[Federal Register Volume 80, Number 92 (Wednesday, May 13, 2015)]
[Notices]
[Pages 27373-27390]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-11587]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-74896; File No. SR-ISE-2015-18]
Self-Regulatory Organizations; International Securities Exchange,
LLC; Notice of Filing and Immediate Effectiveness of Proposed Rule
Change Related to the Nullification and Adjustment of Options
Transactions Including Obvious Errors
May 7, 2015.
Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934
(the ``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given
that, on May 6, 2015 the International Securities Exchange, LLC (the
``Exchange'' or the ``ISE'') filed with the Securities and Exchange
Commission the proposed rule change, as described in Items I and II
below, which items have been prepared by the self-regulatory
organization. The Commission is publishing this notice to solicit
comments on the proposed rule change from interested persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The ISE proposes to amend current Rule 720 (``Current Rule''), and
rename it ``Nullification and Adjustment of Options Transactions
including Obvious
[[Page 27374]]
Errors'' (``Proposed Rule''). Rule 720 relates to the adjustment and
nullification of options transactions executed on the Exchange (``ISE
Options''). The text of the proposed rule change is available on the
Exchange's Web site (http://www.ise.com), at the principal office of
the Exchange, and at the Commission's Public Reference Room.
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 self-regulatory organization
included statements concerning the purpose of, and basis for, the
proposed rule change and discussed any comments it received on the
proposed rule change. The text of these statements may be examined at
the places specified in Item IV below. The self-regulatory organization
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
Background
For several months the Exchange has been working with other options
exchanges to identify ways to improve the process related to the
adjustment and nullification of erroneous options transactions. The
goal of the process that the options exchanges have undertaken is to
adopt harmonized rules related to the adjustment and nullification of
erroneous options transactions as well as a specific provision related
to coordination in connection with large-scale events involving
erroneous options transactions. As described below, the Exchange
believes that the changes the options exchanges and the Exchange have
agreed to propose will provide transparency and finality with respect
to the adjustment and nullification of erroneous options transactions.
Particularly, the proposed changes seek to achieve consistent results
for participants across U.S. options exchanges while maintaining a fair
and orderly market, protecting investors and protecting the public
interest.
The Proposed Rule is the culmination of this coordinated effort and
reflects discussions by the options exchanges to universally adopt: (1)
Certain provisions already in place on one or more options exchanges;
and (2) new provisions that the options exchanges collectively believe
will improve the handling of erroneous options transactions. Thus,
although the Proposed Rule is in many ways similar to and based on the
Exchange's Current Rule, the Exchange is adopting various provisions to
conform with existing rules of one or more options exchanges and also
to adopt rules that are not currently in place on any options exchange.
As noted above, in order to adopt a rule that is similar in most
material respects to the rules adopted by other options exchanges, the
Exchange proposes to delete the Current Rule in its entirety, with two
exceptions,\3\ and to replace it with the Proposed Rule.
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\3\ The Exchange is not proposing to delete from its Current
Rule a provision regarding the treatment of Obvious Errors involving
complex orders. The current rule found in Supplementary Material .06
to Rule 720 provides that ``[i]f both parties to a trade that is one
component of a complex order execution are parties to all of the
trades that together comprise the execution of a complex order at a
single net debit or credit, then if one of those component trades
can be nullified under this Rule 720, all component trades that were
part of the same complex order shall be nullified as well.''
The Exchange also proposes to keep language in Supplementary
Material .01 to Rule 720 that authorizes the Exchange to disclose
the identity of parties to a trade to each other when the Market
Control determines that an Obvious or Catastrophic Error has
occurred. The Exchange believes that this provision is important to
encourage conflict resolution between two parties to a trade.
With the remaining text in the Supplementary Material to Rule
720 now being deleted, the Exchange proposes to renumber
Supplementary Material .01 and .06.
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The Exchange notes that it has proposed additional objective
standards in the Proposed Rule as compared to the Current Rule. The
Exchange also notes that the Proposed Rule will ensure that the
Exchange will have the same standards as all other options exchanges.
However, there are still areas under the Proposed Rule where subjective
determinations need to be made by Exchange personnel with respect to
the calculation of Theoretical Price. The Exchange notes that the
Exchange and all other options exchanges have been working to further
improve the review of potentially erroneous transactions as well as
their subsequent adjustment by creating an objective and universal way
to determine Theoretical Price in the event a reliable NBBO is not
available. For instance, the Exchange and all other options exchanges
may utilize an independent third party to calculate and disseminate or
make available Theoretical Price. However, this initiative requires
additional exchange and industry discussion as well as additional time
for development and implementation. The Exchange will continue to work
with other options exchanges and the options industry towards the goal
of additional objectivity and uniformity with respect to the
calculation of Theoretical Price.
As additional background, the Exchange believes that the Proposed
Rule supports an approach consistent with long-standing principles in
the options industry under which the general policy is to adjust rather
than nullify transactions. The Exchange acknowledges that adjustment of
transactions is contrary to the operation of analogous rules applicable
to the equities markets, where erroneous transactions are typically
nullified rather than adjusted and where there is no distinction
between the types of market participants involved in a transaction. For
the reasons set forth below, the Exchange believes that the
distinctions in market structure between equities and options markets
continue to support these distinctions between the rules for handling
obvious errors in the equities and options markets. The Exchange also
believes that the Proposed Rule properly balances several competing
concerns based on the structure of the options markets.
Various general structural differences between the options and
equities markets point toward the need for a different balancing of
risks for options market participants and are reflected in the Proposed
Rule. Option pricing is formulaic and is tied to the price of the
underlying stock, the volatility of the underlying security and other
factors. Because options market participants can generally create new
open interest in response to trading demand, as new open interest is
created, correlated trades in the underlying or related series are
generally also executed to hedge a market participant's risk. This
pairing of open interest with hedging interest differentiates the
options market specifically (and the derivatives markets broadly) from
the cash equities markets. In turn, the Exchange believes that the
hedging transactions engaged in by market participants necessitates
protection of transactions through adjustments rather than
nullifications when possible and otherwise appropriate.
The options markets are also quote driven markets dependent on
liquidity providers to an even greater extent than equities markets. In
contrast to the approximately 7,000 different securities traded in the
U.S. equities markets each day, there are more than 500,000 unique,
regularly quoted option series. Given this breadth in options series
the options markets are more dependent on liquidity providers than
equities markets; such liquidity is provided most
[[Page 27375]]
commonly by registered market makers but also by other professional
traders. With the number of instruments in which registered market
makers must quote and the risk attendant with quoting so many products
simultaneously, the Exchange believes that those liquidity providers
should be afforded a greater level of protection. In particular, the
Exchange believes that liquidity providers should be allowed protection
of their trades given the fact that they typically engage in hedging
activity to protect them from significant financial risk to encourage
continued liquidity provision and maintenance of the quote-driven
options markets.
In addition to the factors described above, there are other
fundamental differences between options and equities markets which lend
themselves to different treatment of different classes of participants
that are reflected in the Proposed Rule. For example, there is no trade
reporting facility in the options markets. Thus, all transactions must
occur on an options exchange. This leads to significantly greater
retail customer participation directly on exchanges than in the
equities markets, where a significant amount of retail customer
participation never reaches the Exchange but is instead executed in
off-exchange venues such as alternative trading systems, broker-dealer
market making desks and internalizers. In turn, because of such direct
retail customer participation, the exchanges have taken steps to afford
those retail customers--generally Customers--more favorable treatment
in some circumstances.
Definitions
The Exchange proposes to adopt various definitions that will be
used in the Proposed Rule, as described below.
First, the Exchange proposes to adopt a definition of ``Customer,''
to make clear that this term has the same definition as Priority
Customer in Rule 100(a)(37A). Although other portions of the Exchange's
rules address the capacity of market participants, including customers,
the proposed definition is consistent with such rules and the Exchange
believes it is important for all options exchanges to have the same
definition of Customer in the context of nullifying and adjusting
trades in order to have harmonized rules. As set forth in detail below,
orders on behalf of a Customer are in many cases treated differently
than non-Customer orders in light of the fact that Customers are not
necessarily immersed in the day-to-day trading of the markets, are less
likely to be watching trading activity in a particular option
throughout the day, and may have limited funds in their trading
accounts.
Second, the Exchange proposes to adopt definitions for both an
``erroneous sell transaction'' and an ``erroneous buy transaction.'' As
proposed, an erroneous sell transaction is one in which the price
received by the person selling the option is erroneously low, and an
erroneous buy transaction is one in which the price paid by the person
purchasing the option is erroneously high. This provision helps to
reduce the possibility that a party can intentionally submit an order
hoping for the market to move in their favor while knowing that the
transaction will be nullified or adjusted if the market does not. For
instance, when a market participant who is buying options in a
particular series sees an aggressively priced sell order posted on the
Exchange, and the buyer believes that the price of the options is such
that it might qualify for obvious error, the option buyer can trade
with the aggressively priced order, then wait to see which direction
the market moves. If the market moves in their direction, the buyer
keeps the trade and if it moves against them, the buyer calls the
Exchange hoping to get the trade adjusted or busted.
Third, the Exchange proposes to adopt a definition of ``Official,''
which would mean an Officer of the Exchange or such other employee
designee of the Exchange that is trained in the application of the
Proposed Rule.
Fourth, the Exchange proposes to adopt a new term, a ``Size
Adjustment Modifier,'' which would apply to individual transactions and
would modify the applicable adjustment for orders under certain
circumstances, as discussed in further detail below. As proposed, the
Size Adjustment Modifier will be applied to individual transactions as
follows:
------------------------------------------------------------------------
Number of contracts per execution Adjustment--TP plus/minus
------------------------------------------------------------------------
1-50...................................... N/A.
51-250.................................... 2 times adjustment amount.
251-1000.................................. 2.5 times adjustment amount.
1001 or more.............................. 3 times adjustment amount.
------------------------------------------------------------------------
The Size Adjustment Modifier attempts to account for the additional
risk that the parties to the trade undertake for transactions that are
larger in scope. The Exchange believes that the Size Adjustment
Modifier creates additional incentives to prevent more impactful
Obvious Errors and it lessens the impact on the contra-party to an
adjusted trade. The Exchange notes that these contra-parties may have
preferred to only trade the size involved in the transaction at the
price at which such trade occurred, and in trading larger size has
committed a greater level of capital and bears a larger hedge risk.
When setting the proposed size adjustment modifier thresholds the
Exchange has tried to correlate the size breakpoints with typical small
and larger ``block'' execution sizes of underlying stock. For instance,
SEC Rule 10b-18(a)(5)(ii) defines a ``block'' as a quantity of stock
that is at least 5,000 shares and a purchase price of at least $50,000,
among others.\4\ Similarly, NYSE Rule 72 defines a ``block'' as an
order to buy or sell ``at least 10,000 shares or a quantity of stock
having a market value of $200,000 or more, whichever is less.'' Thus,
executions of 51 to 100 option contracts, which are generally
equivalent to executions of 5,100 and 10,000 shares of underlying
stock, respectively, are proposed to be subject to the lowest size
adjustment modifier. An execution of over 1,000 contracts is roughly
equivalent to a block transaction of more than 100,000 shares of
underlying stock, and is proposed to be subject to the highest size
adjustment modifier. The Exchange has correlated the proposed size
adjustment modifier thresholds to smaller and larger scale blocks
because the Exchange believes that the execution cost associated with
transacting in block sizes scales according to the size of the block.
In other words, in the same way that executing a 100,000 share stock
order will have a proportionately larger market impact and will have a
higher overall execution cost than executing a 500, 1,000 or 5,000
share order in the same stock, all other market factors being equal,
executing a 1,000 option contract order will have a larger market
impact and higher overall execution cost than executing a 5, 10 or 50
contract option order.
