[Federal Register Volume 68, Number 223 (Wednesday, November 19, 2003)]
[Notices]
[Pages 65330-65332]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-28850]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-48771; File No. SR-CBOE-2003-25]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendment Nos. 1, 2, and 3 by the Chicago Board Options 
Exchange, Inc. Relating to Bid-Ask Differentials

November 12, 2003.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on June 20, 2003, the Chicago Board Options Exchange, Inc. (``CBOE'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II 
and, III below, which Items have been prepared by the Exchange. The 
CBOE filed Amendments Nos. 1, 2, and 3 to the proposal on July 3, 
2003,\3\ September 10, 2003,\4\ and October 29, 2003,\5\ respectively. 
The Commission is publishing this notice to solicit comments on the 
proposed rule change, as amended, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Steve Youhn, CBOE, to Deborah Flynn, 
Division of Market Regulation (``Division''), Commission, dated July 
2, 2003, and accompanying Form 19b-4 (``Amendment No. 1''). 
Amendment No. 1 converts the proposal from a filing submitted 
pursuant to Section 19(b)(3)(A) of the Act to a proposal filed 
pursuant to Section 19(b)(2) of the Act. In addition, Amendment No. 
1 clarifies that the CBOE's autoquote systems automatically will 
widen quotes to double the applicable bid-ask differential upon the 
occurrence of one of the triggering events and automatically will 
return the quotes to the normal bid-ask differential when the 
triggering event ceases.
    \4\ See letter from Steve Youhn, CBOE, to Deborah Flynn, 
Division, Commission, dated September 9, 2003 (``Amendment No. 2''). 
Amendment No. 2 provides examples illustrating the need for the 
proposed relief, clarifies that CBOE market makers will not be able 
to widen their quotes when the New York Stock Exchange, Inc. 
(``NYSE'') prints a trade at or within its Liquidity Quote, and 
states that neither the CBOE's Retail Automated Execution System 
(``RAES'') nor the CBOE's Hybrid System will automatically execute 
incoming orders at prices inferior to the national best bid or offer 
(``NBBO'').
    \5\ See letter from Steve Youhn, CBOE, to Deborah Flynn, 
Division, Commission, dated October 28, 2003 (``Amendment No. 3''). 
Amendment No. 3 revises the proposal to limit the application of the 
quote width relief to options that trade with a bid price of less 
than $2 and clarifies that the quote width relief provided in the 
proposal will be available only to a market maker who has an 
automated quotation system that will return his or her quotes to the 
normal bid-ask differential when the triggering event ceases.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The CBOE proposes to amend CBOE Rule 8.7, ``Obligations of Market 
Makers,'' to allow the appropriate Market Performance Committee 
(``MPC'') to establish bid-ask differentials that are no more than 
$0.50 wide (``double-width'') for options where the bid price is less 
than $2 when the primary market for the underlying security: (1) 
Reports a trade outside of its disseminated quote, including any 
Liquidity Quote; \6\ or (2) disseminates an inverted quote. The double-
width relief must terminate automatically when the triggering event 
ceases.
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    \6\ The rules of the NYSE permit the dissemination, in selected 
securities, of a ``Liquidity Bid'' and a ``Liquidity Offer'' which 
reflect aggregated NYSE trading interest at a specific price 
interval below the best bid (in the case of a Liquidity Bid) or at a 
specific price interval above the best offer (in the case of a 
Liquidity Offer). See Securities Exchange Act Release No. 47614 
(April 2, 2003), 68 FR 17140 (April 8, 2003) (File No. SR-NYSE-2002-
55).
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    The text of the proposed rule change appears below. Additions are 
in italics.

Rule 8.7 Obligations of Market Makers

    (a) No change.
    (b) No change.
    (i)-(iii) No change.
    (iv) No change.
    (A) Without limiting the authority provided to it in Rule 
8.7(b)(iv), the appropriate MPC may, with respect to options trading 
with a bid price less than $2, establish bid-ask differentials that are 
no more than $0.50 wide (``double-width'') when the primary market for 
the underling security: (a) Reports a trade outside of its disseminated 
quote (including any Liquidity Quote); or (b) disseminates an inverted 
quote. The imposition of double-width relief must automatically 
terminate when the condition that necessitated the double-width relief 
(i.e., condition (a) or (b)) is no longer present. Market makers that 
have not automated this process may not avail themselves of the relief 
provided herein (i.e., they may not manually adjust prices).

