[Federal Register Volume 68, Number 77 (Tuesday, April 22, 2003)]
[Notices]
[Pages 19865-19874]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-9885]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47676; File No. SR-CBOE-2002-05]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendment Nos. 1, 2, 3, and 4 Thereto by the Chicago Board 
Options Exchange, Incorporated Relating to the Introduction of the CBOE 
Hybrid System

April 14, 2003
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(the ``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given 
that on January 18, 2002, April 2, 2002, May 17, 2002, January 16, 
2003, and April 7, 2003, respectively, the Chicago Board Options 
Exchange, Incorporated (``CBOE'' or ``Exchange'') filed with the 
Securities and Exchange Commission (``Commission'') the proposed rule 
change, and Amendments No. 1, 2, 3, and 4 to the proposed rule 
change,\3\ as described in Items I, II, and III below, which Items have 
been prepared by the CBOE. The Commission is publishing this notice to 
solicit comments on the proposed rule change, as amended, from 
interested persons.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 4 supersedes the original filing and 
Amendments No. 1, 2, and 3 in their entirety.
---------------------------------------------------------------------------

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The CBOE proposes to implement the CBOE Hybrid System, a 
revolutionary options trading platform that combines the best features 
of both open outcry and electronic trading systems. When operational, 
the CBOE Hybrid System will offer automatic executions of eligible 
electronic orders and still provide an open-outcry trading

[[Page 19866]]

environment for trades to occur on the floor of the Exchange. The text 
of the proposed rule change is available at the Office of the 
Secretary, CBOE, and at the Commission.

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 on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The Exchange has prepared summaries, set forth in 
Sections A, B, and C below, of the most significant parts 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 hereby proposes the introduction of the CBOE Hybrid 
System (``Hybrid'' or ``Hybrid System''), a revolutionary trading 
platform that will alter the fundamental way in which the Exchange 
conducts business. When operational, Hybrid will combine the features 
of electronic trading with the benefits of open outcry, auction market 
principles to form the most dynamic trading platform in the options 
industry.
    Hybrid merges the electronic and open outcry trading models while 
at the same time it offers market participants the ability to stream 
electronically their own quotes. Today, CBOE's disseminated quote 
represents, for the most part, the DPM's autoquote price and market 
makers are able to affect changes to that quote in open outcry (or by 
putting up manual quotes). Hybrid will offer market participants (which 
are defined as in-crowd market makers, in-crowd DPMs, and in-crowd 
floor brokers) the opportunity to submit their own firm disseminated 
market quotes that represent their own trading interest.\4\ Whereas 
there currently is only one autoquote price comprising the CBOE 
disseminated quote, Hybrid will allow for the introduction of multiple 
quotes in the quoting equation. Market makers will have the ability to 
stream quotes that reflect their individualized trading interest.
---------------------------------------------------------------------------

    \4\ In this respect, in-crowd floor brokers may represent orders 
on behalf of members, broker-dealers, public customers, and the 
firm's proprietary account. Pursuant to Rule 6.75, floor brokers 
generally may not execute any orders for which they have been vested 
with the discretion to choose: the class of options to buy/sell, the 
number of contracts to buy/sell, or whether the transaction shall be 
one to buy or sell. Floor brokers may not stream quotes.
---------------------------------------------------------------------------

    Incoming electronic orders from public customers and certain types 
of broker-dealers that execute against market participants' quotes will 
be allocated to the best quoters pursuant to a novel and unique trading 
algorithm. This ``Ultimate Matching Algorithm'' (``UMA'' or the 
``Algorithm'') retains public customer priority and rewards those 
market participants pursuant to a formula that balances the concepts of 
quoting at the best price with providing liquidity at the best price. 
The result will be substantially enhanced incentives for market 
participants to quote competitively and substantially reduced 
disincentives to quote competitively.\5\ Indeed, the ability to stream 
electronic quotes combined with the ability to receive electronic and 
instantaneous allocations of incoming orders will reward market 
participants that quote at the best price. The Exchange believes that 
Hybrid, with its ability to allow multiple quotes and instantaneous 
allocations, may have the attendant benefit of tightening the 
Exchange's best disseminated quote. Whereas the Exchange's current 
disseminated quote, which is comprised of only one electronic input, 
may be replaced by a disseminated quote that reflects multiple inputs, 
the Exchange expects that spread widths may decline and liquidity may 
increase.
---------------------------------------------------------------------------

    \5\ Subparagraph IV.B.h(i)(aa) of the Commission's September 11, 
2000 Order (``Order'') requires the Exchange to ``adopt new, or 
amend existing, rules concerning its automated quotation and 
execution systems which substantially enhance incentives to quote 
competitively and substantially reduce disincentives for market 
participants to act competitively.'' Order Instituting Public 
Administrative Proceedings Pursuant to Section 19(h)(1) of the 
Securities Exchange Act of 1934, Making Findings and Imposing 
Remedial Sanctions. Securities Exchange Act Release No. 43268 
(September 11, 2000).
---------------------------------------------------------------------------

    Hybrid also retains the benefits inherent in a floor-based, open 
outcry exchange. Order entry firms will continue to have the ability to 
have their floor brokers walk into a trading crowd and request markets 
on behalf of their customers. Trading crowds, as is the case today, may 
continue to offer price improvement to orders of size, complex orders, 
and other orders that are exposed to the open outcry, auction market 
environment. The opportunity for market participants to offer price 
improvement is a concept that exists only in extremely limited 
instances on all-electronic exchanges. The CBOE Hybrid System will 
enhance the ability of order entry firms to satisfy their due diligence 
and best-execution obligations by providing them with a trading 
platform that provides efficient and instantaneous electronic 
executions when CBOE is the NBBO, along with the opportunity for price 
improvement.
    Hybrid will also offer improved access to the broker-dealer 
community. In this respect, non-market maker broker-dealers will have 
the same access to the electronic execution feature of Hybrid that 
public customers will enjoy in designated classes. This will allow 
eligible broker-dealers to receive more automatic executions of the 
orders they route to CBOE. Additionally, the Hybrid rules for the first 
time allow for the ``opening of the book'' to certain types of broker-
dealer orders. Accordingly, these broker-dealer orders will be eligible 
for placement into the electronic book against which they may be 
executed electronically. Finally, Hybrid also allows for the 
opportunity for broker-dealers to electronically access the limit order 
book (i.e., buy or sell the book) in eligible classes. This feature 
will allow for the automatic execution of broker-dealer orders against 
resting limit orders in the book, whether they are public customer or 
broker-dealer orders in the book. Taken together, these features 
greatly enhance the handling of broker-dealer orders, thereby making 
the Exchange more broker-dealer friendly.
    To implement Hybrid the Exchange proposes the adoption of several 
new rules (most notably CBOE Rules 6.13 and 6.45A) and the amendment of 
several existing rules. New CBOE Rule 6.13 replaces the Exchange's RAES 
Rule 6.8 for those classes in which Hybrid is operational and will 
govern the automatic execution of incoming electronic orders. Proposed 
CBOE Rule 6.45A is the new priority and allocation rule and codifies 
UMA. Together, these rules form the backbone of a trading system that 
will provide investors with deeper and more liquid markets, will 
provide market participants with substantially enhanced incentives to 
quote competitively, will greatly expand broker-dealer access, and will 
provide order entry firms with a trading platform CBOE believes is most 
conducive to satisfying their best execution and due diligence 
obligations.
    This proposal will only apply to equity options. Accordingly, the 
Exchange proposes a rollout schedule that will see the introduction of 
equity option classes trading on Hybrid by May 30, 2003. New equity 
option classes will continue to be rolled out gradually as the Exchange 
and its membership become more familiar and acquainted with the 
operation of the system. The determination of which classes to roll

