[Federal Register Volume 69, Number 12 (Tuesday, January 20, 2004)]
[Notices]
[Pages 2775-2798]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-1117]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49068; File No. SR-BSE-2002-15]


Self Regulatory Organizations; Order Granting Approval to 
Proposed Rule Change and Amendment No. 3 and Notice of Filing and Order 
Granting Accelerated Approval to Amendment No. 4 Thereto by the Boston 
Stock Exchange, Inc. Establishing Trading Rules for the Boston Options 
Exchange Facility

January 13, 2004.

I. Introduction

    On October 31, 2002, the Boston Stock Exchange, Inc. (``BSE'' or 
``Exchange''), submitted to 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 establish trading rules for 
the proposed Boston Options Exchange (``BOX'') \3\ facility. On 
December 18, 2002, the BSE filed Amendment No. 1 that entirely replaced 
the original rule filing.\4\ On January 9, 2003, the BSE filed 
Amendment No. 2 that entirely replaced the original rule filing and 
Amendment No. 1.\5\ Amendment No. 2 was published in the Federal 
Register on January 22, 2003 (``BOX Proposing Release'').\6\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ The term ``BOX'' means the Boston Options Exchange or Boston 
Stock Exchange Options Exchange, an options trading facility of the 
Exchange under section 3(a)(2) of the Act. See proposed BOX Rules, 
Chapter I, sec. 1(a)(6) (definition of ``BOX'').
    \4\ See letter from George W. Mann, Jr., Executive Vice 
President and General Counsel, BSE, to Annette Nazareth, Director, 
Division of Market Regulation (``Division''), Commission, dated 
December 18, 2002 (``Amendment No. 1'').
    \5\ See letter from George W. Mann, Jr., Executive Vice 
President and General Counsel, BSE, to Annette Nazareth, Director, 
Division, Commission, dated January 8, 2003 (``Amendment No. 2'').
    \6\ Securities Exchange Act Release No. 47186 (January 14, 
2003), 68 FR 3062 (January 22, 2003).
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    The Commission received 43 comment letters in response to the 
January 22, 2003, notice.\7\
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    \7\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Paul Fred, CEO, PFTC Trading, LLC, dated January 24, 2003; Myron 
Wood, Statistician, Changes, LLC, dated January 30, 2003; Mike 
Ianni, dated February 2, 2003; Shawn Gibson, Senior VP, Equity 
Derivatives, Scott & Stringfellow, dated February 6, 2003; CSFB Next 
Fund, Inc., Interactive Brokers Group, LLC, LabMorgan Corporation, 
Salomon Brothers Holding Company, Inc., UBS (USA) Inc., dated 
February 6, 2003; Sallerson-Troob, LLC, dated February 9, 2003; 
Christopher D. Bernard, dated February 10, 2003; George Papa, 
Director, PEAK6 Investments, dated February 10, 2003; Frank Hirsch, 
CBOE Market Maker, dated February 10, 2003; Richard W. Cusack, 
Operations Manager, Sparta Group of Chicago, LP, dated February 11, 
2003; Paul Britton, CEO, MAKO Global Derivatives LLC, dated February 
11, 2003; John Colletti, Samuelson Trading, dated February 11, 2003; 
Robert S. Smith, Chief Technology Officer, GETCO, LLC, dated 
February 11, 2003; Phillip Sylvester, CBOE Market Maker, dated 
February 11, 2003; Keith Fishe, DRW Holdings, LLC, dated February 
11, 2003; Daniel C. Bigelow, President, Monadnock Capital 
Management, dated February 11, 2003; Erich Tengelsen, Chicago 
Trading Company, dated February 12, 2003; Thomas Peterffy, Chairman, 
David M. Battan, Vice President and General Counsel, Interactive 
Brokers LLC, dated February 12, 2003; John T. Thomas, Van Der Moolen 
USA LLC, dated February 12, 2003; Robert C. Sheehan, Electronic 
Brokerage Systems LLC, dated February 12, 2003; Thomas J. Murphy, 
TJM Investments, LLC, dated February 12, 2003; Meyer S. Frucher, 
Chairman and Chief Executive Officer, Philadelphia Stock Exchange, 
Inc. (``Phlx''), dated February 12, 2003 (``Phlx Letter 1''); 
Michael Resch, dated February 12, 2003; Todd Silverberg, General 
Counsel, Susquehanna International Group LLP, dated February 12, 
2003; Michael J. Simon, Senior Vice President and Secretary, 
International Securities Exchange, Inc. (``ISE''), dated February 
12, 2003 (``ISE Letter 1''); Juan Carlos Pinilla, Managing Director, 
Equity Derivatives Trading, JP Morgan, dated February 12, 2003; Marc 
J. Liu, Options Specialist, AGS Specialist Partners, dated February 
12, 2003; Jan-Joris Hoefnagel, President, Optiver Derivatives 
Trading, dated February 13, 2003; Steve Tumen, CEO, and David 
Barclay, General Counsel, Equitec Group, LLC, dated February 14, 
2003; Michael J. Ryan, Jr., Executive Vice President & General 
Counsel, American Stock Exchange LLC (``Amex''), dated February 14, 
2003 (``Amex Letter 1''); William J. Brodsky, Chairman and Chief 
Executive Officer, Chicago Board Options Exchange, Inc. (``CBOE''), 
dated February 14, 2003 (``CBOE Letter 1''); Paul Roesler, Lead 
Market Maker, Pacific Exchange, Inc. (``PCX''), dated February 14, 
2003; Andrew W. Lo, dated February 15, 2003; Nicholas Bonn, 
Executive Vice President, State Street Global Markets, LLC, dated 
February 21, 2003; Robert Bellick, Christopher Gust, Wolverine 
Trading, LLC, dated February 27, 2003; Philip D. DeFeo, Chairman and 
CEO, PCX, dated February 27, 2003 (``PCX Letter 1''); Thomas N. 
McManus, Executive Director and Counsel, Morgan Stanley, dated March 
3, 2003; Philip C. Smith, Jr., Vice President, Options, The 
Interstate Group, dated March 7, 2003; Bryan Rule, dated March 11, 
2003; Michael J. Ryan, Jr., Executive Vice President & General 
Counsel, Amex, dated March 13, 2003 (``Amex Letter 2''); David 
Hultman, dated March 25, 2003; Stephen D. Barret, dated March 26, 
2003; and John Welker, dated June 11, 2003.
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    In response to the comment letters, the BSE filed Amendment No. 3 
to the proposal.\8\ The proposed changes were published for comment in 
the Federal Register on August 22, 2003.\9\ The Commission received 301 
comment letters in response to Amendment No. 3.\10\ In response to the 
comment letters,

[[Page 2776]]

on January 9, 2004, the BSE filed Amendment No. 4 to the proposed rule 
change, and a written response to comment letters.\11\
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    \8\ See letter from George W. Mann, Jr., Executive Vice 
President and General Counsel, BSE, to Annette Nazareth, Director, 
Division, Commission, dated August 15, 2003 (``Amendment No. 3'').
    \9\ Securities Exchange Act Release No. 48355 (August 15, 2003), 
68 FR 50813 (August 22, 2003) (``Amendment No. 3 Notice'').
    \10\ See letters to Jonathan G. Katz, Secretary, Commission, 
from R.J. Casey, dated September 2, 2003; Gary Sutton, dated 
September 2, 2003; Dr. Jay Charles Soper, dated September 2, 2003; 
Darshan Arora, dated September 2, 2003; Carl Erikson, dated 
September 2, 2003; Dwayne Logie, dated September 2, 2003; David B. 
Pincus, dated September 2, 2003; Dmitri Gerasimenko, dated September 
2, 2003; Dr. Gary T. Hirst, Chairman, Hirst Investment Management 
Inc., dated September 2, 2003; Doug Brunner, dated September 2, 
2003; David Richardson, dated September 2, 2003; Eddie Wan, dated 
September 2, 2003; Donald Tolchin, dated September 2, 2003; Austin 
B. Tucker, dated September 2, 2003; Ilya Dorfman, dated September 2, 
2003; Carey Pierce, dated September 2, 2003; David Maple, dated 
September 2, 2003; Gregory Cone, dated September 2, 2003; Byron 
Sears, dated September 2, 2003; Chad B. Harris, Managing Director, 
Sharp People Scottsdale, dated September 2, 2003; Clint Rasschaert, 
dated September 2, 2003; Michael Burgess, dated September 2, 2003; 
Edward C. Spengler II, dated September 2, 2003; Basilio Chen, dated 
September 2, 2003; Sam Wheat, dated September 2, 2003; Wie-Ming Ang, 
dated September 2, 2003; Douglas A. DeMoss, dated September 2, 2003; 
Karl Aschenbrenner, dated September 2, 2003; C.E. Sherrod, dated 
September 2, 2003; Alan Johnson, dated September 2, 2003; John 
Mazur, dated September 2, 2003; Skyler Christensen, dated September 
2, 2003; Rachel Fitz, dated September 2, 2003; Billb Billb, dated 
September 2, 2003; Damodharan Ramkumar, dated September 3, 2003; Jim 
McNeil, dated September 3, 2003; Dr. Donald R. Berger, dated 
September 3, 2003; Scott Alber, dated September 3, 2003; Eric 
Glasband, dated September 3, 2003; Frank Sandy, dated September 3, 
2003; Mu Chou Liu, ITresources, dated September 3, 2003; Vernon 
Hehn, dated September 3, 2003; Anthony J. Benincasa, dated September 
3, 2003; Gregg Richter, dated September 3, 2003; L. Jerry L. Jones, 
dated September 3, 2003; Francis Borriello, dated September 3, 2003; 
David D. Smith, dated September 3, 2003; Robert H. Dean, dated 
September 3, 2003; Joseph Szoecs, dated September 3, 2003; E. Eimas, 
dated September 3, 2003; Curtis G. Thompson, Black Swan Trading, 
dated September 3, 2003; Tom Harney, dated September 3, 2003; Jim 
Schmechel, dated September 3, 2003; Tom Fisher, dated September 3, 
2003; Andrew Eisenhawer, dated September 3, 2003; David Nemes, dated 
September 3, 2003; Leland Stevenson, dated September 3, 2003; David 
Strauss, dated September 3, 2003; Jim Engelken, dated September 3, 
2003; Jim Woo, dated September 3, 2003; Marc Poussard, Bae Systems, 
dated September 3, 2003; William W. Williams, dated September 3, 
2003; Steve Sundberg, Software Engineer, General Dynamics Land 
Systems, dated September 3, 2003; Fang Gu, dated September 3, 2003; 
Stanley Arron, dated September 3, 2003; Matti Luomanen, dated 
September 3, 2003; Robert Jinks, dated September 3, 2003; Daniel 
Torres, dated September 3, 2003; Michael Vilkin, dated September 3, 
2003; Harvey Carmel, dated September 3, 2003; Barry Wolfe, dated 
September 3, 2003; Zhenyu Yang, dated September 3, 2003; John 
Jagerson, CNBCU Personal Trainer, dated September 3, 2003; Roark 
Janis, dated September 3, 2003; Barry R. Schotz, dated September 3, 
2003; Peter Reese, dated September 3, 2003; Chadwick McHugh, dated 
September 3, 2003; Ray Crews, dated September 3, 2003; Kevin Bates, 
dated September 3, 2003; Vineet Jain, dated September 3, 2003; 
Steven K. Gross, Penso Capital Markets, LLC, dated September 3, 
2003; Jeffrey S. Hauge, dated September 3, 2003; Harry I. Brown, 
Jr., dated September 3, 2003; Sai Rao, dated September 3, 2003; J. 
Mentesseg, dated September 3, 2003; Arthur E. Blossom, dated 
September 3, 2003; Michael Selbs, dated September 3, 2003; Jeff 
Schanker, dated September 3, 2003; L.W. Kramer, dated September 3, 
2003; William J. Sheppard, dated September 3, 2003; Paul Levin, 
dated September 3, 2003; Andre L. Morissette, dated September 3, 
2003; Shuowen Yang, dated September 3, 2003; Steve Kragen, dated 
September 3, 2003; Richard Berry, dated September 3, 2003; Bob 
Palfreeman, dated September 3, 2003; Anthony P. Matthews, dated 
September 3, 2003; Zoran Djokic, dated September 3, 2003; Mark 
Williamson, dated September 3, 2003; Yul Lipner, dated September 3, 
2003; Charles Thompson, dated September 3, 2003; Peter Gum, dated 
September 3, 2003; Harvey Lichterman, dated September 4, 2003; 
Ronald Scott, dated September 3, 2003; Libero Greco, dated September 
3, 2003; Ralph Berry, dated September 3, 2003; Philip Tonne, dated 
September 3, 2003; Bruce, dated September 3, 2003; David E. Banks, 
September 3, 2003; Eli Y. Khoury, dated September 3, 2003; Lawrence 
Soh, dated September 3, 2003; John Davidson, dated September 3, 
2003; Paul Feingold, dated September 3, 2003; Matt Kubitsky, dated 
September 3, 2003; Jesse Principato, dated September 3, 2003; Peter 
Ritter, dated September 3, 2003; Ron Young, dated September 3, 2003; 
Peter Zetlin, dated September 3, 2003; Peter Zwag, dated September 
3, 2003; Daniel Fitzpatrick, dated September 3, 2003; Rick 
Westerfield, dated September 3, 2003; Gary Kemp, dated September 3, 
2003; Larry Pinkus, dated September 3, 2003; Joel Reingold, dated 
September 3, 2003; Harald Kempf, dated September 3, 2003; Domenico 
Ciampa, dated September 3, 2003; Wenhao Li, dated September 3, 2003; 
Doug Layton, dated September 3, 2003; Jack Scholze, dated September 
3, 2003; Doug Churchill, dated September 3, 2003; Bobby Emory, dated 
September 3, 2003; Richard Phillips, dated September 3, 2003; 
Bernhard Abmayr, dated September 3, 2003; Gene Liang, dated 
September 3, 2003; Dvir Langer, dated September 3, 2003; Chin Chin 
Tan, dated September 3, 2003; James F. Kelly, dated September 3, 
2003; Charles M. Steiner, dated September 3, 2003; Joseph Grodsky, 
dated September 3, 2003; Aaron Zalewski, dated September 3, 2003; 
Jay Texan, dated September 3, 2003; Mark Rubensohn, dated September 
3, 2003; Charles LaPointe, dated September 3, 2003; Martin 
Rosenblatt, dated September 3, 2003; Dr. Gunther Hofbauer, dated 
September 3, 2003; Dean Huang, dated September 4, 2003; Roger 
Britton, dated September 4, 2003; N. Kaiser, dated September 4, 
2003; Roger Easton, dated September 4, 2003; Kirk Cooley, dated 
September 4, 2003; Venkatesh Janakiraman, dated September 4, 2003; 
John Welker, September 4, 2003; David Johnston, Mercury Advertising, 
dated September 4, 2003; Wayne LaFlamboy, dated September 4, 2003; 
Joe Milliner, dated September 4, 2003; Ken Peek, dated September 4, 
2003; Ron Bliss, dated September 4, 2003; Rong Lin, dated September 
4, 2003; Ted Kreuser, dated September 4, 2003; Randy G. Malm, dated 
September 4, 2003; Jeff Levitt, Director of Research, Stanton Chase 
International, dated September 4, 2003; Ron Baakkonen, Manager, 
Electronic Trading & Retail Flow, PEAK6 Investments, LP, dated 
September 4, 2003; Wayne Chang, dated September 4, 2003; Jerome 
Ablon, dated September 5, 2003; Tim Crowley, dated September 5, 
2003; Eugen, dated September 5, 2003; Paul Fred, CEO PFTC Trading 
LLC, dated September 5, 2003; Phillip J. Sylvester, dated September 
5, 2003; Wilbur Su, dated September 6, 2003; Mike Rouzer, dated 
September 6, 2003; Bryant Otter, dated September 6, 2003; William 
Christie, dated September 6, 2003; Spencer Ball, dated September 6, 
2003; Neil Lulla, dated September 7, 2003; John Doe, dated September 
7, 2003; Mo Soysa, dated September 7, 2003; Grady G. Thomas, Jr., 
President, The Interstate Group, Division of Morgan Keegan & Co., 
Inc., dated September 8, 2003; Don Bayne, dated September 8, 2003; 
Rolf van der Klink, dated September 8, 2003; Andrew W. Lo, dated 
September 9, 2003; Richard Hallas, dated September 9, 2003; Michael 
Bock, dated September 9, 2003; Nicholas J. Bonn, Executive Vice 
President and CFO, State Street Global Markets, LLC, dated September 
10, 2003; Stephen D. Barrett, Wainwright Financial Services, dated 
September 10, 2003; Miguel Ladios, dated September 10, 2003; Stephen 
Kaelber, dated September 10, 2003; Paul Britton, CEO, MAKO Global 
Derivatives, LLC, dated September 10, 2003; Simon Lubershane, dated 
September 10, 2003; Chris Cobb, dated September 10, 2003; Steven 
Quirk, Saen Options, dated September 10, 2003; Donald W. Pendergast, 
Jr., dated September 10, 2003; Todd Silverberg, General Counsel, 
Susquehanna International Group, LLP, dated September 11, 2003; Todd 
Batiste, dated September 11, 2003; Diane Dowling, dated September 
11, 2003; John Colin Jones, dated September 11, 2003; Kenneth M. 
King, President, K & S Inc., Member Boston Stock Exchange, dated 
September 11, 2003; John Keazirian, Executive Vice President, Rho 
Trading Securities, LLC, dated September 11, 2003; Robert E. Shultz, 
dated September 11, 2003; Simon Yates, Managing Director, Credit 
Suisse First Boston, dated September 11, 2003; Michael J. Ryan, Jr., 
Executive Vice President and General Counsel, Amex, dated September 
12, 2003 (``Amex Letter 3''); David Weisberger, Managing Director, 
Citigroup Global Markets Inc., dated September 12, 2003; Meyer S. 
Frucher, Chairman and Chief Executive Officer, Phlx, dated September 
12, 2003 (``Phlx Letter 2''); William Bartlett, Parallax Fund, LP, 
dated September 12, 2003; Yomo Guiamo, dated September 12, 2003; 
Mike Ianni, dated September 12, 2003; Dennis Michiels, dated 
September 12, 2003; Linda M. Sarkisian, President, Sarkisian 
Securities, dated September 12, 2003; Robert C. Sheehan, Chairman, 
Electronic Brokerage Systems, LLC, dated September 12, 2003; Michael 
J. Simon, Senior Vice President and General Counsel, ISE, dated 
September 12, 2003 (``ISE Letter 2''); Eric Tripp, President, BMO 
Nesbitt Burns Securities Limited, dated September 12, 2003; Joseph 
Lombardi, dated September 13, 2003; Mano Appapillai, dated September 
14, 2003; Derek Mahar, dated September 14, 2003; Philip D. DeFeo, 
Chairman and Chief Executive Officer, PCX, dated September 15, 2003 
(``PCX Letter 2''); Harvey Bernstein, dated September 15, 2003; 
Harilaos Mantzoros, Xenos Trading, dated September 15, 2003; Thomas 
Peterffy, Chairman, Interactive Brokers Group, LLC, dated September 
16, 2003; William J. Brodsky, Chairman and Chief Executive Officer, 
CBOE, dated September 16, 2003 (``CBOE Letter 2''); Andrew Henry, 
Managing Member, Henry Capital Management, LLC, dated September 16, 
2003; Bastiaan van Kempen, Director, Optiver US, LLC, dated 
September 16, 2003; Steve Verbos, dated September 17, 2003; Craig 
Hancey, dated September 18, 2003; Allison Brandsma, dated September 
19, 2003; Fabrizio J. Fili, dated September 20, 2003; Ralph Winters, 
dated September 21, 2003; Mary McDermott-Holland, Senior Vice 
President, Franklin Portfolio Associates, dated September 23, 2003; 
Lewis P. Dickey, General Partner, Options Unlimited, dated September 
24, 2003; James C. Miller III, Chairman, The CapAnalysis Group, LLC, 
dated September 26, 2003; H. Kaur, dated October 17, 2003; Jeff 
Sutton, dated December 14, 2003; and Michael J. Simon, Senior Vice 
President and General Counsel, ISE, dated December 16, 2003 (``ISE 
Letter 3'').
    \11\ See letter from George W. Mann, Jr., Executive Vice 
President and General Counsel, BSE, to Annette Nazareth, Director, 
Division, Commission, dated January 9, 2004 (``Amendment No. 4''). 
As discussed below, in Amendment No. 4, the BSE proposes to clarify 
its rules to address issues raised by commenters, and to make other 
technical, non-material changes. See also letter from George W. 
Mann, Executive Vice President and General Counsel, BSE, to Jonathan 
G. Katz, Secretary, Commission, dated Janaury 9, 2004.
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    This order approves the BSE's proposed rule change, as amended, 
publishes notice of Amendment No. 4 to the proposed rule change, and 
grants accelerated approval to Amendment No. 4.

II. Discussion

    After careful review of the proposal and consideration of the 
comment letters, the Commission finds that the proposed rule change to 
establish trading rules for the BOX facility is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities exchange and, in particular, the 
requirements of section 6 of the Act.\12\ Specifically, the Commission 
finds that the proposal is consistent with section 6(b)(5) of the 
Act,\13\ which requires, in part, that the rules of an exchange be 
designed to prevent fraudulent and manipulative acts and practices; to 
promote just and equitable principles of trade; to foster cooperation 
and coordination with persons engaged in regulating, clearing, 
settling, and 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. Section 
6(b)(5) also requires that the rules of an exchange not be designed to 
permit unfair discrimination among customers, issuers, brokers, or 
dealers.
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    \12\ 15 U.S.C. 78f.
    \13\ 15 U.S.C. 78f(b)(5).
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    Overall, the Commission believes that approving the BSE's proposal 
to establish trading rules for the BOX facility should confer important 
benefits to the public and provide U.S. market participants with a new 
market in which to trade standardized options. As a fully electronic 
options market with relatively lower barriers to access,\14\

[[Page 2777]]

BOX's entry into the options marketplace may potentially reduce the 
costs of trading to investors and market professionals, enhance 
innovation, and increase competition between and among the options 
exchanges, resulting in better prices and executions for investors. In 
addition, the BSE has committed to develop and maintain an appropriate 
system of surveillance and an audit trail.\15\
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    \14\ See Securities Exchange Act Release No. 49066 (January 13, 
2004) (SR-BSE-2003-17) (Order approving BOX fee schedule (``BOX Fee 
Approval'')).
    \15\ See BOX Proposing Release, supra note 6.
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    This discussion does not review every rule and representation made 
by the BSE that has been filed as part of its proposed rule change; 
rather, it focuses on the most prominent rules and policy issues 
considered in review of the BSE's proposal.

