[Federal Register Volume 68, Number 110 (Monday, June 9, 2003)]
[Notices]
[Pages 34441-34448]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-14368]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47959; File No. SR-CBOE-2002-05]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendments No. 1, 2, 3, and 4 Thereto and Notice of Filing 
and Order Granting Accelerated Approval to Amendments No. 5 and 6 
Thereto by the Chicago Board Options Exchange, Incorporated Relating to 
the Introduction of the CBOE Hybrid System

May 30, 2003.

I. Introduction

    On January 18, 2002, the Chicago Board Options Exchange, 
Incorporated (``CBOE'' 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 implement the CBOE 
Hybrid System. The CBOE filed Amendments No. 1, 2, 3, and 4 to the 
proposed rule change on April 2, 2002, May 17, 2002, January 16, 2003, 
and April 7, 2003, respectively.\3\ The proposed rule change and 
Amendments No. 1, 2, 3, and 4 were published for comment in the Federal 
Register on April 22, 2003.\4\ The Commission received two comment 
letters on the proposal.\5\ The Exchange filed Amendments No. 5 and 6 
to the proposal on May 16, 2003\6\ and May 30, 2003,\7\ respectively. 
The CBOE also submitted a letter responding to the ISE Letter on May 
16, 2003.\8\ This order approves the proposed rule change and 
Amendments No. 1, 2, 3, and 4; grants accelerated approval to 
Amendments No. 5 and 6 to the proposed rule change; and solicits 
comments from interested persons on Amendments No. 5 and 6.
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    \1\ 15 U.S.C. 78s(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.
    \4\ Securities Exchange Act Release No. 47676 (April 14, 2003), 
68 FR 19865.
    \5\ Letters from Michael J. Simon, Senior Vice President and 
Secretary, International Securities Exchange (``ISE''), to Jonathan 
G. Katz, Secretary, Commission, dated May 13, 2003 (``ISE Letter''); 
and Philip D. DeFeo, Chairman and Chief Executive Officer, Pacific 
Exchange, Inc. (``PCX''), to Jonathan G. Katz, Secretary, 
Commission, dated May 21, 2003 (``PCX Letter'').
    \6\ Letter from Steve Youhn, CBOE, to Deborah Flynn, Assistant 
Director, Division of Market Regulation (``Division''), Commission, 
dated May 15, 2003 (``Amendment No. 5''). Amendment No. 5 revises 
proposed CBOE Rule 6.13(b)(iii) to clarify that if a marketable 
balance remains after a split price execution, it would be booked 
automatically only if the order is eligible for book entry. 
Otherwise, the balance would route either to PAR or BART, or, at the 
order entry firms' discretion, to the order entry firm's booth 
printer. Amendment No. 5 also revises proposed CBOE Rule 7.4(a) to 
require electronic submission of orders or quotes for entry into the 
electronic book, and to require such orders and quotes to comply 
with format requirements prescribed by the Exchange. Finally, 
Amendment No. 5 moves the sentence, ``Orders not eligible for 
automatic execution instead will route to PAR, BART, or, at the 
order entry firm's discretion, to the order entry firm's booth 
printer'' from proposed CBOE Rule 6.13(b)(i)(B)(ii) to proposed CBOE 
6.13(b)(i)(B), and renumbers subsection (B) as subsection (C).
    \7\ Letter from Steve Youhn, Attorney, CBOE, to Deborah Flynn, 
Assistant Director, Division, Commission, dated May 30, 2003 
(``Amendment No. 6''). First, Amendment No. 6 amends proposed CBOE 
Rule 6.45A(a)(i) to clarify that only in-crowd DPMs can be 
considered to be ``market participants.'' Second, Amendment No. 6 
amends proposed CBOE Rule 6.45A(c), regarding interaction of market 
participant's quotes and/or orders with orders in electronic book, 
to clarify that a trade occurs when a market participant's quote or 
order interacts with the order in the book; and that the CBOE would 
disseminate a last sale report at this point and decrement the 
disseminated quote to reflect the execution. Third, Amendment No. 6 
describes in greater detail the ability of market makers to submit 
two-sided and one-sided quotes (referred to as orders). Fourth, 
Amendment No. 6 clarifies that the FPC generally has the discretion 
to determine whether to route orders through PAR or BART, and 
clarifies how the FPC would use that discretion. Fifth, Amendment 
No. 6 clarifies the routing process for orders that would be 
eligible for automatic execution when the CBOE is not at the NBBO. 
Sixth, Amendment No. 6 amends proposed CBOE Rule 6.45A(c) to clarify 
that customer orders would be the only type of order represented by 
floor brokers that would be eligible to participate in the N-second 
group.
    \8\ Letter from Edward J. Joyce, President and Chief Operating 
Officer, CBOE, to Jonathan G. Katz, Secretary, Commission, dated May 
15, 2003 (``CBOE Response Letter'').
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II. Description of the Proposal

    The Exchange proposes to implement the CBOE Hybrid System 
(``Hybrid'' or

[[Page 34442]]

