[Federal Register Volume 64, Number 229 (Tuesday, November 30, 1999)]
[Notices]
[Pages 66952-66954]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-31027]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-42168; File No. SR-CBOE-99-61]
Self-Regulatory Organizations; Notice of Filing and Order
Granting Accelerated Approval of Proposed Rule Change by the Chicago
Board Options Exchange, Inc. Relating to Non-Automatic Handling of RAES
Orders
November 22, 1999.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on November 8, 1999, 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 and
II below, which Items have been prepared by the Exchange. On November
22, 1999, CBOE submitted Amendment No. 1 to the proposed rule
change.\3\ The Commission is publishing this notice and order to
solicit comments on the proposed rule change from interested persons
and to approve the proposal on an accelerated basis for a ninety day
pilot to expire on February 21, 2000.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ In Amendment No. 1, CBOE shortened the length of the pilot
program from one year to ninety days. See letter from Timothy
Thompson, Director, Regulatory Affairs, CBOE, to Richard Strasser,
Assistant Director, Division of Market Regulation, Commission, dated
November 19, 1999.
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I. Self-Regulatory Organization's Statement of the Terms of
Substance of the Proposed Rule Change
CBOE proposes to amend its rule governing the operation of its
Retail Automatic Execution System (``RAES'') to allow, under certain
circumstances, orders to be rejected from RAES and routed to the Public
Automated Routing terminal (``PAR'') for manual handling. 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 CBOE 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 III below. The CBOE has prepared summaries, set forth in Sections
A, B, and C below, of the most significant aspects of such statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
1. Purpose
The purpose of the proposal is to allow, under certain
circumstances, orders to be rejected from RAES for manual handling
where the bid or offer for a series of options generated by the
Exchange's Autoquote system becomes crossed or locked with the best
offer or bid for that series as established by a booked order. The
proposed rule is intended to correct an unintended consequence of the
planned implementation of the Automated Book Priority (``ABP'') system
that could have significant detrimental effects on the operation of the
RAES as described further below. The CBOE anticipates that the number
of orders that will be rejected from RAES under this proposed rule
should represent only a small subset of the orders that have been and
currently are rejected pending implementation of the ABP system.
The Exchange's ABP system will allow an order entered into RAES to
trade directly with an order on the Exchange's customer limit order
book where the prevailing market bid or offer is equal to the best bid
or offer on the Exchange's book.\4\ The Commission recently approved
the Exchange's rules implementing the ABP system,\5\ which has not yet
been implemented.\6\
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\4\ In the event the order in the book is for a smaller number
of contracts than the RAES order, the balance of the RAES order will
be assigned to participating market-makers at the same price at
which the rest of the order was executed.
\5\ See Securities Exchange Act Release No. 41995 (October 8,
1999), 64 FR 56547 (October 20, 1999) (File No. SR-CBOE-99-29).
\6\ Currently, with certain exceptions discussed below, when a
RAES order is entered into the Exchange's Order Routing System when
the prevailing market bid or offer is equal to the best bid or offer
on the Exchange's book, the order will be routed electronically to a
Floor Broker's terminal or work station in the crowd subject to the
volume parameters of each firm. Today, the orders are routed to the
Floor Brokers instead of being automatically executed in the crowd
at the market price, because execution with the crowd would be
inconsistent with CBOE Rule 6.45, which provides that bids or offers
displayed on the customer limit order book are entitled to priority
over other bids or offers at the same price. CBOE permits RAES
orders in options on IBM, options on the Dow Jones Industrial
Average (DJX) and options on the Standard & Poor's 100 Stock Index
(OEX) to be executed on RAES even if the prevailing market bid or
offer equals the best bid or offer on the Exchange's book. In other
words, RAES orders in these options classes are currently allowed to
``trade through'' the book. Upon implementation of the ABP system,
RAES orders in these option classes, like all other option classes,
will trade against orders in the book in these circumstances.
