[Federal Register Volume 70, Number 117 (Monday, June 20, 2005)]
[Notices]
[Pages 35479-35482]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-3179]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51835; File No. SR-ISE-2004-16]


Self-Regulatory Organizations; International Securities Exchange, 
Inc.; Notice of Filing of Proposed Rule Change and Amendment No. 1 
Thereto Establishing a Directed Order Process

June 13, 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 20, 2004, the International Securities Exchange, Inc. (``ISE'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by the ISE. On April 26, 
2005, the ISE filed Amendment No. 1 to the proposed rule change.\3\ 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    \3\ Amendment No. 1 replaced and superseded the original filing 
in its entirety. Amendment No. 1 to the proposed rule change: (i) 
added a provision to the proposed rule change related to the 
processing of Directed Orders when the market maker to which it is 
directed is the primary market maker in the option and the ISE's 
bid/offer is inferior to the national best bid/offer; (ii) revised 
the purpose section of the filing and maked certain non-substantive 
changes to the text of the proposed rule change; and (iii) removed a 
proposed amendment to ISE Rule 810 related to information barriers 
to allow market maker to handle directed order because the Exchange 
has received approval of a separate proposed rule change to ISE Rule 
810 in this respect (see Securities Exchange Act Release No. 50433 
(September 23, 2004), 69 FR 58563 (September 30, 2004) (SR-ISE-2004-
18)).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The ISE proposes to adopt new ISE Rule 811 to allow Exchange market 
makers to receive Public Customer Orders directed to them from 
Electronic Access Members (``EAMs'') through the Exchange's system 
(``Directed Orders''). Proposed new language is in italics.

Rule 811. Directed Orders

    (a) Definitions.
    (1) A ``Directed Order'' is a Public Customer Order routed from an 
Electronic Access Member to an Exchange market maker through the 
Exchange's System.
    (2) A ``Directed Market Maker'' is a market maker that receives a 
Directed Order.
    (3) The ``NBBO'' is defined in Rule 1900.
    (b) Exchange market makers may only receive and handle orders on an 
agency basis if they are Directed Orders and only in the manner 
prescribed in this Rule 811. A market maker can elect whether or not to 
accept Directed Orders on a daily basis. If a market maker elects to be 
a Directed Market Maker, it must accept Directed Orders from all 
Electronic Access Members. A Directed Market Maker cannot reject a 
Directed Order.
    (c) Obligations of Directed Market Makers.
    (1) Directed Market Makers must hold the interests of orders 
entrusted to them above their own interests and fulfill in a 
professional manner all other duties of an agent, including, but not 
limited to, ensuring that each such order, regardless of its size or 
source, receives proper representation and timely, best possible 
execution in accordance with the terms of the order and the rules and 
policies of the Exchange.
    (2) Directed Market Makers must ensure that their acceptance and 
execution of Directed Orders as agent are in compliance with applicable 
Federal and Exchange rules and policies.
    (3) Within three (3) seconds of receipt of a Directed Order, 
Directed Market Makers must either enter the Directed Order into the 
PIM pursuant to Rule 723 or release the Directed Order to the 
Exchange's limit order book pursuant to paragraph (e) of this Rule.
    (i) If the Directed Market Maker is quoting at the NBBO on the 
opposite side of the Directed Order, the Directed Market Maker is 
prohibited from adjusting the price of its quote to a price that is 
less favorable than the price available at the NBBO or reducing the 
size of its quote prior to submitting the Directed Order to the PIM, 
unless such quote change is the result of an automated quotation system 
that operates independently from the existence or non-existence of a 
pending Directed Order. Otherwise changing a quote on the opposite side 
of the Directed Order except as specifically permitted herein will be a 
violation of Rule 400 (Just and Equitable Principles of Trade).
    (ii) If a Directed Market Maker fails to either enter a Directed 
Order into the PIM or release the order within three (3) seconds of its 
receipt, the Directed Order will be automatically released by the 
System and processed according to paragraph (e) of this Rule.
    (d) Directed Market Maker Guarantee. If the Directed Market Maker 
is quoting at the NBBO on the opposite side of the market from a 
Directed Order at the time the Directed Order is received by the 
Directed Market Maker, and the Directed Order is marketable, the System 
will automatically guarantee execution of the Directed Order against 
the Directed Market Maker at the price and the size of its quote (the 
``Guarantee''). The Directed Market Maker cannot alter the Guarantee.
    (e) Except as provided in this paragraph (e), when a Directed Order 
is released, the System processes the order in the same manner as any 
other order received by the Exchange. Directed Orders will not be 
automatically executed at a price that is inferior to the NBBO and, 
except as provided in subparagraph (e)(3), will be handled pursuant to 
Rule 803(c)(2) when the ISE best bid or offer is inferior to the NBBO.
    (1) A marketable Directed Order will be matched against orders and 
quotes according to Rule 713 except that, at any given price level, the 
Directed Market Maker will be last in priority.
    (i) If, after all other interest at the NBBO is executed in full, 
there is any remaining unexecuted quantity of the Directed Order and 
the Directed Market Maker is quoting at the NBBO or a Guarantee exists, 
a broadcast message will be sent to all Members. After three (3) 
seconds, any additional interest at the same or better price will be 
executed according to Rule 713.
    (ii) If there continues to be any remaining unexecuted quantity of 
the Directed Order, it will be executed against any interest at the 
same price from the Directed Market Maker. If a Guarantee exists at 
that price, an execution will occur for at least the size of the 
Guarantee.
    (iii) If there continues to be any remaining unexecuted quantity of 
the Directed Order and the Directed Order