A. BOX Is an Options Trading Facility of the BSE

    The BSE proposes to establish BOX as an options trading facility of 
the BSE, a registered national securities exchange. BOX would be 
operated by Boston Options Exchange Group LLC (``BOX LLC''). One 
commenter objects to the characterization of BOX as a ``facility'' of 
the BSE and asserts that the Commission should require BOX to file an 
application to register as a national securities exchange under section 
6 of the Act.\16\
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    \16\ 15 U.S.C. 78f. See CBOE Letter 1, supra note 7, at 2-3.
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    The Commission believes that the BSE's proposal to establish BOX as 
its facility \17\ is properly filed under section 19(b)(1) of the 
Act,\18\ and that it is not necessary for BOX to register as a national 
securities exchange independent of the BSE under section 6(a) of the 
Act.\19\ Section 19(b)(1) of the Act requires that every self-
regulatory organization (``SRO'') file with the Commission copies of 
any proposed rule or any proposed change to its rules, accompanied by a 
concise general statement of the basis and purpose of the proposed rule 
change. The Commission is required to publish notice of the filing of a 
proposed rule change and to give interested persons an opportunity to 
submit written data, views, and arguments. Section 19(b)(2) of the Act 
\20\ provides that the Commission shall approve an SRO's proposed rule 
change if it is consistent with the requirements of the Act and the 
rules and regulations thereunder applicable to the SRO, or disapprove 
the proposed rule change if the Commission does not make such a 
finding. In the Commission's view, the BSE's proposal to establish BOX 
as an exchange facility is consistent with the Act, as well as with 
previous proposals of national securities exchanges filed under section 
19(b) of the Act \21\ to use the personnel and equipment of third 
parties to operate trading platforms.\22\
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    \17\ See 15 U.S.C. 78c(a)(2) (definition of ``facility'').
    \18\ 15 U.S.C. 78s(b)(1).
    \19\ 15 U.S.C. 78f(a).
    \20\ 15 U.S.C. 78s(b)(2).
    \21\ 15 U.S.C. 78s(b).
    \22\ See, e.g., Securities Exchange Act Release No. 41210 (March 
24, 1999), 64 FR 15857 (April 1, 1999) (approval of Phlx's VWAP 
Trading System); Securities Exchange Act Release No. 39086 
(September 17, 1997), 62 FR 50036 (September 24, 1997) (approval of 
PCX's Application of the OptiMark System). See also Securities 
Exchange Act Release No. 41967 (September 30, 1999), 64 FR 54704 
(October 7, 1999) (approval of Nasdaq Application of OptiMark 
System); Securities Exchange Act Release No. 35030 (November 30, 
1994), 59 FR 63141 (December 7, 1999) (approval of Chicago Match 
System); Securities Exchange Act Release No. 44983 (October 25, 
2001), 66 FR 55225 (November 1, 2001) (approval of Archipelago 
Exchange).
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    In addition, the Commission believes that the proposal discussed 
herein has provided sufficiently detailed information about the trading 
rules of BOX and that the public has had ample opportunity to comment 
on the proposal. The BSE proposal was originally published for comment 
in January 2003 and an amended proposal was published for further 
comment in August 2003. In the many months that the proposal has been 
in the public domain, interested persons, including other SROs, broker-
dealers, investors, and other market participants have submitted 
comments on the proposal.
    A couple of commenters request that BOX disclose fully the 
relationship of the founding members and investors of BOX LLC, 
including their role in the market and governance, and agreements 
between and among the members and investors or other parties providing 
critical services to BOX.\23\ The Commission notes that the BSE filed 
separate proposed rule changes addressing these matters, all of which 
were published for comment.\24\
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    \23\ See CBOE Letter 1, supra note 7, at 3; see Amex Letter 3, 
supra note 10, at 1.
    \24\ See Securities Exchange Act Release No. 48650 (October 17, 
2003), 68 FR 60731 (October 23, 2003) (Notice of BOX LLC Operating 
Agreement). The Commission approved the BOX LLC Agreement filing 
today. See Securities Exchange Act Release No. 49067 (January 13, 
2004). In addition, the Commission today approved a filing relating 
to the BSE's proposed transfer to a new options regulatory 
subsidiary, Boston Options Exchange Regulation LLC (``BOXR''), a 
Delaware limited liability company and a wholly-owned subsidiary of 
the BSE, all of the assets and liabilities that solely support the 
regulation of the standardized equity options trading business of 
the BSE. Upon this transfer, however, the BSE would continue to be 
the self-regulatory organization for BOXR and BOX. See Securities 
Exchange Act Release No. 49065 (January 13, 2004) (SR-BSE 2003-04) 
(``BOXR Delegation Plan Approval Order'').
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    The Commission further notes that, as a registered exchange, the 
BSE is required to file an amendment to its Form 1 to reflect the 
agreements relating to the operation of BOX and BOXR, including a 
description of its affiliations with other parties, information 
describing the reporting, clearance, or settlement of transactions in 
connection with the operation of the facility, and a copy of existing 
by-laws or corresponding rules and instruments.\25\
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    \25\ See Rule 6a-2 under the Act, 17 CFR 240.6a-2; see also Form 
1, 17 CFR 249.1.
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B. BOX Market Structure Generally

1. BOX Options Participants
    Unlike the existing options exchanges, which have a specialist or 
primary market maker driven system, BOX would have only one category of 
members, known as ``Options Participants.'' \26\ Only Options 
Participants would be permitted to transact business on BOX via the BOX 
Trading Host.\27\ The BSE would authorize any Options Participant who 
meets certain enumerated qualification requirements to obtain access to 
BOX.\28\ An Order Flow Provider (``OFP'') may transact business with 
Public Customers only if it is a member of another national securities 
exchange or association with which the BSE has entered into an 
agreement under Rule 17d-2 \29\ of the Act.\30\
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    \26\ See proposed BOX Rules, Chapter I, sec. 1(a)(40).
    \27\ See proposed BOX Rules, Chapter II, sec. 1(a).
    \28\ The BSE would not limit the number of qualifying entities 
that may become Options Participants. However, approval of 
qualifying applications for Options Participants may be temporarily 
deferred due to system constraints or capacity restrictions. See 
proposed BOX Rules, Chapter II, sec. 1(d).
    \29\ 17 CFR 240.17d-2.
    \30\ See proposed BOX Rules, Chapter XI, sec. 1. See also infra 
notes 299-303 and accompanying text for a discussion of Rule 17d-2.
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    Among other things, Options Participants must be registered as 
broker-dealers pursuant to the Act and have as the principal purpose of 
being an Options Participant the conduct of a securities business.\31\ 
Such a purpose would be deemed to exist if and as long as: (1) The 
Options Participant has qualified and acts in respect of its business 
on BOX as either an OFP or a Market Maker, or both; and (2) all 
transactions effected by the Options Participant are in compliance with 
section 11(a) of the Act \32\ and the rules and regulations 
thereunder.\33\ Options

[[Page 2778]]

Participants may trade options for their own proprietary accounts or, 
if authorized to do so under applicable law, may conduct business on 
behalf of Customers.\34\
a. Order Flow Providers
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    \31\ See proposed BOX Rules, Chapter II, sec. 2(b), (h); see 
also Amendment No. 4, supra note 11.
    \32\ 15 U.S.C. 78k(a).
    \33\ See proposed BOX Rules, Chapter II, sec. 2(h)(i) and (ii).
    \34\ A ``Customer'' means either a ``Public Customer'' or a 
broker-dealer. See proposed BOX Rules, Chapter I, sec. 1(a)(19). A 
``Public Customer'' is a person that is not a broker or dealer in 
securities. See proposed BOX Rules, Chapter I, sec. 1(a)(50).
---------------------------------------------------------------------------

    OFPs would be those Options Participants representing Customer 
Orders \35\ as agent on BOX and those non-market maker Participants 
conducting proprietary trading.\36\ OFPs may also register as Market 
Makers.\37\ OFPs may trade as principal, both as contra party to 
Customer Orders submitted to BOX by such OFP and as contra party to 
unrelated orders submitted to BOX by other Options Participants.
---------------------------------------------------------------------------

    \35\ A ``Customer Order'' means an agency order for the account 
of either a Public Customer or a broker-dealer. See proposed BOX 
Rules, Chapter I, sec. 1(a)(20).
    \36\ See proposed BOX Rules, Chapter I, sec. 1(a)(46).
    \37\ BOX Market Makers are Options Participants registered with 
the Exchange as Market Makers and approved by BOX Regulation 
(``BOXR'') for an appointment in an options class listed on BOX. See 
proposed BOX Rules, Chapter VI, sec. 4(a).
---------------------------------------------------------------------------

    One commenter expresses concern that BOX's proposal lacks a 
provision prohibiting an OFP (non-Market Maker) from entering multiple 
two-sided bids and offers into the system, as principal or agent for 
the account of the same beneficial owner, in such a manner that the 
participant or owner is effectively operating as a Market Maker.\38\ In 
Amendment No. 4, BOX responds directly to this concern by proposing a 
new rule prohibiting an OFP from entering into BOX, as principal or 
agent, Limit Orders in the same options series, for the account or 
accounts of the same or related beneficial owners, in such a manner 
that the OFP or the beneficial owner(s) effectively is operating as a 
Market Maker by holding itself out as willing to buy and sell such 
options contract on a regular or continuous basis. In determining 
whether an OFP or beneficial owner effectively is operating as a Market 
Maker, BOXR would consider, among other things: Simultaneous or near-
simultaneous entry of Limit Orders to buy and sell the same options 
contract; the acquisition and liquidation of positions in the same 
options series during the same day; and the entry of Limit Orders at 
different prices in the same options series.\39\ The Commission 
believes that this provision is consistent with the Act and should help 
to prevent OFPs from reaping the benefits of market making activities 
without having any of the concomitant obligations.\40\ The Commission 
also believes that this provision is designed to prevent Customers from 
acting as unregistered Market Makers.
---------------------------------------------------------------------------

    \38\ See PCX Letter 2, supra note 10, at Appendix at 12.
    \39\ See proposed BOX Rules, Chapter V, sec. 17; see also 
Amendment No. 4, supra note 11.
    \40\ See proposed BOX Rules, Chapter VI, sec. 5.
---------------------------------------------------------------------------

b. Market Makers
    BOX Market Makers are Options Participants registered with the 
Exchange as Market Makers and approved by BOXR \41\ for an appointment 
in an options class listed on BOX.\42\ Registered BOX Market Makers 
would be designated as specialists on the BSE for all purposes under 
the Act.\43\
---------------------------------------------------------------------------

    \41\ As discussed above, BOXR is a wholly-owned subsidiary of 
the Exchange. See BOXR Delegation Plan Approval Order, supra note .
    \42\ See proposed BOX Rules, Chapter VI, sec. 4(a). Subject to 
certain limitations, a Market Maker may enter all order types 
permitted to be entered by Customers under the BOX Rules to buy or 
sell options in classes of options listed on BOX to which the Market 
Maker is not appointed. See proposed BOX Rules, Chapter VI, sec. 
6(e).
    \43\ See proposed BOX Rules Chapter I, sec. 1(a)(32) and Chapter 
VI, sec. 1.
---------------------------------------------------------------------------

    i. Market Maker Qualifications. To become a Market Maker on BOX, an 
Options Participant is required to register as a BOX Market Maker by 
filing a written application with BOXR.\44\ BOXR will not place any 
limit on the number of qualifying entities that may become Market 
Makers.\45\
---------------------------------------------------------------------------

    \44\ See proposed BOX Rules, Chapter VI, sec. 1(a).
    \45\ However, as noted above, supra note 28, based on system 
constraints, capacity restrictions or other factors relevant to 
protecting the integrity of the BOX Trading Host, BOXR may limit 
access to the Trading Host for a period to be determined in its 
discretion. See proposed BOX Rules, Chapter VI, sec. 1(c). The BSE 
would submit any such limitation on access to the BOX Trading Host 
as a proposed rule change to the Commission for approval pursuant to 
section 19(b) of the Act. 15 U.S.C. 78s(b).
---------------------------------------------------------------------------

    In addition to registering as a Market Maker, a Market Maker must 
obtain an appointment in each options class in which it wishes to make 
a market on BOX. In approving the Market Maker's appointment in a 
class, BOXR would consider, among other things: (i) The financial and 
technical resources available to the Market Maker; (ii) the Market 
Maker's experience, expertise, and past performances in making markets 
or options trading; and (iii) the maintenance and enhancement of 
competition among Market Makers in each class of options to which it is 
appointed.\46\
---------------------------------------------------------------------------

    \46\ See proposed BOX Rules, Chapter VI, sec. 4(b).
---------------------------------------------------------------------------

    BOXR may appoint each Market Maker to any options class listed on 
BOX for trading. Such an appointment would consist of at least one 
class and may include all classes traded on the Exchange.\47\ BOXR 
would not list an options class for trading unless at least two Market 
Makers are appointed to the options class.\48\ In addition, before BOXR 
opens trading for any additional series of an options class, it would 
require at least two Market Makers to be appointed for trading that 
particular class. Upon appointment, BOXR would require Market Makers to 
maintain active markets in that class for a period of at least six 
months.\49\
---------------------------------------------------------------------------

    \47\ See proposed BOX Rules, Chapter VI, sec. 4(a).
    \48\ See proposed BOX Rules, Chapter IV, sec. 5(a).
    \49\ See proposed BOX Rules, Chapter VI, sec. 5(a)(viii).
---------------------------------------------------------------------------

    However, BOXR would not require a Market Maker in a class to 
continue trading in that class if BOXR makes an affirmative 
determination that continued trading in that class by a single Market 
Maker is to the detriment of that Market Maker, of no adverse 
consequence to an existing Customer of BOX or an Options Participant, 
and serves no greater purpose in the fair and orderly functioning of 
the marketplace.\50\ BOXR may continue to allow trading in a class 
opened for trading that subsequently has only one Market Maker 
appointed, if it makes an affirmative determination that halting of 
trading in such class would be detrimental to the remaining Market 
Maker and that continued trading in such class by one Market Maker 
would be in the interest of maintaining a fair and orderly marketplace 
and would not create adverse consequences to an existing Customer of 
BOX or an Options Participant.\51\
---------------------------------------------------------------------------

    \50\ See proposed BOX Rules, Chapter IV, sec. 5(b).
    \51\ See proposed BOX Rules, Chapter IV, sec. 5(c).
---------------------------------------------------------------------------

    BOXR may suspend or terminate any appointment of a Market Maker, 
make additional appointments, or change the options classes included in 
a Market Maker's appointment whenever, in BOXR's judgment, the 
interests of a fair and orderly market are best served by such 
action.\52\
---------------------------------------------------------------------------

    \52\ See proposed BOX Rules, Chapter VI, sec. 4(c).
---------------------------------------------------------------------------

    The Commission finds that the BOX's Market Maker qualification 
requirements are consistent with the Act, and notes that they are 
similar to those adopted by other options exchanges.\53\
---------------------------------------------------------------------------

    \53\ See, e.g., CBOE Rule 8.3(a); ISE Rule 802(a).
---------------------------------------------------------------------------

    ii. Market Maker obligations. Market Makers on BOX would be 
required to electronically engage in a course of dealing for their own 
account to enhance liquidity available on BOX and

[[Page 2779]]

to assist in the maintenance of fair and orderly markets.\54\ Among 
other things, Market Makers would have to satisfy the following 
responsibilities and duties during trading: (i) Maintain a two-sided 
market for at least 10 contracts \55\ in at least eighty percent (80%) 
of the options series, for at least ninety percent (90%) of the classes 
to which the Market Maker is assigned, provided that a Market Maker is 
quoting at all times in at least sixty percent (60%) of the options 
series of any class to which the Market Maker is appointed; \56\ (ii) 
participate in the opening; \57\ (iii) maintain minimum net capital in 
accordance with SEC and BOX Rules; \58\ and (iv) within three seconds 
of receiving any Request for Quote (``RFQ''), post or maintain for at 
least 30 seconds, a valid two-sided quote in a series in a class to 
which it is appointed.\59\ If BOXR found any substantial or continued 
failure by a Market Maker to meet any of its obligations and duties, 
BOXR would subject the Market Maker to disciplinary action, suspension, 
or revocation of the Market Maker's appointment in one or more options 
classes.\60\
---------------------------------------------------------------------------

    \54\ See proposed BOX Rules, Chapter VI, sec. 5(a).
    \55\ See proposed BOX Rules, Chapter VI, sec. 6(a).
    \56\ See proposed BOX Rules, Chapter VI, sec. 6(d)(i).
    \57\ See proposed BOX Rules, Chapter VI, sec. 5(a). These quotes 
must be consistent with the spread parameters in Chapter VI, section 
5(a)(vii) of the proposed BOX Rules.
    \58\ See proposed BOX Rules, Chapter VI, sec. 2 and sec. 9, and 
Chapter XXII, sec. 2.
    \59\ The term, ``RFQ,'' refers to a message that may be issued 
by an Options Participant in order to signal an interest in an 
options series and request a response from other Participants. See 
proposed BOX Rules, Chapter I, sec. 1(a)(54); Chapter VI, sec. 
6(b)(ii). See also Amendment No. 4, supra note 11. In Amendment No. 
4, the BSE changed the RFQ period from 15 seconds to three seconds, 
in response to concerns raised by commenters.
    \60\ See proposed BOX Rules, Chapter VI, sec. 5(f).
---------------------------------------------------------------------------

    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.\61\ 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 BOX's rules are consistent with the Act, 
as they impose such affirmative obligations on BOX Market Makers.
---------------------------------------------------------------------------

    \61\ See 12 CFR 221.5(c)(6).
---------------------------------------------------------------------------

    One commenter states that the quoting obligations of Market Makers 
were vague in that there could be no quote in the BOX market for an 
extended period of time.\62\ The Commission agrees that under the BSE's 
proposal certain series may not have continuous quotes disseminated by 
BOX. Nevertheless, because the definition of ``market maker'' includes 
a dealer who holds himself out as being willing to buy and sell a 
security for his account on a regular or continuous basis,\63\ the 
Commission believes that the obligations imposed by the BOX Rules on 
Market Makers are consistent with the Act. The Commission also notes 
that the CBOE Hybrid trading system has market maker obligations 
comparable to those proposed for BOX and also does not require market 
makers to quote all series.\64\
---------------------------------------------------------------------------

    \62\ See PCX Letter 2, supra note 10, at Appendix at 12.
    \63\ See 15 U.S.C. 78c(a)(38) (definition of ``market maker'').
    \64\ See CBOE Rule 8.7, Interpretation .03A.
---------------------------------------------------------------------------

2. The BOX Central Order Book (``BOX Book'')
a. Types of Orders
    There are three types of orders that may be submitted to the BOX 
Trading Host: a Limit Order, a Box-Top Order, and a Market-on-Opening 
Order.\65\ Where no order type is specified, the BOX Trading Host will 
reject the order. In addition, there are several specific designations 
that can be added to Limit Orders or BOX-Top Orders.\66\
---------------------------------------------------------------------------

    \65\ See proposed BOX Rules, Chapter V, sec. 14.
    \66\ These include a Good ``Til Cancelled designation, Fill and 
Kill designation, Fill-or-Kill designation, and Minimum Volume 
designation. A Good ``Til Cancelled, Fill and Kill, or Fill-or-Kill 
designation can be added to Limit Orders. A Minimum Volume 
designation can be added to both Limit Orders and BOX-Top orders. 
See proposed BOX Rules, Chapter V, sec. 14(d).
---------------------------------------------------------------------------

    i. Order Types. Limit Orders entered into the BOX Book are executed 
at the stated limit price or better. Any residual volume left after 
part of a Limit Order has traded is retained in the BOX Book until it 
is withdrawn or traded (unless a specific designation is added which 
prevents the untraded part of a Limit Order from being retained). The 
BOX Trading Host will automatically withdraw all Limit Orders, except 
for those with a Good ``Til Cancelled (``GTC'') designation, at market 
close.\67\
---------------------------------------------------------------------------

    \67\ See proposed BOX Rules, Chapter V, sec. 14(c)(i).
---------------------------------------------------------------------------

    Market-on-Opening Orders entered into the BOX Book are executed on 
the market opening at the best price available in the market until all 
available volume on the opposite side of the market has been traded. 
Any residual volume left after part of a Market-on-Opening Order has 
been executed is automatically converted to a Limit Order at the price 
at which the original Market-on-Opening Order was executed. Market-on-
Opening Orders have priority over Limit Orders.\68\
---------------------------------------------------------------------------

    \68\ See proposed BOX Rules, Chapter V, sec. 14(c)(iii).
---------------------------------------------------------------------------

    BOX-Top Orders entered into the BOX Book are executed at the best 
price available in the market for the total quantity available. Any 
residual volume left after part of a BOX-Top Order has been executed is 
automatically converted to a Limit Order at the price at which the 
original BOX-Top Order was executed.\69\
---------------------------------------------------------------------------

    \69\ See proposed BOX Rules, Chapter V, sec. 14(c)(ii).
---------------------------------------------------------------------------

    One commenter suggests that BOX-Top Orders should continue through 
the price discovery process instead of being converted to a Limit Order 
after being partially executed. In addition, this commenter raises a 
concern that if a BOX-Top Order is converted to a Limit Order and the 
market moves away from the limit price, the proposal does not specify 
whether the BOX system would update the order price to the next limit 
or whether it would remain at the initial limit price. This commenter 
believes that if the order remains at the initial limit price, it would 
be negatively impacted.\70\
---------------------------------------------------------------------------

    \70\ See PCX Letter 2, supra note 10, at Appendix at 3.
---------------------------------------------------------------------------

    The Commission believes that the proposal clearly specifies the 
procedures regarding the handling of BOX-Top orders. Unlike market 
orders that trade at successive price levels, BOX-Top Orders would 
execute at the best price available in the market for the total 
quantity available from any contra side order. Any remaining volume 
would be automatically converted to a Limit Order at the price that the 
original BOX-Top Order was executed. This limit price would not change 
due to market fluctuations. Thus, the Commission does not believe any 
clarification is necessary regarding BOX-Top Orders. The Commission 
also believes that brokers who send a Customer's order to BOX as a BOX-
Top Order must be sure that such an order type is consistent with that 
Customer's expectations.
ii. Order Designations
    Among several designations that can be added to BOX-Top or Limit 
Orders \71\

