[Federal Register Volume 61, Number 246 (Friday, December 20, 1996)]
[Notices]
[Pages 67365-67371]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-32333]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38054; File No. SR-CBOE-95-48]
Self-Regulatory Organizations: Chicago Board Options Exchange,
Inc.; Order Approving a Proposed Rule Change Relating to the Use of
Proprietary Brokerage Order Routing Terminals on the Floor of the
Exchange
December 16, 1996.
I. Introduction
On August 25, 1995, the Chicago Board Options Exchange, Inc.
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange
Commission (``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4
thereunder,\2\ a proposal relating to the use of proprietary brokerage
order routing terminals on the floor of the Exchange. On October 3,
1995, the Exchange filed Amendment No. 1 to its proposal.\3\ The
proposed rule change was published for comment and appeared in the
Federal Register on October 13, 1995.\4\ Three comment letters were
received.\5\ The CBOE responded to the November 1995 Comment Letter.\6\
This order approves the proposal.
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\1\ 15 U.S.C. Sec. 78s(b)(1) (1988).
\2\ 17 CFR 240.19b-4 (1994).
\3\ Letter from Burton R. Rissman, Shiff Hardin & Waite, to
Francois Mazur, Attorney, Office of Market Supervision (``OMS''),
Division of Market Regulation (``Division''), dated October 3, 1995
(``Amendment No. 1'').
\4\ See Securities Exchange Act Release No. 36332 (October 4,
1995), 60 FR 53442.
\5\ Letters from David C. Bohan, Jenner & Block, writing on
behalf of Interactive Brokers Inc. (``IBI''), to Jonathan G. Katz,
Secretary, Commission, dated November 2, 1995 (``November 1995
Comment Letter''), and February 1, 1996 (``February 1996 Comment
Letter''). IBI submitted a comment letter on November 6, 1996
withdrawing its opposition to the rule filing but reserving its
right to comment further on the scope of activity permitted by CBOE
to users of proprietary brokerage order routing terminals. See
Letter from Thomas Peterffy, Chairman, IBI, to Howard L. Kramer,
Senior Associate Director, Division, Commission, dated November 6,
1996 (``November 1996 Letter'').
\6\ Letter from Charles J. Henry, President and Chief Operating
Officer, CBOE, to Jonathan G. Katz, Secretary, Commission, dated
January 16, 1996 (``CBOE Response Letter'').
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II. Description of the Proposal
A. Introduction
The rule change approved today adopts a policy pursuant to CBOE
Rule 6.23 \7\ that will allow the use of a proprietary brokerage order
routing terminal and its related system (``Terminal'') in the S&P 500
Index (``SPX'') options trading crowd. Written Exchange approval will
be required prior to a member establishing, maintaining, or using a
Terminal. The Exchange will not approve a Terminal unless and until the
member who proposes to establish one on the floor of the Exchange has
filed with the Exchange an ``Application & Agreement for Brokerage/
Order Routing Terminals in Trading Crowds'' (``Application
Agreement''), and Terminals could be used only in the crown trading SPX
options to route orders in SPX options.\8\
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\7\ CBOE Rule 6.23 provides that no member shall establish or
maintain any telephone or other wire communications between his or
its office and the Exchange without prior approval by the Exchange.
The Exchange may direct discontinuance of any communication facility
terminating on the floor of the Exchange.
\8\ See infra note 10.
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The rule change also specifies the permitted order-routing uses of
Terminals in light of a pending application which seeks Exchange
approval to establish and use a Terminal in the SPX options crowd.\9\
The firm's proposed Terminal would be a wireless, hand-held device
designed to receive orders entered by the firm or its customers from
off the floor. Use of the Terminal would enable the firm and its
customers to transmit orders electronically from off the trading floor
to one or more of its floor brokers on the floor of the Exchange,
including to a broker who is in the trading crowd. The firm's
application for use of a Terminal, which is the only such application
that has been received to date by the Exchange, has raised a number of
issues that the Exchange has determined to resolve as a matter of
policy that will be applicable to all members in connection with its
proposal to allow Terminals in the SPX options crowd. The policy
primarily is contained in the Application Agreement, as described
below.
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\9\ The firm that submitted the application, which is IBI, has
been approved for membership by the CBOE.
