[Federal Register Volume 62, Number 207 (Monday, October 27, 1997)]
[Notices]
[Pages 55663-55665]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-28307]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39261; File No. SR-CBOE-97-50]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change by the Chicago Board Options Exchange, Inc. to Relating to ``Go
Along'' Orders
October 20, 1997.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on
September 25, 1997, the Chicago Board Options Exchange, Inc. (``CBOE''
or ``Exchange'') filed with the Securities and Exchange Commission
(``Commission'') the proposed rule change as described in Items I, II,
and III below, which Items have been prepared by the self-regulatory
organization. The Commission is publishing this notice to solicit
comments on the proposed rule change from interested persons.
I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The CBOE proposes to issues a regulatory circular which would
establish the representation of ``go along'' orders on the floor of the
Exchange as a violation of just and equitable principles of trade
pursuant to Exchange Rule 4.1. The text of the proposed rule change is
available at the Office of the Secretary, CBOE and at the Commission.
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 Purposes of, and
Statutory Basis for, the Proposed Rule Change
1. Purpose
The purpose of the proposed rule change is to prohibit floor
brokers from representing or executing ``go along'' orders (as further
described below) on the floor of the Exchange. The representation or
execution of such orders will be considered an act inconsistent with
just and equitable principles of trade pursuant to Exchange Rule 4.1.
The Exchange proposes to set forth the prohibition against the
representation of ``go along'' orders in a regulatory circular
describing the types of conduct which would be considered to be
violative of just and equitable principles of trade.
Definition of ``Go Along'' Orders: Generally, a ``go along'' order,
or a ``not held with the crowd'' order, is an order that instructs a
floor broker to bid or offer (as appropriate for the type of order) at
the price established by the other participants in the trading crowd.
Generally, the customer will specify whether the order is to buy or
sell, the number of contracts, the series, and the strike price.
Typically, the floor broker will be instructed to buy when the majority
of the of the market-makers participating on a trade are selling. These
orders often are placed by market-making firms as a side business, by
upstairs broker-dealers who want to participate in ``market making,''
and by specialists on other exchanges. These orders are entered in both
multiply-traded and singly listed option classes. As proposed, such an
order would be prohibited even if the bid or offer does not match
exactly the price established by the other participants in the trading
crowd as long as the customer has given the broker discretion to
determine what to bid or offer based upon the prices established by the
other participants.
Rationale for the Prohibition Against ``Go Along Orders'': The
Exchange believes that the continued representation of this class of
orders on the floor of the Exchange poses a serious threat to the
continued viability of the CBOE market-maker system, as explained
below.
The execution of ``go along'' orders provides a disincentive to the
transaction of a market-making business and thus, threatens the
continued viability of the market-making system.
The CBOE believes its market-marker system has, since its
inception, provided liquid, deep, fair, and reliable markets for
hundreds of option classes in thousands of different series. These
liquid markets are brought about through the efforts of numerous
market-makers who are willing to take on various affirmative
obligations in exchange for the opportunity to stand in a trading crowd
and trade with and against other market participants. The various
affirmative obligations are established by Exchange rules,\1\ including
Rule 8.7 which, among other things, requires market-makers to ``engage
* * * in dealings for his own account when there exists, or it is
reasonably anticipated that there will exist, a lack of price
continuity, a temporary disparity between the supply of and demand for
a particular option contract, or a temporary distortion of the price
relationships between option contracts of the same class.'' Rule 8.7.03
imposes distribution of activity requirements on market-markers. Rule
8.51 obligates market-makers to honor disseminated market quotes. In
addition to being required to meet the above obligations, CBOE market-
makers are subject to plenary oversight and regulation by the CBOE.\2\
In short, the system of affirmative obligations and oversight embodied
in CBOE Rules subjects market-makers to a great deal of responsibility,
in order to assure the quality and liquidity of the CBOE markets.
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\1\ Congress intended that exchanges have the primary
responsibility for the formulation and enforcement of the regulation
of exchange market making. See Report of the Senate Banking, Housing
and Urban Affairs Committee, Senate Report No. 94-75, April 14,
1975, to accompany S. 249, at p. 15. Section 11(b) of the Exchange
Act and Exchange Act Rule 11b-1 codify that policy. In fact, certain
of the obligations imposed on CBOE market-makers by CBOE rules are
mandated by Rule 11b-1.
\2\ Exchange Act Rule 11b-1(a)(2)(v) requires to CBOE to have
procedures ``to provide for effective and systematic surveillance of
the activities'' of its market-makers.
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The CBOE believes that ``go along'' orders interfere with this
obligation-opportunity trade-off of Exchange market-making.
Essentially, those
[[Page 55664]]
market participants, generally professional traders, who enter ``go-
along'' orders are attempting to realize the opportunity of market-
making without accepting any of the obligations. In addition, by their
nature, ``go along'' orders do not provide any incremental liquidity or
price discovery because the market participant entering the ``go
along'' order is merely trading at a price at which the market-makers
were willing to trade. These market participants, as customers,
however, are not obligated to fulfill any of the obligations of market-
makers and their activity is typically not subject to Commission or
Exchange oversight. These orders can be entered from off the floor of
the exchange and can be canceled at the complete discretion of the
customer. Therefore, these orders dilute the participation of those
market-makers who do provide liquidity on a continual basis both in
good times and in bad.
Likewise, common sense dictates these orders do not provide any
price discovery. As explained further below, options are priced in an
efficient market such as the CBOE by the skill of the individual
market-makers and their ability to employ complex pricing models and
strategies. ``Go along'' orders add nothing to this process, but simply
piggyback on the expertise and experience of those participants who
have taken on affirmative obligations and have put their capital at
risk.
