[Federal Register Volume 68, Number 96 (Monday, May 19, 2003)]
[Notices]
[Pages 27129-27138]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-12456]


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

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47838; File No. SR-PCX-2002-36]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendment No. 1 Thereto and Notice of Filing and Order 
Granting Accelerated Approval to Amendments No. 2 and 3 to the Proposed 
Rule Change by the Pacific Exchange, Inc. Relating to the Exchange's 
New Trading Platform for Options, PCX Plus

May 13, 2003.

I. Introduction

    On June 27, 2002, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'' or ``SEC''), 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 adopt new rules for the 
implementation of its new trading platform for options, PCX Plus. The 
PCX's proposal also includes new rules on priority and allocations of 
orders, rule changes to permit options Market Makers \3\ to conduct 
their trading activities from locations away from the trading floor, 
and proposed system changes to accommodate new order handling 
procedures and automated trade processing. On November 6, 2002, the PCX 
filed Amendment No. 1 to the proposed rule change.\4\ The proposed rule 
change and Amendment No. 1 were published for comment in the Federal 
Register on November 18, 2002.\5\ The Commission received four comment 
letters with respect to the proposal and Amendment No. 1.\6\ On April 
9, 2003, the PCX filed Amendment No. 2 to the proposed rule change.\7\ 
On April 16, 2003, the PCX filed Amendment No. 3 to the proposed rule 
change, withdrew Amendment No. 3 on April 22, 2003, and refiled 
Amendment No. 3 on April 22, 2003.\8\ This order approves the proposed 
rule change and Amendment No. 1; grants accelerated approval to 
Amendments No. 2 and 3 to the proposed rule change; and solicits 
comments from interested persons on Amendments No. 2 and 3.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Proposed PCX Rule 6.32(a) (defines ``Market Maker'' as an 
individual who is registered with the Exchange for the purpose of 
making transactions as a dealer-specialist on the floor of the 
Exchange or, in the case of a Remote Market Maker, through the 
facilities of the Exchange).
    \4\ Amendment No. 1 replaced the PCX's original Rule 19b-4 
filing in its entirety.
    \5\ Securities Exchange Act Release No. 46803 (November 8, 
2002), 67 FR 69580 (``Notice of the Proposal'').
    \6\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Thomas Peterffy, Chairman, and David M. Battan, Vice President and 
General Counsel, Interactive Brokers Group LLC (``IB Group''), dated 
December 9, 2002 (``IB Group Letter''); Meyer S. Frucher, Chairman 
and Chief Executive Officer, Philadelphia Stock Exchange, Inc. 
(``Phlx''), dated December 9, 2002 (``Phlx Letter''); Thomas N. 
McManus, Executive Director and Counsel, Morgan Stanley & Co., 
Incorporated (``Morgan Stanley''), dated January 6, 2003 (``Morgan 
Stanley Letter''); and Gerald D. O'Connell, Associate Director, 
Susquehanna International Group, LLP (``Susquehanna''), dated 
January 8, 2003 (``Susquehanna Letter'') (collectively, ``Comment 
Letters'').
    \7\ See letter from Kathryn L. Beck, Senior Vice President, 
General Counsel, and Corporate Secretary, PCX, to Nancy J. Sanow, 
Assistant Director, Division of Market Regulation (``Division''), 
Commission, dated April 7, 2003 (``Amendment No. 2''). See Section 
III. of this order for a detailed description of Amendment No. 2.
    \8\ See letter from Peter D. Bloom, Acting Managing Director, 
Regulatory Policy, PCX, to Deborah L. Flynn, Assistant Director, 
Division, Commission, dated April 14, 2003 (``Amendment No. 3''). 
The PCX withdrew Amendment No. 3 and refiled it on April 22, 2003, 
after making minor technical changes to the proposed rule text. See 
letter from Peter D. Bloom, Acting Managing Director, Regulatory 
Policy, PCX, to Deborah L. Flynn, Assistant Director, Division, 
Commission, dated April 21, 2003. In Amendment No. 3, PCX made 
clarifications to proposed Commentary .02 to PCX Rule 6.64 regarding 
the procedures for determining a single price opening for options 
issues designated for trading on PCX Plus.
---------------------------------------------------------------------------

II. Description of the Proposal

    The Exchange has designed a new trading platform for options, PCX 
Plus. This new hybrid model combines the features of traditional floor-
based markets and new electronic trading systems, while preserving a 
single marketplace with a single book. It allows PCX members to trade 
as Market Makers from locations away from the trading floor. For those 
options designated for trading on PCX Plus, the proposal replaces the 
PCX's current priority rules with new ones and expands upon the 
Exchange's current trading rules by permitting the entry of

[[Page 27130]]

eligible orders of all account types into the Exchange's Consolidated 
Book,\9\ including public customer, Market Maker, and broker-dealer 
orders. The new trading platform will also accommodate independent 
quotations from numerous market participants. In addition, the Exchange 
represents that PCX Plus provides intermarket price protection and 
would operate in a manner consistent with the Options Intermarket 
Linkage Plan (``Linkage Plan'').\10\
---------------------------------------------------------------------------

    \9\ See proposed PCX Rule 6.1(b)(37) (defining ``Consolidated 
Book'' as the Exchange's electronic book of limit orders for the 
accounts of public customers and broker-dealers, and Quotes with 
Size. All orders and Quotes with Size that are entered into the 
Consolidated Book will be ranked and maintained in accordance with 
the rules of priority as provided in proposed PCX Rule 6.76).
    \10\ See Securities Exchange Act Release Nos. 43086 (July 28, 
2000), 65 FR 48023 (August 4, 2000) (order approving the Linkage 
Plan submitted by American Stock Exchange LLC, Chicago Board Options 
Exchange, Inc. and International Securities Exchange, Inc.); 43574 
(November 16, 2000), 65 FR 70850 (November 28, 2000) (order 
approving the PCX as participant in Options Intermarket Linkage 
Plan); and 43573 (November 16, 2000), 65 FR 70851 (November 28, 
2000) (order approving Philadelphia Stock Exchange, Inc. as 
participant in the Linkage Plan).
---------------------------------------------------------------------------

    Under the PCX's proposal, orders would be allocated to Market 
Makers on a ``size pro rata'' basis. This formula would reward larger-
sized bids and offers with greater participation in trades. In 
addition, the proposal would grant significant trade participation 
rights to market participants who are first to improve the PCX quote. 
Under this proposed rule change, a member who improves the quote and 
stands alone at that price for three seconds would receive First 
Improved Quote (``FIQ'') status. Those with FIQ status would be 
guaranteed, at least, the greater of: (1) 40% of the next order(s) to 
buy or sell the same series (for a minimum of 20 contracts), or (2) the 
total size that it would receive pursuant to a size pro rata 
allocation. Market Makers must establish the best bid or offer 
(``BBO'') or quote at the BBO to participate in automated trades.
    The proposed new PCX Plus structure would involve four types of 
Market Makers on the Exchange.\11\ Lead Market Makers (``LMMs'') would 
continue to provide two-sided markets throughout the trading day, while 
conducting their trading activities on the trading floor of the 
Exchange.\12\ Remote Market Makers (``RMMs'') would be permitted to 
enter quotes and effect trades from off-site locations and to select 
their appointed issues. RMMs would be required to provide two-sided 
quotations in each issue in which they are appointed during 60% of the 
time the Exchange is open for trading. Floor Market Makers (``FMMs''), 
who are registered Market Makers with basic obligations on the Options 
Floor, would continue to trade as they do today and would supply 
independently generated Quotes with Size.\13\ Members would also be 
permitted to act as Supplemental Market Makers (``SMMs''), who would be 
provided with tools that allow them to add liquidity at the same price 
that is then being disseminated by the LMM.
---------------------------------------------------------------------------

