[Federal Register Volume 67, Number 186 (Wednesday, September 25, 2002)]
[Notices]
[Pages 60267-60273]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-24293]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46514; File No. SR-ISE-2001-19]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval to 
Amendment No. 1 to the Proposed Rule Change by the International 
Securities Exchange LLC Relating to Facilitation of Customer Orders

September 18, 2002.

I. Introduction

    On May 30, 2001, the International Securities Exchange LLC (``ISE'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a 
proposed rule change to reduce the exposure time required for the 
facilitation of customer orders through the Exchange's Facilitation 
Mechanism from 30 seconds to five seconds. Notice of the proposed rule 
change was published for comment in the Federal Register on August 6, 
2001.\3\ The Commission received thirteen comment letters regarding the 
proposal \4\ and two letters from the ISE responding to the assertions 
of commenters who opposed its proposal.\5\ On January 3, 2002, the ISE 
filed Amendment No. 1 to the proposed rule change, amending the 
proposal to provide for an exposure period of 10 seconds.\6\ This order 
approves the proposed rule change, as amended, grants accelerated 
approval of Amendment No. 1, and solicits comments from interested 
persons on that amendment.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 44612 (July 27, 
2001), 66 FR 41074 (``Notice'').
    \4\ See letters to Jonathan G. Katz, Secretary, Commission, 
from: Joel Greenberg, Managing Director, Susquehanna International 
Group, LLP, dated August 16, 2001 (``Susquehanna Letter I''); Arthur 
Duquette, Senior Managing Director, Bear, Stearns & Co. Inc., dated 
August 24, 2001 (Bear Stearns Letter); Edward J. Joyce, President 
and Chief Operating Officer, Chicago Board Options Exchange, 
Incorporated (``CBOE''), dated August 27, 2001 (``CBOE Letter I''); 
Thomas N. McManus, Executive Director and Counsel, Morgan Stanley & 
Co. Incorporated, dated August 27, 2001 (``Morgan Stanley Letter''); 
Juan Carlos Pinilla, Managing Director, Equity Derivatives Group, 
J.P. Morgan Securities Inc., dated August 27, 2001 (``J.P. Morgan 
Letter''); Arthur S. Margulis, Jr., Managing Principal, Hull Trading 
Company, LLC, dated August 30, 2001 (``Hull Letter''); Michael J. 
Ryan, Executive Vice President and General Counsel, American Stock 
Exchange LLC (``Amex''), dated August 29, 2001 (``Amex Letter I''); 
Matthew D. Wayne, Chief Legal Officer, Knight Financial Products, 
LLC, dated September 14, 2001 (``Knight Letter''); Thomas A. Bond, 
Chief Operating Officer, Lee E. Tenzer Trading Company, dated 
November 9, 2001 (``Letco Letter''); Edward J. Joyce, President and 
Chief Operating Officer, CBOE, dated November 14, 2001 (``CBOE 
Letter II''); Edward J. Joyce, President and Chief Operating 
Officer, CBOE, dated February 25, 2002 (``CBOE Letter III''); Gerald 
D. O'Connell, Associate Director, Susquehanna International Group, 
LLP, dated March 6, 2002 (``Susquehanna Letter II''); and Michael J. 
Ryan, Executive Vice President and General Counsel, Amex, dated 
April 17, 2002 (``Amex Letter II'').
    \5\ See letters from Michael Simon, Senior Vice President and 
Secretary, ISE, to Jonathan G. Katz, Secretary, Commission, dated 
September 25, 2001, and October 5, 2001 (``ISE Letter I'' and ``ISE 
Letter II,'' respectively).
    \6\ See letter from Michael Simon, Senior Vice President and 
General Counsel, ISE, to Nancy Sanow, Assistant Director, 
Commission, dated January 2, 2002.
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II. Description of the Proposal

    ISE rules provide that an Electronic Access Member (``EAM'') 
generally may not trade as principal against an order of a customer 
that it is representing as an agent unless the EAM: (1) Enters the 
customer order into the market and waits at least 30 seconds before 
entering its counter proprietary order; (2) has been bidding or 
offering on the Exchange on behalf of its proprietary account at least 
30 seconds prior to receiving the customer order; or (3) makes use of 
the Exchange's ``Facilitation Mechanism.'' \7\
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    \7\ ISE Rule 717(d). To use the Facilitation Mechanism, an EAM 
must be willing to facilitate the entire size of the customer order. 
See ISE Rule 716(d).
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    When an EAM enters a customer order into this Facilitation 
Mechanism, a broadcast message alerts members of the Exchange's 
electronic ``crowd''--market makers and other members with proprietary 
orders in the relevant series at the inside bid or offer on the ISE 
trading system--to the size and price of the proposed facilitation. 
Crowd participants may indicate within a given time period (currently 
30 seconds) whether they want to participate in the facilitation of the 
customer order at the proposed facilitation price. Crowd participants 
may also indicate that they are willing to participate in the 
facilitation of the customer order at a price better than the proposed 
facilitation price. If, however, this better