[[Page 19867]]

out, and when to roll them out, will be made by the Equity Floor 
Procedures Committee. The Exchange hopes to expand the rollout to the 
Top 200 classes by January 2004 and by the fourth quarter of 2004, to 
expand the rollout to the 500 most active equity options. The Exchange 
intends to implement Hybrid floor-wide in all classes by the fourth 
quarter of 2006.

Non-Hybrid Classes

    For classes in which Hybrid is not yet operational, market makers 
will continue to be able to input manual quotes and receive allocations 
of incoming orders that execute against those quotes, as prescribed by 
existing CBOE Rule 6.8(d)(vi). Following is a descriptive summary of 
the new rules and the amended rules for the new Hybrid System.
Rule 6.13 CBOE Hybrid System's Automatic Execution Feature
    This rule governs the automatic execution of incoming electronic 
customer and certain broker-dealer (``BD'') orders. Just as CBOE Rule 
6.8 has no application to classes trading on Hybrid, this Rule is only 
applicable to classes trading on Hybrid. The allocation of 
electronically executed orders in Hybrid shall be pursuant to new CBOE 
Rule 6.45A.
    Proposed section (b) governs aspects of the automatic execution 
feature, including defining eligible orders and eligible order size, 
the process for automatic execution, split price executions, and 
executions against orders in the electronic book.

Eligible Orders and Order Size

    This section clarifies that eligible orders may be automatically 
executed in accordance with the provisions of this Rule. Hybrid creates 
two broad categories of orders that will be eligible for automatic 
execution. First, orders from non-broker-dealer public customers and 
non-market maker broker-dealers will be eligible for automatic 
execution for the same number of contracts. Second, consistent with 
current CBOE Rule 6.8.01, the appropriate floor procedure committee 
(``FPC'') may determine that orders from market makers and specialists 
may be eligible for automatic execution. Orders not eligible for 
automatic execution instead will route to PAR, BART, or to the order 
entry firm's booth printer.\6\ All BD orders of a particular origin 
code will be routed to the same location (e.g., all orders designated 
by the ``N'' origin code (non-CBOE market makers) will route to the 
firm's booth). Any changes to the routing parameters of non-auto-ex 
eligible BD orders will be made by the appropriate FPC and announced to 
the membership via regulatory circular.
---------------------------------------------------------------------------

    \6\ BART is the Booth Automated Routing Terminal that enables 
firms to maintain orders in electronic format. Orders routed to the 
firm's booth, as opposed to BART, will print at the booth and must 
be handled by the firm manually.
---------------------------------------------------------------------------

    As is the case today, the appropriate FPC shall determine on a 
class-by-class basis the maximum size of orders entitled to receive 
automatic execution through Hybrid. If the eligible order size exceeds 
the disseminated size, incoming eligible orders shall be entitled to 
receive an automatic execution up to the disseminated size. Similarly, 
if the appropriate FPC determines to allow market makers to access the 
automatic execution feature of Hybrid, it may also determine to 
establish the maximum order size eligibility for such orders at a level 
lower than the maximum order size eligibility for non-broker-dealer 
public customers and non-market-maker broker-dealers.

Split-Price Executions

    Eligible orders will be automatically executed. Eligible orders for 
a size greater than the disseminated size will be automatically 
executed in part, up to the disseminated size. The balance of the order 
if marketable will execute automatically at the revised disseminated 
price up to the revised disseminated size (provided it does not violate 
NBBO, in which case it will route to PAR or BART).\7\ If not 
marketable, the balance of the order will book electronically.
---------------------------------------------------------------------------

    \7\ The balance of the order will only route to BART if the 
order entry firm so requests.
---------------------------------------------------------------------------

Automatic Executions at Prices Inferior to NBBO

    When CBOE is not the NBBO, eligible orders will not automatically 
execute and instead, shall route to the DPM's PAR terminal for non-
automated handling. Alternatively, order entry firms will have the 
ability, at their discretion, to have these orders route to the firm's 
booth instead of PAR. Eligible orders received while the CBOE market is 
locked (e.g., $1.00 bid--$1.00 offered) shall be eligible for automatic 
execution on CBOE at the disseminated quote, provided that CBOE's 
disseminated quote is not inferior to the NBBO, in which case the order 
will either route to the DPM's PAR terminal or the firm's booth.

Users, Order Entry Firms, and Prohibited Practices

    CBOE Rule 6.13(c) defines ``User'' as any person or firm that 
obtains electronic access to the automatic execution feature of the 
CBOE Hybrid System through an Order Entry Firm. The term ``Order Entry 
Firm'' (``OEF'') means a member organization of the Exchange that is 
able to route orders to the Exchange's Order Routing System.
    Order Entry Firms are required to comply with all applicable CBOE 
options trading rules and procedures. They are required to provide 
written notice to all Users regarding the proper use of the CBOE Hybrid 
System, including any automated execution features. The Rule also 
requires OEFs to Maintain adequate procedures and controls that will 
permit the OEF to effectively monitor and supervise the entry of 
electronic orders by all Users. OEFs must monitor and supervise the 
entry of orders by Users to prevent the prohibited practices set forth 
below. These requirements are identical to those contained in CBOE Rule 
6.8(e).
    This section also incorporates the provisions found in current CBOE 
Rules 6.8 and 6.8A regarding prohibited practices. In this respect, 
prohibited practices include but are not limited to the following:
    1. Dividing an order into multiple smaller orders for the purpose 
of meeting the eligible order size requirements for automatic execution 
(``unbundling'').
    2. The electronic generation and communication of orders (and 
cancellations) in violation of CBOE Rule 6.8A by non-trading crowd 
participants.
    3. Effecting transactions that constitute manipulation as provided 
in CBOE Rule 4.7 and Rule 10b-5 under the Act.

Trade Nullification Procedure

    A trade executed on the CBOE Hybrid System may be nullified if the 
parties to the trade agree to the nullification. When all parties to a 
trade have agreed to a trade nullification, one party must contact the 
Help Desk, which will confirm the agreement and disseminate 
cancellation information in prescribed OPRA format.