    \11\ See proposed PCX Rule 6.32(a).
    \12\ LMMs will also be responsible for performing certain 
functions under the Linkage Plan. See supra note 10.
    \13\ See proposed PCX Rule 6.1(b)(33) (which defines ``Quote 
with Size'' as a quotation to buy or sell a specific number of 
option contracts at a specific price that a Market Maker has entered 
into PCX Plus through an electronic interface).
---------------------------------------------------------------------------

    Under the proposal, LMMs would be eligible to receive up to 40% in 
guaranteed participation on trades occurring at their disseminated 
markets. Members would also be entitled to receive up to 40% trade 
participation if they maintain FIQ status. Although members may receive 
more than 40% participation by virtue of a pro rata allocation, no 
member would be eligible to receive more than 40% participation as a 
guarantee by rule. LLMs would be entitled only to the greater of their 
40% guaranteed participation or their size pro rata allocation, subject 
to the size of the LMM's disseminated size.\14\ The proposal is also 
designed to limit firms interacting with their customers' orders to 
receiving no more than a 40% share of such orders before the orders are 
exposed to further competition. Finally, no member would be allocated 
option contracts in excess of their expressed trading interest.
---------------------------------------------------------------------------

    \14\ See proposed PCX Rule 6.76(a)(2)(C)(iii).
---------------------------------------------------------------------------

    The proposal would allow available trading interest on the Exchange 
to be aggregated by price and size. Currently, only orders for the 
accounts of public customers are eligible to be represented in the PCX 
order book. Under the proposal, orders for all account types--including 
public customer, Firm, Market Maker and Non-Member Market Maker--may be 
represented in the Consolidated Book, along with Quotes with Size of 
PCX Market Makers (which would be entered for handling as if they were 
orders). Public customer orders displayed at the best price would 
continue to receive first priority on the Exchange.\15\ In addition, 
all classes of market makers will have the same ability to access 
information about the depth and size of quotes and orders on PCX 
Plus.\16\
---------------------------------------------------------------------------

    \15\ Under the PCX's proposal, inbound orders are allocated 
based on the following priority sequence: public customer orders 
have first priority to trade against such orders; quotes with FIQ 
status have second priority (subject to a 40% cap); the portion of 
the order subject to LMM guaranteed participation will be allocated 
next; followed by any trading interest for the accounts of non-
public customers. See proposed PCX Rule 6.76(a).
    \16\ See proposed subsection (c) to PCX Rule 6.57.
---------------------------------------------------------------------------

    Market and marketable limit orders routed electronically to PCX 
Plus would receive immediate executions against bids and offers in the 
Consolidated Book, unless a specified condition applies, in which case 
the order (or a portion of it) would be routed to a Floor Broker Hand 
Held Terminal for execution. The proposal also establishes new 
procedures for Market Makers' trading interest that interact 
electronically with orders in the Consolidated Book. In such 
situations, a Market Maker who initiates a transaction would be limited 
to 40% of the available customer contracts at the execution price or 
the Market Maker's size pro rata share, whichever amount is greater. 
The Market Maker would then be eligible to trade the remaining option 
contracts at the execution price once other Crowd Participants \17\ 
have had an opportunity to participate.
---------------------------------------------------------------------------

    \17\ See proposed PCX Rule 6.1(b)(38) (which defines ``Crowd 
Participants'' as the Market Makers appointed to an option issue 
under Rule 6.35, and any Floor Brokers actively representing orders 
at the best bid or offer on the Exchange for a particular option 
series.)
---------------------------------------------------------------------------

    While the proposal is intended to further automate options trading 
on the Exchange, the Exchange represents that the proposed new system 
would continue to facilitate open outcry trading as currently practiced 
today, particularly for large transactions and executions of complex 
orders and contingency orders. When an order is entered by phone or re-
routed to a Hand Held Terminal for execution, a Floor Broker would 
represent it at the appropriate trading post and would be afforded 
priority first to public customer interest in the Consolidated Book, 
then to bids or offers in the trading crowd, and finally to any Firm or 
Market Maker interest in the Consolidated Book.\18\
---------------------------------------------------------------------------

    \18\ See proposed PCX Rule 6.76(d).
---------------------------------------------------------------------------

    The Exchange proposes to phase in the use of PCX Plus in particular 
issues, while simultaneously phasing out the current Auto-Ex ``wheel'' 
functionality. During the phase-in period, the Exchange represents that 
it would have two sets of trading rules in operation, each applying to 
a different set of option issues traded on the Exchange. PCX represents 
that PCX Plus will be implemented gradually on an issue-by-issue basis 
beginning on December 15, 2003, and will become completely

[[Page 27131]]

operative and applicable to all options issues by June 30, 2004.\19\
---------------------------------------------------------------------------

    \19\ See Amendment No. 2, supra note 7.
---------------------------------------------------------------------------

    For a more detailed description of the specific proposed amendments 
to PCX's rules, see the Section II.A.1.b. (``Summary of Proposed 
Changes to PCX's Rules'') in the Notice of the Proposal.\20\
---------------------------------------------------------------------------

    \20\ See Notice of the Proposal, supra note 5. See also 
Amendment No. 2, supra note 7, which proposes additional amendments 
to some of those PCX rules.
---------------------------------------------------------------------------

III. Description of Amendments No. 2 and 3 to the Proposal

    In Amendments No. 2 and 3, the PCX proposed changes to the proposed 
PCX Plus rules to address specific questions and concerns raised by the 
Comment Letters and by Commission staff.

A. Automated Opening Rotation Process

    The Exchange proposes to modify PCX Rule 6.64(d) to clarify how the 
automated opening rotation would work in PCX Plus and to add PCX Rule 
6.64, Commentary .02 to codify the procedure for determining a single 
price opening for option issues designated for trading on PCX Plus. The 
proposed automated opening rotations used by PCX Plus would differ from 
those currently used on the Trading Floor in the following respects: 
(1) There would be no ``manual'' openings as provided in current PCX 
Rule 6.64(b); (2) all account types (including orders for the accounts 
of broker-dealers and Market Maker Quotes with Size) would be eligible 
to participate in the opening; (3) the concept of an ``imbalance 
threshold'' (as described in current Rule PCX 6.64(c)(2)(D)) would no 
longer apply; and (4) there would be an electronic Requests for Quotes 
(``RFQ'') process when the opening price cannot be determined within 
certain parameters. The manner in which the opening rotation would 
operate is described below.
1. Establishing a Market for the Opening Rotation
    Opening rotations for options designated for trading on PCX Plus 
would be conducted at the commencement of each trading day using the 
process described in proposed PCX Rule 6.64(d). In Amendment No. 2, PCX 
proposes to modify the proposal to specify that the PCX Plus system 
would accept market and limit orders and Quotes with Size for inclusion 
in the opening rotation process (``Rotation Process'') up until the 
Rotation Process is initiated in that option series. PCX further 
clarifies in Amendment No. 2 that market orders would have priority 
over limit orders during the Rotation Process and any open orders 
residing in the Consolidated Book from the previous trading session 
would be included in the Rotation Process. As set forth in the Notice 
of Proposal, contingency orders (except for ``opening only'' orders) 
will not participate in the Rotation Process.\21\ Amendment No. 2 also 
clarifies that after the primary market for the underlying security 
disseminates the opening trade or the opening quote, the related option 
series would be opened automatically based on the following principles 
and procedures set forth in the Notice of Proposal.
---------------------------------------------------------------------------

    \21\ PCX believes that the exclusion of these order types will 
simplify and facilitate the process for completing the opening. 
Market participants that desire to have such orders represented in 
the opening can choose not to impose the contingency until after the 
opening if they want to attempt to participate in the opening.
---------------------------------------------------------------------------