The potential danger of this type of activity and any other
activity that provides a disincentive to market-making is that this
activity could lead to an irremediable decline of CBOE's existing
market-making system and the protections to public investors that that
system provides. It is hard work for CBOE market-makers to stand in
crowds and fulfill their numerous obligations under Exchange rules. The
regulation to which market-makers are subject may be necessary, but it
is burdensome. If the rules of the Exchange allow a trader to send such
orders from off the floor whenever he wants and to be able to cancel
the orders at will, without having an affirmative obligation to stand
behind any quotes and without being subject to oversight, more and more
market-makers may decide to engage in such activity and forgo the
numerous risks involved in market-making.\3\ The resultant decline in
liquidity and capital would inevitably compromise the quality of CBOE's
markets and harm the public. Ultimately, the proliferation of this type
of activity could even threaten the viability of CBOE's markets.
Ironically, these orders rely on the pricing efficiency of a market to
be effective; yet, these orders interfere with that pricing efficiency.
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\3\ Although these orders have been employed for years, the
possibility that market-makers might decide to forgo market-making
to trade from off of the floor is greater now than ever before. The
Commission's approval of risk-based haircuts has reduced the
traditional advantages market-makers have had in the area of capital
charges and margin. In addition, the technological advancement of
order delivery systems continues to erode the time and place
priority that has been one of the inducements to accepting the risks
of market-making.
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Although a ``go along'' order may have some upper or lower limit
price (but often it does not), the essence of a ``go along'' order is
that it relies on the pricing of the market-makers in the crowd. A
person entering a ``go along'' order, therefore, does not make any
independent market judgment on the price of the option. It is the
dependence upon the actions of the market-makers who establish the
prices and provide liquidity that makes this type of order
objectionable. Although market orders arguably also rely on the pricing
of the market-makers, market orders do not provide a disincentive to
market-making as ``go along'' orders do. Even if ``go along'' orders or
similar orders were entered on the floor of the New York Stock Exchange
or another stock exchange, the Exchange does not believe these orders
would be as objectionable in the context of a stock exchange as they
are on the CBOE options floor, because of the nature of the pricing of
these difference securities. On any given market there is only one
market (bid and offer) for a particular stock. The price is determined
according to the fundamentals of the issuer and according to the
principles of supply and demand for the shares of the stock.
Conversely, for any given underlying stock, there may be markets for
twenty or more different puts and calls. Because options are derivative
securities, the markets on these puts and calls are affected by
information about the markets for the underlying securities and related
interests, but also by complex mathematical formulas and volatility
assumptions. The pricing of options is a necessary and critical
function performed by market-makers and because of the complexity
involved and the individual assumptions required it is obviously a
function for which market-makers take a proprietary interest.
Therefore, the use of an order to replicate the actions of the market-
makers and to dilute their participation in a trade provides a
disincentive to a market-maker to meet his affirmative obligations and
to develop pricing formulas and strategies.
The prohibition of these types of orders does not limit market
accessibility.
The Exchange understands the Commission's concern with ensuring the
accessibility of public markets to orders from all market participants.
The proposed prohibition would not be a prohibition against any
category of market participants but against a type of activity that
threatens the system itself. The prohibition would not limit access to
CBOE markets to any person who has access to the market currently; any
participant who currently employs ``go along'' orders would be entitled
to enter limit orders, market orders, and any number of contingency
orders. By specifying that the broker representing the order should
trade with the market-makers in the crowd, the order ensures that these
orders will be inaccessible to those market-makers.
The restriction is also designed to assure equal regulation of and
a fair competition among all persons making markets on the CBOE, thus
serving these important purposes of the Act. Individuals sending these
types of orders as a pattern of behavior are attempting to act as
market-makers without fulfilling affirmative obligations. Any person
who wishes to compete as a market-maker in CBOE securities can do so by
becoming a CBOE member and subjecting himself to the same restrictions,
obligations, and surveillance as every other CBOE market-maker. There
is no burden on competition or unfair limit on market access to require
all competitors to play by the same ground rules.
The CBOE believes that its market-marker system has served and
continues to serve the public well by providing deep and liquid markets
for hundreds of classes of options listed on the Exchange. As a result,
the Exchange believes it is appropriate to prohibit activity that
threatens this system without any resulting public benefit.
2. Statutory Basis
By prohibiting certain types of orders that interfere with the
continued performance of the CBOE market-maker system and assuring
equal regulation of and a fair competition among all persons making
markets on the CBOE, CBOE believes that the proposed rule change is
consistent with and furthers the objectives of Section 6(b)(5) of the
Act \4\ in that it is designed to perfect the mechanisms of a free and
open market and to protect investors and the public interest.
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\4\ 15 U.S.C. 78f(b)(5).
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[[Page 55665]]
B. Self-Regulatory Organization's Statement on Burden on Competition
The Exchange does not believe that the proposed rule change will
impose any inappropriate burden on competition.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
No written comments were either solicited or received.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
Within 35 days of the publication of this notice in the Federal
Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if it finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which the self-regulatory organization consents, the Commission will:
(A) By order approve the proposed rule change, or
(B) Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
Copies of the submission, all subsequent amendments, all written
statements with respect to the proposed rule change that are filed with
the Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for inspection and copying at the
Commission's Public Reference Room. Copies of such filing will also be
available for inspection and copying at the principal office of the
Exchange. All submissions should refer to File No. SR-CBOE-97-50 and
should be submitted by November 13, 1997.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-28307 Filed 10-24-97; 8:45 am]
BILLING CODE 8010-01-M