``Hybrid System''), an options trading platform that would combine the 
features of electronic and open outcry, auction market principles, 
while, at the same time, providing market makers the ability to 
electronically stream their own quotes. Today, CBOE's disseminated 
quote represents, for the most part, only the DPM's automatically 
generated quotations. Market makers are able to affect changes to that 
quote only in open outcry (or by putting up manual quotes). Hybrid 
would offer in-crowd market makers and in-crowd DPMs \9\ the 
opportunity to submit their own firm disseminated market quotes that 
represent their own trading interest.\10\ In addition, in-crowd floor 
brokers would be permitted to enter orders on behalf of their customers 
for display in the CBOE's best bid or offer (``BBO''). Market makers 
would have the ability to stream quotes that reflect their individual 
trading interest.
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    \9\ See Amendment No. 6, supra note 7.
    \10\ In-crowd floor brokers may represent orders on behalf of 
members, broker-dealers, public customers, and the firm's 
proprietary account. Pursuant to CBOE 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 would be 
one to buy or sell. Unlike market makers and the DPM, floor brokers 
may not stream quotes.
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    Incoming electronic orders from public customers and non-market 
maker broker-dealers that automatically execute against market 
participants' quotes would be allocated to the best quoters pursuant to 
a new trading algorithm. This ``Ultimate Matching Algorithm'' (``UMA'' 
or the ``allocation algorithm'') retains public customer priority and 
rewards market participants for quoting at the best price and for 
providing liquidity at the best price.
    Hybrid also retains features of a floor-based, open outcry 
exchange. Order entry firms would continue to have the option of 
sending floor brokers into a trading crowd to request markets on behalf 
of their customers. Trading crowds, as is the case today, would 
continue to have the opportunity to offer price improvement to orders 
that are exposed to the open outcry, auction market environment.
    Under Hybrid, non-market maker broker-dealers would have the same 
access to the automatic execution feature of Hybrid as public 
customers.\11\ In this regard, non-market maker broker-dealers orders 
would be permitted to automatically execute against quotes and resting 
limit orders on the book, whether those orders are public customer 
orders or broker-dealer orders. Additionally, at the discretion of the 
Floor Procedure Committee (``FPC''), broker-dealer orders would be 
eligible for placement into the electronic book, where they may be 
executed electronically.\12\
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    \11\ See proposed CBOE Rule 6.13(b)(i)(B)(1).
    \12\ See proposed CBOE Rule 7.4(a).
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    To implement Hybrid, the Exchange proposes to adopt several new 
rules (most notably, CBOE Rules 6.13 and 6.45A) and to amend several 
existing rules. New CBOE Rule 6.13 would replace the Exchange's RAES 
Rule 6.8 for those classes in which Hybrid is operational and would 
govern the automatic execution of incoming electronic orders. Proposed 
CBOE Rule 6.45A would be the new priority and allocation rule and would 
codify UMA. A more complete description of the proposal is provided in 
Section IV, below.
    This proposal would apply only to equity options. The Exchange 
proposes a rollout schedule to begin trading of equity option classes 
on Hybrid by May 30, 2003. New equity option classes would continue to 
be rolled out gradually as the Exchange and its membership become more 
familiar with the operation of the system. The determination of which 
classes to roll out, and when to roll them out, would be made by the 
Equity FPC. The Exchange plans 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.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendments No. 5 and 6 to the proposed rule 
change, including whether Amendments No. 5 and 6 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, would be 
available for inspection and copying in the Commission's Public 
Reference Room. Copies of such filing would also be available for 
inspection and copying at the principal office of the CBOE. All 
submissions should refer to File No. SR-CBOE-2002-05 and should be 
submitted by June 30, 2003.

IV. 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.\13\ Specifically, the Commission finds that approval of the 
proposed rule change, as amended, is consistent with section 6(b)(5) of 
the Act \14\ 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.
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    \13\ 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).
    \14\ 15 U.S.C. 78f(b)(5).
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A. Automatic Executions

    CBOE Hybrid would permit the automatic execution of incoming 
electronic customer and non-market maker broker-dealer orders in 
classes designated for trading on Hybrid. Pursuant to proposed CBOE 
Rule 6.13(b)(i)(C), two categories of orders would be eligible, for the 
same number of contracts, for automatic execution: orders from non-
broker-dealer public customers and orders from non-market maker broker-
dealers. The appropriate FPC would be permitted to determine that 
orders from market makers and specialists would also be eligible for 
automatic execution.\15\ Orders not eligible for automatic execution 
instead would route to PAR, BART, or, at the order entry firm's 
discretion, to the order entry firm's booth printer.\16\
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    \15\ CBOE market makers who are physically present in the 
trading crowd would be permitted to submit one-sided quotes (also 
referred to as an order) or two-sided quotes. See Amendment No. 6, 
supra note 7.
    \16\ 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, would print at the booth and must 
be handled by the firm manually. As is the case today, the FPC would 
have the discretion, on a class by class basis, to route orders to 
PAR or BART. If market maker orders are not eligible for automatic 
execution, they would all route to PAR or they would all route to 
BART. The FPC could not determine to route, for example, orders for 
CBOE market makers that are not in the crowd to PAR, and competing 
market maker orders to BART. The CBOE represents that routing 
decisions would be changed infrequently. See Amendment No. 6, supra 
note 7.

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[[Page 34443]]

