each price point, including the national best bid and offer 
(``NBBO''). The CHX requests the Commission's approval of the proposed 
rule change on a pilot basis, for six months from the date of the 
Commission's approval order.
Background
    New York Stock Exchange, American Stock Exchange and Nasdaq issues 
are traded on the CHX; each issue traded is assigned to a single 
specialist. The vast

[[Page 57050]]

majority of orders received by a CHX specialist are routed from order-
sending firms via the Exchange's MAX[reg] system, which provides for 
the electronic routing and automatic execution of orders.
    To provide order-sending firms with an incentive to route orders to 
our market, the CHX, like most regional exchanges, has what is referred 
to at the CHX as the ``BEST Rule.'' The BEST Rule provides that if a 
specialist accepts an order (or in actuality the MAX system accepts the 
order for the specialist), the specialist generally must execute the 
order at the NBBO price up to the NBBO displayed quantity, i.e., the 
best price and liquidity available in the national market system.
    In addition to the BEST Rule that governs execution prices, the CHX 
rules also provide for automatic execution of orders, i.e., without 
manual intervention by the CHX specialist, if certain conditions are 
met.\5\ In order to manage his position and prudently limit his auto-
execution exposure, each CHX specialist designates an ``auto-execution 
threshold'' for each issue.\6\ The auto-execution threshold is a number 
of shares, greater than 99 shares that the specialist is willing to 
execute automatically.
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    \5\ See CHX Article XX, Rule 37(b)(6)(automatic execution of 
orders in listed securities); CHX Article XX, Rule 
37(b)(7)(automatic execution of orders in OTC securities).
    \6\ See CHX Article XX, Rule 37(b)(1).
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    Although a specialist can set his auto execution threshold in a 
variety of ways, a fairly typical setting would be to automatically 
execute all orders, in a particular issue, of 599 shares or less 
regardless of the quantity offered at the BBO and automatically execute 
orders up to 1099 shares provided that order size does not exceed the 
BBO displayed quantity. If an order exceeds the specialist's auto-
execution threshold, the order is automatically directed into the 
specialist's book for manual execution, unless the order-sending firm 
has elected to receive partial automatic executions, in which case a 
portion of the order will automatically execute, up to the size of the 
auto-execution threshold, and the balance of the order will be placed 
in the specialist's book for manual execution.\7\ Significantly, under 
the current version of the CHX rules, manual execution generally does 
not excuse a specialist from his or her BEST Rule obligations; an order 
executed manually must be executed at the NBBO price up to the NBBO 
displayed quantity unless the specialist can demonstrate the existence 
of unusual trading conditions.\8\
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    \7\ See CHX Article XX, Rule 37(b)(6) and (7).
    \8\ The other exception to this rule occurs in the trading of 
Nasdaq/NM securities. CHX Article XX, Rule 43(d) provides that, when 
an order that is of a size less than or equal to the specialist's 
auto-execution threshold is not automatically executed, the 
specialist must either ``(1) manually execute such orders at the 
NBBO in existence when the order is received or better, or (2) act 
as agent for such orders in seeking to obtain the best available 
price for such orders on a marketplace other than the Exchange.''
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Issue
    Under the current version of the CHX rules, a CHX specialist has 
unlimited (and the CHX believes unwarranted) auto-execution exposure, 
because a rapid succession of orders entered into the MAX system at or 
below the specialist's auto-execution threshold are due an automatic 
fill at the prevailing NBBO price. For example, if a specialist set the 
auto-execution threshold as described in the preceding paragraph, and 
the NBBO was 600 shares offered at $30.00, the specialist would be 
obligated to automatically execute 10 500-share market orders to buy at 
$30.00 if those orders were rapidly sent by one or more customers while 
the NBBO remained unchanged. The specialist, who intended to offer 
price and liquidity equivalent to the best market, instead provided 
4400 additional shares of liquidity.
    The problem of providing more than the intended amount of liquidity 
through automatic executions has grown more acute since the conversion 
to decimal trading. The availability of liquidity at a price point has 
become a more significant factor in order routing decisions. While the 
quantity offered at the NBBO has generally declined since the 
conversion to decimals, this consequence can be easily avoided by 
rapidly submitting a succession of small orders eligible for automatic 
execution at the NBBO price to a CHX specialist. The specialist, if he 
chooses to offset the position in another market, however, will 
encounter the limited liquidity that drove the order sender to take 
advantage of the specialist's auto execution of orders and the 
liquidity it provides.
Proposal
    After careful consideration of the issue by the leaders of the CHX 
Listed Specialist Product Subcommittee, OTC Specialist Product 
Subcommittee, Rules Subcommittee and Committee on Floor Procedure, the 
CHX proposes amendment of Article XX, Rule 37 to address the foregoing 
issue. Specifically, the CHX believes that in today's decimal trading 
environment, where it is very difficult to find liquidity at the NBBO 
price point and the NBBO price is constantly ``flickering,'' it is 
appropriate for a specialist to limit his or her aggregate auto-
execution and BEST Rule liability to the then-current and accessible 
NBBO price and size. In other words, the specialist's auto-execution 
threshold would no longer constitute a guarantee of automatic execution 
of an unlimited number of orders at the NBBO price. CHX proposes below 
two principal changes to CHX Article XX, Rule 37, which CHX seeks to 
incorporate into its rules and which a specialist could elect to 
enable.
1. Changes to BEST Rule and Calculation of BBO
    Under the proposed revision to CHX Article XX, Rule 37(a), a CHX 
specialist would no longer be obligated to provide the NBBO price for 
every order accepted by the specialist. Instead, the proposed rule 
change incorporates revised standards for handling orders; these 
standards are taken directly from the Commission's order-handling 
rules.\9\ Under these revised standards, automatically executed orders 
must be executed at the ``BBO price'' or better.\10\ ``BBO price'' is 
defined in proposed Interpretation and Policy .10 to CHX Rule 37 as the 
best bid or offer disseminated by a national market participant 
reasonably accessible by the CHX. Specialists will continue to be 
obligated to manually execute all orders not eligible for automatic 
execution at a price equal to or better than the NBBO price at the time 
the order was received, or act as agent for the order in seeking the 
best-available price in the marketplace.\11\
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    \9\ See Order Execution Obligations Release, Securities Exchange 
Act Release No. 37619A (September 6, 1996), 61 FR 48290 (September 
12, 1996), which notes, among other things, that ``* * * the duty of 
best execution requires a broker-dealer to seek the most favorable 
terms reasonably available under the circumstances for a customer's 
transaction.'' Order Execution Obligations Release at 48322.
    \10\ The Exchange represents that this proposal, like the 
proposed change to the BEST Rule guarantee, is taken from the 
Commission's Order Handling Release. See Order Execution Obligations 
Release at 48323 (noting that quotations must be taken into account 
by broker-dealers if reasonably available).
    \11\ See Amendment No. 2, supra note 4. Importantly, the 
Commission has already approved this execution standard for the 
Exchange's rules that apply to the execution of orders in Nasdaq/NM 
securities. See CHX Article XX, Rule 43(d); Securities Exchange Act 
Release No. 37369 (June 25, 1996), 61 FR 34462 (July 2, 1996). This 
proposal, then, simply would extend this standard to the handling of 
orders in listed securities.
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    Significantly, the revised order-handling standards will continue 
to be subject to surveillance by the CHX Department of Market 
Regulation and

