[Federal Register Volume 70, Number 106 (Friday, June 3, 2005)]
[Notices]
[Pages 32686-32689]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-2830]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51740; File No. SR-PCX-2005-64]


Self-Regulatory Organizations; Pacific Exchange, Inc.; Notice of 
Filing and Order Granting Accelerated Approval to a Proposed Rule 
Change and Amendment Nos. 1, 2, 3, and 4 Thereto Relating to the Market 
Maker Risk Limitation Mechanism

May 25, 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 May 2, 2005, the Pacific Exchange, Inc. (``PCX'' 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. On May 19, 2005, the PCX filed 
Amendment No. 1 to the proposed rule change.\3\ On May 23, 2005 the PCX 
filed Amendment No. 2 to the proposed rule change.\4\ On May 24, 2005 
the PCX filed Amendment No. 3 to the proposed rule change.\5\ On May 
24, 2005 the PCX filed Amendment No. 4 to the proposed rule change.\6\ 
The Commission is publishing this notice to solicit comments on the 
proposed rule change, as amended, from interested persons. In addition, 
the Commission is granting accelerated approval of the proposed rule 
change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No. 1, the PCX (a) added language to establish 
certain criteria regarding the use of the Market Maker Risk 
Limitation Mechanism and (b) added language to PCX Rule 6.37(g)(1), 
which governs quoting obligations of Lead Market Makers (``LMMs'').
    \4\ In Amendment No. 2, the PCX corrected certain typographical 
errors in the rule text and amended the proposed rule text of Rule 
6.37(g)(1) to delete an incorrect reference to proposed PCX Rule 
6.40(e).
    \5\ In Amendment No. 3, the PCX corrected certain typographical 
errors in the rule text.
    \6\ In Amendment No. 4, the PCX corrected certain typographical 
errors in Amendment No. 2.
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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 PCX Rule 6.40 to provide PCX Market 
Makers protection from the unreasonable risk associated with an 
excessive number of near simultaneous executions in a single options 
class through the implementation of a Market Maker Risk Limitation 
Mechanism. The text of the proposed rule change, as amended, is below. 
Proposed new language is in italics; proposed deletions are in 
[brackets].
Rule 6
Market Maker Risk Limitation Mechanism
    Rule 6.40 [Reserved.] (a) Trade Counter. The trading engine will 
maintain a ``trade counter'' for each Market Maker on each class to 
which the Market Maker is appointed. This trade counter will be 
incremented by one every time the Market Maker executes a trade on any 
series in the appointed class. The trade counter will automatically 
reset itself every ``n'' seconds.
    (b) Market Maker Risk Limitation Mechanism. The trading engine will 
activate the Market Maker Risk Limitation Mechanism on an appointed 
class whenever the following conditions are met: The trade counter has 
reached ``n'' executions against the quotes of the Market Maker in the 
Market Maker's appointed class during a period of ``n'' seconds. When 
the above conditions are met, the trading engine will automatically 
cancel all quotes posted by the Market Maker on that class by 
generating a ``bulk cancel'' message.
    (c) The bulk cancel message will be processed in time priority with 
any other quote or order message received by the trading engine. Any 
orders or quotes that matched with the Market Maker's quote and were 
received in the trading engine prior to the receipt of the bulk cancel 
message will be automatically executed. Orders or quotes received in 
the trading engine after receipt of the bulk cancel message will not be 
executed against the Market Maker.
    (d) Once the Market Maker Risk Limitation Mechanism has been 
activated for an options class, any bulk quote messages sent by the 
Market Maker on that class would continue to be rejected until the 
Market Maker submits a message to the trading engine to enable new 
quotes.
    (e) In the event that a Lead Market Maker's (``LMM'') quotes are 
cancelled and there are no other Market Makers

[[Page 32687]]

quoting in the issue, the trading engine will automatically provide 
two-sided legal quotes on behalf of the LMM until such time the LMM 
submits a message to the trading engine to enable new quotes. All 
quotes generated by the Exchange on behalf of an LMM will be considered 
``firm quotes'' and shall be the obligation of the LMM.
    (f) Each Market Maker that is quoting in an issue shall determine 
the appropriate trade counter threshold of ``n'' executions and the 
time period of ``n'' seconds as described in paragraph (b) above to 
activate the Market Maker Risk Limitation Mechanism. The trade counter 
threshold must be at least five executions. The time period must be at 
least \1/2\ second. At no time may the trade counter be set for a trade 
rate of less than five executions in a one second period.
    (g) For purposes of this Rule 6.40, a ``bulk quote'' message is a 
single message from a Market Maker that simultaneously updates all of 
the Market Maker's quotes in multiple series in a class at the same 
time.
    Commentary:
    .01 A trade rate of five executions in a one second period will 
allow for Market Makers to provide different risk settings. Based on a 
minimum rate of five executions per second, permissible settings could 
be five executions in a one second period, ten executions in a two 
second period fifteen executions in three a second period and so forth, 
using the same minimum executions per second ratio.
* * * * *
Obligations of Market Makers
Rule 6.37 (a)-(f) No change.
    (g) Quoting Obligations of Market Makers.
    (1) Lead Market Makers. Lead Market Makers must provide continuous 
two-sided quotations throughout the trading day in each of their 
appointed issues for 99% of the time the Exchange is open for trading 
in each issue. Such quotations must meet the legal quote width 
requirements of Rule 6.37(b). LMMs must also specify a size for each of 
their quotations applicable to:
    (A)-(B) No change.
* * * * *

