[Federal Register Volume 64, Number 194 (Thursday, October 7, 1999)]
[Notices]
[Pages 54713-54716]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-26156]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-41970; File No. SR-PCX-99-24]
Self-Regulatory Organizations; Pacific Exchange, Inc.; Order
Granting Accelerated Approval of Proposed Rule Change and Amendments 1
and 2 Thereto and Notice of Filing and Order Granting Accelerated
Approval of Amendment No. 3 to Proposed Rule Change Relating to
Automated Opening Rotations
September 30, 1999.
I. Introduction
On July 13, 1999, the Pacific Exchange, Inc. (``PCX'' or
``Exchange'') filed with the Securities and Exchange Commission
(``Commission'') pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a
proposed rule change to adopt a new Automated Opening Rotation
(``AOR'') system for handling customer orders and executing option
transactions during the opening rotation. On August 4, 1999, the
Exchange filed with the Commission Amendment No. 1 to the proposed rule
change.\3\ Notice of the proposed rule change, as amended, appeared in
the Federal Register on August 30, 1999.\4\ The Commission received no
comments regarding the proposal. On September 1, 1999, the PCX filed
Amendment No. 2 to the proposal.\5\ Notice of Amendment No. 2 appeared
in the Federal Register on September 10, 1999.\6\ On September 27,
1999, the Exchange filed Amendment No. 3.\7\ This Order approves the
proposed AOR pilot until October 1, 2000, as amended. In addition, the
Commission is publishing this notice to solicit comments on Amendment
No. 3 and is simultaneously approving the Amendment No. 3.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Letter from Michael D. Pierson, Director, Regulatory
Policy, PCX, to Michael A. Walinskas, Associate Director, Division
of Market Regulation (``Division''), Commission, dated August 3,
1999 (``Amendment No. 1'').
\4\ See Securities Exchange Act Release No. 41774 (August 20,
1999), 64 FR 47210.
\5\ See Letter from Michael D. Pierson, Director, Regulatory
Policy, PCX, to Richard Strasser, Assistant Director, Division,
Commission, dated September 1, 1999 (``Amendment No. 2'').
\6\ See Securities Exchange Act Release No. 41824 (September 1,
1999), 64 FR 49263 (noticing additions to the proposed rule change
and granting partial accelerated approval for the implementation of
AOR for 16 issues on a thirty day pilot basis). The Commission notes
that the PCX has represented that the Exchange has not experienced
any problems with AOR on the 16 pilot issues. Telephone conversation
between from Michael D. Pierson, Director, Regulatory Policy, PCX,
and Terri Evans, Attorney, Division, Commission, on September 30,
1999.
\7\ In Amendment No. 3, the Exchange proposes to implement the
AOR system for all issues on a one-year pilot basis. See Letter from
Michael D. Pierson, Director, Regulatory Policy, PCX, to Richard C.
Strasser, Associate Director, Division, Commission, dated September
24, 1999 (``Amendment No. 3'').
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II. Description of Proposal
The Exchange is proposing to adopt a new procedure that will allow
the Order Book Official (``OBO'') to establish electronically, for
eligible options series, a single price opening for executing eligible
market and marketable limit orders in the POETS system. The PCX
proposes to implement the new procedure on a one-year pilot basis until
October 1, 2000.\8\ In the event of an imbalance, any remaining orders
in the system that are eligible to be executed will be assigned to
market makers participating on the Auto-Ex System. The new process
involves three basic steps: first, the markets are established; second,
the opening rotation is automatically processed for the majority of
series; and finally, any series with manual orders or complication is
opened manually, i.e., pursuant to the current procedures for opening
rotations.\9\
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\8\ Id.
\9\ See Securities Exchange Act Release No. 41774, supra note 4.
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More specifically, under the new AOR process, opening rotations on
the PCX will occur in the following manner: Prior to the opening the
OBO will determine whether there are any orders in the trading crowd to
be executed at the opening.\10\ Once the underlying
[[Page 54714]]
security has opened and the Auto-Quote values are established,\11\ the
OBO will request from the trading crowd bids and offers in the specific
option issue. The trading crowd may determine that the posted bids and
offers are accurate, or alternatively, may request by public outcry
that certain quotes be modified.
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\10\ These may include, for example, orders that cannot be
represented in POETS, such as contingency orders, broker/dealer
orders, orders designated ``not held,'' orders for spreads or
straddlers, combination orders, all-or-none orders, as well as any
order the floor broker determines to represent manually.
\11\ Telephone conversation between Michael D. Pierson,
Director, Regulatory Policy, PCX and Terri Evans, Attorney, Division
Commission on September 21, 1999.