    In addition, the appropriate FPC would determine, on a class-by-
class basis, the maximum size of orders entitled to receive automatic 
execution through Hybrid. If the appropriate FPC determines to allow 
market makers and specialists to access the automatic execution feature 
of Hybrid, proposed CBOE Rule 6.13(b)(i)(C) would permit the FPC 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.
    Under proposed CBOE Rule 6.13(b)(iii), eligible orders for a size 
greater than the disseminated size would be automatically executed up 
to the disseminated size. The balance of the order, if marketable, 
would be executed automatically at the revised disseminated price up to 
the revised disseminated size. If not marketable, the balance of the 
order would book electronically, if the order were eligible for book 
entry. Otherwise, the balance would route either to PAR or BART, or, at 
the order entry firms' discretion, to the order entry firm's booth 
printer.\17\
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    \17\ See Amendment No. 5, supra note 6.
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    Pursuant to proposed CBOE Rule 6.13(b)(iv), when the CBOE quotation 
is inferior to the NBBO, eligible orders would not automatically 
execute and instead, would route to the DPM's PAR terminal or, at the 
order entry firm's discretion, to BART, for non-automated handling.\18\ 
Eligible orders received while the CBOE market is locked would 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 would route to the DPM's PAR terminal or, at the 
order entry firm's discretion, to BART, for non-automated handling.
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    \18\ In these instances, the order would route to PAR, unless 
the order entry firm decides that these orders should route to BART, 
because routing to PAR would allow the DPM either to send an order 
through the options intermarket linkage or to execute the order at 
the better price. See Amendment No. 6, supra note 7.
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    In its comment letter, the ISE questions why ``an FPC would 
establish a size limit for orders eligible for automatic execution 
under proposed Rule 6.13 when the size of market maker quotes is 
displayed and firm for certain incoming orders.''\19\ The ISE's comment 
suggested that, in its view, the requirements of the Quote Rule \20\ 
and an exchange's automatic execution system parameters must 
necessarily be the same. The Quote Rule, however, does not require an 
automatic execution. For this reason, the Commission has previously 
approved exchange rules that establish automatic execution sizes that 
are different from the sizes for which responsible brokers or dealers 
are obligated under the Quote Rule.\21\
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    \19\ See ISE Letter, supra note.
    \20\ 11Ac1-1 under the Act (``Quote Rule''), 17 CFR 240.11Ac1-1.
    \21\ See, e.g., CBOE Rule 6.8(c)(v), which states that ``[t]he 
appropriate FPC shall determine the size of orders eligible for 
entry into RAES.'' See also PCX Rule 6.76, which states that ``[t]he 
maximum size of an inbound order that may be eligible for execution 
on PCX Plus . . . will initially be established by the LMM in the 
issue, subject to the approval of the Options Floor Trading 
Committee. Any request by the LMM for changes to the Maximum Order 
Size . . . must be approved by two Floor Officials, whose approval 
must be further ratified by the Options Floor Trading Committee.''
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    The ISE also argues that the size restrictions on orders eligible 
for automatic execution, together with ``the requirement that broker-
dealer orders and/or competing market maker orders must be represented 
in the trading crowd * * * raise best execution concerns not only for 
the orders represented in the trading crowd, but also for incoming 
electronic orders and orders on the electronic limit order book that 
may receive automatic executions at inferior prices.''\22\ In response 
to this comment, CBOE notes that proposed CBOE Rule 6.13(b)(iv) 
expressly prohibits the automatic execution of orders at prices 
inferior to the NBBO and that orders do not lose this protection merely 
because they are executed manually instead of electronically.\23\ The 
CBOE also notes that orders executed in open outcry actually have the 
potential opportunity to be executed at better prices than they would 
receive if executed electronically.\24\ The Commission believes that 
the proposed rules are consistent with the Act. Brokers continue to 
have best execution obligations to their customers and must consider 
all facts and circumstances in determining where to route customers' 
orders.
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    \22\ See ISE Letter, supra note 6.
    \23\ See CBOE Response Letter, supra note .
    \24\ Id.
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    Finally, CBOE notes that the ISE is incorrect in its statement that 
orders for competing market makers that are not eligible for automatic 
execution must be routed to a floor broker in the firm's booth.\25\ 
Pursuant to Proposed CBOE Rule 6.13(b)(i)(B), absent specific 
instructions by the order entry firm to the contrary, orders that are 
not eligible for automatic execution may route only to PAR or BART.
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    \25\ Id.
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B. Priority and Allocation

1. Allocation of Incoming Electronic Orders
    Under proposed CBOE Rule 6.45A, incoming electronic orders would be 
allocated to a market participant who is quoting or representing an 
order at the CBOE BBO using UMA for up to the size of its quote.\26\ 
Public customer orders in the electronic book and at the BBO would 
always have priority. Multiple public customer orders in the electronic 
book at the same price would be ranked based on time priority.\27\
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    \26\ 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 would 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'' would be distributed among each 
broker-dealer order comprising the ``market participant'' based on 
UMA. See proposed CBOE Rule 6.45A(a)(i)(A)(2).
    \27\ If a public customer order in the electronic book matches, 
or is matched by, a market participant's quote, the public customer 
order would have priority and, the balance of the electronic order, 
if any, would be allocated based on UMA.
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    A market participant quoting alone at the BBO would have priority 
and would be entitled to receive incoming electronic order(s) up to the 
size of its quote. When more than one market participant is quoting at 
the BBO, inbound electronic orders would be allocated pursuant to UMA. 
UMA allocates orders based on two separate components: parity (i.e., 
multiple participants quoting at the best price) and depth of liquidity 
(i.e., relative size of each market participant's quote).\28\ Component 
A of the UMA is the parity component, which would treat as equal all 
market participants quoting at the relevant best bid or best offer. 
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. Component B of the UMA is the 
size pro-rata component designed to reward and incent market 
participants to quote with size. The percentage used

[[Page 34444]]

