[Federal Register Volume 67, Number 236 (Monday, December 9, 2002)]
[Notices]
[Pages 72988-72990]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-31018]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46935; File No. SR-CBOE-2002-27]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Approving Proposed Rule Change and Amendments No. 1 and 2 
Thereto by the Chicago Board Options Exchange, Inc. Relating to 
Permanent Approval of the 100 Spoke RAES Wheel Pilot Program and 
Elimination of the ``Vacation Penalty''

December 2, 2002.

I. Introduction

    On May 24, 2002, the Chicago Board Options Exchange, Inc. (``CBOE'' 
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 proposal to amend its rules to eliminate the pilot 
program and make permanent the 100 Spoke RAES Wheel System. The CBOE 
further proposed to modify the calculation of the participation 
distribution for market makers participating on the 100 Spoke RAES 
Wheel by eliminating the ``vacation penalty.'' On July 17, 2002, the 
Exchange filed Amendment No. 1 to the proposed rule change.\3\ On 
September 26, 2002, the Exchange filed Amendment No. 2 to the proposed 
rule change.\4\ On October 17, 2002, the Commission published the 
proposed rule change and Amendments No. 1 and 2 in the Federal 
Register.\5\ The Commission received no comments on the proposal. 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\ See Letter from Nancy L. Nielsen, Director of Arbitration 
and Assistant Secretary, CBOE, to Nancy Sanow, Assistant Director, 
Division of Market Regulation, Commission, dated July 16, 2002 
(``Amendment No. 1'').
    \4\ See Letter from Madge M. Hamilton, Legal Division, CBOE, to 
Nancy Sanow, Assistant Director, Division of Market Regulation, 
Commission, dated September 26, 2002 (``Amendment No. 2'').
    \5\ See Securities Exchange Act Release No. 46683 (October 17, 
2002), 67 FR 65384 (October 24, 2002).
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II. Description of the Proposal

    On May 25, 2000, the Commission approved, on a pilot basis, the 
Exchange's proposal to amend Rule 6.8 to provide the appropriate Floor 
Procedure Committee (``FPC'') with a third choice for apportioning RAES 
trades among participating market makers, the 100 Spoke RAES Wheel.\6\ 
In those classes where the 100 Spoke RAES Wheel is employed, the 
allocation of RAES trades to participating market makers is 
commensurate with the distribution of in-person agency market-maker 
trades for non-RAES trades in that class. The pilot program has been 
extended five times, most recently until November 28, 2002.\7\
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    \6\ Securities Exchange Act Release No. 42824 (May 25, 2000), 65 
FR 37442 (June 14, 2000). RAES is the Exchange's automatic execution 
system for public customer market or marketable limit orders of less 
than a certain size.
    \7\ Securities Exchange Act Release No. 46644 (October 10, 2002) 
(pilot program extended until November 28, 2002) (SR-CBOE-2002-60); 
Securities Exchange Act Release No. 46149 (June 28, 2002), 67 FR 
45161 (July 8, 2002) (pilot program extended until September 28, 
2002) (SR-CBOE-2002-34); Securities Exchange Act Release No. 45230 
(January 3, 2002), 67 FR 1380 (January 10, 2002) (pilot program 
extended until June 28, 2002) (SR-CBOE-2001-68); Securities Exchange 
Act Release No. 44749 (August 28, 2001), 66 FR 46487 (September 5, 
2001) (pilot program extended until December 28, 2001) (SR-CBOE-
2001-47); Securities Exchange Act Release No. 44020 (February 28, 
2001), 66 FR 13985 (March 8, 2001) (pilot program extended until 
August 28, 2001) (SR-CBOE-01-07).

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[[Page 72989]]