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The Exchange recently became aware of an unintended consequence of
the operation of the ABP system. That is, in situations where the best
bid or offer for one or more series of a particular option class is
established by one or more orders in the book, the market-makers logged
on to RAES for that class of options could be subject to a substantial
risk in the event that the market in the underlying stock moves
significantly and quickly in a direction that makes the booked order
price substantially better than the price calculated by CBOE's
Autoquote formula. In that event, while the booked order would quickly
be executed, CBOE represents that the ABP system may not be able to
react quickly enough to remove the executed order from the limit order
book. As a result, once ABP is implemented, orders entered in RAES
would automatically be executed against the stale bid or offer still
being shown in the book notwithstanding the booked order having already
been executed. CBOE contends that this result could cause direct and
substantial economic disadvantage to the market-makers who are
obligated to participate in RAES executions. The Exchange believes that
implementing ABP without addressing this potential risk could cause
market-makers to avoid participating on RAES (thus, affecting the
liquidity of lower volume series traded on RAES and endangering the
viability of RAES), or to widen their quotes to minimize the possible
adverse consequences of executing orders based on stale quotes and to
account for the potential losses (thus, affecting the ability of CBOE's
market-makers to compete with competing specialists or market-makers).
In the alternative, market-makers might request that the Equity Floor
Procedure Committee reduce the size of orders eligible for RAES to
minimize the impact of these orders (thus, eliminating a significant
advance in automatic execution that CBOE represents its customers have
requested).
[[Page 66953]]
CBOE explains the potential risk market-makers could be subject to
by implementing the ABP system without the proposed ``carve out'' by
way of example. Assume that in a volatile internet stock (where the
maximum order size for RAES has been established at 50 contracts) small
customer orders in the book are establishing the best bid in six
different series. In one particular series, Series A, assume that the
CBOE market is 5 (bid)--5\1/8\ (offer), with a book order to buy 5
contracts at $5 (which establishes the best bid). Assume further that
the price of the underlying internet stock drops precipitously in a
matter of seconds. When the underlying stock moves, the Exchange's
Autoquote system will update CBOE market-makers' quotes for the options
overlying that stock. \7\ Assume with the drop in the underlying stock,
the Exchange's Autoquote system establishes a bid and offer of 4\3/4\--
4\7/8\ for Series A. (The same scenario would play out with the other
five series whose best bid is established by an order in the book.) The
order in the book representing the best bid will likely be immediately
executed by the crowd in the auction market. For some period of time
after the trade has been consummated in open outcry, however, the bid
will still be displayed as CBOE's bid while the Order Book Official
physically punches the keys to take the bid down from the display.
During the period, the displayed bid of 5 in the book will be out of
line with the theoretical bid 4\3/4\ generated by CBOE's Autoquote
system. In the meantime, traders who have equipped themselves with the
necessary computer equipment and communications facilities could have
identified the pricing disparity between the theoretical price of the
options and the displayed best bids, could automatically generate
orders to sell the affected options and route those orders to RAES. If
RAES is allowed to operate as it does under normal circumstances, each
order to sell that arrives at the Exchange from these investors, for so
long as the out-of-line book bid continues to be displayed, will be
assigned to market-makers in the trading crowd who are logged on to
RAES. These market-makers in turn will be obligated to buy at the $5
bid, which could be significantly away from the theoretical bid.\8\ Of
course, the same adverse consequence could be experienced in the other
five series of the class in which the bid was established by a booked
order.
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\7\ In approving this pilot, the Commission takes no position
with respect to the procedures involved in CBOE's Autoquote system,
which are the subject of pending proposal SR-CBOE-98-04.
\8\ If, for example, six different traders use such a system to
identify pricing disparities and to generate and send orders
instantly for automatic execution, market-makers in the trading
crowd could be responsible for trading 295 or 300 contracts of
Series A options alone, reflecting an aggregate payment of as much
as $150,000 more than their theoretical value. The maximum number of
contracts to be purchased in response to six orders for 50 contracts
each would be 300 contracts, except in the unlikely event that the
original 5 contract order on the book had not yet been filled, in
which case 5 contracts of the orders received would trade with the
booked order, and market makers would be obligated to buy the
remaining 295 contracts.