[[Page 2780]]

is the Minimum Volume (``MV'') designation. MV orders would be executed 
only if the specified minimum volume were immediately available to 
trade (at the specified price or better in the case of Limit Orders). 
If the specified minimum volume were not immediately available, the BOX 
Trading Host would automatically cancel the order. In the case of Limit 
Orders, where a volume equal to or greater than the specified minimum 
volume of an MV order trades, the size remaining in an order would be 
filtered through the BOX National Best Bid and Offer (``NBBO'') filter 
mechanism \72\ and placed on the BOX Book. In the case of BOX-Top 
Orders, where a volume equal to or greater than the specified minimum 
volume of an MV order has traded, the size remaining in an order would 
be converted to a Limit Order at the price at which the BOX-Top Order 
was executed, filtered through the BOX NBBO filter mechanism, and 
placed on the BOX Book.\73\
---------------------------------------------------------------------------

    \71\ See proposed BOX Rules, Chapter V, sec. 14(d)(i)(1)-(3).
    \72\ See infra section II.C for a discussion of the BOX NBBO 
Filter process.
    \73\ See proposed BOX Rules, Chapter V, sec. 14(d)(i)(4).
---------------------------------------------------------------------------

    One commenter queries how MV orders would be represented, which 
Options Participants would be able to view them, and how they might be 
traded-through when the minimum volume cannot be satisfied.\74\ In 
response, in Amendment No. 4, the BSE explains that MV orders would not 
``lurk'' on the book undisplayed. MV orders would either trade 
immediately for at least the minimum specified size or immediately be 
cancelled. As noted above, any size remaining in a Limit Order or BOX-
Top Order would be protected against trading through better prices on 
other markets by being filtered through the BOX NBBO filter 
mechanism.\75\
---------------------------------------------------------------------------

    \74\ See PCX Letter 2, supra note 10, at Appendix at 3.
    \75\ See Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

b. Order Ranking and Display
    The BOX Book is the electronic book of orders maintained by the BOX 
Trading Host. The BOX Book contains all orders of Options Participants. 
Limit Orders of Options Participants submitted to BOX would be ranked 
and maintained in the BOX Book according to price/time priority, such 
that within each price level, all orders would be organized by the time 
of entry.\76\ No distinction is made to this priority with regard to 
account designation (Public Customer, Broker/Dealer or Market Maker). 
An Options Participant must submit a new order if it wishes to refresh 
its order. This new order would be ranked at the specified limit price 
according to the time that the new order was entered.
---------------------------------------------------------------------------

    \76\ See proposed BOX Rules, Chapter V, sec. 16(a)(i).
---------------------------------------------------------------------------

    Trades would occur when orders or quotations match on the BOX Book. 
Orders at the same price would have priority based on the time of order 
entry, as described above.\77\ Limit Orders would trade immediately 
with any orders already in the BOX Book at or better than the limit 
price, up to the available size.\78\ Any size remaining of the Limit 
Order would be filtered to ensure that it does not trade at a price 
outside the NBBO \79\ before being placed on the BOX Book.
---------------------------------------------------------------------------

    \77\ See proposed BOX Rules, Chapter V, sec. 16(a)(iv)(2).
    \78\ See proposed BOX Rules, Chapter V, sec. 16(a)(iv)(3).
    \79\ See infra notes 124-135 and accompanying text.
---------------------------------------------------------------------------

    One commenter expressed concern that BOX participants might have 
the ability to see market information via BOX's internal network on a 
timelier basis than that information would be provided to OPRA. In 
particular, the commenter claims that BOX's marketing documents suggest 
that BOX Options Participants would have faster access to BOX market 
information than OPRA.\80\ BOX represents, however, that it will not 
provide information in a more-timely manner on its internal network 
than it will send that information to OPRA.\81\
---------------------------------------------------------------------------

    \80\ See PCX Letter 2, supra note 10, at Appendix at 13.
    \81\ See Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

3. Opening the Market
    The BOX market will conduct a single price opening. Orders may be 
submitted, modified, and cancelled throughout a pre-opening phase 
preceding the commencement of trading on the market. During this pre-
opening phase, Customers may submit only Market-on-Opening or Limit 
Orders. BOX would calculate a theoretical opening price and broadcast 
it to all BOX market participants through the pre-opening phase.\82\ 
Thereafter, BOX would determine a single price at which a particular 
options series would open.\83\ The determination of the opening match 
price in each series of options would be held promptly following the 
opening of the underlying security in the primary market where it is 
traded.\84\ However, BOXR may delay the opening match in any class of 
options in the interests of a fair and orderly market.\85\
---------------------------------------------------------------------------

    \82\ The theoretical opening price is the price at which the 
opening trades would occur if the opening were to commence at that 
given moment. See proposed BOX Rules, Chapter V, sec. 9(a).
    \83\ See proposed BOX Rules, Chapter V, sec. 9(b).
    \84\ See proposed BOX Rules, Chapter V, sec. 9(c).
    \85\ See proposed BOX Rules, Chapter V, sec. 9(e).
---------------------------------------------------------------------------

    If the BOX market is crossed (bids higher than offers) at the 
market open, BOX would determine the price at which the maximum volume 
can be traded and automatically execute trades accordingly, pursuant to 
BOX Rules, Chapter V, Sec. 9 (Opening the Market).\86\ Any orders 
executed in this way would be traded at a price equal to or better than 
that at which they were entered and any untraded bids and offers would 
remain on the BOX Book.\87\
---------------------------------------------------------------------------

    \86\ One commenter, responding to the Amendment No. 3 Notice, 
supra note 9, suggests that the proposed uncrossing algorithm to 
calculate the price at which the maximum volume could be traded was 
ambiguous. Specifically, the commenter suspects that the uncrossing 
mechanism employed could select a price at which customers would pay 
more (sell for less) at one of the uncrossing algorithm-selected 
prices to the benefit of professionals. See PCX Letter 2, supra note 
10, at Appendix at 3. The Commission notes, however, that the 
``uncrossing algorithm''referred to in Chapter V, section 16(a)(v) 
was actually intended as a cross reference to the BOX ``opening 
match,'' which is discussed in detail under Chapter V, section 9 of 
the proposed BOX Rules. Therefore, in Amendment No. 4, BSE proposes 
to change the reference from ``uncrossing algorithm'' to ``opening 
match'' to remove any confusion. See Amendment No. 4, supra note 11.
    \87\ See proposed BOX Rules, Chapter V, sec. 16(a)(v); see also 
Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    One commenter asks that BOX clarify how it intends to treat the 
opening of trading of Market-on-Opening Orders on BOX. This commenter 
suggests that the use of Market-on-Opening Orders in the opening 
process seems to imply that BOX would trade at multiple prices during 
the opening.\88\ In Amendment No. 4, the BSE proposes to correct the 
typographical error in the definition of Market-on-Opening Order to 
eliminate any implication that BOX would trade at multiple prices 
during the market opening.\89\ Moreover, the BOX Rules specifically 
state that BOX would determine a single price at which a particular 
series would be opened.\90\
---------------------------------------------------------------------------

    \88\ See PCX Letter 2, supra note 10, at Appendix at 1-2.
    \89\ See proposed BOX Rules, Chapter V, sec. 14(c)(iii); see 
also Amendment No. 4, supra note 11.
    \90\ See proposed BOX Rules, Chapter V, sec. 9(b).
---------------------------------------------------------------------------

    However, the Commission believes that the proposed rules do not 
sufficiently describe the procedures for determining the single opening 
price for an options series on the BOX market. Accordingly, the 
Commission's approval of the proposed rule change is on the condition 
that the proposed rule change is not effective until a proposed rule 
change to amend the BOX Rules to provide a more detailed description of 
the market opening procedures becomes

[[Page 2781]]

effective under section 19(b) of the Act.\91\
---------------------------------------------------------------------------

    \91\ 15 U.S.C. 78s(b).
---------------------------------------------------------------------------

4. Unusual Market Conditions
    Rule 11Ac1-1 under the Act, known as the ``Quote Rule,'' requires, 
among other things, that exchanges collect, process, and make available 
to quotation vendors the best bids and offers which are communicated on 
the exchange.\92\ In addition, each responsible broker or dealer must 
execute orders presented to it at a price at least as favorable as its 
best bid or offer in any amount up to the size of that bid or offer, 
subject to certain exceptions.\93\ The BSE has proposed a rule to 
relieve responsible brokers or dealers from their obligations under the 
Quote Rule when the level of trading activities or the existence of 
unusual market conditions is such that the BSE is incapable of 
collecting, processing, and making available to quotation vendors the 
data for the option class in a manner that accurately reflects the 
current state of the market on BOX.\94\ An Options Official would have 
the authority to determine that the level of trading activities or the 
existence of unusual market conditions is such that BOX is incapable of 
collecting, processing, and making available to quotation vendors the 
data for the option class in a manner that accurately reflects the 
current state of the market on BOX.\95\ In such circumstances, an 
Options Official, an officer of BOXR, would be permitted to: (i) 
Suspend the minimum size requirement with respect to Market Maker 
quotations; (ii) turn off the PIP; \96\ or (iii) take such other 
actions as are deemed in the interest of maintaining a fair and orderly 
market.\97\
---------------------------------------------------------------------------

    \92\ 17 CFR 240.11Ac1-1(b)(1).
    \93\ 17 CFR 240.11Ac1-1(c).
    \94\ See proposed BOX Rules, Chapter VI, sec. 6(c)(ii)(2).
    \95\ See proposed BOX Rules, Chapter V, sec. 13(a).
    \96\ See infra section II.E.1 for a description of the PIP.
    \97\ See proposed BOX Rules, Chapter V, sec. 13(b); see also 
Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    The Commission believes that the proposed rule is consistent with 
the Act and the Quote Rule, and notes that the BSE is required to 
enforce compliance by its members with the Federal securities laws and 
the BOX Rules.\98\ Accordingly, the Commission expects that the BSE 
will ensure that sufficient monitoring procedures are in place to fully 
implement the requirements of the Quote Rule. One commenter suggests 
that the BSE automate the process of turning off the PIP, described 
below, when the exchange is relieved of its obligations under the Quote 
Rule.\99\ The Commission does not believe that such automation is 
required to make the BSE's proposal consistent with the Act and that an 
Options Official's discretion to turn off the PIP during unusual market 
conditions is consistent with an exchange official's authority on other 
options exchanges to take action during unusual market conditions.\100\
---------------------------------------------------------------------------

    \98\ 15 U.S.C. 78f(b)(1).
    \99\ See Amex Letter 2, supra note 10, at 5.
    \100\ See, e.g., ISE Rule 704(c).
---------------------------------------------------------------------------

5. Complex Orders
    A Complex Order is any order for the same account, that is composed 
of two or more related orders intended to be executed concurrently as 
part of a single investment strategy, including, among other things, 
combination orders with non-equity options legs.\101\
---------------------------------------------------------------------------

    \101\ See proposed BOX Rules, Chapter V, sec. 27(a)(i)-(ix).
---------------------------------------------------------------------------

    One commenter raises the following questions with respect to 
Complex Orders: (i) Is there a Complex Order Book; (ii) how will 
Options Participants know of Complex Orders; (iii) will Complex Orders 
be separately disseminated; (iv) are OFPs required to monitor and 
execute complex orders like Public Customer PIP Orders (``CPOs''); and 
(v) does BOX plan to provide separate Exchange staff to monitor Complex 
Orders and the Complex Order Book? \102\
---------------------------------------------------------------------------

    \102\ See Amex Letter 3, supra note 10, at 5.
---------------------------------------------------------------------------

    In Amendment No. 4, the BSE provides further explanation in 
response to the commenter's questions. The BSE states that there would 
be a Complex Order Book on BOX, and that BSE's proposal regarding 
Complex Orders is consistent with the current trading of Complex Orders 
by the existing options exchanges.\103\ Prior to entry of a Complex 
Order on the Complex Order Book, a BOX Participant would be required to 
notify BOX of the legs of the strategy it proposes to submit.\104\ If 
the proposed strategy is valid, BOX would send an ``advisory'' message 
notifying all BOX Participants of such proposed strategy and the time 
at which it would start trading.\105\ BOX would maintain a listing, 
accessible to all BOX Participants, of all Complex Order strategies 
available for trading on BOX. The BSE's proposed rules do not specify 
the process for BOX Participants to notify BOX of a proposed strategy 
or the procedures for sending advisory messages. Accordingly, the 
Commission's approval of this proposed rule change will not be 
effective until BSE files a separate proposed rule change with the 
Commission to include these required procedures in its rules that 
becomes effective pursuant to section 19(b) of the Act.
---------------------------------------------------------------------------

    \103\ See, e.g., ISE Rule 722.
    \104\ Telephone conversations between Will Easley, Business 
Development Manager, BOX, Wayne Peston, Bingham McCutchen, and 
Elizabeth King, Deborah Flynn, John Roeser, and Susie Cho, Division, 
Commission on January 7, 2004.
    \105\ Id.
---------------------------------------------------------------------------

    The BSE further represents that Complex Orders would be submitted, 
modified, and cancelled like other orders on BOX.\106\ The Complex 
Orders would be separately disseminated by BOX through a broadcast to 
all BOX Participants showing the five best limit prices for each 
strategy. Complex Orders would not be disseminated to OPRA. OFPs would 
not be required to monitor and execute Complex Orders like CPOs. 
Complex Orders sent to BOX by OFPs would be maintained on the BOX Book 
and would be automatically executed on a price and time priority basis 
when a matching Complex Order is received by BOX.
---------------------------------------------------------------------------

    \106\ See Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    The BSE does not plan to have separate Exchange staff to monitor 
Complex Orders and the Complex Order Book. The BSE believes that 
because of the overall integration of the BOX Trading Host, of which 
the Complex Order trading system is one element, the same staff which 
monitors the Trading Host and the BOX Book would have the appropriate 
resources and expertise to monitor Complex Order trading.\107\
---------------------------------------------------------------------------

    \107\ See Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    Another commenter asserts that the BOX provision appears contrary 
to price and time priority rules of other options exchanges because an 
options leg of a transaction would take priority over other orders at 
the same price.\108\ In response, the BSE, in Amendment No. 4, proposes 
that the option leg of a stock-option order or a SSF-options order 
would be executed according to price-time priority as set forth in the 
proposed BOX Rules, Chapter V, Sec. 16. In addition, the BSE proposes 
that for combination orders with multiple options legs, if the best bid 
or offer on BOX is a Customer Limit Order, the Complex Order would have 
priority over any bid or offer in BOX, regardless of time priority, 
only if at least one leg of the Complex Order trades at a price better 
than the best price available on BOX.
---------------------------------------------------------------------------

    \108\ See PCX Letter 2, supra note 10, at Appendix at 11.
---------------------------------------------------------------------------

    A third commenter questions whether Complex Orders would interact 
in the PIP.\109\ In response, BSE proposes to

[[Page 2782]]

amend its proposed rules to explicitly prohibit Options Participants 
from submitting Complex Orders either to BOX as Directed Orders or to 
the PIP.\110\
---------------------------------------------------------------------------

    \109\ Telephone call between James Harkness, Christopher Gust, 
Robert Bellick, Matthew Abraham, and Judy Kula, Wolverine Trading, 
and Bob Colby, Elizabeth King, Deborah Flynn, John Roeser, and Susie 
Cho, Division, Commission, on November 12, 2003.
    \110\ Proposed BOX Rules, Chapter V, section 27(b)(v); see also 
Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    The Commission believes that the modifications proposed by the BSE 
in Amendment No. 4 clarify the priority of Complex Orders relative to 
the Limit Orders of Customers. Specifically, the BSE's modified 
proposal is now consistent with the rules of other exchanges, regarding 
the priority of Complex Orders with multiple options legs. Unlike the 
other options exchanges, the BSE proposes not to provide Public 
Customer Orders with priority over Complex Orders at the same price, 
unless such Public Customer Order had time priority. Despite this 
difference, the Commission finds the proposed BOX Rules relating to 
Complex Orders to be consistent with the Act.
6. Obvious Error Rule
    The BSE proposes to permit BOXR to either break a transaction or 
adjust the execution price of a transaction that results from an 
obvious error. Under the proposed rule, an obvious error would be 
deemed to have occurred when the execution price of a transaction is 
higher or lower than the theoretical price for the series by an amount 
equal to at least: $.25 where the theoretical price is below $2; $.40 
where the theoretical price is $2-$5; $.50 where the theoretical price 
is above $5-$10; $.80 where the theoretical price is above $10-$20; and 
$1.00 where the theoretical price is above $20.\111\ If the series is 
traded on at least one other options exchange, the theoretical price of 
an options series would be the last bid price with respect to an 
erroneous sell transaction, and last offer price with respect to an 
erroneous buy transaction, just prior to the trade, disseminated by the 
competing options exchange that has the most liquidity in the option. 
If there were no quotes for comparison purposes, the theoretical price 
would be determined by the BSE Market Control Center (``MRC'').\112\ 
The proposed obvious error rule provides for a procedure whereby an 
Options Participant may notify the MRC if it believes an order it 
executed on BOX was the result of an obvious error.\113\ A party to the 
trade that disagrees with the determination of the MRC can appeal the 
determination to the BOXR Chief Regulatory Officer.\114\
---------------------------------------------------------------------------

    \111\ See proposed BOX Rules, Chapter V, sec. 20(b); see also 
Amendment No. 4, supra note 11.
    \112\ See proposed BOX Rules, Chapter V, sec. 20(c); see also 
Amendment No. 4, supra note 11.
    \113\ See proposed BOX Rules, Chapter V, sec. 20(d); see also 
Amendment No. 4, supra note 11.
    \114\ See proposed BOX Rules, Chapter V, sec. 20(e); see also 
Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    One commenter suggests that BOX should define what it means when it 
refers to the exchange with the ``most liquidity'' under the obvious 
error rule.\115\ In response, BOX proposes to amend the rule to 
describe specifically how it would determine which is the options 
exchange with the most liquidity.\116\
---------------------------------------------------------------------------

    \115\ See PCX Letter 2, supra note 10, at Appendix at 10.
    \116\ See proposed BOX Rules, Chapter V, sec. 20, Supp. Mat. 
.03; see also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    The Commission believes that, in most circumstances, trades that 
are executed between parties should be honored. On rare occasions, the 
price of the executed trade indicates an ``obvious error'' may exist, 
suggesting that it may be unrealistic to conclude that the parties to 
the trade had come to a meeting of the minds regarding the terms of the 
transaction. In the Commission's view, the determination of whether 
such an ``obvious error'' has occurred should be based on specific and 
objective criteria and subject to specific and objective procedures. 
The Commission believes that the BSE's proposed obvious error rule 
establishes specific and objective criteria for determining when a 
trade is an ``obvious error.'' The Commission also believes that the 
proposal establishes specific and objective procedures governing the 
adjustment or nullification of such trade. The Commission further notes 
that several provisions of the BOX obvious error rule are substantially 
the same as the obvious error rule of another options exchange, which 
was recently approved by the Commission.\117\
---------------------------------------------------------------------------

    \117\ See ISE Rule 720; see also Securities Exchange Act Release 
No. 48097 (June 26, 2003), 68 FR 39604 (July 2, 2003) (SR-ISE-2003-
10) (order approving amendments to ISE's obvious error rule).
---------------------------------------------------------------------------

7. Cabinet Trading
    As originally proposed, the BOX Rules did not contain any 
provisions with regard to cabinet trades (also known as accommodation 
liquidations), generally transacted at the expiration of worthless 
options for tax purposes. One commenter suggests that the BOX proposal 
should include provisions relating to cabinet trading and how the BSE 
intends to regulate cabinet trading.\118\
---------------------------------------------------------------------------

    \118\ See PCX Letter 2, Appendix at 13.
---------------------------------------------------------------------------

    In response, the BSE proposes, in Amendment No. 4, to permit 
cabinet trading in each series of options contracts open for trading on 
BOX.\119\ The proposed cabinet trading rules are substantially similar 
to the cabinet trading rules of the other options exchanges \120\ and 
the Commission believes they are consistent with the Act.
---------------------------------------------------------------------------

    \119\ See proposed BOX Rules, Chapter V, sec. 28; see also 
Amendment No. 4, supra note 11.
    \120\ See, e.g., ISE Rule 718; CBOE Rule 6.54; and PCX Rule 
6.80.
---------------------------------------------------------------------------

8. Anticipatory Hedge Rule
    The BSE has not proposed a rule that would prohibit what is known 
as ``anticipatory hedging.'' All of the options exchanges have 
anticipatory hedging rules, which generally prohibit a member that has 
knowledge of all material terms of a solicited order, an order being 
facilitated, or orders being crossed, the execution of which is 
imminent, from buying or selling (1) an option on the same underlying 
security as the option that is the subject of the order, (2) the 
underlying security itself, or (3) any related instrument until either 
the terms of the order are disclosed to the trading crowd or the 
options order can no longer be considered imminent in view of the 
passage of time since the order was received.\121\ The Commission 
believes that the options exchanges' anticipatory hedging rules prevent 
the misuse of non-public information and afford trading crowds a full 
and fair opportunity to make informed trading decisions.\122\ In 
addition, the Commission believes that anticipatory hedging could 
threaten the integrity of the auction market or disadvantage other 
market participants.\123\ Accordingly, the Commission's approval of 
this proposed rule change will not be effective until BSE files a 
separate proposed rule change with the Commission to adopt an 
anticipatory hedging rule comparable to those of the other options 
exchanges that becomes effective pursuant to section 19(b) of the Act.
---------------------------------------------------------------------------

    \121\ See Amex Rule 950(d), Commentary .04; CBOE Rule 6.9(e); 
ISE Rule 400, Supplementary Material .02; PCX Rule 6.49(b); and Phlx 
Rule 1064(d).
    \122\ See Securities Exchange Act Release No. 44208 (April 20, 
2001), 66 FR 21423 (April 30, 2001) (SR-ISE-01-02).
    \123\ See Securities Exchange Act Release Nos. 42894 (June 2, 
2000), 65 FR 36850 (June 12, 2000) (SR-Amex-99-36); and 34959 
(November 9, 1994), 59 FR 59446 (November 17, 1994) (SR-CBOE-94-15).