Removal of Unreliable Quotes

    The Exchange incorporates from existing CBOE Rule 6.8.02 language 
pertaining to the removal of unreliable quotes or markets from NBBO 
calculation. To summarize, floor officials may remove unreliable quotes 
in one or more options classes upon: (1) Direct communication from the 
affected market or the dissemination through OPRA of a message 
indicating that disseminated quotes are not firm; or (2) direct 
communication from the affected market that it is experiencing systems 
or

[[Page 19868]]

other problems affecting the reliability of its disseminated quotes. 
Any decision to remove a market or its quotes from NBBO calculation 
will be promptly communicated to the affected market and duly recorded 
by the Exchange.
Rule 6.45A Priority and Allocation of Trades for CBOE Hybrid System
    This rule establishes the priority principles applicable to Hybrid 
and provides for the allocation of trades. The rules of priority and 
order allocation procedures set forth in this rule shall apply only to 
option classes designated by the Exchange for trading on the CBOE 
Hybrid System. For those classes not trading on the Hybrid System, CBOE 
Rule 6.45 will govern. This section has four main parts:
[sbull] Allocation of Incoming Electronic Orders
[sbull] Allocation of Orders Represented in the Trading Crowd
[sbull] Interaction of Market Participant's Quotes and/or Orders with 
Orders in Electronic Book
[sbull] Quotes Interacting with Quotes
A. Allocation of Incoming Electronic Orders
    Electronic orders will be allocated using UMA, the Exchange's 
Ultimate Matching Algorithm. In UMA, any market participant (defined as 
an in-crowd market maker, in-crowd floor broker, or DPM for the class) 
who enters a quotation that is represented in the disseminated CBOE 
best bid or offer (``BBO'') shall be eligible to receive allocations of 
incoming electronic orders for up to the size of its quote. If the 
number of contracts represented in the disseminated quote is less than 
the number of contracts in an incoming electronic order(s), the 
incoming electronic order(s) shall only be entitled to receive a number 
of contracts up to the size of the disseminated quote. The balance of 
the electronic order will be eligible to be filled at the refreshed 
quote either electronically or manually and, as such, may receive a 
split price execution (as provided in CBOE Rule 6.13).

Priority of Orders in the Electronic Book

    Public customer orders in the electronic book have priority. 
Multiple public customer orders in the electronic book at the same 
price are ranked based on time priority. If a public customer order(s) 
in the electronic book matches, or is matched by, a market participant 
quote, the public customer order(s) shall have priority and, the 
balance of the electronic order, if any, will be allocated via UMA.
    If pursuant to CBOE Rule 7.4(a) the appropriate FPC determines to 
allow certain types of broker-dealer orders to be placed in the 
electronic book, then for purposes of this rule, the cumulative number 
of broker-dealer orders in the electronic book at the best price shall 
be deemed one ``market participant'' regardless of the number of 
broker-dealer orders in the book. The allocation due the broker-dealer 
orders in the electronic book by virtue of their being deemed a 
``market participant'' shall be distributed among each broker-dealer 
order comprising the ``market participant'' via UMA. For example, if 
there were five BD orders in the book for a cumulative 100 contracts, 
those five BD orders would be deemed ``one market participant'' for 100 
contracts. The allocation of incoming orders among the five BD orders 
in the book would be done pursuant to UMA.

Operation of the Allocation Algorithm

    When a market participant is quoting alone at the disseminated CBOE 
BBO and is not subsequently matched in the quote by other market 
participants prior to execution, it will be entitled to receive 
incoming electronic order(s) up to the size of its quote. In this 
respect, market participants quoting alone at the BBO have priority.
    When more than one market participant is quoting at the BBO, 
inbound electronic orders shall be allocated pursuant to UMA. UMA is an 
algorithm that allocates orders based on two separate yet important 
aspects: parity (i.e., multiple participants quoting at the best price) 
and depth of liquidity (i.e., relative size of each market 
participant's quote).\8\ Each of these components is described in 
greater detail below.
---------------------------------------------------------------------------

    \8\ UMA operates electronically and, as such, only market 
participants that are represented in the disseminated quote will 
participate in the allocation of incoming electronic orders. 
Multiple incoming orders will execute in accordance with CBOE Rule 
8.51, Firm Disseminated Market Quotes.
---------------------------------------------------------------------------

    The UMA formula is as follows:

Allocation Algorithm
[GRAPHIC] [TIFF OMITTED] TN22AP03.015

    Component A: This is the parity component of UMA. In this 
component, UMA treats as equal all market participants quoting at the 
relevant best bid or best offer (or both). Accordingly, the percentage 
used for Component A is an equal percentage, derived by dividing 100 by 
the number of market participants quoting at the best price. For 
instance, if there were four market participants quoting at the best 
price, each is assigned 25% for Component A (or 100/4). This component 
rewards and incents market participants that quote at a better price 
than do their counterparts even if they quote for a smaller size.
    Component B: This size pro-rata component is designed to reward and 
incent market participants to quote with size. As such, the percentage 
used for Component B of the Allocation Algorithm formula is that 
percentage that the size of each market participant's quote at the best 
price represents relative to the total number of contracts in the 
disseminated quote. For example, if the disseminated quote represents 
the quotes of market makers X, Y, and Z who quote for 20, 30, and 50 
contracts respectively, then the percentages assigned under Component B 
are 20% for X, 30% for Y, and 50% for Z.
    Final Weighting: The final weighting, which shall be determined by 
the appropriate FPC, shall be a weighted average of the percentages 
derived for Components A and B multiplied by the size of the incoming 
order. Initially, the weighting of components A and B shall be equal, 
represented mathematically by the formula: ((Component A Percentage 
+Component B Percentage)/2) * incoming order size. The final weighting 
shall apply uniformly across all options under the jurisdiction of the 
appropriate FPC.\9\ Changes made to the weighting of Components A and B 
shall be announced to the membership in

[[Page 19869]]

advance of implementation via Regulatory Circular.
---------------------------------------------------------------------------

    \9\ While the initial weighting of Components A and B will be 
equal, the rule allows the appropriate FPC to adjust the weighting 
percentages, which it would do if it believed such modifications 
would further enhance market participants' incentives to quote 
competitively or reduce disincentives to quote competitively, in 
accordance with the terms of the Order.
---------------------------------------------------------------------------

DPM's Participation Entitlement

    By virtue of their performance of additional obligations, DPMs 
generally are entitled to receive a participation entitlement for 
transactions that occur at the DPM's quote.\10\ If a DPM is eligible 
for an allocation pursuant to the operation of the Algorithm described 
above, its allocation shall be either: \11\
---------------------------------------------------------------------------