[[Page 35480]]

is marketable at the next price level without trading through the NBBO, 
the Directed Order will be allocated according to Rule 713 except that 
the Directed Market Maker will be last in priority. If an execution at 
any given price level would cause the Directed Order to be executed at 
a price inferior to the NBBO, the order will be presented to the PMM 
for handling according to Rule 803(c)(2).
    (iv) Subparagraph (e)(1)(iii) will be repeated until the Directed 
Order is (A) fully executed, (B) presented to the Primary Market Maker 
for handling according to Rule 803(c)(2), or (C) no longer marketable, 
in which case it will be placed on the limit order book.
    (2) If a Directed Order is not marketable at the time it is 
released:
    (i) If a Guarantee exists, a broadcast message will be sent to all 
Members. After three (3) seconds, the Directed Order will be executed 
against any contra interest at the Guarantee price or better according 
to Rule 713. Thereafter, the Directed Order will be executed against 
the Directed Market Maker for at least the size of the Guarantee. If 
there is any remaining unexecuted quantity of the Directed Order, it 
will be placed on the Exchange's limit order book.
    (ii) If no Guarantee exists, the Directed Order will be placed on 
the Exchange's limit order book. In this case, the Directed Market 
Maker may not enter a proprietary order to execute against the Directed 
Order during the three (3) seconds following the release of the 
Directed Order.
    (3) If, at the time a Directed Order is released by the Directed 
Market Maker, the Directed Order is marketable but the ISE best bid or 
offer is inferior to the NBBO, and the Directed Market Maker is the 
Primary Market Maker in the option class for the Directed Order, then a 
broadcast message shall be sent to all Members displaying the Directed 
Order. After three (3) seconds, the Directed Order will be executed 
against any contra interest at the NBBO price or better according to 
Rule 713, except that the Directed Market Maker will be last in 
priority. Thereafter, if there is any remaining unexecuted quantity of 
the Directed Order, it will be presented to the Primary Market Maker 
for handling according to Rule 803(c)(2).
* * * * *