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B. Surveillance, Audit Trails and Compliance
Paragraph D of the Application Agreement will require an applicant
to agree that the use of its Terminal will conform to all applicable
laws, the rules, policies and procedures of the
[[Page 67366]]
Commission and the Exchange, and the provisions of the Application
Agreement. Paragraph F of the Application Agreement will require an
applicant to agree that the operation and use of all aspects of its
Terminal and all orders entered through the Terminal will be subject to
inspection and audit by the Exchange at any time upon reasonable
notice. It also will require the applicant to furnish the Exchange with
such information as the Exchange may request concerning the Terminal.
C. Physical, Electrical and Communications Requirements
The Application Agreement will require an applicant to specify the
necessary physical, electrical and communication requirements of its
proposed Terminal and to describe its Terminal system in detail.
Paragraph H of the Application Agreement will require the applicant to
coordinate the installation, maintenance and use of the Terminal on the
trading floor through the Exchange's Telecommunications Department, and
Paragraph K permits the Exchange to reallocate the space allocated to
the applicant's Terminal. Moreover, although the Exchange will not
immediately require the Terminals to interface with other Exchange
systems (such as the Exchange trade match and price reporting systems),
Paragraph K of the Application Agreement will allow the Exchange to
require such interfaces in the future.
D. Market Making Restriction
Paragraph C of the Application Agreement will require an applicant
to agree that its Terminal will be used to receive brokerage orders
only, and that it will not be used to perform a market making function.
Any system used to operate the Terminal must be separate and distinct
from any system that may be used by the applicant or its associated
persons in connection with market making. For purposes of Paragraph C,
orders initiated from off the floor of the Exchange that are not
counted as ``market maker transactions'' within the meaning of Exchange
Rule 8.1 and that do not create a pattern of offering in the aggregate
either to make two-sided markets or simultaneously to represent
opposite sides of the market in any class of options are not deemed to
be used to perform a market making function.
According to the Exchange, the speed with which Terminals could be
used to transmit orders directly to the point of the trade on the
Exchange floor could make it possible for persons not subject to
Exchange control to perform market making functions from off the floor
of the Exchange without being burdened by the cost of maintaining an
Exchange membership, or the obligations imposed on Exchange market
makers. CBOE expressed concern that if Terminals can be used to perform
market making functions from off the floor of the Exchange, it may
become undesirable for Exchange market makers to continue to assume the
costs and obligations associated with being a registered market maker,
which in turn could harm the liquidity and quality of the Exchange's
market.
E. Use of Information
Paragraph E of the Application Agreement will require an applicant
to agree that neither it nor its associated persons (as defined in the
Application Agreement) will trade with orders transmitted through the
Terminal, except in two limited situations as described below. First,
an applicant or an associated person would be able to trade with an
order in the Terminal system if no one else wanted to trade with it
(i.e., the member is the contra-party of last recourse). Second, an
applicant or an associated person would be able to participate in the
order on the same basis that other market makers who do not have
priority participate. Under this exception to the trading restriction,
the member or an associated person may trade with an order as long as
(a) the member in the trading crowd who is the first to respond to such
order (other than the applicant or an associated person) has priority
in taking the other side of such order, and (b) the aggregate portion
of such order taken by the applicant and associate persons is not
greater than the portion of the order taken by every other Exchange
market maker in the crowd who wishes to participate in the order in the
same aggregate quantity. Paragraph E also will prohibit an applicant or
an associated person from using for their own benefit any information
contained in any order in the Terminal system until that information
has been disclosed to the trading crowd.
F. Termination
Paragraph L of the Application Agreement allows the Exchange, upon
30 days notice, to terminate all approvals for Terminals in trading
crowds on the CBOE floor or at particular posts. In addition, if the
CBOE gives a member notice that any statement in a member's Application
Agreement is inaccurate or incomplete, that the member has failed to
comply with any provision of the Application Agreement, or that the
operation of the Terminal is causing operational difficulties on the
floor of the Exchange, the member normally would have seven calendar
days to address the matter. The CBOE Office of the Chairman may then
determine to terminate summarily the operation of that member's
Terminal. Paragraph L does not affect a member's right to seek relief
pursuant to Chapter XIX of the Exchange's Rules (Hearings and Review).