    First, PCX Plus would verify that a Quote with Size has been 
received from the LMM before a series is eligible for the Rotation 
Process. Second, PCX Plus would determine a single price at which a 
particular option series would be opened, as provided in proposed 
Commentary .02 and as described below. Third, orders in the PCX Plus 
system would maintain priority over Market Maker bids and offers that 
are not being represented in the Consolidated Book as Quotes with Size. 
Orders in the PCX Plus system would be matched up with one another, 
based on the priority rules as set forth in proposed Rule 6.76(a); 
provided, however, that (1) Market Maker Quotes with Size would have 
priority over orders for Firms, Market Makers, and Non-Member Market 
Makers during the Rotation Process and (2) orders for the accounts of 
Firms, Market Makers, and Non-Member Market Makers would be executed 
based on price/time priority during the Rotation Process. Finally, 
following the opening, any unexecuted contracts would be represented as 
bids and offers on the Exchange.
2. Determining the Opening Price for Option Issues Designated for 
Trading on PCX Plus
    In Amendments No. 2 and 3, PCX proposes to add Commentary .02 to 
PCX Rule 6.64 to establish the process by which PCX Plus would 
automatically determine a single price at which a particular option 
series would be opened. The opening price is that price at which the 
maximum number of contracts may be executed within the established 
market. The opening price would always be on or between the bid and 
offer established by the Rotation Process. If there were two or more 
prices at which the maximum number of contracts are executable within 
the established market, then the opening price would be the midpoint of 
the available prices. If, however, the midpoint of the available prices 
is not consistent with the minimum price variation (``MPV''),\22\ the 
opening price would be determined as follows: (1) At the next higher 
(lower) price that is consistent with the MPV if that price is closer 
to the midpoint than the next lower (higher) price that is consistent 
with the MPV; (2) if the next higher and lower prices that are 
consistent with the MPV are equidistant from the midpoint, at the next 
higher or lower price consistent with the MPV that leaves the least 
residual customer limit order volume;\23\ or (3) if the next higher and 
lower prices consistent with the MPV are equidistant from the midpoint 
price and leave the same residual customer limit order volume, at the 
price that the next MPV greater than the midpoint price.\24\
---------------------------------------------------------------------------

    \22\ The Exchange's current MPV for option contracts quoted 
under $3 is $0.05 and for option contracts quoted at or above $3 is 
$0.10. See PCX Rule 6.72.
    \23\ PCX believes that this opening match criterion is 
reasonable and is structured fairly by selecting an opening price 
that would leave the fewest resting customer orders in the 
Consolidated Book.
    \24\ See Amendment No. 2, supra note 7 and Amendment No. 3, 
supra note 8.
---------------------------------------------------------------------------

    To illustrate how the PCX proposes to establish the opening price, 
assume that the established market is 6.00-6.50 and that the maximum 
number of options contracts that could be matched is 250 contracts at 
prices on or between 6.10 and 6.40. Since the resulting midpoint price 
of 6.25 represents a price increment other than an eligible MPV 
permitted under the Exchange's rules, the PCX Plus system will select 
the eligible MPV that is closest to the 6.25 midpoint which, in this 
case, is either 6.20 or 6.30. Since the midpoint at the MPV is 
equidistant (i.e., 0.05) from both the higher and lower prices, the 
opening price will be set at the price that will result in the least 
trading on the customer limit orders residing in the Consolidated Book. 
If the customer limit order volume is the same amount for both the 
higher and lower prices, then the opening price will be set at the 
nearest MPV that is greater than the midpoint which, in this example, 
would be 6.30.
    In the event that the opening price cannot be determined within the 
range of 75% of the lowest Quote with Size bid and 125% of the highest 
Quote with Size offer, the PCX proposes that the PCX Plus system would 
initiate an RFQ

[[Page 27132]]

process as follows: First, an RFQ would be sent to all Crowd 
Participants. The RFQ would indicate the series and the total sell 
(buy) interest at the lowest Quote with Size bid (highest Quote with 
Size offer), if insufficient bids (offers) have been submitted. Second, 
all opening eligible bids and offers would continue to be accepted 
during the RFQ period for inclusion in the opening transaction 
calculation. At the conclusion of the RFQ period, the Rotation Process 
would determine an opening price pursuant to proposed subsection (b) of 
Commentary .02 to proposed PCX Rule 6.64(d). Third, if the Rotation 
Process cannot be completed after the first RFQ, a second RFQ would be 
disseminated. Fourth, if the Rotation Process cannot be completed 
following the second RFQ period, a third, expanded, RFQ would be 
disseminated to all Crowd Participants and any other Market Makers 
logged on to the system. PCX proposes that the expanded RFQ would 
include: (1) The series; (2) the volume representing the total sell 
(buy) interest at the lowest Quote with Size bid (highest Quote with 
Size offer), if insufficient bids (offers) have been submitted; and (3) 
the side of the market with the imbalance. Finally, if the Rotation 
Process cannot be completed following the third RFQ period, an alert 
would be generated to Exchange staff. No additional RFQs would be 
disseminated. The Rotation Process would attempt to open the series 
every 30 seconds until it can be successfully completed.

B. Appointment of RMMs

    In Amendment No. 2, the Exchange proposes to add a new proposed 
subsection (h) \25\ to PCX Rule 6.35 to allow Member Firms \26\ who own 
or lease multiple seats to have an equal number of primary appointments 
available to them as would an individual that owns or leases the same 
number of seats. Under proposed PCX Rule 6.35(h), if a Member Firm has 
two or more Nominees \27\ that are registered as RMMs, then the number 
of seats held in the name of such RMMs may be aggregated for the 
purpose of determining the number of options issues eligible for 
primary appointment pursuant to proposed PCX Rule 6.35(g)(2). The 
distribution of the option issues as primary appointments for each RMM 
would be at the discretion of the Member Firm; however, an RMM would be 
prohibited from concurrently trading or quoting the same option issue 
as an RMM who is a Nominee for the same Member Firm. Additionally, for 
purposes of PCX Rule 6.35, the primary appointment would apply 
collectively to the Member Firm (subject to the approval of the Options 
Allocation Committee), rather than to each Nominee registered as a RMM.
---------------------------------------------------------------------------

    \25\ Proposed Rule 6.35(h) is being renumbered as proposed PCX 
Rule 6.35(i).
    \26\ A ``Member Firm'' means ``a partnership, corporation, 
limited liability company or other organization in good standing who 
owns or leases a membership or upon whom a member has conferred 
privileges of membership pursuant to and in compliance with Article 
VIII of the PCX Constitution.'' See PCX Rule 1.1(j).
    \27\ A ``Nominee'' means ``a Member Firm which owns more than 
one membership may register such additional membership or 
memberships in the name of a nominee or nominees subject to such 
conditions and requirements as the Board of Governors may 
prescribe.'' See Article VIII, Section 2(a) of the PCX Constitution.
---------------------------------------------------------------------------

    The PCX believes that the proposed new subsection (h) to PCX Rule 
6.35 is consistent with current membership rules as each RMM that 
performs market-making activities on behalf of the Member Firm would 
have to be assigned a membership in order to trade on PCX Plus. In 
addition, each RMM would have to be registered and properly qualified 
pursuant to current PCX Rule 6.33.