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\4\ See 17 CFR 240.10b-18(a)(5)(ii).
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Calculation of Theoretical Price
Theoretical Price in Normal Circumstances
Under both the Current Rule and the Proposed Rule, when reviewing a
transaction as potentially erroneous, the Exchange needs to first
determine the ``Theoretical Price'' of the option, i.e., the Exchange's
estimate of the correct market price for the option. Pursuant to the
Proposed Rule, if the applicable option series is traded on at least
one other options exchange, then the Theoretical Price of an option
series is the last national best bid (``NBB'') just prior to the trade
in question with
[[Page 27376]]
respect to an erroneous sell transaction or the last national best
offer (``NBO'') just prior to the trade in question with respect to an
erroneous buy transaction unless one of the exceptions described below
exists. Thus, the Exchange proposes that whenever the Exchange has a
reliable NBB or NBO, as applicable, just prior to the transaction, then
the Exchange will use this NBB or NBO as the Theoretical Price.
The Exchange also proposes to specify in the Proposed Rule that
when a single order received by the Exchange is executed at multiple
price levels, the last NBB and last NBO just prior to the trade in
question would be the last NBB and last NBO just prior to the
Exchange's receipt of the order.
The Exchange also proposes to set forth in the Proposed Rule
various provisions governing specific situations where the NBB or NBO
is not available or may not be reliable. Specifically, the Exchange is
proposing additional detail specifying situations in which there are no
quotes or no valid quotes (as defined below), when the national best
bid or offer (``NBBO'') is determined to be too wide to be reliable,
and at the open of trading on each trading day.
No Valid Quotes
As is true under the Current Rule, pursuant to the Proposed Rule
the Exchange will determine the Theoretical Price if there are no
quotes or no valid quotes for comparison purposes. As proposed, quotes
that are not valid are all quotes in the applicable option series
published at a time where the last NBB is higher than the last NBO in
such series (a ``crossed market''), quotes published by the Exchange
that were submitted by either party to the transaction in question, and
quotes published by another options exchange against which the Exchange
has declared self-help. Thus, in addition to scenarios where there are
literally no quotes to be used as Theoretical Price, the Exchange will
exclude quotes in certain circumstances if such quotes are not deemed
valid. The Proposed Rule is consistent with the Exchange's application
of the Current Rule but the descriptions of the various scenarios where
the Exchange considers quotes to be invalid represent additional detail
that is not included in the Current Rule.
The Exchange notes that Exchange personnel currently are required
to determine Theoretical Price in certain circumstances. While the
Exchange continues to pursue alternative solutions that might further
enhance the objectivity and consistency of determining Theoretical
Price, the Exchange believes that the discretion currently afforded to
Exchange Officials is appropriate in the absence of a reliable NBBO
that can be used to set the Theoretical Price. Under the current Rule,
Exchange personnel will generally consult and refer to data such as the
prices of related series, especially the closest strikes in the option
in question. Exchange personnel may also take into account the price of
the underlying security and the volatility characteristics of the
option as well as historical pricing of the option and/or similar
options.
Wide Quotes
Similarly, pursuant to the Proposed Rule the Exchange will
determine the Theoretical Price if the bid/ask differential of the NBB
and NBO for the affected series just prior to the erroneous transaction
was equal to or greater than the Minimum Amount set forth below and
there was a bid/ask differential less than the Minimum Amount during
the 10 seconds prior to the transaction. If there was no bid/ask
differential less than the Minimum Amount during the 10 seconds prior
to the transaction then the Theoretical Price of an option series is
the last NBB or NBO just prior to the transaction in question. The
Exchange proposes to use the following chart to determine whether a
quote is too wide to be reliable:
------------------------------------------------------------------------
Bid price at time of trade Minimum amount
------------------------------------------------------------------------
Below $2.00............................................. $0.75
$2.00 to $5.00.......................................... 1.25
Above $5.00 to $10.00................................... 1.50
Above $10.00 to $20.00.................................. 2.50
Above $20.00 to $50.00.................................. 3.00
Above $50.00 to $100.00................................. 4.50
Above $100.00........................................... 6.00
------------------------------------------------------------------------
The Exchange notes that the values set forth above generally
represent a multiple of 3 times the bid/ask differential requirements
of other options exchanges, with certain rounding applied (e.g., $1.25
as proposed rather than $1.20).\5\ The Exchange believes that basing
the Wide Quote table on a multiple of the permissible bid/ask
differential rule provides a reasonable baseline for quotations that
are indeed so wide that they cannot be considered reliable for purposes
of determining Theoretical Price unless they have been consistently
wide. As described above, while the Exchange will determine Theoretical
Price when the bid/ask differential equals or exceeds the amount set
forth in the chart above and within the previous 10 seconds there was a
bid/ask differential smaller than such amount, if a quote has been
persistently wide for at least 10 seconds the Exchange will use such
quote for purposes of Theoretical Price. The Exchange believes that
there should be a greater level of protection afforded to market
participants that enter the market when there are liquidity gaps and
price fluctuations. The Exchange does not believe that a similar level
of protection is warranted when market participants choose to enter a
market that is wide and has been consistently wide for some time. The
Exchange notes that it has previously determined that, given the
largely electronic nature of today's markets, as little as one second
(or less) is a long enough time for market participants to receive,
process and account for and respond to new market information.\6\ While
introducing this new provision the Exchange believes it is being
appropriately cautious by selecting a time frame that is an order of
magnitude above and beyond what the Exchange has previously determined
is sufficient for information dissemination. The table above bases the
wide quote provision off of bid price in order to provide a relatively
straightforward beginning point for the analysis.
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\5\ See, e.g., NYSE Arca Options Rule 6.37(b)(1).
\6\ See, e.g., Supplementary Material .04 to Exchange Rule 717,
which requires certain orders to be exposed for at least one second
before they can be executed; see also Securities Exchange Act
Release No. 66306 (February 2, 2012), 77 FR 6608 (February 8, 2012)
(SR-BX-2011-084) (order granting approval of proposed rule change to
reduce the duration of the PIP from one second to one hundred
milliseconds).
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As an example, assume an option is quoted $3.00 by $6.00 with 50
contracts posted on each side of the market for an extended period of
time. If a market participant were to enter a market order to buy 20
contracts the Exchange believes that the buyer should have a reasonable
expectation of paying $6.00 for the contracts which they are buying.
This should be the case even if immediately after the purchase of those
options, the market conditions change and the same option is then
quoted at $3.75 by $4.25. Although the quote was wide according to the
table above at the time immediately prior to and the time of the
execution of the market order, it was also well established and well
known. The Exchange believes that an execution at the then prevailing
market price should not in and of itself constitute an erroneous trade.
Transactions at the Open
Under the Proposed Rule, for a transaction occurring during the
[[Page 27377]]
opening rotation the Exchange will determine the Theoretical Price
where there is no NBB or NBO for the affected series just prior to the
erroneous transaction or if the bid/ask differential of the NBBO just
prior to the erroneous transaction is equal to or greater than the
Minimum Amount set forth in the chart proposed for the wide quote
provision described above. The Exchange believes that this discretion
is necessary because it is consistent with other scenarios in which the
Exchange will determine the Theoretical Price if there are no quotes or
no valid quotes for comparison purposes, including the wide quote
provision proposed by the Exchange as described above. If, however,
there are valid quotes and the bid/ask differential of the NBBO is less
than the Minimum Amount set forth in the chart proposed for the wide
quote provision described above, then the Exchange will use the NBB or
NBO just prior to the transaction as it would in any other normal
review scenario.
As an example of an erroneous transaction for which the NBBO is
wide at the open, assume the NBBO at the time of the opening
transaction is $1.00 x $5.00 and the opening transaction takes place at
$1.25. The Exchange would be responsible for determining the
Theoretical Price because the NBBO was wider than the applicable
minimum amount set forth in the wide quote provision as described
above. The Exchange believes that it is necessary to determine
theoretical price at the open in the event of a wide quote at the open
for the same reason that the Exchange has proposed to determine
theoretical price during the remainder of the trading day pursuant to
the proposed wide quote provision, namely that a wide quote cannot be
reliably used to determine Theoretical Price because the Exchange does
not know which of the two quotes, the NBB or the NBO, is closer to the
real value of the option.
Obvious Errors
The Exchange proposes to adopt numerical thresholds that would
qualify transactions as ``Obvious Errors.'' These thresholds are
similar to those in place under the Current Rule. As proposed, a
transaction will qualify as an Obvious Error if the Exchange receives a
properly submitted filing and the execution price of a transaction is
higher or lower than the Theoretical Price for the series by an amount
equal to at least the amount shown below:
------------------------------------------------------------------------
Theoretical price Minimum amount
------------------------------------------------------------------------
Below $2.00............................................. $0.25
$2.00 to $5.00.......................................... 0.40
Above $5.00 to $10.00................................... 0.50
Above $10.00 to $20.00.................................. 0.80
Above $20.00 to $50.00.................................. 1.00
Above $50.00 to $100.00................................. 1.50
Above $100.00........................................... 2.00
------------------------------------------------------------------------
Applying the Theoretical Price, as described above, to determine
the applicable threshold and comparing the Theoretical Price to the
actual execution price provides the Exchange with an objective
methodology to determine whether an Obvious Error occurred. The
Exchange believes that the proposed amounts are reasonable as they are
generally consistent with the standards of the Current Rule and reflect
a significant disparity from Theoretical Price. The Exchange notes that
the Minimum Amounts in the Proposed Rule and as set forth above are
identical to the Current Rule except for the last two categories, for
options where the Theoretical Price is above $50.00 to $100.00 and
above $100.00. The Exchange believes that this additional granularity
is reasonable because given the proliferation of additional strikes
that have been created in the past several years there are many more
high-priced options that are trading with open interest for extended
periods. The Exchange believes that it is appropriate to account for
these high-priced options with additional Minimum Amount levels for
options with Theoretical Prices above $50.00.
Under the Proposed Rule, a party that believes that it participated
in a transaction that was the result of an Obvious Error must notify
the Exchange's Market Control \7\ in the manner specified from time to
time by the Exchange in a circular distributed to Members. The Exchange
believes that maintaining flexibility in the Rule is important to allow
for changes to the process.
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\7\ Market Control consists of designated personnel in the
Exchange's market control center.
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The Exchange also proposes to adopt notification timeframes that
must be met in order for a transaction to qualify as an Obvious Error.
Specifically, as proposed a filing must be received by the Exchange
within thirty (30) minutes of the execution with respect to an
execution of a Customer order and within fifteen (15) minutes of the
execution for any other participant. The Exchange also proposes to
provide additional time for trades that are routed through other
options exchanges to the Exchange. Under the Proposed Rule, any other
options exchange will have a total of forty-five (45) minutes for
Customer orders and thirty (30) minutes for non-Customer orders,
measured from the time of execution on the Exchange, to file with the
Exchange for review of transactions routed to the Exchange from that
options exchange and executed on the Exchange (``linkage trades'').
This includes filings on behalf of another options exchange filed by a
third-party routing broker if such third-party broker identifies the
affected transactions as linkage trades. In order to facilitate timely
reviews of linkage trades the Exchange will accept filings from either
the other options exchange or, if applicable, the third-party routing
broker that routed the applicable order(s). The additional fifteen (15)
minutes provided with respect to linkage trades shall only apply to the
extent the options exchange that originally received and routed the
order to the Exchange itself received a timely filing from the entering
participant (i.e., within 30 minutes if a Customer order or 15 minutes
if a non-Customer order). The Exchange believes that additional time
for filings related to Customer orders is appropriate in light of the
fact that Customers are not necessarily immersed in the day-to-day
trading of the markets and are less likely to be watching trading
activity in a particular option throughout the day. The Exchange
believes that the additional time afforded to linkage trades is
appropriate given the interconnected nature of the markets today and
the practical difficulty that an end user may face in getting requests
for review filed in a timely fashion when the transaction originated at
a different exchange than where the error took place. Without this
additional time the Exchange believes it would be common for a market
participant to satisfy the filing deadline at the original exchange to
which an order was routed but that requests for review of executions
from orders routed to other options exchanges would not qualify for
review as potential Obvious Errors by the time filings were received by
such other options exchanges, in turn leading to potentially disparate
results under the applicable rules of options exchanges to which the
orders were routed.