[[Page 57051]]

members will remain subject to discipline for violations of CHX Article 
XX, Rule 37(a). But the Exchange believes that the rule revision, 
particularly with a more realistic definition of BBO price, will permit 
specialists to meet their order handling obligations without being 
subject to BEST Rule guarantees that, according to the Exchange, are 
sometimes impossible to satisfy in today's post-decimalization 
environment.
2. Incorporation of Aggregate Share Threshold Into Automatic Execution 
Rules
    This second proposal would amend CHX Article XX, Rule 37(b) to 
limit a specialist's unintended automatic execution liability by 
incorporating an Aggregate Share Threshold into the specialist's 
designated auto-execution parameters. The Aggregate Share Threshold 
could be enabled by a specialist on an issue-by-issue basis. This 
functionality would be entirely optional, however, and a specialist 
could still elect to provide additional liquidity guarantees. Under 
this voluntary systems enhancement, the specialist would agree to auto-
execution (at the BBO price) of an aggregate number of shares (the 
``Aggregate Share Threshold''). Once an aggregate number of shares 
equal to the Aggregate Share Threshold was automatically executed, 
whether as a result of one order or numerous orders, subsequent orders 
would be directed into the specialist's book for manual execution. 
Under the proposed rule change, these subsequent orders would not 
necessarily be due a fill at the BBO price, but would be subject to the 
specialist's best execution obligation under revised Rule 37(a). The 
specialist could act as agent to obtain the best available price on a 
marketplace other than the Exchange or could voluntarily elect to fill 
the order at the BBO price. The Aggregate Share Threshold would reset 
after a prescribed amount of time designated by a specialist \12\ and 
could never be set at a level less than the shares included in the 
specialist's own bid or offer.
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    \12\ A specialist choosing to enable the Aggregate Share 
Threshold functionality would be required to provide CHX staff with 
the designated time increment for each issue. The time increment 
would commence (and restart) upon any change in the NBBO.
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    The following examples illustrate how the automatic executions 
would work. They assume that the specialist has set his or her 
Aggregate Share Threshold at a level equal to the size at the 
prevailing NBBO.