    \10\ Among the obligations, which are codified in CBOE Rule 
8.85, are: The requirement to quote continuously, the obligation to 
make legal width markets; the obligation to book eligible orders; 
the requirement to represent orders routed to the PAR station; the 
obligation under Linkage to handle all inbound linkage orders and to 
send satisfaction orders on behalf of customer orders in CBOE's 
book.
    \11\ In either case, the DPM's entitlement cannot exceed the 
size of the DPM's quote.
---------------------------------------------------------------------------

    (1) The greater of the amount it would be entitled to pursuant to 
the DPM participation right established pursuant to CBOE Rule 8.87 (and 
Regulatory Circulars issued thereunder) or the amount it would 
otherwise receive pursuant to the operation of the Algorithm described 
above; or
    (2) The amount it would be entitled to pursuant to the DPM 
participation right established pursuant to CBOE Rule 8.87 (and 
Regulatory Circulars issued thereunder).
    The appropriate FPC shall determine which of the above two formulas 
will be applicable to all classes over which it has jurisdiction.\12\ 
Each pronouncement regarding which formula to be used will be made via 
Regulatory Circular.
---------------------------------------------------------------------------

    \12\ Due to a systems limitation, the Exchange initially will 
use method two and set the DPM's participation entitlement at the 
amount it would be entitled to pursuant to CBOE Rule 8.87 (and 
Regulatory Circulars issued thereunder).
---------------------------------------------------------------------------

B. Allocation of Orders Represented in the Trading Crowd
    This section governs the allocation of orders that are represented 
in the trading crowd by floor brokers (including DPMs acting as agent 
under CBOE Rule 8.85(b)).

Priority of Orders in the Electronic Book

    As an initial matter, public customer orders in the electronic book 
have priority. Multiple public customer orders in the electronic book 
at the same price are ranked based on time priority. If a public 
customer order(s) in the electronic book matches, or is matched by, an 
oral bid or offer provided by a member of the trading crowd, the public 
customer order(s) shall have priority and the balance of the order, if 
any, will be allocated in open outcry, as described below.
    If pursuant to CBOE Rule 7.4(a) the appropriate FPC determines to 
allow broker-dealer orders to be placed in the electronic book, then 
for purposes of this rule, the cumulative number of broker-dealer 
orders in the electronic book at the best price shall be deemed one 
``book market participant'' (or ``BMP'') regardless of the number of 
broker-dealer orders in the book. Any allocation due the broker-dealer 
orders in the electronic book by virtue of their being deemed a ``book 
market participant'' shall be distributed among each broker-dealer 
order comprising the BMP in accordance with UMA.

Allocation

    The method for allocating orders that are represented in the 
trading crowd by floor brokers is dependent upon whether there are any 
book market participants quoting at the prevailing price.
    1. No BMP Present at the Prevailing Price. If there is no BMP 
present at the prevailing price, allocation of open outcry orders shall 
be pursuant to existing CBOE Rule 6.45(a) and (b).
    2. BMP is Present at the Prevailing Price. In an effort to ensure 
that BMPs receive at least partial allocations of orders received in 
open outcry, CBOE proposes to adopt an allocation rule that will limit 
market participants in the crowd to a predetermined percentage. If two 
or more bids (offers) represent the best price, priority shall continue 
to be afforded in the sequence in which the bids (offers) were made 
subject to the restriction that the first market participant to respond 
shall be entitled to 70% of the order. The second market participant to 
respond (if ascertainable) shall be entitled to 70% of the remainder of 
the order (i.e., 70% of 30%). The balance of the order shall be 
apportioned equally among the remaining market participants bidding 
(offering) at the same price and the BMP. The portion allocated to the 
BMP shall be distributed amongst each book market participant pursuant 
to the allocation algorithm described in CBOE Rule 6.45A(a)(i)(B)(2) 
above.
    If at any point the order in which market participants respond is 
not ascertainable, the balance of the incoming order, if any, shall be 
apportioned equally among the remaining market participants bidding 
(offering) at the same price and, if applicable, the book market 
participant. If a market participant declines to accept any portion of 
the available contracts, any remaining contracts shall be apportioned 
equally among the other participants who bid (offered) at the best 
price (including the book market participant, if applicable) at the 
time the market was established until all contracts have been 
apportioned.

Complex Order Exception

    The CBOE Hybrid System will continue to utilize the exception to 
the general priority rules for complex orders. As such, the Exchange 
incorporates existing Rule 6.45(e). CBOE, however, takes this 
opportunity to shorten it considerably. The revisions do not change the 
substance of the rule.
C. Interaction of Market Participant's Quotes and/or Orders With Orders 
in Electronic Book
    Under proposed CBOE Rule 6.45A(c), market participants may also 
submit orders electronically to trade with orders in the electronic 
book. If only one market participant submits an electronic order or 
quote to trade with an order in the electronic book, that market 
participant shall be entitled to receive an allocation of the order in 
the electronic book up to the size of the market participant's order. 
If, however, more than one market participant submits an order to trade 
with the book, each market participant that submits an order or quote 
to buy (sell) an order in the electronic book within a period of time 
not to exceed 5 seconds \13\ of the first market participant to submit 
an order (``N-second group'') shall be entitled to receive an 
allocation of the order in the electronic book pursuant to the 
following allocation algorithm:
---------------------------------------------------------------------------

    \13\ This N-second period is configurable by the appropriate FPC 
but shall never exceed 5-seconds. Any reduction of this N-second 
period (or subsequent increase) shall be announced to the membership 
in advance of implementation via Regulatory Circular. Furthermore, 
this time period shall apply uniformly among all classes under the 
FPC's jurisdiction.
---------------------------------------------------------------------------

Allocation Algorithm

[[Page 19870]]

[GRAPHIC] [TIFF OMITTED] TN22AP03.016

    Component A: The percentage to be used for Component A shall be an 
equal percentage derived by dividing 100 by the number of market 
participants in the ``N-second group.''
    Component B: Size Pro-rata Allocation: The percentage to be used 
for Component B of the Allocation Algorithm formula is that percentage 
that each participant of the ``N-second group's'' quote at the best 
price represents relative to the total number of contracts of all 
market participants of the ``N-second group.'' \14\
---------------------------------------------------------------------------

    \14\ As noted in Rule 6.45A(c)(ii), the appropriate FPC may 
determine that the maximum quote size to be used for each market 
participant in the Component B calculation shall be no greater than 
the cumulative size of orders resident in the electronic book at the 
best price at which market participants are attempting to buy 
(sell). This would prevent a market participant from ``sizing out'' 
competing market participants by, for example, submitting an order 
for 1,000 contracts to buy a book order for 10 contracts.
---------------------------------------------------------------------------