Pursuant to the Proposed Rule, an Official may review a transaction
believed to be erroneous on his/her own motion in the interest of
maintaining a fair and orderly market and for the protection of
investors. This proposed provision is designed to give an Official the
ability to provide parties relief in those situations where they have
failed to report an apparent error within the
[[Page 27378]]
established notification period. A transaction reviewed pursuant to the
proposed provision may be nullified or adjusted only if it is
determined by the Official that the transaction is erroneous in
accordance with the provisions of the Proposed Rule, provided that the
time deadlines for filing a request for review described above shall
not apply. The Proposed Rule would require the Official to act as soon
as possible after becoming aware of the transaction; action by the
Official would ordinarily be expected on the same day that the
transaction occurred. However, because a transaction under review may
have occurred near the close of trading or due to unusual
circumstances, the Proposed Rule provides that the Official shall act
no later than 8:30 a.m. Eastern Time on the next trading day following
the date of the transaction in question.
The Exchange also proposes to state that a party affected by a
determination to nullify or adjust a transaction after an Official's
review on his or her own motion may appeal such determination in
accordance with paragraph (k), which is described below. The Proposed
Rule would make clear that a determination by an Official not to review
a transaction or determination not to nullify or adjust a transaction
for which a review was conducted on an Official's own motion is not
appealable and further that if a transaction is reviewed and a
determination is rendered pursuant to another provision of the Proposed
Rule, no additional relief may be granted by an Official.
If it is determined that an Obvious Error has occurred based on the
objective numeric criteria and time deadlines described above, the
Exchange will adjust or nullify the transaction as described below and
promptly notify both parties to the trade electronically or via
telephone. The Exchange proposes different adjustment and nullification
criteria for Customers and non-Customers.
As proposed, where neither party to the transaction is a Customer,
the execution price of the transaction will be adjusted by the Official
pursuant to the table below.
------------------------------------------------------------------------
Buy transaction Sell transaction
Theoretical price (TP) adjustment-- TP adjustment-- TP
plus minus
------------------------------------------------------------------------
Below $3.00....................... $0.15 $0.15
At or above $3.00................. 0.30 0.30
------------------------------------------------------------------------
The Exchange believes that it is appropriate to adjust to prices a
specified amount away from Theoretical Price rather than to adjust to
Theoretical Price because even though the Exchange has determined a
given trade to be erroneous in nature, the parties in question should
have had some expectation of execution at the price or prices
submitted. Also, it is common that by the time it is determined that an
obvious error has occurred additional hedging and trading activity has
already occurred based on the executions that previously happened. The
Exchange is concerned that an adjustment to Theoretical Price in all
cases would not appropriately incentivize market participants to
maintain appropriate controls to avoid potential errors.
Further, as proposed any non-Customer Obvious Error exceeding 50
contracts will be subject to the Size Adjustment Modifier described
above. The Exchange believes that it is appropriate to apply the Size
Adjustment Modifier to non-Customer orders because the hedging cost
associated with trading larger sized options orders and the market
impact of larger blocks of underlying can be significant.
As an example of the application of the Size Adjustment Modifier,
assume Exchange A has a quoted bid to buy 50 contracts at $2.50,
Exchange B has a quoted bid to buy 100 contracts at $2.05 and there is
no other options exchange quoting a bid priced higher than $2.00.
Assume that the NBBO is $2.50 by $3.00. Finally, assume that all orders
quoted and submitted to Exchange B in connection with this example are
non-Customer orders.
Assume Exchange A's quoted bid at $2.50 is either executed
or cancelled.
Assume Exchange B immediately thereafter receives an
incoming market order to sell 100 contracts.
The incoming order would be executed against Exchange B's
resting bid at $2.05 for 100 contracts.
Because the 100 contract execution of the incoming sell
order was priced at $2.05, which is $0.45 below the Theoretical Price
of $2.50, the 100 contract execution would qualify for adjustment as an
Obvious Error.
The normal adjustment process would adjust the execution
of the 100 contracts to $2.35 per contract, which is the Theoretical
Price minus $0.15.
However, because the execution would qualify for the Size
Adjustment Modifier of 2 times the adjustment price, the adjusted
transaction would instead be to $2.20 per contract, which is the
Theoretical Price minus $0.30.
By reference to the example above, the Exchange reiterates that it
believes that a Size Adjustment Modifier is appropriate, as the buyer
in this example was originally willing to buy 100 contracts at $2.05
and ended up paying $2.20 per contract for such execution. Without the
Size Adjustment Modifier the buyer would have paid $2.35 per contract.
Such buyer may be advantaged by the trade if the Theoretical Price is
indeed closer to $2.50 per contract, however the buyer may not have
wanted to buy so many contracts at a higher price and does incur
increasing cost and risk due to the additional size of their quote.
Thus, the proposed rule is attempting to strike a balance between
various competing objectives, including recognition of cost and risk
incurred in quoting larger size and incentivizing market participants
to maintain appropriate controls to avoid errors.
In contrast to non-Customer orders, where trades will be adjusted
if they qualify as Obvious Errors, pursuant the Proposed Rule a trade
that qualifies as an Obvious Error will be nullified where at least one
party to the Obvious Error is a Customer. The Exchange also proposes,
however, that if any Member submits requests to the Exchange for review
of transactions pursuant to the Proposed Rule, and in aggregate that
Member has 200 or more Customer transactions under review concurrently
and the orders resulting in such transactions were submitted during the
course of 2 minutes or less, where at least one party to the Obvious
Error is a non-Customer, the Exchange will apply the non-Customer
adjustment criteria described above to such transactions. The Exchange
based its proposal of 200 transactions on the fact that the proposed
level is reasonable as it is representative of an extremely large
number of orders submitted to the Exchange that are, in turn, possibly
erroneous. Similarly, the Exchange based its proposal of orders
received in 2 minutes or less on the fact that this is
[[Page 27379]]
a very short amount of time under which one Member could generate
multiple erroneous transactions. In order for a participant to have
more than 200 transactions under review concurrently when the orders
triggering such transactions were received in 2 minutes or less, the
market participant will have far exceeded the normal behavior of
customers deserving protected status.\8\ While the Exchange continues
to believe that it is appropriate to nullify transactions in such a
circumstance if both participants to a transaction are Customers, the
Exchange does not believe it is appropriate to place the overall risk
of a significant number of trade breaks on non-Customers that in the
normal course of business may have engaged in additional hedging
activity or trading activity based on such transactions. Thus, the
Exchange believes it is necessary and appropriate to protect non-
Customers in such a circumstance by applying the non-Customer
adjustment criteria, and thus adjusting transactions as set forth
above, in the event a Member has more than 200 transactions under
review concurrently.
---------------------------------------------------------------------------
\8\ The Exchange notes that in the third quarter of this year
across all options exchanges the average number of valid Customer
orders received and executed was less than 38 valid orders every two
minutes. The number of obvious errors resulting from valid orders
is, of course, a very small fraction of such orders.
---------------------------------------------------------------------------
Catastrophic Errors
Consistent with the Current Rule, the Exchange proposes to adopt
separate numerical thresholds for review of transactions for which the
Exchange does not receive a filing requesting review within the Obvious
Error timeframes set forth above. Based on this review these
transactions may qualify as ``Catastrophic Errors.'' As proposed, a
Catastrophic Error will be deemed to have occurred when the execution
price of a transaction is higher or lower than the Theoretical Price
for the series by an amount equal to at least the amount shown below:
------------------------------------------------------------------------
Theoretical price Minimum amount
------------------------------------------------------------------------
Below $2.00............................................. $0.50
$2.00 to $5.00.......................................... 1.00
Above $5.00 to $10.00................................... 1.50
Above $10.00 to $20.00.................................. 2.00
Above $20.00 to $50.00.................................. 2.50
Above $50.00 to $100.00................................. 3.00
Above $100.00........................................... 4.00
------------------------------------------------------------------------
Based on industry feedback on the Catastrophic Error thresholds set
forth under the Current Rule, the thresholds proposed as set forth
above are more granular and lower (i.e., more likely to qualify) than
the thresholds under the Current Rule. As noted above, under the
Proposed Rule as well as the Current Rule, parties have additional time
to submit transactions for review as Catastrophic Errors. As proposed,
notification requesting review must be received by the Exchange's
Market Control by 8:30 a.m. Eastern Time on the first trading day
following the execution. For transactions in an expiring options series
that take place on an expiration day, a party must notify the
Exchange's Market Control within 45 minutes after the close of trading
that same day. As is true for requests for review under the Obvious
Error provision of the Proposed Rule, a party requesting review of a
transaction as a Catastrophic Error must notify the Exchange's Market
Control in the manner specified from time to time by the Exchange in a
circular distributed to Members. By definition, any execution that
qualifies as a Catastrophic Error is also an Obvious Error. However,
the Exchange believes it is appropriate to maintain these two types of
errors because the Catastrophic Error provisions provide market
participants with a longer notification period under which they may
file a request for review with the Exchange of a potential Catastrophic
Error than a potential Obvious Error. This provides an additional level
of protection for transactions that are severely erroneous even in the
event a participant does not submit a request for review in a timely
fashion.
The Proposed Rule would specify the action to be taken by the
Exchange if it is determined that a Catastrophic Error has occurred, as
described below, and would require the Exchange to promptly notify both
parties to the trade electronically or via telephone. In the event of a
Catastrophic Error, the execution price of the transaction will be
adjusted by the Official pursuant to the table below.
------------------------------------------------------------------------
Buy transaction Sell transaction
Theoretical Price (TP) adjustment-- TP adjustment-- TP
plus minus
------------------------------------------------------------------------
Below $2.00....................... $0.50 $0.50
$2.00 to $5.00.................... 1.00 1.00
Above $5.00 to $10.00............. 1.50 1.50
Above $10.00 to $20.00............ 2.00 2.00
Above $20.00 to $50.00............ 2.50 2.50
Above $50.00 to $100.00........... 3.00 3.00
Above $100.00..................... 4.00 4.00
------------------------------------------------------------------------
Although Customer orders would be adjusted in the same manner as
non-Customer orders, any Customer order that qualifies as a
Catastrophic Error will be nullified if the adjustment would result in
an execution price higher (for buy transactions) or lower (for sell
transactions) than the Customer's limit price. Based on industry
feedback, the levels proposed above with respect to adjustment amounts
are the same levels as the thresholds at which a transaction may be
deemed a Catastrophic Error pursuant to the chart set forth above.
As is true for Obvious Errors as described above, the Exchange
believes that it is appropriate to adjust to prices a specified amount
away from Theoretical Price rather than to adjust to Theoretical Price
because even though the Exchange has determined a given trade to be
erroneous in nature, the parties in question should have had some
expectation of execution at the price or prices submitted. Also, it is
common that by the time it is determined that a Catastrophic Error has
occurred additional hedging and trading activity has already occurred
based on the executions that previously happened. The Exchange is
concerned that an adjustment to Theoretical Price in all cases would
not appropriately incentivize market participants to maintain
appropriate controls to avoid potential errors. Further, the Exchange
believes it is appropriate to maintain a higher adjustment level for
Catastrophic
[[Page 27380]]
Errors than Obvious Errors given the significant additional time that
can potentially pass before an adjustment is requested and applied and
the amount of hedging and trading activity that can occur based on the
executions at issue during such time. For the same reasons, other than
honoring the limit prices established for Customer orders, the Exchange
has proposed to treat all market participants the same in the context
of the Catastrophic Error provision. Specifically, the Exchange
believes that treating market participants the same in this context
will provide additional certainty to market participants with respect
to their potential exposure and hedging activities, including comfort
that even if a transaction is later adjusted (i.e., past the standard
time limit for filing under the Obvious Error provision), such
transaction will not be fully nullified. However, as noted above, under
the Proposed Rule where at least one party to the transaction is a
Customer, the trade will be nullified if the adjustment would result in
an execution price higher (for buy transactions) or lower (for sell
transactions) than the Customer's limit price. The Exchange has
retained the protection of a Customer's limit price in order to avoid a
situation where the adjustment could be to a price that the Customer
could not afford, which is less likely to be an issue for a market
professional.