C. Restriction on the Entry of Two-Sided Quotations

    Under proposed PCX Rule 6.37(h)(5), as published in the Notice of 
the Proposal, RMMs would be required to trade at least 75% of their 
average daily trading volume per quarter in issues included in their 
primary appointments. RMMs would be permitted to trade up to 25% of 
their quarterly contract volume in option issues that are not included 
within their primary appointments. In Amendment No. 2, the Exchange 
proposes to amend its proposal to include a provision that would 
restrict RMMs from entering two-sided quotations in option issues that 
are not included within their primary appointments. However, RMMs would 
be permitted to enter single-sided quotes \28\ and multiple orders to 
buy and sell the same option series. PCX believes that such restriction 
is necessary to ensure the proper performance of the PCX Plus system 
and to prevent RMMs from circumventing the spirit and intent of 
limiting the number of option issues per seat as set forth in proposed 
PCX Rule 6.35(g)(2).
---------------------------------------------------------------------------

    \28\ RMMs enter single-sided quotes directly into an interface 
with PCX Plus. RMMs would not be permitted, however, to stream 
quotes in such issues. RMMs also could enter orders through a 
proprietary brokerage terminal, which would be routed to a floor 
broker for representation. An RMM may choose to enter an order, 
rather than a single-sided quote, when the order is complex, is 
being entered on a contingency basis, or involves other discretion. 
Telephone call between Sonia Trocchio, Special Counsel, Division, 
Commission, and Pete Armstrong, Senior Vice President, Options Floor 
Operations, PCX on April 16, 2003.
---------------------------------------------------------------------------

D. LMM Trade Allocation Methodology

    The Exchange proposes to amend proposed PCX Rule 6.76(a)(2)(C) 
concerning the methodology used to allocate trades to LMMs. As 
discussed in the Notice of the Proposal, LMMs in options trading in PCX 
Plus would be guaranteed an allocation up to 40% of the incoming 
trading interest on trades occurring at their disseminated markets. The 
LMM's 40% participation would apply to the quantity remaining after all 
public customer orders and quotes with FIQ status, if any, have first 
been executed.\29\ In addition, if there were contracts remaining to be 
executed, the remaining portion of the LMM's bid or offer would have 
participated in the ``size pro rata'' allocation, as provided in 
proposed PCX Rule 6.76(a)(4). Thus, LMMs would have received both a 40% 
guaranteed participation and a size pro rata allocation.
---------------------------------------------------------------------------

    \29\ Proposed PCX Rule 6.76(a)(2)(C)(ii).
---------------------------------------------------------------------------

    In response to the Phlx Letter, which argued that the proposed 
trade allocation methodology would provide LMMs with a disproportionate 
share of the incoming order flow, PCX proposes in Amendment No. 2 to 
eliminate proposed PCX Rule 6.76(a)(2)(C)(iv) and proposes to amend 
proposed PCX Rule 6.76(a)(2)(C)(iii) so that LMMs would receive an 
allocation representing the greater of their 40% guaranteed 
participation or their size pro rata allocation, but no greater than 
the size of the LMM's disseminated size.\30\
---------------------------------------------------------------------------

    \30\ The LMM's disseminated size would not include the size of 
any SMMs quoting at the LMM's disseminated price. Telephone call 
between Sonia Trocchio, Special Counsel, Division, Commission, and 
Pete Armstrong, Senior Vice President, Options Floor Operations, PCX 
on April 17, 2003.
---------------------------------------------------------------------------

E. Obvious Error and Trade Nullification/Price Adjustment Rules

    In a separate rule filing, the Exchange proposes to adopt new rules 
that would allow it to either adjust or nullify a transaction in 
circumstances where a member or its customer has made an error and the 
price of the execution is ``obviously'' not correct.\31\ The proposed 
rules will contain objective standards regarding when a transaction was 
clearly the result of an ``obvious error,'' under what circumstances a 
trade would be adjusted or nullified, and to what price a trade would 
be adjusted if adjustment were appropriate under the circumstances. The 
Exchange represents that its obvious error and trade nullification/
price adjustment rules applicable to PCX Plus will be based

[[Page 27133]]

upon the rules that the Commission ultimately approves in File No. SR-
PCX-2002-01, and not the existing Price Adjustment rules.\32\ The 
Exchange further represents that it will not implement PCX Plus before 
File No. SR-PCX-2002-10 has been approved by the Commission.
---------------------------------------------------------------------------

    \31\ See File No. SR-PCX-2002-01.
    \32\ Telephone call between Deborah Flynn, Assistant Director, 
Division, Commission, and Kathryn Beck, Senior Vice President, 
General Counsel, and Corporate Secretary, PCX on April 14, 2003.
---------------------------------------------------------------------------

F. System Phase-In and Applicability of Rules

    In response to the request of Commission staff, PCX proposes to 
amend proposed PCX Rule 6.90(b) to clarify the application of trading 
rules in option issues traded on PCX Plus during the phase-in period. 
During the phase-in period, PCX would have two sets of trading rules in 
operation, each applying to a different set of option issues traded on 
the Exchange. Accordingly, PCX estimates that the rules applicable to 
PCX Plus would be implemented gradually on an issue-by-issue basis 
beginning on December 15, 2003, and would become completely operative 
and applicable to all options issues by June 30, 2004. At that time, 
the rules relating to PCX Plus would supercede existing rules that are 
inapplicable to the new trading environment.\33\ The PCX represents 
that the purpose of the gradual rollout schedule is to give PCX and its 
members the opportunity to observe and gain experience with the new 
system and to give PCX the opportunity to make any adjustments and 
changes to the system (in consultation with and approval by the 
Commission), if and when necessary.
---------------------------------------------------------------------------

    \33\ See proposed PCX Rule 6.90(b).
---------------------------------------------------------------------------

G. Prevention of the Misuse of Material, Non-Public Information

    In Amendment No. 2, PCX represents that PCX Rule 2.6(e) (Prevention 
of the Misuse of Material, Non-Public Information) would apply to 
members trading on PCX Plus. PCX believes that PCX Rule 2.6(e) would 
require a PCX Market Maker to maintain information barriers (that are 
reasonably designed to prevent the misuse of material, non-public 
information by such member) with any affiliates that may act as a 
specialist or market maker in any security underlying the options for 
which the PCX member acts as a Market Maker.

H. Maximum Order Size Eligibility

    As discussed in the Notice of the Proposal, proposed PCX Rule 6.76 
provides that the maximum size of an inbound order (the ``Maximum Order 
Size'') that may be eligible for execution on PCX Plus will be 
established by the LMM in the issue, subject to the approval of two 
Floor Officials, whose approval must be further ratified by the Options 
Floor Trading Committee. In Amendment No. 2, the Exchange proposes to 
modify this provision to require approval of the LMM's initial 
determination of the Maximum Order Size by the Options Floor Trading 
Committee. In addition, the Exchange proposed to add the following 
text: ``Any request by the LMM for changes to the Maximum Order Size 
must be accompanied by a verified statement indicating the business 
reason for the change and the estimated duration of such change. Such 
requests must be approved by two Floor Officials, whose approval must 
be further ratified by the Options Floor Trading Committee.'' 
Furthermore, in Amendment No. 2, PCX proposes to add language to 
proposed PCX Rule 6.76 to prohibit a LMM from requesting changes to the 
Maximum Order Size in order to manipulate the operation of PCX Plus or 
for any anti-competitive purposes.
    The Exchange believes that the proposed amendment to proposed PCX 
Rule 6.76 addresses the competitive concerns raised by the Commission 
staff and is consistent with the terms and spirit of the Commission's 
Order.\34\
---------------------------------------------------------------------------

    \34\ See Order Instituting Public Administrative Proceedings 
Pursuant to section 19(h)(1) of the Act, Making Findings and 
Imposing Remedial Sanctions (``Settlement Order''). Securities 
Exchange Act Release No. 43268 (September 11, 2000) (File No. 3-
10282).
---------------------------------------------------------------------------

I. Linkage Plan

    The Commission staff requested the Exchange to clarify the 
application of the definition of ``Eligible Market Maker,'' as that 
term is used in the Linkage Plan \35\ and in PCX Rule 6.92. In this 
regard, for purposes of the Linkage Plan, PCX represents in Amendment 
No. 2 that a PCX Market Maker would be considered an Eligible Market 
Maker if the PCX Market Maker is logged on to the PCX Plus system and 
provides continuous two-sided quotations (or, in the case of a SMM, the 
size of its quotation) through an electronic interface to the PCX Plus 
System.
---------------------------------------------------------------------------

    \35\ See Linkage Plan, supra note 10, section 2(7) (definition 
of ``Eligible Market Maker'').
---------------------------------------------------------------------------

J. Quoting Obligations of SMMs and FMMs

    The quoting obligations of SMMs and FMMs are set forth in proposed 
PCX Rule 6.37(g)(3) and (4), respectively. In Amendment No. 2, the 
Exchange proposes to modify these proposed rules to clarify that when 
the aforementioned Market Makers are present in the trading crowd, they 
would be required to provide quotations on PCX Plus through an 
electronic interface with the Exchange, but would be permitted to also 
provide quotations by public outcry. In addition, whenever a Floor 
Broker represents an order in the trading crowd and calls for a market 
in a particular options series, each SMM and FMM present at the trading 
post would be obligated to vocalize a two-sided, legal-width market 
(pursuant to PCX Rule 6.37(b)(1)).
    The Exchange believes that this proposed amendment to proposed PCX 
Rule 6.37 will ensure that SMMs and FMMs meet their affirmative 
obligations and be entitled to receive special margin treatment by 
assisting the LMM in maintaining a fair and orderly market.