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 IV below. The ISE 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 proposes to adopt new ISE Rule 811 to allow Exchange 
market makers to receive Directed Orders. A Directed Order is defined 
as a Public Customer Order routed from an EAM to an Exchange market 
maker through the Exchange's system.\4\ A ``Directed Market Maker'' is 
an Exchange market maker that receives a Directed Order. Market makers 
may elect whether to receive Directed Orders on a daily basis. Directed 
Market Makers must accept Directed Orders from all EAMs and may not 
reject any Directed Orders. Directed Market Makers must either enter 
Directed Orders into the Price Improvement Mechanism (``PIM'') pursuant 
to ISE Rule 723 or release the Directed Orders to the Exchange's limit 
order book. The ISE would give a Directed Market Maker three seconds to 
take one of these actions, after which the Exchange system would 
automatically release the Directed Order. Directed Orders are 
anonymous, so that Directed Market Makers would not know which EAM 
routed a Directed Order.
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    \4\ The proposal is similar to Chapter VI, Section 5(b) and (c), 
and Section 10, of the rules of the Boston Stock Exchange.
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    When a Directed Order is not entered into the PIM, and thus is 
released to the Exchange's limit order book, the Exchange would process 
the order like any other incoming order, other than as follows:
    i. When an order is directed to a market maker that is quoting at 
the national best bid or offer (``NBBO''), the system automatically 
guarantees the price and size of the market maker's quote (the 
``Guarantee''). This assures that if the price or size of the Directed 
Market Maker's quote changes between the time the Directed Order was 
received and the time that it is released (because, for example, there 
is a change in the market for the underlying security), the Directed 
Order is not disadvantaged.
    ii. At any given price level, a Directed Order is executed 
according the Exchange's standard allocation process provided in ISE 
Rule 713, except that the Directed Market Maker is put last in priority 
and the Directed Order is exposed to all Members for three seconds 
prior to executing any portion of the Directed Order against the 
Directed Market Maker. This assures that the Directed Market Maker does 
not benefit from the fact that it had knowledge of the Directed Order 
prior to its entry into the Exchange's system.
    Applying these principles, a marketable Directed Order released 
into the Exchange's system would trade as follows:
     When the Directed Order is released, the system would 
execute the Directed Order pursuant to ISE Rule 713, initially 
excluding the Directed Market Maker.
     If there is any remaining unexecuted quantity of the 
Directed Order, and the Directed Market Maker is quoting at the same 
price or there is a Guarantee at the same price, the system would 
generate a broadcast message to all Members, who would have three 
seconds to respond with additional interest at the same or a better 
price.
     After this three second exposure, the system would again 
execute the Directed Order pursuant to the ISE Rule 713 algorithm 
against all interest except for the Directed Market Maker. If there 
continues to be any remaining unexecuted quantity of the Directed 
Order, the system would automatically execute the Directed Order 
against the Directed Market Maker's quote and/or Guarantee (if the 
Directed Market Maker has a quote at the same price as the Guarantee 
for a greater size, the order would receive the greater size).
     Following any execution against the Directed Market Maker, 
and if there continues to be any unexecuted quantity: If the order is 
not marketable, the system would place the order on the limit order 
book; or, if the order is marketable at that price without trading 
through the NBBO, execute the order at the next price level. At each 
such price level, the Directed Order is executed pursuant to the ISE 
Rule 713 algorithm except that the Directed Market Maker is put last in 
priority.
     At each price level, the Exchange's system would assure 
that the Directed Order is not automatically executed at a price that 
is inferior to the NBBO. When the ISE best bid or offer is inferior to 
the NBBO, marketable orders would be presented to the Primary Market 
Maker (``PMM'') for handling pursuant to ISE Rule 803(c)(2), unless the 
PMM is the Directed Market Maker that released the Directed Order, in 
which case the Directed Order would first be exposed to all Members, as 
described below.