Significant Market Events
In order to improve consistency for market participants in the case
of a widespread market event and in light of the interconnected nature
of the options exchanges, the Exchange proposes to adopt a new
provision that calls for coordination between the options exchanges in
certain circumstances and provides limited flexibility in the
application of other provisions of the Proposed Rule in order to
promptly respond to a widespread market event.\9\ The Exchange proposes
to describe such an event as a Significant Market Event, and to set
forth certain objective criteria that will determine whether such an
event has occurred. The Exchange developed these objective criteria in
consultation with the other options exchanges by reference to
historical patterns and events with a goal of setting thresholds that
very rarely will be triggered so as to limit the application of the
provision to truly significant market events. As proposed, a
Significant Market Event will be deemed to have occurred when proposed
criterion (A) below is met or exceeded or the sum of all applicable
event statistics, where each is expressed as a percentage of the
relevant threshold in criteria (A) through (D) below, is greater than
or equal to 150% and 75% or more of at least one category is reached,
provided that no single category can contribute more than 100% to the
sum. All criteria set forth below will be measured in aggregate across
all exchanges.
---------------------------------------------------------------------------
\9\ Although the Exchange has proposed a specific provision
related to coordination amongst options exchanges in the context of
a widespread event, the Exchange does not believe that the
Significant Market Event provision or any other provision of the
proposed rule alters the Exchange's ability to coordinate with other
options exchanges in the normal course of business with respect to
market events or activity. The Exchange does already coordinate with
other options exchanges to the extent possible if such coordination
is necessary to maintain a fair and orderly market and/or to fulfill
the Exchange's duties as a self-regulatory organization.
---------------------------------------------------------------------------
The proposed criteria for determining a Significant Market Event
are as follows:
(A) Transactions that are potentially erroneous would result in a
total Worst-Case Adjustment Penalty of $30,000,000, where the Worst-
Case Adjustment Penalty is computed as the sum, across all potentially
erroneous trades, of: (i) $0.30 (i.e., the largest Transaction
Adjustment value listed in sub-paragraph (e)(3)(A) below); times; (ii)
the contract multiplier for each traded contract; times (iii) the
number of contracts for each trade; times (iv) the appropriate Size
Adjustment Modifier for each trade, if any, as defined in sub-paragraph
(e)(3)(A) below;
(B) Transactions involving 500,000 options contracts are
potentially erroneous;
(C) Transactions with a notional value (i.e., number of contracts
traded multiplied by the option premium multiplied by the contract
multiplier) of $100,000,000 are potentially erroneous;
(D) 10,000 transactions are potentially erroneous.
As described above, the Exchange proposes to adopt a Worst Case
Adjustment Penalty, proposed as criterion (A), which is the only
criterion that can on its own result in an event being designated as a
significant market event. The Worst Case Adjustment Penalty is intended
to develop an objective criterion that can be quickly determined by the
Exchange in consultation with other options exchanges that approximates
the total overall exposure to market participants on the negatively
impacted side of each transaction that occurs during an event. If the
Worst Case Adjustment criterion is equal to or exceeds $30,000,000,
then an event is a Significant Market Event. As an example of the Worst
Case Adjustment Penalty, assume that a single potentially erroneous
transaction in an event is as follows: sale of 100 contracts of a
standard option (i.e., an option with a 100 share multiplier). The
highest potential adjustment penalty for this single transaction would
be $6,000, which would be calculated as $0.30 times 100 (contract
multiplier) times 100 (number of contracts) times 2 (applicable Size
Adjustment Modifier). The Exchange would calculate the highest
potential adjustment penalty for each of the potentially erroneous
transactions in the event and the Worst Case Adjustment Penalty would
be the sum of such penalties on the Exchange and all other options
exchanges with affected transactions.
As described above, under the Proposed Rule if the Worst Case
Adjustment Penalty does not equal or exceed $30,000,000, then a
Significant Market Event has occurred if the sum of all applicable
event statistics (expressed as a percentage of the relevant
thresholds), is greater than or equal to 150% and 75% or more of at
least one category is reached. The Proposed Rule further provides that
no single category can contribute more than 100% to the sum. As an
example of the application of this provision, assume that in a given
event across all options exchanges that: (A) the Worst Case Adjustment
Penalty is $12,000,000 (40% of $30,000,000), (B) 300,000 options
contracts are potentially erroneous (60% of 500,000), (C) the notional
value of potentially erroneous transactions is $30,000,000 (30% of
$100,000,000), and (D) 12,000 transactions are potentially erroneous
(120% of 10,000). This event would qualify as a Significant Market
Event because the sum of all applicable event statistics would be 230%,
far exceeding the 150% threshold. The 230% sum is reached by adding
40%, 60%, 30% and last, 100% (i.e., rounded down from 120%) for the
number of transactions. The Exchange notes that no single category can
contribute more than 100% to the sum and any category contributing more
than 100% will be rounded down to 100%.
As an alternative example, assume a large-scale event occurs
involving low-priced options with a small number of contracts in each
execution. Assume in this event across all options exchanges that: (A)
the Worst Case Adjustment Penalty is $600,000 (2% of $30,000,000), (B)
20,000 options contracts are potentially erroneous (4% of 500,000), (C)
the notional value of potentially erroneous transactions is $20,000,000
(20% of $100,000,000), and (D) 20,000 transactions are potentially
erroneous (200% of 10,000, but rounded
[[Page 27381]]
down to 100%). This event would not qualify as a Significant Market
Event because the sum of all applicable event statistics would be 126%,
below the 150% threshold. The Exchange reiterates that as proposed,
even when a single category other than criterion (A) is fully met, that
does not necessarily qualify an event as a Significant Market Event.
The Exchange believes that the breadth and scope of the obvious
error rules are appropriate and sufficient for handling of typical and
common obvious errors. Coordination between and among the exchanges
should generally not be necessary even when a member has an error that
results in executions on more than one exchange. In setting the
thresholds above the Exchange believes that the requirements will be
met only when truly widespread and significant errors happen and the
benefits of coordination and information sharing far outweigh the costs
of the logistics of additional intra-exchange coordination. The
Exchange notes that in addition to its belief that the proposed
thresholds are sufficiently high, the Exchange has proposed the
requirement that either criterion (A) is met or exceeded or the sum of
applicable event statistics for proposed (A) through (D) equals or
exceeds 150% in order to ensure that an event is sufficiently large but
also to avoid situations where an event is extremely large but just
misses potential qualifying thresholds. For instance, the proposal is
designed to help avoid a situation where the Worst Case Adjustment
Penalty is $15,000,000, so the event does not qualify based on
criterion (A) alone, but there are transactions in 490,000 options
contracts that are potentially erroneous (missing criterion (B) by
10,000 contracts), there are transactions with a notional value of
$99,000,000 (missing criterion (C) by $1,000,000), and there are 9,000
potentially erroneous transactions overall (missing criterion (D) by
1,000 transactions). The Exchange believes that the proposed formula,
while slightly more complicated than simply requiring a certain
threshold to be met in each category, may help to avoid inapplicability
of the proposed provisions in the context of an event that would be
deemed significant by most subjective measures but that barely misses
each of the objective criteria proposed by the Exchange.
To ensure consistent application across options exchanges, in the
event of a suspected Significant Market Event, the Exchange shall
initiate a coordinated review of potentially erroneous transactions
with all other affected options exchanges to determine the full scope
of the event. Under the Proposed Rule, the Exchange will promptly
coordinate with the other options exchanges to determine the
appropriate review period as well as select one or more specific points
in time prior to the transactions in question and use one or more
specific points in time to determine Theoretical Price. Other than the
selected points in time, if applicable, the Exchange will determine
Theoretical Price as described above. For example, around the start of
a SME that is triggered by a large and aggressively priced buy order,
three exchanges have multiple orders on the offer side of the market:
Exchange A has offers priced at $2.20, $2.25, $2.30 and several other
price levels to $3.00, Exchange B has offers at $2.45, $2.30 and
several other price levels to $3.00, Exchange C has offers at price
levels between $2.50 and $3.00. Assume an event occurs starting at
10:05:25 a.m. ET and in this particular series the executions begin on
Exchange A and subsequently begin to occur on Exchanges B and C.
Without coordination and information sharing between the exchanges,
Exchange B and Exchange C cannot know with certainty that whether or
not the execution at Exchange A that happened at $2.20 immediately
prior to their executions at $2.45 and $2.50 is part of the same
erroneous event or not. With proper coordination, the exchanges can
determine that in this series, the proper point in time from which the
event should be analyzed is 10:05:25 a.m. ET, and thus, the NBO of
$2.20 should be used as the Theoretical Price for purposes of all buy
transactions in such options series that occurred during the event.
If it is determined that a Significant Market Event has occurred
then, using the parameters agreed with respect to the times from which
Theoretical Price will be calculated, if applicable, an Official will
determine whether any or all transactions under review qualify as
Obvious Errors. The Proposed Rule would require the Exchange to use the
criteria in Proposed Rule 720(c), as described above, to determine
whether an Obvious Error has occurred for each transaction that was
part of the Significant Market Event. Upon taking any final action, the
Exchange would be required to promptly notify both parties to the trade
electronically or via telephone.
The execution price of each affected transaction will be adjusted
by an Official to the price provided below, unless both parties agree
to adjust the transaction to a different price or agree to bust the
trade.
------------------------------------------------------------------------
Buy transaction Sell transaction
Theoretical price (TP) adjustment-- TP adjustment-- TP
plus minus
------------------------------------------------------------------------
Below $3.00....................... $0.15 $0.15
At or above $3.00................. 0.30 0.30
------------------------------------------------------------------------
Thus, the proposed adjustment criteria for Significant Market
Events are identical to the proposed adjustment levels for Obvious
Errors generally. In addition, in the context of a Significant Market
Event, any error exceeding 50 contracts will be subject to the Size
Adjustment Modifier described above. Also, the adjustment criteria
would apply equally to all market participants (i.e., Customers and
non-Customers) in a Significant Market Event. However, as is true for
the proposal with respect to Catastrophic Errors, under the Proposed
Rule where at least one party to the transaction is a Customer, the
trade will be nullified if the adjustment would result in an execution
price higher (for buy transactions) or lower (for sell transactions)
than the Customer's limit price. The Exchange has retained the
protection of a Customer's limit price in order to avoid a situation
where the adjustment could be to a price that the Customer could not
afford, which is less likely to be an issue for a market professional.
The Exchange has otherwise proposed to treat all market participants
the same in the context of a Significant Market Event to provide
additional certainty to market participants with respect to their
potential exposure as soon as an event has occurred.