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

[[Page 2783]]

C. Filtering of BOX In-Bound Orders To Prevent Trade-Throughs

    All in-bound agency orders to BOX (whether on behalf of Customers, 
non-BOX Participant broker-dealer proprietary accounts or market makers 
at other exchanges) as well as inbound Principal (``P'') and Principal 
as Agent (``P/A'') orders received via the intermarket linkage \124\ 
would be filtered by BOX prior to entry on the BOX Book to ensure that 
these orders do not trade at a price outside the current NBBO (``trade-
throughs''). The filter would operate by analyzing all such orders as 
follows:
---------------------------------------------------------------------------

    \124\ Plan for the Purpose of Creating and Operating an 
Intermarket Options Linkage (the ``Linkage Plan''). See Securities 
Exchange Act Release Nos. 43086 (July 28, 2000), 65 FR 48023 (August 
4, 2000) (order approving the Linkage Plan submitted by the Amex, 
CBOE, and ISE); 43574 (November 16, 2000), 65 FR 70850 (November 28, 
2000) (order approving PCX as participant in Options Intermarket 
Linkage Plan); and 43573 (November 16, 2000), 65 FR 70851 (November 
28, 2000) (order approving Phlx as participant in the Linkage Plan).
---------------------------------------------------------------------------

    Step 1: If the order were a BOX-Top Order, BOX would handle the 
order in the following manner:
    Where the best price on the BOX Book on the opposite side of the 
market from the BOX-Top Order is equal to the NBBO, the BOX-Top Order 
would be executed for all the quantity available on the BOX Book at 
this price. Any remaining quantity would be converted to a Limit Order 
at this execution price and filtered as described in steps 2 through 4 
below.\125\
---------------------------------------------------------------------------

    \125\ See proposed BOX Rules, Chapter V, sec. 16(b)(ii)(1).
---------------------------------------------------------------------------

    If the best bid (offer) disseminated by BOX were not equal to the 
NBBO, the BOX-Top Order to sell (buy) would be converted to a Limit 
Order for its total quantity at a price equal to the NBBO and filtered 
as described in steps 2 through 4 below.\126\
---------------------------------------------------------------------------

    \126\ See proposed BOX Rules, Chapter V, sec. 16(b)(ii)(2).
---------------------------------------------------------------------------

    Step 2: The filter would determine whether the order is executable 
against the NBBO.\127\ If the order were not executable against the 
NBBO, the order would be placed on the BOX Book at its limit price, 
unless the order were a P or P/A Order, in which case it would be 
immediately cancelled.\128\ If the order were executable against the 
NBBO, the filter would determine whether there is a quote on BOX that 
is equal to the NBBO.
---------------------------------------------------------------------------

    \127\ The BSE has clarified in Amendment No. 4 that an order 
would be deemed ``executable against the NBBO'' when, in the case of 
an order to sell (buy), its limit price is equal to or lower 
(higher) than the best bid (offer) across all options exchanges. All 
BOX-Top Orders are deemed to be executable against the NBBO. See 
Amendment No. 4, supra note 11.
    \128\ See proposed BOX Rules, Chapter V, sec. 16(b)(iii)(1); see 
also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    Step 3: If there were a quote on BOX that is equal to the NBBO, 
then the order would be executed against that quote. Any remaining 
quantity of the order would be exposed on the BOX Book at the price the 
order was partially executed for a period of three seconds. During the 
exposure period, any Options Participant may trade with the order. If 
the order were not executed during the three-second exposure period, 
then the order would be handled by BOX pursuant to Step 4 below.\129\
---------------------------------------------------------------------------

    \129\ See proposed BOX Rules, Chapter V, sec. 16(b)(iii)(2)(a); 
see also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    With respect to P and P/A Orders in which the size of a P/A Order 
is larger than the Firm Customer Quote Size or the size of a P Order is 
larger than the Firm Principal Quote Size, and any quantity remains 
after trading against the BOX quote at the NBBO, then such remaining 
quantity would be exposed on the BOX Book at the price the order was 
partially executed for a period of three seconds. During the exposure 
period, any Options Participant may trade with the order. Any quantity 
remaining on the BOX Book after the three-second exposure period would 
be cancelled. BOX would inform the sending Participant exchange of the 
amount of the order that was executed and the amount, if any, 
cancelled.\130\
---------------------------------------------------------------------------

    \130\ Id.
---------------------------------------------------------------------------

    If there were not a quote on BOX that is equal to the NBBO, then 
the order, unless such order is a P or P/A Order, would be exposed on 
the BOX Book at the NBBO for a period of three seconds. During the 
exposure period, any Options Participant may trade with the order. If 
the order were not executed during the three-second exposure period, 
then the order would be handled by BOX pursuant to Step 4 below.\131\ 
However, if the order were a P or P/A Order, it would not be exposed 
for the three-second period and, instead, would be immediately 
cancelled.
---------------------------------------------------------------------------

    \131\ See proposed BOX Rules, Chapter V, sec. 16(b)(iii)(b); see 
also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    Step 4: At the end of the three-second exposure period, any 
unexecuted quantity of an order would be handled by BOX in one of the 
following ways:
    (1) If the best BOX price were now equal to the NBBO, the remaining 
unexecuted quantity would immediately trade with that quote or order. 
Any remaining quantity would be (i) in the case of a Public Customer 
Order, sent as a P/A Order to an exchange displaying the NBBO; or (ii) 
in the case of a market maker or proprietary broker-dealer order, 
returned to the submitting Options Participant; \132\

    \132\ See proposed BOX Rules, Chapter V, sec. 16(b)(iii)(c)(1); 
see also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

or

    (2) If the best BOX price is not equal to the NBBO, then any 
remaining unexecuted quantity would be (i) in the case of a Public 
Customer Order, sent as a P/A Order to an exchange displaying the NBBO; 
or (ii) in the case of a market maker or proprietary broker-dealer 
order, returned to the submitting Options Participant.\133\
---------------------------------------------------------------------------

    \133\ See proposed BOX Rules, Chapter V, sec. 16(b)(iii)(c)(2); 
see also Amendment No. 4, supra note .
---------------------------------------------------------------------------

    One commenter asks for more clarity regarding which BOX 
participants will be able to view the internal message disseminating 
the in-bound order in the BOX filter.\134\ The Commission does not 
agree with the commenter that the BOX Rules are unclear with respect to 
order exposure on the BOX book during the filter process, as the 
proposed rules state that the order would be exposed on the BOX 
Book.\135\
---------------------------------------------------------------------------

    \134\ See PCX Letter 2, supra note, at Appendix at 4.
    \135\ See proposed BOX Rules, Chapter V, sec. 16(b); see also 
Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    The Commission believes that the proposed rules regarding the NBBO 
filter process are in accordance with Section 6(b)(5) of the Act \136\ 
because they are designed to facilitate transactions in securities, and 
remove impediments to and perfect the mechanism of a free and open 
market and national market system. The NBBO filter is designed to 
protect against incoming agency orders trading at prices that trade 
through better prices on other markets as required under the Linkage 
Plan.\137\ In addition, the Commission believes that the BOX NBBO 
filter rules outlined above should allow Market Makers and OFPs to 
provide efficient and competitive executions for in-bound agency 
orders, subject to priority and allocation principles.
---------------------------------------------------------------------------

    \136\ 15 U.S.C. 78f(b)(5).
    \137\ See infra notes 282-289 and accompanying text.
---------------------------------------------------------------------------

D. Directed Orders Process

    Under BSE's proposal, a ``Directed Order'' refers to a Customer 
Order that an OFP directs to a particular Market Maker.\138\ A Market 
Maker who wishes to accept Directed Orders must systemically indicate 
that it wishes to receive Directed Orders each day, must be willing to 
accept Directed Orders from all OFPs, may receive Directed

[[Page 2784]]

Orders only through the BOX Trading Host, and may not reject Directed 
Orders.\139\
---------------------------------------------------------------------------

    \138\ See proposed BOX Rules, Chapter I, sec. 1(a)(21); see also 
Amendment No. 4, supra note 11.
    \139\ See proposed BOX Rules, Chapter VI, sec. 5(c)(i); see also 
Amendment No. 4, supra note 11. If a Market Maker does not 
systemically indicate that it will receive Directed Orders, the BOX 
Trading Host will not forward any Directed Orders to that Market 
Maker.
---------------------------------------------------------------------------

    A Market Maker receiving a Directed Order would have to, within 
three seconds of receipt of the order, either submit the Directed Order 
to the PIP, discussed below,\140\ or send the order to the BOX 
Book.\141\ If the Market Maker submits the order to the PIP and is 
quoting at the NBBO on the opposite side of the Directed Order, it 
would be prohibited from changing its quotation prior to submitting the 
Directed Order to the PIP.\142\ If the Market Maker sends the Directed 
Order to the BOX Book (or BOX releases the order to the book) the 
following rules would apply.
---------------------------------------------------------------------------

    \140\ See infra notes 169-252 and accompanying text.
    \141\ If, three seconds after receipt of a Directed Order, a 
Market Maker has not taken any action on the Directed Order, BOX 
will automatically release the Directed Order to the BOX Book. See 
proposed BOX Rules, Chapter VI, sec. 5(c)(ii)(2); see also Amendment 
No. 4, supra note 11.
    \142\ See proposed Box Rules, Chapter VI, sec. 5(c)(ii)(1); see 
also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    First, the Market Maker sending the Directed Order to the BOX Book 
would be prohibited for three seconds from submitting to BOX a contra 
order to the Directed Order for its proprietary account.\143\ This 
requirement would allow the Directed Order to be exposed to other 
market participants to give them the opportunity to trade with the 
Directed Order.
---------------------------------------------------------------------------

    \143\ See proposed BOX Rules, Chapter VI, secs. 5(c)(iii)(2)(a) 
and 5(c)(iii)(1)(a); see also Amendment No. 4, supra note 11. 
According to the BSE, BOX surveillance systems would detect 
violations of the three-second requirement. See Amendment No. 4, 
supra note 11.
---------------------------------------------------------------------------

    Second, if the Market Maker's quotation on the opposite side of the 
market from the Directed Order is not equal to the NBBO, immediately 
upon the submission of the Directed Order to BOX, the Trading Host 
would determine if the Directed Order is executable against the NBBO 
according to the NBBO filter process discussed above.\144\ If the 
Market Maker's quotation on the opposite side of the market from the 
Directed Order were equal to the NBBO, then prior to submitting the 
Directed Order to the BOX Book, the Market Maker would determine 
whether the Directed Order is executable against the NBBO.\145\
---------------------------------------------------------------------------

    \144\ See proposed BOX Rules, Chapter VI, sec. 5(c)(iii)(1). See 
also supra notes 124-137 and accompanying text.
    \145\ See proposed BOX Rules, Chapter VI, sec. 5(c)(iii)(2).
---------------------------------------------------------------------------

    Third, if the Directed Order were not executable against the NBBO, 
it would be placed on the BOX Book to be treated as any other 
order.\146\ If the Directed Order were executable against the NBBO, and 
the Market Maker sending the Directed Order to the BOX Book has a quote 
on the opposite side of the Directed Order equal to the NBBO, then the 
Market Maker must guarantee execution of the Directed Order at the 
current NBBO for at least the size of its current quote.\147\ This 
guarantee would be defined as a Guaranteed Directed Order 
(``GDO'').\148\ The Market Maker must then immediately send the 
Directed Order and the GDO to the BOX Book. If the Directed Order were 
executable against the NBBO and the Market Maker sending the Directed 
Order to the BOX Book does not have a quote on the opposite side of the 
market equal to the NBBO, the Trading Host would execute the Directed 
Order against any quotes or orders on the BOX Book equal to the NBBO 
and then filter the order against trading through the NBBO and, if 
applicable, then place the Directed Order on the BOX Book.\149\ The 
Directed Order would trade against any quotes or orders on the BOX 
Book, except the GDO,\150\ and any quantity remaining would be exposed 
to all BOX Participants at the GDO price for three seconds. During this 
period, any BOX Participant, except the Market Maker who submitted the 
Directed Order, could trade with the Directed Order.\151\ After three 
seconds of exposure, BOX would release the GDO, which would trade with 
any remaining quantity of the Directed Order.\152\ If there were still 
any quantity remaining of the Directed Order, it would be filtered 
against trading through the NBBO according to the procedures described 
above. If the Directed Order were not executed or routed to another 
exchange through the filter process, it would then be placed on the BOX 
Book.\153\
---------------------------------------------------------------------------

    \146\ See proposed BOX Rules, Chapter VI, secs. 5(c)(iii)(1)(b) 
and 5(c)(iii)(2)(a).
    \147\ See proposed BOX Rules, Chapter VI, sec. 5(c)(iii)(2)(b).
    \148\The Market Maker would be prohibited from trading from its 
proprietary account against the Directed Order for at least three 
seconds. During that time the Market Maker would not be allowed to 
decrement the size or worsen the price of its GDO, but could 
increase the size of its GDO. If the Market Maker received a 
subsequent Directed Order during this three-second period it would 
be able to either submit it to the PIP or send it to the BOX Book, 
following the same process as for the first Directed Order. See 
proposed BOX Rules, Chapter VI, sec. 5(c)(iii)(2)(b).
    \149\ See proposed BOX Rules, Chapter VI, sec. 5(c)(iii)(1)(c).
    \150\ See proposed BOX Rules, Chapter VI, sec. 
5(c)(iii)(2)(b)(2).
    \151\ See proposed BOX Rules, Chapter VI, sec. 
5(c)(iii)(2)(b)(3).
    \152\ See proposed BOX Rules, Chapter VI, sec. 
5(c)(iii)(2)(b)(4). Unless modified by the Market Maker, BOX would 
reestablish the quote of the Market Maker decremented by any 
executed portion of the GDO. Id.
    \153\ See proposed BOX Rules, Chapter VI, sec. 
5(c)(iii)(2)(b)(5).
---------------------------------------------------------------------------

    Some commenters argue that the Directed Order process amounts to 
preferencing or internalization by the Market Makers, which would 
threaten market integrity.\154\ In addition, some commenters contend 
that Directed Orders would allow payment for order flow, an arrangement 
where a Market Maker would offer an order entry firm cash or other 
economic inducement to route its Directed Orders to that firm.\155\
---------------------------------------------------------------------------

    \154\ See Amex Letter 3, supra note 10, at 4-5; ISE Letter 2, 
supra note 10, at 10.
    \155\ See Amex Letter 3, supra note 10, at p. 4; CBOE Letter 2, 
supra note 10, at p.9; and ISE Letter 2, supra note 10, at p. 9.
---------------------------------------------------------------------------

    The Commission believes, however, that the proposed restrictions on 
Market Makers receiving Directed Orders described above should limit 
the Market Maker's ability to internalize these orders without 
undermining competitive markets. In particular, the Commission believes 
that the Directed Order process will not jeopardize market integrity or 
the incentive for market participants to post competitive quotes 
because Market Makers receiving Directed Orders must accept all orders 
directed to them and must send such orders only to the PIP or to the 
BOX Book, and because a Market Maker is prohibited from interacting 
with a Directed Order it receives for three seconds, regardless of the 
price at which the Market Maker was quoting when the Directed Order was 
received.
    One commenter suggests that the BSE's proposal would penalize 
Market Makers that quote at the NBBO because, if the Market Maker that 
receives the Directed Order were quoting at the NBBO at the time it 
receives the Directed Order, it would be required to couple the 
Directed Order with a GDO, guaranteeing the execution of the Directed 
Order at the then-current NBBO for at least the size of the Market 
Maker's quotation.\156\ Moreover, the Market Maker's quotation loses 
any priority it may have had at the NBBO because its GDO is not 
released for the three-second exposure period, and the Market Maker 
would trade only when all other trading interest is exhausted.\157\ 
Also, this commenter argues that the proposed BOX market would provide 
a strong incentive to maintain wide quotations and to quote in small 
size because, among other things, Market

[[Page 2785]]

Makers could receive Directed Orders from small Customers--the most 
attractive order flow available--regardless of the quality of their 
quotations.\158\ Finally, the commenter argues that the Commission 
should permit Directed Orders only if the proposal would: (1) Prohibit 
sending Directed Orders to a Market Maker not quoting at the inside 
market; and (2) prohibit an OFP from sending Directed Orders to a 
Market Maker for a size larger than the Market Maker's then-current 
quotation.\159\
---------------------------------------------------------------------------

    \156\ See ISE Letter 2, supra note 10, at 12.
    \157\ Id.
    \158\ Id.
    \159\ See ISE Letter 2, supra note 10, at 6, 10.
---------------------------------------------------------------------------

    The Commission, however, does not believe that it is necessary for 
these restrictions to be included in the BOX Rules to be consistent 
with the Act. In response to the other comments raised by this 
commenter, the BSE has changed its proposal to clarify that a Market 
Maker, who receives a Directed Order when not quoting at the NBBO, as 
well as when quoting at the NBBO, would have to wait three seconds 
before trading with the Directed Order.\160\ This provision would allow 
the Directed Order to be exposed to other market participants to give 
them the first opportunity to trade with the Directed Order. 
Accordingly, the Commission believes that the Directed Order process 
would not provide any disincentive for Market Makers who receive 
Directed Orders to quote competitively, and may, in fact, provide some 
incentive for other Market Makers to quote competitively because it 
will give them priority with respect to all other orders entered onto 
the BOX Book, including orders directed to other Market Makers.
---------------------------------------------------------------------------

    \160\ See proposed BOX Rules, Chapter VI, sec. 5(c)(iii)(1)(a); 
see also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    Currently, the rules of several of the SROs impose certain 
restrictions on the business activities of a member or member 
organization that is affiliated with a specialist or member 
organization. The requirements in the BOX Rules regarding Directed 
Orders are intended to address any concerns regarding informational 
barriers and the transfer of information (intended or not) between 
Options Participants. To this effect, as noted above, under the BOX 
Rules, a BOX Market Maker who decides to accept Directed Orders, must 
agree to accept them from all sources. Upon receipt of a Directed 
Order, a Market Maker has only two choices--either submit the order 
into the PIP, or send the order back to the BOX Book.
    The BSE has proposed a number of safeguards designed to limit the 
disclosure of market information, the description of which follows in 
section II.E. These proposed measures should help to ensure that 
information is not used inappropriately for the benefit of the Market 
Maker receiving the Directed Order.

E. Rules To Limit Internalization

    Following the widespread multiple listing of options in the fall of 
1999, a number of broker-dealers handling customer orders pressured the 
options exchanges to allow them to trade with their customer orders. In 
addition, some specialists began paying broker-dealers to send them 
their customer orders, and sought greater guarantees that specialists 
could trade with these and other orders. In response to these 
pressures, member firms have been given increased opportunities (both 
by exchange rule and floor practice) to trade with (or internalize) the 
customer orders they bring to an exchange. While all of these practices 
were a response to greater competition between markets, they also raise 
structural issues because of their potential to decrease quote 
competition. As more customer orders are retained by a specialist or 
the firm that brought the order to the exchange, and therefore are 
unavailable to other members who are competing for orders based on 
price, these other members could have less incentive to compete by 
offering better prices on an exchange, and price competition may 
suffer. Eventually, if particular exchange members lock up too great a 
share of customer orders, the number of competing market makers within 
the market could diminish, and with them, active or potential 
intramarket price competition.
    As a result, the disseminated quotations, and the prices available 
on a market, could deteriorate'ultimately harming investors. Moreover, 
because a firm can profit by internalizing its customers' orders while 
matching the best displayed quotes, rules that guarantee firms a right 
to trade with some or all of their own customers' orders may interfere 
with a broker-dealer seeking better prices that might be available in 
the market. For this reason, the Commission has closely scrutinized 
proposals by exchanges to guarantee specialists a proportion of orders 
traded on an exchange \161\ and to guarantee that firms bringing their 
customers' orders to an exchange can trade with a certain proportion of 
those orders.
---------------------------------------------------------------------------

    \161\ All five existing options exchanges have rules that 
guarantee a specialist a proportion of each order when its quote is 
equal to the best price on the exchange. See, e.g., Amex Rule 
933(h); CBOE Rule 8.87; ISE Rule 713, Supplementary Material .01; 
Phlx Rule 1014(g), and PCX Rule 6.75(f)(4). These guarantees are 
special allocation provisions that differ from the general rules of 
the exchanges that assign executions based on priority, parity, nad 
precedence. Specialist guarantees reward market making firms willing 
to perform the obligations of a specialist by ensuring them that 
they will be able to interact as principal with a certain percentage 
of incoming orders. The Commission has generally found specialist 
guarantees to be consistent with the Act as a reasonable means for 
an exchange to attract and retain well-capitalized specialists that 
are responsible for assuring fair and orderly markets and fulfilling 
other responsibilities. The Commissioner has more closely 
scrutinized proposals, however, where the percentage of specialist 
participation would rise to a level that could have a material 
adverse impact on quote competition within a particular exchange. 
See, e.g., Exchange Act Release No. 4311 (July 31, 2000), 65 FR 
48778 (August 9, 2000) (Phlx's ``80/20'' proposal, which the 
exchange ultimately withdrew, would have increased its enhanced 
specialist participation to 80% for certain options orders) (``Phlx 
80/20 Note''). In particular, the Commission is concerned that large 
specialist guarantees could significantly discourage intramarket 
price competition by ``locking up'' such a large proportion of each 
order that market makers in the crowd would be seriously hindered in 
their ability to compete with the specialist. Over the long-term, 
the decrease in intraexchange competition could widen spreads and 
diminish the quality of prices available to investors. Id.
---------------------------------------------------------------------------

    Several commenters express concern that the BOX proposal would 
encourage internalization \162\ more than any other exchange \163\ and 
would lead to a ``slippery slope'' or ``race to the bottom'' as other 
exchanges modify their market models to compete with BOX.\164\ The 
Commission is keenly concerned about the issues raised by 
internalization in the options markets, and has been particularly 
vigilant with respect to proposed rule changes that would permit 
broker-dealers to internalize their customers' orders in a manner that 
could interfere with order interaction and discourage the display of 
aggressively-priced quotations. Indeed, the Commission is disinclined 
to approve not only those proposals by options exchanges that would 
guarantee broker-dealers the ability to internalize a significant 
portion of their own customers' orders, but also those proposed rule 
changes that would guarantee a large percentage of each customer order 
to any market participant. The Commission is concerned that such 
proposals may lock

[[Page 2786]]

away so much of each order that crowd members will no longer have an 
incentive to compete. To evaluate those comments contending that the 
BSE's proposal would encourage internalization more than existing 
options exchanges, it is necessary to first consider the level of 
internalization permitted on the other options exchanges.
---------------------------------------------------------------------------

    \162\ ``Internalization'' is generally known as the direction of 
order flow by a broker-dealer to an affiliated specialist or order 
flow executed by that broker-dealer as principal. See Securities 
Exchange Act Release No. 37619A (September 6, 1996), 61 FR 48290 
(September 12, 1996) at n.22 (File No. S7-30-95).
    \163\ See Amex Letter 3, supra note 10, at 2; CBOE Letter 2, 
supra note 10, at 1; ISE Letter 2, supra note 10, at 1; PCX Letter 
2, supra note 10, at 2; and Phlx Letter 2, supra note 10, at 2.
    \164\ See CBOE Letter 2, supra note 10, at 2-3; ISE Letter 2, 
supra note 10, at 1-3, and PCX Letter 2, supra note 10, at 2.
---------------------------------------------------------------------------