[[Page 35481]]

    When a non-marketable Directed Order is released and a Guarantee 
exists, the Exchange's system would broadcast a message to all Members 
for three seconds before executing the Directed Order against the 
Guarantee. This would happen where the Directed Market Maker was 
quoting at the NBBO at the time that a marketable Directed Order was 
received, but the NBBO moved prior to the release of the Directed Order 
so that the Directed Order was no longer marketable.
    If, at the time a Directed Order is released by the Directed Market 
Maker, the Directed Order is marketable but the ISE best bid or offer 
is inferior to the NBBO, and the Directed Market Maker is the PMM in 
the option class for the Directed Order, then a broadcast message would 
be sent to all Members displaying the Directed Order. After three (3) 
seconds, the Directed Order would be executed against any contra 
interest at the NBBO price or better according to ISE Rule 713, except 
that the PMM would be last in priority. Thereafter, if there is any 
remaining unexecuted quantity of the Directed Order, it would be 
presented to the PMM for handling according to ISE Rule 803(c)(2). This 
assures that the PMM does not benefit from the fact that it had 
knowledge of the Directed Order prior to its entry into the Exchange's 
system by allowing other market participants an opportunity to execute 
against the Directed Order before the PMM.
    In addition to the procedures described above, the proposed rule 
contains two restrictions regarding Directed Market Makers. First, if 
the Directed Market Maker is quoting at the NBBO on the opposite side 
of the Directed Order, the Directed Market Maker is prohibited from 
adjusting the price of its quote to a price that is less favorable than 
the price available at the NBBO or reducing the size of its quote prior 
to submitting the Directed Order to the PIM, unless such quote change 
is the result of an automated quotation system that operates 
independently from the existence or non-existence of a pending Directed 
Order. Otherwise changing a quote on the opposite side of the Directed 
Order except as specifically permitted herein would be a violation of 
ISE Rule 400 (Just and Equitable Principles of Trade). The Exchange 
would conduct routine surveillance of such quote changes to identify 
potential violations of ISE Rule 400.
    The purpose of this limitation is to prohibit a Directed Market 
Maker from manipulating the market by moving the NBBO to an inferior 
price prior to submitting an order into the PIM. The occasion where 
this type of manipulation might be possible is remote, as a Directed 
Market Maker would have to be the only market maker quoting at the NBBO 
in the national market system. Nevertheless, we believe the restriction 
is carefully tailored so that price discovery through the use of 
automated quotation systems would not be unnecessarily disrupted, while 
assuring that Directed Market Makers are not permitted to disadvantage 
orders they represent as agent.
    The second restriction applies when a Directed Market Maker 
releases a non-marketable Directed Order without a Guarantee (that is, 
where the Directed Market Maker is not quoting at the NBBO). In that 
situation, the Directed Market Maker must wait at least three seconds 
before entering a contra order to execute against the Directed Order as 
principal. The purpose of this restriction is to allow other market 
participants an opportunity to execute against the Directed Order 
before the Directed Market Maker who had knowledge of the Directed 
Order before it was released.
2. Statutory Basis
    The ISE believes the basis under the Exchange Act for this proposed 
rule change is the requirement under Section 6(b)(5) that an exchange 
have rules that are designed to foster cooperation and coordination 
with persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transaction in 
securities, to remove impediments to and perfect the mechanism for a 
free and open market and a national market system, and, in general, to 
protect investors and the public interest. In particular, this proposed 
rule change would allow the Exchange to better compete with other 
options exchanges, while assuring the fair handling of Directed Orders.

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

    The ISE does not believe that the proposed rule change, as amended, 
would impose any burden on competition not necessary or appropriate in 
furtherance of the purposes of the Act.

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

    The Exchange has not solicited, and does not intend to solicit, 
comments on this proposed rule change. The Exchange has not received 
any unsolicited written comments from members or other interested 
parties.

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

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding, or (ii) as to 
which the ISE 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-ISE-2004-16 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, Station Place, 100 F 
Street, NE., Washington, DC 20549-9303.
    All submissions should refer to File Number SR-ISE-2004-16. 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, 100 F Street, 
NE., Washington, DC 20549. Copies of such filing also will be available 
for inspection and copying at the principal office of the ISE. All

[[Page 35482]]

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-ISE-2004-16 and should be 
submitted on or before July 11, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\5\
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    \5\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. E5-3179 Filed 6-17-05; 8:45 am]
BILLING CODE 8010-01-P