for Component B 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. The final relative 
weighting of Components A and B would be determined by the appropriate 
FPC,\29\ but initially, would be equal. The assigned weightings of 
Components A and B would be multiplied by the percentages derived for 
Components A and B, respectively, and then would be multiplied by the 
size of the incoming order.
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    \28\ UMA operates electronically and, as such, only market 
participants that are represented in the disseminated quote would 
participate in the allocation of incoming electronic orders. 
Multiple incoming orders would execute in accordance with CBOE Rule 
8.51, Firm Disseminated Market Quotes.
    \29\ See CBOE Response Letter, supra note 8 .
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    In its comment letter, the ISE argues that the proposal ``will 
allow an FPC to change the allocation algorithm in many different ways 
* * * '' and that ``[s]uch a broad range of allocation possibilities 
cannot be equally fair and equally provide the best incentives for 
competition.'' \30\ In response to ISE's comment, the CBOE represents 
that changes to these weightings would be made very infrequently and 
would apply floorwide in all classes within that FPC's 
jurisdiction.\31\ The CBOE further notes that the proposal requires 
that changes to these weightings must be announced to Exchange members 
in advance of implementation. Thus, the CBOE concludes that there is no 
possibility of ``gaming'' the formulas to disproportionately benefit 
certain trading crowds.
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    \30\ See ISE Letter, supra note 5.
    \31\ See CBOE Response Letter, supra note 8.
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    As stated above, the proposed allocation algorithm consists of the 
weighting of two components: the parity component, which treats as 
equal all market participants quoting at the relevant best bid or best 
offer, and the size pro-rata component, which provides greater 
allocations to market participants with larger quotes. The Commission 
must consider whether each component and all possible combinations of 
each component are consistent with the Act. The Commission has 
previously approved allocation algorithms that provide an equal 
allocation to participants quoting at the best price, as well as 
algorithms that provide for size pro rata allocations.\32\ The 
Commission also believes that any combination of these two algorithms 
would be consistent with the Act. In addition, the Commission believes 
that the proposed Hybrid System, including the proposed allocation 
algorithm, should substantially enhance incentives to quote 
competitively by providing market participants with the ability to 
independently submit their quotes and then rewarding market 
participants that quote at the best price with an allocation of the 
resulting trade.\33\
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    \32\ See PCX Rule 6.75(c); CBOE Rule 6.45(a)(ii)(2); and PCX 
Rule 6.76(a)(4).
    \33\ 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 CBOE (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.
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    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 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 CBOE will surveil its market to ensure that market 
makers are not coordinating quotes in the Hybrid System or engaging in 
other anticompetitive conduct.
2. Allocation of Orders Represented in the Trading Crowd by Floor 
Brokers
    Orders represented in the trading crowd would first be executed 
against public customer orders in the electronic book. Multiple public 
customer orders in the electronic book at the same price would be 
ranked based on time priority.\34\
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    \34\ See proposed CBOE Rule 6.45A(b)(i)(A).
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    After public customer orders on the book at the best price are 
exhausted, the method for allocating the remainder of orders that are 
represented in the trading crowd by floor brokers would depend upon 
whether there were any book market participants (``BMP'') \35\ quoting 
at the prevailing price. If there were no BMP present at the prevailing 
price, open outcry orders would be allocated pursuant to existing CBOE 
Rule 6.45(a) and (b). If there were a BMP quoting at the prevailing 
price, open outcry orders would be allocated as follows: If two or more 
bids (offers) represent the best price, priority would continue to be 
afforded in the sequence in which the bids (offers) were made, subject 
to the restriction that the first market participant to verbally 
respond would be entitled to 70% of the order. The second market 
participant to verbally respond (if ascertainable) would be entitled to 
70% of the remainder of the order (i.e., 70% of 30%). The balance of 
the order would be apportioned equally among the remaining market 
participants verbally bidding (offering) at the same price and the BMP. 
The portion allocated to the BMP would be distributed among each book 
market participant pursuant to the UMA.
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    \35\ 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 proposed CBOE Rule 6.45A(b), 
the cumulative number of broker-dealer orders in the electronic book 
at the best price would be deemed one BMP, regardless of the number 
of broker-dealer orders in the book.
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    If, at any point, the sequence in which market participants 
verbally respond is not ascertainable, any remaining balance of an 
incoming order would be apportioned equally among the remaining market 
participants bidding (offering) at the same price and, if applicable, 
the BMP. If a market participant declines to accept any portion of the 
available contracts, any remaining contracts would 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.
    The Commission believes that the proposed rules governing 
allocation of orders represented in the trading crowd are consistent 
with the Act.
3. Interaction of Market Participant's Quotes/Orders with Orders in the 
Book
    Under proposed CBOE Rule 6.45A(c), market participants would be 
permitted to submit orders or quotes electronically to trade with 
orders in the electronic book. However, for purposes of proposed CBOE 
Rule 6.45A(c), a floor broker market participant would be permitted 
only to represent as agent customer orders.\36\ When a market 
participant's quote or order interacts with the order in the book, a 
trade occurs, and CBOE would disseminate a last sale report, and the 
size of the order would be decremented to reflect the execution.\37\ If 
only one market participant submits an electronic order or quote to 
trade with an order in the electronic book, that market participant 
would be entitled to receive an allocation of that order in the 
electronic book up to the size of the market participant's quote or 
order. If, however, more than one market participant submits a quote or 
order to trade with the book within a period of time not to exceed 5-
seconds \38\ of the first market

[[Page 34445]]

