[Federal Register Volume 69, Number 42 (Wednesday, March 3, 2004)]
[Notices]
[Pages 10087-10089]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-4716]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49323; File No. SR-ISE-2003-06]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendment No. 1 Thereto by the International Securities 
Exchange, Inc. to Establish Rules Implementing a Price Improvement 
Mechanism

February 26, 2004.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on February 25, 2003, the International Securities Exchange, Inc. 
(``ISE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by the 
Exchange. On February 25, 2004, the ISE submitted Amendment No. 1 to 
the proposed rule change.\3\ The Commission is publishing this notice 
to solicit comments on the proposed rule change, as amended, from 
interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Letter from Michael Simon, Senior Vice President and 
General Counsel, ISE, to Nancy Sanow, Assistant Director, Division 
of Market Regulation, Commission, dated February 24, 2004 
(``Amendment No. 1''). In Amendment No. 1, the ISE replaced the 
proposed rule text in its entirety.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange is proposing to adopt rules implementing a ``Price 
Improvement Mechanism'' (``PIM''). Proposed new language is italicized; 
proposed deletions are in [brackets].
* * * * *
    Rule 717. Limitations on Orders.
* * * * *
    (d) Principal Transactions.
    Electronic Access Members may not execute as principal orders they 
represent as agent unless (i) agency orders are first exposed on the 
Exchange for at least thirty (30) seconds, (ii) the Electronic Access 
Member has been bidding or offering on the Exchange for at least thirty 
(30) seconds prior to receiving an agency order that is executable 
against such bid or offer, [or] (iii) the Member utilizes the 
Facilitation Mechanism pursuant to Rule 716(d), or (iv) the Member 
utilizes the Price Improvement Mechanism for Crossing Transactions 
pursuant to Rule 723.
    (e) Solicitation Orders.
    Electronic Access Members must expose orders they represent as 
agent on the Exchange for at least thirty (30) seconds before such 
orders may be executed in whole or in part by orders solicited from 
Members and non-member broker-dealers to transact with such orders, 
unless with respect to orders solicited from Members, the Member 
utilizes the Price Improvement Mechanism for Crossing Transactions 
pursuant to Rule 723.
* * * * *

Rule 723. Price Improvement Mechanism for Crossing Transactions

    (a) The Price Improvement Mechanism is a process by which an 
Electronic Access Member can provide price improvement opportunities 
for a transaction wherein the Electronic Access Member seeks to 
facilitate an order it represents as agent, or a transaction wherein 
the Electronic Access Member solicited an order from a Member to 
execute against an order it represents as agent (a ``Crossing 
Transaction'').
    (b) Crossing Transaction Entry. A Crossing Transaction is comprised 
of the order the Electronic Access Member represents as agent (the 
``Agency Order'') and a counter-side order for the full size of the 
Agency Order (the ``Counter-Side Order'').
    (1) A Crossing Transaction must be entered only at a price that is 
better than the national best bid or offer (``NBBO''), and only when 
there are at least three (3) market makers quoting in the options 
series. 
    (2) The Crossing Transaction may be priced in one-cent increments. 
    (3) The Crossing Transaction may not be canceled, but the price of 
the Counter-Side Order may be improved during the exposure period. 
    (c) Exposure Period. Upon entry of a Crossing Transaction into the 
Price Improvement Mechanism, a broadcast message will be sent to all 
Members. This broadcast message will not be included in the ISE 
disseminated best bid or offer and will not be disseminated through 
OPRA. 
    (1) Members will be given three seconds to indicate the size and 
price at which they want to participate in the execution of the Agency 
Order (``Improvement Orders''). 
    (2) Improvement Orders may be entered by all Members for their own 
account or for the account of a Public Customer in one-cent increments 
at the same price as the Crossing Transaction or at an improved price 
for the Agency Order, and for any size up to the size of the Agency 
Order. 
    (3) During the exposure period, Improvement Orders may not be 
canceled, but may be modified to (1) increase the size at the same 
price, or (2) improve the price of the Improvement Order for any size 
up to the size of the Agency Order. 
    (4) During the exposure period, the aggregate size of the best-
priced Improvement Orders will continually be updated and broadcast to 
all Members. 
    (5) The exposure period will automatically terminate (i) at the end 
of the three second period, (ii) upon the receipt of a market or 
marketable limit order on the Exchange in the same series, or (iii) 
upon the receipt of a non-marketable limit order in the same series on 
the same side of the market as the Agency Order that would cause the 
price of the Crossing Transaction to be outside of the best bid or 
offer on the Exchange. 
    (d) Execution. At the end of the exposure period the Agency Order 
will be executed in full at the best prices available, taking into 
consideration orders and quotes in the Exchange market, Improvement 
Orders and the Counter-Side Order. The Agency Order will receive 
executions at multiple price levels if there is insufficient size to 
execute the entire order at the best price. 
    (1) At a given price, Public Customer interest is executed in full 
before any Non-Customer interest. 
    (2) After Public Customer interest at a given price, agency orders 
for the account of non-Member broker-dealers