[[Page 60268]]

price is equal to or better than the ISE best bid or offer, the crowd 
participant must indicate its willingness to participate in the 
facilitation of the customer order by entering an order or changing its 
quote on the Exchange's trading system, not through the Facilitation 
Mechanism.
    Public customer orders that have been entered on the Exchange's 
trading system that are priced equal to or better than the facilitation 
price have priority, and are given the right to trade against the 
customer order being facilitated at the facilitation price. After any 
such public customer orders have been satisfied, the EAM is entitled to 
trade against 40% of the original size of the customer order being 
facilitated. Any responses at the facilitation price entered by crowd 
participants through the Facilitation Mechanism, or other orders and 
quotes at the facilitation price entered on the Exchange's trading 
system by crowd participants or other ISE members, share in the 
remainder of the order being facilitated proportionally according to 
the size they have indicated.
    If, however, any crowd participants have indicated a willingness to 
participate at a price that improves upon the facilitation price--
through the Facilitation Mechanism where appropriate, or by entering 
orders or changing their quotes on the Exchange--they take priority 
over the EAM. In addition, any other ISE members that have entered 
orders on the Exchange that are superior to the facilitation price 
similarly take priority over the EAM.\8\
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    \8\ When orders and quotes improve upon the proposed 
facilitation price but cannot fill the entire order being 
facilitated, customers participate at the facilitation price, while 
non-customers trade at the improved price to which they committed.
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    Under the ISE's current rules, the electronic crowd is given 30 
seconds to respond. Moreover, to indicate a willingness to facilitate 
an order at an improved price that is equal to or better than the best 
bid or offer on the Exchange, a crowd participant must change its quote 
or order at least 10 seconds before the end of this exposure period. 
The ISE now proposes to amend its rules to reduce the exposure period 
from 30 seconds to 10 seconds. The proposed rule change would also 
eliminate as unnecessary the requirement that, to improve the 
facilitation price at a price equal to or better than the ISE best bid 
or offer, a member must change its quotation or enter an order at least 
10 seconds prior to the expiration of the exposure period.
    In explaining the purpose of its proposal, the ISE states that the 
Facilitation Mechanism has failed to capture significant facilitation 
order flow. The ISE further states that its members explain that the 
current 30-second exposure requirement is a primary reason why they do 
not use this mechanism. The Exchange maintains that the rules of other, 
floor-based options exchanges permit a member to facilitate a customer 
order by taking it to the floor, exposing it for an instant by 
announcing it to the trading crowd, and then immediately trading 
against a guaranteed percentage of the order.\9\ Thus, the ISE argues, 
a reduction of the exposure period on its own Facilitation Mechanism is 
necessary to allow it to compete on an equal footing with other 
exchanges to attract facilitation order flow.
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    \9\ See Commentary .02 to Rule 950(d) of the American Stock 
Exchange (``Amex''), Rule 6.74(d) of the CBOE, and Rule 6.47(b)(4) 
of the Pacific Exchange (``PCX''), which, under certain conditions, 
guarantee a firm sending a customer's order to the exchange floor a 
participation right of 20% in that order (25% on the PCX) when the 
firm matches the best price given by the crowd in response to the 
floor broker's initial request for a market, and 40% when it 
improves upon the crowd's price. As detailed below, commenters 
opposed to the ISE proposal dispute the ISE's description of the 
exposure period and facilitation process on these exchanges. See 
infra notes 30-33 and accompanying text.
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    The ISE believes that this shortened exposure period would be fully 
consistent with the electronic nature of its trading system. According 
to the Exchange, ISE members have implemented, or have the ability to 
implement, systems that monitor the Facilitation Mechanism broadcast 
messages and can automatically respond based upon pre-set parameters. 
In this electronic environment, the Exchange states, it is not 
necessary to provide an exposure time sufficiently long to permit a 
person, in all cases, to manually respond to a facilitation broadcast 
in order to provide the opportunity for crowd interaction. Thus, the 
Exchange believes that an exposure period of ten seconds would permit 
exposure of orders on the ISE in a manner consistent with its 
electronic market while addressing the Exchange's competitive concerns.

III. Summary of Comments

    In the Notice, the Commission solicited views generally from 
interested persons on any aspect of the proposed rule change. In 
addition, the Commission requested that commenters express their views 
on: (1) Whether electronic programs or systems are available that would 
enable ISE members to monitor the Facilitation Mechanism broadcast 
messages and automatically respond based upon pre-set parameters, such 
that a five-second exposure period \10\ would provide adequate time for 
crowd members to interact with an order before it is executed by the 
EAM; and (2) whether the manner in which orders are exposed and 
executed through the Facilitation Mechanism under the proposed rule 
change would be comparable to the manner in which orders subject to 
facilitation are exposed and executed on floor-based exchanges.
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    \10\ The question in the Notice referred to the five-second 
exposure period proposed in the original version of the proposed 
rule change.
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    The Commission received thirteen comment letters concerning the ISE 
proposal, expressing the views of five commenters opposed to,\11\ and 
four commenters supportive of,\12\ the proposed rule change. Many of 
the commenters addressed specifically the questions noted above. In 
addition, the ISE submitted two letters responding to the arguments of 
those who opposed the proposal.\13\
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    \11\ See Amex Letters I and II; CBOE Letters I, II, and III; 
Knight Letter; Letco Letter; and Susquehanna Letters I and II.
    \12\ See Bear Stearns Letter; Hull Letter; J.P. Morgan Letter; 
Morgan Stanley Letter.
    \13\ See supra note .
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A. Comments Opposing the Proposal