participant to submit an order (``N-second group''), each member of the 
N-second group would be entitled to share in the trade with the 
electronic book pursuant to the allocation algorithm described 
below.\39\
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    \36\ See Amendment No. 6, supra note 7.
    \37\ Id.
    \38\ This N-second period is configurable by the appropriate FPC 
but would never exceed 5-seconds. Any reduction of this N-second 
period (or subsequent increase) would be announced to the membership 
in advance of implementation via Regulatory Circular. Furthermore, 
this time-period would apply uniformly among all classes under the 
FPC's jurisdiction. See CBOE Response Letter, supra note 8.
    \39\ See Amendment No. 6, supra note . The trade occurs when the 
first market participant's quote or order interacts with the order 
in the book, not at the expiration of the N-second period.
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    Component A of the proposed allocation algorithm is an equal 
percentage based on the number of market participants in the N-second 
group. Component B of the proposed allocation algorithm is that 
percentage that the order or quote of each market participant in the N-
second group represents relative to the total number of contracts of 
such orders or quotes. The final relative weighting of Components A and 
B would be determined by the appropriate FPC,\40\ but initially, would 
be equal. The assigned weightings of Components A and B would be 
multiplied by the percentages derived for Components A and B, 
respectively, and then would be multiplied by the size of the incoming 
order.
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    \40\ As stated above, CBOE represents that these weightings 
would be changed very infrequently. See CBOE Response Letter, supra 
note 8.
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    If a DPM were eligible for an allocation by virtue of being a 
member of the N-second group, the DPM would 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), discussed below. 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.
    In its comment letter, ISE raises several concerns about the 
proposed N-second period.\41\ First, ISE questions whether a marketable 
public customer order that is received during the N-second period would 
receive an automatic execution against orders in the limit order book 
during the N-second period. The ISE also questions whether, if the 
incoming order trades against orders in the limit order book and the 
best price moves, the interest in the N-second group would be 
automatically cancelled.\42\
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    \41\ See ISE Letter, supra note 5.
    \42\ Id.
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    The Commission believes that ISE's questions are answered by CBOE's 
amendment clarifying when a trade occurs in the context of an N-second 
group transaction.\43\ Specifically, as amended, proposed CBOE Rule 
6.45A(c) indicates that a trade would occur when a market participant's 
quote or order interacts with the order in the book. At this point, 
CBOE would disseminate a trade report and decrement its disseminated 
quote to reflect the execution. The N-second group is relevant only to 
determining the appropriate allocation of the trade among market 
participants. According to the CBOE, the N-second period prevents 
millisecond priority by giving a form of parity to market participant 
orders submitted at virtually the same time. Moreover, because the N-
second group is relevant only to the allocation of the trade, members 
of the N-second group would not have an opportunity to cancel 
trades.\44\
---------------------------------------------------------------------------

    \43\ See Amendment No. 6, supra note 7.
    \44\ See CBOE Response Letter, supra note 8.
---------------------------------------------------------------------------

    In addition, ISE questions how a participant in the N-second group 
representing a customer order would be treated.\45\ CBOE's amendment 
also clarifies that if a floor broker agent submits a customer order to 
buy (sell) the book, and that order is first in time (i.e., ahead of 
all other market participants), it would have priority.\46\ CBOE's 
amendment further clarifies that a floor broker submitting a customer 
order after a market participant would become part of the N-second 
group.\47\ Floor broker handheld quoting/order entry terminals provide 
floor brokers with the ability to designate orders as customer 
orders.\48\
---------------------------------------------------------------------------

    \45\ Id.
    \46\ See Amendment No. 6, supra note 7.
    \47\ Id. The Hybrid System, at least temporarily, would not 
recognize in-crowd orders from floor broker handheld devices for 
purposes of allowing these orders to participate in the N-second 
group. To address this systems limitation, the Exchange proposes to 
designate in each trading crowd ``Temporary Order Access Terminals'' 
(``T-OATs'') that would allow floor brokers to enter customer orders 
that would be eligible to participate in the N-second group. The 
CBOE represents that these terminals would provide to floor brokers 
the same functionality in terms of order entry that in-crowd market 
makers currently have. The CBOE also represents that these T-OATs 
would be reserved exclusively for the use of floor brokers holding 
customer orders and would be conveniently located in the trading pit 
such that they are readily available and easily accessible. The CBOE 
commits to place at least one T-OAT in each trading pit in which 
Hybrid is operational and further commits to provide as many T-OATs 
as are necessary to accommodate demand. The CBOE will provide these 
T-OATs for floor brokers' use until the above-mentioned Hybrid 
System limitation is resolved in such a manner that floor brokers 
have direct order entry access via floor broker workstations. The 
Exchange will continue to provide T-OATs until either November 28, 
2003 or until the Hybrid System is capable of accepting orders from 
floor broker workstations, whichever occurs first. See proposed CBOE 
Rule 6.45A(c)(iv).
    \48\ Id.
---------------------------------------------------------------------------

    Finally, the ISE questions the discretion given the FPC with 
respect to the length of the N-second interval. The Commission notes 
that the FPC may only shorten the length of this interval and, as 
represented by CBOE, any changes to the N-second interval would be 
announced to the membership in advance of implementation and would 
apply uniformly across all classes under the FPC's jurisdiction.
    Accordingly, the Commission believes that this proposed algorithm 
is consistent with the Act and should ensure that additional market 
participants have an opportunity to interact with orders resting on the 
Exchange's electronic book.
4. Quotes Interacting with Quotes
    Because Hybrid allows the simultaneous entry of quotes by multiple 
market makers, there may be instances where quotes become locked. If an 
in-crowd market maker's (including the DPM) disseminated quote were to 
interact with the disseminated quote(s) of another in-crowd market 
maker (including the DPM), resulting in the dissemination of a 
``locked'' quote, the following would occur:
    (A) The Exchange would disseminate the locked market and both 
quotes would be deemed ``firm'' disseminated market quotes.
    (B) The market makers whose quotes are locked would receive a quote 
update notification advising that their quotes are locked.
    (C) A ``counting period'' would begin during which market makers 
whose quotes are locked may eliminate the locked market.\49\ Provided, 
however, that in accordance with subparagraph (A) above, a market maker 
would be obligated to execute customer and broker-dealer orders 
eligible for automatic execution pursuant to proposed CBOE Rule 6.13 at 
his disseminated quote in accordance with CBOE Rule 8.51. During the 
``counting period,'' market makers would 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

[[Page 34446]]

period, the quotes remain locked, the locked quotes would automatically 
execute against each other in accordance with the allocation algorithm 
described above in proposed CBOE Rule 6.45A(a).
---------------------------------------------------------------------------