    Under the 100 Spoke RAES Wheel, RAES orders are assigned to market 
makers according to the percentage of their in-person agency contracts 
(excluding RAES contracts) traded in that class compared to the in-
person agency contracts (excluding RAES contracts) of all of the market 
makers traded during the review period. Agency contracts are any 
contracts represented by an agent (booked orders and orders represented 
by brokers) and do not include contracts traded between market makers 
in person in the trading crowd. A particular market maker's entitlement 
will change based upon the percentage of agency contracts that market-
maker traded in the review period. For example, if a particular market 
maker traded 10% of all the in-person agency contracts (excluding RAES 
contracts) of class ABC for a particular review period, then that 
market maker would be assigned 10% of the RAES contracts during the 
next trading period. The review period is determined by the appropriate 
FPC.
    The RAES Wheel can be envisioned as having a number of spokes, each 
generally representing one percent of the total participation of all 
market makers in the class. Thus, a market maker generally will be 
assigned one spoke for each one percent of his or her market maker 
participation during the review period. If the spoke size is one and 
all market makers who traded in-person agency contracts in that option 
class during the review period are logged onto RAES, and no other 
market makers are logged on, the RAES Wheel would consist of 100 
spokes, representing 100 percent of all market maker activity during 
the review period. The appropriate FPC may establish a larger spoke 
size. Setting the spoke size to five contracts, for example, would 
redefine the RAES Wheel for a particular option class as a Wheel of 500 
contracts. A larger Wheel would mean the Wheel would not revolve as 
quickly through the logged on market makers, but a larger Wheel would 
not change the participation percentage of the individual market 
makers.
    A wedge is the maximum number of spokes that may be consecutively 
assigned at any one time to a market maker during a rotation of the 
RAES Wheel. The purpose of the wedge is to break up the distribution of 
contracts into smaller groupings to reduce the exposure of any one 
market maker to market risk. If the size of the wedge is smaller than 
the number of spokes to which a particular market maker may be entitled 
based on his or her participation percentage, then that market maker 
would receive one or more additional assignments during one revolution 
of the RAES Wheel. For example, in the case where one spoke is equal to 
one contract and the market maker's participation percentage is 15 
percent (15 percent of 100 spokes) and the wedge size is ten, that 
market maker first would be assigned ten contracts on the RAES Wheel 
and then five contracts at a different place on the RAES during the 
same revolution of the RAES Wheel. The wedge size is variable at the 
discretion of the appropriate FPC and may be established at different 
levels for different classes, or at the same level for all classes.
    In its filing, the Exchange represented that the 100 Spoke RAES 
Wheel has worked as anticipated by providing an efficient and effective 
alternative allocation method for assigning RAES trades. The Exchange 
further represented that, in those classes where the 100 Spoke RAES 
Wheel is employed, the distribution of RAES trades is essentially 
identical to the distribution of in-person agency market maker trades 
on non-RAES trades in that class during the relevant review period.
    The Exchange also clarified the calculation of the participation 
distribution for market makers participating on the 100 Spoke RAES 
Wheel.\8\ Specifically, the applicable review period would be adjusted 
to account for vacations by market makers. CBOE indicated that without 
this revision, if a market maker takes even a single trading day off 
over the two-week review period, the market maker is allocated a number 
of spokes that is less than the market-maker's average daily percentage 
of the trading volume, resulting in a ``vacation penalty.'' Thus, 
rather than a maximum review period of two weeks, as provided in the 
current rule, the review period will be a maximum of 10 trading days, 
i.e., last ten days in which the market maker had trading activity, 
subject to the condition that the review period cannot extend back more 
than 30 calendar days (in order to assure that the review period is not 
based on stale activity). Under the proposed rule, the trading days 
within the review period may be non-consecutive trading days, and the 
percentage allocation will be calculated at the conclusion of each 
trading day and will be applied to the 100 Spoke RAES Wheel 
distribution on the following trading day.
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    \8\ See Amendment No. 1, supra n. 3.
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    Further, CBOE explained that, in calculating the review period, the 
10 trading days used to compute one market maker's RAES participation 
distribution may be a different 10 trading days than another market 
maker signed onto RAES in the same trading crowd, and that the 10-day 
review periods of individual market makers may overlap.\9\ In addition, 
CBOE clarified that the individual market makers have no discretion 
over which 10 trading days will be used in the calculation. The 
proposed rule change permits the appropriate FPC to set a review period 
not to exceed 10 trading days.\10\ Once the appropriate FPC has set the 
number of days to be used in the calculation of the market maker's 
participation distribution, the Exchange looks back that number of 
trading days to calculate each market maker's participation right.
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    \9\ See Amendment No. 2, supra n. 4. As noted above, the review 
period of a maximum of 10 trading days (i.e., the last ten days in 
which the market maker had trading activity) cannot extend back more 
than 30 calendar days.
    \10\ The Exchange represents that under the proposed rule 
change, as amended, all market makers' review periods will be of 
equal size, regardless of whether the Exchange may look at different 
underlying time periods to ascertain the most recent days of trading 
activity for a specific market maker. Telephone conference among 
Madge Hamilton, Legal Division, CBOE, Nancy Sanow, Assistant 
Director, Division of Market Regulation, Commission, and Geoffrey 
Pemble, Special Counsel, Division of Market Regulation, Commission 
(November 26, 2002).
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    CBOE further noted that, under the proposed rule, the Exchange will 
conduct the calculation for the market maker participation distribution 
at the conclusion of each trading day and apply the market makers' RAES 
participation distribution to the following trading day. CBOE further 
explained that, since the calculation of the participation distribution 
is done at the end of each trading day, the 10 day review period for 
each market maker will be done on a rolling basis, i.e., each time the 
calculation is conducted, the non-RAES agency trading volume for the 
current day, if any, is added to the 10 day review period, and the non-
RAES agency trading volume for the oldest day used for the previous 
day's calculation is deleted. According to CBOE, this calculation 
encourages market makers to actively trade every day, since each day's 
trading activity will have an effect on the market maker's RAES 
participation distribution for the next trading day.\11\ Finally,

[[Page 72990]]