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 had received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item III below. The PCX has prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

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

1. Purpose
    The purpose of the proposed rule change is to provide all PCX 
Market Makers protection from the unreasonable risk of multiple nearly 
simultaneous executions. Like auto-quote systems used on other options 
exchanges, the primary method for Market Makers to update their markets 
on the PCX is to post and update quotes on multiple series of options 
at the same time through the use of ``bulk quotes.'' Generally, these 
quotes are based on the Market Maker's proprietary pricing models that 
rely on various factors, including the price of the underlying security 
and that security's market volatility. As these variables change, a 
Market Maker's pricing model and automated quote system will 
continuously enter bulk quote updates for all series in the class.
    A PCX Market Maker's risk is not limited to the risk in a single 
series of a particular class. Rather, a Market Maker faces exposure in 
all series of a class, requiring the Market Maker off set or otherwise 
hedge its overall position in a class. In addition to the Market 
Maker's own proprietary quoting system, the Market Maker Risk 
Limitation Mechanism would provide an additional tool to manage the 
risk associated with providing liquidity in a large number of series 
across an options class.
    Because Market Makers provide quotes in all series in a class, they 
are exposed to the possibility of nearly simultaneous multiple 
executions that can create huge unintended principal positions for the 
Market Makers and expose them to unnecessary market risk. Firm risk 
management procedures dictate that Market Makers must take into account 
the possibility of such actions and the corresponding risk to the 
Market Makers and the firm. As a result, the PCX believes that Market 
Makers widen their quotes, quote less aggressively, and limit their 
quote size in order to avoid such unintended executions and the 
attendant risks and costs involved, all to the detriment of customers 
and other market participants. The proposed rule addresses these 
concerns.

Market Maker Risk Limitation Mechanism

    The Market Maker Risk Limitation Mechanism feature on the PCX would 
protect all PCX Market Makers from excessive multiple and unintended 
automatic executions. The Market Maker Risk Limitation Mechanism would 
begin with a ``trade counter'' for each class where the Market Maker 
has a market making appointment. This trade counter would be 
incremented by one every time the Market Maker executes a trade on any 
series of the assigned class. The trade counter would reset itself 
every ``n'' seconds. The individual Market Maker supplying the quotes 
in a particular issue would define the threshold number for the trade 
counter to reach in order to trigger the implementation of the Market 
Maker Risk Limitation Mechanism. The individual Market Maker supplying 
the quotes in a particular issue would also define the time period for 
the trade counter to reset itself. The trade counter would have a 
minimum setting of five executions in a one second period. Using a 
trade rate of five executions in a one second period will allow for a 
Market Maker to provide different risk settings for different issue. 
This would limit the number of consecutive executions a given Market 
Maker could have automatically executed on an assigned class in a 
predefined period of time.
    Once the trade counter has reached the defined threshold number, 
the trading engine would automatically cancel all quotes posted by that 
Market Maker on that class by generating a bulk cancel message. The 
bulk cancel message would have the same time priority as any other 
quote update or order message the trading engine receives, so that any 
orders or quotes that matched with the Market Maker's quote and were 
received by the trading engine prior to the receipt of the cancel 
message would be automatically executed pursuant to PCX rules. Orders 
or quotes received by the trading engine after receipt of the cancel 
message would not be executed against the Market Maker.
    As soon as the Market Maker Risk Limitation Mechanism is triggered, 
the Market Maker would receive a message to confirm the cancellation of 
the Market Maker's quotes on the given class. The Market Maker could 
then respond with an enabling message to the trading engine to update 
or refresh quotes. If there is no reply, PCX would

[[Page 32688]]