    Final Weighting: The final weighting, which shall be determined by 
the appropriate FPC, shall be a weighted average of the percentages 
derived for Components A and B, multiplied by the size of the order(s) 
in the electronic book. Initially, the weighting of components A and B 
shall be equal, represented mathematically by the formula: ((Component 
A Percentage + Component B Percentage)/2) * electronic book order size.
    If a DPM is eligible for an allocation by virtue of being a member 
of the ``N-second group'' as described in paragraph (C)(2) above, the 
DPM shall be entitled to receive an allocation equal to the amount it 
would be entitled to pursuant to the DPM participation right 
established pursuant to CBOE Rule 8.87 (and Regulatory Circulars issued 
thereunder). The DPM's entitlement percentage is expressed as a 
percentage of the remaining quantity after all public customer orders 
in the electronic book have been executed.
    The Exchange believes this process whereby all members of the ``N-
second group'' receive an allocation of orders in the book will enhance 
competition. As discussed above, this process only applies when market 
participants attempt to access orders resting in the electronic book 
(i.e., liquidity-taking). As such, this process has no effect on a 
market participant's liquidity-providing activities where he receives 
allocation of incoming orders. Thus, market makers will always have an 
incentive to quote competitively (provide liquidity). Second, this 
process ensures that the market-making organization with the deepest 
pockets and fastest technology does not monopolize every order in the 
electronic book. This ``arms race'' scenario would create a situation 
where the fastest machine wins every time, even if it was faster by a 
number as miniscule as a few milliseconds.\15\ This in turn would 
create a disincentive to other market participants who would be unable 
to interact with orders in the book. Creation of an ``N-second group,'' 
conversely, gives these market participants an incentive to continue to 
submit orders and hence more of an incentive to remain on the floor of 
the exchange making markets, providing crucial liquidity.
---------------------------------------------------------------------------

    \15\ The Exchange notes that customers or anyone else eligible 
to submit orders electronically may access the book ahead of market 
participants. In this instance, customers would have absolute 
priority and would not be required to share the order allocation 
with members of the N-second group.
---------------------------------------------------------------------------

D. Quotes Interacting With Quotes (Proposed Rule 6.45A(d))
    Because Hybrid allows the simultaneous entry of quotes by multiple 
market makers,\16\ there may be instances where quotes may become 
locked. If an in-crowd market maker's (including the DPM) disseminated 
quote interacts with the disseminated quote(s) of another in-crowd 
market maker (including the DPM), resulting in the dissemination of a 
``locked'' quote (e.g., $1.00 bid `` 1.00 offer), the following shall 
occur:

    \16\ At the Exchange's request, the term ``market participant'' 
has been replaced with the term ``market maker'' throughout the 
discussion of proposed CBOE Rule 6.45A(d). Telephone conversation 
between Stephen Youhn, Senior Attorney, CBOE and Deborah Flynn, 
Assistant Director, Division of Market Regulation, Commission, on 
April 7, 2003.
---------------------------------------------------------------------------

    (A) The Exchange will disseminate the locked market and both 
quotes will be deemed ``firm'' disseminated market quotes.
    (B) The market makers whose quotes are locked will receive a 
quote update notification advising that their quotes are locked.
    (C) A ``counting period'' will begin during which market makers 
whose quotes are locked may eliminate the locked market. Provided, 
however, that in accordance with subparagraph (A) above a market 
maker will be obligated to execute customer and broker-dealer orders 
eligible for automatic execution pursuant to CBOE Rule 6.13 at his 
disseminated quote in accordance with CBOE Rule 8.51. During the 
``counting period'' market makers will continue to be obligated for 
one contract in open outcry to other market makers, in accordance 
with CBOE Rules 8.51 and 6.48. If at the end of the counting period 
the quotes remain locked, the locked quotes will automatically 
execute against each other in accordance with the allocation 
algorithm described above in CBOE Rule 6.45A(a).

    For the first 60 days after a class begins trading on the Hybrid 
System, the length of the ``counting period'' for that particular class 
may not exceed ten seconds. For the next 60 days thereafter (i.e., days 
61-120) the length of the ``counting period'' may not exceed seven 
seconds in that class. Commencing on the 121st day after a class begins 
trading on the Hybrid System, the length of the ``counting period'' may 
not exceed four seconds in that class. Beginning April 1, 2004, all 
classes trading on Hybrid will be subject to a counting period not to 
exceed four seconds. The appropriate FPC may shorten the duration of 
the ``counting period.''
    The Exchange notes that the Hybrid System will not disseminate an 
internally crossed market (i.e., the CBOE Bid is higher than the CBOE 
offer--$1.10 bid x $1.00 offer). If a market maker submits an incoming 
quote that would cross an existing quote, the Exchange will alter the 
incoming such that it locks the existing quote, at which point the 
locked quotes will be treated in accordance with the procedures 
described above. Correspondingly, the Exchange will notify the second 
market maker that its quote has been changed.\17\
---------------------------------------------------------------------------

    \17\ During the lock period, if the existing quote is cancelled 
subsequent to the changing of the incoming quote, the incoming quote 
will be restored to its original value. For example, assume MM A 
quotes 1.00-1.20 (which is the CBOE's disseminated quote) and MM B 
submits a 1.25-1.40 quote. Because MM B's quote would invert MM A's 
disseminated quote, MM B's quote will be changed to 1.20-1.40 and 
the disseminated quote will be 1.20-1.20. If during the lock period, 
MM A cancels its quote, MM B's quote (which is currently 1.20-1.40) 
will revert to its original value of 1.25-1.40.
---------------------------------------------------------------------------

    The Exchange adds new Interpretations .01 and .02 to clarify that 
order entry firms may not bypass the crossing (CBOE Rule 6.74) and 
solicitation (CBOE Rule 6.9) rules without exposing orders they 
represent as agent for at least 30 seconds prior to electronically 
executing against those

[[Page 19871]]

orders through the auto-ex feature of Hybrid.