Another significant distinction between the proposed Obvious Error
provision and the proposed Significant Market Event provision is that
if the Exchange, in consultation with other
[[Page 27382]]
options exchanges, determines that timely adjustment is not feasible
due to the extraordinary nature of the situation, then the Exchange
will nullify some or all transactions arising out of the Significant
Market Event during the review period selected by the Exchange and
other options exchanges. To the extent the Exchange, in consultation
with other options exchanges, determines to nullify less than all
transactions arising out of the Significant Market Event, those
transactions subject to nullification will be selected based upon
objective criteria with a view toward maintaining a fair and orderly
market and the protection of investors and the public interest. For
example, assume a Significant Market Event causes 25,000 potentially
erroneous transactions and impacts 51 options classes. Of the 25,000
transactions, 24,000 of them are concentrated in a single options
class. The exchanges may decide the most appropriate solution because
it will provide the most certainty to participants and allow for the
prompt resumption of regular trading is to bust all trades in the most
heavily affected class between two specific points in time, while the
other 1,000 trades across the other 50 classes are reviewed and
adjusted as appropriate. A similar situation might arise directionally
where a Customer submits both erroneous buy and sell orders and the
number of errors that happened that were erroneously low priced (i.e.,
erroneous sell orders) were 50,000 in number but the number of errors
that were erroneously high (i.e., erroneous buy orders) were only 500
in number. The most effective and efficient approach that provides the
most certainty to the marketplace in a reasonable amount of time while
most closely following the generally prescribed obvious error rules
could be to bust all of the erroneous sell transactions but to adjust
the erroneous buy transactions.
With respect to rulings made pursuant to the proposed Significant
Market Event provision the Exchange believes that the number of
affected transactions is such that immediate finality is necessary to
maintain a fair and orderly market and to protect investors and the
public interest. Accordingly, rulings by the Exchange pursuant to the
Significant Market Event provision would be non-appealable pursuant to
the Proposed Rule.
Additional Provisions
Mutual Agreement
In addition to the objective criteria described above, the Proposed
Rule also proposes to make clear that the determination as to whether a
trade was executed at an erroneous price may be made by mutual
agreement of the affected parties to a particular transaction. The
Proposed Rule would state that a trade may be nullified or adjusted on
the terms that all parties to a particular transaction agree, provided,
however, that such agreement to nullify or adjust must be conveyed to
the Exchange in a manner prescribed by the Exchange prior to 8:30 a.m.
Eastern Time on the first trading day following the execution.
The Exchange also proposes to explicitly state that it is
considered conduct inconsistent with just and equitable principles of
trade for any Member to use the mutual adjustment process to circumvent
any applicable Exchange rule, the Act or any of the rules and
regulations thereunder. Thus, for instance, a Member is precluded from
seeking to avoid applicable trade-through rules by executing a
transaction and then adjusting such transaction to a price at which the
Exchange would not have allowed it to execute at the time of the
execution because it traded through the quotation of another options
exchange. The Exchange notes that in connection with its obligations as
a self-regulatory organization, the Exchange's Surveillance Department
reviews adjustments to transactions to detect potential violations of
Exchange rules or the Act and the rules and regulations thereunder.
Trading Halts
Exchange Rule 702 describes the Exchange's authority to declare
trading halts in one or more options traded on the Exchange. The
Exchange proposes to make clear in the Proposed Rule that it will
nullify any transaction that occurs during a trading halt in the
affected option on the Exchange pursuant to Rule 702, or with respect
to equity options (including options overlying ETFs), during a
regulatory halt as declared by the primary listing market for the
underlying security.\10\ If any trades occur notwithstanding a trading
halt then the Exchange believes it appropriate to nullify such
transactions. While trading may be halted for various reasons, such a
scenario almost certainly is due to extraordinary circumstances and is
potentially the result of market-wide coordination to halt options
trading or trading generally. Accordingly, the Exchange does not
believe it is appropriate to allow trades to stand if such trades
should not have occurred in the first place.
---------------------------------------------------------------------------
\10\ After a regulatory halt, if it is determined that trading
should resume according to Rule 702(b), trades occurring after the
resumption will be valid and not subject to nullification under
Supplementary Material .01(b) to Rule 702, unless trading is
subsequently subject to another separate regulatory halt.
---------------------------------------------------------------------------
The Exchange currently does not have a rule that permits the
nullification of transactions that occur during a trading halt of an
option class on the Exchange, or with respect to equity options
(including options overlying ETFs), during a regulatory halt as
declared by the primary listing market for the underlying security. As
part of the harmonization effort, the Exchange proposes to adopt rule
text to permit the Exchange to nullify transactions, as described
above. The Exchange's ability to nullify the affected transactions will
ensure consistency with the trading halt provision of the Proposed
Rule.
Erroneous Print and Quotes in Underlying Security
Market participants on the Exchange likely base the pricing of
their orders submitted to the Exchange on the price of the underlying
security for the option. Thus, the Exchange believes it is appropriate
to adopt provisions that allow adjustment or nullification of
transactions based on erroneous prints or erroneous quotes in the
underlying security.
The Exchange proposes to adopt language in the Proposed Rule
stating that a trade resulting from an erroneous print(s) disseminated
by the underlying market that is later nullified by that underlying
market shall be adjusted or busted as set forth in the Obvious Error
provisions of the Proposed Rule, provided a party notifies the
Exchange's Market Control in a timely manner, as further described
below. The Exchange proposes to define a trade resulting from an
erroneous print(s) as any options trade executed during a period of
time for which one or more executions in the underlying security are
nullified and for one second thereafter. The Exchange believes that one
second is an appropriate amount of time in which an options trade would
be directly based on executions in the underlying equity security. The
Exchange also proposes to require that if a party believes that it
participated in an erroneous transaction resulting from an erroneous
print(s) pursuant to the proposed erroneous print provision it must
notify the Exchange's Market Control within the timeframes set forth in
the Obvious Error provision described above. The
[[Page 27383]]
Exchange has also proposed to state that the allowed notification
timeframe commences at the time of notification by the underlying
market(s) of nullification of transactions in the underlying security.
Further, the Exchange proposes that if multiple underlying markets
nullify trades in the underlying security, the allowed notification
timeframe will commence at the time of the first market's notification.
As an example of a situation in which a trade results from an
erroneous print disseminated by the underlying market that is later
nullified by the underlying market, assume that a given underlying is
trading in the $49.00-$50.00 price range then has an erroneous print at
$5.00. Given that there is the potential perception that the underlying
has gone through a dramatic price revaluation, numerous options trades
could promptly trigger based off of this new price. However, because
the price that triggered them was not a valid price it would be
appropriate to review said option trades when the underlying print that
triggered them is removed.
The Exchange also proposes to add a provision stating that a trade
resulting from an erroneous quote(s) in the underlying security shall
be adjusted or busted as set forth in the Obvious Error provisions of
the Proposed Rule, provided a party notifies the Exchange's Market
Control in a timely manner, as further described below. Pursuant to the
Proposed Rule, an erroneous quote occurs when the underlying security
has a width of at least $1.00 and has a width at least five times
greater than the average quote width for such underlying security
during the time period encompassing two minutes before and after the
dissemination of such quote. For purposes of the Proposed Rule, the
average quote width will be determined by adding the quote widths of
sample quotations at regular 15-second intervals during the four-minute
time period referenced above (excluding the quote(s) in question) and
dividing by the number of quotes during such time period (excluding the
quote(s) in question).\11\ Similar to the proposal with respect to
erroneous prints described above, if a party believes that it
participated in an erroneous transaction resulting from an erroneous
quote(s) it must notify the Exchange's Market Control in accordance
with the notification provisions of the Obvious Error provision
described above. The Proposed Rule, therefore, puts the onus on each
Member to notify the Exchange if such Member believes that a trade
should be reviewed pursuant to either of the proposed provisions, as
the Exchange is not in position to determine the impact of erroneous
prints or quotes on individual Members. The Exchange notes that it does
not believe that additional time is necessary with respect to a trade
based on an erroneous quote because a Member has all information
necessary to detect the error at the time of an option transaction that
was triggered by an erroneous quote, which is in contrast to the
proposed erroneous print provision that includes a dependency on an
action by the market where the underlying security traded.
---------------------------------------------------------------------------
\11\ The Exchange has proposed the price and time parameters for
quote width and average quote width used to determine whether an
erroneous quote has occurred based on established rules of options
exchanges that currently apply such parameters. See, e.g., CBOE Rule
6.25(a)(5); NYSE Arca Rule 6.87(a)(5). Based on discussions with
these exchanges, the Exchange believes that the parameters are a
reasonable approach to determine whether an erroneous quote has
occurred for purposes of the proposed rule.
---------------------------------------------------------------------------
As an example of a situation in which a trade results from an
erroneous quote in the underlying security, assume again that a given
underlying is quoting and trading in the $49.00-$50.00 price range then
a liquidity gap occurs, with bidders not representing quotes in the
market place and an offer quoted at $5.00. Quoting may quickly return
to normal, again in the $49.00-$50.00 price range, but due to the
potential perception that the underlying has gone through a dramatic
price revaluation, numerous options trades could trigger based off of
this new quoted price in the interim. Because the price that triggered
such trades was not a valid price it would be appropriate to review
said option trades.
Stop (and Stop-Limit) Order Trades Triggered by Erroneous Trades
The Exchange notes that certain market participants and their
customers enter stop or stop limit orders that are triggered based on
executions in the marketplace. As proposed, transactions resulting from
the triggering of a stop or stop-limit order by an erroneous trade in
an option contract shall be nullified by the Exchange, provided a party
notifies the Exchange's Market Control in a timely manner as set forth
below. The Exchange believes it is appropriate to nullify executions of
stop or stop-limit orders that were wrongly triggered because such
transactions should not have occurred. If a party believes that it
participated in an erroneous transaction pursuant to the Proposed Rule
it must notify the Exchange's Market Control within the timeframes set
forth in the Obvious Error Rule above, with the allowed notification
timeframe commencing at the time of notification of the nullification
of transaction(s) that triggered the stop or stop-limit order.
Linkage Trades
The Exchange also proposes to adopt language that clearly provides
the Exchange with authority to take necessary actions when another
options exchange nullifies or adjusts a transaction pursuant to its
respective rules and the transaction resulted from an order that has
passed through the Exchange and been routed on to another options
exchange on behalf of the Exchange. Specifically, if the Exchange
routes an order pursuant to the Options Order Protection and Locked/
Crossed Market Plan \12\ that results in a transaction on another
options exchange (a ``Linkage Trade'') and such options exchange
subsequently nullifies or adjusts the Linkage Trade pursuant to its
rules, the Exchange will perform all actions necessary to complete the
nullification or adjustment of the Linkage Trade. Although the Exchange
is not utilizing its own authority to nullify or adjust a transaction
related to an action taken on a Linkage Trade by another options
exchange, the Exchange does have to assist in the processing of the
adjustment or nullification of the order, such as notification to the
Member and the OCC of the adjustment or nullification. Thus, the
Exchange believes that the proposed provision adds additional
transparency to the Proposed Rule.
---------------------------------------------------------------------------
\12\ As defined in Exchange Rule 1900(n).
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Appeals
The Exchange proposes to generally maintain its current appeals
process in connection with the Proposed Rule with minor adjustments to
accommodate a harmonized rule. Specifically, if a Member affected by a
determination made under the Proposed Rule requests within the time
permitted below, the Obvious Error Panel (``Obvious Error Panel'') will
review decisions made by the Exchange Official, including whether an
obvious error occurred and whether the correct determination was made.
In order to maintain a diverse group of participants, the Obvious
Error Panel will be comprised of representatives from four (4) Members.
Two (2) of the representatives must be directly engaged in market
making (any such representative, a ``MM Representative'') and the other
two (2) representatives must be employed by an Electronic Access Member
(any such representative, a ``Non-MM
[[Page 27384]]
Representative'').\13\ To qualify as a Non-MM Representative a person
must: Be employed by a Member whose revenues from options market making
activity do not exceed ten percent (10%) of its total revenues; or have
as his or her primary responsibility the handling of Public Customer
orders or supervisory responsibility over persons with such
responsibility, and not have any responsibilities with respect to
market making activities.