    As the options markets began to more aggressively list multiply 
list the most active options, the options exchanges adopted rules that 
allowed upstairs firms more rights to participate in certain customer 
orders they bring to the exchanges. For example, the ISE adopted a rule 
that permits upstairs firms to interact as principal with up to 40% of 
orders of 50 contracts or more that the firm presents to the exchange 
after an auction and other conditions are satisfied.\165\
---------------------------------------------------------------------------

    \165\ See Securities Exchange Act Release No. 42455 (February 
24, 2000), 65 FR 11388 (March 2, 2000) (Order approving registration 
of the ISE as a national securities exchange) (ISE Exchange Approval 
Release''). ISE's rules permit upstairs firms to enter orders of 50 
contracts or more into the facilitation mechanism. Upon entry of an 
order into the facilitation mechanism, ISE sends a broadcast to 
crowd participants informing them of the proposed transaction, and 
the crowd is given ten seconds to respond. The upstairs firm 
entering the facilitation order will be allocated 40% of the 
original size of the facilitation order, but only after better-
priced orders, quotes, and public customer orders at the 
facilitation price are executed. See ISE Rule 716(d).
---------------------------------------------------------------------------

    In response to the ISE's ``facilitation'' rule, each of the other 
options exchanges adopted similar rules.\166\ While certain provisions 
of the exchanges' facilitation guarantees vary,\167\ to qualify for the 
guarantee all require the facilitation orders to be at least 50 
contracts and the guarantee is limited to 40% of the contracts in each 
order. In addition, the options exchanges' rules permit a firm to trade 
with its own customer only after an auction in which other members of 
that market have an opportunity to participate in the trade at the 
proposed price or to improve the price. An auction prior to permitting 
a firm to internalize any portion of its customer's order gives some 
assurance that the price at which the trade takes place is the best 
price then available in the market. Moreover, if both a specialist and 
an upstairs firm would be entitled to a guarantee with respect to the 
same trade, the exchanges' rules do not permit the combined guarantee 
of the two firms to exceed 40% of the contracts to be traded, thereby 
allowing the trading crowd to compete for at least 60% of any 
order.\168\ Of course, if members of the trading crowd are unwilling to 
trade with a particular order, the upstairs firm may internalize the 
entire order.
---------------------------------------------------------------------------

    \166\ See Securities Exchange Act Release Nos. 42835 (May 26, 
2000), 65 FR 35683 (June 5, 2000); 42848 (May 26, 2000), 65 FR 36206 
(June 7, 2000); 42894 (June 2, 2000), 65 FR 36850 (June 12, 2000); 
and 47819 (May 8, 2003), 68 FR 25924 (May 14, 2003) (orders 
approving, respectively, File Nos. SR-CBOE-99-10; SR-PCX-99-18; SR-
AMEX-99-36; and SR-PHLX-2002-17).
    \167\ For example, some of the exchanges' rules allow an 
upstairs firm to participate in an order even when it does not 
improve upon the price offered by the trading crowd. CBOE's Rule 
6.74(d) is illustrative. If an upstairs firm chooses a facilitation 
price that matches the price offered by the trading crowd, the firm 
can participate in up to 20% of the facilitated order, whereas if it 
improves the trading crowd's price, its participation right rises to 
40%. In either case, public customer orders must first be satisfied 
prior to the upstairs firm's participation in the facilitated order. 
See Exchange Act Release No. 42835, 65 FR 35683 (May 26, 2000) 
(order approving SR-CBOE-99-10).
    \168\ See Phlx 80/20 Notice, supra note , 65 FR at 48786.
---------------------------------------------------------------------------

1. PIP Auction
    The BOX Rules provide for an auction process, known as the PIP, 
which can be used by Options Participants seeking to execute their 
agency orders as principal. With certain exceptions, an Options 
Participant is not otherwise permitted to trade with its agency 
orders.\169\ In addition, prior to submitting an order to the PIP, an 
OFP cannot inform an Options Participant or any other third party of 
any of the terms of the order, except as provided for in the BOX Rules 
regarding Directed Orders.\170\
---------------------------------------------------------------------------

    \169\ See infra notes 253-259--and accompanying text; proposed 
BOX Rules, Chapter V, sec. 17, Supplementary Material .03. See also 
Amendment No. 4, supra note 11.
    \170\ See proposed BOX Rules, Chapter V, sec. 17, Supplementary 
Material .04; see also Amendment No. 3, supra note 8.
---------------------------------------------------------------------------

    The PIP features these key aspects:
    [sbull] An Options Participant may submit any size Customer Order 
\171\ for price improvement into the PIP, along with a matching contra 
order for the Options Participant's proprietary account at a price of 
at least one penny better than the prevailing NBBO at the commencement 
of the PIP (the ``Primary Improvement Order'').\172\ The Primary 
Improvement Order may not be cancelled or modified, except by improving 
its price. Thus, the Customer Order is guaranteed an execution at a 
price at least one penny better than the NBBO.
---------------------------------------------------------------------------

    \171\ There would be no minimum size requirement for orders 
entered into the PIP, for a pilot period to extend eighteen months 
from the day trading commences on BOX. See proposed BOX Rules, 
Chapter V, sec. 18, Supplementary Material .01.
    \172\ See BOX Rules, Chapter V, sec. 18(e).
---------------------------------------------------------------------------

    [sbull] Market Makers assigned to the class, Options Participants 
with proprietary orders at the BOX inside bid or offer for the 
particular series (``PPOs''),\173\ CPO \174\ and the Options 
Participant who submitted the Primary Improvement Order may compete to 
trade with the Customer Order in one-penny increments during a three-
second auction. These market participants can enter competing 
Improvement Orders \175\ at penny increments to match or improve the 
price of the Primary Improvement Order. All other BOX Participants are 
informed of each PIP and may submit competing orders at standard price 
increments.
---------------------------------------------------------------------------

    \173\ See infra notes 199-201--and accompanying text.
    \174\ See infra notes 189-198--and accompanying text.
    \175\ An Improvement Order is any order entered by a Market 
Maker assigned to the class, a CPO, or a PPO priced at or better 
than the Options Participant's Primary Improvement Order. See 
proposed BOX Rules, Chapter V, sec.18(e)(i)-(ii).
---------------------------------------------------------------------------

    [sbull] The trade is allocated based on price and time priority at 
the end of the PIP, with certain exceptions. Specifically, Public 
Customer Orders and non-BOX Participant broker-dealer orders would have 
priority over any order of an OFP at the same price. In addition, 
Public Customer Orders would have priority over an unmodified Primary 
Improvement Order for the account of a Market Maker at the same price, 
and would have priority over a modified Primary Improvement Order for 
the account of a Market Maker that matches such Public Customer Orders.
    [sbull] Because the execution of the Customer Order is guaranteed 
at the start of the PIP, the Customer Order has priority over all other 
orders on its side of the market that are entered on the BOX Book 
during the PIP.
    The Commission finds that the PIP, as part of the BOX facility, is 
consistent with section 6(b)(5) of the Act. In general, the Commission 
believes that the proposed BOX Rules provide comparable limitations on 
internalization as the other exchange's rules that guarantee members 
the right to internalize their customers' orders. In particular, the 
BSE's proposal would require a firm to expose its customer order in the 
PIP before trading with that order.
    As discussed below, the Commission believes that the three-second 
electronic auction proposed by the BSE should provide sufficient time 
for an electronic crowd to compete for a Customer Order. Moreover, the 
Commission believes that the access to the PIP by those who may wish to 
compete for a Customer Order is sufficient to provide opportunities for 
a meaningful, competitive auction. In fact, the Commission believes, as 
discussed below, that the BSE's proposal provides an opportunity for a

[[Page 2787]]

greater number of market participants to compete in a PIP than current 
exchanges provide. The Commission believes that the only significant 
distinctions between the BSE's proposed PIP auction and the rules of 
other options exchanges that guarantee members the right to internalize 
customers' orders, is that orders of fewer than fifty contracts could 
be entered into the BOX PIP \176\ and trades could take place in 
pennies,\177\ whereas other exchanges' rules do not guarantee that 
members will be able to trade with such small-sized customer orders and 
require that trades all be in standard increments. The Commission 
discusses below the features of the BSE's proposal that it believes 
make these distinctions consistent with the Act.
---------------------------------------------------------------------------

    \176\ See Discussion infra at section II.E.1.g.
    \177\ See Discussion infra at section II.E.1.d.
---------------------------------------------------------------------------

a. Three Market Maker Requirement
    There must be at least three Market Makers quoting in a relevant 
series at the time an Options Participant submits its Customer Order 
and Primary Improvement Order to initiate a PIP.\178\ The Commission 
believes that this requirement will improve the opportunity for a 
Customer Order to be exposed to a competitive auction, and represents 
an improvement over current exchange auction rules. Specifically, 
current exchange rules that permit members to internalize their 
customers' orders do not require any market makers (other than a 
specialist) to be quoting in a series before a member trades with its 
customer.
b. Three-Second PIP
    The BSE proposes that the duration of each PIP be 3 seconds, unless 
it concludes sooner due to the receipt on BOX of an unrelated order on 
the same side of the market as the Customer Order (such that it would 
cause an execution to occur).\179\ In cases where an executable 
unrelated order on the same side as the Customer Order is submitted to 
BOX during a PIP, such that it would cause an execution to occur before 
the end of the three-second PIP, the PIP would conclude and the 
Customer Order would be matched with the Improvement Order(s) to the 
fullest extent possible.\180\
---------------------------------------------------------------------------

    \178\ See proposed BOX Rules, Chapter V, sec. 18(e).
    \179\ See proposed BOX Rules, Chapter V, sec. 18(i). With 
respect to the same series, no PIP will run simultaneously with 
another PIP, nor will PIPs be permitted to queue or overlap in any 
manner. See proposed BOX Rules, sec. 18, Supplementary Material .02; 
see also Amendment No. 4, supra note 11.
    \180\ See proposed BOX Rules, Chapter V, sec. 18(i).
---------------------------------------------------------------------------

    Some commenters criticize the proposed time period of the auction, 
arguing that the three-second PIP would favor highly capitalized firms 
with faster technology over smaller market participants.\181\ Critics 
also argue that the three-second PIP would permit more internalization 
because orders are exposed to the market for only a very short period 
of time and many market participants, including CPOs, would be unable 
to assess their risks and market conditions in 3 seconds.\182\ Another 
commenter contends that the PIP would afford the initiating Options 
Participant a ``last look'' to match the last price and take 
priority.\183\
---------------------------------------------------------------------------

    \181\ See Phlx Letter 2, supra note 10, at 3; CBOE Letter 2, 
supra note 10, at 9.
    \182\ See Amex Letter 3, supra note 10, at 3; PCX Letter 2, 
supra note 10, at 3; and ISE Letter 2, supra note 10, at 5.
    \183\ See ISE Letter 1, supra note 7, at 6.
---------------------------------------------------------------------------

    The Commission believes that a three-second PIP should afford 
electronic crowds sufficient time to compete for Customer Orders 
submitted by an Options Participant. In reaching this conclusion, the 
Commission believes that the timeframes necessary for exposure and 
execution of orders be adjudged in light of the BOX market structure. 
The Commission believes that the critical issue is determining whether 
the three-second timeframe gives participants in a fully automated 
marketplace sufficient time to respond to a PIP broadcast to compete 
and provide price improvement for Customer Orders, and that electronic 
systems are available to BOX Options Participants that would allow them 
to respond to PIP broadcasts in a meaningful way within the proposed 
timeframe. The Commission notes that Market Makers and OFPs can either 
develop their own software to manage trading on BOX, or utilize one of 
the many front-end solutions that have been written to connect with 
electronic-based exchanges. All Options Participants should have the 
opportunity to develop or avail themselves of such systems, and 
although these automated systems will entail additional costs, the 
markets for derivative products are by their nature automation-
intensive, and require a higher capital base than for other simpler 
financial products.
    With respect to the comments that BSE's proposal would permit 
greater internalization due to the relatively short duration of the 
PIP, the Commission believes that the ability of Market Makers and 
other Options Participants on BOX to electronically monitor for PIP 
broadcasts, and to program competitive responses based on pre-set 
parameters, should provide a fair opportunity and incentive to compete 
for Customer Orders submitted to the PIP. Moreover, the Commission 
believes that one important difference between the BSE's proposed PIP 
and floor-based markets is that the BOX Options Participants do not 
know the identity of the Options Participant that submitted the 
Customer Order to the PIP. Accordingly, like the ISE's Facilitation 
Mechanism, the automated, non-personal nature of BOX's PIP provides no 
opportunity for agreements between the facilitating firm and the 
trading crowd whereby, for example, the trading crowd agrees not to 
break up a firm's proposed facilitation in exchange for that firm's 
agreement to bring order flow to the exchange.\184\ Moreover, the PIP 
provides for price priority and competing Market Makers are entitled to 
an execution of some portion of the Customer Order even when the 
facilitating firm matches the Market Maker at the best quote at the 
conclusion of the PIP. In addition, the Options Participant who has 
submitted its Customer Order into the PIP does not have an opportunity 
for a ``last look'' to match the prices bid or offered during the PIP. 
The Commission believes that these features should limit 
internalization, while encouraging Options Participants to submit their 
most competitive orders/quotes first, before the PIP ends. Accordingly, 
the Commission believes that a three-second PIP is consistent with the 
Act.
---------------------------------------------------------------------------

    \184\ See Securities Exchange Act Release No. 46514 (September 
18, 2002), 67 FR 60267 (September 25, 2002).
---------------------------------------------------------------------------

c. Competition in the PIP
    In addition to the Options Participant that submitted the Customer 
Order and Primary Improvement Order, all Market Makers assigned to a 
class would be permitted to compete in penny increments for orders in 
that class entered into a PIP.\185\ Public Customers may also 
participate in a PIP through the use of CPOs.\186\ In addition, Options 
Participants not assigned to a class as a Market Maker may submit PIP 
Proprietary Orders (``PPOs'') to compete for Customer Orders, if they 
meet certain requirements to submit a PPO.\187\ Other market 
participants may submit orders to the BOX Book during the PIP. These 
``unrelated orders'' would participate in a trade at the

[[Page 2788]]

conclusion of the PIP at the standard minimum price increments.\188\
---------------------------------------------------------------------------

    \185\ See proposed BOX Rules, Chapter V, sec. 18(e)(i).
    \186\ See infra notes 189-195 and accompanying text; proposed 
BOX Rules, Chapter V, sec. 18(g).
    \187\ See infra notes 199-201 and accompanying text; proposed 
BOX Rules, Chapter V, sec. 18(e)(i).
    \188\ An ``unrelated order'' is a non-Improvement Order entered 
into the BOX market during a PIP. See infra note 202 and 
accompanying text; proposed BOX Rules, Chapter V, sec. 18(e), (f), 
(g).
---------------------------------------------------------------------------

    i. Customer PIP Order. Public Customers may participate in a PIP 
through the use of CPOs.\189\ A CPO states a price in standard 
increments (five or 10 cents) at which the order would be placed on the 
BOX Book, as well as a price in pennies at which the Public Customer 
wishes to participate in any PIPs that might occur while its order is 
on the BOX Book (``CPO PIP Reference Price''). In addition, the terms 
of each CPO must include a specific order size (``CPO Total Size''). 
The number of contracts that may be entered into a PIP must be no 
greater than the lesser of (a) the CPO Total Size remaining on the BOX 
Book, or (b) the size of the Primary Improvement Order submitted to the 
PIP.\190\ A CPO would be eligible to participate in a PIP, if the CPO 
is priced at or better than the best BOX price (``BOX BBO''),\191\ and 
may participate in the PIP only on the same side of the market as the 
Primary Improvement Order. CPOs eligible to participate in a PIP may be 
submitted on behalf of Public Customers by OFPs. At any time during the 
PIP, the OFP may modify the price of the CPO submitted to the PIP to 
any price level up to the CPO PIP Reference Price.\192\
---------------------------------------------------------------------------

    \189\ See Amendment No. 3 Notice, supra note 9. One commenter 
objected to the original BOX Proposing Release, stating that the BSE 
discriminated among its Participants by not permitting Public 
Customers to participate in the PIP at penny increments. See CBOE 
Letter 1, supra note 7, at 5. In response to comments, the BSE 
proposed in Amendment No. 3 to introduce the CPO.
    \190\ See proposed BOX Rules, Chapter V, sec. 18(g)(ii); see 
also Amendment No. 4, supra note 11.
    \191\ In response to comments, the BSE changed its proposal to 
permit a CPO to participate in a PIP if the CPO is priced at or 
better than the BOX BBO, rather than the NBBO. See proposed BOX 
Rules, Chapter V, sec. 18(g)(iii); see also Amendment No. 4, supra 
note 11.
    \192\ See proposed BOX Rules, Chapter V, sec. 18(g)(v); see also 
Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    One commenter believes that the CPO procedures would not provide 
significant opportunities for Public Customer participation in PIP 
auctions because, while Market Makers would be able to decide at the 
time a PIP commences whether to compete, Public Customers would have to 
make that determination in advance.\193\ The same commenter also 
criticizes the requirement that the CPO be on the BOX Book at the NBBO, 
while Market Makers have no similar requirement.\194\ The Commission 
notes that in Amendment No. 4, the BSE proposes to change its proposed 
rules to permit a CPO to participate in a PIP when it is on the BOX 
Book at the BOX BBO, which would expand the opportunities for Public 
Customers to participate in the PIP. Moreover, the Commission believes 
that Public Customer access to the PIP is comparable to customers' 
access to open outcry auctions on the current floor-based exchange and 
potentially greater than their access to the ISE's Facilitation 
Mechanism. Specifically, customers must rely on floor brokers to 
represent any interest they may have in open outcry auctions. Also, the 
ISE does not currently broadcast notice of orders in its Facilitation 
Mechanism to members representing public customer orders, unless that 
member happens to have a proprietary order at the best ISE bid or 
offer, and permits customer orders to trade with orders in its 
Facilitation Mechanism if the customer order is displayed on the ISE at 
a price equal to or better than the facilitation price.\195\
---------------------------------------------------------------------------

    \193\ See ISE Letter 2, supra note 10, at 4.
    \194\ Id.
    \195\ See ISE Rule 716(d).
---------------------------------------------------------------------------

    Another commenter points out that the OFP may but is not required 
to submit a CPO to the PIP and surmised that, as a result, BOX could 
not guarantee customer access to the PIP.\196\ Consequently, because 
many OFPs will not have technology to be able to submit CPOs to the 
PIP, the BOX trading system should be required to perform this 
function.\197\ Alternatively, one commenter asserts that the BSE should 
require that OFPs be subject to a certification process, whereby they 
would demonstrate that they have the ability and capacity to support 
CPO order types.\198\
---------------------------------------------------------------------------

    \196\ See Amex Letter 3, supra note 10, at 4.
    \197\ See Amex Letter 3, supra note 10, at 4; ISE Letter 2, 
supra note 10, at 4-5.
    \198\ See PCX Letter 2, supra note 10, at Appendix at 5.
---------------------------------------------------------------------------

    The Commission believes that permitting Public Customer Orders to 
participate in the PIP through the use of CPOs is an adequate means of 
Public Customer access to the PIP. The Commission also believes that an 
OFP need not be required to submit a CPO to the PIP. In this regard, 
the Commission notes that none of the current options exchanges' rules 
obligate their members to bring agency orders to an auction, but give 
them the discretion about how best to execute their customers' orders.
    ii. PIP Proprietary Order (``PPO''). In response to concerns 
regarding access to the PIP auction, the BSE, in Amendment No. 4, 
proposes also to permit Options Participants to submit proprietary 
orders in penny increments into the PIP (``PPO''). Options Participants 
may enter a PPO for their proprietary accounts, provided that, at the 
commencement of the PIP, they already have a proprietary order or quote 
on the BOX Book at the inside bid or offer.\199\ The size of the PPO 
must be no greater than the lesser of: (1) The total size remaining on 
the BOX Book for the proprietary order; or (2) the size of the Primary 
Improvement Order submitted to the PIP. At any time during the PIP, the 
Options Participant may improve the price of its PPO.\200\
---------------------------------------------------------------------------

    \199\ See proposed BOX Rules, Chapter V, sec. 18(h); see also 
Amendment No. 4, supra note 11.
    \200\ See proposed BOX Rules, Chapter V, sec. 18(h)(iii); see 
also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    The Commission believes that this change should allow for greater 
competition in the PIP auction and should, therefore, benefit Customers 
by providing them with greater opportunities for better prices. The 
Commission notes that the BSE's proposal is similar to the rules of 
other options exchanges, including the ISE's facilitation mechanism in 
which members with proprietary orders at the inside bid or offer for a 
particular series can participate in the facilitation mechanism.\201\
---------------------------------------------------------------------------

    \201\ See ISE Rule 716(d).
---------------------------------------------------------------------------

    iii. Unrelated Orders. Under the BSE's proposal, unrelated orders 
could compete in standard increments to trade with the Customer Order 
in the PIP. Such unrelated orders could include agency orders on behalf 
of Public Customers, market makers on other exchanges, and non-BOX 
Options Participant broker-dealers, as well as non-PPO orders submitted 
by Options Participants.\202\ Unrelated orders would be permitted to 
compete in the PIP only in standard increments.
---------------------------------------------------------------------------

    \202\ See proposed BOX Rules, Chapter V, sec. 18(e)(iii); see 
also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

d. Price Improvement in Penny Increments
    As discussed above, during the PIP, Market Makers may submit 
Improvement Orders for those classes within their appointment. 
Improvement Orders would be submitted in penny increments and are valid 
only in the PIP process.
    Several commenters argue that permitting penny increments in the 
PIP is likely to save the internalizing firm money while bringing 
little price improvement to customers. Specifically, commenters 
criticize the BSE proposal that an OFP would need to offer only penny 
price improvement in the PIP to internalize the order, while on other 
exchanges, the internalizing firm would have to offer improvement in 
standard

[[Page 2789]]

increments.\203\ One of these commenters further predicts that all 
exchanges would have to quote in pennies to compete and OPRA may not be 
able to handle the increased message traffic that would result.\204\
---------------------------------------------------------------------------