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Once the bid and asking price in each series has been ascertained,
the OBO and AOR System will identify all series that are eligible for
the AOR and that can be opened immediately, and will also identify all
series that are not eligible for the AOR. Those that are not eligible
for the AOR must be opened manually. Procedures for automatic and
manual opening are discussed below.
A. Automatic Opening
To prepare for an automated opening the AOR will first exclude
series for which there are no market or marketable limit orders in the
system, as well as all series deemed ineligible for AOR. The series
eligible for AOR will be promptly opened in accordance with the
following principles and procedures: First, the system will determine a
single price at which the series will be opened.\12\ Second, orders in
the system will maintain priority over market maker bids and offers, so
orders in the system will be matched up with on another,if possible,
before executing against the accounts of market makers. Third, if there
is an imbalance in the number of contracts to buy or sell at the
opening, then the imbalance will be ``cleaned up'' by the market makers
who are participating on the Auto-Ex system, i.e., the system will
assign a set number of contracts to each participating market maker
until the imbalance has been exhausted. Under the proposal, the
imbalance will be allocated to the members of the trading crowd using
the Exchange's existing Auto-Ex system.
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\12\ The appropriate price that is used in a single price
opening is determined in the following manner: Once the bid and
offering prices in a particular series have been determined, the OBO
will identify the number of contracts available to sell at the bid
price and the number of contracts available to buy at the offering
price. If the number available to sell at the bid price is greater
than the number available to buy at the offering price, then the
opening price will be the bid price, and vice versa. If the number
of contracts to sell is equal to the number to buy, then the opening
price will be established halfway between the bid and offering
price. However, if there is no trading increment available at the
halfway point between the bid and offering prices (e.g., as in the
case of a market 2 bid, 2\1/16\, asked), then the opening price will
be established at the price closest to the last sale price of option
contracts of that series.
If market and marketable limit orders can be completely
satisfied by trading against other orders in the Book, then the
market may open between the established bid and ask prices, with no
market maker participation. For example, if the market is 22\1/4\,
with an order in the Book to sell 20 contracts at 2\1/8\, and a
market order to buy 5 contracts, the single price opening will occur
with 5 contracts trading at 2\1/8\ (public customer to public
customer). The market quote at the opening will then be 22\1/8\.
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Under the proposal, orders may participate in the AOR regardless of
size. An order will not be prohibited from participating in the
automated opening rotation on the ground that the order is ineligible
from being executed over the Auto-Ex System due to its size.
The proposed rule change also provides for the manual accommodation
of certain non-bookable orders represented in the trading crowd and
disclosed to the OBO prior to an AOR. Generally, if the order is either
a market order or a limit order with a limit price equal to the opening
price of the particular series, then that order will be entitled to an
execution immediately following the opening of that series. If the
order is a market order or limit order for a public customer, the order
will be filled in its entire size by the market makers in the trading
crowd. If the order is a limit order for a broker-dealer, the order
will be entitled to be filled up to a number of contracts equal to a
pro rata share of the number of contracts that the Auto-Ex system
assigns to the market makers. If a broker is holding more than one
order to trade at the same limit price, then that broker is limited to
no more than one pro rata share of the number of contracts that the
Auto-Ex System assigns to the market makers.
B. Manual Opening
The Exchange intends to use the AOR in all issues traded on the
PCX. The Exchange also expects that particular series will only be
designated for manual opening (i.e., ``de-selected'' from the automated
procedure) in unusual circumstances. The Exchange does not anticipate
any situations where all series of a given issue will be opened
manually when the AOR is operational. The Exchange also does not
anticipate that any particular series will be de-selected and opened
manually on a routine or regular basis.
As noted above, all series that are not eligible for AOR will have
been identified before any series are opened automatically. The OBO can
designate a series as ineligible for the AOR by deliberately not
entering a quote into the system for that series. Series not eligible
for the AOR include series for which: (a) There are orders requiring
special handling; \13\ (b) there is an imbalance of contracts exceeding
an established threshold; or (c) the trading crowd and OBO determine
that the series should be opened manually.
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\13\ The following types of orders are ineligible to participate
in the automated opening rotation: (1) Broker/dealer orders; (2)
contingency orders; (3) spreads; (4) straddles; (5) not held orders;
and (6) combination orders. These types of orders are defined in PCX
Rule 6.62. If any of these types of orders are being represented in
the trading crowd and are likely to participate in the opening based
on price, a manual opening rotation will be held in that series.
Market orders are plain limit orders (i.e., limit orders with no
contingencies) are eligible to participate in the AOR.
