[Federal Register Volume 70, Number 94 (Tuesday, May 17, 2005)]
[Notices]
[Pages 28326-28338]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-2441]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51680; File No. SR-CBOE-2004-87]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Notice of Filing of Proposed Rule Change and Amendment 
Nos. 1 and 2 Thereto Relating to Trading Rules on the Hybrid System for 
Index Options and Options on ETFs

May 10, 2005.
    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 December 17, 2004, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by the CBOE. 
On March 23, 2005, the CBOE submitted Amendment No. 1 to the proposed 
rule change.\3\ On April 26, 2005, the CBOE submitted Amendment No. 2 
to the proposed rule change.\4\ 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    \3\ Amendment No. 1 replaced and superseded the originally filed 
proposed rule change.
    \4\ Amendment No. 2 replaced and superseded the originally filed 
proposed rule change and Amendment No. 1.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to adopt index hybrid trading rules 
applicable to classes in which there are Designated Primary Market-
Makers (``DPMs''), Lead Market-Makers (``LMMs'') or, alternatively, 
Market-Makers (``MMs''). Below is the text of the proposed rule change, 
as amended. Proposed new language is in italics; proposed deletions are 
in [brackets].

Rule 6.1 Days and Hours of Business

* * * * *

[[Page 28327]]

Interpretations and Policies
    .01-.03 No change.
    .04 For those option classes and within such time periods as the 
appropriate Floor Procedure Committee, MTS or the President of the 
Exchange may designate, members may, prior to the scheduled opening 
rotation, enter option market quote indications based upon the 
anticipated opening price of the security underlying such designated 
option class. This interpretation will not impose upon members an 
affirmative responsibility to provide and post pre-opening option 
market quote indicators. Generally, pre-opening option market quote 
indications would be provided by members for options classes whose 
underlying security is sold over-the-counter and those option classes 
whose underlying security shows little market volatility. The following 
procedures shall be followed by members and the Order Book Official, 
[or] DPM, or LMM when posting pre-opening option market quote 
indications.
    (a) For those options classes designated as eligible for pre-
opening option market quote indications the OBO, [or] DPM, or LMM 
shall, no earlier than 8:15 a.m. (CT), request market quote indications 
from the members present in the trading crowd.
    (b) The members and DPM or LMM may then provide pre-opening option 
market quote indications at which time the OBO, [or] DPM, or LMM shall 
post these indications. Upon the opening of the underlying security and 
in no case earlier than 8:30 a.m. (CT) the OBO, [or] DPM, or LMM shall 
request verbal confirmation from the trading crowd that such pre-
opening option market quote indications reflect the actual market and 
constitute valid opening quotations. If the crowd indicates that such 
pre-opening option market quote indications reflect the actual market 
and constitute valid opening quotations, the OBO, [or] DPM, or LMM 
shall determine that a simultaneous opening rotation has occurred. If 
they do not confirm the indications, an opening rotation in accordance 
with applicable Exchange Rules for all series in which floor brokers in 
the crowd or the Book hold executable limit or market orders will be 
held. After such orders have been executed, the OBO, [or] DPM, or LMM 
shall declare the option class open and the series subject to 
applicable Exchange Rules.
    (c) Notwithstanding paragraphs (a) and (b), the OBO, [or] DPM, or 
LMM shall direct that an opening rotation take place pursuant to 
applicable exchange Rules if (i) the OBO, [or] DPM, or LMM fails to 
receive market quote indications; or (ii) the underlying security opens 
substantially higher or lower than the opening price anticipated by the 
crowd that provided the pre-opening market quote indications; or (iii) 
there are substantial order imbalances affecting the options class; or 
(iv) for such other reasons as appropriate Floor Officials, the OBO, 
the DPM, or LMM or the Exchange may determine.
* * * * *

Rule 6.2 Trading Rotations

* * * * *
Interpretations and Policies
    .01 (a) Trading rotations shall be employed at the opening of the 
Exchange each business day. For each class of option contracts that has 
been approved for trading, the opening rotation shall be conducted by 
the [Board Broker,] Designated Primary Market-Maker (``DPM''), Lead 
Market-Maker (``LMM''), or Order Book Official (``OBO'') acting in such 
class of options. The opening rotation in each class of options shall 
be held promptly following the opening of the underlying security on 
the principal market where it is traded or after 8:30 a.m. for index 
options. As a rule, a [Board Broker,] DPM, LMM, or OBO acting in more 
than one class of options should open them in the same order in which 
the underlying securities are opened.
    (b) In conducting each such opening rotation, the [Board Broker,] 
DPM, LMM, or OBO should ordinarily first open the one or more series of 
options of a given class having the nearest expiration, then proceed to 
the series of options having the next most distant expiration, and so 
forth, until all series have been opened. If both puts and calls 
covering the same underlying security are traded, the [Board Broker,] 
DPM, LMM, or OBO shall determine which type of option will open first, 
and shall alternate the opening of put series and call series. A [Board 
Broker,] DPM, LMM, or OBO may conduct the opening rotation in another 
manner only with the approval of two Floor Officials or at the 
direction of the appropriate Floor Procedure Committee. A modified 
opening rotation such as that described in Interpretation .02 to Rule 
24.13 may be conducted for certain index options classes.
    (c) In the event an underlying security has not opened within a 
reasonable time after 8:30 a.m. (Chicago time), the [Board Broker,] 
DPM, LMM, or OBO acting in option contracts on such security shall 
report the delay to a Floor Official and an inquiry shall be made to 
determine the cause of the delay. The opening rotation for option 
contracts in such security shall be delayed until the underlying 
security has opened unless two Floor Officials determine that the 
interests of a fair and orderly market are best served by opening 
trading in the option contracts.
    (d) No change.
    .02-.05 No change.

Rule 6.2B Hybrid Opening System

    (a) For a period of time before the opening of trading in the 
underlying security (or in the case of index options, prior to 8:30 
a.m., CT), as determined by the appropriate Floor Procedure Committee 
(FPC) and announced to the membership via Regulatory Circular, the 
Hybrid System will accept orders and quotes. The Hybrid System will 
disseminate to market participants (as defined in Rule 6.45A or 6.45B) 
information about resting orders in the Book that remain from the prior 
business day and any orders submitted before the opening. At a randomly 
selected time within a number of seconds after the primary market for 
the underlying security disseminates the opening trade or the opening 
quote (or after 8:30 a.m. for index options unless unusual 
circumstances exist), the System initiates the opening procedure and 
sends a notice (``Opening Notice'') to market participants who may then 
submit their opening quotes. The DPM or any appointed LMM for the class 
must enter opening quotes. Spread orders and contingency orders do not 
participate in the opening trade or in the determination of the opening 
price.
    (b) After the Opening Notice is sent, the System will calculate and 
provide the Expected Opening Price (``EOP'') and expected opening size 
(``EOS'') given the current resting orders during the EOP Period (``EOP 
Period''). The appropriate FPC will establish the duration of the EOP 
Period on a class basis at between five and sixty seconds. The EOP, 
which will be calculated and disseminated to market participants every 
few seconds, is the price at which the greatest number of orders in the 
Book are expected to trade. After the Opening Notice is sent, quotes 
and orders may be submitted without restriction. An EOP may only be 
calculated if: (i) there are market orders in the Book, or the Book is 
crossed (highest bid is higher than the lowest offer) or locked 
(highest bid equals lowest offer), and (ii) the DPM's quote (or if 
there is no DPM appointed to the class, at least one quote from either 
a market-maker or LMM with an appointment in the class) is present and 
complies with the legal width quote requirements of Rule 8.7(b)(iv).
    (c)-(d) No change.

[[Page 28328]]

    (e) The System will not open a series if one of the following 
conditions is met:
    (i) In classes in which a DPM has been appointed, [T]there is no 
quote from the DPM for the series. In classes in which no DPM has been 
appointed, there is no quote from at least one market-maker or LMM with 
an appointment in the class;
    (ii)-(iii) No change.
    (f)-(i) No change.