    In general, five commenters believed that a shortened response 
period would not allow enough time for members of the electronic 
trading crowd to respond to a facilitation broadcast and thus would 
defeat the notion of an auction market.\14\
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    \14\ See supra note .
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    These commenters argued that specialists and market makers could 
not possibly respond with informed and careful judgment within such a 
shortened exposure period. They noted that crowd participants need time 
to assess their positions, market conditions, pricing analytics, and 
risk to be able to react to an order appropriately.\15\ Some further 
noted that the EAM that submitted the facilitation broadcast, with whom 
these crowd participants must compete, likely has had knowledge of the 
order for a considerable amount of time--particularly in the case of an 
institutional customer order.\16\
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    \15\ See, e.g., Susquehanna Letters I and II; CBOE Letter II.
    \16\ Knight Letter; Letco Letter.
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    Because these commenters contend that the trading crowd would be 
unable to respond to facilitation broadcasts within the proposed time 
frame, they conclude that EAMs would be able to trade with a 
significant share of their customers' orders. In the words of one 
commenter, the ISE would become a

[[Page 60269]]

``crossing exchange'' providing EAMs with ``unfettered rights for 
internalization,'' enabling them to trade against up to 100% of a 
customer order.\17\ Customers would be harmed, because their orders 
would not receive opportunity for price improvement.\18\ Liquidity 
providers--specialists and market makers--would also be highly 
disadvantaged.\19\
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    \17\ Knight Letter.
    \18\ Amex Letters I and II; CBOE Letters I, II, and III; Knight 
Letter; Susquehanna Letters I and II.
    \19\ Knight Letter. Some commenters add that even existing ISE 
rules governing the Facilitation Mechanism are ``not sufficient to 
provide facilitated orders with meaningful opportunities for order 
interaction and price improvement,'' see CBOE Letter II, and 
``facilitate the transformation of the ISE to an internalization and 
crossing exchange.'' Susquehanna Letter I.
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    Moreover, one commenter argued that the marketplace as a whole 
would be impaired because the proposed rule change would result in EAMs 
taking an increasingly large share of orders, particularly the large 
institutional orders that represent a substantial percentage of the 
market.\20\ This commenter believed that, as a result, no purpose would 
remain for market participants to act as liquidity providers, and ``the 
order flow providers [would] become the market and the pricing process 
[would be] determined in a non-competitive manner by the order flow 
providers.''\21\
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    \20\ Knight Letter. According to the Knight Letter, ``Although 
it is difficult to state with certainty what percentage of national 
options order flow is represented by institutions, [Knight Financial 
Products] estimates that the figure may very well be approximately 
50%.'' Id.
    \21\ Id.
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    Some commenters also took issue with the ISE's argument that, in 
its electronic environment, members have implemented, or have the 
ability to implement, systems that monitor the Facilitation Mechanism 
and can automatically respond to broadcasts based upon pre-set 
parameters.\22\ One commenter drew the conclusion that most ISE members 
in fact do not currently have automatic response systems in place,\23\ 
and stated that its own ``informal discussions with market participants 
confirm that developing such systems is a complex, expensive 
undertaking that many ISE members have not begun and indeed may not 
begin for quite some time.''\24\
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    \22\ CBOE Letters I and II; Susquehanna Letter I.
    \23\ CBOE Letter I.
    \24\ CBOE Letter II.
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    Several commenters contended that reducing the exposure period as 
proposed would exclude persons who do not have this kind of response 
capacity or whose systems prove to be inadequate.\25\ One commenter 
declared that the proposal would ``unfairly discriminate against the 
many market participants who are unable to automatically reply to ISE 
broadcast messages.''\26\
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    \25\ CBOE Letters I and II; Letco Letter; Susquehanna Letter I.
    \26\ CBOE Letter I.
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    Some opponents of the proposal added that pre-set parameter systems 
are ``unlikely to offer price improvement, as they would inevitably be 
conservative due to the large amount of risk associated with block size 
orders and the fact that market and hedging conditions are different 
for each trade.''\27\ Computer-generated responses, they believe, ``are 
far less likely to offer price improvement than if sufficient time is 
allowed for the human beings who did the programming to be able to take 
a ``fresh look'' and have a chance to revise their opinions about the 
options and/or underlying stock.''\28\ Moreover, one commenter 
maintained, even those ISE members who confirm that they can implement 
their systems to respond within a reduced exposure period cannot 
confirm that they will.\29\
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    \27\ Susquehanna Letter I, also quoted in CBOE Letter II.
    \28\ CBOE Letter II.
    \29\ Id.
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    Commenters also challenged as ``erroneous and overly simplistic'' 
the ISE's contention that the rules of floor-based exchanges permit a 
member to facilitate a customer order by taking it to the floor, 
exposing it for an instant, and then immediately trading against a 
guaranteed portion of the order.\30\ These commenters maintain that the 
rules of floor-based exchanges, which require that crowd members be 
given adequate opportunity to react to an order that a floor broker 
hopes to facilitate--and the assessment, analysis, and human 
interactive process that is necessary for them to exercise that 
opportunity--often demand that a facilitation transaction take at least 
30 seconds \31\ and can sometimes take as long as a minute \32\ or more 
\33\ to conclude.
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    \30\ Susquehanna Letter I. See also CBOE Letters I and II; Amex 
Letters I and II; Knight Letter; Letco Letter.
    \31\ Knight Letter.
    \32\ CBOE Letter II. See also Amex Letter II, stating that the 
facilitation process ``typically, will take a minute or more to 
complete.''
    \33\ See Amex Letter I, stating that more complex facilitation 
orders in some cases can take several minutes.
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    One commenter further contended that the rules of the ISE should 
not always mirror the rules of floor-based exchanges, in any case.\34\ 
An electronic market, it argued, does not include the physical 
proximity that enables all members of a trading crowd to see each 
other, communicate through open outcry, and participate in the market 
instantaneously, and thus holds greater risks that any particular order 
will not be exposed to a large enough group of other market 
participants to realize price improvement.
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    \34\ CBOE Letter I.
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    Some commenters added that a shortened exposure period would 
exacerbate the effect of another provision in ISE's rules, which 
restricts the composition of the electronic crowd that receives 
Facilitation Mechanism broadcasts to market makers and EAMs with 
proprietary quotations at the ISE's inside bid or offer.\35\ In their 
view, this provision also limits price competition and encourages 
internalization.
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    \35\ See, e.g., Susquehanna Letter I. Susquehanna Letter I also 
included a request that the Commission reconsider its approval of 
the ISE provision governing composition of the trading crowd.
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    One commenter argued that the proposed rule change would undermine 
the goal of greater linkage among options markets because traders on 
other exchanges would not even learn of pending trades at the ISE, much 
less have the chance to offer price improvement, before the exposure 
period would elapse.\36\
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    \36\ CBOE Letter I. See also Amex Letter II.
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    Three commenters provided additional comments after the filing of 
Amendment No. 1 to the proposal to provide for an exposure period of 10 
seconds rather than five seconds.\37\ Two of these commenters 
maintained that the amendment did not in any way alleviate the concerns 
they voiced with respect to the initial proposal.\38\ The third 
commenter viewed the amendment as an admission that five seconds was 
too short an exposure period, and continued to maintain that a 
reduction from 30 seconds was unwarranted.\39\ All three commenters 
reiterated the contention that the proposal would allow the ISE to 
become a vehicle for internalization. Two of these commenters 
elaborated on the argument that neither five nor 10 seconds would 
suffice for crowd members to respond to a facilitation broadcast in 
view of the assessment of conditions and risk they must make to be able 
to do so.\40\ These commenters