K. Suspension of the PCX Plus System

    In the Notice of the Proposal, proposed PCX Rule 6.90(g) included 
provisions regarding the suspension of the PCX Plus system in the event 
of any disruption or malfunction in the use or operation of system, as 
well as any other unusual market conditions not involving a system 
malfunction. In Amendment No. 2, the Exchange proposes to amend 
proposed PCX Rule 6.90(g) as follows:
    First, the Exchange proposes to eliminate that portion of the text 
in proposed Rule 6.90(g)(1) that refers to the declaration of a ``fast 
market'' by two Floor Officials. The Exchange believes that the deleted 
phrase ``declare a fast market'' is inapplicable given its market 
structure and trading system. The PCX Plus system enables Market Makers 
to set parameters establishing the amount of their quotation size that 
would be available for execution against inbound interest, with the 
system automatically executing such orders according to these 
parameters. Consequently, when a system disruption or malfunction 
occurs but the Exchange is able to process and disseminate quotes 
accurately, any orders received by the Exchange would be routed to 
Floor Broker Hand Held Terminals for representation in the trading 
crowd. In such circumstances, Market Maker bids and offers would 
continue to be firm pursuant to PCX Rule 6.86 and SEC Rule 11Ac1-1 
under the Act. Regular trading procedures would be resumed by the 
Exchange when two Floor Officials determine that the disruption or 
malfunction is corrected.
    Second, the Exchange proposes to add language to proposed PCX Rule 
6.90(g)(1) to clarify that those orders

[[Page 27134]]

that are routed to Floor Broker Hand Held Terminals for manual 
representation during a system disruption or malfunction would be 
executed pursuant to the order execution and priority principles set 
forth in proposed PCX Rule 6.76(d).
    Finally, the Exchange proposes to eliminate proposed PCX Rule 
6.90(g)(2), which relates to other unusual market conditions not 
involving a system malfunction, because it is superfluous. The Exchange 
believes that under any circumstance where a fair and orderly market 
cannot be maintained, the trading halt guidelines set forth in current 
PCX Rule 6.65 will be followed. Trading may be resumed whenever two 
Floor Officials determine that a fair and orderly market may be 
maintained. The Exchange also proposes to make a conforming change to 
PCX Rule 6.28(c)(6) by eliminating that portion of the text that refers 
to the suspension of the PCX Plus system during fast markets and 
unusual market conditions, as this provision is no longer applicable.

L. Applicability of Automated System Access Privileges (``ASAP'') 
Memberships

    ASAP Memberships are governed by current PCX Rule 1.14, which 
allows certain qualified broker-dealers (``ASAP Members'') electronic 
access to the Exchange's automated options trading system, Pacific 
Options Exchange Trading System (``POETS''), as well as any other 
systems approved by the PCX's Board of Governors. In Amendment No. 2, 
PCX represents that an ASAP Membership cannot be utilized: (1) To 
effect trades via PCX Plus, or (2) by a member to act as a RMM.

M. Miscellaneous Changes

    Finally, in Amendment No. 2, the PCX proposes the following 
technical and miscellaneous changes:
    1. PCX Rule 6.52--The Exchange proposes to change the text of 
proposed PCX Rule 6.52(a) to clarify that, for those option issues 
designated for trading on PCX Plus, limit orders for the accounts of 
public customers, broker-dealers, and Market Makers, and Quotes with 
Size of Market Makers will be eligible for placement in the 
Consolidated Book. In option issues not designated for trading on PCX 
Plus, the Exchange proposes to retain the provisions contained in 
current PCX Rule 6.52(a) and (c),\36\ which would be renumbered as 
subsections (b) and (d), respectively (current PCX Rule 6.52(b) would 
be renumbered as subsection (c)).
---------------------------------------------------------------------------

    \36\ Current PCX Rule 6.52(c) describes the circumstances and 
procedures to be followed by Floor Brokers for the entry, 
cancellation and changes of orders held by the Order Book Official.
---------------------------------------------------------------------------

    2. Proposed PCX Rule 6.76(b)(2)(B)--The Exchange also proposes to 
change the text in proposed PCX Rule 6.76(b)(2)(B) to clarify that the 
provisions in paragraph (B) would apply to a Firm or Non-Member Market 
Maker order that was entered one minute or more before the inbound 
order.
    3. Proposed PCX Rule 6.90(e)--Proposed PCX Rule 6.90(e) sets forth 
the practices that would be prohibited on PCX Plus. The Exchange 
represents that the requirements of this rule would apply only to 
members and member organizations that have direct electronic access to 
PCX Plus and are responsible for the execution and settlement of any 
resulting trades.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendments No. 2 and 3 to the proposed rule 
change, including whether Amendments No. 2 and 3 are 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 PCX. All 
submissions should refer to File No. SR-PCX-2002-36 and should be 
submitted by June 9, 2003.

V. Discussion

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the Act and the rules and 
regulations promulgated thereunder applicable to a national securities 
exchange and, in particular, with the requirements of section 6(b) of 
the Act.\37\ Specifically, the Commission finds that approval of the 
proposed rule change, as amended, is consistent with section 6(b)(5) of 
the Act \38\ in that it is designed to facilitate transactions in 
securities; to prevent fraudulent and manipulative acts and practices; 
to promote just and equitable principles of trade; to foster 
cooperation and coordination with persons engaged in regulating, 
clearing, settling, processing information with respect to, and 
facilitating transactions in securities; to remove impediments to and 
perfect the mechanism of a free and open market and a national market 
system; and in general, to protect investors and the public interest.
---------------------------------------------------------------------------

    \37\ 15 U.S.C. 78f(b). 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).
    \38\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

A. Obligations of Market Makers

    The PCX Plus proposal contemplates four types of Maker Makers: 
LMMs, RMMs, FMMs, and SMMs. LMMs are required to provide continuous 
two-sided quotes that meet certain spread parameters throughout the 
trading day in each of their appointed issues. LMMs must enter their 
quotations through an automated quotation system, but may also provide 
quotations by public outcry.
    RMMs enter quotations from off-floor locations through an 
electronic interface with the Exchange.\39\ Further, because PCX Rule 
6.37(h)(1) states that all rules applicable to market makers apply to 
RMMs unless otherwise provided, PCX Rule 6.37(a)-(c) would apply to 
RMMs.\40\ In addition, RMMs are required to provide continuous two-
sided quotations that meet certain quote spread parameters in each of 
their appointed issues 60% of the time that the Exchange is open for 
options trading, and may not enter two-sided quotes in options issues 
that are not included in the RMMs primary appointment. RMMs could, 
however, enter single-sided quotes and multiple orders to buy and sell 
the same option series in issues outside their primary appointment.
---------------------------------------------------------------------------

    \39\ The Commission notes that, in Amendment No. 2, PCX 
represented that an ASAP Membership, governed by PCX Rule 1.14, 
cannot be used to effect trades via PCX Plus, or to act as a RMM. 
See Amendment No. 2, supra note 7.
    \40\ PCX Rule 6.37(a) states that transactions of a market maker 
should constitute a course of dealings reasonably calculated to 
contribute to the maintenance of a fair and orderly market. PCX Rule 
6.37(b) states, among other things, that a market maker is expected 
to engage, to a reasonable degree under the existing circumstances, 
in dealings for his own account when there is a lack of price 
continuity, a temporary disparity between the supply of and demand 
for a particular option contract, or a temporary distortion of the 
price relationships between option contracts of the same class. PCX 
Rule 6.37(c) sets forth the requirements for trading by a market 
maker in options classes to which the market maker is not appointed.
---------------------------------------------------------------------------