Rule 6.45A Priority and Allocation of Equity Option Trades on the [for] 
CBOE Hybrid System

    Generally: The rules of priority and order allocation procedures 
set forth in this rule shall apply only to equity option classes 
designated by the Exchange to be traded on the CBOE Hybrid System and 
has no applicability to index option and options on ETF classes. The 
term ``market participant'' as used throughout this rule refers to a 
Market-Maker, an in-crowd DPM, an e-DPM, a Remote Market-Maker, and a 
floor broker representing orders in the trading crowd. The term ``in-
crowd market participant'' only includes an in-crowd Market-Maker, in-
crowd DPM, and floor broker representing orders in the trading crowd.
    (a) Allocation of Incoming Electronic Orders: The Exchange shall 
apply, for each class of options, the following rules of trading 
priority.
    (i) * * *
    (A) No change.
    (B) Allocation
    (1) No change.
    (2) * * *
    Component A: No change.
    Component B: No change.
    Final Weighting: The final weighting formula for equity options, 
which shall be determined by the appropriate FPC and apply uniformly 
across all options under its jurisdiction, shall be a weighted average 
of the percentages derived for Components A and B multiplied by the 
size of the incoming order. Initially, the weighting of components A 
and B shall be equal, represented mathematically by the formula: 
((Component A Percentage + Component B Percentage)/2) * incoming order 
size. [The final weighting formula for index options and options on 
ETFs shall be established by the appropriate FPC and may vary by 
product. Changes made to the percentage weightings of Components A and 
B shall be announced to the membership via Regulatory Circular at least 
one day before implementation of the change.]
    (C) No change.
    (b) No change.
    (c) Interaction of Market Participant's Quotes and/or Orders with 
Orders in Electronic Book
* * * * *
    (i) No change.
    (ii) * * *
    Component A: No change.
    Component B: No change.
    Final Weighting: The final weighting formula for equity options, 
which shall be determined by the appropriate FPC and apply uniformly 
across all options under its jurisdiction, shall be a weighted average 
of the percentages derived for Components A and B, multiplied by the 
size of the order(s) in the electronic book. Initially, the weighting 
of components A and B shall be equal, represented mathematically by the 
formula: ((Component A Percentage + Component B Percentage)/2) * 
electronic book order size.
    [The final weighting formula for index options and options on ETFs 
shall be established by the appropriate FPC and may vary by product. 
Changes made to the percentage weightings of Components A and B shall 
be announced to the membership via Regulatory Circular at least one day 
before implementation of the change.]
    (iii) No change.
    (d) No change.
    (e) Classes Trading on Hybrid
    [By December 31, 2003, Hybrid will be operational in CBOE's 200 
most active equity option classes and, by December 31, 2004, Hybrid 
will be operational in CBOE's 500 most active equity option classes.] 
The Exchange intends to implement Hybrid floorwide in all other equity 
classes by the fourth quarter of 2006. [Index option classes and 
options on ETFs specifically designated by the appropriate Floor 
Procedure Committee may trade on the Hybrid System. In order to be 
eligible for trading on Hybrid, index option classes and options on 
ETFs must utilize an in-crowd Designated Primary Market Maker.]
    Interpretations and Policies . . . No change.

Rule 6.45B Priority and Allocation of Trades in Index Options and 
Options on ETFs on the CBOE Hybrid System

    Generally: The rules of priority and order allocation procedures 
set forth in this rule shall apply only to index options and options on 
ETFs that have been designated by the appropriate Exchange procedures 
committee for trading on the CBOE Hybrid System. The term ``market 
participant'' as used throughout this rule refers to a Market-Maker, a 
Remote Market-Maker, an in-crowd DPM or LMM, an e-DPM with an 
appointment in the subject class, and a floor broker representing 
orders in the trading crowd. The term ``in-crowd market participant'' 
only includes an in-crowd Market-Maker, in-crowd DPM or LMM, and floor 
broker representing orders in the trading crowd.
    (a) Allocation of Incoming Electronic Orders: The appropriate 
Exchange procedures committee will determine to apply, for each class 
of options, one of the following rules of trading priority described in 
paragraphs (i) or (ii). The Exchange will issue a Regulatory Circular 
periodically specifying which priority rules will govern which classes 
of options any time the appropriate Exchange committee changes the 
priority.
    (i) Price-Time or Pro-Rata Priority
    Price-Time Priority: Under this method, resting quotes and orders 
in the book are prioritized according to price and time. If there are 
two or more quotes or orders at the best price then priority is 
afforded among these quotes or orders in the order in which they were 
received by the Hybrid System; or
    Pro Rata Priority: Under this method, resting quotes and orders in 
the book are prioritized according to price. If there are two or more 
quotes or orders at the best price then trades are allocated 
proportionally according to size (in a pro rata fashion). The 
executable quantity is allocated to the nearest whole number, with 
fractions \1/2\ or greater rounded up and fractions less than \1/2\ 
rounded down. If there are two market participants that both are 
entitled to an additional \1/2\ contract and there is only one contract 
remaining to be distributed, the additional contract will be 
distributed to the market participant whose quote or order has time 
priority.
    Additional Priority Overlays Applicable to Price-Time or Pro-Rata 
Priority Methods
    In addition to the base allocation methodologies set forth above, 
the appropriate Exchange procedures committee may determine to apply, 
on a class-by-class basis, either or both of the following designated 
market participant overlay priorities. The Exchange will issue a 
Regulatory Circular periodically which will specify which classes of 
options are subject to these additional priorities as well as any time 
the appropriate Exchange procedures committee changes these priorities.
    (1) Public Customer: When this priority overlay is in effect, the 
highest bid and lowest offer shall have priority except that public 
customer orders shall have priority over non-public customer orders at 
the same price. If there are two or more public customer orders for the

[[Page 28329]]

same options series at the same price, priority shall be afforded to 
such public customer orders in the sequence in which they are received 
by the System, even if the Pro Rata Priority allocation method is the 
chosen allocation method. For purposes of this Rule, a Public Customer 
order is an order for an account in which no member, non-member 
participant in a joint-venture with a member, or non-member broker-
dealer (including a foreign broker-dealer) has an interest.
    (2) Participation Entitlement: The appropriate Exchange procedures 
committee may determine to grant DPMs, LMMs, or e-DPMs participation 
entitlements pursuant to the provisions of Rule 8.87 or 8.15B. In 
allocating the participation entitlement, all of the following shall 
apply:
    (A) To be entitled to their participation entitlement, a DPM's or 
LMM's or e-DPM's order and/or quote must be at the best price on the 
Exchange.
    (B) A DPM or LMM or e-DPM may not be allocated a total quantity 
greater than the quantity that the DPM or LMM or e-DPM is quoting 
(including orders not part of quotes) at that price. If Pro Rata 
Priority is in effect, and the DPM's or LMM's or e-DPM's allocation of 
an order pursuant to its participation entitlement is greater than its 
percentage share of quotes/orders at the best price at the time that 
the participation entitlement is granted, the DPM or LMM or e-DPM shall 
not receive any further allocation of that order.
    (C) In establishing the counterparties to a particular trade, the 
DPM's or LMM's or e-DPM's participation entitlement must first be 
counted against the DPM's or LMM's or e-DPM's highest priority bids or 
offers.
    (D) The participation entitlement shall not be in effect unless the 
Public Customer priority is in effect in a priority sequence ahead of 
the participation entitlement and then the participation entitlement 
shall only apply to any remaining balance.
    (ii) Ultimate Matching Algorithm (``UMA''): Under this method, a 
market participant who enters a quotation and whose quote is 
represented by the disseminated CBOE best bid or offer (``BBO'') shall 
be eligible to receive allocations of incoming electronic orders for up 
to the size of its quote, in accordance with the principles described 
below. As an initial matter, if the number of contracts represented in 
the disseminated quote is less than the number of contracts in an 
incoming electronic order(s), the incoming electronic order(s) shall 
only be entitled to receive a number of contracts up to the size of the 
disseminated quote, in accordance with Rule 6.45B(a)(ii)(B). The 
balance of the electronic order will be eligible to be filled at the 
refreshed quote either electronically (in accordance with paragraph 
(a)(ii)(B) below) or manually (in accordance with Rule 6.45B(b)) and, 
as such, may receive a split price execution.

(A) Priority of Orders in the Electronic Book

    (1) Public Customer Orders: Public customer orders in the 
electronic book have priority. Multiple public customer orders in the 
electronic book at the same price are ranked based on time priority. If 
a public customer order(s) in the electronic book matches, or is 
matched by, a market participant quote, the public customer order(s) 
shall have priority, and the balance of the incoming order, if any, 
will be allocated pursuant to Rule 6.45B(a)(ii).
    (2) Broker-dealer Orders: If pursuant to Rule 7.4(a) the 
appropriate Exchange procedures committee determines to allow certain 
types of broker-dealer orders to be placed in the electronic book, then 
for purposes of this rule, the cumulative number of broker-dealer 
orders in the electronic book at the best price shall be deemed one 
``market participant'' regardless of the number of broker-dealer orders 
in the book. The allocation due the broker-dealer orders in the 
electronic book by virtue of their being deemed a ``market 
participant'' shall be distributed among each broker-dealer order 
comprising the ``market participant'' pursuant to Rule 6.45B(a)(ii)(B).