[[Page 60270]]

further argued that, because the Commission has not approved proposals 
by other, floor-based exchanges to permit participation rights in more 
than 40% of an order to any market participant, Commission approval of 
the ISE proposal would result in disparate treatment of the ISE and the 
floor-based exchanges, and, in the words of one commenter, ``unequal 
regulation.''\41\
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    \37\ Amex Letter II; CBOE Letter III; and Susquehanna Letter II.
    \38\ CBOE Letter III and Susquehanna Letter II.
    \39\ Amex Letter II.
    \40\ For instance, one commenter maintained that when the ISE 
adopted, in 2001, its rule that bars anticipatory hedging by a firm 
before it discloses a facilitation order to the crowd, the Exchange 
``stated that crowd participants be able (sic) to participate in the 
execution of orders at equally favorable terms as the member 
representing the order,'' and thereby acknowledged that members of 
the electronic crowd need time to assess the availability of hedging 
stock before they can act on a facilitation broadcast. See 
Susquehanna Letter II. See also Securities Act Exchange Release No. 
44208 (April 20, 2001), 66 FR 21423 (April 30, 2001) (Order 
approving Supplementary Material .02 to ISE Rule 400 (Just and 
Equitable Principals of Trade)).
    \41\ Susquehanna Letter II.
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    One of these commenters further expanded on the reasons why, in its 
view, a 10-second exposure period is inadequate to allow for price 
improvement of orders that a firm proposes to facilitate.\42\ This 
commenter identified a ``probe phase'' that is part of the process of 
crossing an order on a floor-based exchange, during which time, in the 
commenter's description, the broker ``works'' the order for a 
considerable period before the cross order is bid and offered and can 
obtain significant price improvement for the customer.\43\ Absent the 
equivalent of this probe phase to ``work'' the order prior to the 10-
second bid-offer process, this commenter argues, the ISE proposal would 
allow an increased number of facilitation crosses to be transacted on 
the Exchange at biased prices, to the detriment of customers.
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    \42\ Id.
    \43\ According to this commenter, a broker who proposes a 
``biased cross''--that is, a cross at a price that is away from the 
midpoint of the bid-ask spread or attempted during a volatile 
market--will usually encounter significant trading interest from the 
crowd and a high potential for price improvement for the customer's 
order, and will invariably need to grant additional time to the 
crowd to assess conditions and give improved prices. Therefore, this 
commenter argues, ``a broker will generally not even attempt to 
execute biased crosses without first probing the market by asking 
for a size market before attempting to bid and offer the cross,'' so 
that all sources of liquidity in the crowd are aware that liquidity 
is being sought, and ``everyone will have an opportunity to make a 
competitive quote at the onset.''
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    One commenter raised the issue of best execution, stating that, 
absent a step-up requirement of the options linkage plan, if a 
significant portion of options order flow is internalized, firms would 
need to address how they would comply with their best execution 
duties.\44\
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    \44\ See Amex Letter II.
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B. Comments Supporting the Proposal

