[Federal Register Volume 72, Number 21 (Thursday, February 1, 2007)]
[Notices]
[Pages 4754-4756]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-1590]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-55161; File No. SR-ISE-2006-62]


Self-Regulatory Organizations; International Securities Exchange, 
LLC; Order Granting Approval to Proposed Rule Change as Modified by 
Amendment Nos. 1 and 2 Thereto, To Implement a Penny Pilot Program To 
Quote Certain Options in Pennies

January 24, 2007.

I. Introduction

    On October 11, 2006, the International Securities Exchange, LLC 
(``ISE'' 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 permit certain option classes 
to be quoted in pennies on a pilot basis and to adopt certain quote 
mitigation strategies. The proposed rule change was published for 
comment in the Federal Register on October 20, 2006.\3\ The Commission 
received three comment letters on the proposed rule change.\4\ On 
November 6, 2006, the Exchange filed Amendment No. 1 to the proposed 
rule change.\5\ The Exchange filed Amendment No. 2 to the proposal on 
January 5, 2007.\6\ The Exchange

[[Page 4755]]

responded to the comment letters on January 11, 2007.\7\ This order 
approves the proposed rule change as modified by Amendment Nos. 1 and 
2.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 54603 (October 16, 
2006), 71 FR 62024.
    \4\ See letters to Nancy M. Morris, Secretary, Commission, from 
Christopher Nagy, Chair, Securities Industry and Financial Markets 
Association (``SIFMA'') Options Committee, dated December 20, 2006 
(``SIFMA Letter''); from Patrick Sexton, Associate General Counsel, 
CBOE, dated November 13, 2006 (``CBOE Letter''); and from Peter J. 
Bottini, Executive Vice President, optionsXpress, Inc., dated 
October 31, 2006 (``optionsXpress Letter'').
    \5\ Amendment No. 1 made a clarifying change to proposed rule 
text in ISE Rule 804(h). Amendment No. 1 is technical in nature, and 
the Commission is not publishing Amendment No. 1 for public comment.
    \6\ Amendment No. 2 revised the Regulatory Information Circular 
ISE will distribute to its members to reflect the replacement of 
Glamis Gold, which was delisted, with Agilent Tech, Inc. in the list 
of options classes permitted to be quoted in pennies. Amendment No. 
2 is technical in nature, and the Commission is not publishing 
Amendment No. 2 for public comment.
    \7\ See letter to Nancy M. Morris, Secretary, Commission, from 
Michael J. Simon, Secretary, ISE, submitted January 11, 2007. On 
January 23, 2007, ISE supplemented its initial response by providing 
additional information about its Holdback Timer. See letter to Nancy 
Morris, Secretary, Commission, from Michael J. Simon, Secretary, 
ISE, dated January 23, 2007 (collectively ``Exchange Response'').
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II. Description of the Proposal

A. Scope of the Penny Pilot Program

    ISE proposes to amend its rules to permit certain options classes 
to be quoted in pennies during a six-month pilot (``Penny Pilot 
Program''), which would commence on January 26, 2007. Specifically, the 
Exchange proposes to amend ISE Rule 710 to specify that the Exchange 
will: (1) Participate in the Penny Pilot Program, and (2) state that 
the parameters of the Penny Pilot Program will be communicated to its 
members via Regulatory Information Circular.
    Currently, all six options exchanges, including ISE, quote options 
in nickel and dime increments. The minimum price variation for 
quotations in options series that are quoted at less than $3 per 
contract is $0.05 and the minimum price variation for quotations in 
options series that are quoted at $3 per contract or greater is $0.10. 
Under the Penny Pilot Program, beginning on January 26, 2007, market 
participants would be able to begin quoting in penny increments in 
certain series of option classes.
    The Penny Pilot Program would include the following thirteen 
options: Ishares Russell 2000 (IWM); NASDAQ-100 Index Tracking Stock 
(QQQQ); SemiConductor Holders Trust (SMH); General Electric Company 
(GE); Advanced Micro Devices, Inc. (AMD), Microsoft Corporation (MSFT); 
Intel Corporation (INTC); Caterpillar, Inc. (CAT); Whole Foods Market, 
Inc. (WFMI); Texas Instruments, Inc. (TXN); Flextronics International 
Ltd. (FLEX); Sun Microsystems, Inc. (SUNW); and Agilent Technologies, 
Inc. (A). The Exchange will communicate the list of options to be 
included in the Penny Pilot Program to its membership via Regulatory 
Information Circular.
    The minimum price variation increment for all classes included in 
the Penny Pilot Program, except for the QQQQs, would be $0.01 for all 
quotations in option series that are quoted at less than $3 per 
contract and $0.05 for all quotations in option series that are quoted 
at $3 per contract or greater. The QQQQs would be quoted in $0.01 
increments for all options series.
    ISE commits to deliver a report to the Commission during the fourth 
month of the pilot, which would be composed of data from the first 
three months of trading. The report would analyze the impact of penny 
pricing on market quality and options system capacity.
    In addition, the Exchange will amend ISE Rule 716, which currently 
permits trades in the Exchange's Block, Facilitation and Solicitation 
Mechanisms to be effected at ``split prices,'' which are the mid-points 
of the current standard trading increments, to clarify that options 
trading in penny increments will not be eligible for split pricing.