(B) Allocation

    (1) Market Participant Quoting Alone at BBO: When a market 
participant is quoting alone at the disseminated CBOE BBO and is not 
subsequently matched in the quote by other market participants prior to 
execution, it will be entitled to receive incoming electronic order(s) 
up to the size of its quote. If another market participant joins in the 
disseminated quote prior to execution of an incoming electronic 
order(s) such that more than one market participant is quoting at the 
BBO, incoming electronic order(s) will be distributed in accordance 
with (B)(2) below.
    (2) More than One Market Participant Quoting at BBO: When more than 
one market participant is quoting at the BBO, inbound electronic orders 
shall be allocated pursuant to the following allocation algorithm:

Allocation Algorithm
[GRAPHIC] [TIFF OMITTED] TN17MY05.004

    Where:
    Component A: The percentage to be used for Component A shall be an 
equal percentage, derived by dividing 100 by the number of market 
participants quoting at the BBO.
    Component B: Size Prorata Allocation. The percentage to be used for 
Component B of the Allocation Algorithm formula is that percentage that 
the size of each market participant's quote at the best price 
represents relative to the total number of contracts in the 
disseminated quote.
    Final Weighting: The final weighting formula, which shall be 
established by the appropriate Exchange procedures committee and may 
vary by product, shall be a weighted average of the percentages derived 
for Components A and B multiplied by the size of the incoming order. 
Changes made to the percentage weightings of Components A and B shall 
be announced to the membership via Regulatory Circular at least one day 
before implementation of the change.
    (C) Participation Entitlement: If a DPM, LMM, or e-DPM is eligible 
for an allocation pursuant to the operation of the Algorithm described 
in paragraph (a) of Rule 6.45B, the DPM, LMM, or e-DPM may be entitled 
to receive an

[[Page 28330]]

allocation (not to exceed the size of its quote) equal to either:
    (1) The greater of the amount it would be entitled to pursuant to 
the participation right established pursuant to Rule 8.87 or 8.15B (and 
Regulatory Circulars issued thereunder) or the amount it would 
otherwise receive pursuant to the operation of the Algorithm described 
above provided, however, that in calculating the DPM's or LMM's 
allocation under the Algorithm, DPMs or LMMs utilizing more than one 
membership in the trading crowd where the subject class is traded shall 
count as two market participants for purposes of Component A of the 
Algorithm; or
    (2) The amount it would be entitled to pursuant to the 
participation right established pursuant to Rule 8.87 or 8.15B (and 
Regulatory Circulars issued thereunder); or
    (3) The amount it would be entitled to receive pursuant to the 
operation of the Algorithm described above provided, however, that in 
calculating the DPM's or LMM's allocation under the Algorithm, DPMs or 
LMMs utilizing more than one membership in the trading crowd where the 
subject class is traded shall count as two market participants for 
purposes of Component A of the Algorithm. The appropriate Exchange 
procedures committee shall determine which of the preceding three 
entitlement formulas will be in effect on a class by class basis. All 
pronouncements regarding the entitlement formula shall be made via 
Regulatory Circular. The participation entitlement percentage is 
expressed as a percentage of the remaining quantity after all public 
customer orders in the electronic book have been executed.
    (b) Allocation of Orders Represented in Open Outcry: The allocation 
of orders that are represented in the trading crowd by floor brokers 
(including DPMs acting as agent under 8.85(b)) shall be as described 
below in subparagraphs (b)(i) and (b)(ii). With respect to subparagraph 
(b)(ii), the floor broker representing the order (including DPMs acting 
as agent under 8.85(b)) shall determine the sequence in which bids 
(offers) are made.

(i) Priority of Orders in the Electronic Book

    (A) Public Customer Orders: Public customer orders in the 
electronic book have priority. Multiple public customer orders in the 
electronic book at the same price are ranked based on time priority. If 
a public customer order(s) in the electronic book matches, or is 
matched by, an oral bid or offer provided by a member of the trading 
crowd, the public customer order(s) shall have priority and the balance 
of the order, if any, will be allocated in open outcry in accordance 
with paragraph (b)(ii).
    (B) Broker-dealer Orders: If pursuant to Rule 7.4(a) the 
appropriate Exchange procedures committee determines to allow broker-
dealer orders to be placed in the electronic book, then for purposes of 
this rule, the cumulative number of broker-dealer orders in the 
electronic book at the best price shall be deemed one ``book market 
participant'' regardless of the number of broker-dealer orders in the 
book. The allocation due the broker-dealer orders in the electronic 
book by virtue of their being deemed a ``book market participant'' 
shall be in accordance with paragraph (ii) below and shall be 
distributed among each broker-dealer order comprising the ``book market 
participant'' in accordance with the Allocation Algorithm formula 
described in paragraph 6.45B(a)(ii)(B).

(ii) Allocation

    (A) The highest bid (lowest offer) shall have priority
    (B) If two or more bids or offers represent the best price, each of 
which is NOT a book market participant, priority shall be afforded in 
accordance with the allocation principles contained in CBOE Rule 
6.45(a) or (b) and NOT Rule 6.45B(b).
    If two or more bids (offers) represent the best price, one of which 
represents a book market participant, priority shall be afforded to the 
market participants in the sequence in which their bids (offers) were 
made. Provided however that the first market participant to respond 
shall be entitled to 70% of the order. The second market participant to 
respond (if ascertainable) shall be entitled to 70% of the remainder of 
the order (i.e., 70% of 30%). The balance of the order shall be 
apportioned equally among the remaining market participants bidding 
(offering) at the same price and the book market participant (as 
defined in Rule 6.45B(b)(i)(B) above). If it is not possible to 
determine the order in which market participants responded, the balance 
of the order shall be apportioned equally among the remaining market 
participants bidding (offering) at the same price and, if applicable, 
the book market participant.
    In the event a market participant declines to accept any portion of 
the available contracts, any remaining contracts shall be apportioned 
equally among the other participants who bid (offered) at the best 
price (including the book market participant, if applicable) at the 
time the market was established until all contracts have been 
apportioned. The floor broker representing the order (including DPMs 
acting as agent under 8.85(b)) shall determine the sequence in which 
bids (offers) are made.

(iii) Exception: Complex Order Priority:

    A member holding a spread, straddle, or combination order (or a 
stock-option order or security future-option order as defined in Rule 
1.1(ii)(b) and Rule 1.1(zz)(b), respectively) and bidding (offering) on 
a net debit or credit basis (in a multiple of the minimum increment) 
may execute the order with another member without giving priority to 
equivalent bids (offers) in the trading crowd or in the electronic book 
provided at least one leg of the order betters the corresponding bid 
(offer) in the book. Stock-option orders and security future-option 
orders, as defined in Rule 1.1(ii)(a) and Rule 1.1(zz)(a), 
respectively, have priority over bids (offers) of the trading crowd but 
not over bids (offers) of public customers in the limit order book.

(c) Interaction of Market Participant's Quotes and/or Orders with 
Orders in Electronic Book

    Market participants, as defined in Rule 6.45B, may submit quotes or 
orders electronically to trade with orders in the electronic book. A 
floor broker market participant may only represent as agent customer 
orders or orders from unaffiliated broker-dealers. When a market 
participant's quote or order interacts with the order in the book, a 
trade occurs, CBOE will disseminate a last sale report, and the size of 
the book order will be decremented to reflect the execution. In the 
limited instance when the appropriate Exchange procedures committee has 
determined that the allocation of incoming electronic orders shall be 
pursuant to price-time priority as described in Rule 6.45B(a)(i), 
allocation of orders in the Electronic Book pursuant to this paragraph 
shall be based on time-priority (i.e., allocated to the first market 
participant to interact with the order in the book, up to the size of 
that market participant's order). In all other instances, the 
allocation of the book order shall be as follows:
    (i) One Market Participant Trades with the Electronic Book: If only 
one market participant submits an electronic order or quote to trade 
with an order in the electronic book, that market participant shall be 
entitled to receive an allocation of the order in the electronic book 
up to the size of the market participant's order.
    (ii) Multiple Market Participant Trade with the Electronic Book: 
Each market participant that submits an order or

[[Page 28331]]

quote to buy (sell) an order in the electronic book within a period of 
time not to exceed 5-seconds of the first market participant to submit 
an order (``N-second group'') shall be entitled to receive an 
allocation of the order in the electronic book pursuant to the 
following allocation algorithm:

Allocation Algorithm
[GRAPHIC] [TIFF OMITTED] TN17MY05.005

    Where:
    Component A: The percentage to be used for Component A shall be an 
equal percentage derived by dividing 100 by the number of market 
participants in the ``N-second group.''
    Component B: Size Prorata Allocation. The percentage to be used for 
Component B of the Allocation Algorithm formula is that percentage that 
each market participant of the ``N-second group's'' quote at the best 
price represents relative to the total number of contracts of all 
market participants of the ``N-second group.'' The appropriate Exchange 
procedures committee may determine that the maximum quote size to be 
used for each market participant in the Component B calculation shall 
be no greater than the cumulative size of orders resident in the 
electronic book at the best price at which market participants are 
attempting to buy (sell).
    Final Weighting: The final weighting formula, which shall be 
established by the appropriate Exchange procedures committee and may 
vary by product, shall be a weighted average of the percentages derived 
for Components A and B, multiplied by the size of the order(s) in the 
electronic book. Changes made to the percentage weightings of 
Components A and B shall be announced to the membership via Regulatory 
Circular at least one day before implementation of the change.
    Length of ``N-Second Group'' Timer: The appropriate Exchange 
procedures committee will determine the length of the ``N-second 
group'' timer on a class by class basis provided, however, that the 
duration of the ``N-second group'' timer shall not exceed five seconds. 
Any changes to the duration of the ``N-second group'' timer shall be 
announced via Regulatory Circular.
    (iii) Participation Entitlement: There is no DPM or LMM 
participation entitlement applicable to orders allocated pursuant to 
this paragraph (c).