    The four commenters supporting the proposal, all member firms of 
the ISE,\45\ believe that, contrary to the opinion of opponents, the 
shortened exposure period would still leave ample time for electronic 
crowd participants on the ISE to respond to facilitation broadcasts.
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    \45\ See supra note 12.
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    These commenters responded affirmatively to the question of whether 
electronic systems are available that would enable ISE members to 
monitor facilitation broadcasts and automatically respond based upon 
pre-set parameters.\46\ One commenter stated that, although it does not 
currently have a system that responds automatically, five seconds is 
more than adequate for its traders to react to facilitation broadcasts, 
which are highlighted by its custom software.\47\ This commenter added 
that automation is possible in the near future, and remarked that while 
it would likely develop a response functionality on its own, it is 
certain that such functionality could also be made available by 
software providers. Another commenter stated that it already employs an 
electronic system in its market making capacity that responds to 
facilitation broadcasts based on pre-set parameters, in an average of 
less than one second.\48\ It added that it understands anecdotally that 
other ISE market makers utilize similar systems. A third commenter 
stated that it understands that ISE members have, or are capable of 
building, electronic vehicles to respond with pre-programmed 
instructions.\49\ The fourth commenter stated that its systems can 
easily be adapted to monitor broadcasts and respond within five 
seconds, and that it believes that other ISE members have similar 
capabilities.\50\
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    \46\ Bear Stearns Letter; Hull Letter; J.P. Morgan Letter; 
Morgan Stanley Letter.
    \47\ Bear Stearns Letter.
    \48\ Morgan Stanley Letter.
    \49\ J.P. Morgan Letter.
    \50\ Hull Letter.
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    Supporters of the proposal further expressed the view that an 
electronic market should not be limited by the kinds of time 
considerations that may apply on floor-based exchanges. ``In the 
Internet age,'' wrote one commenter, ``time is no longer measured in 
seconds. Our proprietary systems are programmed to perform critical 
functions within a fraction of a second. Ability to respond manually is 
not the relevant benchmark in an all-electronic marketplace, where five 
seconds does give the crowd a meaningful opportunity to interact and 
price improve.''\51\
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    \51\ Hull Letter. See also J.P. Morgan Letter, arguing that the 
proposal would limit risk, and that ISE members have or can build 
electronic systems to read and respond to facilitation broadcasts 
with pre-programmed instructions. In sum, the J.P. Morgan Letter 
declares: ``This is the essence of an electronic market[.]''
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    Three of the supporters of the proposal wrote that use of the 
Facilitation Mechanism on the ISE, with its current 30-second response 
period, is not a viable alternative for them on this electronic 
exchange, because its duration--in the words of one, an ``eternity'' in 
today's marketplace \52\--exposes them to significant risk that the 
market will have significantly moved by the time the facilitation 
transaction is executed.\53\ These commenters maintained--in contrast 
to the assertion of some opponents of the proposal--that because there 
is by rule no minimum exposure time on floor-based exchanges, 
facilitation on those exchanges often takes substantially less than 30 
seconds,\54\ and, in the words of one, is typically a ``nearly 
instantaneous'' process.\55\ This is a primary reason, these firms 
indicated, that ISE members take their facilitation trades to other 
options exchanges. All three commenters believe that the proposed rule 
change would enable the ISE to compete on a more equal footing with the 
floor-based exchanges to attract order flow.
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    \52\ J.P. Morgan Letter.
    \53\ Hull Letter; J.P. Morgan Letter; Morgan Stanley Letter. The 
Morgan Stanley Letter also cited risk to the client. See, on the 
other hand, CBOE Letter II, which questioned the risk to the EAM, 
``particularly in light of the fact that, as several of the comment 
letters confirmed, floor-based exchanges typically take 30 seconds 
or more to complete a facilitation order,'' and maintained that any 
market risk to the client is more than offset by the potential price 
improvement that may occur in a 30-second period.
    \54\ Hull Letter.
    \55\ See Morgan Stanley Letter, which expressly factors in the 
time it takes for crowd members to respond to the announcement of 
the facilitation. See also J.P. Morgan Letter, describing the 
execution of the order as ``instantaneous'' after the announcement 
of the proposed facilitation at the floor post.
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    Some commenters indicated that the proposed rule change would 
increase the opportunities for market making firms to respond to 
proposed facilitations and interact with customer orders, thus 
benefiting investors. As one explained, it does not currently reply to 
proposed facilitation crosses on floor-based exchanges because it is 
not physically present at every trading post where it makes markets 
electronically.\56\ In general, supportive commenters wrote, the 
proposed rule change would benefit customers by allowing for more

[[Page 60271]]

flexibility and efficiency in the handling of customer orders, and 
acting as an incentive for crowd participants to compete based on price 
and to commit additional liquidity.\57\
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    \56\ Bear Stearns Letter. See also Morgan Stanley Letter.
    \57\ Hull Letter; J.P. Morgan Letter.
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C. ISE's Responses

