[Federal Register Volume 69, Number 52 (Wednesday, March 17, 2004)]
[Notices]
[Pages 12724-12727]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-5950]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49393; File No. SR-ISE-2003-26]


Self-Regulatory Organizations; Notice of Filing of a Proposed 
Rule Change and Amendments No. 1, 2 and 3 Thereto by the International 
Securities Exchange, Inc. To Amend Its Rules Governing Limits on the 
Entry of Orders of Less Than Ten Contracts and Revise the Quotation 
Size Requirements for Market Makers

March 10, 2004.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934

[[Page 12725]]

(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on October 14, 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 ISE. 
On January 13, 2004, the ISE filed Amendment No. 1 to the proposed rule 
change (``Amendment No. 1'').\3\ On January 30, 2004, the ISE filed 
Amendment No. 2 to the proposed rule change (``Amendment No. 2'').\4\ 
On March 8, 2004, the ISE filed Amendment No. 3 to the proposed rule 
change (``Amendment No. 3'').\5\ 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 J. Sanow, Assistant Director, 
Division of Market Regulation (``Division''), Commission, dated 
January 12, 2004. In Amendment No. 1, the ISE made technical 
corrections to the text of the proposed rule change. In addition, in 
Amendment No. 1, the ISE corrected an omission in the original rule 
text, amending ISE Rule 1614(d)(5) to include ISE Rule 717(f) as a 
minor rule violation meriting the fines set forth in ISE Rule 
1614(d)(5) (addressing violations of order-entry rules).
    \4\ See letter from Michael Simon, Senior Vice President and 
General Counsel, ISE, to Nancy J. Sanow, Assistant Director, 
Division, Commission, dated January 29, 2004. In Amendment No. 2, 
the ISE amended the text of the proposed rule change to clarify that 
Primary Market Makers must buy (sell) the number of contracts needed 
to maintain a firm quote for ten contracts when the disseminated ISE 
quotation is less than ten contracts for orders incoming from the 
Options Intermarket Linkage.
    \5\ See letter from Michael Simon, Senior Vice President and 
General Counsel, ISE, to Nancy J. Sanow, Assistant Director, 
Division, Commission, dated March 5, 2004. In Amendment No. 3, the 
ISE amended the text of the proposed rule change to incorporate 
recently-approved changes to ISE Rule 804. See Securities Exchange 
Act Release No. 49278 (February 19, 2004), 69 FR 8716 (February 25, 
2004) (SR-ISE-2003-34).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to modify ISE Rules 717, 803-805 and 1614 to 
repeal the limits on the entry of orders and revise the quotation 
requirements of market makers. The text of the proposed rule change is 
set forth below. Proposed new language is in italics; proposed 
deletions are in [brackets].
* * * * *
Rule 717. Limitations on Orders
    (c) Reserved. [Order Size.
    (1) Electronic Access Members are prohibited from entering into the 
System, as principal or agent, multiple orders for a single trading 
interest if one or more orders is for fewer than ten (10) contracts.
    (2) Non-Customer Orders for fewer than ten (10) contracts will be 
rejected or cancelled automatically if such orders would cause the size 
of the Exchange's best bid or offer to be fewer than ten (10) 
contracts.]
Rule 803. Obligations of Market Makers
    (c) Primary Market Makers. In addition to the obligations contained 
in this Rule for market makers generally, for options classes to which 