(d) Quotes Interacting With Quotes

    (i) In the event that a Market-Maker's disseminated quotes interact 
with the disseminated quote(s) of other Market-Makers, resulting in the 
dissemination of a ``locked'' quote (e.g., $1.00 bid--1.00 offer), the 
following shall occur:
    (A) The Exchange will disseminate the locked market and both quotes 
will be deemed ``firm'' disseminated market quotes.
    (B) The Market-Makers whose quotes are locked will receive a quote 
update notification advising that their quotes are locked, unless the 
``counting period'' referenced below is set to zero seconds.
    (C) When the market locks, a ``counting period'' will begin during 
which Market-Makers whose quotes are locked may eliminate the locked 
market. Provided, however, that in accordance with subparagraph (A) 
above, a Market-Maker will be obligated to execute customer and broker-
dealer orders eligible for automatic execution pursuant to Rule 6.13 at 
his disseminated quote in accordance with Rule 8.51. If at the end of 
the counting period the quotes remain locked, the locked quotes will 
automatically execute against each other in accordance with the 
allocation algorithm described above in Rule 6.45B(a). The length of 
the counting period will be established by the appropriate Exchange 
procedures committee, may vary by product, and will not exceed one 
second.
    (ii) Inverted Quotes: The Hybrid System will not disseminate an 
internally crossed market (i.e., the CBOE best bid is higher than the 
CBOE best offer). If a Market-Maker submits a quote (``incoming 
quote'') that would invert an existing quote (``existing quote''), the 
Hybrid System will change the incoming quote such that it locks the 
first quote and sends a notice to the second Market-Maker indicating 
that its quote was changed. Locked markets are handled in accordance 
with paragraph (d)(i) above. During the lock period, if the existing 
quote is cancelled subsequent to the time the incoming quote is 
changed, the incoming quote will automatically be restored to its 
original terms.

Interpretations and Policies . . .

    .01 Principal Transactions: Order entry firms may not execute as 
principal against orders they represent as agent unless: (i) Agency 
orders are first exposed on the Hybrid System for at least thirty (30) 
seconds, (ii) the order entry firm has been bidding or offering for at 
least thirty (30) seconds prior to receiving an agency order that is 
executable against such bid or offer, or (iii) the order entry firm 
proceeds in accordance with the crossing rules contained in Rule 6.74.
    .02 Solicitation Orders. Order entry firms must expose orders they 
represent as agent for at least thirty (30) seconds before such orders 
may be executed electronically via the electronic execution mechanism 
of the Hybrid System, in whole or in part, against orders solicited 
from members and non-member broker-dealers to transact with such 
orders.

Rule 7.4 Obligations for Orders

(a) Eligibility and Acceptance
    (1) Eligibility: Public customer orders are eligible for entry into 
the electronic book. Market participants, as defined in Rule 6.45A[(a)] 
or 6.45B, shall be eligible to submit orders for entry into the book. 
The appropriate FPC may determine on an issue-by-issue basis that the 
following types of orders may also be eligible for entry into the 
electronic book:
* * * * *
    (2) Acceptance: An Order Book Official (``OBO'') shall ordinarily 
be expected to accept orders for all option contracts of the class or 
classes to which his appointment extends that are properly submitted 
for entry into the electronic book. An Order Book Official shall not 
accept orders from any source other than a member or, with respect to 
orders submitted through the Intermarket Options Linkage in index 
options classes on the Hybrid Trading System that are not assigned to a 
DPM, from an exchange (other than CBOE) that is a participant in the 
Intermarket Options Linkage Plan. For the purposes

[[Page 28332]]

of this rule, an order shall be deemed to be from a member if the order 
is placed with an Order Book Official by a person associated with a 
member or through the telecommunications system of a member firm.
    For Index option classes on the Hybrid Trading System that are not 
assigned a DPM, the OBO shall be responsible for (1) routing linkage 
Principal Acting as Agent (P/A) Orders and Satisfaction orders 
(utilizing the LMM's account for the benefit of an underlying order) to 
other markets based on prior written instructions that must be provided 
by the LMM to the OBO; (2) handling all linkage orders or portions of 
linkage orders received by the Exchange that are not automatically 
executed.
    (b) Types of Orders. Orders which may be placed with an Order Book 
Official or directly into the electronic book, shall include the 
following:
    (i)-(iii) No change.
    (iv) Orders from market participants (as defined in Rule 
6.45A[(a)(2)] or 6.45B).
    (c)-(g) No change.
Interpretations and Policies . . .
    .01-.05 No change.
    .06 Electronic execution of certain orders on the Exchange's 
electronic limit order book is provided for under sub-paragraphs 
(d)(iv) and (v) of Rule 6.8, subparagraphs (a)-(d) of Rules 6.45A and 
6.45B, and subparagraph (b) of Rule 6.13.

Rule 8.14 Index Hybrid Trading System Classes: Market-Maker 
Participants

    (a) Generally: The Exchange procedures committee may authorize for 
trading on the CBOE Hybrid Trading System or Hybrid 2.0 Program index 
options and options on ETFs currently trading on the Exchange. The 
appropriate Exchange procedures committee shall determine the eligible 
categories of market maker participants for option classes currently 
trading on the Exchange, which may include:
    Designated Primary Market-Makers (``DPM''): Market makers as 
defined in Rule 8.80 whose activities are governed by, among other 
rules, CBOE Rules 8.80-8.91.
    Lead Market-Makers (``LMM''): Market makers as defined in Rule 
8.15A whose activities are governed by, among other rules, CBOE Rule 
8.15A.
    Electronic DPMs (``e-DPM''): Market makers as defined in Rule 8.92 
whose activities are governed by, among other rules, CBOE Rules 8.92-
8.94.
    Market-Makers (``MM''): Market makers as defined in Rule 8.1 whose 
activities are governed by, among other rules, CBOE Rules 8.1-8.11.
    (b) Each class designated by the appropriate Exchange committee for 
trading on Hybrid or the Hybrid 2.0 Platform shall have an assigned DPM 
or LMM. The appropriate Exchange committee may determine to designate 
classes for trading on Hybrid or the Hybrid 2.0 Platform without a DPM 
or LMM provided the following conditions are satisfied:
    1. There are at least four (4) market makers quoting in the class;
    2. Each market maker with an appointment in the class is subject to 
the continuous quoting obligations imposed by CBOE Rule 8.7(d);
    3. In the event CBOE activates request-for-quote (``RFQ'') 
functionality in index classes, each MM will have an obligation to 
respond to that percentage of RFQs as determined by the appropriate 
Exchange procedures committee, provided however, that such percentage 
shall not be less than 80%. Regarding RFQ responses:
    (i) MMs must comply with the bid-ask differential contained in Rule 
8.7(b)(iv).
    (ii) Responses must be submitted within the amount of time 
specified by the appropriate Exchange procedures committee from the 
time the RFQ is entered.
    (iii) Responses must be for a minimum of ten contracts or a size 
specified by the appropriate Exchange procedures committee, whichever 
is greater.
    (iv) MMs responding to an RFQ must maintain a continuous market in 
that series for a subsequent 30-second period (or for some other time 
specified by the appropriate EPC) or until his/her quote is filled in 
its entirety. A MM may change his/her quotes during this 30-second 
period but he/she may not cancel them without replacing them. If the MM 
does cancel without replacing the quote his/her response to the RFQ 
will not count toward the MM's response rate requirement set forth 
above. A MM will be considered to have responded to the RFQ if he/she 
has a quote in the market for the series at the time the RFQ is 
received and he/she maintains it for the appropriate period of time.
    4. In order to allow a multiply-listed product trade without a DPM 
or LMM, the Exchange must amend its Market-Maker obligation rules (and 
receive Commission approval thereof) to indicate how orders will be 
submitted to other exchanges on behalf of Market-Makers in accordance 
with the Intermarket Options Linkage Plan requirements.

Rule 8.15 Lead Market Makers and Supplemental Market Makers in Non-
Hybrid Classes

    No change.