Rule 8.7. Obligations of Market Makers

    CBOE Rule 8.7 governs market maker obligations. Market Makers on 
the CBOE Hybrid System will continue to be subject to the obligations 
imposed by this rule, as amended.
    The proposed change to section (b)(ii) of CBOE Rule 8.7 clarifies 
that market makers will be obligated to honor their quotes for up to 
their disseminated size, in accordance with the Quote Rule. Under 
Hybrid, market makers will be deemed the ``responsible broker or 
dealer'' for quotes they cause to be disseminated. Currently, the 
entire trading crowd is considered the ``responsible broker or 
dealer.'' This represents a fundamental change and will also be 
reflected in CBOE Rule 8.51.
    The proposed change to section (b)(iii) of CBOE Rule 8.7 imposes 
upon market makers an obligation to ensure that their quotes are 
accurate. This section also provides guidance as to the permissible 
methods by which market makers may quote. Under Hybrid, market makers 
will be able to quote verbally by open outcry in response to a request 
for a market or they may quote electronically (or submit orders 
electronically) by use of an exchange-approved quoting device. This 
rule also clarifies that market makers must be physically present in 
the trading crowd to quote and submit orders. This is designed to 
prevent remote market making.
    The Exchange proposes to adopt new paragraph (d) to CBOE Rule 8.7 
to govern market maker obligations in Hybrid classes. The proposed 
obligations in paragraph (d) will only apply to market makers trading 
classes on the CBOE Hybrid System and only in those Hybrid classes. As 
such, this section has no applicability to non-Hybrid classes. Proposed 
paragraph (d) to CBOE Rule 8.7 clarifies that unless otherwise provided 
in this Rule, market makers on the Hybrid System are subject to all 
obligations imposed by CBOE Rule 8.7. To the extent another obligation 
contained elsewhere in CBOE Rule 8.7 is inconsistent with an obligation 
contained in paragraph (d) of Rule 8.7, paragraph (d) shall govern.
    The Exchange proposes an introductory rollout period with respect 
to the obligations contained in paragraph (d). Accordingly, for a 
period of ninety (90) days commencing immediately after a class begins 
trading on the Hybrid System, the provisions of proposed paragraph 
(d)(i) shall govern trading in that class. Upon completion of this 90-
day rollout period, a market maker's electronic trading volume will 
determine whether (d)(i) or (d)(ii) shall govern his trading 
activities, as described more fully below.
    The Exchange notes that the requirements in proposed paragraph (d) 
to CBOE Rule 8.7 will be applicable on a per class basis depending upon 
the percentage of volume a market maker transacts electronically versus 
in open outcry. In making this determination, the Exchange will monitor 
market makers' trading activity every calendar quarter to determine 
whether they exceed the thresholds established below in paragraph 
(d)(i). If a market maker exceeds the threshold established below, the 
obligations contained in (d)(ii) will be effective the next calendar 
quarter.
Proposed Rule 8.7(d)(i) Market Maker Trades Less Than 20% Volume 
Electronically
    If a market maker on the CBOE Hybrid System transacts 20% or less 
of his contract volume electronically in an appointed Hybrid class 
during any calendar quarter, the following provisions shall apply to 
that market maker in that class:
    (A) Quote Widths: With respect to electronic quoting, the market 
maker will not be required to comply with the quote width requirements 
of CBOE Rule 8.7(b)(iv).
    (B) Continuous Electronic Quoting Obligation: The market maker will 
not be obligated to quote electronically in any designated percentage 
of series within that class. If a market maker quotes electronically, 
its undecremented quote must be for at least ten contracts.
    (C) Continuous Open Outcry Quoting Obligation: In response to any 
request for quote by a floor broker or DPM representing an order as 
agent, market makers must provide a two-sided market complying with the 
current quote width requirements contained in CBOE Rule 8.7(b)(iv) for 
a minimum of ten contracts.
    (D) In-Person Quoting Requirement: Any volume transacted 
electronically will not count towards the market maker's in-person 
requirement contained in CBOE Rule 8.7.03(B).
Proposed Rule 8.7(d)(ii) Market Maker Trades More Than 20% Volume 
Electronically
    If a market maker on the CBOE Hybrid System transacts more than 20% 
of his contract volume electronically in an appointed Hybrid class 
during any calendar quarter, beginning the next calendar quarter he 
will be subject to the following quoting obligations in that class for 
as long as he remains in that class:
    (A) Quote Widths: The market maker must comply with the quote width 
requirements contained in Rule 8.7(b)(iv).
    (B) Continuous Quoting Obligation: A market maker will be required 
to maintain continuous two-sided quotes for at least ten contracts 
(undecremented size) in a designated percentage of series within the 
class, in accordance with the schedule below:

------------------------------------------------------------------------
                                                              Electronic
                                                              Quoting %
  % of Overall Class Volume Transacted on CBOE During the    Requirement
    Previous Quarter that was Transacted Electronically      (Percentage
                                                              of series)
------------------------------------------------------------------------
50% or Below...............................................           20
51-75%.....................................................           40
Above 75%..................................................           60
------------------------------------------------------------------------

    The Exchange will monitor on a calendar quarter basis the 
percentage of business transacted electronically on CBOE in each 
particular class for the purpose of adjusting the applicable electronic 
quoting percentage during the next succeeding calendar quarter. For 
example, if during the preceding calendar quarter 83% of the volume 
transacted on CBOE in a particular class is done electronically, market 
makers subject to paragraph (d)(ii) of CBOE Rule 8.7 will have an 
obligation to make continuous markets in 50% of the series trading in 
that class.
    (C) Continuous Open Outcry Quoting Obligation: In response to any 
request for quote by a floor broker or DPM representing an order as 
agent, market makers must provide a two-sided market complying with the 
current quote width requirements contained in Rule 8.7(b)(iv) for a 
minimum of ten contracts.
    The Exchange proposes minor non-substantive wording changes to 
Interpretation .02 to CBOE Rule 8.7. First, in Interpretation .02, the 
Exchange removes the first six words of the sentence ``although each 
pricing decision has many elements'' as they are superfluous.
    The change to Interpretation .05 imposes a minimum quote size 
obligation upon market makers. Specifically, market maker quotes may 
not be for less than ten contracts. The Exchange notes that this size 
obligation only applies to a market maker's initial undecremented 
quote. Accordingly, if a market maker puts up a quote for 20 contracts 
and an incoming order executes against 15 of those contracts causing 
the market maker's disseminated size to decline to five

[[Page 19872]]

contracts, the market maker will not be in violation of any exchange 
rule. The CBOE Hybrid System will not accept any market maker quotes 
without an attached size. Closely related to this change is the 
proposed change to Interpretation .06 to CBOE Rule 8.7. Because the 
Hybrid System will not accept one-sided quotes, the current rule would 
have no applicability to electronic quotes. Accordingly, Interpretation 
.06 will now only apply to open outcry quotes.
    The proposed change to Interpretation .07 to CBOE Rule 8.7 
clarifies that this provision only applies in classes in which Hybrid 
is not operational. Because market makers will have the ability to 
submit their own quotes, this rule will not have any applicability.
    The Exchange proposes to amend Interpretation .11 to clarify its 
applicability to different systems. New section (a) will only apply to 
classes on RAES while section (b) will apply to Hybrid classes. Section 
(b) for the most part is identical to section (a) except for the 
elimination of the reference to RAES, an elimination necessitated by 
the fact that RAES will not exist in the Hybrid environment.

