[Federal Register Volume 69, Number 128 (Tuesday, July 6, 2004)]
[Notices]
[Pages 40696-40698]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-15192]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49931; File No. SR-ISE-2004-24]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change by the 
International Securities Exchange, Inc. Relating to the Interaction of 
Market Maker Quotations

June 28, 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 June 21, 2004, 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 and 
II below, which Items have been prepared by the Exchange. This order 
approves the proposal on an accelerated basis and publishes notice of 
the proposed rule change to solicit comments from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to codify in its rules a one-second ``timer'' 
that it employs before the quotations of ISE market makers interact. 
Below is the text of the proposed rule change. Proposed new language is 
italicized; proposed deletions are in [brackets].
* * * * *

Rule 804. Market Maker Quotations

* * * * *
    (d) Firm Quotes. (1) Market maker bids and offers are firm for 
orders and Exchange market maker quotations both under this Rule and 
Rule 11Ac1-1 under the Exchange Act (``Rule 11Ac1-1'') for the number 
of contracts specified according to the requirements of paragraph (b) 
above. Market maker bids and offers are not firm under this Rule and 
Rule 11Ac1-1 if:
    (i) a system malfunction or other circumstance impairs the 
Exchange's ability to disseminate or update market quotes in a timely 
and accurate manner;
    (ii) the level of trading activities or the existence of unusual 
market conditions is such that the Exchange is incapable of collecting, 
processing, and making available to quotation vendors the data for the 
option in a manner that accurately reflects the current state of the 
market on the Exchange, and as a result, the market in the option is 
declared to be ``fast'' pursuant to Rule 704;
    (iii) during trading rotations; or
    (iv) any of the circumstances provided in paragraph (c)(3) of Rule 
11Ac1-1 exist.
    (2) Notwithstanding Paragraph (1) above, if a market maker's bid 
(offer) can trade with the offer (bid) of another market maker, no 
execution shall occur between such quotations for a period of no more 
than one second. During this period, the System will update quotations 
that may be received; provided however, that during this period all 
quotations shall otherwise remain firm and the System will 
automatically execute all incoming orders against such quotations.
    (3) [(2)] Within thirty seconds of receipt of an order to buy or 
sell an option in an amount greater than the Order Execution Size, or 
within thirty seconds of another Exchange market maker entering a 
quotation at a price executable against the market maker's quotation, 
that portion of the order equal to the Order Execution Size, or the 
Quotation Execution Size, as the case may be, will be executed and the 
bid or offer price will be revised.
* * * * *

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 III 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 ISE proposes to codify in its rules a one-second ``timer'' that 
it employs before the quotations of ISE market makers interact. The ISE 
treats orders and quotations differently, with ISE Rule 804(a) stating 
that only market makers may enter quotations on the ISE. Market makers 
use quotations to input and update prices on multiple series of options 
at the same time. Quotations generally are based on pricing models that 
rely on various factors, including the price and volatility of the 
underlying security. As these variables change, a market maker's 
pricing model automatically updates quotations for some or all of an 
option's series. In contrast, an order is an interest to buy a stated 
number of contracts of one specific options series. All ISE members, 
including ISE market makers, can enter orders.\3\
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    \3\ ISE Rule 717 imposes various limitations on orders that 
Electronic Access Members may enter on the ISE, while ISE Rule 805 
governs market maker orders.
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    When stock prices change, ISE market makers update quotations in 
multiple series at the same time. The ISE represents that it promptly 
processes such quotation changes when it receives them. However, there 
is invariably a lag between the time the stock price first changes and 
the time by which the ISE can process all the corresponding option 
quotation changes. During this short period, the ISE may update one 
market maker's bid price to be the same as

[[Page 40697]]