Rule 8.15A Lead Market Makers in Hybrid Classes

    (a) Assignment, Removal, and Evaluation of LMMs: The appropriate 
Market Performance Committee (the ``Committee'') may appoint one or 
more market makers in good standing with an appointment in an option 
class for which a DPM has not been appointed as Lead Market-Makers 
(``LMMs'').
    (i) LMMs shall be appointed on the first day following an 
expiration for a period of no less than one month (``expiration 
month'') and may be assigned to a class with one or more LMMs.
    A. Factors to be considered by the Committee in selecting LMMs 
include: adequacy of capital, experience in trading index options or 
options on ETFs, presence in the trading crowd, adherence to Exchange 
rules and ability to meet the obligations specified below. An 
individual may be appointed as an LMM for one expiration month at a 
time. When individual members are associated with one or more other 
members, only one member may receive an LMM appointment.
    B. Removal of LMMs may be effected by the Committee on the basis of 
the failure of one or more LMMs assigned to the class to meet the 
obligations set forth below, or any other applicable Exchange rule. An 
LMM removed under this rule may seek review of that decision under 
Chapter XIX of the Rules.
    C. If one or more LMMs are removed or if for any reason an LMM 
shall no longer be eligible for or shall resign his appointment or 
shall fail to perform his duties, the Committee may appoint an interim 
LMM to complete the monthly obligations of the former LMM.
    D. The Committee shall review and evaluate the conduct of LMMs, 
including but not limited to compliance with Rules 8.1, 8.2, 8.3, and 
8.7 and may hold all LMMs responsible for the performance of each LMM 
in the class.
    (b) LMM Obligations: LMMs are required to:
    (i) Provide continuous market quotations that comply with the bid/
ask differentials permitted by Rule 8.7(b) in 90% of the option series 
within their assigned classes;
    (ii) Assure that each of its displayed market quotations is honored 
for at least the number of contracts prescribed pursuant to Rule 8.51;
    (iii) Perform the above obligations for a period of one expiration 
month

[[Page 28333]]

commencing on the first day following an expiration. Failure to perform 
such obligations for such time may result in suspension of up to three 
months from trading in all series of the option class;
    (iv) Participate in the Hybrid Opening System; and
    (v) Respond to any open outcry request for quote by a floor broker 
with a two-sided quote complying with the current quote width 
requirements of Rule 8.7(b)(iv) for a minimum of ten contracts for non-
broker-dealer orders and one contract for broker-dealer orders.
    (vi) Act as agent for orders routed to other exchanges that are 
participants in the Intermarket Options Linkage Plan. The LMM's account 
shall be used for P/A and Satisfaction orders routed by the Order Book 
Official for the benefit of an underlying order, and the LMM shall be 
responsible for any charges incurred from the execution of such orders. 
LMMs shall also provide written instructions to Order Book Officials 
regarding the routing of P/A and Satisfaction orders.

8.15B Participation Entitlement of LMMs

    (a) The appropriate Market Performance Committee may establish, on 
a class by class basis, a participation entitlement formula that is 
applicable to LMMs.
    (b) To be entitled to a participation entitlement, the LMM must be 
quoting at the best bid/offer on the Exchange and the LMM may not be 
allocated a total quantity greater than the quantity for which the LMM 
is quoting at the best bid/offer on the Exchange. The participation 
entitlement is based on the number of contracts remaining after all 
public customer orders in the book at the best bid/offer on the 
Exchange have been satisfied.
    (c) The LMM participation entitlement shall be: 50% when there is 
one Market-Maker also quoting at the best bid/offer on the Exchange; 
40% when there are two Market-Makers also quoting at the best bid/offer 
on the Exchange; and, 30% when there are three or more Market-Makers 
also quoting at the best bid/offer on the Exchange. If more than one 
LMM is entitled to a participation entitlement, such entitlement shall 
be distributed equally among all eligible LMMs provided, however, that 
an LMM may not be allocated a total quantity greater than the quantity 
for which the LMM is quoting at the best bid/offer on the Exchange.
    The appropriate Market Performance Committee may determine, on a 
class-by-class basis, to decrease the LMM participation entitlement 
percentages from the percentages specified in paragraph (c). Such 
changes will be announced to the membership in advance of 
implementation via Regulatory Circular.
* * * * *
* * * * *

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, as 
amended. 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 Exchange currently trades equity options, index options, and 
options on exchange-traded funds (``ETFs'') on its Hybrid Trading 
System (``Hybrid''). Currently, one prerequisite for trading a class on 
Hybrid, that there be a DPM assigned to the class, prevents the 
Exchange from introducing Hybrid into those classes in which there is 
no DPM. The Exchange states that the purpose of this rule filing is to 
extend the Hybrid trading rules to classes of index options and options 
on ETFs (collectively, ``index classes'') without an assigned DPM. In 
this regard, the proposal would allow the trading of these index 
classes on Hybrid either with a DPM, a LMM, or without a DPM or LMM in 
classes where there are a requisite number of assigned MMs.

I. Trading Without an LMM or DPM

    The Exchange proposes to adopt new CBOE Rule 8.14 to specify the 
permitted categories of market participants in index classes. The 
proposed rule allows the appropriate Exchange procedures committee 
(``EPC''), for classes currently trading on the Exchange, to authorize 
for trading on the CBOE Hybrid Trading System or Hybrid 2.0 Program 
index options and options on ETFs. Additionally, the appropriate EPC 
would determine the eligible categories of market maker participants 
for each of these option classes currently trading on the Exchange, 
which may include DPMs, LMMs, Electronic DPMs (``e-DPMs''), and MMs.\5\ 
In this regard, the Exchange believes that the appropriate EPC is in 
the best position to determine which trading platform (Hybrid or Hybrid 
2.0) maximizes the competitive position of the Exchange and, 
accordingly, would make this determination along with the determination 
of which categories of market participants will trade in the product.
---------------------------------------------------------------------------

    \5\ CBOE Rule 8.1 provides that the term ``Market-Maker'' 
includes Remote Market-Makers, as defined in CBOE Rule 8.4.
---------------------------------------------------------------------------

    Proposed paragraph (b) of CBOE Rule 8.14 also provides that each 
class designated for trading on Hybrid must have a DPM or LMM assigned 
to it, unless there are at least four (4) MMs quoting in the class and 
each MM that has an appointment in the class is subject to the 
continuous quoting obligations imposed by CBOE Rule 8.7(d).\6\ In those 
classes in which there is no DPM or LMM, the proposed rule provides 
that in the event the CBOE activates request-for-quote (``RFQ'') 
functionality, each MM would have an obligation to respond to that 
percentage of RFQs as determined by the appropriate EPC provided, 
however, that such percentage shall not be less than 80%. The following 
requirements would be applicable to RFQ responses: \7\
---------------------------------------------------------------------------

    \6\ CBOE Rule 8.7(d) governs the quoting obligations for MMs in 
Hybrid classes.
    \7\ These requirements are based on similar requirements 
contained in CBOE Rule 44.4(b).
---------------------------------------------------------------------------

     MMs must comply with the bid-ask differential contained in 
CBOE Rule 8.7(b)(iv);
     Responses must be submitted within the amount of time 
specified by the appropriate EPC from the time the RFQ is entered;
     Responses must be for a minimum of ten (10) contracts or a 
size specified by the appropriate EPC, whichever is greater; and
     MMs responding to an RFQ must maintain a continuous market 
in that series for a subsequent 30-second period (or for some other 
time specified by the appropriate EPC) or until his/her quote is filled 
in its entirety. A MM may change his/her quotes during this 30-second 
period but may not cancel them without replacing them. If the MM does 
cancel without replacing the quote, his/her response to the RFQ would 
not count toward the MM's response rate requirement set forth above. A 
MM would be considered to have responded to the RFQ if he/she has a 
quote in the market for the series at the time the RFQ is received and 
he/she maintains it for the appropriate period of time.

[[Page 28334]]

    Proposed CBOE Rule 8.14(b)(4) provides that in order to allow a 
multiply-listed product trade without a DPM or LMM, the Exchange will 
need to amend its Market-Maker obligation rules (and receive Commission 
approval thereof) to indicate how orders will be submitted to other 
exchanges on behalf of Market-Makers in accordance with the Intermarket 
Options Linkage Plan requirements.