    The ISE submitted two letters responding to various arguments and 
factual assertions of commenters opposing the proposal.\58\ In its 
first letter, the ISE insisted that any comparison of the exposure 
period for facilitated orders on floor-based exchanges and on 
electronic markets should focus solely on the time that it takes to 
execute an order once it is exposed to the crowd, not the time it takes 
to bring it to the floor.\59\ On a floor-based exchange, the ISE 
maintained again, the execution can be instantaneous, while on its own 
electronic market, the mandatory exposure period is currently 30 
seconds, putting the Exchange at a competitive disadvantage.
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    \58\ See supra note 5.
    \59\ ISE Letter I. The ISE was taking issue with the point made 
by one opposing commenter, who argued that even just the preliminary 
processing of a facilitation cross on a floor-based exchange--in 
which a customer order is first related by telephone to a floor 
brokerage booth together with a contra-side facilitation order, the 
order tickets are next prepared, and then the orders are walked over 
to the trading crowd--may often take more than 30 seconds.
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    The purpose of the exposure period, the ISE argued, is to allow 
customer orders the opportunity to receive price improvement, as well 
as to give liquidity providers the opportunity to participate in 
facilitation trades. The Exchange maintained that the comments of ISE 
market makers in support of the proposed rule change demonstrate that 
crowd participants will, in fact, be able to respond within a shortened 
period and that the proposal will enhance competition for customer 
orders.
    The ISE further responded to the objection that not all ISE members 
are included in the trading crowd that receives facilitation 
broadcasts, and that, hence, competition is already hampered. The ISE 
argued that it should not be obligated to provide competing market 
makers from other exchanges unrestricted opportunity to participate in 
its trading crowds. It further maintained that, in fact, the Exchange's 
members have more opportunity to participate in a crowd than at a 
floor-based exchange, where a member must be physically at the post to 
participate.\60\
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    \60\ In this regard, the ISE noted that it provides access to 
EAMs in its order routing and execution systems and includes them in 
an electronic crowd when they are quoting for their proprietary 
accounts at the Exchange's best bid or offer.
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    In its second letter, the ISE responded to the contention of a 
commenter that the discussions generated in a floor-based auction forum 
generally require a longer time period to complete the price discovery 
process than the ISE's proposed exposure period, and do not allow for 
instant facilitation as the ISE claims.\61\ The ISE countered that 
because its own exchange is an electronic marketplace, it includes no 
such discussions, and because participants instead rely on 
sophisticated technology, they can respond within a shortened period to 
interact with order flow.\62\
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    \61\ ISE Letter II.
    \62\ The ISE also noted the statement by this same commenter 
that in the discussions in floor-based auction forums, many order 
flow provider firms place undue pressure on trading crowds to permit 
them to effect facilitation crosses, notwithstanding rules that 
prohibit intimidation in the marketplace. This statement, the ISE 
maintained, confirms that it is at a competitive disadvantage, 
because its own electronic system assures compliance with the 
participation rules.
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IV. Discussion

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the provisions of the Act 
applicable to a national securities exchange, particularly those of 
Section 6(b)(5) \63\ and Section 6(b)(8) \64\ of the Act, and the rules 
and regulations thereunder.\65\ Specifically, the Commission believes 
that, in the ISE's fully automated market, a 10-second response period 
will afford electronic crowds sufficient time to compete for customer 
orders submitted by an EAM into the Exchange's Facilitation Mechanism, 
thereby promoting just and equitable principles of trade, protecting 
investors and the public interest, and not imposing any burden on 
competition.
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    \63\ 15 U.S.C. 78f(b)(5). Section 6(b)(5) requires that the 
rules of a national securities exchange be designed to, among other 
things, promote just and equitable principles of trade, remove 
impediments to and perfect the mechanism of a free and open market, 
and, in general, to protect investors and the public interest. It 
also requires that those rules not be designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers.
    \64\ 15 U.S.C. 78f(b)(8). Section 6(b)(8) requires that the 
rules of the exchange not impose any burden on competition not 
necessary or appropriate in furtherance of the purposes of the Act.
    \65\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
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    In assessing the ISE proposal, the Commission concurs with the view 
of one commenter, who stated that the Commission ``should apply the 
same standard to the ISE's Facilitation Mechanism (including the length 
of the exposure period) as it applies to the floor-based exchanges' 
rules--specifically, does the trading crowd have a meaningful 
opportunity to interact with the facilitation order and to provide 
price improvement.'' \66\
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    \66\ Hull Letter.
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    Although several commenters emphasized that on floor-based 
exchanges, trading crowds are given at least 30 seconds, if they so 
require--and sometimes longer--to respond to a customer order subject 
to facilitation, the Commission believes that this comparison is 
irrelevant in considering the ISE proposal. Instead, the critical issue 
in determining whether to approve the ISE's proposed rule change is 
this: Does an exposure period of ten seconds, within the ISE's own 
model, give an electronic crowd sufficient time to respond to a 
facilitation broadcast to compete with the EAM and provide price 
improvement for customer orders?
    In responding to this inquiry, the Commission believes that the 
timeframes necessary for exposure and execution of orders be adjudged 
in light of that marketplace's model. For this reason, the Commission 
does not believe that a fully automated market such as the ISE should 
be tied to timeframes relevant to the procedures of a floor-based 
exchange, notwithstanding that the procedures and the nature of the 
human interactive process on a floor-based exchange may have advantages 
of their own. Unlike floor-based exchanges, where there is significant 
human interaction in each trading crowd with respect to the handling of 
orders, the ISE is a wholly automated marketplace where crowd members 
interact by electronic means. Thus, the Commission must consider 
whether electronic systems are readily available to ISE members that 
would allow them to respond to facilitation broadcasts in a meaningful 
way within the proposed timeframe.
    The comment letters from four ISE member firms, as well as the 
Commission's own inquiry into available technology, indicating that 
such systems are indeed available, if not already in place--and that 
they can be obtained from vendors, if not developed by a firm on its 
own--persuade the Commission that a ten-second exposure period will 
provide adequate opportunity for crowd participants in an electronic 
environment to compete with an EAM for its customer orders. Because all 
ISE members will have the opportunity to develop or avail themselves of 
such systems, the Commission does not agree that the proposal would 
constitute unfair discrimination against market participants who are 
presently unable to