    \49\ For the first 60 days after a class begins trading on the 
Hybrid System, the length of the ``counting period'' for that 
particular class would not exceed ten seconds. For the next 60 days 
thereafter (i.e., days 61-120) the length of the ``counting period'' 
would 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'' would not exceed four seconds in 
that class. Beginning April 1, 2004, all classes trading on Hybrid 
would be subject to a counting period not to exceed four seconds. 
The appropriate FPC may shorten the duration of the ``counting 
period.''
---------------------------------------------------------------------------

    The Hybrid System would not disseminate an internally crossed 
market (i.e., the CBOE bid is higher than the CBOE offer). If a market 
maker were to submit an incoming quote that would cross an existing 
quote, the Exchange would automatically alter the incoming quote such 
that it locks the existing quote, at which point the locked quotes 
would be treated in accordance with the procedures described above. The 
Exchange would notify the second market maker that its quote has been 
changed.\50\ The Commission believes that the proposed provisions are 
consistent with the Quote Rule. Market makers would continue to be 
required to honor their quotes and, thus, would be obligated to execute 
incoming orders pursuant to proposed CBOE Rule 6.13. The Commission 
notes that the market makers whose quotes are locked would continue to 
be obligated under the Quote Rule for at least one contract to each 
other during the counting period. At the end of the counting period, 
assuming neither market maker has changed its quotes, the market 
makers' quotes would execute against each other in all series.
---------------------------------------------------------------------------

    \50\ During the lock period, if the first quote is cancelled or 
changed, the second quote would 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 would 
be changed to 1.20-1.40 and the disseminated quote would 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) would revert to 1.25-1.40.
---------------------------------------------------------------------------

    PCX argues \51\ that these proposed rules are inconsistent with the 
Options Intermarket Linkage Plan (``Linkage Plan'').\52\ The Commission 
notes that the Linkage Plan's admonition to avoid the dissemination of 
locked and crossed markets \53\ would apply to CBOE Hybrid. The 
Commission believes that the proposed ``counting period'' provides a 
reasonable method for market makers that lock or cross a market to 
unlock or uncross the market, as required by the Linkage Plan.\54\ 
Importantly, during the ``counting period,'' the market makers whose 
quotes are locked would remain obligated to execute customer and 
broker-dealer orders eligible for automatic execution at the locked 
price.\55\
---------------------------------------------------------------------------

    \51\ See PCX Letter, supra note 5.
    \52\ 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).
    \53\ See Section 7(a)(i)(C) of the Linkage Plan.
    \54\ Id.
    \55\ See proposed CBOE Rule 6.45A(d).
---------------------------------------------------------------------------

    PCX also argues that the proposal would ``exacerbate the occurrence 
of * * * non-disclosed crossed markets to the detriment of public 
investors.''\56\ The Linkage Plan requires the CBOE and the other 
options exchanges to avoid the dissemination of locked or crossed 
markets. If a market maker were to submit an incoming quote that would 
cross an existing quote, the Exchange proposed to automatically alter 
the incoming quote such that it locks the existing quote, thus avoiding 
the dissemination of a crossed market. The Commission believes the 
proposed rules regarding crossed markets provide a reasonable method of 
avoiding the dissemination of inverted markets.
---------------------------------------------------------------------------

    \56\ See PCX Letter, supra note 5.
---------------------------------------------------------------------------

5. DPM's Participation Entitlement
    Under proposed CBOE Rule 6.45(a)(i)(C), if a DPM is eligible for an 
allocation pursuant to the operation of the UMA described above, the 
appropriate FPC would determine whether a DPM's allocation would 
be:\57\
---------------------------------------------------------------------------

    \57\ See proposed CBOE Rule 6.45A(a)(i)(C). Each pronouncement 
regarding which allocation alternative to be used would be made via 
Regulatory Circular.
---------------------------------------------------------------------------

    (A) 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)\58\ or the amount it would 
otherwise receive pursuant to the operation of the proposed allocation 
algorithm described above; or
---------------------------------------------------------------------------

    \58\ CBOE Rule 8.87 states that ``[s]ubject to the review of the 
Board of Directors, the MTS Committee may establish from time to 
time a participation entitlement formula that is applicable to all 
DPMs.'' Any changes to this formula are required to be filed as a 
proposed rule change pursuant to Section 19(b) of the Act. 
Currently, a DPM's participation entitlement is 40% when there are 
two market makers at parity with the DPM and 30% when there are 
three or more market makers at parity with the DPM. See Securities 
Exchange Act Release No. 43750 (December 20, 2000), 65 FR 82420 
(December 28, 2000) (SR-CBOE-00-52).
---------------------------------------------------------------------------

    (B) 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).\59\
---------------------------------------------------------------------------

    \59\ Due to a systems limitation, the Exchange initially would 
use method two and set the DPM's allocation at the amount it would 
be entitled to pursuant to CBOE Rule 8.87 (and Regulatory Circulars 
issued thereunder).
---------------------------------------------------------------------------

    In either case, the DPM's entitlement cannot exceed the size of the 
DPM's quote.
    ISE expressed its concern that ``the ability to * * * decide 
between alternative DPM entitlement formulas might be used to protect 
the DPM or maximize its participation based upon the level of 
competition it faces.'' \60\ In response, the CBOE states that the 
Hybrid filing does not propose to change the level of the participation 
right guaranteed to DPMs and that changes to the DPM participation 
right are governed by CBOE Rule 8.87 and are subject to Board review. 
The Commission also notes that any changes to the DPM's participation 
rights must be filed with the Commission as a proposed rule change 
pursuant to Section 19(b) of the Act.
---------------------------------------------------------------------------

    \60\ See ISE Letter, supra note 5.
---------------------------------------------------------------------------