II. Index Classes Trading With an LMM: LMM Obligations

    The Exchange operates an LMM system in several index classes. 
Current CBOE Rule 8.15, Lead Market-Makers and Supplemental Market-
Makers, governs the LMM appointment process and imposes obligations 
upon LMMs. The Exchange proposes to adopt new CBOE Rule 8.15A, Lead 
Market Makers in Hybrid Classes, which mimics current CBOE Rule 8.15 
with few changes. \8\ As an initial matter, the Exchange eliminates 
reference to Supplemental Market-Makers as they would not exist in 
Hybrid. Next, with respect to appointments of LMMs, the Exchange 
eliminates all references in the proposed rules to ``zones'' as LMMs in 
Hybrid would not be assigned to zones. Instead, there would only be one 
LMM at any time in a particular class. The Exchange anticipates that, 
in any given class, there may be several approved LMMs; however, only 
one LMM would function at any given time. Current CBOE Rule 8.15(b) 
governs LMM obligations and the Exchange proposes to adopt similar 
obligations in proposed paragraph (b) of CBOE Rule 8.15A. In this 
regard, the Exchange proposes to adopt in paragraph (b)(i) of proposed 
CBOE Rule 8.15A a continuous quoting obligation to mandate LMMs in a 
class to quote a legal width market in 90% of the option series. This 
requirement would apply at all times, not just during the opening 
rotation. Proposed paragraph (b)(ii) would obligate LMMs to assure that 
their displayed market quotations are honored for at least the number 
of contracts prescribed pursuant to CBOE Rule 8.51 (i.e., the firm 
quote rule). Proposed paragraph (b)(iii) requires an LMM to perform the 
above obligations for a period of one (1) expiration month commencing 
on the first day following an expiration. Failure to perform such 
obligations for such time may result in suspension of up to three (3) 
months from trading in all series of the option class. Proposed 
paragraph (b)(iv) requires LMMs to participate in the Hybrid Opening 
System (as described in CBOE Rule 6.2B). As such, LMMs would be 
required to submit quotes during the opening rotation. Proposed 
paragraph (v) requires LMMs to respond to any open outcry request for 
quote by a floor broker with a two-sided quote complying with the 
current quote width requirements of CBOE Rule 8.7(b)(iv) for a minimum 
of ten (10) contracts for non-broker-dealer orders and one (1) contract 
for broker-dealer orders.
---------------------------------------------------------------------------

    \8\ The Exchange proposes to amend CBOE Rule 8.15 to limits its 
application to non-Hybrid classes.
---------------------------------------------------------------------------

    The Exchange also proposes to modify rules to accommodate trading 
in multiply listed classes that would be subject to the Intermarket 
Options Linkage. DPMs currently handle linkage functions with respect 
to routing of linkage orders to other markets on behalf of customer 
orders and representing inbound linkage orders from other markets that 
are not automatically executed on the CBOE. The Exchange believes the 
DPMs linkage obligations can be carried out by Order Book Officials 
(``OBOs'') and LMMs for Index option classes on the Hybrid Trading 
System that are assigned an LMM. The Exchange states that, in essence, 
OBOs would represent inbound linkage order and would be responsible for 
transmitting outbound linkage orders on behalf of underlying customer 
orders but would do so using the LMMs trading account and with 
instruction and input from the LMM. An LMM, as opposed to a DPM, 
currently does not have agency obligations. For this reason, the 
Exchange proposes to add an LMM obligation in proposed paragraph (vi) 
of proposed CBOE Rule 8.15A to require an LMM, in multiply-listed 
products, to act as agent for orders routed to other exchanges that are 
participants in the Intermarket Options Linkage Plan.\9\ The proposed 
paragraph also provides that an LMM's account would be used for 
Principal Acting as Agent (``P/A'') and Satisfaction orders routed by 
the OBO for the benefit of an underlying customer order, and the LMM 
would be responsible for any charges incurred from the execution of 
such orders.
---------------------------------------------------------------------------

    \9\ See Securities Exchange Act Release No. 43086 (July 28, 
2000), 65 FR 48023 (Aug. 4, 2000) (order approving the Options 
Intermarket Linkage Plan submitted by the American Stock Exchange 
LLC, CBOE, and International Securities Exchange LLC (``ISE'')).
---------------------------------------------------------------------------

    The Exchange proposed to make a corresponding change to CBOE Rule 
7.4(a)(2) to permit OBOs to receive Linkage orders from exchanges that 
are participants in the Intermarket Options Linkage Plan (other than 
CBOE).\10\ In this regard, the proposed change to CBOE Rule 7.4(a)(2) 
also provide that, for Index option classes on the Hybrid Trading 
System that are not assigned a DPM, the OBO shall be responsible for 
(1) routing linkage P/A and Satisfaction orders (utilizing the LMM's 
account) to other markets based on prior written instructions that must 
be provided by the LMM to the OBO; and (2) handling all linkage orders 
or portions of linkage orders received by the Exchange that are not 
automatically executed. This proposed amendment to CBOE Rule 7.4(a)(2) 
provides OBOs with the ability to route outbound linkage orders to 
other exchanges and to handle inbound linkage orders received from 
other exchanges. In this regard, orders routed by the OBO in accordance 
with this rule would be routed in accordance with written instructions 
provided by the LMM.\11\ With respect to handling inbound linkage 
orders, OBOs would handle only those orders that do not automatically 
execute via the Exchange's systems. The CBOE notes that the vast 
majority of inbound linkage orders that receive executions are 
automatically executed.
---------------------------------------------------------------------------

    \10\ The Exchange makes minor changes to CBOE Rules 7.4(a)(1) 
and (b)(iv), and Interpretations and Policies .06 thereto, to 
include references to CBOE Rule 6.45B in each place where CBOE Rule 
6.45A is mentioned.
    \11\ All linkage fees incurred for routing P/A and Satisfaction 
orders for the benefit of underlying orders would be borne by the 
LMM.
---------------------------------------------------------------------------

    There are some obligations currently applicable in CBOE Rule 8.15 
that the Exchange does not propose to adopt in CBOE Rule 8.15A. First, 
the Exchange proposes not to adopt the requirement that an LMM 
facilitate imbalances of customer orders in all series.\12\ Instead, 
the Exchange proposes to replace this obligation with a requirement 
that LMMs respond to any open outcry RFQ with a two-sided legal-width 
quote. In practice, LMMs facilitate order imbalances in open outcry. 
Accordingly, the Exchange believes that obligating an LMM to respond to 
all floor broker RFQs should achieve the same result. Second, the 
Exchange also proposes to not adopt in CBOE Rule 8.15A the language 
contained in CBOE Rule 8.15(d). CBOE Rule 8.15(d) operates under the 
assumption that only the LMM disseminates a quote, for which the entire 
trading crowd is required under CBOE Rule 8.51 to be firm. In a Hybrid 
system, each MM posts its own quotes, hence there is no need for MMs to 
know which variables an LMM uses in its pricing calculation.
---------------------------------------------------------------------------

    \12\ CBOE Rule 8.15(b)(2).
---------------------------------------------------------------------------

III. LMM Participation Entitlement

    Today, LMMs do not receive participation entitlements nor does CBOE 
Rule 8.87 address granting a participation entitlement to LMMs.

[[Page 28335]]

Because LMMs serve in much the same capacity as a DPM and perform many 
of the same functions as an e-DPM, the Exchange believes that it is 
reasonable to allow the LMM to receive a participation entitlement. 
Accordingly, the Exchange proposes to adopt new CBOE Rule 8.15B, 
Participation Entitlement of LMMs, which is based on CBOE Rule 8.87, 
Participation Entitlement of DPMs and e-DPMs.
    As proposed, paragraph (a) would allow the appropriate Market 
Performance Committee to establish, on a class by class basis, a 
participation entitlement formula that is applicable to LMMs. Proposed 
paragraph (b) states that, to be entitled to a participation 
entitlement, the LMM must be quoting at the best bid/offer on the 
Exchange and the LMM may not be allocated a total quantity greater than 
the quantity for which the LMM is quoting at the best bid/offer on the 
Exchange.\13\
---------------------------------------------------------------------------

    \13\ The participation entitlement is based on the number of 
contracts remaining after all public customer orders in the book at 
the best bid/offer on the Exchange have been satisfied.
---------------------------------------------------------------------------

    Paragraph (c) establishes the percentages of the participation 
entitlement at the same levels currently in effect in CBOE Rule 8.87, 
which means that the LMM participation entitlement shall be: 50% when 
there is one Market-Maker also quoting at the best bid/offer on the 
Exchange; 40% when there are two Market-Makers also quoting at the best 
bid/offer on the Exchange; and 30% when there are three or more Market-
Makers also quoting at the best bid/offer on the Exchange. If more than 
one LMM is entitled to a participation entitlement, such entitlement 
shall be distributed equally among all eligible LMMs provided, however, 
that an LMM may not be allocated a total quantity greater than the 
quantity for which the LMM is quoting at the best bid/offer on the 
Exchange.
    Finally, proposed paragraph (c) also allows the appropriate Market 
Performance Committee (``MPC'') to determine, on a class-by-class 
basis, to decrease the LMM participation entitlement percentages from 
the percentages specified in paragraph (c). The Exchange believes that 
this ability to decrease the participation entitlement is more 
important on the index product side, where trading crowds often are 
significantly larger than they are on the equity side. For example, 
awarding an LMM a 30% entitlement in a product with 100 quoters could 
be disproportionate. For this reason, the appropriate MPC may lower the 
percentages. Any such reductions would be announced to the membership 
via Regulatory Circular in advance of implementation. The Exchange 
states that, in the unlikely event the Exchange seeks to increase the 
participation entitlement, obviously it will submit a ``regular-way'' 
rule filing to the Commission.
    The Exchange believes it is reasonable to grant LMMs a 
participation entitlement for several reasons, chief among them being 
the LMM would perform many of the same functions that DPMs perform. 
First, an LMM, like a DPM, has enhanced quoting obligations, as 
evidenced by the proposed 90% continuous quoting obligation. In this 
regard, MMs have only a 60% continuous quoting obligation, which means 
that LMMs must quote 50% more series than MMs.\14\ Second, an LMM's 
proposed obligations are as stringent as are those of e-DPMs, who also 
receive participation entitlements. In this regard, e-DPMs, who share 
in the participation entitlement pursuant to CBOE Rule 8.87, have the 
same 90% continuous quoting obligation as proposed herein for LMMs.\15\ 
Third, LMMs are required to participate in the Hybrid Opening System in 
the same fashion as DPMs, while there is no such requirement for MMs. 
These heightened obligations justify the granting of a participation 
entitlement to LMMs.
---------------------------------------------------------------------------

    \14\ Mathematically, a 90% quoting obligation is 50% greater 
than a 60% quoting obligation ((90-60)/60).
    \15\ See CBOE Rule 8.93(i).
---------------------------------------------------------------------------

IV. Allocation of Trades

    Current CBOE Rule 6.45A governs the allocation of trades on the 
Hybrid System. The Exchange proposes to adopt new CBOE Rule 6.45B, 
which is substantially similar in most respects to CBOE Rule 6.45A, and 
restrict its application to index classes. The Exchange proposes to 
amend current CBOE Rule 6.45A, therefore, to limit its applicability to 
equity classes only.