    \203\ See CBOE Letter 2, supra note 10, at 3-4; and PCX Letter 
2, supra note 10, at 5.
    \204\ See CBOE Letter 2, supra note 10, at 7.
---------------------------------------------------------------------------

    The Commission believes that, because the PIP is designed to 
guarantee Customers a price at least a penny better than the NBBO, 
Customer Orders should benefit. At this point, the Commission has no 
reason to believe that the PIP auction would not be active and 
competitive.\205\ BSE proposes relatively low barriers to Market Maker 
registration, as the fees are relatively low \206\ and there are no 
limits on the number of qualifying entities that may become Market 
Makers.\207\ In addition, execution in the PIP is, for the most part, 
based on price/time priority; thus, Market Makers would have an 
incentive to post their best prices quickly. Furthermore, the PIP is 
open to a wide variety of participants: BOX Market Makers assigned to 
the class, CPOs, and Options Participants with proprietary orders at 
the inside bid or offer. Also, the Commission notes that a firm can 
trade with its own customers' orders at the NBBO pursuant to the rules 
of the other options exchanges.
---------------------------------------------------------------------------

    \205\ The Commission notes that BSE would have no minimum size 
requirement for orders entered into the PIP, for at least a pilot 
period to extend 18 months from the day trading commences on BOX. 
See Section II.E.h. If the Commission believed that the PIP had 
eroded Market Maker incentives to quote competitively, the 
Commission has the ability not to extend the pilot period beyond the 
18 months.
    \206\ See BOX Fee Approval, supra note 14.
    \207\ But see supra notes 28 and 45.
---------------------------------------------------------------------------

    With respect to the commenter's prediction that Commission approval 
of the BOX market, with its PIP auction, would result in quoting in 
pennies by all markets, the Commission does not believe this to be a 
foregone conclusion. The PIP uses pennies in an auction, not in public 
quotations. Given the implications of penny quoting for OPRA, penny 
quoting would require very careful review by the Commission. Moreover, 
the approval of any proposed rule change is based upon the Commission's 
determination that the proposal is consistent with the Act, not that 
the proposal mimics one feature of the market structure of a competing 
exchange.
e. PIP Trade Allocation and Priority
    At the conclusion of the PIP, the Customer Order would be matched 
against the best priced orders, whether Improvement Orders, or orders 
unrelated to the PIP that were received by BOX during the PIP 
process.\208\ Orders would have priority at the same price based on 
time, with the following exceptions:
---------------------------------------------------------------------------

    \208\ Such unrelated orders may include agency orders on behalf 
of Public Customers, market makers at other exchanges, and non-BOX 
Participant broker-dealers, as well as non-PIP proprietary orders 
submitted by Options Participants. See proposed BOX Rules, Chapter 
V, sec. 18(e)(iii); see also Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

    [sbull] The Options Participant who submitted the Customer Order 
into the PIP would have priority for 40% of the Customer Order, and 
would be allocated additional contracts only after all other competing 
orders have been filled at that price level.\209\ Such Options 
Participant would yield this special priority under the following 
circumstances: (1) If such Options Participant were a Market Maker that 
had modified its Primary Improvement Order, it would yield this special 
priority to a Public Customer Order or an order of a non-BOX 
Participant broker-dealer that had time priority over the modified 
Primary Improvement Order; \210\ (2) if such Options Participant were a 
Market Maker that had not modified its Primary Improvement Order (i.e., 
at the initial PIP price level), would yield this special priority to a 
Public Customer Order or an order of a non-BOX Participant broker-
dealer; \211\ and (3) if such Options Participant were not a Market 
Maker, it would yield this special priority to a Public Customer Order 
or an order of a non-BOX Participant broker-dealer.\212\
---------------------------------------------------------------------------

    \209\ See proposed BOX Rules, Chapter V, sec. 18(f)(i).
    \210\ See proposed BOX Rules, Chapter V, sec. 18(f)(ii)(C).
    \211\ See proposed BOX Rules, Chapter V, sec. 18(f)(ii)(2); see 
also Amendment No. 4, supra note 11.
    \212\ See proposed BOX Rules, Chapter V, sec. 18(e)(iv) and 
18(f)(ii)(1).
---------------------------------------------------------------------------

    [sbull] After the Options Participant who submitted the Customer 
Order to the PIP receives its allocation, a Market Maker designated as 
the Market Maker Prime \213\ would have priority over all other 
Improvement Orders, including CPOs and PPOs, and unrelated orders up to 
one-third of the portion of the Customer Order remaining at that price 
level.\214\ This special priority, however, would apply only if the 
Market Maker Prime enters an Improvement Order during the PIP.\215\
---------------------------------------------------------------------------

    \213\ A Market Maker Prime is a Market Maker who has a quote 
that is equal to the NBBO on the same side of the market as the 
Primary Improvement Order at the initiation of the PIP. If more than 
one Market Maker meets this criterion, the Market Maker whose quote 
has time priority would be the Market Maker Prime for that PIP. 
However, an Options Participant initiating a PIP on behalf of an 
agency order may not be the Market Maker Prime for that PIP. At the 
conclusion of that PIP, the Market Maker loses its status as Market 
Maker Prime. A Market Maker Prime would be determined each time a 
new PIP is initiated. See proposed BOX Rules, Chapter V, sec. 19.
    \214\ See proposed BOX Rules, Chapter V, sec. 19(b) and (c); see 
also Amendment No. 4, supra note 11.
    \215\ If the Market Maker Prime modifies its quote during the 
PIP to meet the best limit price instead of entering an Improvement 
Order into the PIP process, the Market Maker Prime allocation would 
not apply to the modified quote. Instead, the Market Maker Prime's 
modified quote would be treated as an unrelated order. See proposed 
BOX Rules, Chapter V, sec. 19(e).
---------------------------------------------------------------------------

    [sbull] All non-Market Maker Options Participants, including an 
Options Participant that submitted the Customer Order to the PIP, would 
yield priority to non-BOX member orders.\216\
---------------------------------------------------------------------------

    \216\ See proposed BOX Rules, Chapter V, sec. 18(e)(iv)(1) and 
18 (f)(ii)(1).
---------------------------------------------------------------------------

    i. Trade Participation Right. The Commission finds that the BSE's 
proposal to grant participation rights, under certain conditions, to 
the Options Participant that submitted a Customer Order to the PIP is 
reasonable and consistent with the Act. As discussed previously, the 
Commission is concerned that proposals by options exchanges that 
guarantee a significant portion of orders to any market participant 
could erode the incentive to display aggressively priced quotes.\217\ 
Thus, the Commission must weigh whether the proposed participation 
right would so substantially reduce the ability of other market 
participants to trade with an order that it would reduce price 
competition. As the Commission has noted previously:
---------------------------------------------------------------------------

    \217\ See, e.g., Securities Exchange Act Release No. 43100 (July 
31, 2000), 65 FR 48778 (August 9, 2000).
---------------------------------------------------------------------------

    It is difficult to assess the precise level at which guarantees may 
begin to erode competitive market maker participation and potential 
price competition within a given market. In the future, after the 
Commission has studied the impact of guarantees, the Commission may 
need to reassess the level of these guarantees. For the immediate term, 
the Commission believes that 40% is not clearly inconsistent with the 
statutory standards of competition and free and open markets.\218\
---------------------------------------------------------------------------

    \218\ See Securities Exchange Act Release No. 42455 (February 
24, 2000), 65 FR 11388 (March 2, 2000) (order approving registration 
of the ISE as a national securities exchange).
---------------------------------------------------------------------------

    The Commission believes that the BSE's proposal, which entitles 
(subject to certain exceptions) an Options Participant who submits the 
Primary Improvement Order to 40% of the Customer Order, is not 
inconsistent with the Act.\219\ In addition, the

[[Page 2790]]

Commission notes that, except for BSE's proposal to permit orders of 
any size to be submitted to the PIP, the facilitation guarantee for the 
Options Participant bringing a Customer Order to the PIP is consistent 
with the facilitation guarantees in place at the existing options 
exchanges.\220\ One commenter argues that the BSE should require its 
Options Participants to post the best price at which they are willing 
to trade against a Customer Order at the start of the PIP.\221\ 
Although the BSE proposes to permit Market Makers to initiate a PIP and 
be eligible for the 40% guarantee without being at the BOX BBO at the 
time the PIP commences, this proposal is analogous to floor-based 
exchange rules that permit market makers to participate in open outcry 
auctions without quoting at the BBO before the order is presented to 
the crowd.\222\
---------------------------------------------------------------------------

    \219\ See proposed BOX Rules, Chapter V, sec. 19.
    \220\ See supra note 161.
    \221\ See ISE Letter 2, supra note 10, at 3, 10-11.
    \222\ See, e.g., CBOE Rules 6.43 and 8.50.
---------------------------------------------------------------------------

    The Commission believes that the BSE Rules should promote price 
competition within BOX by providing Options Participants with a 
reasonable opportunity to compete for a significant percentage of the 
incoming order and, therefore, should protect investors and the public 
interest. For the immediate term, the Commission continues to believe 
that a 40% allocation is consistent with the statutory standards for 
competition and free and open markets.
    ii. Market Maker Prime The BSE's proposal would give priority to a 
Market Maker designated as a Market Maker Prime over other competing 
orders in the PIP. This priority is designed to provide an incentive 
for Market Makers to quote aggressively. A couple of commenters state 
that it is unfair that a Market Maker Prime has priority in the PIP, 
while CPOs also at the NBBO at the start of the PIP do not.\223\ The 
Commission believes that the BSE's proposal to give priority to a 
Market Maker who quotes aggressively before a PIP is initiated, is 
consistent with the Act and may provide a further incentive for Market 
Makers to publicly display their best quotes, which would benefit all 
options market participants.
---------------------------------------------------------------------------

    \223\ See Amex Letter 3, supra note 10, at 4; PCX Letter 2, 
supra note 10, at 3-4.
---------------------------------------------------------------------------

    iii. Section 11(a) of the Act. Section 11(a) of the Exchange Act 
\224\ prohibits a member of a national securities exchange from 
effecting transactions on that exchange for its own account, the 
account of an associated person, or an account over which it or its 
associated person exercises discretion (collectively, ``covered 
accounts'') unless an exception applies. Transactions by dealers acting 
in the capacity of market makers, however, are excepted from these 
prohibitions.\225\ Accordingly, the Commission believes that the BSE's 
proposal to give a Market Maker Prime priority over CPOs and other non-
member broker-dealers is consistent with the Act. In addition, the 
Commission does not believe that section 11(a) requires other Market 
Makers to yield priority to non-members.
---------------------------------------------------------------------------

    \224\ 15 U.S.C. 78k(a).
    \225\ 15 U.S.C. 78k(a)(1)(A).?
---------------------------------------------------------------------------

    One commenter asserts that the lack of customer priority on BOX is 
inconsistent with section 11(a) of the Act with regard to OFPs.\226\ 
This commenter argues that the BSE proposal is not consistent with 
section 11(a) because such Options Participants would not be required 
to yield priority to Public Customer Orders and non-BOX Participant 
broker-dealer orders in the PIP.\227\
---------------------------------------------------------------------------

    \226\ See Amex Letter 3, supra note 10, at 3; see also PCX 
Letter 2, supra note 10, at Appendix, at 8.
    \227\ See Amex Letter 3, supra note 10, at 3.
---------------------------------------------------------------------------

    In response to the commenter's concerns, the BSE proposes to amend 
its proposal to prohibit any orders for the accounts of non-Marker 
Maker Options Participants to be executed prior to the execution of 
Public Customer Orders, both CPO and unrelated Customer Orders, and 
non-BOX-Participant broker-dealer orders at the same price.\228\ 
Section 11(a)(1)(G) and Rule 11a1-1(T) under the Act provide an 
exception to the general prohibition in section 11(a) on an exchange 
member effecting transactions for its own account. Specifically, a 
member that ``is primarily engaged in the business of underwriting and 
distributing securities issued by other persons, selling securities to 
customers, and acting as broker, or any one or more of such activities, 
and whose gross income normally is derived principally from such 
business and related activities'' \229\ and effects a transaction in 
compliance with the requirements in Rule 11a1-1(T)(a) \230\ may effect 
a transaction for its own account. Among other things, Rule 11a1-
1(T)(a) requires that an exchange member presenting a bid or offer for 
its own account or the account of another member shall grant priority 
to any bid or offer at the same price for the account of a non-member 
of the exchange.\231\ Because BSE's proposed rules would now require 
Options Participants that are not Market Makers to yield priority in 
the PIP to all non-member orders, the Commission believes that the 
proposal is consistent with the requirements in section 11(a) and Rule 
11a1-1(T) under the Act. The Commission also reminds exchanges and 
their members that, in addition to yielding priority to non-member 
orders at the same price, members must also meet the other requirements 
under section 11(a)(1)(G) and Rule 11a1-1(T) (or satisfy the 
requirements of another exception) to effect transactions for their own 
accounts.\232\
---------------------------------------------------------------------------

    \228\ See proposed BOX Rules, Chapter V, sec. 18(e)(iv) and 
(f)(ii)(1); see also, Amendment No. 4, supra note 11.
    \229\ 15 U.S.C. 78k(a)(1)(G)(i). Paragraph (b) of Rule 11a1-1(T) 
under the Act provides that the requirements of section 
11(a)(1)(G)(i) of the Act if during its preceding fiscal year more 
than 50% of its gross revenues was derived from one or more of the 
sources specified in that section. In addition to any revenue which 
independently meets the requirements of section 11(a)(1)(G)(i), 
revenue derived from any transaction specified in paragraph (A), 
(B), or (D) of section 11(a)(1) of the Act or specified in Rule 
11a1-4(T) shall be deemed to be revenue derived from one or more of 
the sources specified in section 11(a)(1)(G)(i).
    \230\ 15 U.S.C. 78k(a)(1)(G)(ii).
    \231\ 17 CFR 240.11a1-1(T)(a)(3).
    \232\ For a discussion of the application of section 11(a) of 
the Act to trades that take place on BOX other than through the PIP, 
see notes--and accompanying text.
---------------------------------------------------------------------------

    iv. Section 11(b) of the Act. Section 11(b) of the Act \233\ and 
Rule 11b-1 thereunder \234\ permit national securities exchanges to, by 
rule, permit their members registered as specialists to act as both 
brokers and dealers, consistent with certain negative and affirmative 
obligations to maintain a fair and orderly market. Like the other 
options exchanges, BSE proposes to deem all of its Marker Makers to be 
specialists,\235\ which provides a Marker Maker with certain benefits, 
such as the ability under Regulation M to continue to trade an option 
on a security when the market making firm is involved in the 
underwriting of the security underlying the option. However, as 
specialists, Marker Makers would be subject to section 11(b) under the 
Act \236\ and Rule 11b-1 thereunder.\237\
---------------------------------------------------------------------------

    \233\ 15 U.S.C. 78k(b).
    \234\ 17 CFR 240.11b-1.
    \235\ See proposed BOX Rules, Chapter I, sec. 1(32).
    \236\ 15 U.S.C. 78k(b).
    \237\ 17 CFR 240.11b-1.
---------------------------------------------------------------------------

    One commenter asserts that the BSE's proposal to provide a BOX 
Marker Maker that submits a Directed Order to the PIP, and is at the 
best price at the conclusion of the PIP, with an allocation of 40% of 
the Directed Order ahead of Customer Orders at that price, would be 
inconsistent with a specialist's negative obligations as required by 
Rule 11b-1 under of the Act.\238\
---------------------------------------------------------------------------

    \238\ See ISE Letter 2, supra note 10, at 15.

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

[[Page 2791]]

    As described above, an OFP or Market Maker that submits a Customer 
Order to the PIP will be allocated 40% of that order, if at the end of 
the PIP, its Primary Improvement Order is at the best price and it was 
first in time at that price.\239\ In response to the commenter's 
concern, the BSE proposes to modify its proposal to provide that a BOX 
Marker Maker that submitted an order to the PIP would yield priority, 
including its 40% allocation, to Public Customer Orders, unless the 
Market Maker modifies its Primary Improvement Order and has time 
priority over the Public Customer Order. The Commission believes it is 
appropriate for customer orders to have priority over a specialist's 
trade participation right,\240\ and that such priority is consistent 
with section 11(b) of the Act. The Commission does not, however, 
believe that customers who may electronically generate orders must be 
accorded priority over market makers who are not acting as agent with 
respect to those customers.\241\ BSE's proposal, as amended by 
Amendment No. 4, would give Public Customer Orders priority over a 
Market Maker who submitted a Directed Order to the PIP, if the trade 
took place at the initial price level. However, a Marker Maker 
submitting a Directed Order to the PIP would not be required to yield 
priority to Public Customer Orders if the Market Maker has time 
priority at subsequent price levels. Accordingly, the Commission finds 
that BSE's proposal is consistent with the Act.
---------------------------------------------------------------------------

    \239\ See proposed BOX Rules, Chapter V, sec. 18(f)(i).
    \240\ See Securities Exchange Act Release No. 47628 (April 3, 
2003), 68 FR 17697 (April 10, 2003) (Order approving CBOEdirect 
trading system).
    \241\ Id.
---------------------------------------------------------------------------

f. Private Auction
    Under the BSE's proposal, Customer Orders submitted to the PIP and 
the responding Improvement Orders would not be displayed or 
disseminated outside the BOX market. Several commenters argue that the 
PIP lacks transparency and amounts to a shadow or hidden market, in 
violation of the Commission's Quote Rule.\242\ One commenter says that 
the disseminated quote from the BOX market would be meaningless, 
because the real market would be the non-public quoting in pennies in 
the PIP.\243\Under the Commission's Quote Rule, an exchange is required 
to collect, process, and make available to quotation vendors the best 
bids and offers that are communicated on the exchange.\244\ The BSE 
proposes that Improvement Orders, including CPOs and PPOs, would be 
displayed to BOX Options Participants, but would not be disseminated to 
OPRA.\245\ Commenters assert that the PIP would violate the Quote Rule 
because BSE proposes to limit the dissemination of Improvement Orders 
to BOX participants and to not make them available to quotation 
vendors.\246\ The Commission believes that, for purposes of Quote Rule 
analysis, because the PIP is only three seconds in length, it is 
analogous to the open outcry auctions currently conducted on the floor-
based exchanges, where auction prices are not widely disseminated and 
are available only for the order that initiated the auction and other 
orders in the crowd at that particular time. On the floor-based 
exchanges, a floor broker walks into a trading crowd and requests a 
market. The prices in the auction that then ensue are not disseminated 
outside of the floor and are not provided to other orders 
simultaneously executed at the disseminated quotation through the 
exchanges' automatic execution systems.
---------------------------------------------------------------------------

    \242\ See PCX Letter 2, supra note 10, at 2-3; Phlx Letter 2, 
supra note 10, at 4.
    \243\ See CBOE Letter 2, supra note 10, at 6.
    \244\ Rule 11Ac1-1(b)(1)(i) under the Act, 17 CFR 240.11Ac1-
1(b)(1)(i).
    \245\ See proposed BOX Rules, Chapter V, sec. 18(j).
    \246\ See ISE Letter 2, supra note 10, at 5.
---------------------------------------------------------------------------

    In addition, another commenter argues that the PIP would violate 
the Quote Rule \247\ because unrelated Customer Orders on the same side 
of the market as the Customer Order being internalized would not trade 
with the liquidity in the PIP.\248\ When an unrelated order concludes 
the PIP prior to the end of the three-second auction, the Customer 
Order submitted to the PIP is executed at the best price available in 
the PIP at that point in time. Neither an unrelated Customer Order at a 
better price on the same side of the market nor an unrelated BOX-Top 
Order on the same side of the market would be permitted to interact 
with Improvement Orders. The Commission does not agree that the 
proposed PIP would violate the Quote Rule. Instead, the Commission 
notes that the BOX proposal is consistent with the way in which the 
floor-based options exchanges operate today, where an incoming 
electronic order is automatically executed at the disseminated quote, 
even when an auction on the floor is underway at a better price. In 
addition, orders that are routed to the New York Stock Exchange 
(``NYSE'') through DirectPlus do not receive the benefit of any better 
prices available through the open outcry auction on the NYSE.
---------------------------------------------------------------------------

    \247\ 17 CFR 240.11Ac1-1.
    \248\ See CBOE Letter 2, supra note 10, at 8.
---------------------------------------------------------------------------

g. No Minimum Size Requirement for PIP
    As stated above, the Commission believes that one of the principal 
differences between the BSE's proposed PIP and other exchanges' rules 
that guarantee members the right to trade with their customer orders is 
that the BOX PIP would be available for orders of fewer than 50 
contracts. Under the BSE's proposal, BOX would have no minimum size 
requirement for orders entered into the PIP, for a pilot period to 
extend eighteen months from the day trading commences on BOX.
    One commenter objects to the inclusion of orders of fewer than 50 
contracts into the PIP,\249\ because it would allow OFPs to internalize 
smaller customer orders, leaving only undesirable, unprofitable order 
flow for the regular auction, resulting in wider quotations 
overall.\250\ The commenter asserts that small customer orders are the 
foundation for the auction pricing mechanism in the options market--
i.e., that Market Makers' posted prices take into account their ability 
to trade with these customer orders.\251\ The commenter is therefore 
concerned that removing small customer orders from the public market 
could adversely affect the pricing mechanisms, because Market Makers on 
BOX and on other markets would be less willing to quote 
aggressively.\252\
---------------------------------------------------------------------------

    \249\ See ISE Letter 1, supra note 7, at 7.
    \250\ See ISE Letter 2, supra note 10, at 1-2.
    \251\ Id. at 3.
    \252\ Id. at 3.
---------------------------------------------------------------------------

    The Commission believes, however, that the BSE's proposal provides 
small customer orders with benefits not available under the rules of 
other exchanges, and is consistent with the Act. In particular, any 
order entered into the PIP is guaranteed an execution at the end of the 
auction at a price at least a penny better than the NBBO. In addition, 
the Commission believes that BSE's proposal provides the opportunity 
for more market participants to compete. For example, the BSE has not 
limited the number of Market Makers assigned to each class, and would 
permit Public Customers and Options Participants that were not Market 
Makers to participate in the PIP through the use of CPOs and PPOs.
    The Commission, however, understands the concern of commenters who 
fear that including orders of fewer than 50 contracts in the PIP may 
result in less competitive quotes. Therefore,

[[Page 2792]]