[[Page 60272]]

reply to ISE broadcast messages automatically.\67\
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    \67\ As discussed at supra note 35 and accompanying text, some 
commenters have argued that the ISE unnecessarily restricts the 
universe of crowd participants who can respond to a facilitation 
broadcast to ISE market makers and EAMs at the inside bid or offer. 
The Commission has previously found that the composition of trading 
crowds as defined in the ISE's rules is consistent with the Act, and 
believes it unnecessary to revisit this issue at this time. See 
Securities Exchange Act Release No. 42455 (February 24, 2000), 65 FR 
11388 (March 2, 2000).
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    In addition, some commenters have argued that even if electronic 
monitoring and response systems are available, market makers would not 
necessarily use them. Some commenters further believe that automatic, 
pre-programmed competition, even when used, would result in more 
conservative responses than the competition of trading crowd 
participants reacting live on a floor-based exchange. The Commission 
believes that, given the competitive capabilities and built-in 
efficiencies that an automatic system could afford, and, in general, 
considering the nature of pricing in a derivative marketplace, such 
predictions are at best speculative. Many of the factors that govern 
options pricing are objective, keyed off of and limited by the price of 
the underlying security. In the areas where parameters can be adjusted 
to anticipate or create pricing differentials, areas that require human 
input, estimation, and anticipation, a firm may be tempted to be 
conservative. However, as in any market, a firm that is conservative in 
its pre-programmed responses runs the risk of being shut out completely 
from the trading by the quotes of more aggressive competitors.
    Moreover, in considering the various proposals by the options 
exchanges to permit greater internalization of orders, the Commission 
believes the relevant inquiry is whether market makers have a fair 
opportunity and incentive to compete on an equal basis to trade with 
orders brought to the exchange, not whether--given that opportunity--
they choose to avail themselves of it.\68\
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    \68\ One commenter argued that the ISE's proposal would 
undermine linkage among the options markets because traders on other 
exchanges would not be able to participate in trades by offering 
price improvement within the 10-second exposure period. See supra 
note and accompanying text. The Commission notes, however, that the 
goal of linkage is to preclude the execution of a customer order on 
one exchange at price inferior to the best price currently 
disseminated by another exchange. Linkage will not allow non-members 
of an exchange to participate in the auction process of the exchange 
where the customer order is brought for execution.
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    Several commenters correctly noted that the Commission is keenly 
concerned about the issues raised by internalization in the options 
markets, and has been particularly vigilant with respect to proposed 
rule changes that would permit broker-dealers to internalize their 
customers' orders in a manner that could interfere with order 
interaction and discourage the display of aggressively-priced 
quotations. Indeed, the Commission is disinclined to approve not only 
those proposals by options exchanges that would guarantee broker-
dealers the ability to internalize a significant portion of their own 
customers' orders, but also those proposed rule changes that would 
guarantee a large percentage of each customer order to any market 
participant. The Commission's concern with such proposals is that they 
may lock away so much of each order that crowd members will no longer 
have an incentive to compete.
    The Commission believes, however, that the ability of market makers 
on the ISE to electronically monitor for facilitation broadcasts, and 
to program competitive responses based on pre-set parameters, 
undermines the assertion by these commenters that the proposed rule 
change would enable EAMs on the ISE to internalize up to 100% of their 
orders. Accordingly, the Commission does not agree that the ISE's 
proposed rule change is analogous to other proposals that would 
guarantee to certain market participants large percentages of each 
order.\69\ Moreover, the Commission believes that one important 
difference between the ISE's market and, in particular, its 
Facilitation Mechanism, and floor-based markets is that the ISE's 
trading crowd does not know the identity of the EAM seeking to 
facilitate its customer's order. Accordingly, the automated, non-
personal nature of ISE's market provides no opportunity for agreements 
between the facilitating firm and the trading crowd whereby, for 
example, the trading crowd agrees not to break up a firm's proposed 
facilitations in exchange for that firm's agreement to bring order flow 
to the exchange.
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    \69\ Further, the Commission does not accept the contention of 
some commenters that even under existing rules, the ISE's 
Facilitation Mechanism does not allow meaningful opportunities for 
order interaction and price improvement and facilitates the 
transformation of the ISE to an internalization and crossing 
exchange. See supra note 19. The Commission has examined data 
provided by the ISE that, in its view, substantially refute this 
contention. One set of these data indicates that, over the six-month 
period from April through September 2001, facilitation trades 
represented only 3.12% of the volume on the Exchange. Another set of 
these data, compiled for the period from August through November 
2001, indicates that market makers on the ISE are participating in 
trades submitted by EAMs through the Facilitation Mechanism. These 
data show that market makers traded with 33.4%, 43.4%, 24.0%, and 
37.2% of the facilitation volume on the ISE, respectively, in each 
of the four months in this period.
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    When an EAM on the ISE broadcasts its intention to facilitate a 
customer order and crowd members respond at a price that matches the 
EAM's price, an EAM is guaranteed only 40% of the order, a 
participation percentage the Commission found to be consistent with the 
Act in its initial approval of the ISE as a national securities 
exchange.\70\ Moreover, if crowd members improve upon the facilitation 
price for the entire size of the order, the EAM will receive nothing. 
Thus, approval of the ISE proposal will in no way signify ``disparate 
treatment'' or ``unequal regulation'' of exchanges.
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    \70\ See Securities Exchange Act Release No. 42455 (February 24, 
2000), 65 FR 11388 (March 2, 2000).
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    Further, the Commission notes that, although it agrees with the 
assertion of commenters that market makers must compete with an EAM who 
may have had knowledge of the order for a considerable amount of time 
before submitting the facilitation broadcast,\71\ this potential 
advantage to the facilitating firm exists in all facilitation 
transactions, including those executed on floor-based exchanges.\72\
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    \71\ See supra note and accompanying text.
    \72\ See supra note . The Commission notes that the ISE rule 
against anticipatory hedging, see supra note 40, is similar to 
longstanding rules of this kind on all the other options exchanges, 
and was adopted by the Exchange at the Commission staff's urging 
after a market participant raised the concern that the ISE's rules, 
too, should contain such a provision. See generally Amex Rule 
950(d), Commentary .04; CBOE Rule 6.9(e); Philadelphia Stock 
Exchange Rule 1064(d); and PCX Rule 6.49(b). These rules against 
anticipatory hedging generally state that it may be considered 
conduct inconsistent with just and equitable principles of trade for 
any member or associated person who has knowledge of all material 
terms and conditions of orders being crossed, an order being 
facilitated, or an order and a solicited order--the execution of 
which are imminent--to enter an order to buy or sell an option for 
the same underlying security or a related instrument until the terms 
of the order of which the member or associated person has knowledge 
have been disclosed to the trading crowd or the trade can no longer 
be considered imminent. These provisions were originally developed 
in the context of similar rules designed to prevent frontrunning of 
block transactions, and were conceived to preclude a member or 
associated person from using undisclosed information about an 
imminent cross, facilitation, or solicitation transactions in one 
option from trading a relevant option or other related instrument in 
advance of persons represented in the relevant option crowd. See 
Securities Exchange Release Act No. 34959 (November 9, 1994), 59 FR 
59446 (November 17, 1994) (concerning the CBOE rule), also cited in 
Securities Exchange Release Act Nos. 42894 (June 2, 2000), 65 FR 
36850 (June 12, 2000) (concerning approval of the Amex rule), and 
44150 (April 4, 2001), 66 FR 19271 (April 13, 2001) (concerning the 
PCX rule). While the rule against anticipatory hedging may also 
result in giving crowd members time to assess the availability of 
hedging stock, as understood by the commenter cited at supra note 37 
to be the ISE's intent, the Commission does not believe that this 
was the primary purpose of the rule. The Commission further does not 
believe that this result is significant to market makers, except in 
the case of orders of unusual size. Moreover, a large institutional 
customer with an order of unusual size may turn to another venue for 
facilitation if it is concerned that it will not see price 
improvement because of this dynamic.