A. Allocation of Incoming Electronic Orders: CBOE Rule 6.45B(a)

    Regarding the allocation of incoming electronic orders, CBOE Rule 
6.45B(a) provides the appropriate EPC with the ability to adopt on a 
class by class basis one of two allocation models, both of which have 
been approved by the Commission in different contexts. The first 
allocation model is a scaled-down version of the Exchange's Screen-
Based Trading (``SBT'') Rule 43.1, while the second allocation model is 
the Exchange's current Ultimate Matching Algorithm (``UMA''). The 
Exchange believes it appropriate for the EPC to make these 
determinations because it has the greatest familiarity with the trading 
dynamics of each product under its jurisdiction, which makes it best-
positioned to determine which allocation model to utilize in order to 
enhance the competitiveness of the Exchange in that product.\16\ For 
example, the EPC may determine that trading of a particular product 
would be enhanced by utilizing a strict price-time allocation model. At 
the same time, the EPC may determine that a second index product, which 
perhaps does not trade as actively as the first index product, may be 
better suited to using UMA for its allocation model. The ability to 
choose from several allocation models provides flexibility to the EPC 
to choose the allocation model it believes is best-suited for a 
particular product.
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    \16\ The ``trading dynamics'' of a particular product refers to 
numerous factors including, but not limited to: Type of order flow 
(customer vs. institutional); size of order flow (small vs. large); 
and where execution occurs (in open outcry or electronically).
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1. CBOE Rule 6.45B(a)(i): Price-Time or Pro-Rata Priority
    The first allocation model comes from the Exchange's SBT rules and 
is substantially reproduced in proposed paragraph (a)(i). Pursuant to 
this model, the Exchange may on a class by class basis adopt either a 
price-time or pro-rata allocation model.\17\ Accordingly, the EPC 
committee would determine whether to utilize a price-time model in 
which the first quote or order at the best price has priority. 
Alternatively, the committee may determine to utilize a pro-rata 
priority model whereby the size of an individual's allocation of an 
incoming order is a function of the relative size of his/her quote/
order compared to all others at the same price.
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    \17\ See CBOE Rule 43.1(a)(1) (price-time priority) and (a)(2) 
(pro rata priority). The ISE utilizes a pro rata priority model for 
market-makers and non-customers (see ISE Rule 713.01) while the 
Boston Options Exchange (``BOX'') utilizes the price-time priority 
model (see BOX Trading Rules, Chapter V, Sec. 16).
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    Additionally, the Exchange may determine to utilize one or two 
priority overlays in any class using a price-time or pro-rata 
allocation model: Public customer priority \18\ or participation 
entitlement priority.\19\ A priority overlay functions as an exception 
to the general priority rule in effect. Under the public customer 
overlay, public customers have priority over all others, and multiple 
public customer orders are

[[Page 28336]]

ranked based on time priority. Under the participation entitlement 
overlay, DPMs/e-DPMs/LMMs at the best price receive their participation 
entitlement provided their order/quote is at the best price on the 
Exchange.
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    \18\ See CBOE Rule 43.1(b)(1). Under the public customer 
priority model, public customers at the highest bid or lowest offer 
will have priority over non-public customers at the same price.
    \19\ See CBOE Rule 43.1(b)(3) (trade participation right 
priority).
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    As an example, in a class using price-time priority with a public 
customer priority overlay, the first order/quote at the best price has 
priority, unless there is a public customer order at that best price, 
in which case the public customer moves to the front of the line and 
takes priority (up to the size of his/her order). In this example, 
after the public customer order is satisfied, any remainder of the 
order would be allocated using the price-time priority principles.
    Both priority overlays may be in effect in a particular class at 
one time or, alternatively, neither need be operational. The 
participation right overlay is akin to the DPM participation 
entitlement. In determining which overlays would be in effect, the EPC 
is bound by the requirement that it may not offer a participation 
entitlement unless it also offers public customer priority and that the 
public customer priority overlay applies before the participation 
entitlement does.\20\
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    \20\ See proposed CBOE Rule 6.45B(a)(i)(2)(D).
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2. CBOE Rule 6.45B(a)(ii): UMA
    Under the proposal, the appropriate EPC would have the ability to 
use the allocation method currently used in all classes trading on 
Hybrid. When a market participant is quoting alone at the disseminated 
CBOE BBO and is not subsequently matched in the quote by other market 
participants prior to execution, it would be entitled to receive 
incoming electronic order(s) up to the size of its quote. In this 
respect, market participants quoting alone at the BBO have priority. 
When more than one market participant is quoting at the BBO, inbound 
electronic orders shall be allocated pursuant to UMA. UMA rewards 
market participants quoting at the best price with allocations of 
incoming orders. The UMA formula is a weighted average consisting of 
two components, one based on the number of participants quoting at the 
best price (Component A), and the second based on the relative size of 
each participant's quote (Component B), as described below.
    Component A: This is the parity component of UMA. In this 
component, UMA treats as equal all market participants quoting at the 
relevant best bid or best offer (or both). Accordingly, the percentage 
used for Component A is an equal percentage, derived by dividing 100 by 
the number of market participants quoting at the best price. For 
instance, if there are four (4) market participants quoting at the best 
price, each is assigned 25% for Component A (or 100/4). This component 
rewards and incents market participants that quote at a better price 
than do their counterparts even if they quote for a smaller size.
    Component B: This size prorata component is designed to reward and 
incent market participants to quote with size. As such, the percentage 
used for Component B of the Allocation Algorithm formula is that 
percentage that the size of each market participant's quote at the best 
price represents relative to the total number of contracts in the 
disseminated quote. For example, if the disseminated quote represents 
the quotes of market makers X, Y, and Z who quote for 20, 30, and 50 
contracts respectively, then the percentages assigned under Component B 
are 20% for X, 30% for Y, and 50% for Z.
    Final Weighting: The final weighting, which shall be determined by 
the appropriate EPC, shall be a weighted average of the percentages 
derived for Components A and B multiplied by the size of the incoming 
order. Initially, the weighting of Components A and B shall be equal, 
represented mathematically by the formula: ((Component A Percentage + 
Component B Percentage)/2) * incoming order size.
    Under current CBOE Rule 6.45A, the appropriate index floor 
procedures committee has the ability, for index options and options on 
ETFs, to vary the weights of Components A and B on a product by product 
basis.\21\ Proposed CBOE Rule 6.45B retains this flexibility. All other 
aspects of the UMA methodology remain unchanged, with the exception of 
the participation entitlement, as described below.
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    \21\ The Exchange proposes to delete this section from current 
CBOE Rule 6.45A and move it to CBOE Rule 6.45B.
---------------------------------------------------------------------------

    Currently, the appropriate committee establishes the participation 
entitlement methodology, which generally must be either: the 
entitlement percentage established by CBOE Rule 8.87 or the greater of 
the DPM's (or e-DPM's) UMA share or the amount the DPM/e-DPM would be 
entitled to by virtue of CBOE Rule 8.87.\22\ The Exchange proposes in 
CBOE Rule 6.45B(a)(ii)(C) to retain this provision (simply adding 
references to LMMs) and to add a third alternative, which would allow 
the Exchange to not award a participation entitlement.\23\ In this 
regard, proposed paragraph (a)(ii)(C) incorporates this change by 
stating that the amount of the DPM's (or LMM's or e-DPM's) entitlement 
would be equal to the amount it otherwise would receive by virtue of 
the operation of UMA. Aside from this change, the proposed 
participation entitlement as it relates to the allocation of incoming 
electronic orders pursuant to UMA would operate the same as it does 
today.
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    \22\ See current CBOE Rule 6.45A(a)(i)(C).
    \23\ The Exchange also amends the references to CBOE Rule 8.87 
to include references to new CBOE Rule 8.15B. As such, CBOE Rule 
8.87 will govern participation entitlements for DPMs and e-DPMs 
while new CBOE Rule 8.15B will govern participation entitlements for 
LMMs. CBOE Rule 8.15B is discussed in greater detail supra.
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B. Allocation of Orders in Open Outcry