    In addition, CBOE notes that the decision by the FPC regarding the 
allocation a DPM would receive under proposed CBOE Rule 6.45A(i)(C) 
would be in effect floorwide in all classes under the FPC's 
jurisdiction and would be announced to the membership in advance of 
implementation. CBOE believes this would preclude switching between the 
two allocation alternatives on a class basis based upon the level of 
competition faced by a DPM.
    The Commission recognizes that a large guaranteed participation 
right would 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.\61\ 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.\62\ The

[[Page 34447]]

Commission notes that under the proposed rules, the most to which the 
DPM would be entitled would be either the guarantee, which is capped at 
40%, or the amount to which it would be entitled pursuant to the 
proposed allocation algorithm, discussed above. This approach is 
consistent with rules previously approved by the Commission.\63\
---------------------------------------------------------------------------

    \61\ 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).
    \62\ 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 61.
    \63\ See Supplementary Material .01(b) to ISE Rule 713, which 
states that ``[i]f the Primary Market Maker is quoting at the best 
price, it has participation rights equal to the greater of (i) the 
proportion of the total size at the best price represented by the 
size of its quote, or (ii) sixty percent (60%) of the contracts to 
be allocated if there is only one (1) other Non-Customer Order or 
market maker quotation at the best price, forty percent (40%) if 
there are two (2) other Non-Customer Orders and/or market maker 
quotes at the best price, and thirty percent (30%) if there are more 
than two (2) other Non-Customer Orders and/or market maker quotes at 
the best price.'' See also PCX Rule 6.76(a)(2)(C)(iii), which states 
that the ``LMM will be allocated a number of contracts equal to the 
greater of their guaranteed participation or their `size pro rata' 
allocation * * *.''
---------------------------------------------------------------------------

C. Orders on the Book

    The Exchange proposes to amend CBOE Rule 7.4(a) to expand the types 
of orders eligible for entry into the electronic book.\64\ Market 
participants would be permitted to place orders in the book (in those 
classes in which Hybrid is operational.) Proposed paragraph (a)(1) to 
CBOE Rule 7.4 would enable the FPC to allow all broker-dealer orders to 
be book eligible or, to allow orders from those broker-dealers that are 
not market makers or specialists to enter the book. This proposed rule 
also would require members submitting orders or quotes for entry into 
the electronic book to do so electronically and require them to comply 
with such format requirements as may be prescribed by the Exchange.\65\
---------------------------------------------------------------------------

    \64\ Currently, only public customer orders are eligible for 
entry in the book.
    \65\ See Amendment No. 5, supra note 6.
---------------------------------------------------------------------------

    ISE contends that the proposal allows ``an FPC to distinguish 
between broker-dealer orders and competing market maker orders on a 
class basis, and to decide whether one or both categories of orders may 
be permitted on the book and/or be eligible for automatic execution.'' 
\66\ In its response, CBOE states that the Hybrid proposal does not 
discriminate against competing market maker orders because they are 
treated the same way that orders for CBOE market makers who are not 
physically present in the trading crowd are treated.\67\ In this 
regard, a CBOE market maker that is not physically present in the 
trading crowd would be eligible to receive automatic executions in that 
class only if all other market makers (including competing market 
makers) were also eligible.\68\
---------------------------------------------------------------------------

    \66\ See ISE Letter, supra note 5.
    \67\ See CBOE Response Letter, supra note 8.
    \68\ Id.
---------------------------------------------------------------------------

    However, a market maker who is physically present in the trading 
crowd would be permitted to submit one-sided quotes (also referred to 
as an order) or two-sided quotes.\69\ These one and two-sided quotes 
would be treated in the same manner by the Hybrid System.\70\ Such 
quotes would route directly to the CBOEdirect platform; would have the 
same participation entitlements in UMA; would be eligible to 
participate in the N-second group as described in proposed CBOE Rule 
6.45A(c); and would be subject to proposed CBOE Rule 6.45A(d) if they 
locked the quote of another market maker.\71\ Furthermore, an in-crowd 
market maker would be required to be firm pursuant to the Quote Rule 
for a one-sided quote to the same extent he or she would be for a two-
sided quote.\72\
---------------------------------------------------------------------------

    \69\ See Amendment No. 6, supra note 7.
    \70\ Id.
    \71\ Id.
    \72\ Id.
---------------------------------------------------------------------------

    The Commission believes that the proposal does not unfairly 
discriminate against competing market makers and may enhance access to 
the book.

D. Firm Quotations

    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 would be the responsible broker or dealer for that quote 
for purposes of the Exchange's rule and the Quote Rule. Proposed 
subparagraph (c)(1)(a)(i) to CBOE Rule 8.51 states that the firm quote 
requirement for customer orders would be the size disseminated to 
vendors. In subparagraph (a)(ii), the Exchange proposes to clarify that 
the firm quote requirement for broker-dealer orders would be the lesser 
of the size it disseminates to vendors or periodically publishes in a 
different manner. This proposed rule is almost identical to the CBOE's 
current rule, except that it provides flexibility to allow the Exchange 
to disseminate its broker-dealer firm quote size (rather than to 
periodically publish it).
    In addition, CBOE proposes a change to Interpretation .10 to CBOE 
Rule 8.51 to clarify the timing of when an order has been presented to 
a responsible broker or dealer. Currently, because the trading crowd as 
a whole is the responsible broker or dealer, an order is considered to 
be presented to the responsible broker or dealer at the time it is 
received on a PAR station. This interpretation would remain the same 
for non-Hybrid classes. For Hybrid classes, an order received on a PAR 
station is presented to a responsible broker or dealer that is not the 
DPM when the order is announced to the trading crowd.\73\ However, an 
order is considered presented to the DPM at the time of receipt of the 
order on PAR. Thus when an order is received on PAR when the 
disseminated quote represents the DPM and other market makers, there 
would be two separate times when the order has been presented for Quote 
Rule purposes: the order would be presented to the DPM at the time the 
order is received on PAR, while the order would be presented to another 
responsible broker or dealer when the order is announced to the crowd.
---------------------------------------------------------------------------