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\13\ The composition of the Obvious Error Panel will be similar
to that of the Review Panel currently utilized by the Exchange to
determine whether erroneous trades due to system disruptions and
malfunctions should be adjusted or nullified. See ISE Rule 720A.
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In order to further assure a diverse group of potential
participants on an Obvious Error Panel, the Exchange shall designate at
least ten (10) MM Representatives and at least ten (10) Non-MM
Representatives to be called upon to serve on the Obvious Error Panel
as needed. To assure fairness, in no case shall an Obvious Error Panel
include a person affiliated with a party to the trade in question.
Also, to the extent reasonably possible, the Exchange shall call upon
the designated representatives to participate on an Obvious Error Panel
on an equally frequent basis.
Under the Proposed Rule a request for review on appeal must be made
in writing via email or other electronic means specified from time to
time by the Exchange in a circular distributed to Members within thirty
(30) minutes after the party making the appeal is given notification of
the initial determination being appealed. The Obvious Error Panel shall
review the facts and render a decision as soon as practicable, but
generally on the same trading day as the execution(s) under review. On
requests for appeal received after 3:00 p.m. Eastern Time, a decision
will be rendered as soon as practicable, but in no case later than the
trading day following the date of the execution under review.
The Obvious Error Panel may overturn or modify an action taken by
the Exchange Official under this Rule. All determinations by the
Obvious Error Panel shall constitute final action by the Exchange on
the matter at issue. The Exchange believes that this is necessary given
the purpose of the appeal is finality.
In order to deter frivolous appeals, if the Obvious Error Panel
votes to uphold the decision made pursuant to the Proposed Rule, the
Exchange will assess a $5,000.00 fee against the Member(s) who
initiated the request for appeal. In addition, in instances where the
Exchange, on behalf of a Member, requests a determination by another
market center that a transaction is clearly erroneous, the Exchange
will pass any resulting charges through to the relevant Member.
Any determination by an Official or by the Obvious Error Panel
shall be rendered without prejudice as to the rights of the parties to
the transaction to submit their dispute to arbitration.
Limit Up-Limit Down Plan
The Exchange is proposing to adopt Supplementary Material .01 to
the Proposed Rule to provide for how the Exchange will treat Obvious
and Catastrophic Errors in response to the Regulation NMS Plan to
Address Extraordinary Market Volatility Pursuant to Rule 608 of
Regulation NMS under the Act (the ``Limit Up-Limit Down Plan'' or the
``Plan),\14\ which is applicable to all NMS stocks, as defined in
Regulation NMS Rule 600(b)(47).\15\ Under the Proposed Rule, during a
pilot period to coincide with the pilot period for the Plan, including
any extensions to the pilot period for the Plan, an execution will not
be subject to review as an Obvious Error or Catastrophic Error pursuant
to paragraph (c) or (d) of the Proposed Rule if it occurred while the
underlying security was in a ``Limit State'' or ``Straddle State,'' as
defined in the Plan. The Exchange, however, proposes to retain
authority to review transactions on an Official's own motion pursuant
to sub-paragraph (c)(3) of the Proposed Rule and to bust or adjust
transactions pursuant to the proposed Significant Market Event
provision, the proposed trading halts provision, the proposed
provisions with respect to erroneous prints and quotes in the
underlying security, or the proposed provision related to stop and stop
limit orders that have been triggered by an erroneous execution. The
Exchange believes that these safeguards will provide the Exchange with
the flexibility to act when necessary and appropriate to nullify or
adjust a transaction, while also providing market participants with
certainty that, under normal circumstances, the trades they affect with
quotes and/or orders having limit prices will stand irrespective of
subsequent moves in the underlying security.
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\14\ Securities Exchange Act Release No. 67091 (May 31, 2012),
77 FR 33498 (June 6, 2012) (order approving the Plan on a pilot
basis).
\15\ 17 CFR 242.600(b)(47).
---------------------------------------------------------------------------
During a Limit or Straddle State, options prices may deviate
substantially from those available immediately prior to or following
such States. Thus, determining a Theoretical Price in such situations
would often be very subjective, creating unnecessary uncertainty and
confusion for investors. Because of this uncertainty, the Exchange is
proposing to amend Rule 720 to provide that the Exchange will not
review transactions as Obvious Errors or Catastrophic Errors when the
underlying security is in a Limit or Straddle State.
The Exchange notes that there are additional protections in place
outside of the Obvious and Catastrophic Error Rule that will continue
to safeguard customers. First, the Exchange rejects all un-priced
options orders received by the Exchange (i.e., Market Orders) during a
Limit or Straddle State for the underlying security. Second, SEC Rule
15c3-5 requires that, ``financial risk management controls and
supervisory procedures must be reasonably designed to prevent the entry
of orders that exceed appropriate pre-set credit or capital thresholds,
or that appear to be erroneous.'' \16\ Third, the Exchange has price
checks applicable to limit orders that reject limit orders that are
priced sufficiently far through the national best bid or national best
offer (``NBBO'') that it seems likely an error occurred. The rejection
of Market Orders, the requirements placed upon broker dealers to adopt
controls to prevent the entry of orders that appear to be erroneous,
and Exchange functionality that filters out orders that appear to be
erroneous, will all serve to sharply reduce the incidence of erroneous
transactions.
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\16\ See Securities and Exchange Act Release No. 63241 (November
3, 2010), 75 FR 69791 (November 15, 2010) (File No. S7-03-10).
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The Exchange represents that it will conduct its own analysis
concerning the elimination of the Obvious Error and Catastrophic Error
provisions during Limit and Straddle States and agrees to provide the
Commission with relevant data to assess the impact of this proposed
rule change. As part of its analysis, the Exchange will evaluate (1)
the options market quality during Limit and Straddle States, (2) assess
the character of incoming order flow and transactions during Limit and
Straddle States, and (3) review any complaints from Members and their
customers concerning executions during Limit and Straddle States. The
Exchange also agrees to provide to the Commission data requested to
evaluate the impact of the inapplicability of the Obvious Error and
Catastrophic Error provisions, including data relevant to assessing the
various analyses noted above.
[[Page 27385]]
In connection with this proposal, the Exchange will provide to the
Commission and the public a dataset containing the data for each
Straddle State and Limit State in NMS Stocks underlying options traded
on the Exchange beginning in the month during which the proposal is
approved, limited to those option classes that have at least one (1)
trade on the Exchange during a Straddle State or Limit State. For each
of those option classes affected, each data record will contain the
following information:
Stock symbol, option symbol, time at the start of the
Straddle or Limit State, an indicator for whether it is a Straddle or
Limit State.
For activity on the Exchange:
[cir] Executed volume, time-weighted quoted bid-ask spread, time-
weighted average quoted depth at the bid, time-weighted average quoted
depth at the offer;
[cir] high execution price, low execution price;
[cir] number of trades for which a request for review for error was
received during Straddle and Limit States;
[cir] an indicator variable for whether those options outlined
above have a price change exceeding 30% during the underlying stock's
Limit or Straddle State compared to the last available option price as
reported by OPRA before the start of the Limit or Straddle State (1 if
observe 30% and 0 otherwise). Another indicator variable for whether
the option price within five minutes of the underlying stock leaving
the Limit or Straddle State (or halt if applicable) is 30% away from
the price before the start of the Limit or Straddle State.
In addition, by May 29, 2015, the Exchange shall provide to the
Commission and the public assessments relating to the impact of the
operation of the Obvious Error rules during Limit and Straddle States
as follows: (1) Evaluate the statistical and economic impact of Limit
and Straddle States on liquidity and market quality in the options
markets; and (2) Assess whether the lack of Obvious Error rules in
effect during the Straddle and Limit States are problematic. The timing
of this submission would coordinate with Participants' proposed time
frame to submit to the Commission assessments as required under
Appendix B of the Plan. The Exchange notes that the pilot program is
intended to run concurrent with the pilot period of the Plan, which has
been extended to October 23, 2015. The Exchange proposes to reflect
this date in the Proposed Rule.
No Adjustments to a Worse Price
Finally, the Exchange proposes to include Supplementary Material
.02 to the Proposed Rule, which would make clear that to the extent the
provisions of the proposed Rule would result in the Exchange applying
an adjustment of an erroneous sell transaction to a price lower than
the execution price or an erroneous buy transaction to a price higher
than the execution price, the Exchange will not adjust or nullify the
transaction, but rather, the execution price will stand.
Implementation Date
In order to ensure that other options exchanges are able to adopt
rules consistent with this proposal and to coordinate the effectiveness
of such harmonized rules, the Exchange proposes to delay the operative
date of this proposal to May 8, 2015.
2. Statutory Basis
The Exchange believes that its proposal is consistent with the
requirements of the Act and the rules and regulations thereunder that
are applicable to a national securities exchange, and, in particular,
with the requirements of section 6(b) of the Act.\17\ Specifically, the
proposal is consistent with section 6(b)(5) of the Act \18\ because it
would promote just and equitable principles of trade, remove
impediments to, and perfect the mechanism of, a free and open market
and a national market system, and, in general, protect investors and
the public interest.
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\17\ 15 U.S.C. 78f(b).
\18\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------
As described above, the Exchange and other options exchanges are
seeking to adopt harmonized rules related to the adjustment and
nullification of erroneous options transactions. The Exchange believes
that the Proposed Rule will provide greater transparency and clarity
with respect to the adjustment and nullification of erroneous options
transactions. Particularly, the proposed changes seek to achieve
consistent results for participants across U.S. options exchanges while
maintaining a fair and orderly market, protecting investors and
protecting the public interest. Based on the foregoing, the Exchange
believes that the proposal is consistent with section 6(b)(5) of the
Act \19\ in that the Proposed Rule will foster cooperation and
coordination with persons engaged in regulating and facilitating
transactions.
---------------------------------------------------------------------------
\19\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------
The Exchange believes the various provisions allowing or dictating
adjustment rather than nullification of a trade are necessary given the
benefits of adjusting a trade price rather than nullifying the trade
completely. Because options trades are used to hedge, or are hedged by,
transactions in other markets, including securities and futures, many
Members, and their customers, would rather adjust prices of executions
rather than nullify the transactions and, thus, lose a hedge
altogether. As such, the Exchange believes it is in the best interest
of investors to allow for price adjustments as well as nullifications.
The Exchange further discusses specific aspects of the Proposed Rule
below.
The Exchange does not believe that the proposal is unfairly
discriminatory, even though it differentiates in many places between
Customers and non-Customers. The rules of the options exchanges,
including the Exchange's existing Obvious Error provision, often treat
Customers differently, often affording them preferential treatment.
This treatment is appropriate in light of the fact that Customers are
not necessarily immersed in the day-to-day trading of the markets, are
less likely to be watching trading activity in a particular option
throughout the day, and may have limited funds in their trading
accounts. At the same time, the Exchange reiterates that in the U.S.
options markets generally there is significant retail customer
participation that occurs directly on (and only on) options exchanges
such as the Exchange. Accordingly, differentiating among market
participants with respect to the adjustment and nullification of
erroneous options transactions is not unfairly discriminatory because
it is reasonable and fair to provide Customers with additional
protections as compared to non-Customers.
The Exchange believes that its proposal with respect to the
allowance of mutual agreed upon adjustments or nullifications is
appropriate and consistent with the Act, as such proposal removes
impediments to and perfects the mechanism of a free and open market and
a national market system, allowing participants to mutually agree to
correct an erroneous transactions without the Exchange mandating the
outcome. The Exchange also believes that its proposal with respect to
mutual adjustments is consistent with the Act because it is designed to
prevent fraudulent and manipulative acts and practices by explicitly
stating that it is considered conduct inconsistent with just and
equitable principles of trade for any
[[Page 27386]]
Member to use the mutual adjustment process to circumvent any
applicable Exchange rule, the Act or any of the rules and regulations
thereunder.