B. Quote Mitigation Strategies

    To mitigate quote message traffic, ISE has represented to the 
Commission that it intends to codify certain quote mitigation 
strategies, which are currently in place on the Exchange.\8\
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    \8\ In addition to the quote mitigation strategies discussed 
herein, the ISE also proposed a fee program that requires market 
makers to purchase more APIs as the market maker generates more 
quotes, thus imposing economic incentives on market makers to limit 
the number of quotations they disseminate. See Securities Exchange 
Act Release No. 53522 (March 20, 2006), 71 FR 14975 (March 24, 2006) 
(SR-ISE-2006-09).
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    [cir] Monitoring. The ISE submits that it actively monitors the 
quotation activity of its market makers. When the Exchange detects that 
a market maker is disseminating significantly more quotes than an 
average market maker, the Exchange contacts that market maker and 
alerts it to such activity. Such monitoring frequently reveals that the 
market maker may have internal system issues or has incorrectly-set 
system parameters that were not immediately apparent. The Exchange 
believes that, even without uncovering problems, alerting a market 
maker to possible excessive quoting usually leads the market maker to 
take steps to reduce the number of its quotes.
    [cir] Holdback Timer. The ISE has the systemic ability to limit the 
dissemination of quotations and other changes to the ISE best bid and 
offer according to prescribed time criteria (a ``Holdback Timer''). For 
example, if there is a change in the price of a security underlying an 
option, multiple market makers likely will adjust the price or size of 
their quotes. Rather than disseminating each individual change, the 
Holdback Timer permits the Exchange to wait until all market makers 
have adjusted their quotes and then to disseminate a new quotation. 
This helps prevent the ``flickering'' of quotations. The ISE proposes 
to codify the Holdback Timer. As proposed in ISE Rule 804, the ISE will 
utilize a Holdback Timer that delays quotation updates for up to, but 
not longer than, one second.
    [cir] Delisting. The ISE has committed to the Commission that it 
will delist options with average daily volume (``ADV'') of less than 20 
contracts.\9\ However, it has been the ISE's policy to be more 
aggressive in delisting relatively inactive options, thereby 
eliminating the quotation traffic attendant to such listings. 
Currently, it is the ISE's policy to delist options with ADV of less 
than 50, even with the advent of the Exchange's new ``Second Market,'' 
\10\ which provides liquidity for less-active options.
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    \9\ See Securities Exchange Act Release No. 47483 (March 11, 
2003), 68 FR 13352 (March 19, 2003) (SR-ISE-2003-04).
    \10\ See Securities Exchange Act Release No. 54340 (August 21, 
2006), 71 FR 51240 (August 29, 2006) (SR-ISE-2006-40).
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III. Discussion

    After careful review of the proposal, the comment letters and the 
Exchange's response thereto, the Commission finds that the proposed 
rule change, as modified by Amendment Nos. 1 and 2, is consistent with 
the requirements of the Act and the rules and regulations thereunder 
applicable to a national securities exchange.\11\ In particular, the 
Commission finds that the proposal is consistent with Section 6(b)(5) 
of the Act,\12\ which requires, among other things, that the rules of 
an exchange be 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.
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    \11\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
    \12\ 15 U.S.C. 78f(b)(5).
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    The Commission believes that the implementation of a limited six-
month Penny Pilot Program by the ISE and the five other options 
exchanges will provide valuable information to the exchanges, the 
Commission and others about the impact of penny quoting in the options 
market. In particular, the Penny Pilot Program will allow analysis of 
the impact of penny quoting on: (1) Spreads; (2) transaction costs; (3) 
payment for order flow; and (4) quote message traffic.