G. Initial Scope of the Proposal
Initially, the Exchange proposes to limit the use of Terminals to
the SPX options trading crowd for routing of orders in SPX options. The
Exchange stated that this limitation should give it the opportunity to
observe how the Terminals are being used in a crowd which is active
enough to bring to light any unforeseen problems and to gain experience
with the use of Terminals in that trading crowd before floor-wide
implementation of the policy were to occur.\10\
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\10\ The Commission notes that any decision to extend the policy
floor-wide would have to be submitted to the Commission as a
proposed rule change pursuant to Section 19(b) of the Act.
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III. Summary of Comments
A. November 1995 Comment Letter
In its November 1995 Comment Letter, IBI expressed support for the
proposal's aim to open the SPX pit to the Terminals, but objected to
Paragraph C of the Application Agreement that would prohibit a Terminal
from being used to perform a market making function. IBI interpreted
Paragraph C to prohibit the use of Terminals to receive two-sided limit
orders. IBI requested the Commission to commence disapproval
proceedings with respect to the prohibition against the receipt of two-
sided limit orders for a number of reasons. First, IBI argued that
Paragraph C is overly broad because it effectively would prohibit an
investor from occasionally using a Terminal to enter two-sided limit
orders. IBI noted that although Paragraph C purported to ban only two-
sided limit orders that created a pattern of offering in the aggregate
either to make two-sided markets or simultaneously to represent
opposite sides of the market, CBOE provided no guidelines that would
enable a member firm to determine when a combination of buy and sell
orders would establish a pattern, and would even prohibit buy and sell
orders represented by the member from different customers. Second, IBI
argued it would be impractical for a floor broker to determine whether
its customers are performing a market making function. In this context,
IBI noted that the Terminal
[[Page 67367]]
identifies the firm transmitting the order, but not the customer.
Accordingly, the only way a floor broker could ensure it was not
performing a market making function would be to restrict orders to buy
or sell sides only. Third, because Terminal users would be restricted
from entering certain two-sided limit orders, whereas other customers
and brokers using telephones or other means to place such orders would
face no similar restrictions, IBI claimed the provision is inconsistent
with Section 6(b)(5) of the Act which requires that the rules of an
exchange not be designed to permit unfair discrimination between
customers, issuers, brokers, or dealers. Fourth, IBI argued the
proposal would place an unnecessary burden on competition by limiting
``quote competition.'' IBI argued that because two-sided limit orders
can result in narrower spreads, improved liquidity, and better
executions, the restriction is inconsistent with the requirement of
Section 6(b)(8) of the Act that the rules of an exchange not impose any
burden on competition not necessary or appropriate in furtherance of
the purposes of the Act. Fifth, IBI argued that the proposal would
inhibit price discovery and better executions for customers,
inconsistent with requirements set forth in Section 6(b)(5) of the Act
that the rules of an exchange remove impediments to and perfect the
mechanism of a free and open market. Sixth, IBI also maintained that
the proposal is inconsistent with Section 11A(a) of the Act concerning
economically efficient execution of securities transactions, fair
competition, and best execution. IBI noted that the Act acknowledges
the benefit of new data processing and communications techniques, and
argued, consistent with the Commission's views, that the Terminals will
provide investors with a cheaper and speedier means to route orders to
the floor. IBI argued that the CBOE's market making restriction imposes
restrictions that do not apply to other devices, and thereby would
unfairly penalize IBI for its technological achievements. Finally, IBI
argued that the provision provides no regulatory benefit, merely
serving to protect market makers from competition. IBI claimed that the
CBOE's concern that without the prohibition market makers will withdraw
from its floor is not true. IBI noted that other benefits accrue to
being on the floor, and believes that by increasing volume, the
Terminals could encourage market maker floor participation, rather than
discourage it.
B. CBOE Response Letter
The CBOE Response Letter to the November 1995 Comment Letter stated
that IBI misread Paragraph C to prohibit two-sided limit orders.
Rather, the provision is meant to restrict the acceptance of orders
placed in the performance of a market making function. According to the
CBOE, this would require an aggregate pattern of orders from an
investor indicating the performance of a market making function, not
merely the entry from time to time of two-sided limit orders.