BSE has represented that it will provide the following information each 
month:
    (1) The number of orders of fewer than 50 contracts entered into 
BOX's PIP, including the number of orders submitted by OFPs and the 
number of orders submitted by Market Makers;
    (2) The percentage of all orders of fewer than 50 contracts sent to 
BOX that are entered into BOX's PIP;
    (3) The percentage of all BOX trades represented by orders of fewer 
than 50 contracts;
    (4) The percentage of all BOX trades effected through the PIP 
represented by orders of fewer than 50 contracts;
    (5) The percentage of all contracts traded on BOX represented by 
orders of fewer than 50 contracts;
    (6) The percentage of all contracts effected through the PIP 
represented by orders of fewer than 50 contracts;
    (7) The spread in the option, at the time an order of fewer than 50 
contracts is submitted to the PIP;
    (8) Of PIP trades, the percentage done at the NBBO plus $.01, plus 
$.02, plus $.03, etc.;
    (9) The number of orders submitted by OFPs when the spread was 
$.05, $.10, $.15, etc. For each spread, specify the percentage of 
contracts in orders of fewer than 50 contracts submitted to BOX's PIP 
that were traded by: (a) The OFP that submitted the order to the PIP; 
(b) BOX Market Makers assigned to the class; (c) PPOs (other BOX 
Participants who were at the BBO at the time the PIP started); (d) CPOs 
(customers at the BBO at the time the PIP started); and (e) unrelated 
orders (orders in standard increments entered during PIP); and
    (10) The number of orders submitted by Market Makers when the 
spread was $.05, $.10, $.15, etc. For each spread, specify the 
percentage of contracts in orders of fewer than 50 contracts submitted 
to BOX's PIP that were traded by: (a) The Market Maker that submitted 
the order to the PIP; (b) BOX Market Makers assigned to the class, 
other than a Marker Maker who submitted the order to the PIP; (c) PPOs 
(other BOX Participants who were at the BBO at the time the PIP 
started); (d) CPOs (customers at the BBO at the time the PIP started); 
and (e) unrelated orders (orders in standard increments entered during 
PIP). The Commission will evaluate the PIP during the pilot period to 
determine whether it would be beneficial to customers and to the 
options market as a whole to approve any proposal requesting permanent 
approval to permit orders of fewer than 50 contracts to be submitted to 
the PIP.
2. Other BOX Rules to Limit Internalization Outside the PIP
    The BOX Rules contain certain provisions restricting 
internalization by Options Participants outside of the PIP process, 
described below.\253\ The Commission believes that the proposed rules 
regarding the limitations on principal transactions and solicited 
orders are consistent with the Act in that they should adequately 
protect against the internalization of Customer Order flow by a firm 
representing an order as agent.
---------------------------------------------------------------------------

    \253\ See Amendment No. 4, supra note 11.
---------------------------------------------------------------------------

a. Principal Transactions
    The BSE proposes to limit an Options Participant's ability to trade 
as principal with an order it represents as agent, unless the order is 
first given the opportunity to interact with other trading interest on 
the Exchange. Specifically, OFPs may not execute as principal an order 
it represents as agent unless: (i) The agency order is first exposed on 
the BOX Book for at least 30 seconds; (ii) the OFP has been bidding or 
offering on BOX for at least 30 seconds prior to receiving an agency 
order that is executable against such bid or offer; or (iii) the OFP 
submits the agency order to the PIP, described above.\254\ In addition, 
the BOX Rules would preclude an Options Participant from executing 
agency orders to increase its economic gain from trading with the order 
without first giving other trading interest on BOX an opportunity to 
trade with the agency order pursuant to the PIP rules. Specifically, it 
would be a violation of the BOX Rules for an Options Participant to 
provide an opportunity for a Customer to execute against agency orders 
handled by the Options Participant immediately upon their entry into 
the Trading Host.\255\ The Commission believes that these restrictions 
on Options Participants trading as principal with orders they represent 
as agent, including the prohibition on doing indirectly what they are 
prohibited from doing directly, should protect against the 
internalization of order flow.
---------------------------------------------------------------------------

    \254\ See proposed BOX Rules, Chapter V, sec. 17, Supplementary 
Material .03; see also Amendment No. 4, supra note 11. The proposed 
BOX Rule is substantially similar to ISE Rule 717(d).
    \255\ See proposed BOX Rules, Chapter V, sec. 17, Supplementary 
Material .01. This interpretation is substantially similar to ISE 
Rule 717, Supplemental Material .01.
---------------------------------------------------------------------------

    The BSE proposes to prohibit the disclosure of information about 
agency orders to third parties. Specifically, an Options Participant, 
prior to submitting an order to BOX, including submitting an order to 
the PIP, cannot disclose to another Options Participant or any other 
third party of any of the terms of the order, except as provided for in 
the Directed Order process.\256\ The Commission believes that this rule 
should help to prevent Options Participants from doing indirectly what 
they are prohibited from doing directly, to prevent ``gaming.'' An 
Options Participant generally must expose orders it represents as agent 
before it may execute them as principal. Absent the prohibition on the 
disclosure of this type of information, an Options Participant and a 
third party could potentially use BOX to execute their orders with each 
other without exposing these orders to other trading interest. The 
Commission believes this rule will do much to prevent a firm from 
trading as principal with orders it represents as agent with a third 
party with whom it shares a beneficial interest.
---------------------------------------------------------------------------

    \256\ See proposed BOX Rules, Chapter V, sec. 17, Supplementary 
Material .04. This provision is comparable to ISE Rule 400, 
Supplemental Material .01.
---------------------------------------------------------------------------

b. Solicited Orders
    The BSE proposes, in Amendment No. 4, to require Options 
Participants to expose orders they represent as agent on BOX for at 
least thirty seconds before such orders may be executed in whole or in 
part by orders solicited from other Options Participants and non-member 
broker-dealers to transact with such orders.\257\ In addition, it would 
also be a violation of the BOX Rules for an Options Participant to 
cause the execution of an order it represents as agent on BOX by orders 
it solicited, if the Options Participant fails to expose those orders 
on BOX as required above.\258\ As with Options Participant principal 
transactions, the purpose of the order exposure requirement is to 
assure that agency orders have an opportunity to interact on BOX before 
they are executed either by the broker representing the order or by 
another order solicited by the broker.
---------------------------------------------------------------------------

    \257\ See proposed BOX Rules, Chapter V, sec. 17, Supplementary 
Material .02; see also Amendment No. 4, supra note 11.
    \258\ Id.
---------------------------------------------------------------------------

F. Application of the ``Effect versus Execute'' Exemption From Section 
11(a) of the Act

    Section 11(a) of the Exchange Act \259\ prohibits a member of a 
national securities exchange from effecting transactions on that 
exchange for its own account, the account of an associated person, or 
an account over which it or its associated person exercises discretion 
(collectively,

[[Page 2793]]

``covered accounts'') unless an exception applies. In addition to the 
exceptions set forth in the statute, Rule 11a2-2(T) \260\ provides 
exchange members with an exemption from this prohibition. Known as the 
``effect versus execute'' rule, Rule 11a2-2(T) permits an exchange 
member, subject to certain conditions, to effect transactions for 
covered accounts by arranging for an unaffiliated member to execute the 
transactions on the exchange. To comply with the rule's conditions, a 
member (i) must transmit the order from off the exchange floor; (ii) 
may not participate in the execution of the transaction once it has 
been transmitted to the member performing the execution; \261\ (iii) 
may not be affiliated with the executing member; and (iv) with respect 
to an account over which the member has investment discretion, neither 
the member nor its associated person may retain any compensation in the 
connection with effecting the transaction except as provided in the 
Rule.
---------------------------------------------------------------------------

    \259\ 15 U.S.C. 78k(a).
    \260\ 17 CFR 240.11a2-2(T).
    \261\ The member, however, may participate in clearing and 
settling the transaction.
---------------------------------------------------------------------------

    In Amendment No. 4, the BSE represents that transactions effected 
on BOX, excluding those transactions effected through the PIP process, 
satisfy the conditions of Rule 11a2-2(T). Based on these 
representations, the Commission finds that the order execution 
algorithm of BOX complies with the requirements of section 11(a) of the 
Exchange and Rule 11a2-2(T) thereunder.
    In particular, the BSE states that ``BOX will place all of its 
participants on the `same footing' '' and that ``no participant will 
enjoy any special control over the timing of execution or special order 
handling advantages, as all orders will be centrally processed for 
execution by computer.'' Specifically, orders sent to BOX will be 
transmitted from remote terminals directly to the system by electronic 
means. Once an order is submitted to BOX, the order is executed against 
another order based on an established matching algorithm. As the BSE 
explains, the execution does not depend on the Options Participant but 
rather upon what other orders are entered into BOX at or around the 
same time as the subject order, what orders are on the BOX Book and 
where the order is ranked based on the strict price-time priority 
ranking algorithm. Accordingly, Options Participants do not control or 
influence the result or timing of orders submitted to BOX.
    Based on these representations, the Commission finds that BOX's 
electronic order submission and execution process satisfies the four 
conditions of Rule 11a2-2(T).\262\ First, all orders are electronically 
submitted through remote terminals. Second, because a member 
relinquishes control of its order after it is submitted to BOX, the 
member does not receive special or unique trading advantages. Third, 
although the rule contemplates having an order executed by an exchange 
member who is not affiliated with the member initiating the order, the 
Commission recognizes that this requirement is satisfied when automated 
exchange facilities are used.\263\ Fourth, the BSE states that BOX 
Options Participants that rely on Rule 11a2-2(T) for a managed account 
transaction must comply with the limitations on compensation set forth 
in the rule.
---------------------------------------------------------------------------

    \262\ The Commission and its staff, on numerous occasions, have 
considered the application of Rule 11a2-2(T) to electronic trading 
and order routing systems. See, e.g., Securities Exchange Act 
Release Nos. 44983 (October 25, 2001) (Order approving the 
Archipelago Exchange as the equities trading facility of PCX 
Equities Inc.); and 29237 (May 31, 1991) (regarding NYSE's Off-Hours 
Trading Facility); 15533 (January 29, 1979) (regarding the Amex Post 
Execution Reporting System, the Amex Switching System, the 
Intermarket Trading System, the Multiple Dealer Trading Facility of 
the Cincinnati Stock Exchange, the PCX's Communications and 
Execution System, and the Phlx's Automated Communications and 
Execution System); and 14563 (March 14, 1978) (regarding the NYSE's 
Designated Order Turnaround System). See also Letter from Larry E. 
Bergmann, Senior Associate Director, Division, SEC to Edith 
Hallahan, Associate General Counsel, Phlx (March 24, 1999) 
(regarding Phlx's VWAP Trading System); letter from Catherine 
McGuire, Chief Counsel, Division, SEC, to David E. Rosedahl, PCX 
(November 30, 1998) (regarding Optimark); and Letter from Brandon 
Becker, Director, Division, SEC, to George T. Simon, Foley & Lardner 
(November 30, 1994) (regarding Chicago Match).
    \263\ In considering the operation of automated execution 
systems operated by an exchange, the Commission noted that while 
there is no independent executing exchange member, the execution of 
an order is automatic once it has been transmitted into the systems. 
Because the design of these systems ensures that members do not 
possess any special or unique trading advantages in handling their 
orders after transmitting them to the exchange, the Commission has 
stated that executions obtained through these systems satisfy the 
independent execution requirement of Rule 11a2-2(T). See Securities 
Exchange Act Release No. 15533 (January 29, 1979).
---------------------------------------------------------------------------

G. Best Execution of Customer Limit Orders

    As discussed above, customer Limit Orders would not have priority 
over professional trading interest in the BOX market. Thus, if a 
broker-dealer sends a non-marketable Public Customer Limit Order to 
BOX, and professional trading interest already is on the book at the 
same price, the professional interest would have priority. One 
commenter notes that, in contrast, if the broker-dealer sends that 
Public Customer Order to any other options exchange, the Public 
Customer would have priority over any pre-existing professional 
interest on the book.\264\ Because a broker-dealer would be aware of 
this difference when it makes its order-routing decisions, this 
commenter contends that a broker-dealer would violate its best 
execution responsibility to its customers any time the broker-dealer 
sends a customer order to BOX without first confirming that there is no 
professional orders on the BOX book at the same price.\265\
---------------------------------------------------------------------------

    \264\ See ISE Letter 2, supra note 10, at 11-12.
    \265\ Id.
---------------------------------------------------------------------------

    The Commission disagrees that a broker sending its customer orders 
to BOX would be per se violating its best execution obligation. The 
Commission has long held the view that in satisfying its duty of best 
execution,\266\ which requires a broker to seek the most favorable 
terms reasonably available under the circumstances for a customer's 
transaction, a broker must periodically assess the quality of competing 
markets to assure that order flow is directed to markets providing the 
most beneficial terms for their customers' orders.\267\ Moreover, the 
contention that all existing options exchanges provide strict customer 
priority is an overstatement. In fact, several options exchanges 
currently have rules that permit market makers to be on parity with 
customer orders in certain circumstances.\268\ The Commission continues 
to believe that best execution requires the broker, in evaluating its 
procedures for handling customer orders, to take into account any 
material differences in execution quality among the various markets to 
which such orders may be routed.\269\ These differences could arise 
from different priority rules, as the commenter suggests, or from a 
different frequency of execution. If a market gave less preferential 
treatment to customer orders, yet customer orders still received faster 
executions at comparable prices in that market, a broker could conclude 
that that market offered the possibility of best execution. Of course, 
a broker could not, consistent with its best execution obligations, 
permit the

[[Page 2794]]

opportunity either to internalize a portion of its customer order or to 
obtain payment-for-order flow to color its view of the execution 
quality afforded its customer orders.
---------------------------------------------------------------------------

    \266\ A broker-dealer's duty of best execution derives from 
common law agency principals and fiduciary obligations and is 
incorporated both in SRO rules, and through judicial and Commission 
decisions, in the antifraud provisions of the federal securities 
laws. See Securities Exchange Act Release No. 37619A (September 6, 
1996), 61 FR 48290 (September 12, 1996) (``Order Handling Rules 
Release''), n.348 and accompanying text.
    \267\ Order Handling Rules Release, supra note 266.
    \268\ See Amex Rule 111, Commentary .07 and Phlx Rule 
1014(d)(ii); see also CBOE Rule 43.1.
    \269\ Order Handling Rules Release, supra note .
---------------------------------------------------------------------------

    The same commenter noted that when an Options Participant initiates 
a PIP, it does not have to initiate the PIP at the best price it is 
willing to trade. Instead, the Options Participant may improve the 
price it is willing to offer its customer during the three-second 
auction in response to higher prices offered by others. The commenter 
argues that this is a clear violation of an Options Participant's 
fiduciary obligations, because an Options Participant who does not put 
forward its best price in initiating a PIP auction would not provide 
the best opportunity for price improvement to its customer. This 
commenter believes that there is a similar violation of fiduciary 
obligations when an OFP directs the order to a preferenced Marker 
Maker.\270\
---------------------------------------------------------------------------

    \270\ See ISE Letter 2, supra note 10, at 10-11.
---------------------------------------------------------------------------

    The Commission does not agree with the commenter's assertion that 
that an Options Participant's duty of best execution requires the 
Options Participant to submit its best price when initiating a PIP. The 
Primary Improvement Order is entered into the PIP at the guaranteed 
price, which, by definition, is at least one penny better than the best 
price available on any other options exchange at that time. The OFP or 
Marker Maker guarantees to execute its Customer's order at this price 
and ensures that the Customer will receive an execution at a price no 
worse, and possibly better, than the guaranteed price. After the order 
is guaranteed, the three-second auction begins. At that point, all 
those entitled to participate in the PIP have an equal opportunity to 
match or improve the guaranteed price. The OFP or Marker Maker that 
initiated the PIP will receive its 40% guarantee only if it is at the 
best price at the conclusion of the PIP auction.
    Moreover, the vast majority of customer orders are executed at the 
disseminated NBBO in automatic execution systems on each of the floor-
based options exchanges, which do not provide any opportunity for price 
improvement. Despite the fact that if such orders were instead directed 
to the exchange floors, such orders might receive price improvement, 
the Commission has never taken the position that best execution 
requires that brokers bring each and every customer order to the floor 
of the exchanges for the possibility of price improvement over the 
disseminated NBBO.
    The proposed BOX Rules also contain a number of requirements to 
guide Options Participants that facilitate customer orders as principal 
towards fulfilling their best execution duty to their customers. These 
rules supplement the broker's best execution obligation. For example, 
Options Participants must ensure that when executing a Customer Order 
in the PIP, they act with due skill, care, and diligence, and that the 
interests of their Customers are not prejudiced.\271\ Further, an 
Options Participant must not use the PIP to create a misleading 
impression of market activity.\272\
---------------------------------------------------------------------------

    \271\ See proposed BOX Rules, Chapter V, sec. 18(b).
    \272\ See proposed BOX Rules, Chapter V, sec. 18(d).
---------------------------------------------------------------------------

    In addition, certain features of the BOX PIP help ensure that 
Options Participants comply with their duty of best execution. For 
example, no Options Participant is permitted to cancel or to modify the 
size of its Primary Improvement Order or the Customer Order at any time 
during the PIP, and the Options Participant may modify the price of its 
Primary Improvement Order only by improving it.\273\
---------------------------------------------------------------------------

    \273\ See proposed BOX Rules, Chapter V, sec. 18(e)(ii). The 
ISE's Supplementary Material to ISE Rule 716 states that it will be 
violation of a member's duty of best execution to its customer if it 
were to cancel a facilitation order to avoid execution of the order 
at a better price. The BOX PIP goes one step further by prohibiting 
cancellation of the OFP's facilitation order.
---------------------------------------------------------------------------

H. Linkage Plan Rules

    BSE represents that it intends to participate in the Options 
Intermarket Linkage Plan (``Linkage Plan.''). In order to do so, BSE 
would be required to comply with the obligations of Participants under 
the Linkage Plan and, therefore, proposes certain rules relating to the 
Linkage as part of the proposed BOX Rules.\274\ These proposed rules 
are substantially similar to the rules in place on all of the options 
exchanges that are Participant to the Linkage Plan.\275\
---------------------------------------------------------------------------

    \274\ See proposed BOX Rules, Chapter XII, secs. 1-6.
    \275\ See Amex Rules 940-945, CBOE Rules 6.80-6.85, ISE Rules 
1900-1905, PCX Rules 6.92-6.96, and Phlx Rules 1083-87.
---------------------------------------------------------------------------

    In general, the proposed BOX Rules contain relevant definitions, 
establish the conditions pursuant to which Market Makers may enter 
Linkage orders, impose obligations on the Exchange regarding how it 
must process incoming Linkage orders, and establish a general standard 
that Options Participants should avoid trade-throughs. The proposed BOX 
Rules establish potential regulatory liability for Options Participants 
who engage in a pattern or practice of trading through other exchanges, 
establish obligations with respect to locked and crossed markets, and 
restrict a market maker on an Exchange from sending principal orders 
(other than P/A orders, which reflect unexecuted customer orders) 
through the Linkage if the market maker affects less than 80 percent of 
specified order flow on the Exchange.
    In addition to these Linkage Rules, as part of its proposed trading 
rules, BSE proposes several rules that affect order handling through 
the linkage. Further, certain of the BOX Linkage Rules are unique to 
BOX and thus warrant further description.
1. Role of the BOX InterMarket Linkage Market Market and Eligible 
Market Makers
    In Amendment No. 3 to the proposed rule change, BSE proposed rules 
that were intended to bring the BOX Rules into conformity with the 
requirements of the Linkage Plan so that BSE would be eligible to 
become a Participant in the Linkage Plan. Under the Linkage Plan, an 
``Eligible Market Maker,'' defined as, among other things, a market 
maker who is assigned to, and provides two-sided quotations in an 
option class eligible for trading through the Linkage,\276\ undertakes 
several agency responsibilities, including the handling of P/A orders 
and Satisfaction (``S'') orders if a trade-through has occurred.\277\
---------------------------------------------------------------------------

    \276\ See section 2(7) of the Linkage Plan.
    \277\ See section 7(a)(ii) of the Linkage Plan.
---------------------------------------------------------------------------

    Two commenters express concern that the BOX's order handling 
process would be inconsistent with the Linkage Plan because it would 
permit BOX Market Makers to send orders through the Linkage with the 
agency responsibilities that the Linkage Plan requires for Eligible 
Market Makers.\278\ The commenters note that it would be the BOX System 
and not an Eligible Market Maker who would handle certain aspects of 
the P/A order and S order process.\279\ Another commenter states that 
the proposal did not address how BSE would determine which BOX Market 
Maker would be designated as the BOX Eligible Market Maker for each 
Eligible Options Class.\280\
---------------------------------------------------------------------------

    \278\ See ISE Letter 2, supra note 10, at 13; and PCX Letter 2, 
supra note 10, at 7; See also section 2(16)(a) (defining ``P/A 
Order''), section 7(a)(ii) of the Plan (providing that market makers 
may send P/A Orders through Linkage).
    \279\ See ISE Letter 2, supra note 10, at 13; and PCX Letter 2, 
supra note 10, at 7.
    \280\ See Amex Letter 3, supra note 10, at 6.
---------------------------------------------------------------------------

    To ensure that there is an Eligible Market Maker per Eligible Class 
(as those terms are defined in the Linkage

[[Page 2795]]

Plan and the proposed BOX Rules) for the submission of P/A and S orders 
to away markets, and in response to commenters' concerns, in Amendment 
No. 4, the BSE proposes to amend its rules to specifically define a BOX 
InterMarket Linkage Market Maker (``BIMM'') as the BOX Eligible Market 
Maker (``BEMM'') designated with the responsibility for settling P/A 
and S orders that would be sent to away markets through the Linkage for 
a given class on BOX.\281\ A BIMM responsible for such orders would be 
specifically designated in each Eligible Class traded on BOX. The BIMM 
would adhere to the responsibilities of an Eligible Market Maker, as 
set forth in the Linkage Plan.
---------------------------------------------------------------------------

    \281\ See proposed BOX Rules, Chapter VI, sec. 5(a)(ix).
---------------------------------------------------------------------------