    FMMs would be physically located in the trading crowd, and like 
RMMs,

[[Page 27135]]

would be required to provide two-sided quotations that meet certain 
quote spread parameters through an auto-quoting device when present in 
the trading crowd. FMMs would also be obligated to vocalize a two-sided 
legal-width market whenever a floor broker enters the trading crowd.
    Finally, when present in the trading crowd, SMMs would be required 
to provide the size of their quotations at the LMM's bid or offer 
through an electronic interface device. Also, like FMMs, SMMs would be 
obligated to vocalize a two-sided, legal-width market whenever a floor 
broker enters the trading crowd.
    In addition, all Market Makers must trade at least 75% of their 
average daily trading volume per quarter in issues included in their 
primary appointment.\41\ All Market Makers, except RMMs, must also 
execute at least 60% of their transactions in-person.
---------------------------------------------------------------------------

    \41\ PCX represents that this 75% average daily trading volume 
requirement will apply to all PCX Market Makers pursuant to PCX Rule 
6.35, Commentary .03. Telephone conversation between Kathryn Beck, 
Senior Vice President, General Counsel, and Corporate Secretary, 
PCX, and Sapna C. Patel, Attorney, Division, Commission, on April 
10, 2003.
---------------------------------------------------------------------------

    Market Makers receive certain benefits for carrying out their 
duties. For example, a lender may extend credit to a broker-dealer 
without regard to the restrictions in Regulation T of the Board of 
Governors of the Federal Reserve system if the credit is to be used to 
finance the broker-dealer's activities as a specialist or market maker 
on a national securities exchange.\42\ The Commission believes that a 
Market Maker must have an affirmative obligation to hold itself out as 
willing to buy and sell options for its own account on a regular or 
continuous basis to justify this favorable treatment. In this regard, 
the Commission believes that PCX's rules impose such affirmative 
obligations on PCX Plus Market Makers.
---------------------------------------------------------------------------

    \42\ See 12 CFR 221.5(c)(6).
---------------------------------------------------------------------------

B. Priority and Allocation

    Under the proposal, the best priced bids and offers have priority 
over worse priced bids and offers. The Commission believes that the 
capability that PCX Plus provides to market makers to independently 
submit their quotes and then reward market makers with better quotes 
through this priority rule should substantially enhance incentives to 
quote competitively by providing market participants that improve the 
quote with an allocation of the resulting trade.\43\
---------------------------------------------------------------------------

    \43\ The Exchange has submitted the proposed rule change 
pursuant to subparagraph IV.B.h.(i)(aa) of the Commission's 
September 11, 2000 Order Instituting Public Administrative 
Proceedings Pursuant to section 19(h)(1) of the Securities Exchange 
Act of 1934, Making Findings and Imposing Remedial Sanctions, which 
required the PCX (as well as other floor-based option market 
exchanges) to adopt new, or amend existing rules to substantially 
enhance incentives to quote competitively and substantially reduce 
disincentives to act competitively. See Settlement Order, supra note 
34.
---------------------------------------------------------------------------

    In addition, bids and offers for public customers would get first 
priority over other bids or offers at the same price. If there is more 
than one highest bid or lowest offer for a public customer, the bids/
offers would be ranked based on time priority. Non-customer orders and 
Quotes with Size would be allocated (after any LMM or FIQ guarantees, 
discussed below) on a size pro rata basis.
1. LMM Guarantee
    PCX Rule 6.82 currently provides LMMs with a 40% participation 
right in transactions occurring at their disseminated bids and/or 
offers in their allocated issues. PCX Plus rules would also guarantee 
to the LMM 40% of the portion of an order traded at the LMM's quote 
that remains after the execution of all public customer orders and 
quotes with FIQ status. The LMM, however, would be entitled to its size 
pro rata allocation, if it were greater than the allocation it would 
receive under the LMM guarantee. In no event would the LMM be allocated 
contracts greater than its disseminated size.\44\
---------------------------------------------------------------------------

    \44\ Proposed PCX Rule 6.76(a)(2)(C)(iii).
---------------------------------------------------------------------------

    The Commission recognizes that a large guaranteed participation 
right will erode the incentive of other market makers to make 
competitive markets. Thus, the Commission must weigh whether a proposed 
participation right adequately balances the aim of rewarding the 
specialist or lead market maker with the aim of leaving a sizeable 
enough portion of the incoming order for the other market makers 
quoting at the same price.\45\ The Commission has previously taken the 
position that a trade participation right that does not exceed 40%, 
including any guaranteed percentage of the trade to be accorded to any 
other trade participant, is not inconsistent with the Act.\46\
---------------------------------------------------------------------------

    \45\ See Securities Exchange Act Release No. 43100 (July 31, 
2000), 65 FR 48778, 48787-90 (August 9, 2000) (``Phlx 80/20 
Proposal'') (Commission requested comment on whether the proposal by 
the Phlx to establish an 80% specialist guarantee would be 
consistent with the Act).
    \46\ See, e.g., Securities Exchange Act Release No. 45936 (May 
15, 2002), 67 FR 36279, 26280 (May 23, 2002) (SR-CBOE-2002-10) 
(approving participation entitlements that range from 34 percent to 
40 percent for the DPM providing the primary quote feed, depending 
on the total number of appointed market makers in the option); 
Securities Exchange Act Release No. 42835 (May 26, 2000), 65 FR 
35683, 35685-66 (June 5, 2000) (SR-CBOE-99-10) (approving DPM 
guarantee for crossed orders that, when combined with the percentage 
crossed by the floor broker, cannot exceed 40% of the original order 
(after relevant public customer orders have been satisfied)); and 
Securities Exchange Act Release No. 42455 (February 24, 2000), 65 FR 
11388, 11398 (March 2, 2000) (approving International Securities 
Exchange's application for registration as a national securities 
exchange, which contains a 40% participation right for facilitating 
EAMs); see also Phlx 80/20 Proposal, supra note 45.
---------------------------------------------------------------------------

2. FIQ Status
    A non-customer order or Quote with Size that improves the best bid 
or offer on the Exchange will have FIQ status with respect to other 
bids or offers at the same price, unless it is matched or further 
improved within three seconds. An order or Quote with Size with FIQ 
status is entitled to trade against the greater of: (1) 40% of the next 
inbound electronic order or orders (after public customer orders have 
been executed), and (2) the total size that the order or Quote with 
Size with FIQ status would be entitled to receive pursuant to a size 
pro rata allocation. An order or Quote with Size with FIQ status would 
not be awarded a greater number of contracts than the size of the bid 
or offer with FIQ status. LLMs would be entitled only to the greater of 
their 40% guaranteed participation or the number of contracts the LMM 
would be entitled to receive for having FIQ status.\47\
---------------------------------------------------------------------------

    \47\ See proposed PCX Rule 6.76(a)(3)(C).
---------------------------------------------------------------------------

    The Phlx commented that because the ``LMM need only match the price 
improving quote (as opposed to further improving it), LMMs likely would 
automate the matching process to ensure that no Market Maker that 
improves the quote would ever be able to maintain FIQ status.''\48\ The 
Commission, however, does not believe that giving any preference to a 
Market Maker that first improves the quote is required by the Act. The 
Commission also believes that because all PCX Plus Market Makers will 
be able to independently and automatically generate quotes in all 
series and will participate in the trade pursuant to the size pro rata 
allocation when they are at the best price, that even if the Market 
Maker loses its FIQ status because its quote is matched by another 
Market Maker or the LMM, the proposal substantially enhances incentives 
to quote competitively.\49\ Finally, although it is not unlawful for a 
market maker to take the prices offered by its competitors into account 
when setting its own prices, or to follow or copy prices of its