Therefore, the CBOE believes that Paragraph C is not overly broad
because it would permit two-sided limit orders occasionally to be
entered by the same customer and would not, as IBI suggests, restrict
different investors from inputting orders on opposite sides of the
market.
In response to IBI's concerns about the enforcement of the
restriction by floor brokers, the CBOE argued that it is the member's
responsibility to ensure compliance with the market making restriction.
In support of this, the CBOE noted that the Application Agreement is
between the Exchange and a member organization doing business with the
public, and, in addition, Paragraph F of the Application Agreement
would require a member to maintain an adequate audit trail of
transactions and customer activities, ensuring the ability of the
Exchange to enforce Paragraph C. In support of its argument, the CBOE
cited various rules which require members to know their customers and
what their customers are doing with respect to their transactions on
the CBOE. The Exchange noted that compliance with the market making
restriction lies with the member firm and not the floor broker.
The CBOE further argued that Paragraph C does not discriminate
between customers as IBI alleges because the restriction applies
equally to all customers. According to the CBOE, the reason a market
making prohibition does not exist for other CBOE order delivery systems
is that it would be impractical for customers to use such systems to
perform market making functions. The CBOE argued that allowing
investors to use terminals to perform off-floor market making functions
in SPX options would grant them all the advantages enjoyed by a market
maker without imposing any of the concomitant obligations, thereby
compromising the viability of CBOE's markets. The CBOE also noted that
the off-floor market maker would receive other benefits not available
to CBOE market makers.\11\ In this context, the CBOE notes that if a
market maker had the freedom to leave the floor and perform market
making through a Terminal, many would do so to avoid the obligations of
being a market maker. The CBOE believes this would compromise the
continued viability of its markets.
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\11\ For example, an off-floor market maker would be entitled to
the firm quote accorded customers under CBOE Rule 8.51, Retail
Automatic Execution System executions, participate in cross
transactions under Rule 6.74(b), and enter its orders in the limit
order book under CBOE Rule 7.4.
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The CBOE also disputed the ``burden on competition'' and ``price
discovery'' arguments by repeating that the provision does not bar all
two-sided limit orders, just the entry of such orders that constitute
market making. The CBOE also argued that to the extent the market
making prohibition could be deemed a burden on competition, it is
necessary and appropriate in furtherance of the Act, including Sections
6(b)(5) and 11A of the Act, given the CBOE's expressed concern that,
absent the prohibition, the introduction of Terminals would cause CBOE
market makers to leave the floor.
C. February 1996 Comment Letter
In its February 1996 Comment Letter, IBI disputed the CBOE Response
Letter's contention that to allow Terminals to be used to perform
market making functions could compromise the quality and viability of
the CBOE's markets. First, IBI claimed that CBOE market makers enjoy
many benefits and few burdens. In doing so, IBI referred to CBOE Rule
8.7, Interpretation .03B., which states that only 25% of a market
maker's trades need be executed in person in a given calendar
quarter.\12\ Second, IBI claimed that there is no evidence that market
makers would leave the CBOE floor if IBI's position were to prevail.
Finally, IBI argued that if the public benefits from market
participants' willingness to make continuous two-sided markets, then
there is no reason to restrict those investors who have no obligation
to make two-sided markets from making regular or continuous two-sided
markets. IBI concluded that for these reasons, Paragraph C does not
represent a proper exercise of the CBOE's rulemaking authority under
the Act. Rather, IBI argued that the market
[[Page 67368]]
making restriction contravenes the policies of the Act favoring
competition among market participants, investor protection, and the
introduction of new communication technologies.
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\12\ The Commission notes, however, that for a market maker to
receive market maker treatment for off-floor orders, the market
maker must execute at least 80% of its transactions in person. CBOE
Rule 8.7, Interpretation .03B. Moreover, at least 75% of a market
maker's total contract volume must be in option classes to which it
has been appointed. CBOE Rule 8.7, Interpretation .03A.
