[Federal Register Volume 70, Number 116 (Friday, June 17, 2005)]
[Notices]
[Pages 35321-35327]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-3128]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51822; File No. SR-CBOE-2004-87]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Granting Accelerated Approval of a Proposed Rule 
Change and Amendment Nos. 1 and 2 Thereto and Notice of Filing and 
Order Granting Accelerated Approval to Amendment No. 3 Thereto Relating 
to Trading Rules on the Hybrid System for Index Options and Options on 
ETFs

June 10, 2005.

I. Introduction

    On December 17, 2004, the Chicago Board Options Exchange, 
Incorporated (``CBOE'' or ``Exchange'') filed with the Securities and 
Exchange Commission (``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder, \2\ a proposed rule change 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''). The CBOE filed Amendment Nos. 1 
and 2 to the proposed rule change on March 23, 2005 \3\ and April 26, 
2005, \4\ respectively. The proposed rule change, as amended by 
Amendment Nos. 1 and 2, was published for comment in the Federal 
Register on May 17, 2005. \5\ The Commission received no comments on 
the proposal.
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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    \3\ Amendment No. 1 replaced and superseded the originally filed 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    \4\ Amendment No. 2 replaced and superseded the originally filed 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.
    \5\ See Securities Exchange Act Release No. 51680 (May 10, 
2005), 70 FR 28326.
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    On June 3, 2005, the CBOE filed Amendment No. 3 to the proposed 
rule change. \6\ This order grants accelerated approval the proposed 
rule change, as amended by Amendment Nos. 1 and 2. Simultaneously, the 
Commission is providing notice of filing of Amendment No. 3 and 
granting accelerated approval of Amendment No. 3.
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    \6\ Amendment No. 3 amended note 7 in Item 3 of Form 19b-4 of 
Amendment No. 2 and the parallel reference in Exhibit 1 to Amendment 
No. 2 to delete the reference to Satisfaction Orders and made two 
technical corrections to the proposed rule text.
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II. Description

    The Exchange currently trades equity options, index options, and 
options on exchange-traded funds (``ETFs'') on its Hybrid Trading 
System (``Hybrid''), which is an options trading platform that combines 
the features of electronic and open outcry, auction market principles, 
while, at the same time, providing market makers the ability to 
electronically stream their own quotes. 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 assigned DPM. The Exchange proposes to extend the 
Hybrid trading rules that currently apply to classes of equity options 
(``equity classes'') to classes of index options and options on ETFs 
(collectively, ``index classes'') without an assigned DPM, with some 
proposed rule modifications. In this regard, the proposal would allow 
the trading of these index classes on Hybrid either with a DPM, LMM, or 
without a DPM or LMM in classes where there are a requisite number of 
assigned MMs.
    To implement this proposal, the Exchange proposes to adopt several 
new rules (most notably CBOE Rules 6.45B, 8.14, 8.15, and 8.15B), and 
to amend several existing rules (i.e., CBOE Rules 6.1, 6.2, 6.2B, 
6.45A, 7.4, and 8.15). New CBOE Rule 6.45B would contain the rules 
pertaining to priority and allocation of trades for index classes, 
while existing CBOE Rule 6.45A would be amended to apply solely to 
equity options. New proposed CBOE Rule 8.14 describes the market maker 
participants permissible for index classes trading in Hybrid. New 
proposed CBOE Rule 8.15A contains provisions relating to LMMs in Hybrid 
classes, while existing CBOE Rule 8.15 would be amended to apply to 
LMMs in non-Hybrid classes. Finally, new proposed CBOE Rule 8.15B 
describes the participation entitlement applicable to LMMs. A more 
complete

[[Page 35322]]

description of the proposal, as amended, is provided in Section IV, 
below.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether Amendment No. 3 
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, 100 F Street, NE., 
Washington, DC 20549-9303.
    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 the 
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 July 
8, 2005.