The Exchange believes its proposal to provide within the Proposed
Rule definitions of Customer, erroneous sell transaction and erroneous
buy transaction, and Official is consistent with section 6(b)(5) of the
Act because such terms will provide more certainty to market
participants as to the meaning of the Proposed Rule and reduce the
possibility that a party can intentionally submit an order hoping for
the market to move in their favor in reliance on the Rule as a safety
mechanism, thereby promoting just and fair principles of trade.
Similarly, the Exchange believes that proposed Supplementary Material
.02 is consistent with the Act as it would make clear that the Exchange
will not adjust or nullify a transaction, but rather, the execution
price will stand when the applicable adjustment criteria would actually
adjust the price of the transaction to a worse price (i.e., higher for
an erroneous buy or lower for an erroneous sell order).
As set forth below, the Exchange believes it is consistent with
section 6(b)(5) of the Act for the Exchange to determine Theoretical
Price when the NBBO cannot reasonably be relied upon because the
alternative could result in transactions that cannot be adjusted or
nullified even when they are otherwise clearly at a price that is
significantly away from the appropriate market for the option.
Similarly, reliance on an NBBO that is not reliable could result in
adjustment to prices that are still significantly away from the
appropriate market for the option.
The Exchange believes that its proposal with respect to determining
Theoretical Price is consistent with the Act in that it has retained
the standard of the current rule, which is to rely on the NBBO to
determine Theoretical Price if such NBBO can reasonably be relied upon.
Because, however, there is not always an NBBO that can or should be
used in order to administer the rule, the Exchange has proposed various
provisions that provide the Exchange with the authority to determine a
Theoretical Price. The Exchange believes that the Proposed Rule is
transparent with respect to the circumstances under which the Exchange
will determine Theoretical Price, and has sought to limit such
circumstances as much as possible. The Exchange notes that Exchange
personnel currently are required to determine Theoretical Price in
certain circumstances. While the Exchange continues to pursue
alternative solutions that might further enhance the objectivity and
consistency of determining Theoretical Price, the Exchange believes
that the discretion currently afforded to Exchange Officials is
appropriate in the absence of a reliable NBBO that can be used to set
the Theoretical Price.
With respect to the specific proposed provisions for determining
Theoretical Price for transactions that occur during the opening
rotation and in situations where there is a wide quote, the Exchange
believes both provisions are consistent with the Act because they
provide objective criteria that will determine Theoretical Price with
limited exceptions for situations where the Exchange does not believe
the NBBO is a reasonable benchmark or there is no NBBO. The Exchange
notes in particular with respect to the wide quote provision that the
Proposed Rule will result in the Exchange determining Theoretical Price
less frequently than it would pursuant to wide quote provisions that
have previously been approved. The Exchange believes that it is
appropriate and consistent with the Act to afford protections to market
participants by not relying on the NBBO to determine Theoretical Price
when the quote is extremely wide but had been, in the prior 10 seconds,
at much more reasonable width. The Exchange also believes it is
appropriate and consistent with the Act to use the NBBO to determine
Theoretical Price when the quote has been wider than the applicable
amount for more than 10 seconds, as the Exchange does not believe it is
necessary to apply any other criteria in such a circumstance. The
Exchange believes that market participants can easily use or adopt
safeguards to prevent errors when such market conditions exist. When
entering an order into a market with a persistently wide quote, the
Exchange does not believe that the entering party should reasonably
expect anything other than the quoted price of an option.
The Exchange believes that its proposal to adopt clear but
disparate standards with respect to the deadline for submitting a
request for review of Customer and non-Customer transactions is
consistent with the Act, particularly in that it creates a greater
level of protection for Customers. As noted above, the Exchange
believes that this is appropriate and not unfairly discriminatory in
light of the fact that Customers are not necessarily immersed in the
day-to-day trading of the markets and are less likely to be watching
trading activity in a particular option throughout the day. Thus,
Members representing Customer orders reasonably may need additional
time to submit a request for review. The Exchange also believes that
its proposal to provide additional time for submission of requests for
review of linkage trades is reasonable and consistent with the
protection of investors and the public interest due to the time that it
might take an options exchange or third-party routing broker to file a
request for review with the Exchange if the initial notification of an
error is received by the originating options exchange near the end of
such options exchange's filing deadline. Without this additional time,
there could be disparate results based purely on the existence of
intermediaries and an interconnected market structure.
In relation to the aspect of the proposal giving Officials the
ability to review transactions for obvious errors on their own motion,
the Exchange notes that an Official can adjust or nullify a transaction
under the authority granted by this provision only if the transaction
meets the specific and objective criteria for an Obvious Error under
the Proposed Rule. As noted above, this is designed to give an Official
the ability to provide parties relief in those situations where they
have failed to report an apparent error within the established
notification period. However, the Exchange will only grant relief if
the transaction meets the requirements for an Obvious Error as
described in the Proposed Rule.
The Exchange believes that its proposal to adjust non-Customer
transactions and to nullify Customer transactions that qualify as
Obvious Errors is appropriate for reasons consistent with those
described above. In particular, Customers are not necessarily immersed
in the day-to-day trading of the markets, are less likely to be
watching trading activity in a particular option throughout the day,
and may have limited funds in their trading accounts.
The Exchange acknowledges that the proposal contains some
uncertainty regarding whether a trade will be adjusted or nullified,
depending on whether one of the parties is a Customer, because a party
may not know whether the other party to a transaction was a Customer at
the time of entering into the transaction. However, the Exchange
believes that the proposal nevertheless promotes just and equitable
principles of trade and protects investors as well as the public
interest because it eliminates the possibility that a Customer's order
will be adjusted to a significantly different price. As noted above,
the Exchange believes it is consistent with the Act to
[[Page 27387]]
afford Customers greater protections under the Proposed Rule than are
afforded to non-Customers. Thus, the Exchange believes that its
proposal is consistent with the Act in that it protects investors and
the public interest by providing additional protections to those that
are less informed and potentially less able to afford an adjustment of
a transaction that was executed in error. Customers are also less
likely to have engaged in significant hedging or other trading activity
based on earlier transactions, and thus, are less in need of
maintaining a position at an adjusted price than non-Customers.
If any Member submits requests to the Exchange for review of
transactions pursuant to the Proposed Rule, and in aggregate that
Member has 200 or more Customer transactions under review concurrently
and the orders resulting in such transactions were submitted during the
course of 2 minutes or less, the Exchange believes it is appropriate
for the Exchange apply the non-Customer adjustment criteria described
above to such transactions. The Exchange believes that the proposed
aggregation is reasonable as it is representative of an extremely large
number of orders submitted to the Exchange over a relatively short
period of time that are, in turn, possibly erroneous (and within a time
frame significantly less than an entire day), and thus is most likely
to occur because of a systems issue experienced by a Member
representing Customer orders or a systems issue coupled with the
erroneous marking of orders. The Exchange does not believe it is
possible at a level of 200 Customer orders over a 2 minute period that
are under review at one time that multiple, separate Customers were
responsible for the errors in the ordinary course of trading. In the
event of a large-scale issue caused by a Member that has submitted
orders over a 2 minute period marked as Customer that resulted in more
than 200 transactions under review, the Exchange does not believe it is
appropriate to nullify all such transactions because of the negative
impact that nullification could have on the market participants on the
contra-side of such transactions, who might have engaged in hedging and
trading activity following such transactions. In order for a
participant to have more than 200 transactions under review
concurrently when the orders triggering such transactions were received
in 2 minutes or less, the Exchange believes that a market participant
will have far exceeded the normal behavior of customers deserving
protected status. While the Exchange continues to believe that it is
appropriate to nullify transactions in such a circumstance if both
participants to a transaction are Customers, the Exchange does not
believe it is appropriate to place the overall risk of a significant
number of trade breaks on non-Customers that in the normal course of
business may have engaged in additional hedging activity or trading
activity based on such transactions. Thus, the Exchange believes it is
necessary and appropriate to protect non-Customers in such a
circumstance by applying the non-Customer adjustment criteria, and thus
adjusting transactions as set forth above, in the event a Member has
more than 200 transactions under review concurrently. In summary, due
to the extreme level at which the proposal is set, the Exchange
believes that the proposal is consistent with Section 6(b)(5) of the
Act in that it promotes just and equitable principles of trade by
encouraging market participants to retain appropriate controls over
their systems to avoid submitting a large number of erroneous orders in
a short period of time.
Similarly, the Exchange believes that the proposed Size Adjustment
Modifier, which would increase the adjustment amount for non-Customer
transactions, is appropriate because it attempts to account for the
additional risk that the parties to the trade undertake for
transactions that are larger in scope. The Exchange believes that the
Size Adjustment Modifier creates additional incentives to prevent more
impactful Obvious Errors and it lessens the impact on the contra-party
to an adjusted trade. The Exchange notes that these contra-parties may
have preferred to only trade the size involved in the transaction at
the price at which such trade occurred, and in trading larger size has
committed a greater level of capital and bears a larger hedge risk.
The Exchange similarly believes that its Proposed Rule with respect
to Catastrophic Errors is consistent with the Act as it affords
additional time for market participants to file for review of erroneous
transactions that were further away from the Theoretical Price. At the
same time, the Exchange believes that the Proposed Rule is consistent
with the Act in that it generally would adjust transactions, including
Customer transactions, because this will protect against hedge risk,
particularly for transactions that may have occurred several hours
earlier and thus, which all parties to the transaction might presume
are protected from further modification. Similarly, by providing larger
adjustment amounts away from Theoretical Price than are set forth under
the Obvious Error provision, the Catastrophic Error provision also
takes into account the possibility that the party that was advantaged
by the erroneous transaction has already taken actions based on the
assumption that the transaction would stand. The Exchange believes it
is reasonable to specifically protect Customers from adjustments
through their limit prices for the reasons stated above, including that
Customers are less likely to be watching trading throughout the day and
that they may have less capital to afford an adjustment price. The
Exchange believes that the proposal provides a fair process that will
ensure that Customers are not forced to accept a trade that was
executed in violation of their limit order price. In contrast, market
professionals are more likely to have engaged in hedging or other
trading activity based on earlier trading activity, and thus, are more
likely to be willing to accept an adjustment rather than a
nullification to preserve their positions even if such adjustment is to
a price through their limit price.
The Exchange believes that proposed rule change to adopt the
Significant Market Event provision is consistent with section 6(b)(5)
of the Act in that it will foster cooperation and coordination with
persons engaged in regulating the options markets. In particular, the
Exchange believes it is important for options exchanges to coordinate
when there is a widespread and significant event, as commonly, multiple
options exchanges are impacted in such an event. Further, while the
Exchange recognizes that the Proposed Rule will not guarantee a
consistent result for all market participants on every market, the
Exchange does believe that it will assist in that outcome. For
instance, if options exchanges are able to agree as to the time from
which Theoretical Price should be determined and the period of time
that should be reviewed, the likely disparity between the Theoretical
Prices used by such exchanges should be very slight and, in turn, with
otherwise consistent rules, the results should be similar. The Exchange
also believes that the Proposed Rule is consistent with the Act in that
it generally would adjust transactions, including Customer
transactions, because this will protect against hedge risk,
particularly for liquidity providers that might have been quoting in
thousands or tens of thousands of different series and might have
affected executions throughout such quoted series. The Exchange
believes that when weighing the competing interests between preferring
[[Page 27388]]
a nullification for a Customer transaction and an adjustment for a
transaction of a market professional, while nullification is
appropriate in a typical one-off situation that it is necessary to
protect liquidity providers in a widespread market event because,
presumably, they will be the most affected by such an event (in
contrast to a Customer who, by virtue of their status as such, likely
would not have more than a small number of affected transactions). The
Exchange believes that the protection of liquidity providers by
favoring adjustments in the context of Significant Market Events can
also benefit Customers indirectly by better enabling liquidity
providers, which provides a cumulative benefit to the market. Also, as
stated above with respect to Catastrophic Errors, the Exchange believes
it is reasonable to specifically protect Customers from adjustments
through their limit prices for the reasons stated above, including that
Customers are less likely to be watching trading throughout the day and
that they may have less capital to afford an adjustment price. The
Exchange believes that the proposal provides a fair process that will
ensure that Customers are not forced to accept a trade that was
executed in violation of their limit order price. In contrast, market
professionals are more likely to have engaged in hedging or other
trading activity based on earlier trading activity, and thus, are more
likely to be willing to accept an adjustment rather than a
nullification to preserve their positions even if such adjustment is to
a price through their limit price. In addition, the Exchange believes
it is important to have the ability to nullify some or all transactions
arising out of a Significant Market Event in the event timely
adjustment is not feasible due to the extraordinary nature of the
situation. In particular, although the Exchange has worked to limit the
circumstances in which it has to determine Theoretical Price, in a
widespread event it is possible that hundreds if not thousands of
series would require an Exchange determination of Theoretical Price. In
turn, if there are hundreds or thousands of trades in such series, it
may not be practicable for the Exchange to determine the adjustment
levels for all non-Customer transactions in a timely fashion, and in
turn, it would be in the public interest to instead more promptly
deliver a simple, consistent result of nullification.