another market maker's asked price, resulting in a temporary market 
``lock.'' In addition, quotations may also ``cross'' each other. The 
ISE believes that if it were to permit executions at such prices, they 
would not properly reflect the true nature of the market. Rather, they 
would result in executions against quotations that simply were in the 
processing queue awaiting updating. According to the ISE, without there 
being some protection against this happening, the ISE would execute 
multiple market-maker-to-market-maker trades, subjecting market makers 
to multiple execution and clearing fees, with no real economic 
justification behind the trades. In addition, in the ISE's view, to 
avoid such executions and the attendant costs, market makers would 
widen their quotations or limit their size, to the detriment of 
customers and other market participants.
    In order to address this concern, the ISE has established a one-
second ``timer'' pursuant to which locked or crossed market maker 
quotations would not trade against each other. During this brief 
period, market maker quotations would remain firm for all orders the 
ISE may receive. That is, all orders would be executed at the 
``locked'' or ``crossed'' price up to the full size of the quotations, 
effectively resulting in a ``zero spread'' (or, for crossed markets, a 
``negative spread'') during this time period. This includes orders from 
customers, broker-dealers and even other market makers. The only 
exclusion is for executions against other market maker quotes.
    The ISE believes that, the timer allows (1) market makers to update 
their quotations and (2) the ISE to process these updates, without 
effecting multiple executions during the update process. If a market 
maker has not entered a new quotation price during this brief period, 
trades would occur in all locked or crossed series up to the full size 
of the quotations upon the expiration of the time. In the ISE's view, 
this brief timer allows market prices to reach true pricing equilibrium 
without the execution of trades lacking economic substance.
2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with section 6(b) of the Act \4\ in general, and furthers the 
objectives of section 6(b)(5) \5\ in particular, in that it is designed 
to prevent fraudulent and manipulative acts and practices, to promote 
just and equitable principles of trade, 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. 
In particular, the Exchange believes that the proposed rule change will 
enhance the pricing efficiency on the ISE.
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    \4\ 15 U.S.C. 78f(b).
    \5\ 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 
result in any burden on competition.

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

    No written comments were solicited or received with respect to the 
proposed rule change.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-ISE-2004-24 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.

All submissions should refer to File Number SR-ISE-2004-24. 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, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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 Section, 450 Fifth Street, 
NW., Washington, DC 20549. Copies of such filing also will be available 
for inspection and copying at the principal office of the ISE. All 
comments received will be posted without change; the Commission does 
not edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly. All 
submissions should refer to File Number SR-ISE-2004-24 and should be 
submitted on or before July 27, 2004.

IV. Commission's Findings and Order Granting Accelerated Approval of 
Proposed Rule Change

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to a national securities exchange.\6\ 
In particular, the Commission finds that the proposed rule change is 
consistent with section 6(b)(5) of the Act, which requires 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 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.\7\
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    \6\ In approving this proposal, the Commission has considered 
its impact on efficiency, competition, and capital formation. 15 
U.S.C. 78c(f).
    \7\ 15 U.S.C. 78f(b)(5).
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    The Commission notes that the ISE believes that, without the 
proposed one-second ``timer'' function, pricing inefficiencies would 
result on the Exchange and ISE market makers would widen their 
quotations or limit size to avoid multiple executions against other 
market makers. The Commission also notes that the ISE would continue to 
require its market makers to be firm for their quotations for the same 
size to customers and broker-dealer orders, including orders for the 
account of other ISE market makers. Further, if a market maker does not 
revise its quotation during the one-second period, trades would execute 
against the quotations of other ISE market makers. Based on the 
foregoing, the Commission finds good cause, pursuant to Section 
19(b)(2) of the Act,\8\ for approving the proposed rule change prior to 
the thirtieth day after the date of publication of notice thereof in 
the Federal Register.
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    \8\ 15 U.S.C. 78s(b)(2).

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[[Page 40698]]

    To implement this proposal, the ISE would require a limited 
exemption from Rule 11Ac1-1 under the Act (the ``Quote Rule'') \9\ to 
permit the Exchange to relieve an ISE market maker from its obligation 
under the Quote Rule to trade with matching quotations from another ISE 
market maker.\10\ In connection with the approval of this proposal, the 
Commission granted ISE's request for a limited exemption from the Quote 
Rule. Specifically, the Commission granted ISE market makers an 
exemption from their obligations under paragraph (c)(2) of the Quote 
Rule with respect to trades with matching ISE market maker quotations 
for no more than one second, provided that the quotations are locked or 
crossed for no more than one second, and that such ISE market maker is 
firm to all other customer and broker-dealer orders, including orders 
for the accounts of other ISE market makers.\11\
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    \9\ 17 CFR 240.11Ac1-1.
    \10\ The ISE submitted a separate letter requesting a limited 
exemption from the Quote Rule. See letter from Michael Simon, Senior 
Vice President and General Counsel, ISE, to Annette Nazareth, 
Director, Division of Market Regulation (``Division''), Commission, 
dated June 14, 2004.
    \11\ See letter from Robert Colby, Deputy Director, Division, 
Commission, to Michael Simon, Senior Vice President and General 
Counsel, ISE, dated June 24, 2004.
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V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\12\ that the proposed rule change (SR-ISE-2004-24), is hereby 
approved on an accelerated basis.
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    \12\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\13\
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    \13\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. 04-15192 Filed 7-2-04; 8:45 am]
BILLING CODE 8010-01-P