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[[Page 60273]]

    The sole issue, then, is whether in the instant proposal the crowd 
members in fact have a reasonable time and opportunity to respond to 
the broadcast message and compete for the order. As discussed above, 
the Commission believes that an exposure period of ten seconds on an 
electronic exchange such as the ISE affords an adequate opportunity for 
crowd members to respond in such a venue. Therefore, the Commission 
does not agree with the view of some commenters that an electronic 
exchange must accommodate manual responses by market makers.
    With regard to the comment that floor-based exchanges allow for a 
``probe phase'' before a facilitation cross is bid and offered, which 
may serve to decrease the possibility of ``biased crosses'' on those 
exchanges, the Commission believes that the need for this process on 
exchange floors may reflect a weakness of incentives on these floors to 
maintain or respond with quality quotes in the first place.
    Accordingly, the Commission believes that it is appropriate for the 
Exchange to reduce the length of the Facilitation Mechanism's exposure 
period to 10 seconds. The Commission, however, intends to monitor 
closely the impact of this reduced exposure period. Therefore, the 
Commission has requested from the ISE, and the ISE has agreed to 
provide, statistics reflecting, for each month, the contract and trade 
volume of transactions executed through the Facilitation Mechanism as 
compared to total contract and trade volume executed on the Exchange; 
the extent to which crowd participants traded with orders submitted 
through the Facilitation Mechanism; and the extent to which EAMs 
submitting orders through the Facilitation Mechanism traded as 
principal with such orders.
    The Commission also notes its agreement with the comment that an 
EAM that trades against part or all of a customer's order must satisfy 
its fiduciary duty to that customer of best execution. The Commission's 
approval of the proposed rule change in no way relieves a firm from 
best execution analysis of trades it executes through the ISE's 
Facilitation Mechanism. For example, if a firm believes it can obtain 
better terms for its customer by exposing that customer's order to the 
auction on the floor of another exchange, it may be obligated to do so, 
depending on the totality of facts and circumstances surrounding the 
facilitation and the customer's best interests. Moreover, if a firm 
cancels a customer order after it has been submitted into the 
Facilitation Mechanism, an investigation into the reason the order was 
canceled, and whether the customer received a better price elsewhere, 
may be warranted.
    The Commission finds good cause for approving Amendment No. 1 to 
the proposal prior to the thirtieth day after the date of publication 
of notice of filing thereof in the Federal Register. Amendment No. 1 
revised the proposed rule change to provide an exposure period of 10 
seconds, affording more time for the ISE crowd to respond to 
facilitation broadcasts than under the original proposal. Thus, the 
amendment should alleviate somewhat concerns about shortening the 
Facilitation Mechanism's exposure time, and does not raise any other 
regulatory issues. Accordingly, the Commission finds good cause, 
consistent with Sections 6(b)(5) \73\ and 19(b)(2) \74\ of the Act to 
accelerate approval of Amendment No. 1 to the proposed rule change.
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    \73\ 15 U.S.C. 78f(b)(5).
    \74\ 15 U.S.C. 78s(b)(2).
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1, including whether the amendment 
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 in the Commission's 
Public Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the ISE. All 
submissions should refer to File No. SR-ISE-2001-19 and should be 
submitted by October 16, 2002.

VI. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act and the rules and regulations 
thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (SR-ISE-2001-19), as amended, be and 
hereby is approved.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\75\
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    \75\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-24293 Filed 9-24-02; 8:45 am]
BILLING CODE 8010-01-P