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1. Manual Orders Requiring Special Handling
A series will be deemed ineligible for AOR if a broker in the crowd
is holding an order \14\ that is likely to be executed during the
opening. In general, manual orders to buy at relatively low prices or
to sell at relatively high prices generally will not likely participate
in the opening.
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\14\ The Exchange clarified that brokers hold orders as agent.
Telephone conversation between Michael D. Pierson, Director,
Regulatory Policy, PCX, and Kenneth Rosen, Attorney, Division,
Commission, on September 14, 1999.
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2. Imbalance of Contracts Exceeding Established Thresholds
The Exchange will establish, for each option issue, a number of
contracts that constitutes an imbalance threshold. Initially, each
option issue will have a minimum imbalance threshold of 20 contracts.
However, a Lead Market Maker in an issue may increase the imbalance
threshold in that issue to a number greater than 20, but not exceeding
999 contracts (due to system constrains). The decision to change the
imbalance threshold will be made as follows. Prior to the opening the
OBO, in conjunction with the Lead Market Maker in the issue, will set
for each option issue a number of contracts that constitute an
imbalance threshold. This number will attempt to reflect the relative
liquidity in the trading crowd and size of the following crowd.\15\ The
AOR will calculate imbalances on a series-by-series basis and flag
those series for which the imbalance threshold has been exceeded.
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\15\ The Options Floor Trading Committee will monitor and
supervise the general process of designating imbalance thresholds on
the trading floor. The Exchange believes that it is necessary to
provide a reasonable amount of flexibility in the process of
establishing particular thresholds. The Exchange also believes that
there is little risk of abuse in providing flexibility because if
low thresholds are established, then the series will have to be
opened manually. Although the Exchange does not anticipate that
there will be any problems in this area, the Exchange will study the
process during the first six months of use of the new system. If a
rule change appear necessary, the Exchange will file a rule filing
with the Commission to effect the changes necessary.
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[[Page 54715]]
3. Crowd's Request for Manual Opening
A member or members of a trading crowd may request a particular
series to be opened manually, and the OBO will honor reasonable
requests. These requests may typically be made in a series with a large
amount of open interest or for other reasons.\16\ Although the Exchange
does not anticipate problems resulting from such requests, in the event
of a dispute the matter would be resolved by floor officials.
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\16\ Generally, a series will not be eligible for an AOR if one
or more members of the trading crowd has reasonably requested a
manual opening rotation in that series. The Exchange anticipates
that such requests will fall into two general categories. The first
category involves mergers and takeovers. The second category would
cover system problems or system limitations. For example, the POETS
system may be unable to generate an accurate market because it is
unable to take into account the fact that a takeover will occur on
the following day, and as such, the system is unable to factor in
the correct model. In these situations, the series will be opened
manually.
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C. Obligations and Eligibility of Market Makers
Market makers may participate in the AOR if they are otherwise
eligible to participate on the Auto-Ex system during the trading day
pursuant to PCX Rule 6.87. Generally, to participate on Auto-Ex, a
market maker must be present in the trading crowd and that trading
crowd must be included within that market maker's appointment zone. If
there is adequate participation in a particular option issue, two floor
officials may require market makers who are members of the trading
crowd, as defined in subsection (6) of PCX Rule 6.87, to log on to
Auto-Ex, while present in the trading crowd, absent reasonable
justification or excuse for non-participation. The Exchange proposes
that these rules will apply to market maker participation in the AOR
with respect to contracts allocated to market makers during the opening
rotation process.
D. Surveillance of Market Maker Procedures
The market makers participating on AOR will be required to price
the contracts fairly, in a manner consistent with their obligations
under PCX Rule 6.37. In conjunction with the implementation of the AOR
system, the Exchange will publish a regulatory bulletin to remind
market makers of their obligation to set Auto-Quote fairly. The
Exchange believes that a number of factors, including scrutiny by
customers and firms representing customer orders, will ensure that
market makers adjust the Auto-Quote values consistent with their
obligation. Moreover, market makers are required to vocalize their
changes to Auto-Quote, which allows OBO's to oversee the markets and
alerts market makers who may want to improve the markets. In addition,
if an OBO notices any unusual activity in the setting of Auto-Quote
values the OBO must fill out an OBO Unusual Activity Report which will
be investigated by the Exchange. Finally, the Exchange's Auto-Quote has
an audit trail log that details every quote change resulting from the
use of Auto-Quote. This audit trail report can be studied in the event
of any concerns with the way the Auto-Quote values were established for
AOR.