a market maker is the appointed Primary Market Maker, it shall have the 
responsibility to:
    (1) [Assure that each disseminated market quotation in each series 
of options is for a minimum of ten (10) contracts, or such other 
minimum number as the Exchange shall set from time to time. When the 
best bid (offer) on the Exchange represents one or more Public Customer 
Orders for less than a total of ten (10) contracts at that price, the 
Primary Market Maker is obligated to] When the disseminated market 
quotation in a series of options is for less than ten (10) contracts, 
buy (sell) at that price the number of contracts needed to make the 
disseminated quote firm for ten (10) contracts to incoming Linkage 
orders as provided in Rule 1900(7) and (8).
    (2) Address Public Customer Orders that are not automatically 
executed because there is a displayed bid or offer on another exchange 
trading the same options contract that is better than the best bid or 
offer on the Exchange.
    (3) Initiate trading in each series pursuant to Rule 701.
Rule 804. Market Maker Quotations
    (b) Size Associated with Quotes. A market maker's bid and offer for 
a series of options contracts shall be accompanied by the number of 
contracts at that price the market maker is willing to buy or sell upon 
receipt of an order or upon interaction with a quotation entered by 
another market maker on the Exchange. Unless the Exchange has declared 
a fast market pursuant to Rule 704, a market maker may not initially 
enter a bid or offer of less than ten (10) contracts. [Where the size 
associated with a market maker's bid or offer falls below ten (10) 
contracts due to executions at that price and consequently the size of 
the best bid or offer on the Exchange would be for less than ten (10) 
contracts, the market maker shall enter a new bid or offer for at least 
ten (10) contracts, either at the same or a different price.]
Rule 805. Market Maker Orders
    (b) Options Classes Other Than Those to Which Appointed.
    (1) A market maker may enter all order types permitted to be 
entered by non-customer participants under the Rules to buy or sell 
options in classes of options listed on the Exchange to which the 
market maker is not appointed under Rule 802, provided that:
    (i) market maker orders are subject to the limitations contained in 
Rule 717[(c) and] (f) as [those] that paragraph[s apply] applies to 
principal orders entered by Electronic Access Members;
    (ii) the spread between a limit order to buy and a limit order to 
sell the same options contract complies with the parameters contained 
in Rule 803(b)(4); and
    (iii) the market maker does not enter orders in options classes to 
which it is otherwise appointed, either as a Competitive or Primary 
Market Maker.
Rule 1614. Imposition of Fines for Minor Rule Violations
    (d) Violations Subject to Fines. The following is a list of the 
rule violations subject to, and the applicable sanctions that may be 
imposed by the Exchange pursuant to, this Rule:
    (5) Order Entry (Rule 717). Violations of Rule 717(a), [(c)-(e)] 
(d)-(f) regarding limitations on orders entered into the System by 
Electronic Access Members, as well as violations of Rule 805(b)(1)(i) 
regarding [restrictions on] orders entered by market makers, will be 
subject to the fines listed below. Each paragraph of Rule 717 subject 
to this Rule shall be treated separately for purposes of determining 
the number of cumulative violations.
* * * * *