[[Page 27136]]

competitors, such a decision must be a unilateral business judgment not 
intended to harass or punish a competitor for improving prices or 
otherwise acting competitively and not the result of collusive 
agreement. Accordingly, the Commission expects that the PCX will 
surveil its market to ensure that market makers are not coordinating 
quotes in PCX Plus or engaging in other anticompetitive conduct.
---------------------------------------------------------------------------

    \48\ See Phlx Letter, supra note 6.
    \49\ Currently, a Market Maker that improves the quote would be 
able to participate in the resulting trade only if that Market Maker 
happens to be next on the Auto-Ex ``wheel.''
---------------------------------------------------------------------------

C. Linkage Obligations

    Under PCX Rule 6.92(a), an ``Eligible Market Maker'' for purposes 
of the Linkage Plan is defined as ``a market maker that: (i) Is 
assigned to, and is providing two-sided quotations in, the Eligible 
Option Class; (ii) is logged on to participate in Auto-Ex in such 
Eligible Option Class; \50\ and (iii) is in compliance with the 
requirements of PCX Rule 6.95 (relating to limitation on principal 
order access).'' \51\ PCX Market Makers would be considered to be 
Eligible Market Makers participating in the automated execution system 
for PCX Plus issues if they are logged on to the PCX Plus system and 
provide continuous two-sided quotes (or, with respect to SMMs, the size 
of their quote) through an electronic interface to the PCX Plus System. 
The Commission notes that to enable PCX to comply with its obligations 
under the Linkage Plan, PCX Rules 6.92 through 6.96 will apply to the 
PCX Plus system.\52\ The Commission also notes that PCX clarified in 
Amendment No. 2 that LLMs have responsibility for handling incoming 
Linkage orders. The Commission believes that these provisions should 
assure other Linkage Plan participants that the introduction of PCX 
Plus should not jeopardize the PCX's ability to satisfy its obligations 
under the Linkage Plan.
---------------------------------------------------------------------------

    \50\ PCX represents that it will amend this rule to clarify that 
a market maker logged on to participate in PCX Plus would also 
satisfy the requirements of this provision. Telephone call between 
Kathryn L. Beck, Senior Vice President, PCX and Sonia Trocchio, 
Special Counsel, Division, Commission on April 8, 2003.
    \51\ The Commission approved the Linkage Plan in July 2000. See 
supra note .
    \52\ PCX represents that it will amend these rules, as 
necessary, to clarify their applicability to PCX Plus. Telephone 
call between Kathryn L. Beck, Senior Vice President, PCX and Sonia 
Trocchio, Special Counsel, Division, Commission on April 8, 2003.
---------------------------------------------------------------------------

D. PCX Plus Executions

    PCX Plus provides for automated executions and manual executions, 
as well as split-price executions and electronic book executions. The 
PCX represents that once PCX Plus is completely phased in, it will 
replace the PCX's current Auto-Ex ``wheel'' in its entirety.
    Under PCX's current rules, an incoming eligible market or 
marketable limit order is automatically executed against an order in 
the PCX order book if there is an order representing the best price on 
the Exchange. Otherwise, the inbound order, or a portion of it, is 
executed by Market Makers in the trading crowd who are logged onto 
PCX's Auto-Ex ``wheel.''
    Under PCX Plus, inbound marketable orders would be immediately 
executed against bids and offers in the Consolidated Book unless: (1) 
The size of the inbound order exceeds the PCX's established Maximum 
Order Size; \53\ or (2) the inbound order is for the account of a Firm 
or Non-Market Maker and more than 50% of the aggregate trading interest 
in the Consolidated Book at the execution price is for the account(s) 
of public customers. If either of these two conditions exist, the 
inbound order would be routed to a Floor Broker Hand Held Terminal for 
manual execution by the trading crowd based on priority rules in 
proposed PCX Rule 6.76(d).
    If the inbound marketable order does not meet the two conditions 
above, the way it would be executed under the proposed rules would 
differ depending on whether a single firm or Non-Member Market Maker 
order at the best price on the Consolidated Book was entered less than 
one minute, or one minute or more, before the inbound order.\54\
---------------------------------------------------------------------------

    \53\ Proposed PCX Rule 6.76(b)(1). The Maximum Order Size 
eligible for execution on PCX Plus will be established by the LLM in 
the issue, subject to approval of the Options Floor Committee.
    \54\ Proposed PCX Rule 6.76(b)(2).
---------------------------------------------------------------------------

    The Commission notes that inbound electronic orders entered through 
PCX Plus will receive split-price execution at multiple price levels if 
there is insufficient trading interest at the best price in the 
Consolidated Book and the remainder of the order can be filled at one 
or more other price levels in the Consolidated Book. The Commission 
notes that, consistent with the Linkage Plan, under the PCX's proposed 
rules for PCX Plus, the order cannot be executed at a price that trades 
through another market, and so the balance of the order, if any, will 
either be placed on the Consolidated Book, or, if it locks or crosses 
the NBBO, routed to a Floor Broker Hand Held Terminal for manual 
execution.\55\
---------------------------------------------------------------------------

    \55\ PCX Rule 6.76(b)(3).
---------------------------------------------------------------------------

    Under the PCX Plus system, Market Makers can receive electronic 
book executions when they enter a Quote with Size that initiates a 
trade with the Consolidated Book. The initiating Quote with Size will 
immediately execute against the Consolidated Book if the percentage of 
the transaction including public customer interest comprises no more 
than 40% of the transaction. If the public customer interest is more 
than 40% of the transaction, the initiating Quotes with Size will 
receive the greater of the 40% of the public customer interest in the 
Consolidated Book at that price, or the total size that the initiating 
Quote with Size would receive on a size pro rata allocation. The Crowd 
Participants will then have an opportunity to obtain the balance of the 
Consolidated Book on a size pro rata basis. The Commission notes that 
split-price executions will not occur with electronic book executions.
    The Commission believes that the various types of PCX Plus 
executions, including automated and manual executions, as well as 
split-price and electronic book executions, should allow Market Makers 
and floor brokers to provide more efficient and immediate executions 
for inbound orders and Quotes with Size, subject to priority and 
allocation principles.

E. Section 11(a) of the Act

    Under the proposed rules, public customer orders would always 
receive first priority. Therefore, the Commission believes that the PCX 
Plus system should comply with section 11(a) of the Act.\56\
---------------------------------------------------------------------------

    \56\ 15 U.S.C. 78k(a).
---------------------------------------------------------------------------

F. NBBO Step-Up Feature

    The PCX proposes to incorporate an NBBO Step-Up feature for PCX 
Plus that is similar to its current PCX Rule 6.87(i), which allows PCX 
members logged on to Auto-Ex to step up to the NBBO in executing 
incoming orders. Under PCX Plus, an LMM in an issue would have the 
discretion, subject to the approval of two Floor Officials, to use the 
NBBO Step-Up feature to step up and execute orders at the NBBO price 
when the NBBO is better than the PCX's disseminated price. The LMM also 
would have the discretion to use the NBBO Step-Up feature to 
disseminate Quotes with Size at the NBBO, which would then be 
disseminated via Options Price Reporting Authority.
    The Commission notes that the LMM in an issue may not use the NBBO 
Step-Up feature to match quotations of other PCX participants who are 
quoting at the NBBO.\57\ The Commission further notes that SMMs may 
choose, but are not required, to participate in the NBBO Step-Up 
feature.\58\ Thus, SMMs cannot

[[Page 27137]]

be required to trade at a price that is not their own quote, unless 
they so choose. As a result, the Commission believes that the NBBO 
step-up feature will not undermine SMMs' incentives to add size to the 
LMM's quotes.
---------------------------------------------------------------------------