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Exchange included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The Exchange has prepared summaries, set forth in 
Sections A, B, and C below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    CBOE Rule 8.7(b)(iv) establishes bid-ask differentials and allows 
the appropriate MPC to establish differences for one or more options 
series.\7\ The

[[Page 65331]]

Exchange proposes to amend this rule to codify two instances when the 
bid-ask differential for options trading with a bid price of less than 
$2 may be wider than the $0.25 interval expressly required for such 
options by CBOE Rule 8.7(b)(iv). Specifically, proposed CBOE Rule 
8.7(b)(iv)(A) authorizes the appropriate MPC, with respect to options 
trading with a bid price less than $2, to establish bid-ask 
differentials that are no more than $0.50 wide (``double-width'') when 
the primary market for the underlying security: (a) Reports a trade 
that occurs outside of its disseminated quote (including any Liquidity 
Quote); or (b) disseminates an inverted quote (together, the 
``triggering events''). The proposed quote width relief will apply to 
options on stocks and options on exchange-traded funds (``ETFs'').\8\
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    \7\ CBOE Rule 8.7(b)(iv) requires market makers to bid and/or 
offer so as to create differences of no more than $0.25 between the 
bid and the offer for each option contract for which the bid is less 
than $2; no more than $0.40 where the bid is at least $2 but does 
not exceed $5; no more than $0.50 where the bid is more than $5 but 
does not exceed $10; no more than $0.80 where the bid is more than 
$10 but does not exceed $20; and no more than $1.00 where the bid is 
more than $20. The bid/ask differentials do not apply to in-the-
money series where the underlying securities market is wider than 
the differentials set forth in CBOE Rule 8.7(b)(iv). For those 
series, the bid/ask differential may be as wide as the quotation on 
the primary market of the underlying security.
    \8\ Upon Commission approval of the proposal, the CBOE, prior to 
the effective date of the rule, will disseminate to members a 
Regulatory Circular that identifies the specific ETF that will serve 
as the underlying security for each option class. See Amendment No. 
3, supra note 5.
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    The proposed quote width relief will apply only to options that 
trade with a bid price of less than $2.\9\ Thus, options trading at a 
price of $2 (bid) or higher will not be eligible for the proposed quote 
width relief. The CBOE notes that options trading at less than $2 are 
subject to a $0.25 bid-ask differential, which generally means that 
market makers have only $0.125 of pricing latitude on either side of 
the theoretical value to widen their quotes to take into account any 
pricing discrepancy in the underlying security. As described more fully 
below, the CBOE believes that the grant of double-width relief for low-
priced options will provide market makers with more pricing flexibility 
with which to protect themselves.
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    \9\ See Amendment No. 3, supra note 5.
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    Under the proposal, CBOE market makers will not be permitted to 
widen their quotes when the NYSE prints a trade at or within its 
Liquidity Quote. Because the NYSE disseminates Liquidity Quotes, which 
are quotes of substantial size outside of the regular disseminated 
quote, the CBOE notes that CBOE market makers should not be surprised 
if the NYSE prints a trade outside of its regular quote but at or 
within its Liquidity Quote. For this reason, the CBOE does not propose 
to allow the MPC to authorize CBOE market makers to widen their quotes 
when the NYSE prints a trade at or within its Liquidity Quote. However, 
if the NYSE prints a trade outside of the Liquidity Quote, a CBOE 
market maker would be able to widen its quotes. The following example 
illustrates the operation of the proposal with respect to Liquidity 
Quotes:

[sbull] NYSE disseminated quote:
    $23.10-$23.20, 300 x 1000
[sbull] NYSE Liquidity Quote:
    $22.95-$23.35, 15,000 x 15,000

    With the above quotes, if the NYSE reports a trade between $22.95 
and $23.35, CBOE market makers would not be permitted to quote double-
wide. If the NYSE reports a trade below $22.95 or above $23.35 without 
changing its disseminated quote, CBOE market makers would be permitted 
to quote double-wide.
    The CBOE intends to automate its systems so that the CBOE's 
autoquote systems automatically will widen the quote to double the bid-
ask differential upon the occurrence of either of the two triggering 
events.\10\ The quotes will remain double-width until the triggering 
event ceases, at which time CBOE systems automatically will return the 
quote to the normal bid-ask differential. Accordingly, if the primary 
market's quotes invert and the CBOE quotes double-wide, the CBOE's 
quotes must return to normal width when the underlying market's quotes 
no longer are inverted. Similarly, if the primary market prints a trade 
outside of its disseminated quote, the CBOE may quote double-wide until 
the print is no longer outside of the disseminated quotes (i.e., until 
the quotes move to encompass the previous print or the next print is 
inside of the disseminated quotes).\11\
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    \10\ See Amendment No. 1, supra note 3.
    \11\ See Amendment No. 3, supra note 5.
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    The CBOE notes that the automation of this process ensures that 
double-width relief will take effect only when permissible and, more 
importantly, will last only as long as the condition that necessitated 
it occurs. Thus, there will be no sustained dissemination of stale 
double-wide quotes when one of the triggering events is not 
present.\12\ In addition, the CBOE states that a market maker will be 
able to utilize the double-width relief only if the market maker has an 
automated quotation system that returns the market maker's quotes to 
normal width upon the termination of the triggering event.\13\ Double-
width relief will not be available to market makers who must rely on 
manual input to restore quote values to normal width.
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    \12\ See Amendment No. 1, supra note 3.
    \13\ See Amendment No. 3, supra note 5.
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    The CBOE notes that the grant of double-width relief will not 
result in the automatic execution of customer orders at artificially 
wide prices.\14\ According to the CBOE, neither RAES nor the CBOE 
Hybrid System will automatically execute incoming orders at prices 
inferior to the NBBO. Instead, orders received while the CBOE is not 
the NBBO will route to PAR, where the DPM can expose the order to the 
crowd or send a linkage order to an away market. Accordingly, the CBOE 
notes that orders received while the CBOE's quotes are double-wide 
would receive a measure of price protection.
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    \14\ See Amendment No. 2, supra note 4.
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    In addition, the CBOE represents that the purpose of the proposal 
is not to create a heightened profit opportunity by allowing CBOE 
market makers to execute trades at widened quotes and, hence, increased 
profits.\15\ Instead, the CBOE believes that the proposal represents a 
narrowly-tailored protective measure designed to enable CBOE market 
makers to widen their quotes when a situation occurs in the underlying 
market that prevents accurate pricing. Under the proposal, market 
makers will have the ability, if they choose, to widen their quotes to 
limit the losses that may occur when the underlying market disseminates 
faulty or delayed information.
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    \15\ See Amendment No. 2, supra note 4.
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Necessity for the Relief Requested