CBOE noted the formula for determining market maker participation 
percentage on the 100 Spoke RAES Wheel. CBOE explained that in order to 
calculate a market maker's participation percentage, the ``non-RAES 
agency trading volume'' for a given market maker is divided by the 
``total volume,'' i.e., the sum of the volume of the non-RAES agency 
trades for all traders in a particular options class (which is 
determined by adding together the trading volume for each market maker 
and DPM during his or her relevant review period).
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    \11\ Any market maker that logs on the system during a 
particular review period will be guaranteed to receive an 
entitlement during that review period of no less than 1 percent of 
RAES contracts, or one ``spoke.'' The minimum entitlement applies to 
any market maker in a particular option class who logs on RAES 
during a given review period. Thus, new market makers who have not 
yet had time to acquire market share on the trading floor will be 
allocated a single spoke if they log on RAES during the first review 
period they traded that class on the Exchange floor. Telephone 
conference among Madge Hamilton, Legal Division, CBOE, Nancy Sanow, 
Assistant Director, Division of Market Regulation, Commission, and 
Geoffrey Pemble, Special Counsel, Division of Market Regulation, 
Commission (November 26, 2002).
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III. Discussion

    After careful review, the Commission finds that implementation of 
the proposed rule change, as amended, is consistent with the 
requirements of Section 6 of the Act \12\ and the rules and regulations 
thereunder applicable to a national securities exchange.\13\ 
Specifically, the Commission believes that the proposal, as amended, is 
consistent with Sections 6(b)(5) and 6(b)(8) of the Act.\14\ Section 
6(b)(5) requires, among other things, that the rules of an exchange be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to facilitate 
transactions in securities, to remove impediments to and perfect the 
mechanisms of a free and open market and a national market system, and, 
in general, to protect investors and the public interest.\15\ Section 
6(b)(5) also requires that those rules not be designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers. Section 
6(b)(8) of the Act requires that the rules of an exchange not impose 
any burden on competition not necessary or appropriate in furtherance 
of the purposes of the Act.
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    \12\ 15 U.S.C. 78f.
    \13\ 15 U.S.C. 78f(b)(5).
    \14\ 15 U.S.C. 78f(b)(5) and (b)(8).
    \15\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
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    As the Commission stated in its original approval order for the 100 
Spoke RAES Wheel as a pilot program, the Commission believes that 
CBOE's implementation of the 100 Spoke RAES Wheel system as a pilot 
program was an important step forward, as it rewarded those market 
makers who consistently execute a greater portion of agency orders in 
the trading crowd, rather than randomly assigning contracts to all 
market makers logged on RAES. Although the 100 Spoke RAES Wheel does 
not reward a market maker for improving the Exchange's displayed 
quotation, it does reward the market maker for providing liquidity to 
orders in the trading crowd by linking the market maker's percentage of 
RAES contracts to the percentage of agency contracts it executed in the 
trading crowd.
    Unlike the two means of allocation that were used exclusively prior 
to the 100 Spoke RAES Wheel pilot program, under which the size of the 
order assigned to a particular market maker is determined randomly,\16\ 
the 100 Spoke RAES Wheel more closely allocates the percentage of 
contracts that a particular market maker can receive on a single 
revolution of the Wheel to the percentage of in-person agency contacts 
(excluding RAES contracts) traded on CBOE by that market maker. With 
the 100 Spoke RAES Wheel, market makers have a greater incentive to 
compete effectively for orders in the crowd, and this, in turn, should 
benefit investors and promote the public interest.
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    \16\ Under Variable RAES, the market maker has some flexibility 
in limiting the extent of its exposure during each revolution of the 
Wheel.
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    The Commission reiterates that implementation of the 100 Spoke RAES 
Wheel will have no effect on the prices offered to customers. Under 
CBOE Rule 6.8(d)(i), RAES automatically provides to each retail 
customer order its execution price, generally determined by the 
prevailing market quote at the time of the order's entry into the 
system. The 100 Spoke RAES Wheel merely provides for a different 
contract allocation system than currently exists for automatic 
execution of small retail orders.
    The proposed rule change also will eliminate the ``vacation 
penalty'' that resulted under the original rule when a market maker was 
absent for one or more days. Under the proposed rule change, as 
amended, the review period will be the period not in excess of 10 
trading days, i.e., last ten days in which the market maker had trading 
activity, subject to the condition that the review period cannot extend 
back more than 30 calendar days (in order to assure that the review 
period is not based on stale activity). In addition, the Commission 
notes that under the proposal, all market maker's review periods will 
be of equal size, regardless of whether the Exchange may look at 
different underlying time periods to ascertain the most recent days of 
trading activity for a specific market maker. The Commission finds that 
these changes relating to the ``vacation penalty'' are consistent with 
the Act.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\17\ that the proposed rule change, as amended (SR-CBOE-2002-27) is 
approved on a permanent basis.
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    \17\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\18\
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    \18\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-31018 Filed 12-6-02; 8:45 am]
BILLING CODE 8010-01-P