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D. November 1996 Letter
The November 1996 Letter withdrew without prejudice IBI's objection
to the proposed rule change, in order to permit floor brokers to begin
using terminals to represent customer orders in accordance with the
CBOE's proposal. In withdrawing its opposition, IBI stated that it is
in the best interest of its customers in the short run to permit use of
the Terminals quickly. The November 1996 Letter also requested that the
Commission interpret the term ``market making function'' used in
Paragraph C in a manner that could not be used to restrict unduly
market access and broad competition. The November 1996 Letter asked the
Commission to provide specific examples of permitted conduct in an
approval order of the proposed rule change, such that market
participants would be able to provide more efficient pricing.
The November 1996 Letter expressed concern that a Commission order
recognize that there is less depth and liquidity prevailing in certain
equity options and industry index products than in the SPX. IBI
requested that the Commission recognize the role of two-sided limit
orders in narrowing spreads and providing liquidity in markets that are
not as deep and liquid as the SPX.\13\
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\13\ The Commission recognizes that markets for certain equity
options can be less deep and liquid than the SPX market. However,
the rule change approved today concerns the use of Terminals only in
the SPX crowd. The Commission will consider the merits of permitting
the use of Terminals to represent two-sided limit orders that
effectively create regular two-sided markets in less liquid options
crowds when it is presented with that issue.
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IV. Discussion
A. General
Section 6(b)(5) of the Act \14\ requires that the rules of an
exchange be designed to prevent fraudulent and manipulative acts and
practices, promote just and equitable principals of trade, remove
impediments to and perfect the mechanism of a free and open market, and
in general to protect investors and the public interest. Section
6(b)(7) of the Act \15\ requires that the rules of an Exchange be in
accordance with Section 6(d) of the Act,\16\ and in general provide a
fair procedure for the disciplining of members and the prohibition or
limitation by an exchange of a person's access to services offered by
the exchange. Section 6(b)(8) of the Act \17\ requires that the rules
of an exchange not impose any burden on competition not necessary or
appropriate in furtherance of the purposes of the Act. Section
11A(a)(1)(C)(ii) of the Act \18\ states that it is in the public
interest and appropriate for the protection of investors and the
maintenance of fair and orderly markets to assure fair competition
among brokers and dealers. For the reasons set forth below, the
Commission finds that the proposed rule change is consistent with the
requirements of the Act and the rules and regulations thereunder
applicable to a national securities exchange, and, in particular, the
requirements of Sections 6(b)(5), 6(b)(7), 6(b)(8), and 11A(a)(1)(C) of
the Act.
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\14\ 15 U.S.C. Sec. 78f(b)(5) (1988).
\15\ 15 U.S.C. Sec. 78f(b)(7) (1988).
\16\ 15 U.S.C. Sec. 78f(d) (1988). Section 6(d) of the Act,
among other things, requires that an exchange, in any proceeding to
determine whether a member should be disciplined, bring specific
charges, notify such member of and provide him with an opportunity
to defend himself against such charges, and keep a record.
\17\ 15 U.S.C. Sec. 78f(b)(8) (1988).
\18\ 15 U.S.C. Sec. 78k-1(a)(1)(C) (1988).
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The Commission believes that the CBOE's proposal should foster
coordination with persons engaged in facilitating transactions in
securities, remove impediments to and perfect the mechanism of a free
and open market, and protect investors and the public interest by
expediting and making more efficient the process by which members can
receive and execute SPX orders on the floor of the Exchange. The
proposal also will promote fair competition among brokers and dealers
and facilitate transactions in options on the Exchange. The Commission
also believes that the requirement that an applicant file the
Application Agreement with the Exchange and comply with it is
reasonable and ensures adequate surveillance and compliance with CBOE
Rules. Finally, for the reasons described in more detail below, the
Commission believes that the market making prohibition on the use of
the Terminals adequately balances the potential benefits to the derived
from Terminals with the important regulatory issues that are raised in
connection with the potential use of Terminals for market making in SPX
options.
B. Application Agreement
Paragraphs H and K of the Application Agreement address the
physical, electrical and communication issues presented by the
introduction of Terminals. These provisions should allow the Exchange
to take into consideration the needs of all members in the allocation
of limited space and communication resources to ensure that Terminals
do not interfere with one another or with other Exchange systems.