[[Page 10088]]

will be executed in full before any proprietary interest of Members 
(i.e., proprietary interest from Electronic Access Members and Exchange 
market makers). 
    (3) After Public Customer interest and agency orders for the 
account of non-Member broker-dealers, Member proprietary interest will 
participate in the execution of the Agency Order based upon the 
percentage of the total number of contracts available at the price that 
is represented by the size of the Non-Customer's interest. 
    (4) In the case where the Counter-Side Order is at the same price 
as Member interest in (d)(3), the Counter-Side order will be allocated 
the greater of one (1) contract or forty percent (40%) of the initial 
size of the Agency Order before other Member interest is executed.
    (5) When a market order or marketable limit order on the opposite 
side of the market from the Agency Order ends the exposure period, it 
will participate in the execution of the Agency Order at the price that 
is mid-way between the best counter-side interest and the bid or offer 
on the Exchange, so that both the market order and the Agency Order 
receive price improvement. Transactions will be rounded, when 
necessary, to the $.01 increment that favors the Agency Order.
    (6) When a market order or marketable limit order on the same side 
of the market as the Agency Order ends the exposure period, it will 
execute against any unexecuted interest in the Price Improvement 
Mechanism after the Agency Order is executed in full, so that the 
market order or marketable limit order receives an opportunity for 
price improvement.

Supplementary Material to Rule 723

    .01 It shall be considered conduct inconsistent with just and 
equitable principles of trade for any Member to enter orders, quotes, 
Agency Orders, Counter-Side Orders or Improvement Orders for the 
purpose of disrupting or manipulating the Price Improvement Mechanism.
    .02 The Price Improvement Mechanism may only be used to execute 
bona fide Crossing Transactions.
    .03 Initially, and for at least a Pilot Period expiring on July 18, 
2005, there will be no minimum size requirements for order to be 
eligible for the Price Improvement Mechanism. During the Pilot Period, 
the Exchange will submit certain data, periodically as required by the 
Commission, to provide supporting evidence that, among other things, 
there is meaningful competition for all size order within the Price 
Improvement Mechanism, that there is significant price improvement for 
all orders executed through the Price Improvement Mechanism, and that 
there is an active and liquid market functioning on the Exchange 
outside of the Price Improvement Mechanism. Any data which is submitted 
to the Commission will be provided on a confidential basis.
    .04 Only one PIM may be ongoing at any given time in a series. PIMs 
will not queue or overlap in any manner.
* * * * *

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

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

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

1. Purpose
    The purpose of this proposed rule change is to adopt rules 
implementing the ISE's PIM. The PIM is a mechanism that would allow an 
ISE Electronic Access Member (``EAM'') to enter matched trades called 
``Crossing Transactions.'' Similar to the ISE's Facilitation 
Mechanism,\4\ a Crossing Transaction would be comprised of an order 
that the EAM represents as agent (``Agency Order'') and an order that 
is executable against the Agency Order for the full size of the Agency 
Order (the ``Counter-Side Order''). In the case of the PIM, the 
Counter-Side Order could be either the EAM's own principal interest, 
one or more orders the EAM solicited to trade against the Agency Order 
from other ISE members, or a combination of the EAM's own principal 
interest and such solicited order(s). A Member must enter the Crossing 
Transaction at a price at least one cent better than the national best 
bid and offer (``NBBO'').\5\
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    \4\ See ISE Rule 716(d).
    \5\ A PIM could not be initiated unless there are at least three 
ISE market makers quoting in the series. Moreover, there could be 
only one PIM ongoing in a series at any given time. Therefore, a PIM 
could not be initiated during an ongoing PIM in the same series.
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    The ISE would broadcast the Crossing Transaction to all ISE 
members. During a three-second auction, all ISE members could enter 
``Improvement Orders,'' in pennies, to improve the price of the Agency 
Order.\6\ Improvement Orders may be for the account of a Public 
Customer or for the member's own account. After three seconds, the ISE 
would execute the Agency Order against the best prices as follows: (1) 
All Public Customer Improvement Orders and unrelated Public Customer 
orders on the book at the best price would be executed first; (2) all 
unrelated agency orders on the book for the account of a non-Member 
broker-dealer would then be executed; (3) if the entering EAM is at the 
best price, it would then execute against the greater of one contract 
or 40 percent of the Agency Order; and (4) the remainder of the order 
would be allocated to all other interest, which includes Improvement 
Orders and unrelated orders on the book for the account of an ISE 
member (including ISE market makers), at the best price pro-rata based 
on size.\7\
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    \6\ The ISE would broadcast Improvement Orders to all members. 
Crossing Transactions and Improvement Orders would not be displayed 
in the ISE BBO and would not be disseminated to the Options Price 
Reporting Authority.
    \7\ This sized-based allocation formula for the remainder of the 
order would be the same formula the Exchange applies in the regular 
market, without any special allocation rights for the Primary Market 
Maker. See ISE Rule 713, Supplementary Material .01. Improvement 
Orders entered by the Primary Market Maker would be treated the same 
as Improvement Orders entered by other broker-dealers. See also ISE 
Rule 716(d)(4)(ii) (providing for the same allocation formula in the 
Facilitation Mechanism).
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    The three-second PIM exposure period would be ended immediately 
upon the receipt of certain orders in the regular Exchange market. 
Specifically, the PIM would end immediately when a market or marketable 
limit order is received in the same series or when a limit order on the 
same side of the market as the Agency Order is received that would 
cause the price of the Crossing Transaction to be outside of the best 
bid or offer on the Exchange. In the case where a market or marketable 
limit order on the opposite side of the market from the Agency Order is 
received, the order would execute against the Agency Order at a price 
that is mid-way between the best PIM price and the bid or offer on the 
Exchange. As a result, both orders would receive an improved price.\8\ 
In addition, when a