III. Discussion
After careful review, the Commission finds that the proposed rule
change, as amended, is consistent with the requirements of Section 6 of
the Act. In particular, the Commission finds the proposal is consistent
with Section 6(b)(5) of the Act.\17\ Section 6(b)(5) requires, among
other things, that the rules of the exchange be designed to remove
impediments to and perfect the mechanism of a free and open market and
a national market system and not be designed to permit unfair
discrimination between customers, issuers, brokers or dealers.
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\17\ 15 U.S.C. 78f(b)(5). In approving this rule, the Commission
has considered the proposed rule's impact on efficiency,
competition, and capital formation. 15 U.S.C. 78c(f).
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The proposed rule change represents an effort to facilitate the
execution of orders at the opening by providing an electronic means of
establishing a single price opening. The Exchange believes that this
will expedite the opening of option issues on the Exchange, which will
serve all market participants. Further, the Exchange believes it will
eliminate problems associated with later openings, including the
elimination of blacklogs of unexecuted orders that can result when
opening rotations are conducted entirely manually and thus, improve
market efficiency for all market participants. In addition, the
Commission believes that the proposal should promote fair participation
in openings by all market participants by providing for the
participation of non-market-maker broker-dealer orders in the opening
process.
The Commission recognizes that certain aspects of AOR may require
heightened scrutiny by PCX to ensure that market makers are not
permitted to use the flexibility they have to set an opening price to
the disadvantage of investors and other market participants. The
Exchange has assured the Commission that it will ensure that market-
makers exercise their discretion in a manner consistent with their
obligation to price options fairly. The Commission expects that the PCX
will develop objective, quantifiable standards for ensuring that the
market-makers are satisfying those obligations and to surveil for such
compliance. The pilot offers an opportunity for the Commission to
evaluate the Exchange's efforts at surveilling market-maker activities
associated with AOR. Prior to permanent approval, the Commission
expects to review the results of the applied surveillance program. The
Exchange has also stated that it intends to monitor the process by
which imbalance thresholds are established.\18\ The Commission expects
to review the results of the Exchange's surveillance of the
establishment of the imbalance thresholds.
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\18\ See supra note 15.
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Although AOR is likely to greatly improve the opening on PCX, the
Commission believes that the system can and should be improved to
permit participation by non-bookable orders. The Commission does not
view the manual handling of non-bookable orders as the optimal solution
for ensuring that those orders are fairly incorporated into the
opening. It would be preferable for such orders to be electronically
incorporated into an AOR opening. Prior to permanent approval, the
Commission expects the Exchange to develop a workable plan for
incorporation non-bookable orders on AOR.
The Commission finds good cause for approving the proposal, as
amended, prior to the thirtieth day after the date of publication of
notice of filing of the proposed rule change in the Federal Register.
The Commission finds that the proposed rule change is designed to
remove impediments to and perfect the mechanisms of a free and open
market and a national market system by expediting the opening of option
issues on the Exchange.
The Commission also finds good cause for approving proposed
Amendment No. 3 prior to the thirtieth day after the date of
publication of notice of filing of the amendment in the Federal
Register. The amendment merely proposes to implement AOR on a pilot
basis.\19\ By implementing AOR on a pilot basis, the Exchange can
immediately address difficulties associated with lengthy opening
rotations and study AOR under market conditions while giving the
Commission an opportunity to view the operation of
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AOR under market conditions before approving it permanently.
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\19\ See Amendment No. 3, supra note 7.
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The Commission expects the PCX to study issues related to the
Commission's concerns during the pilot period and to report back to the
Commission at least sixty days prior to seeking permanent approval of
AOR. In addition to issues discussed above, among the issues that the
Exchange should explore are: The effect of AOR on the quality of
customer executions, any effects on existing order execution priority,
and the handling of non-bookable orders.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendment No. 3, including whether Amendment No. 3
is consistent with the Act. Persons making written submissions should
file six copies thereof with the Secretary, Securities and Exchange
Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Copies of
the submission, all subsequent amendments, all written statements with
respect to the proposed rule change that are filed with the Commission,
and all written communications relating to the proposed rule change
between the Commission and any person, other than those that may be
withheld from the public in accordance with the provisions of 5 U.S.C.
552, will be available for inspection and copying in the Commission's
Public Reference Room. Copies of 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-PCX-99-24 and should be
submitted by October 28, 1999.
V. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\20\ that the proposed rule change (SR-PCX-99-24), as amended, is
approved on a pilot basis until October 1, 2000, on an accelerated
basis.
\20\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\21\
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\21\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 99-26156 Filed 10-6-99; 8:45 am]
BILLING CODE 8010-01-M