Paragraph E of the Application Agreement generally will prohibit a
member or associated person from trading with orders transmitted
through a Terminal, unless no other member were to trade with the
order, or the applicant were to trade on the same basis as other
members who do not have priority. In addition, Paragraph E will
prohibit a member from using for its benefit information transmitted
through a Terminal before that information is disclosed to the trading
crowd.\19\ The Commission believes that these restrictions are
appropriate given the two concerns the Exchange asserted Paragraph E is
designed to address. First, that the applicant or one of its associated
persons might interact with an order--in effect internalizing it--prior
to information relating to such order becoming known to the trading
crowd, which would be inconsistent with the open auction market
principles governing the Exchange's trading system. Second, the
knowledge of order information in the system could give the applicant
or an associated person the ability to effect transactions or to change
quotes in the Exchange's market or in the markets for the underlying
interest or related interests before the information were available in
the market. The Commission also believes that the two exceptions to the
general restriction on trading with orders in the Terminal system are
consistent with these concerns, and ensure that members using Terminals
trade on the same terms and conditions as other market participants and
do not receive any trading advantages to interact with orders
transmitted through the Terminals.
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\19\ The Exchange believes that it would be inconsistent with
just and equitable principles of trade for a member or its
associated persons to use, or to permit the use of, information in a
customer's order prior to the disclosure of that information to the
market, except if such use is in accordance with the instructions of
the customer and is consistent with Exchange rules. Amendment No. 1,
supra note 3.
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Paragraphs D and F of the Applicant Agreement relate to
surveillance, audit trails, and compliance. The Commission believes
that these provisions should serve to ensure that an applicant clearly
understands its obligation to adhere to the applicable laws, rules,
policies, and procedures of the Application Agreement, Exchange, and
Commission. The Exchange will oversee that obligation through
inspection and audit.
[[Page 67369]]
The Application Agreement explicitly limits the use of a Terminal
to the SPX options trading crowd. The Commission believes that it is
consistent with the Act for the Exchange to limit the introduction of
Terminals at this time given the Exchange's stated desire to gain
experience in their use and address any problems which may arise. The
Commission notes that any decision to expand the use of Terminals
beyond the SPX options trading crowd would require that the CBOE submit
a proposed rule change to the Commission pursuant to Section 19(b) of
the Act.
Paragraph L of the Application Agreement provides for the
termination of the Exchange's approval of a member's Terminal under
certain circumstances. As noted above, Paragraph L allows the Exchange,
with 30 days notice, to terminate all approvals for Terminals in
trading crowds on the CBOE floor or at particular posts. In addition,
the Exchange summarily could terminate its approval of a member's
Terminal use following a determination by the Office of the Chairman of
the Exchange that the Exchange has given a member notice that a
statement in that member's Application Agreement is inaccurate or
incomplete, the member has failed to comply with any provision of the
Application Agreement, or the Terminal is causing operational
difficulties on the floor of the Exchange, and that member has failed
to cure the same within seven calendar days following the giving of
such notice. The Commission believes that the Paragraph L termination
procedures are consistent with the Act, including Sections 6(b)(7) and
6(d) of the Act,\20\ and are designed to provide affected members with
adequate due process. The Commission notes that a member so affected
could seek relief pursuant to the Hearings and Review provisions of
Chapter XIX of the Exchange's Rules. These provisions provide specific
procedures to seek Exchange hearing and review for persons aggrieved by
action of the Exchange in terminating or enforcing the terms of the
Application Agreement.\21\
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\20\ See supra notes 15-16, and accompanying text.
\21\ See CBOE Rules 19.4, Hearing, and 19.5, Review.
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C. Market Making Restriction
Paragraph C of the Application Agreement will allow a Terminal to
be used to receive brokerage orders only, and not to perform a market
making function. Orders that will be deemed to ``perform a market
making function'' are those that create a pattern of offering in the
aggregate either to make two-sided markets or simultaneously to
represent opposite sides of the market in any class of options.