IV. Commission's Findings and Order Granting Accelerated Approval of 
Amendment No. 3 and Accelerated Approval of Proposed Rule Change, As 
Amended

    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 \7\ and, in particular, the requirements of Section 
6(b) of the Act. \8\ Specifically, the Commission finds that the 
proposed rule change, as amended, is consistent with Section 6(b)(5) of 
the Act \9\ in that it is designed to facilitate transactions in 
securities, 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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    \7\ In approving this proposed rule change, as amended, the 
Commission has considered the proposed rule's impact on efficiency, 
competition, and capital formation. 15 U.S.C. 78c(f).
    \8\ 15 U.S.C. 78f(b).
    \9\ 15 U.S.C. 78f(b)(5).
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A. Trading Without a DPM or LMM

    The Exchange proposes to adopt new CBOE Rule 8.14 to specify the 
permitted categories of market participants in index classes. The 
proposed rule would allow 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 classes. 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.\10\
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    \10\ CBOE Rule 8.1 provides that the term ``Market-Maker'' 
includes Remote Market-Makers, as defined in CBOE Rule 8.4.
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    Proposed paragraph (b) of CBOE Rule 8.14 would provide 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).\11\ 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:\12\
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    \11\ CBOE Rule 8.7(d) governs the quoting obligations for MMs in 
Hybrid classes.
    \12\ These requirements are based on similar requirements 
contained in CBOE Rule 44.4(b).
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     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.
    Proposed CBOE Rule 8.14(b)(4) provides that, in order to allow a 
multiply-listed product to 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.
    The Commission believes that the proposed rules governing trading 
without a DPM or LMM are consistent with the Act. In addition, the 
Commission notes that the current proposal does not permit the Exchange 
to allow a multiply-listed product to trade without a DPM or LMM unless 
the Exchange submits a new proposed rule change to the Commission (and 
receives Commission approval thereof) relating to its market maker 
obligation rules indicating how such orders would be submitted to other 
exchanges on behalf of market makers in accordance with the Intermarket 
Options Linkage Plan requirements.

B. Index Classes Trading With an LMM: LMM Obligations

    The Exchange operates an LMM system in several index classes. 
Current

[[Page 35323]]

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 proposed CBOE Rule 8.15A, Lead 
Market Makers in Hybrid Classes, which mimics current CBOE Rule 8.15 
with few changes.\13\ 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.
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    \13\ The Exchange proposes to amend CBOE Rule 8.15 to limits its 
application to non-Hybrid classes.
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    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.
    The Exchange also proposes to modify rules to accommodate trading 
in multiply-listed classes that would be subject to the Intermarket 
Options Linkage Plan. 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. Under the 
proposal, LMMs and Order Book Officials (``OBOs'') would handle linkage 
functions for classes without a DPM. OBOs would represent inbound 
linkage orders 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.\14\ 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 the P/A orders.\15\
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    \14\ See Securities Exchange Act Release No. 43086 (July 28, 
2000), 65 FR 48023 (Aug. 4, 2000) (order approving the Options 
Intermarket Linkage Plan).
    \15\ See Amendment No. 3, supra note 6.
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    The Exchange proposes to make a corresponding change to CBOE Rule 
7.4(a)(2) to permit OBOs to receive Linkage orders from other exchanges 
that are participants in the Intermarket Options Linkage Plan.\16\ 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 change would provide 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.\17\ With 
respect to handling inbound linkage orders, OBOs would handle only 
those orders that do not automatically execute via the Exchange's 
systems.
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    \16\ 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.
    \17\ All linkage fees incurred for routing P/A orders for the 
benefit of underlying orders would be borne by the LMM.
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    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.\18\ 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. 
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.
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    \18\ CBOE Rule 8.15(b)(2).
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    The Commission believes that the proposed rules regarding LMM 
obligations are consistent with the Act. In particular, the Commission 
believes that the proposed use of the OBO, together with the proposed 
agency responsibility of the LMM in handling P/A and Satisfaction 
orders, should ensure that these orders will be handled properly in 
accordance with the Intermarket Options Linkage Plan.

C. LMM Participation Entitlement

    Today, LMMs do not receive participation entitlements nor does CBOE 
Rule 8.87 address granting a participation entitlement to LMMs. The 
Exchange proposes to adopt new proposed 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 (``MPC'') 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

[[Page 35324]]