Example 1: NBBO is 2000 shares offered at 30.
    Specialist has designated Aggregate Share Threshold of 2000 shares.
    MAX accepts 5 500-share buy market orders.
Outcome: 4 orders executed automatically upon receipt at 30.
    1 order is directed into the specialist's book for manual 
execution.
Example 2: NBBO is 2000 shares offered at 30 at 12:00:00.
    Specialist has designated Aggregate Share Threshold of 2000 shares.
    The Aggregate Share Threshold is calibrated to reset after 15 
seconds
    MAX accepts 5 500 share buy market orders between 12:00 and 
12:00:15
    NBBO remains at 2000 shares offered at 30 at 12:00:15.
    MAX accepts 1 500-share buy market order at 12:00:17
    NBBO remains at 2000 shares offered at 30 at 12:00:17.
Outcome: 4 orders received between 12:00:00 and 12:00:15 execute 
automatically upon receipt.
    5th order received between 12:00:00 and 12:00:15 is directed into 
the specialist's book for manual execution.
    The 500-share buy market order received at 12:00:17 executes 
automatically upon receipt.
Example 3: NBBO is 2000 shares offered at 30 at 12:00:00
    Specialist has designated Aggregate Share Threshold of 2000 shares.
    The Aggregate Share Threshold is calibrated to reset upon a change 
in the NBBO.
    MAX accepts 5 500-share buy market orders between 12:00:00 and 
12:00:10.
    NBBO remains at 2000 shares offered at 30 at 12:00:10
    NBBO changes to 1000 shares offered at 30 at 12:00:11
    MAX accepts 2 500-share market buy orders at 12:00:12
    NBBO remains 1000 shares offered at 30 at 12:00:12.
Outcome: 4 orders received between 12:00:00 and 12:00:10 execute 
automatically upon receipt
    5th order received between 12:00:00 and 12:00:10 is directed into 
the specialist's book for manual execution
    2 500-share market buy orders received at 12:00:12 execute 
automatically upon receipt

    The CHX believes that these two proposed rule changes would be 
sufficient to address the unintended adverse consequences of current 
CHX rules relating to auto-execution liquidity and price guarantees. It 
is important to note that neither of the proposed changes would operate 
to discriminate against order-sending firms in any way; operation of 
these changes to the MAX system would be enabled on an issue-by-issue 
basis and would apply equally to all order-sending firms. Similarly, 
the Exchange believes that the intended outcome of the MAX changes 
would not have a disparate impact on any order-sending firm or class of 
firm.
    The CHX would further note that in today's market environment, 
where specialists are required to make public their quality-of-
execution statistics and broker-dealers are bound as fiduciaries to 
make order-routing decisions in accordance with best execution 
practices, there exist sufficient market-based incentives for 
specialists to continue to provide execution prices and liquidity akin 
to the best available in the national market. These incentives render a 
rule-based requirement largely obsolete, and amply support the rule 
changes proposed herein.
2. Statutory Basis
    The proposed rule is consistent with the requirements of the Act 
and the rules and regulations thereunder that are applicable to a 
national securities exchange, and, in particular, with the requirements 
of section 6(b) of the Act.\13\ In particular, the proposed rule is 
consistent with section 6(b)(5)\14\ in that it is designed to promote 
just and equitable principles of trade, to remove impediments and to 
perfect the mechanism of a free and open market and a national market 
system, and, in general, to protect investors and the public interest.
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    \13\ 15 U.S.C. 78f(b).
    \14\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement of Burden on Competition

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

C. Self-Regulatory Organization's Statement on Comments Regarding 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 other period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or

[[Page 57052]]

(ii) as to which he self-regulatory organization consents, the 
Commission will:
    (A) By order approve the 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 foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW, Washington DC 20549-0609. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying at the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
Exchange. All submissions should refer to File No. SR-CHX-2002-20 and 
should be submitted by September 27, 2002.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\15\
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    \15\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-22654 Filed 9-5-02; 8:45 am]
BILLING CODE 8010-01-P