    Further, the BIMM would be required to act with due diligence with 
regard to the interests of orders entrusted to it and fulfill other 
duties of an agent, including, but not limited to, ensuring that such 
orders, regardless of their size or source, receive proper 
representation and timely execution in accordance with the terms of the 
orders and the rules of the Exchange. To enable the BIMM to carry out 
its agency responsibilities with respect to P/A orders submitted 
through the Linkage, the BSE would require that a BIMM submit prior 
written instructions to BOX regarding the routing of any P/A orders 
that the Market Maker would send through the Linkage. BOX would 
immediately route all P/A orders on behalf of the Market Maker 
according to these instructions. The order would be generated 
automatically by BOX and routed to the away exchange with the required 
BIMM clearing and valid-clearing-firm (``VCF'') information included. 
Each execution received from an away exchange would result in the 
automatic generation of a trade execution on BOX between the original 
Public Customer Order and the BIMM.
    The addition of a BIMM should ensure that a Market Maker on BOX is 
ultimately responsible for decisions regarding the routing of P/A and S 
orders and exercises appropriate discretion over such orders. While BOX 
may carry out the mechanics of routing such orders, a BIMM will be 
responsible for providing BOX with instructions on how and where to 
route order. Further, all P/A orders routed from BOX will carry a 
BIMM's clearing and VCF information and any execution received from an 
away exchange will result in a trade execution on BOX between the 
original Public Customer Order and the BIMM. The Commission believes 
that the proposed use of a BIMM addresses the concerns of commenters 
and should ensure that P/A and S orders will be handled in accordance 
with the Linkage Plan.
2. Use of the Trade-Through Filter
    As discussed above, under the proposed BOX Rules, all in-bound 
agency orders received by BOX, including P orders and P/A orders, would 
be checked against the NBBO using BOX's trade-through filter mechanism 
as set forth in Chapter V, section 16(b).\282\ Accordingly, the Trading 
Host would not permit the execution of an order submitted by an Options 
Participant on behalf of a Public Customer or broker-dealer that is not 
registered with BOX as an Options Participant, as well as an incoming P 
or P/A Order, unless BOX was disseminating the NBBO.
---------------------------------------------------------------------------

    \282\ See supra notes 124-137--and accompanying text.
---------------------------------------------------------------------------

    As proposed in Amendment No. 3, if BOX were not quoting at the 
NBBO, an incoming P or P/A Order would be exposed on the BOX Book for 
three seconds at the NBBO price, during which time any Options 
Participant would be able to execute against the order. At the end of 
this three-second period, if the order were not fully executed and a 
better price existed at an away exchange(s), a P/A order would be 
generated automatically by the BOX, and routed to the away exchange. In 
the event that BOX was no longer quoting at the best price when it 
received the P or P/A Order, the BSE proposed that these orders also 
would be processed through the filter. Any unexecuted quantity that 
remained on the book after the three-second exposure period would be 
returned to the originating exchange.
    Commenters express concern that BSE's proposal to expose incoming P 
and P/A orders from away markets to the three-second exposure when BOX 
was no longer disseminating the NBBO would be inconsistent with the 
Linkage Plan \283\ and would permit BOX Options Participants an 
impermissible ``second-look'' at incoming Linkage Orders when BOX was 
no longer quoting at the best price.\284\
---------------------------------------------------------------------------

    \283\ See section 2(16) of the Linkage Plan (defining ``Linkage 
Order'').
    \284\ See Phlx Letter 2, supra note 10, at 5-6 and ISE Letter 2, 
supra note 10, at 14 (citing section 7(a)(ii)(A) of the Linkage 
Plan, providing that an exchange receiving a P/A order must execute 
the P/A Order in its automatic execution system, if available, if 
its disseminated quotation is equal to or better than the Reference 
Price when that order arrives. The ISE argues that implicit in this 
requirement is that the receiving exchange reject the order if it is 
not then at the NBBO). See also section 7(a)(ii)(C) of the Linkage 
Plan (providing similar obligations for Eligible Market Makers who 
receive P Orders).
---------------------------------------------------------------------------

    BSE responded to commenters' concerns in Amendment No. 4 by 
proposing to amend its proposed rules to exclude incoming P and P/A 
Orders from exposure for three seconds when BOX was no longer 
disseminating the NBBO at the time it receives an incoming P or P/A 
Order.\285\ Therefore, in the event that BOX is no longer quoting at 
the Linkage Reference Price, as that term is defined in the Linkage 
Plan, at the time it receives a P or P/A order from an away market, BOX 
would immediately reject the order. The Commission believes that these 
provisions, which require BOX to immediately reject a P or P/A order in 
the event that BOX is no longer quoting at the Reference Price, are 
appropriate and should ensure that these orders are handled in 
compliance with the Linkage Plan.
---------------------------------------------------------------------------

    \285\ See proposed BOX Rules, Chapter V, sec. 16(b)(iii)(2)(b).
---------------------------------------------------------------------------

    The Commission believes that the proposed use of the filter for 
agency orders submitted by a BOX Participant should provide an 
effective means for avoiding trade-throughs.\286\ The filter should 
ensure that in the event that BOX is not quoting at the best price, a 
P/A order is automatically generated and routed in accordance with 
instructions from the responsible BIMM, or the order is rejected. The 
Linkage Plan requires that, absent reasonable justification and during 
normal market conditions, exchange members should not effect trade-
throughs.\287\ In addition, Chapter XII, section 3(a) of the BOX Rules 
would require members to avoid initiating trade-throughs when 
purchasing or selling either as principal or agent, any options series. 
Accordingly, the Commission believes that BOX Participants must avoid 
initiating trade-throughs when they effect transactions for their own 
accounts, as well as when they submit agency orders. Therefore, the 
Commission believes that there is nothing in the BOX Rules that is 
inconsistent with the Linkage Plan. Nevertheless, the Commission's 
approval of the proposed rule change will not be effective until the 
BSE can demonstrate to the Commission staff that BOX Options 
Participants can comply with the trade-through requirements of the 
Linkage Plan with regard to all trades effected through BOX or any 
exemption from such Linkage Plan requirements.
---------------------------------------------------------------------------

    \286\ See supra note 124.
    \287\ See section 8(c) of the Linkage Plan.
---------------------------------------------------------------------------

    Another commenter questions why BOX proposes to expose the 
unexecuted portion of incoming P orders to BOX

[[Page 2796]]

Options Participants for only three seconds, when the Linkage Plan and 
another part of BOX's proposed rules provide BOX Options Participants 
15 seconds to respond to incoming P and P/A orders larger than the Firm 
Principal Quote Size or the Firm Customer Quote size, 
respectively.\288\
---------------------------------------------------------------------------

    \288\ See Amex Letter 3, supra note 10, at p. 6. Compare 
proposed BOX Rules, Chapter V, sec. 16(b)(iii)(2) (describing the 
BOX filtering mechanism) to sections 7(a)(ii)(B) and 7(a)(ii)(C) of 
the Linkage Plan and proposed BOX Rules, Chapter XII, sec. 2(f).
---------------------------------------------------------------------------

    The Linkage Plan permits Linkage Orders that are larger than the 
Firm Principal Quote Size or the Firm Customer Quote Size to be handled 
outside of the automatic execution systems of the Linkage Participants 
and and provides Participants with up to 15 seconds to reply to a 
sending Participant.\289\ Therefore, the Commission believes that the 
BOX's proposal to expose the unexecuted portion of any P or P/A orders 
that are larger than the Firm Principal Quote Size or Firm Customer 
Quote Size for only three seconds is consistent with the Linkage Plan.
---------------------------------------------------------------------------

    \289\ See section 7(a)(ii)(B)(1) of the Linkage Plan.
---------------------------------------------------------------------------

3. PIP and Trade-Throughs
    As described in more detail above, the proposed BOX Rules provide 
for a PIP during which an OFP or Market Maker may submit a Customer 
Order for price improvement at a price of at least one cent better than 
the prevailing NBBO. Upon entering the Customer Order into the PIP, the 
OFP or Market Maker ``guarantees'' the Customer Order at that better 
price. Thus, the Customer Order is guaranteed at the end of the PIP an 
execution of at least one penny better than the NBBO was at the 
commencement of the PIP.
    One commenter argues that use of the PIP may result in a pattern or 
practice of trade-throughs in violation of the Linkage Plan \290\ if 
the NBBO moves to a price more favorable to the Customer Order during 
the PIP.\291\ The Commission disagrees with this commenter that use of 
the PIP would result in a pattern or practice of trade-throughs in the 
scenario that that commenter describes. Because the BSE proposes to 
require that a Customer Order be ``guaranteed'' at a better price than 
the NBBO at the initiation of the PIP, the Commission believes that the 
trade should be considered to have occurred at the time the order is 
provided the guarantee.\292\ Accordingly, the Commission does not 
believe that it should be considered a trade-through if a trade is 
executed through the PIP at a price that is better than the NBBO at the 
commencement of the PIP, but--because of a change in the NBBO--inferior 
to the NBBO at the conclusion of the PIP. The Commission reminds 
brokers, however, that they must always consider their best execution 
obligations.
---------------------------------------------------------------------------

    \290\ See section 8(c)(i)(C) of the Linkage Plan.
    \291\ See CBOE Letter 2, supra note 10, at 9.
    \292\ See Division of Market Regulation, Staff Legal Bulletin 
12R, ``Frequently Asked Questions About Rule 11Ac1-5,'' June 22, 
2001.
---------------------------------------------------------------------------

    Finally, two commenters also contend that the PIP would result in 
trade-throughs because orders on the BOX Book would not be able to 
trade against the price at which a CPO is willing to buy or sell in a 
PIP, the CPO PIP Reference Price.\293\ Similarly, one commenter 
questions how a BIMM would handle a Satisfaction Order that it receives 
as a result of its execution of a block-size order in penny increments 
at a price inferior to the NBBO given that other Linkage Participants 
only trade at minimum price increments of $.05 or $.10.\294\ Under the 
Linkage Plan, when an Exchange executes a ``block trade'' of 500 
contracts at a price that trades through a price on another exchange, 
the other exchange can submit through the Linkage a Satisfaction Order 
at the price of the block trade.\295\ The commenter believes that if 
the block order execution occurred between intervals of $.05 (i.e., 
$1.17, $1.18, etc.), an exchange whose system cannot format 
Satisfaction Orders in penny increments would not be able to use the 
Linkage to send the Satisfaction Order.
    The Commission notes that only orders executed during BOX's PIP may 
be priced in penny increments and that the OFP who represents the CPO 
would be the only Options Participant aware of the price at which a CPO 
is willing to buy or sell (the CPO PIP Reference Price.) As described 
above, all orders executed in the PIP are ``guaranteed'' at a better 
price than the NBBO at the initiation of the PIP.
---------------------------------------------------------------------------

    \293\ See CBOE Letter 2, supra note 10, at 8, and Amex Letter 3, 
supra note 10, at 4.
    \294\ See PCX Letter 2, supra note 10, Appendix at 13.
    \295\ See sections 8(c)(ii)(B)(1) and 2(26) of the Linkage Plan.
---------------------------------------------------------------------------

    Because the CPO PIP Reference Price is not a displayed interest, 
the requirement to avoid trading through that price would not apply. 
The Commission believes that the trade should be considered to have 
occurred at the time the order is guaranteed at a price at least a 
penny better than the NBBO. Accordingly, the Commission believes that 
no trade-through could result from an execution during a PIP. 
Therefore, the Commission finds that BSE's proposed PIP is appropriate 
and is consistent with the Linkage Plan.
4. BOX-Top Orders and Locked and Crossed Markets
    As described above, BSE proposes to have ``BOX-Top Orders'' in lieu 
of market orders. BOX-Top Orders entered into the BOX Book are executed 
at the best price available in the BOX market for the total quantity 
available from any contra bid (offer). Any residual volume would be 
automatically converted to a Limit Order at the price at which part of 
the original BOX-Top Order was executed.
    One commenter states that the process of automatically converting 
the unexecuted portion of a BOX-Top Order into a Limit Order is 
inconsistent with the Linkage Plan because the unexecuted remaining 
portion of a BOX-Top Order could lock or cross other markets, which the 
Linkage Plan requires Participants to avoid.\296\
---------------------------------------------------------------------------

    \296\ See Phlx Letter 2, supra note 10, at 5.
---------------------------------------------------------------------------

    The commenter correctly states that the Linkage Plan provides that 
dissemination of locked or crossed markets shall be avoided.\297\ The 
Commission, however, does not believe that the process proposed by BSE 
for converting the unexecuted portion of a BOX-Top Order into a Limit 
Order would result in locked or crossed markets. In making this 
determination, the Commission notes that before any portion of a BOX-
Top Order is placed on the BOX book following a partial execution at 
the market price, the remainder of the order would be processed through 
the BOX filter.\298\ The filter would expose the remainder of the order 
for three seconds at the NBBO for execution. If there were any 
unexecuted quantity at the end of the three seconds, this quantity 
would be sent as a P/A Order to the away market displaying the NBBO if 
the order is marketable at the NBBO displayed by another market. If the 
order cannot be routed to another exchange for execution because the 
limit price is better than the NBBO, the unexecuted quantity would then 
be booked at the limit price. The Commission believes that this process 
should ensure that BOX-Top Orders would not result in locked or crossed 
market in violation of the Linkage Plan.
---------------------------------------------------------------------------

    \297\ See section 7(a)(i)(C) of the Linkage Plan.
    \298\ See Discussion section II.C., supra.
---------------------------------------------------------------------------

I. Rule 17d-2 Agreements

    Section 17 of the Act \299\ and Rule 17d-2 thereunder \300\ permit 
SROs,

[[Page 2797]]

through so-called Rule 17d-2 agreements, to allocate certain regulatory 
responsibilities. Specifically, Rule 17d-2 under the Act \301\ permits 
SROs to file with the Commission plans under which the SROs allocate 
among each other the responsibility to receive regulatory reports from, 
and examine and enforce compliance with specified provisions of the Act 
and rules thereunder and SRO rules by firms that are members of more 
than one SRO (``common members''). If such a plan is declared effective 
by the Commission, an SRO that is a party to the plan is relieved of 
regulatory responsibility as to any common member for whom 
responsibility is allocated under the plan to another SRO. These 
agreements help to avoid duplicative oversight and regulation. In this 
regard, the Commission approved a 17d-2 agreement (``Agreement'') among 
the Amex, CBOE, ISE, the National Association of Securities Dealers, 
the NYSE, PCX, and Phlx that allocates the regulatory responsibilities 
among these SROs for common members relating to the conduct of broker-
dealers of accounts for listed options or index warrants.\302\
---------------------------------------------------------------------------

    \299\ 15 U.S.C. 78q.
    \300\ 17 CFR 240.17d-2.
    \301\ 17 CFR 240.17d-2.
    \302\ See Securities Exchange Act Release No. 46590 (October 2, 
2002), 67 FR 63474 (October 11, 2003).
---------------------------------------------------------------------------

    The BSE plans to become a participant in this Agreement. Under this 
Agreement, the examining SROs will examine firms that are common 
members of the BSE and the particular examining SRO for compliance with 
certain provisions of the Act, certain of the rules and regulations 
adopted thereunder, certain examining SRO rules, and certain BOX Rules. 
In addition, the BOX Rules contemplate participation in this Agreement 
by requiring that any OFP be a member of at least one of the examining 
SROs.\303\ Accordingly, the Commission's approval of the BSE's proposed 
rule change will not be effective until the BSE enters into the 
Agreement and the Agreement has been filed with, and approved by, the 
Commission.
---------------------------------------------------------------------------

    \303\ See proposed BOX Rules, Chapter XI, sec. 1.
---------------------------------------------------------------------------

J. National Market System (``NMS'') Plans and the Options Clearing 
Corporation

    The Commission's approval of the BSE's proposed rule change will 
not be effective until the BSE has become a participant in several NMS 
plans. Specifically, the BSE must join the Plan for the Reporting of 
Consolidated Options Last Sale Reports and Quotation Information (known 
as the Options Price Reporting Authority (``OPRA'')), the Linkage Plan, 
and the Options Listing Procedures Plan (``OLPP''). In addition, the 
BSE will need to become a participant in the Options Clearing 
Corporation.

IV. Consideration of Burden on Competition and Promotion of Efficiency, 
Competition, and Capital Formation

    In reviewing the BSE's proposal, the Commission is required under 
section 3(f) of the Act,\304\ to consider whether the proposal will 
promote competition, efficiency, and capital formation. In addition, 
section 6(b)(8) requires that the rules of an exchange not impose any 
burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.\305\
---------------------------------------------------------------------------

    \304\ 15 U.S.C. 78c(f).
    \305\ 15 U.S.C. 78f(b)(8).
---------------------------------------------------------------------------

    As noted above, the proposed BOX facility would provide a new fully 
automatic electronic trading market for options. In the Commission's 
view, if the BOX market is successful in attracting new market 
participants and order flow, the facility could serve as a new source 
of liquidity for options investors and promote greater competition 
among options market centers. In particular, the BOX system, in 
contrast to the other options exchanges, would have multiple and 
competing market makers rather than a specialist-driven system. There 
would be no designated specialists, primary market makers, or lead 
market makers with authority to control trading in a particular options 
class. Market making in an options class on BOX would be open to all 
qualified Options Participants who are approved by the Exchange as 
Market Makers.
    Additionally, BOX's trading rules are designed to establish an 
anonymous central order book with price/time priority, which may result 
in better pricing because trading participants have an incentive to 
post their very best prices rapidly. Moreover, the BOX PIP presents the 
opportunity for increased competition for Customer Orders and will 
guarantee the Customer Order that initiates the PIP receives price 
improvement of at least $.01 over the current NBBO.
    If BOX succeeds in attracting order flow, it may serve as a great 
source of liquidity for investors, and this, in turn, could promote 
greater efficiency of executions. Similarly, the availability of novel 
features should provide investors and issuers with new opportunities to 
interact, thereby encouraging capital formation.

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 4, including whether the proposed 
amendment 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. Comments may also be submitted electronically at the 
following e-mail address: [email protected]. All comment letters 
should refer to File No. SR-BSE-2002-15. This file number should be 
included on the subject line if e-mail is used. To help us process and 
review comments more efficiently, comments should be sent in hardcopy 
or by e-mail but not by both methods. 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 be submitted by February 10, 2004.

VI. Accelerated Approval of Amendment No. 4

    Pursuant to section 19(b)(2) of the Act,\306\ the Commission may 
not approve any proposed rule change, or amendment thereto, prior to 
the 30th day after the date of publication of notice of the filing 
thereof, unless the Commission finds good cause for so doing and 
publishes its reasons for so finding. The Commission hereby finds good 
cause for approving Amendment No. 4 to the proposal, prior to the 30th 
day after publishing notice of Amendment No. 4 in the Federal Register. 
Many of the revisions made to the proposal in the BSE's Amendment No. 4 
are modeled on existing rules of the other options exchanges. The 
Commission previously approved these rules and, therefore, believes 
that accelerating such rules for the BOX market is appropriate because 
these revisions do not raise new regulatory issues. Other revisions, 
although not based on existing SRO rules, were not

[[Page 2798]]

material to the overall proposal. The Commission believes that little 
purpose would be served by delaying approval of the proposal until 
those additional revisions had been published for comment. The 
Commission believes that it has received and fully considered 
substantial, meaningful comments with respect to the BSE's proposal, as 
amended, and that Amendment No. 4 does not raise issues that warrant 
further delay. Accordingly, pursuant to section 19(b)(2) of the 
Act,\307\ the Commission finds good cause to approve Amendment No. 4 
prior to the 30th day after notice of the Amendment is published in the 
Federal Register.
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    \306\ 15 U.S.C. 78s(b)(2).
    \307\ 15 U.S.C. 78s(b)(2).
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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.\308\
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    \308\ 15 U.S.C. 78f(b)(5). In connection with the issuance of 
this approval order, neither the Commission nor the staff is 
granting any exemptive or no-action relief from the requirements of 
Rule 10b-10 under the Act. 17 CFR 240.10b-10. Accordingly, a broker-
dealer executing a customer order through BOX will need to comply 
with all applicable requirements of this Rule.
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    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\309\ that the proposed rule change (SR-BSE-2002-15), as amended, 
is hereby finally approved, and Amendment No. 4 to the proposed rule 
change is hereby granted accelerated approval.
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    \309\ 15 U.S.C. 78s(b)(2).
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    Although, the Commission's approval of the BSE's proposed rule 
change to establish trading rules for the BOX facility is final, it 
will not be effective until the BSE takes the following actions:
    (1) Participation in the Options Self-Regulatory Council 
(``OSRC''). The BSE must become a signatory to the 17d-2 agreement 
administered by the OSRC, which is a plan for the allocation of 
regulatory responsibility approved by the Commission under Rule 17d-2 
of the Exchange Act.
    (2) Participation in the National Market System Plans relating to 
options trading. The BSE must join the Options Price Reporting 
Authority, the Options Listing Procedures Plan, and the Options Linkage 
Authority.
    (3) Examination by the Commission. The BSE must demonstrate to the 
satisfaction of Commission staff in the Office of Compliance 
Inspections and Examinations (``OCIE'') that it has adequate 
surveillance programs and procedures in place to monitor trading on BOX 
and that BOX Options Participants can comply with the trade-through 
requirements of the Linkage Plan with regard to all trades effected 
through BOX or any exemption from such Linkage Plan requirements. OCIE 
shall evidence its satisfaction by issuing a letter to the BSE.
    (4) The BSE must file a separate proposed rule change with the 
Commission pursuant to section 19(b) of the Act,\310\ to amend the BOX 
Rules as follows:\311\
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    \310\ 15 U.S.C. 78s(b).
    \311\ The Commission is requiring these amendments so that the 
BOX Rules are comparable with the rules of the other options 
exchanges.
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    [sbull] Market Opening. As noted above, the BSE must amend Chapter 
V, section 9 of the proposed BOX Rules relating to the market opening 
to provide a more detailed description of the market opening 
procedures. Among other things, the BSE must clarify the proposed 
procedures for determining an opening price, including the pre-opening 
and the Theoretical Opening Price. In addition, the BSE must add a 
provision relating to the interaction of Customer Orders during the 
market opening.
    [sbull] Anticipatory Hedging. As noted above, the BSE must amend 
the proposed BOX Rules to prohibit any person associated with an 
Options Participant who has knowledge of all material terms and 
conditions of (i) an order and a solicited order, (ii) an order being 
facilitated, or (iii) orders being crossed, the execution of which are 
imminent, to enter, based on such knowledge, an order to buy/sell the 
option, the underlying security, or any related instrument until the 
terms are disclosed to the trading crowd or the trade can no longer be 
considered imminent.
    [sbull] Exercise of Options Contracts. The BSE must amend Chapter 
VII, section 1 of the proposed BOX Rules to clarify the provisions 
relating to contrary exercise advice.
    [sbull] Complex Orders. As noted above, the BSE must amend the 
proposed BOX rules to specify the process for BOX Participants to 
notify BOX of a proposed strategy and the procedure for sending 
advisory messages.
    Each of these conditions to file proposed rule changes will be 
satisfied upon effectiveness under section 19(b) of the Act.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-1117 Filed 1-16?-04; 8:45 am]
BILLING CODE 8010-01-P