allocated a total quantity greater than the quantity for which the LMM 
is quoting at the best bid/offer on the Exchange.\19\
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    \19\ 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.
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    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.\20\
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    \20\ A single LMM would function in any given class at one time, 
though there may be several LMMs approved in such class. Should more 
than one LMM function in a given class at the same time, the 
Exchange would need to file a proposed rule change with the 
Commission to address potential rule changes required in such a 
situation (e.g., how linkage orders would be handled). Telephone 
conversation between David Doherty, Attorney II, CBOE and David Liu, 
Attorney, Division of Market Regulation, Commission, on June 8, 
2005.
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    Finally, proposed paragraph (c) also allows the appropriate MPC to 
determine, on a class-by-class basis, to decrease the LMM participation 
entitlement percentages from the percentages specified in paragraph 
(c). 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, it will submit a ``regular-way'' rule filing 
to the Commission.
    The Commission believes that the proposed rules governing LMM 
participation entitlements are consistent with the Act. The Commission 
believes that, under the proposed new rules, LMMs would have many of 
the same functions and obligations as DPMs and e-DPMs, both of which 
receive participation entitlements, and therefore, it would be 
reasonable for LMMs to receive a participation entitlement not to 
exceed the percentage previously approved by the Commission. The 
Commission also believes that it is reasonable for the MPC to have 
discretion to decrease the participation entitlement for a given index 
class after advance notice has been given via Regulatory Circular to 
the membership. The Commission emphasizes that the CBOE must submit a 
proposed rule change to the Commission if it seeks to increase the LMM 
participation entitlement beyond the 30/40/50 percent entitlement.

D. Allocation of Trades

    Current CBOE Rule 6.45A governs the allocation of trades on the 
Hybrid System. The Exchange proposes to adopt new proposed CBOE Rule 
6.45B, which is substantially similar in most respects to CBOE Rule 
6.45A, and restricts its application to index classes. The Exchange 
proposes to amend current CBOE Rule 6.45A, therefore, to limit its 
applicability to equity classes only.
1. 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. 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''). 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.
a. 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.\21\ 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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    \21\ See CBOE Rule 43.1(a)(1) (price-time priority) and (a)(2) 
(pro rata priority). The International Stock Exchange, Inc. 
(``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 \22\ or participation 
entitlement priority.\23\ 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 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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    \22\ 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.
    \23\ 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.\24\
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    \24\ See proposed CBOE Rule 6.45B(a)(i)(2)(D).
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b. 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

[[Page 35325]]

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 classes, to vary the 
weights of Components A and B on a product by product basis.\25\ 
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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    \25\ The Exchange proposes to delete this section from current 
CBOE Rule 6.45A and move it to CBOE Rule 6.45B.
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    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.\26\ 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.\27\ 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 Exchange has 
represented that 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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    \26\ See current CBOE Rule 6.45A(a)(i)(C).
    \27\ 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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    The Commission believes that the proposed rules regarding 
allocation of incoming electronic orders are consistent with the Act. 
The Commission notes that the allocation provisions are based on rules 
currently in place at the Exchange, including current rules relating to 
SBT and UMA. The Commission notes that the CBOE believes that providing 
the EPC with the ability to determine which allocation methodology is 
best for a given index class should be appropriate because the EPC 
should have the best familiarity with the product and its trading 
dynamics, which should allow it to determine which allocation 
methodology is most appropriate for it. In addition, the Commission 
believes that the proposed allocation algorithms should provide 
incentives to quote competitively by providing market participants with 
the ability to independently submit their quotes and then rewarding the 
market participants that quote at the best price with an allocation of 
the resulting trade. The Commission also expects the Exchange to ensure 
compliance with the requirements of Section 11(a) of the Act.\28\
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    \28\ 28 15 U.S.C. 78k(a).
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2. 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.\29\ 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.
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    \29\ A broker-dealer order is an order for the account of a non-
public customer broker-dealer.
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    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 Rules 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 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.
    The Commission believes that the proposed rules governing 
allocation of orders represented in open outcry are consistent with the 
Act. The Commission also expects the CBOE to comply with the 
requirements of Section 11(a) of the Act \30\ in dealing

[[Page 35326]]

with the allocation of orders in open outcry.
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    \30\ 15 U.S.C. 78k(a).
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3. 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.
    The Commission believes that this algorithm, which is similar to 
the algorithm adopted for the Exchange's equity classes, is consistent 
with the Act, and should ensure that additional market participants 
have an opportunity to interact with orders resting on the Exchange's 
electronic book. The Commission also notes that, given that the sizes 
of index option trading crowds vary considerably, the Exchange provides 
flexibility and discretion to its EPC to set, on a class by class basis 
for index classes, a shorter time period than the 5-second timer 
applicable to equity classes. The Commission also notes that any 
changes to the N-second interval would be announced to the CBOE 
membership in advance of implementation.
4. 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 (1) 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.\31\ 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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    \31\ Equity classes utilize a one-second times 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.
    The Commission notes that the proposed provisions regarding locked 
quotes are substantially similar to provisions previously approved by 
the Commission. The Commission believes that the proposed provisions 
are consistent with the Quote Rule.\32\ Market makers would continue to 
be required to honor their quotes and thus would be obligated to 
execute incoming orders pursuant to CBOE Rule 6.13. In addition, the 
Commission believes that the proposed ``counting period'' provides a 
reasonable method for market makers that lock or cross a market to 
unlock or uncross the market, as required by the Intermarket Options 
Linkage Plan. Moreover, during the ``counting period,'' the market 
makers whose quotes are locked would remain obligated to execute 
customer and broker-dealer orders eligible for automatic execution at 
the locked price.\33\
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    \32\ 17 CFR 240.11Ac1-1.
    \33\ See Proposed CBOE Rule 6.45B(d).
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E. Other Changes