    According to the CBOE, the main component of equity option pricing 
is the value of the underlying security. The CBOE states that accurate 
option pricing is impossible if the value of the underlying security is 
unreliable or indiscernible. The following examples provided by the 
CBOE highlight the difficulties and risks in pricing options when the 
quote for the underlying security is inverted and/or when the 
underlying market prints a trade outside of its disseminated quote.

a. Underlying Market Disseminates an Inverted Quote

    Assume that the quote for stock ABCD is $21.06-$21.16 and that, 
based on those prices, the quote for the July 20 call option is $1.15-
$1.25. Now assume that the stock quote changes to $21.12-$21.02, 
creating an inversion. Under these circumstances, it is not clear which 
price, the bid or the offer, is correct, or whether both prices are 
incorrect. If the bid is correct, the quote for the underlying stock 
might be

[[Page 65332]]

$21.12-$21.22, which might drive the options quote to $1.25-$1.35. If 
the offer is correct, the quote for the underlying stock might be 
$20.92-$21.02, which might drive the options quote to $1.05-$1.15. If 
both the bid and the offer for the underlying stock are incorrect, it 
is difficult to know what the price of the underlying stock might be. 
Assuming that either the bid or the offer is correct, but not both, the 
stock price probably ranges somewhere between $20.92-$21.22, which is 
three times wider than the original non-inverted quote.
    If a CBOE market maker believes that the bid for the underlying 
stock is correct and has a quote size of 25-up at $1.25-$1.35, assume 
he executes an incoming market order to sell at $1.25. Now assume that 
the price of the underlying stock corrects to $20.92-$21.02, sending 
the market maker's quote to $1.05-$1.15, and that the market maker 
receives an incoming market order to buy, which he executes at $1.15. 
Under these circumstances, the market maker has purchased the options 
(i.e., the market maker was on the contra side of the first market 
order to sell) at $1.25 and sold the options (i.e., the market maker 
was on the contra side of the second market order to buy) at $1.15, 
locking in a loss of $0.10, 25 times.

b. Underlying Market Reports a Trade Outside of the Disseminated Quote

    According to the CBOE, it is not uncommon for the primary market 
for an underlying security, in its haste to report trades to the tape, 
to report trades before changing the disseminated quote, resulting in a 
transaction that falls outside of the disseminated quote. For example, 
assume that the disseminated quote for a stock is $22.10-$22.25 and 
that the last sale was $22.15. Without a change in the quote the next 
sale is reported at $22. In this instance, the market for the 
underlying security could come out in any direction, i.e., it could be 
$21.75-$22, it could be unchanged, or it could be $22.00-$22.25. As in 
the previous example, the CBOE market maker must attempt to guess where 
the market for the underlying security will come out. If the market 
maker guesses incorrectly, he has exposure. Allowing the market maker 
to widen his quote allows him a measure of protection until the market 
for the underlying security again reports trades within the 
disseminated quote.
2. Statutory Basis
    The Exchange believes the proposed rule change is consistent with 
the Act and the rules and regulations under the Act applicable to a 
national securities exchange and, in particular, the requirements of 
section 6(b) of the Act.\16\ Specifically, the Exchange believes the 
proposed rule change is consistent with the Section 6(b)(5) \17\ 
requirements that the rules of an exchange be designed to promote just 
and equitable principles of trade, to prevent fraudulent and 
manipulative acts and, in general, to protect investors and the public 
interest.
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    \16\ 15 U.S.C. 78(f).
    \17\ 15 U.S.C. 78(f)(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

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

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

    No written comments were solicited or received.

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

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

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609. Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying at the Commission's Public Reference Room. Copies of such 
filing will also be available for inspection and copying at the 
principal office of the Exchange. All submissions should refer to File 
No. SR-CBOE-2003-25 and should be submitted by December 10, 2003.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\18\
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    \18\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-28850 Filed 11-18-03; 8:45 am]
BILLING CODE 8010-01-P