The Exchange believes that proposed rule change related to review,
nullification and/or adjustment of erroneous transactions during a
trading halt (including the proposed modification to Rule 702), an
erroneous print in the underlying security, an erroneous quote in the
underlying security, or an erroneous transaction in the option with
respect to stop and stop limit orders is likewise consistent with
section 6(b)(5) of the Act because the proposal provides for the
adjustment or nullification of trades executed at erroneous prices
through no fault on the part of the trading participants. Allowing for
Exchange review in such situations will promote just and fair
principles of trade by protecting investors from harm that is not of
their own making. Specifically with respect to the proposed provisions
governing erroneous prints and quotes in the underlying security, the
Exchange notes that market participants on the Exchange base the value
of their quotes and orders on the price of the underlying security. The
provisions regarding errors in prints and quotes in the underlying
security cover instances where the information market participants use
to price options is erroneous through no fault of their own. In these
instances, market participants have little, if any, chance of pricing
options accurately. Thus, these provisions are designed to provide
relief to market participants harmed by such errors in the prints or
quotes of the underlying security.
The Exchange believes that the proposed provision related to
Linkage Trades is consistent with the Act because it adds additional
transparency to the Proposed Rule and makes clear that when a Linkage
Trade is adjusted or nullified by another options exchange, the
Exchange will take necessary actions to complete the nullification or
adjustment of the Linkage Trade.
The Exchange believes that retaining the same appeals process as
the Exchange maintains under the Current Rule is consistent with the
Act because such process provides Members with due process in
connection with decisions made by Exchange Officials under the Proposed
Rule. The Exchange believes that this process provides fair
representation of Members by ensuring diversity amongst the members of
any Obvious Error Review Panel, which is consistent with sections
6(b)(3) and 6(b)(7) of the Act. The Exchange also believes that the
proposed appeals process is appropriate with respect to financial
penalties for appeals that result in a decision of the Exchange being
upheld because it discourages frivolous appeals, thereby reducing the
possibility of overusing Exchange resources that can instead be focused
on other, more productive activities. The fees with respect to such
financial penalties are the same as under the Current Rule, and are
equitable and not unfairly discriminatory because they will be applied
uniformly to all Members and are designed to reduce administrative
burden on the Exchange as well as market participants that volunteer to
participate on Obvious Error Review Panels.
With regard to the portion of the Exchange's proposal related to
the applicability of the Obvious Error Rule when the underlying
security is in a Limit or Straddle State, the Exchange believes that
the proposed rule change is consistent with section 6(b)(5) of the Act
because it will provide certainty about how errors involving options
orders and trades will be handled during periods of extraordinary
volatility in the underlying security. Further, the Exchange believes
that it is necessary and appropriate in the interest of promoting fair
and orderly markets to exclude from Rule 720 those transactions
executed during a Limit or Straddle State.
The Exchange believes the application of the Proposed Rule without
the proposed provision would be impracticable given the lack of
reliable NBBO in the options market during Limit and Straddle States,
and that the resulting actions (i.e., nullified trades or adjusted
prices) may not be appropriate given market conditions. The Proposed
Rule change would ensure that limit orders that are filled during a
Limit State or Straddle State would have certainty of execution in a
manner that promotes just and equitable principles of trade, removes
impediments to, and perfects the mechanism of a free and open market
and a national market system.
Moreover, given the fact that options prices during brief Limit or
Straddle States may deviate substantially from those available shortly
following the Limit or Straddle State, the Exchange believes giving
market participants time to re-evaluate a transaction would create an
unreasonable adverse selection opportunity that would discourage
participants from providing liquidity during Limit or Straddle States.
In this respect, the Exchange notes that only those orders with a limit
price will be executed during a Limit or Straddle State. Therefore, on
balance, the Exchange believes that removing the potential inequity of
nullifying or adjusting executions occurring during Limit or Straddle
States outweighs any potential benefits from applying certain
provisions during such unusual market conditions. Additionally, as
discussed
[[Page 27389]]
above, there are additional pre-trade protections in place outside of
the Obvious and Catastrophic Error Rule that will continue to safeguard
customers.
The Exchange notes that under certain limited circumstances the
Proposed Rule will permit the Exchange to review transactions in
options that overlay a security that is in a Limit or Straddle State.
Specifically, an Official will have authority to review a transaction
on his or her own motion in the interest of maintaining a fair and
orderly market and for the protection of investors. Furthermore, the
Exchange will have the authority to adjust or nullify transactions in
the event of a Significant Market Event, a trading halt in the affected
option, an erroneous print or quote in the underlying security, or with
respect to stop and stop limit orders that have been triggered based on
erroneous trades. The Exchange believes that the safeguards described
above will protect market participants and will provide the Exchange
with the flexibility to act when necessary and appropriate to nullify
or adjust a transaction, while also providing market participants with
certainty that, under normal circumstances, the trades they effect with
quotes and/or orders having limit prices will stand irrespective of
subsequent moves in the underlying security. The right to review those
transactions that occur during a Limit or Straddle State would allow
the Exchange to account for unforeseen circumstances that result in
Obvious or Catastrophic Errors for which a nullification or adjustment
may be necessary in the interest of maintaining a fair and orderly
market and for the protection of investors. Similarly, the ability to
nullify or adjust transactions that occur during a Significant Market
Event or trading halt, erroneous print or quote in the underlying
security, or erroneous trade in the option (i.e., stop and stop limit
orders) may also be necessary in the interest of maintaining a fair and
orderly market and for the protection of investors. Furthermore, the
Exchange will administer this provision in a manner that is consistent
with the principles of the Act and will create and maintain records
relating to the use of the authority to act on its own motion during a
Limit or Straddle State or any adjustments or trade breaks based on
other proposed provisions under the Rule.
B. Self-Regulatory Organization's Statement on Burden on Competition
ISE believes the entire proposal is consistent with section 6(b)(8)
of the Act \20\ in that it does not impose any burden on competition
that is not necessary or appropriate in furtherance of the purposes of
the Act as explained below.
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\20\ 15 U.S.C. 78f(b)(8).
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Importantly, the Exchange believes the proposal will not impose a
burden on intermarket competition but will rather alleviate any burden
on competition because it is the result of a collaborative effort by
all options exchanges to harmonize and improve the process related to
the adjustment and nullification of erroneous options transactions. The
Exchange does not believe that the rules applicable to such process is
an area where options exchanges should compete, but rather, that all
options exchanges should have consistent rules to the extent possible.
Particularly where a market participant trades on several different
exchanges and an erroneous trade may occur on multiple markets nearly
simultaneously, the Exchange believes that a participant should have a
consistent experience with respect to the nullification or adjustment
of transactions. The Exchange understands that all other options
exchanges intend to file proposals that are substantially similar to
this proposal.
The Exchange does not believe that the proposed rule change imposes
a burden on intramarket competition because the provisions apply to all
market participants equally within each participant category (i.e.,
Customers and non-Customers). With respect to competition between
Customer and non-Customer market participants, the Exchange believes
that the Proposed Rule acknowledges competing concerns and tries to
strike the appropriate balance between such concerns. For instance, as
noted above, the Exchange believes that protection of Customers is
important due to their direct participation in the options markets as
well as the fact that they are not, by definition, market
professionals. At the same time, the Exchange believes due to the
quote-driven nature of the options markets, the importance of liquidity
provision in such markets and the risk that liquidity providers bear
when quoting a large breadth of products that are derivative of
underlying securities, that the protection of liquidity providers and
the practice of adjusting transactions rather than nullifying them is
of critical importance. As described above, the Exchange will apply
specific and objective criteria to determine whether an erroneous
transaction has occurred and, if so, how to adjust or nullify a
transaction.
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
Because the proposed rule change does not (i) significantly affect
the protection of investors or the public interest; (ii) impose any
significant burden on competition; and (iii) become operative for 30
days from the date on which it was filed, or such shorter time as the
Commission may designate if consistent with the protection of investors
and the public interest, the proposed rule change has become effective
pursuant to section 19(b)(3)(A) of the Act \21\ and Rule 19b-4(f)(6)
thereunder.\22\
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\21\ 15 U.S.C. 78s(b)(3)(A).
\22\ 17 CFR 240.19b-4(f)(6). As required under Rule 19b-
4(f)(6)(iii), the Exchange provided the Commission with written
notice of its intent to file the proposed rule change, along with a
brief description and the text of the proposed rule change, at least
five business days prior to the date of filing of the proposed rule
change, or such shorter time as designated by the Commission.
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The Exchange has asked the Commission to waive the 30-day operative
delay so that the proposal may become operative immediately upon
filing. The Commission believes that waiving the 30-day operative delay
is consistent with the protection of investors and the public interest,
as it will enable the Exchange to meet its proposed implementation date
of May 8, 2015, which will help facilitate the implementation of
harmonized rules related to the adjustment and nullification of
erroneous options transactions across the options exchanges. For this
reason, the Commission designates the proposed rule change to be
operative upon filing.\23\
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\23\ For purposes only of waiving the 30-day operative delay,
the Commission has also considered the proposed rule's impact on
efficiency, competition, and capital formation. See 15 U.S.C.
78c(f).
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At any time within 60 days of the filing of the proposed rule
change, the Commission summarily may temporarily suspend such rule
change if it appears to the Commission that such action is necessary or
appropriate in the public interest, for the protection of investors, or
otherwise in furtherance of the purposes of the Act. If the
[[Page 27390]]
Commission takes such action, the Commission shall institute
proceedings to determine whether the proposed rule should be approved
or 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 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 email to [email protected]. Please include
File Number SR-ISE-2015-18 on the subject line.
Paper Comments
Send paper comments in triplicate to Brent J. Fields,
Secretary, Securities and Exchange Commission, 100 F Street NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number SR-ISE-2015-18. This file
number should be included on the subject line if email 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 Web site viewing and
printing in the Commission's Public Reference Room, 100 F Street NE.,
Washington, DC 20549, on official business days between the hours of
10:00 a.m. and 3:00 p.m. Copies of the filing also will be available
for inspection and copying at the principal office of the Exchange. 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-ISE-2015-18 and should be
submitted on or before June 3, 2015.
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\24\
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\24\ 17 CFR 200.30-3(a)(12).
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Robert W. Errett,
Deputy Secretary.
[FR Doc. 2015-11587 Filed 5-12-15; 8:45 am]
BILLING CODE 8011-01-P