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 ISE 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 prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

[[Page 12726]]

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

1. Purpose
    The purpose of the proposed rule change is to revise the ISE's 
restrictions on the entry of orders of less than 10 contracts, along 
with related market maker quotation requirements. Currently, ISE rules 
require that the Exchange's best bid and offer (``BBO'') be at a size 
of at least 10 contracts at all times. To assure that the Exchange's 
BBO is at least 10 contracts, ISE rules contain several restrictions on 
orders of less than 10 contracts and certain market maker obligations.
    First, ISE Rule 804 requires market makers to establish quotations 
of at least 10 contracts. That rule also provides that if there is 
partial execution against a quotation resulting in the size of the ISE 
BBO falling below 10 contracts, the market maker must refresh its 
quotation (either at the same or different price) so that it is firm 
for at least 10 contracts. Similarly, ISE Rule 717 prohibits Electronic 
Access Members (``EAMs'') from submitting orders for non-customers of 
less than 10 contracts that would cause the ISE BBO to be for less than 
10 contracts. If an EAM enters an order for a Public Customer at the 
BBO for less than 10 contracts, Rule 803 requires that the Primary 
Market Maker (``PMM'') either trade that order or supplement the size 
of the order so that the displayed quotation is for at least 10 
contracts. The Exchange refers to the supplemental quoting obligation 
as the need for the PMM to ``derive'' the additional size. Finally, to 
avoid manipulative practices related to the PMM's obligation to derive 
additional size, an EAM is prohibited under Rule 717 from entering 
multiple orders of less than 10 contracts for the same trading 
interest.\6\
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    \6\ The derived order obligation can lead to market manipulation 
called ``small order baiting,'' where customers enter small orders 
seeking to induce a PMM to display greater size at that price, and 
then enter an order to execute against that derived size.
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    This proposed rule change will not change the requirement that 
market makers enter all quotations with a size of at least 10 
contracts. It will: (1) Remove the prohibition on EAMs entering non-
customers orders that improve the ISE's BBO for less than 10 contracts, 
(2) repeal the obligation of the PMM either to ``trade out'' customer 
orders of less than 10 contracts or derive additional size to maintain 
a 10-contract displayed size, and (3) since there will no longer be an 
obligation for PMMs to derive additional size, remove the prohibition 
on EAMs entering multiple orders for the same trading interest if one 
or more orders are for less than 10 contracts. In addition, this 
proposed rule change will repeal the requirement that market makers 
refresh their quotations if there is a partial execution that results 
in the ISE's BBO size's falling below 10 contracts.\7\ However, pending 
possible future changes to the rules governing trading in the Linkage, 
the Exchange does not propose to change the obligations in ISE Rule 
1900 that the ISE quotation be firm for at least 10 contracts for 
Principal Orders and Principal Acting as Agent Orders received through 
the Linkage. The PMM will continue to provide ``derived'' size when 
necessary for such Linkage orders.
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    \7\ The ISE represents, however, that their system makes it 
impossible for a market maker's quote ever to drop to zero, and that 
this proposed rule filing will not therefore change the obligation 
of a market maker to maintain a continuous quote for options in 
which they make a market. See ISE Rules 803(b) and 804(e). Telephone 
conversation between Katherine Simmons, Associate General Counsel, 
ISE, and John Roeser, Special Counsel and Elizabeth MacDonald, 
Attorney, Division, Commission, February 11, 2004.
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    Lastly, the Exchange is proposing to amend ISE Rule 1614(d)(5) to 
include ISE Rule 717(f) as a minor rule violation subject to the fines 
applicable to violations of order-entry rules.\8\ The Exchange proposes 
to include 717(f) as a minor rule violation harmonizes the treatment of 
EAMs and market makers pursuant to that rule.\9\
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    \8\ Telephone conversations between Joe Ferraro, Assistant 
General Counsel, ISE, and Elizabeth MacDonald, Attorney, Division, 
Commission, February 18, 2004, and February 19, 2004.
    \9\ Id.
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    The Exchange believes that the proposed rule change will provide 
significant benefits. First, the Exchange believes that the proposed 
rule change will provide non-customers with more flexibility in the 
entry of orders by allowing them to enter orders of less than 10 
contracts. It also will remove the burden on PMMs either to trade out 
small customer orders or derive size for such orders, which the 
Exchange believes will eliminate ``small order baiting'' manipulative 
conduct. At the same time, the Exchange will retain the obligation that 
market makers initially enter quotations for a size of at least 10 
contracts. The Exchange believes that this is a necessary obligation 
for market makers to provide reasonable liquidity to the market place.
2. Statutory Basis
    The ISE believes that the rule change is consistent with Section 
6(b) of the Act in general \10\ and Section 6(b)(5) of the Act in 
particular.\11\ The Exchange believes that the proposed rule change is 
intended 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. Specifically, the Exchange 
believes that allowing EAMs to enter non-customer orders of less than 
10 contracts will provide non-customers with greater flexibility to 
improve the ISE's BBO. Also, the Exchange believes that by allowing 
market makers to maintain quotations of less than 10 contracts, they 
can continue to provide investors with liquidity at their stated prices 
without having to refresh their quotations for 10 contracts at a 
potentially inferior price. Finally, the Exchange believes that 
eliminating the need for PMMs to ``derive'' quotations will eliminate 
opportunities for manipulative practices, such as ``small order 
baiting.''
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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 proposed rule change does not 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 has not solicited, and does not intend to solicit, 
comments on this proposed rule change. The Exchange has not received 
any unsolicited written comments from members or other interested 
parties.

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 self-regulatory organization 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,

[[Page 12727]]

including whether the amended proposal 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-2003-26. This 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 hard copy 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 ISE. All submissions should refer to File No. 
SR-ISE-2003-26 and should be submitted by April 7, 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).

J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 04-5950 Filed 3-16-04; 8:45 am]
BILLING CODE 8010-01-P