assume there is a communication or system problem with the Market 
Maker.
    In the event that a LMM is unable to provide an updated quote, and 
there are no other quotes in the PCX Plus system for that issue, the 
trading engine will create two sided, legal spread markets on behalf of 
the LMM. Quotes generated by the exchanges on behalf of the LMM would 
be considered firm quotes and would be the obligation of the LMM. When 
there are other quotes in the PCX system for that issue, the Exchange 
would not generate quotes on behalf of the LMM. Additionally, the 
Exchange proposes to amend PCX Rule 6.37(g)(1) to lower a LMM's 
continuous quotation obligation from 100% of the trading day to 99% of 
the trading day. This is designed to provide the LMM an appropriate 
amount of time to replenish quotes when the Exchange does not do this 
on the LMM's behalf. The Exchange anticipates that this new proposed 
functionality would be used in limited circumstances and only for brief 
periods of time.
    The Market Maker Risk Limitation Mechanism would protect both 
Market Maker quotes currently posted and in the PCX Consolidated Book, 
as well as those incoming bulk quotes that a Market Maker may 
erroneously generate as part of an automatic update. For example, a new 
bulk quote message from a Market Maker that is immediately executable 
across multiple series would not generate a number of executions 
greater than the defined threshold number (i.e. would not allow the 
Market Maker to unintentionally sweep the book).
    Without these protection mechanisms, multiple unintentional trades 
could automatically occur. These executions would not properly reflect 
the true nature of the market and would subject Market Makers to 
unreasonable market risk and multiple execution and clearing fees, with 
no real economic justification behind the trades. The Exchange believes 
the proposed rule change would reduce these inefficiencies and risks by 
preventing a PCX Market Maker from erroneously trading automatically 
multiple times. Under normal circumstances, PCX Market Maker quotes do 
match and are automatically executed; however, these are usually only 
on a few series in a class and involve immediate quote updates after an 
execution. The trade counter would not reach the threshold level, nor 
would the Risk Limitation Mechanism be activated under most 
circumstances.
    The Exchange believes these protection mechanisms would eliminate 
trades that are involuntary, the result of technological error or 
inaccuracy, and that impede certain liquidity providers' ability to 
competitively quote. Also, the Exchange believes the protection 
mechanisms would increase the liquidity available in the PCX market and 
would enhance competition because Market Makers would be better able to 
quote large orders aggressively and with fewer concerns over 
technological breakdowns and system inaccuracies.
    These Market Maker protections do not relieve a LMM or Market 
Maker's obligations pursuant to PCX Rule 6.37(g), which addresses a 
Market Maker's obligation to enter quotations for the option classes to 
which it is appointed, except as noted in proposed change to PCX Rule 
6.37(g)(1). In addition, these Market Maker protections do not relieve 
a LMM or Market Maker's obligations pursuant to Rule 6.86 to provide 
firm quotations. After a Market Maker protection has been utilized, all 
other Market Makers are expected to resume entering quotations for the 
options classes to which they are appointed as soon as practicable.
2. Statutory Basis
    The Exchange believes the proposed rule change is consistent with 
Section 6(b) of the Act,\7\ in general, and furthers the objectives of 
Section 6(b)(5) of the Act,\8\ in particular, in that it is designed to 
facilitate transactions in securities, to promote just and equitable 
principles of trade, to enhance competition and to protect investors 
and the public interest.
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    \7\ 15 U.S.C. 78f(b).
    \8\ 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, as 
amended, would 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

    Written comments on the proposed rule change were neither solicited 
nor received.

III. 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-PCX-2005-64 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-PCX-2005-64. 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 PCX. 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 publicly available. All 
submissions should refer to File Number SR-PCX-2005-64 and should be 
submitted on or before June 24, 2005.

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

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of the Act and 
the rules and regulations thereunder, applicable to a national 
securities exchange.\9\ In

[[Page 32689]]

particular, the Commission believes that the proposed rule change is 
consistent with Section 6(b)(5) of the Act,\10\ which requires among 
other things, that the rules of the Exchange are designed 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. 
The Commission notes that the proposal does not alter the obligations 
of PCX Market Makers, except for the fact that it will reduce a LMM's 
continuous quoting obligation from 100% of the trading day to 99% of 
the trading day for each of its appointed classes. The Commission notes 
that this reduction should provide the LMM a brief amount of time to 
update its quotes when the Exchange does not generate quotes on behalf 
of the LMM because no other market makers are quoting. In addition, the 
Commission believes that the proposed rule change should provide PCX 
Market Makers assistance in effectively managing their quotations.
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    \9\ In approving this proposal, the Commission has considered 
its impact on efficiency, competition, and capital formation. 15 
U.S.C. 78c(f).
    \10\ 15 U.S.C. 78f(b)(5).
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    The PCX has requested that the Commission find good cause for 
approving the proposed rule change and Amendment Nos. 1, 2, 3, and 4 
thereto prior to the thirtieth day after publication of notice thereof 
in the Federal Register. The Commission notes that similar proposals to 
provide protection from risk for market makers have been approved for 
other options exchanges.\11\ The Commission believes that granting 
accelerated approval of the proposal should provide PCX Market Makers 
with similar protections from the risk associated with an excessive 
number of near simultaneous executions in a single options class. 
Accordingly, the Commission finds good cause, pursuant to Section 
19(b)(2) of the Act,\12\ for approving the proposed rule change, as 
amended, prior to the thirtieth day after the date of publication of 
notice thereof in the Federal Register.
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    \11\ See Securities Exchange Act Release Nos. 51049 (January 28, 
2005), 70 FR 3756 (January 26, 2005) (SR-BSE-2004-52); and 51050 
(January 18, 2005), 70 FR 3758 (January 26, 2005) (SR-ISE-2004-31).
    \12\ 15 U.S.C. 78s(b)(2).
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V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\13\ that the proposed rule change (SR-PCX-2005-64), and Amendment 
Nos. 1, 2, 3, and 4 thereto, are hereby approved on an accelerated 
basis.
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    \13\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
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    \14\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. E5-2830 Filed 6-2-05; 8:45 am]
BILLING CODE 8010-01-P