Amendment of Additional Rules

    The Exchange notes that to accommodate the introduction of Hybrid, 
it must amend numerous of its existing rules. While CBOE does not 
believe that the changes to these rules are as substantive as those 
made to the rules described above, they nevertheless are described 
below.
Rule 6.2 Trading Rotations
    The Exchange amends existing CBOE Rule 6.2 to specifically 
reference the Hybrid Opening System (``HOSS'') in order to indicate 
that trading rotations may occur via HOSS. The amendment to CBOE Rule 
6.2.05 clarifies that the automatic execution feature of Hybrid may be 
disengaged during any closing rotation.
Rule 6.2A Rapid Opening System
    The Exchange amends its ROS rule to clarify it has no applicability 
to series trading on the CBOE Hybrid Opening System.
Rule 6.2B Hybrid Opening System
    This rule governs the opening procedures for the CBOE Hybrid 
System. HOSS is the Exchange's automated system for initiating trading 
at the beginning of each trading day. For each class of options 
contracts that has been approved for Hybrid trading, the System shall 
conduct an opening rotation, which shall be held promptly following the 
opening of the underlying security in the primary market in accordance 
with the procedures contained in CBOE Rule 6.2B.
Rule 6.7 Exchange Liability
    The Exchange amends this rule to clarify its applicability to 
Hybrid.
Rule 6.8 RAES Operations
    The amendment clarifies that the RAES rule has no applicability to 
options classes traded on the CBOE Hybrid System. For classes not 
trading on Hybrid, Rule 6.8 will continue to be applicable.
Rule 6.20 Admission to and Conduct on the Trading Floor; Member 
Education
    The Exchange proposes to amend Interpretations .04, .05 and .09 to 
make them applicable to Hybrid. In this respect, CBOE eliminates in 
Interpretation .04(i) the reference to CBOE Rule 6.43 as Hybrid allows 
market participants to effect transactions electronically. Thus, the 
prohibition against effecting a transaction without public outcry no 
longer violates CBOE Rule 6.43. The Exchange does not amend that 
portion of the rule referencing CBOE Rule 6.74.
    The change to Interpretation .05 provides Floor Officials with the 
same authority to nullify transactions occurring in violation of 
proposed CBOE Rule 6.45A that they currently have with respect to CBOE 
Rule 6.45 (i.e., non-Hybrid trades).
    Current Interpretation .09 provides that Market Performance 
Committee members have Floor Official responsibilities with respect to 
enforcing rules relating to RAES. This amendment simply extends that 
authority to Hybrid.
Rule 6.43 Manner of Bidding and Offering
    The proposed amendment to CBOE Rule 6.43(a) gives market 
participants the ability to enter quotes and orders electronically via 
Exchange-approved quoting devices. Previously, CBOE Rule 6.43(a) 
allowed only those bids and offers entered via open outcry. Proposed 
Rule 6.43(b) preserves the ability of trading crowd members to enter 
manual quotes in non-Hybrid classes. In classes trading on Hybrid, 
trading crowd members may enter their own quotes or orders through 
their own handhelds.\18\
---------------------------------------------------------------------------

    \18\ An individual market maker may use the same handheld 
quoting device to enter both quotes and orders.
---------------------------------------------------------------------------

Rule 6.45 Priority of Bids and Offers--Allocation of Trades
    The Exchange proposes two changes to CBOE Rule 6.45. The first 
change clarifies that the rules of priority in CBOE Rules 6.13 and 
6.45A shall operate independent of the priority rules contained in CBOE 
Rule 6.45. Second, the Exchange amends CBOE Rule 6.45(e) for the 
purpose of making it easier to read. This section, as amended, is 
identical to proposed CBOE Rule 6.45A(b)(iii).
Rule 6.47 Priority on Split Price Transactions Occurring in Open Outcry
    The changes to CBOE Rule 6.47 clarify that split price priority 
only applies to those transactions effected in open outcry. There will 
be no split price priority for electronic transactions.
Rule 6.54 Accommodation Liquidations
    The Exchange proposes to add new Section (b) to allow for 
accommodation liquidations to occur in Hybrid. Given current system 
limitations, cabinet trades may only occur in open outcry trading and 
thus will not be eligible for placement into the limit order book.
Rule 7.4 Obligations for Orders
    The Exchange proposes to amend CBOE Rule 7.4(a) to expand the types 
of orders eligible for entry into the electronic book.\19\ Proposed 
paragraph (a)(1) gives the appropriate FPC the ability to determine the 
categories of orders eligible for entry into the book. This paragraph 
authorizes market participants to place orders in the book (in those 
classes in which Hybrid is operational.)\20\ Additionally, this section 
enables the FPC to allow all BD orders to be book eligible or, as with 
current RAES access rules for BDs, to allow orders from those BDs that 
are not market makers or specialists to enter the book. Both methods 
substantially enhance book access for non-customers.
---------------------------------------------------------------------------

    \19\ Currently only public customer orders are eligible for 
entry in the book.
    \20\ In this respect, market participants may place orders in 
the book. Regarding the entry of orders into the book from market 
participants in non-designated classes, they will not have ``market 
participant'' status and thus will be eligible for book entry only 
if the FPC has determined that all BD orders are eligible for book 
entry in that particular class.
---------------------------------------------------------------------------

    This proposed rule also preserves that section of the current rule 
that allows the FPC to determine the manner and form in which orders 
are submitted.\21\ Similarly, the Exchange deletes the last sentence of 
current CBOE Rule 7.4(a)(2)

[[Page 19873]]

regarding the non-eligibility of BD orders for entry into the book.
---------------------------------------------------------------------------

    \21\ This, for example, would allow the FPC to require orders be 
submitted electronically into the book.
---------------------------------------------------------------------------

    The changes to proposed section (b) clarify that orders from market 
participants may be placed in the book (whether the order first routes 
to the OBO or directly into the book). The Exchange proposes to limit 
the applicability of paragraph (g) to non-Hybrid classes because ``live 
ammo'' functionality will not be available in Hybrid.
    The Exchange proposes to delete existing Interpretation .05 to CBOE 
Rule 7.4 as obsolete. The Order Support System has been absent from the 
Exchange for more than ten years. Finally, the Exchange amends current 
Interpretation .07 by renumbering it as .06 and by adding reference to 
the automatic execution provisions of new CBOE Rules 6.13 and 6.45A.
Rule 7.7 Displaying Bids and Offers in the Book
    The exchange also amends CBOE Rule 7.7 regarding the display of 
orders in the book. Specifically, the Exchange removes as obsolete the 
section of the rule that allows the OBO to display indications of book 
size when the book contains orders for at least 25 contracts. Because 
the Exchange currently disseminates the actual size of orders in the 
book, this section is obsolete. The Exchange also deletes 
Interpretation .01 in its entirety as obsolete.\22\
---------------------------------------------------------------------------

    \22\ Exchange quote display systems automatically incorporate 
into the disseminated market quote all booked orders that improve 
the market (price or size). For this reason, the OBO does not have 
any ability to display the full (or less than full) size of an 
order.
---------------------------------------------------------------------------