    \57\ Proposed PCX Rule 6.76(b)(5)(B).
    \58\ Proposed PCX Rule 6.76(b)(5).
---------------------------------------------------------------------------

G. Crossing Rules

    The PCX Plus proposal incorporates a new crossing mechanism that 
would permit the cross and execution of two orders with instructions to 
match the identified buy-side with the identified sell-side at a 
specified cross price.\59\ Under the crossing mechanism, a PCX Broker 
(defined as a member, member organization, or associated person who 
enters orders as agent for accounts other than for Market Makers) would 
enter certain terms of each cross order into PCX Plus for electronic 
execution. If the cross price entered is outside of the BBO, PCX Plus 
would reject the cross orders. If the cross price is between the BBO, 
the order designated by the PCX Broker as the side to be exposed to the 
market would be displayed to the other members for 30 seconds. The 
exposed order would also be sent to OPRA for public dissemination.\60\
---------------------------------------------------------------------------

    \59\ Proposed PCX Rule 6.76(c). In addition, PCX Rule 6.94 
prohibits crosses from occurring outside of the NBBO.
    \60\ Telephone call between Sonia Trocchio, Special Counsel, 
Division, Commission, and Pete Armstrong, Senior Vice President, 
Options Floor Operations, PCX on April 16, 2003.
---------------------------------------------------------------------------

    The PCX proposal establishes certain prohibitions regarding cross 
orders to prevent internalization and to promote competition. Under the 
proposal, it would be a violation of PCX rules for a PCX Broker to be a 
party to any arrangement designed to circumvent proposed PCX Rule 
6.76(c) by providing an opportunity for a public customer or a broker-
dealer to execute against agency orders handled by the PCX Broker 
immediately upon their entry into PCX Plus. PCX Brokers also would not 
be permitted to execute as principal any orders they represent as agent 
unless: (1) Agency orders are first exposed on the Exchange for at 
least 30 seconds; (2) the PCX Broker utilizes the crossing mechanism 
pursuant to proposed PCX Rule 6.76(c)(2); or (3) the PCX Broker 
executes the orders pursuant to PCX Rule 6.47 (``Crossing'' Orders and 
Stock/Option Orders). The Commission believes that these rules should 
promote intramarket price competition by providing market makers with a 
reasonable opportunity to compete for a significant percentage of the 
incoming order and, therefore, should protect investors and the public 
interest.

H. Integrated Market Making and Side-by-Side Trading

    The PCX has indicated that PCX Rule 2.6(e), which governs the use 
of material, non-public information, would apply to members trading on 
PCX Plus. The PCX has represented that this rule would require a PCX 
Market Maker to maintain information barriers--that are reasonably 
designed to prevent the misuse of material, non-public information by 
such member--with any affiliates that may act as specialist or market 
maker in any security underlying the options for which the PCX member 
acts as a Market Maker. The Commission believes that the requirement 
that there be an information barrier between the PCX Market Maker and 
its affiliates with respect to transactions in the option and the 
underlying security serve to reduce the opportunity for unfair trading 
advantages or misuse of material, non-public information.

I. Prohibited Practices

    The PCX proposal includes certain prohibited practices for PCX 
members entering orders through PCX Plus.\61\ The proposed prohibitions 
are similar to those under current PCX Rule 6.87(d).
---------------------------------------------------------------------------

    \61\ Proposed PCX Rule 6.90(e).
---------------------------------------------------------------------------

    PCX members would be prohibited from dividing up orders considered 
to be part of a single investment decision into small lots in order to 
stay within the Maximum Order Size established pursuant to PCX Rule 
6.76. Multiple orders to trade the same option issue that are on the 
same side of the market, whether long or short, and multiple orders to 
trade the same options series entered within any 15-second period for 
the account of the same beneficial owner will be presumed to be based 
on a single investment decision. The Commission finds that the 15-
second requirement as applicable to multiple orders for the same 
beneficial owner is consistent with the provisions of the Act and the 
rules and regulations thereunder. The Commission believes that fifteen 
seconds is a sufficient time period to allow Market Makers to change 
their quotations following an execution, while at the same time not 
unduly long as to place a burden on investors seeking to execute 
transactions on the Exchange. The Commission believes that this 
prohibition should prevent the splitting of orders on behalf of the 
same beneficial owner to meet PCX Plus eligibility, while providing a 
safe-harbor rule for multiple orders entered after the 15-second time 
period. The Exchange has represented and the Commission notes that the 
prohibition against splitting orders applies only to PCX members and 
member organizations that have direct electronic access to PCX Plus, 
and does not apply in any way to customers.

J. Suspension of PCX Plus

    The PCX Plus proposal includes rules regarding the suspension of 
PCX Plus.\62\ Under the proposed PCX Plus rules, PCX Plus could be 
suspended in the event of any disruption or malfunction in the use or 
operation of the system by two Floor Officials. The Commission notes 
that if the PCX Plus system is suspended for any reason, the priority 
and allocation rules of PCX Plus set forth in PCX Rule 6.76(d) would 
apply.
---------------------------------------------------------------------------

    \62\ PCX Rule 6.90(g).
---------------------------------------------------------------------------

K. Obvious Error

    The Exchange represents that its obvious error and trade 
nullification/price adjustment rules applicable to PCX Plus will be 
based upon the rules that the Commission ultimately approves in File 
No. SR-PCX-2002-01, and not the existing Price Adjustment rules. 
Further, PCX represents that it will not implement PCX Plus until File 
No. SR-PCX-2002-01 has been approved by the Commission. Thus, the 
implementation of PCX Plus is contingent upon the Commission's approval 
of SR-PCX-2002-01.

VI. Accelerated Approval of Amendments No. 2 and 3

    The Commission finds good cause for approving Amendments No. 2 and 
3 to the proposed rule change prior to the thirtieth day after the 
amendments are published for comment in the Federal Register pursuant 
to section 19(b)(2) of the Act.\63\ Amendment No. 2 addresses concerns 
raised in some of the Comment Letters,\64\ as well as issues and 
concerns raised by Commission staff. Amendment No. 3 clarifies proposed 
Commentary .02 of PCX Rule 6.64 regarding procedures for determining a 
single price opening for options issues designated for trading on PCX 
Plus. The

[[Page 27138]]

Commission believes that the proposed changes in Amendments No. 2 and 3 
are necessary to the proper functioning and implementation of PCX Plus, 
and therefore, believes that accelerated approval of Amendments No. 2 
and 3 is appropriate.
---------------------------------------------------------------------------

    \63\ 15 U.S.C. 78s(b)(2).
    \64\ The Commission notes that two of the commenters, IB Group 
and Morgan Stanley, supported the PCX's proposal and urged the 
Commission to approve the proposal. The other two commenters, the 
Phlx and Susquehanna, raised concerns regarding the PCX's proposal. 
The Phlx's comments focused mainly on preferential treatment 
afforded to LMMs. As discussed above, the PCX addressed the concerns 
raised by the Phlx Letter and the Commission staff in Amendment No. 
2. The Susquehanna Letter raised general concerns about the practice 
of internalization in the options markets, not limited to PCX's 
proposal, and asked the Commission to consider its policy against 
internalization in reviewing the PCX's proposed rules. See Comment 
Letters, supra note 6.
---------------------------------------------------------------------------

VII. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule change, as amended, is consistent with the Act and the rules and 
regulations thereunder applicable to a national securities exchange, 
and, in particular, with section 6(b)(5) of the Act.\65\
---------------------------------------------------------------------------

    \65\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\66\ that the proposed rule change (SR-PCX-2002-36) and Amendment 
No. 1 are approved, and that Amendments No. 2 and 3 thereto are 
approved on an accelerated basis.
---------------------------------------------------------------------------

    \66\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\67\
---------------------------------------------------------------------------

    \67\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Jill M. Peterson,
Assistant Secretary.
[FR Doc. 03-12456 Filed 5-16-03; 8:45 am]
BILLING CODE 8010-01-P