    \73\ In Amendment No. 4, the Exchange noted that market makers 
in the crowd have no control over PAR and no access to PAR and would 
be unaware that an order resides on PAR until that order is 
announced to them. Currently, 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 market maker has its own quote. See Amendment No. 4, 
supra note 3.
---------------------------------------------------------------------------

    ISE argues that ``the proposal changes the point at which firm 
quote obligations attached to orders represented by floor brokers to 
the time they are presented to the crowd so there is greater potential 
for the quote to have changed from the time the order was received at 
the CBOE to the time it is walked into the crowd.'' The Quote Rule, 
among other things, requires a responsible broker or dealer to execute 
orders presented to it by another broker-dealer, at a price at least as 
favorable as the responsible broker or dealer's published bid or offer. 
The Commission believes that CBOE's proposed rule amendment is 
consistent with the Quote Rule because a responsible broker or dealer 
in the trading crowd would not be ``presented'' with an order until it 
is announced to the crowd.
    The Commission, nonetheless, has concerns about the potential for 
responsible brokers or dealers to improperly avoid their Quote Rule 
obligations. The Commission expects the CBOE to surveil not only for 
violations of the Quote Rule by the DPM and/or other responsible 
brokers or dealers, but also, for the DPM's handling

[[Page 34448]]

of orders received by it for presentation to responsible brokers or 
dealers. The Commission intends to monitor closely the CBOE's efforts 
in this regard.

E. Obligations of Market Makers

    CBOE Rule 8.7 governs market maker obligations. Market makers on 
the CBOE Hybrid System would 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 would be 
obligated to honor their quotes for up to their disseminated size, in 
accordance with the Quote Rule. In addition, market makers would be 
deemed the ``responsible broker or dealer'' for quotes they cause to be 
disseminated.
    Under Hybrid, market makers would be able to quote verbally in open 
outcry in response to a request for a market, or to quote 
electronically (or submit orders electronically) by use of an exchange-
approved quoting device. CBOE Rule 8.7 also would clarify that market 
makers must be physically present in the trading crowd to quote and 
submit orders. Market maker quotes would be required to be for ten 
contracts or more. This size obligation would apply only to a market 
maker's initial undecremented quote.
    In addition, the Exchange proposes new paragraph (d) to CBOE Rule 
8.7, which would establish additional obligations for market makers 
trading Hybrid classes.\74\ Specifically, if a market maker on the CBOE 
Hybrid System transacts more than 20% of its contract volume 
electronically in an appointed Hybrid class during any calendar 
quarter, the market maker would be required to maintain continuous, 
two-sided quotes for at least ten contracts in a designated percentage 
of series within the class, depending on the percentage of the market 
maker's contract volume transacted electronically.75 The 
following schedule would apply:
---------------------------------------------------------------------------

    \74, 75\ The proposed obligations in paragraph (d) would be 
applicable on a per class basis and would apply only to market 
makers trading on the CBOE Hybrid System and only in those Hybrid 
classes.

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

    Such market makers also would be required to provide a two-sided 
market for a minimum of ten contracts in response to any request for 
quote by a floor broker or DPM representing an order as agent. Finally, 
such market makers would be required to comply with the quote-width 
requirements contained in CBOE Rule 8.7(b)(iv).
    Market makers that transact 20% or less of their contract volume 
electronically would be required to provide a two-sided market for a 
minimum of ten contracts in response to any request for quote by a 
floor broker or DPM representing an order as agent. Such verbal quotes 
would be required to comply with the quote-width requirements in CBOE 
Rule 8.7(b)(iv). These market markers' electronic quotes, however, 
would not be required to comply with the quote-width requirements of 
CBOE Rule 8.7(b)(iv). Although these market makers would not be 
obligated to quote electronically in any designated percentage of 
series within that class, any volume transacted electronically by such 
market maker would not count towards their in-person requirement in 
CBOE Rule 8.7.03(B).\76\
---------------------------------------------------------------------------

    \76\ All market makers electronically quoting in a Hybrid classs 
would be required to post an initial undecremented bid or offer of 
at least ten contracts.
---------------------------------------------------------------------------

    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.\77\ 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, 
by excluding electronic transactions from satisfying a market maker's 
in-person requirements where the market maker transacts only 20% or 
less of its contract volume electronically and is not required to 
continuously quote or comply with quote-width requirements, the 
Commission believes that CBOE's rules impose such affirmative 
obligations on CBOE Hybrid market makers.
---------------------------------------------------------------------------

    \77\ See 12 CFR 221.5(c)(6).
---------------------------------------------------------------------------

V. Accelerated Approval of Amendments No. 5 and 6

    The Commission finds good cause for approving Amendments No. 5 and 
6 to the proposed rule change prior to the thirtieth day after the 
amendment is published for comment in the Federal Register pursuant to 
Section 19(b)(2) of the Act.\78\ Amendments No. 5 and 6 merely make 
clarifications to the proposed rule text in response to comments made 
in the ISE Letter and by Commission staff. Therefore, the Commission 
believes that accelerated approval of Amendments No. 5 and 6 is 
appropriate.
---------------------------------------------------------------------------

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

VI. 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.\79\
---------------------------------------------------------------------------

    \79\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\80\ that the proposed rule change (SR-CBOE-2002-05) and Amendments 
No. 1, 2, 3, and 4 are approved, and that Amendments No. 5 and 6 
thereto are approved on an accelerated basis.
---------------------------------------------------------------------------

    \80\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\81\
---------------------------------------------------------------------------

    \81\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-14368 Filed 6-6-03; 8:45 am]
BILLING CODE 8010-01-P