1. 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 a DPM, LMM, or neither.
    First, the Exchange proposes to amend paragraph (a) of CBOE Rule 
6.2B to provide 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 also proposes to amend paragraph (b) of CBOE Rule 6.2B 
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

[[Page 35327]]

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) of CBOE Rule 6.2B 
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.
    The Commission believes that the proposed rule changes are 
consistent with the Act to ensure that: (1) An opening price is 
calculated if a class trades without a DPM or LMM; (2) a class will not 
be opened on HOSS (i) without a quote from the DPM, in classes which a 
DPM has been appointed; and (ii) when there is no quote from at least 
one MM or LMM with an appointment in the class, in classes in which no 
DPM has been appointed.
2. CBOE Rules 6.1 and 6.2
    The Exchange also proposes to amend Interpretation and Policy .05 
to CBOE Rule 6.1\34\ 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.
---------------------------------------------------------------------------

    \34\ See Amendment No. 3, supra note 6.
---------------------------------------------------------------------------

    The Commission believes that these proposed rule changes are also 
consistent with the Act.

F. Accelerated Approval of Amendment No. 3 and the Proposed Rule Change 
and Amendment Nos. 1 and 2 Thereto

    In Amendment No. 3, the Exchange proposes to: (1) Clarify that 
linkage fees do not apply to Satisfaction orders; (2) change the 
reference from CBOE Rule 6.1, Interpretation .04 to CBOE Rule 6.1, 
Interpretation .05 to more accurately reflect the proposed rule text; 
and (3) insert in the proposed rule text the reference to CBOE Rule 
6.45A(c)(ii)(A) that the CBOE inadvertently left out of the proposed 
rule text. The Commission notes that the changes contained in Amendment 
No. 3 are non-substantive in nature and are necessary to clarify the 
proposal, as well as to correct technical omissions in the proposed new 
rules.\35\ Accordingly, the Commission finds that there is good cause, 
consistent with Section 6(b)(5) \36\ and Section 19(b)(2) of the 
Act,\37\ to approve Amendment No. 3 on an accelerated basis prior to 
the 30th day after the date of publication of notice of filing thereof 
in the Federal Register.
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    \35\ See Amendment No. 3, supra note 6.
    \36\ 15 U.S.C. 78f(b)(5).
    \37\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    Pursuant to Section 19(b)(2) of the Act,\38\ the Commission may not 
approve any proposed rule change prior to the thirtieth day after the 
date of publication of the notice of filing thereof, unless the 
Commission finds good cause for so finding. The Commission hereby finds 
good cause for approving the proposed rule change prior to the 30th day 
after publishing notice thereof in the Federal Register. The Commission 
notes that the proposed rule change, as amended, has been subject to a 
full notice and comment period, and that no comments have been 
received.
---------------------------------------------------------------------------

    \38\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    By permitting the Exchange to trade index classes on Hybrid without 
an assigned DPM, the Exchange will have the flexibility to trade index 
classes on Hybrid either with a DPM, LMM, or without a DPM or LMM in 
classes where there are a requisite number of assigned MMs. The 
Commission believes that the proposed rule change, which provides for a 
variety of different participants to trade index classes on Hybrid, 
will greatly benefit the way investors trade their index classes. 
Therefore, the Commission finds good cause exists to accelerate 
approval of the proposal, as amended, pursuant to Section 19(b)(2) of 
the Act.\39\
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    \39\ Id.
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V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\40\ that the proposed rule change (File No. SR-CBOE-2004-87), as 
amended by Amendment Nos. 1, 2, and 3, be, and hereby is, approved on 
an accelerated basis.
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    \40\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\41\
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    \41\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. E5-3128 Filed 6-16-05; 8:45 am]
BILLING CODE 8010-01-P