[[Page 10089]]

market order or marketable limit order on the same side of the market 
as the Agency Order ends the PIM, it would execute against any 
unexecuted Improvement Orders after the Agency Order is executed in 
full. The ISE believes that this would provide an opportunity for price 
improvement to orders in the regular Exchange market.\9\
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    \8\ For example, assume (i) the NBBO is $5 to $5.10, (ii) a PIM 
has been initiated for an Agency Order to sell 100 contracts, and 
(iii) the best PIM price is $5.06. If a market order to buy 50 
contracts is received, the PIM would terminate and the market order 
would execute against the Agency Order for 50 contracts at $5.08. 
This represents a $.02 improvement for the market order over the 
best offer price and a $.02 improvement for the Agency Order over 
the PIM price. The 50 contracts remaining in the Agency Order would 
be executed at the PIM price of $5.06, assuming that there were 50 
contracts available at that price. Telephone conversation between 
Michael Simon, Senior Vice President and General Counsel, ISE, and 
Deborah Flynn, Assistant Director, Division, Commission, on February 
25, 2004. All executions would be in $.01 increments, and rounding 
would be in favor of the Agency Order. Thus, in this example, if the 
best PIM price had been $5.07, the market order would have executed 
against the Agency Order for 50 contracts at $5.09.
    \9\ For example, assume (i) the NBBO is $5 to $5.10, (ii) a PIM 
has been initiated for an Agency Order to sell 100 contracts, and 
(iii) the best PIM price is $5.06 for 125 contracts. If a market 
order to sell 50 contracts is received, the PIM would terminate, the 
Agency Order would be executed at $5.06 and the market order to sell 
would receive 25 contracts at $5.06.
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    The PIM would be available for orders of all sizes for a Pilot 
Period expiring on July 13, 2005. The ISE represents that during this 
pilot period it would provide the Commission with the following 
information on a monthly basis:
    (1) The number of orders of fewer than 50 contracts entered into 
the PIM;
    (2) The percentage of all orders of fewer than 50 contracts sent to 
the ISE that are entered into the PIM;
    (3) The percentage of all ISE trades represented by orders of fewer 
than 50 contracts;
    (4) The percentage of all ISE trades effected through the PIM 
represented by orders of fewer than 50 contracts;
    (5) The percentage of all contracts traded on the ISE represented 
by orders of fewer than 50 contracts;
    (6) The percentage of all contracts effected through the PIM 
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 PIM;
    (8) Of PIM trades, the percentage done at the NBBO plus $.01, plus 
$.02, plus $.03, etc.; and
    (9) The number of PIM orders submitted when the spread was $.05, 
$.10, $.15, etc. For each spread, we will specify the percentage of 
contracts in orders of fewer than 50 contracts submitted to the PIM 
that were traded by: (a) The EAM that submitted the order to the PIM; 
(b) ISE market makers assigned to the class; (c) Improvement Orders; 
and (d) unrelated orders (orders in standard increments entered during 
the PIM).
2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with section 6(b) of the Act \10\ in general, and furthers the 
objectives of section 6(b)(5)\11\ in particular, in that it is designed 
to remove impediments to and perfect the mechanism for a free and open 
market and a national market system, and, in general, to protect 
investors and the public interest. In particular, the ISE believes that 
the proposal would provide an opportunity for Public Customers to 
receive price improvement of their orders.
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    \10\ 15 U.S.C. 78f(b).
    \11\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

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

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

    The Exchange did not solicit or receive written comments on the 
proposed rule change.

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

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

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposal, as 
amended, is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. 
Comments may also be submitted electronically at the following e-mail 
address: [email protected]. All comment letters should refer to 
File No. SR-ISE-2003-06. The file number should be included on the 
subject line if e-mail is used. To help the Commission process and 
review your 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 in the Commission's 
Public Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the Amex. All 
submissions should be submitted by March 24, 2004.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\12\
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    \12\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-4716 Filed 3-2-04; 8:45 am]
BILLING CODE 8010-01-P