[[Page 4756]]

    The Commission believes that the thirteen options classes to be 
included in the penny pilot program represent a diverse group of 
options classes with varied trading characteristics. This diversity 
should facilitate analyses by the Commission, the options exchanges and 
others. The Commission also believes that the Penny Pilot Program is 
sufficiently limited that it is unlikely to increase quote message 
traffic beyond the capacity of market participants' systems and disrupt 
the timely receipt of quote information.\13\ Nevertheless, because the 
Commission expects that the Penny Pilot Program will increase quote 
message traffic, the Commission is also approving the Exchange's 
proposals to reduce the number of quotations it disseminates.
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    \13\ In addition, the Commission believes that it is appropriate 
for ISE to amend ISE Rule 716 to clarify that options trading in 
penny increments is not eligible for split pricing.
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    In this regard, the commenters expressed concern about ISE's 
proposed quote mitigation strategy. In particular, although 
optionsXpress generally supported ISE's Holdback Timer, it expressed 
concern that a longer holdback timer period could negatively impact 
market quality and undermine transparency in the options market.\14\
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    \14\ See optionsXpress Letter, supra note 4. OptionsXpress also 
stated its view that current problems with the intermarket linkage 
will be exacerbated in the option classes participating in the Penny 
Pilot Program. Id.
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    In addition, SIFMA recommends that all six of the option exchanges 
adopt a comprehensive and uniform quote mitigation strategy.\15\ In 
particular, SIFMA strongly supports the adoption of the Holdback Timer 
mitigation proposal as the most efficient means of reducing quotation 
traffic. SIFMA, however, expressed concern that the lack of uniformity 
among the quote mitigation proposals adopted by the exchanges will 
impose a burden on member firms and cause confusion for market 
participants, especially retail investors.
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    \15\ See SIFMA Letter, supra note 4.
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    Although SIFMA urges the adoption of a uniform and comprehensive 
approach to quote mitigation, it does not oppose ISE's quote mitigation 
proposals. In fact, SIFMA acknowledges that certain of ISE's proposals, 
such as notifying members whose quote activity suggests systems 
malfunctions or wrong settings and delisting inactive series can 
contribute to quote mitigation. SIFMA, however, expressed its belief 
that these proposals do not go far enough to resolve the industry's 
concerns regarding systems capacity.
    The Commission supports efforts to implement a uniform, industry-
wide quote mitigation plan. It does not, however, believe such efforts 
preclude individual exchanges from initiating their own quote 
mitigation strategies. The Commission does not believe that ISE's 
proposed quote mitigation strategies will lead to confusion among 
market participants.
    Finally, CBOE commented that it did not have a fundamental 
objection to ISE's use of the Holdback Timer, but instead sought 
additional information concerning how the Holdback Timer functions and 
how orders sent to ISE by CBOE members or by CBOE though linkage might 
be impacted by the Holdback Timer.\16\ Specifically, CBOE requested 
additional information about the extent to which the Holdback Timer is 
utilized throughout the day and whether it is used uniformly in all 
option classes traded on ISE. In response, ISE indicated that it 
intends to use the Holdback Timer uniformly in all option classes.\17\ 
In addition, the ISE committed to apply the Holdback Timer mechanism 
throughout the trading day for a period of up to, but no more than, one 
second.\18\ In further response to inquiry from CBOE, the ISE 
represented that it does not intend to disclose the precise length of 
the timer to its members, to non-members or to the other exchanges.\19\
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    \16\ See CBOE Letter, supra note 4.
    \17\ Telephone conversation between Katherine Simmons, Deputy 
General Counsel, ISE, and Jennifer L. Colihan, Special Counsel and 
Cyndi N. Rodriguez, Special Counsel, Division of Market Regulation, 
Commission, on January 23, 2007. See also Exchange Response, supra 
note 6.
    \18\ Telephone conversation between Katherine Simmons, Deputy 
General Counsel, ISE and Jennifer L. Colihan, Special Counsel, and 
Cyndi N. Rodriguez, Division of Market Regulation, Commission, on 
January 23, 2007.
    \19\ Id.
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    In addition, CBOE inquired whether the Holdback Timer will apply 
only to market maker quotations and asked the Exchange to clarify what 
information will be delayed by the Holdback Timer. ISE clarified that 
the Holdback Timer will be applied when there is a change in the price 
and/or size of the security underlying an option. The Exchange will 
wait (for a period up to one second) until multiple market participants 
have adjusted their quotes and then will disseminate a new quotation. 
The Exchange will apply the Holdback Timer to all data that it sends to 
OPRA.\20\ Finally, in response to CBOE's inquiry regarding the 
treatment of incoming marketable orders, ISE indicated that Holdback 
Timer ``does not affect the receipt or processing of quotes, orders or 
trades within the Exchange's system in any way.'' \21\ Therefore, 
incoming marketable orders sent to the Exchange will be executed 
against the prices and sizes available in ISE's system without regard 
to the application of the Holdback Timer.\22\
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    \20\ See Exchange Response, supra note 7.
    \21\ Id.
    \22\ Id.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\23\ that the proposed rule change (SR-ISE-2006-62), as modified by 
Amendment Nos. 1 and 2, be, and hereby is, approved on a six-month 
pilot basis, which will commence on January 26, 2007.
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    \23\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\24\
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    \24\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
 [FR Doc. E7-1590 Filed 1-31-07; 8:45 am]
BILLING CODE 8011-01-P