    With respect to the allocation of orders in the trading crowd, 
proposed CBOE Rule 6.45B(b) would govern. This rule is substantially 
similar to current CBOE Rule 6.45A(b). The section ``Allocation of 
Orders Represented in the Trading Crowd'' provides two alternative 
methods for allocating trades occurring in open outcry depending on 
whether there are any broker-dealer (``BD'') orders in the book.\24\ If 
there are no BD orders in the book when the trade occurs in open 
outcry, allocation would be as it is today (i.e., first to respond may 
take 100%). If, however, there are BD orders in the book, the rule 
provides an alternative allocation mode. The first person to respond in 
open outcry would be entitled to take up to 70% of the order, the 
second person to respond may take 70% of the balance, and all others 
who responded (including those in the book) shall participate in the 
remainder of the order pursuant to the UMA allocation methodology, as 
is currently the case. Throughout both methods, public customers have 
absolute priority.
---------------------------------------------------------------------------

    \24\ A broker-dealer order is an order for the account of a non-
public customer broker-dealer.
---------------------------------------------------------------------------

    The CBOE Hybrid System would continue to utilize the exception to 
the general priority rules for complex orders in index products. As 
such, the Exchange proposes to incorporate the existing provision 
contained in CBOE Rule 6.45(e) and 6.45A(b)(iii). Under this rule, a 
member holding a spread, straddle, or combination order (or a stock-
option order or security future-option order as defined in CBOE Rule 
1.1(ii)(b) and CBOE Rule 1.1(zz)(b), respectively) and bidding 
(offering) on a net debit or credit basis (in a multiple of the minimum 
increment) may execute the order with another member without giving 
priority to equivalent bids (offers) in the trading crowd or in the 
electronic book, provided at least one leg of the order betters the 
corresponding bid (offer) in the book. Stock-option orders and security 
future-option orders, as defined in CBOE Rule

[[Page 28337]]

1.1(ii)(a) and CBOE Rule 1.1(zz)(a), respectively, have priority over 
bids (offers) of the trading crowd but not over bids (offers) of public 
customers in the limit order book.

C. Interaction of Market Participant's Quotes/Orders With Orders in the 
Electronic Book

    The Exchange proposes to adopt CBOE Rule 6.45B(c) to govern the 
interaction of market participants' quotes or orders with orders in the 
book. This rule, with minor modifications, operates in the same manner 
as does existing CBOE Rule 6.45A(c), which governs the allocation of 
orders resting in the Exchange's electronic book (``book'' or 
``Ebook'') among market participants. Generally, under the existing 
rule, if only one market participant interacts with the order in the 
book, he/she would be entitled to full priority. If, however, more than 
one market participant attempts to interact with the same order in the 
book, a ``quote trigger'' process initiates. Under the quote trigger 
process, the first market participant to interact with the book order 
starts a counting period lasting N-seconds whereby each market 
participant that submits an order within that ``N-second period'' 
becomes part of the ``N-second group'' and is entitled to share in the 
allocation of that order via the formula contained in the rule.
    The Exchange proposes minor modifications to the operation of the 
current rule. First, the second paragraph of proposed section (c) 
provides that if the appropriate EPC has determined that the allocation 
of incoming electronic orders shall be pursuant to price-time priority 
as described in CBOE Rule 6.45B(a)(i), then the allocation of orders in 
the Electronic Book pursuant to paragraph (c) must also be based on 
time-priority (i.e., allocated to the first market participant to 
interact with the order in the book, up to the size of that market 
participant's order). In all other instances (i.e., when pro-rata 
priority or UMA is in effect), the allocation of the book order would 
be as it is today (i.e., allocation via the ``N-second group'').
    Second, whereas the N-second timer must be uniform across equity 
classes, this proposed rule allows for different durations on a class-
by-class basis. The sizes of index option trading crowds vary 
considerably, from perhaps five traders in a less-active class to more 
than one hundred traders in options on the S&P 500 (``SPX''). The 
Exchange states that a 5-second timer in the SPX could result in 
numerous traders executing against the same order, which could mean 
very small allocations and rounding nightmares. The ability to vary the 
timer would allow the EPC to set a considerably shorter time-period. 
The Exchange states that, as with equities, changes to the timers would 
be announced to the membership via Regulatory Circular.

D. Interaction of Market Participants' Quotes

    The Exchange also proposes to adopt CBOE Rule 6.45B(d) governing 
the interaction of quotes when they are locked. Because Hybrid allows 
for the simultaneous entry of quotes by multiple market participants, 
there would be instances in which quotes from competing market 
participants become locked. Currently, CBOE Rule 6.45A(d) provides that 
when the quotes of two market participants interact (i.e., ``quote 
lock''), either party has one (1) second during which it may move its 
quote without obligation to trade with the other party. If, however, 
the quotes remain locked at the conclusion of one second, the quotes 
trade in full against each other. Proposed CBOE Rule 6.45B(d) is based 
on the equity rule (CBOE Rule 6.45A(d)) with one modification relating 
to the length of the timer. The proposal allows the appropriate EPC to 
vary by product the length of the quote lock timer provided it does not 
exceed one (1) second.\25\ The ability to vary the timer by product is 
more important in an index setting where there are larger trading 
crowds than there are in an equity setting. In the event the 
appropriate committee determines to eliminate the timer (i.e., set it 
to zero seconds), the Exchange would not be required to send out the 
quote update notification otherwise required in paragraph (d)(i)(B).
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    \25\ Equity classes utilize a one-second timer across-the-board.
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    Additionally, the Exchange proposes to amend paragraph (e) to CBOE 
Rule 6.45A in order to remove references to expired dates. Finally, the 
Exchange removes reference to the listing of index options and options 
on ETFs, as this would now be addressed in the introductory paragraph 
of proposed CBOE Rule 6.45B.

V. Other Changes

A. HOSS: CBOE Rule 6.2B

    The Exchange proposes to amend certain aspects of its opening rule, 
CBOE Rule 6.2B, Hybrid Opening System (``HOSS''). HOSS establishes 
opening procedures and, today, only applies in classes in which there 
are DPMs. The changes proposed herein would allow HOSS to be utilized 
in classes in which there is either an LMM, DPM, or neither.
    The first change, to paragraph (a), provides that HOSS would accept 
orders and quotes for a period of time prior to 8:30 a.m. Central Time. 
The absence of an underlying security for index options necessitates 
this change. Similarly, the second change to paragraph (a) allows the 
opening process to begin after 8:30 a.m., as opposed to when the 
underlying security opens. The third change to paragraph (a) obligates 
the appointed LMM in the class to submit opening quotes. The purpose of 
this requirement is to ensure the existence of a quote so that the 
class may open. This is the same requirement that exists for DPMs.
    The Exchange proposes to amend paragraph (b) to provide that in 
classes without a DPM, an expected opening price would be calculated if 
there is a quote from either an LMM or MM in the class. This 
requirement recognizes that because a class may trade without a DPM or 
LMM, the opening procedure would need to operate with only quotes from 
MMs. Similarly, the proposed change to paragraph (e) provides that HOSS 
would not open a class unless there is a quote from either a MM or LMM 
with an appointment in the class. This is equivalent to the equities 
side, where a class will not open without a quote from the DPM.

B. CBOE Rules 6.1 and 6.2

    The Exchange also proposes to amend Interpretation and Policy .04 
to CBOE Rule 6.1 and Interpretation and Policy .01 to Rule 6.2 by 
inserting the term ``LMM'' next to every reference to DPM. As LMMs 
would perform essentially the same functions as DPMs, this change is 
necessary. The Exchange also proposes in CBOE Rule 6.2 to eliminate 
reference to the term ``Board Broker'' since there is no such person 
anymore.
2. Statutory Basis
    The Exchange proposes to list and trade on the Exchange's Hybrid 
System index options and options on ETFs without a DPM pursuant to 
allocation models that the Commission has previously approved. For the 
reasons stated above, the Exchange believes that the proposed rule 
change, as amended, is consistent with Section 6(b) of the Act \26\ in 
general, and furthers the objectives of Section 6(b)(5) \27\ in 
particular, in that it is designed to prevent fraudulent and 
manipulative acts, to promote just and equitable principles of trade 
and, in general, to protect investors and the public interest.
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    \26\ 15 U.S.C. 78f(b).
    \27\ 15 U.S.C. 78f(b)(5).

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[[Page 28338]]

B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change, as 
amended, 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

    No written comments were either solicited or received.

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

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

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act. 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-CBOE-2004-87 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-CBOE-2004-87. 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 Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of the CBOE. 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-CBOE-2004-87 and should be submitted on or before June 
7, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\28\
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    \28\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. E5-2441 Filed 5-16-05; 8:45 am]
BILLING CODE 8010-01-P