Rule 8.51 Firm Disseminated Market Quotes
    The Exchange proposes to amend CBOE Rule 8.51(a)(1) to clarify that 
in Hybrid classes, the market participant who submits a quote that is 
disseminated shall be the responsible broker or dealer for that quote. 
In paragraph (c)(1), the Exchange removes the sentence indicating it 
will periodically publish the firm quote requirement for both BD and 
public customer orders. In this respect, the Exchange notes that in new 
subparagraph (c)(1(a)(i) to CBOE Rule 8.51 the firm quote requirement 
for customer orders shall be the size disseminated to vendors. In 
subparagraph (a)(ii), the Exchange clarifies that the firm quote 
requirement for BD orders will be the lesser of the size it 
disseminates to vendors or publishes in a different manner. This is 
almost identical to the current rule except that it provides 
flexibility to allow the Exchange to disseminate its BD firm quote size 
(rather than publish it).
    The Exchange also strikes existing Rule 8.51(c)(2)(a) as obsolete. 
In this respect, the Exchange disseminates actual size regardless of 
whether that size represents autoquote, an order in the book, or both. 
In any instance, the Exchange is firm for its disseminated size, as 
required by proposed CBOE Rule 8.51(c)(1)(a)(i).
    The Exchange proposes to delete current Interpretation .01 and 
replace it with the definition of ``Responsible broker or 
dealer''contained in Rule 11Ac1-1(a)(21) under the Act. The Exchange 
deletes the existing portion of Interpretation .01 as obsolete. In this 
respect, the Exchange disseminates the actual size of its firm quote 
obligation that, intuitively, can never be less than the disseminated 
size. The Exchange also amends Interpretation .02 to replace reference 
to the terms floor broker, DPM, or OBO with the term market 
participant. Because under Hybrid, the market participant will be the 
responsible broker or dealer, it will be responsible for removing its 
quote.
    The proposed amendment to Interpretation .08 does not change the 
intent of the rule: that the responsible broker or dealer not be 
required to honor quotes that are erroneous as the result of a third 
party. Because the trading crowd will not be the responsible broker or 
dealer in Hybrid, however, the Exchange amends the rule to remove 
reference to the trading crowd.
    Finally, CBOE proposes a change to Interpretation .10 to clarify 
the timing of when firm quote obligations attach. Currently, firm quote 
obligations attach to an order received on a PAR station at the time 
the order is received on PAR. This interpretation remains intact for 
non-Hybrid classes. For Hybrid classes, firm quote obligations will 
attach to an order received on a PAR station depending upon who is the 
responsible broker or dealer. If the responsible broker or dealer is 
not the DPM, firm quote will attach when the order is announced to the 
trading crowd. If, however, the DPM is a responsible broker or dealer 
for that order, firm quote obligations attach at the time of receipt of 
that order on PAR. The Exchange notes that in instances when an order 
is received on PAR when the disseminated quote represents the DPM and 
other market makers, there will be two separate firm quote obligations: 
the DPM's firm quote obligation will attach at the time the order is 
received on PAR while the market makers' firm quote obligations will 
attach when the order is announced to the crowd.\23\
---------------------------------------------------------------------------

    \23\ Market makers in the crowd have no control over PAR and no 
access to PAR. They will be completely unaware that an order resides 
on PAR until that order is announced to them. Contrast this to the 
present situation where even though a market maker may be unaware of 
the receipt of an order on PAR, because the disseminated quote 
represents the entire trading crowd, the entire crowd is deemed to 
receive the order upon receipt of the order on PAR. In Hybrid, each 
quote represents a completely different entity and not the crowd.
---------------------------------------------------------------------------

Rule 8.85 DPM Obligations
    To accommodate Hybrid, the Exchange proposes to amend CBOE Rule 
8.85 regarding DPM obligations. First, the Exchange proposes to amend 
CBOE Rule 8.85(a)(i) to indicate that a DPM has a continuous quoting 
obligation with respect to its assigned classes. This ensures the DPM 
will quote at all times. Second, the Exchange clarifies subsection (ii) 
to indicate that the DPM must assure that each of its quotations is 
honored in accordance with the requirements of the Quote Rule. This 
change clarifies that DPMs must ensure their own compliance with the 
Quote Rule. Finally, the Exchange restricts the applicability of 
subparagraph (x) to non-Hybrid classes. In Hybrid, all market 
participants will have their own proprietary quoting systems. It would 
be anticompetitive to require the DPM to disclose its pricing formula 
to other members. In non-Hybrid classes, because there is only one 
autoquote that binds the entire crowd, this requirement remains.
2. Statutory Basis
    The CBOE Hybrid System will provide investors with deeper and more 
liquid markets, will provide market participants with substantially 
enhanced incentives to quote competitively, and will provide order 
entry firms with a trading platform the exchange believes is most 
conducive to satisfying their best execution and due diligence 
obligations. For these reasons, the Exchange believes the proposed rule 
change is consistent with the Act and the rules and regulations under 
the Act applicable to a national securities exchange and, in 
particular, the requirements of Section 6(b) of the Act.\24\ 
Specifically, the Exchange believes the proposed rule change is 
consistent with the Section 6(b)(5) \25\ requirements that the rules of 
an exchange be designed to promote just and equitable principles of 
trade, to prevent fraudulent and manipulative

[[Page 19874]]

acts and, in general, to protect investors and the public interest.
---------------------------------------------------------------------------

    \24\ 15 U.S.C. 78f(b).
    \25\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

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

    CBOE does not believe that the proposed rule change will impose any 
burden on competition not necessary or appropriate in furtherance of 
the purposes of the Act.

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

    The Exchange has engaged in a substantial and extensive educational 
program to apprise members of the features of the CBOE Hybrid System. 
During this two-month long process, members and staff of the Exchange 
conducted weekly seminars for CBOE members to provide guidance as to 
how the CBOE Hybrid System would operate. To date, the Exchange 
received one comment letter.\26\ The Arciero Letter primarily expressed 
concern regarding the future of the trading floor in the hybrid 
environment when the Exchange allows electronic quoting. The Arciero 
Letter indicated that largely capitalized market making organizations 
would have sufficient competitive advantages in Hybrid by virtue of 
their larger capitalization structures. In response to the Arciero 
Letter, the Exchange scheduled additional educational seminars 
identical to those previously conducted during September and October of 
this year. The Exchange notes that most, if not all, of the Arciero 
Letter concerns were addressed in those educational seminars.
---------------------------------------------------------------------------

    \26\ Letter from Tony Arciero, CBOE Member, to Ed Tilly, 
Chairman, Equity Floor Procedure Committee, CBOE, dated November 7, 
2002 (``Arciero Letter'').
---------------------------------------------------------------------------

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, 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 Section, 450 Fifth Street, 
NW., Washington, DC 20549. Copies of such filing will also be available 
for inspection and copying at the principal office of CBOE. All 
submissions should refer to File No. SR-CBOE-2002-05 and should be 
submitted by May 13, 2003.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\27\
---------------------------------------------------------------------------

    \27\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-9885 Filed 4-21-03; 8:45 am]
BILLING CODE 8010-01-P