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The Exchange believes that by rejecting orders from RAES in the
limited situation where the bids or offers generated by Autoquote
become crossed or locked with the CBOE's best bid or offer as
established by an order in the Exchange's customer limit order book,
the problem described above can be resolved without any significant
disruption in the proper handling of customer orders or to the market
as a whole. The Exchange will then be able to offer RAES to its
customers together with the benefit of the ABP system, which will allow
RAES orders to trade directly with orders on the Exchange's customer
limit order book. Those orders that are rejected from RAES in the
limited circumstances when Autoquote crosses or locks the book will be
immediately and automatically routed to a broker's PAR terminal in the
trading crowd (absent contrary instructions of the firm), where they
will be represented by the broker and, if executable, will ordinarily
be executed in seconds. Because these orders remain RAES eligible, they
will be entitled to receive firm quote treatment when they are
represented in the crowd.
The Exchange represents that during the course of the pilot
program, the Exchange will monitor those situations in which RAES
orders are rejected as provided in the rule and will prepare a report
to the Commission describing its experience with the rule before the
end of the pilot program.
2. Statutory Basis
The Exchange believes that the proposed rule change is consistent
with and furthers the objectives of Section 6(b)(5)\9\ of the Act in
that it is designed to remove impediments to a free and open market and
to protect investors and the public interest.
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\9\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition
The CBOE does not believe that the proposed rule change will impose
any 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 solicited or received with respect to the
proposed rule change.
III. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing, including whether the proposed rule
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 CBOE. All
submissions should refer to File No. SR-CBOE-99-61 and should be
submitted by December 21, 1999.
IV. Commission's Findings and Order Granting Accelerated Approval
of Proposed Rule Change
After careful review, the Commission finds that the proposed pilot
is consistent with the requirements of the Act.\10\ In particular, the
Commission finds the proposal is consistent with Section 6(b)(5) \11\
of the Act. Section 6(b)(5) requires, among other things, that the
rules of an exchange be designed to promote just and equitable
principles of trade and to protect investors and the public interest.
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\10\ In addition, pursuant to Section 3(f) of the Act, the
Commission has considered the proposed rule's impact on efficiency,
competition, and capital formation. 15 U.S.C. 78c(f).
\11\ 15 U.S.C. 78f(b)(5).
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The Commission believes that it is imperative that CBOE implement
the ABP system as expeditiously as possible to ensure that all customer
limit orders on CBOE are, where appropriate, given priority over other
interest on the Exchange. After the ABP system is implemented, RAES
orders will be able to trade against orders in the book when the
prevailing market bid or offer equals the best bid or offer in the
Exchange's
[[Page 66954]]
limit order book. Implementation of the ABP system should provide for
more efficient execution of both RAES and booked orders. The proposed
rule change, which would result in RAES orders being routed to the
trading crowd when the Exchange's Autoquote system locks or crosses
CBOE's best bid or offer as established by the book, limits market-
maker risk where CBOE is unable to remove a quote based on a customer
limit order that has already been executed. The Exchange has
represented that this exception should occur very infrequently.
In light of the likely benefits to customer limit orders expected
to be gained by implementation of the ABP system, particularly in those
classes, discussed above, where CBOE currently permits RAES orders to
trade through orders on the limit order book, the Commission finds good
cause for approving the proposed rule change prior to the thirtieth day
after the date of publication of notice thereof in the Federal
Register. The Commission hereby requests that CBOE provide monthly
reports to the Commission regarding the number of times the exception
that is the subject of this pilot is used to allow the Commission to
determine whether to approve the proposal permanently.\12\
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\12\ The approval of the pilot should not be interpreted as
suggesting that the Commission is predisposed to approving the
proposal permanently.
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\13\ that the proposed rule change (SR-CBOE-99-61) is hereby
approved through February 21, 2000.
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\13\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\14\
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\14\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-31027 Filed 11-29-99; 8:45 am]
BILLING CODE 8010-01-M