Although IBI has withdrawn its objections to Paragraph C of the
Application Agreement,\22\ for the reasons set forth below, the
Commission believes that the November 1995 Comment Letter and the
February 1996 Comment Letter raise some valid concerns about the CBOE
proposal. For the reasons set forth below, the Commission finds that
these objections have been adequately addressed and finds that the
market maker restriction is consistent with the Act. Specifically, the
Commission believes that Paragraph C currently represents an acceptable
balancing by the Exchange of the potential benefits to be derived from
Terminals against the CBOE's stated concern that to allow unrestricted
off-floor market making could undermine the CBOE market maker system
and could create disincentives for CBOE market makers to remain on the
floor of the Exchange. The CBOE expressed concern that such off-floor
market making effectively would establish a market making structure
devoid of affirmative market making obligations. This could result in
less deep and liquid markets, particularly during periods of market
stress, when Terminal users engaged in unrestricted off-floor market
making would be under no obligation to continue making markets. The
Commission believes these concerns are reasonable, and disagrees with
IBI's contention that Paragraph C represents an unacceptable exercise
of the Exchange's rulemaking authority. Similarly, the Commission
disagrees with IBI that the CBOE is attempting to limit the
introduction of new technology. The CBOE's proposal will allow the
introduction of an innovative technology into one of its most active
trading crowds, while doing so in a manner designed to ensure the
continued viability of its market maker system.
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\22\ November 1995 Comment Letter and February 1996 Comment
Letter, supra note 5; and supra Parts III.A. and C.
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IBI claimed that CBOE market makers enjoy many benefits, but few
burdens. The Commission notes, however, that while market makers derive
certain benefits in connection with their market making functions, the
obligations they assume are substantial. For example, CBOE Rule 8.7
requires generally that a market maker's transactions constitute a
course of dealing reasonably calculated to contribute to the
maintenance of a fair and orderly market. Specific requirements include
a market maker's continuous obligation to deal for his or her own
account when there is a lack of price continuity, or when there is a
disparity between supply and demand for a particular option contract,
or between option contracts of the same class. In fulfilling these
requirements, a market maker must, among other things, compete with
other market makers to improve markets, make markets, and update market
quotations in response to changed market conditions. Moreover, market
makers are specifically required to establish firm quotes with regard
to public customer transactions, must meet specific trading
requirements within their assigned options classes, and generally
participate in Exchange sponsored automated trading systems. Although
it is true as IBI states that only 25% of a market maker's trades must
be executed in person, in actuality a much greater percentage of its
transactions must be in person to be able to avail itself of the full
benefits of market maker status.\23\ In contrast, a customer using a
Terminal to make markets would be entitled to benefits denied CBOE
market makers.\24\ Consequently, the Commission does not agree with
IBI's contention that CBOE market makers' obligations are illusory.
Rather, it is legitimate for the CBOE to be concerned about significant
unfair competition if IBI customers were allowed to make markets
whenever they so chose while still receiving the benefits of being a
public customer under CBOE rules.
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\23\ See supra note 12.
\24\ See supra note 11.
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IBI maintained that a non-market maker should be able to make two-
sided markets on a continuous or regular basis even though he has no
obligation to do so because it would benefit the public. The Commission
believes, however, that any purported benefit to be derived from such
off-floor market making could be more than off-set by the potential
harm identified by the CBOE regarding such activity. Notably, Terminal
users acting as market makers by making, in the aggregate, a pattern of
two-sided markets would not be subject to CBOE requirements to make
continuous markets, nor to direct CBOE surveillance and monitoring.
Because off-floor market makers potentially would enjoy the benefits of
other ``public customers,'' while not having the concomitant
obligations and responsibilities of CBOE market makers, the Commission
does not believe it is unreasonable for the CBOE to determine that the
introduction of unregulated
[[Page 67370]]
market making through Terminals could undermine its market maker
system.
The Commission also believes that the CBOE restriction on market
making through the use of Terminals has been effected in a clear and
reasonable manner that is not ambiguous nor overboard, and that takes
into account regulatory and market impact concerns, including those
relating to quote competition and price discovery.\25\ Notably, the
CBOE's proposal does not bar all two-sided limit orders. Instead it
only restricts the acceptance of orders placed in the performance of a
market making function. The distinction between market making and
brokerage activity is well established among market participants.
Moreover, the language of Paragraph C expressly restricts only an
aggregate pattern of orders from an investor which indicates whether an
investor is performing a market making function, not the occasional
entry of two-sided limit orders. Thus, the restriction on Terminal use
for routing limit orders is the minimum necessary for the CBOE to bar
Terminal use for off-floor market making.
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\25\ Cf., Securities Exchange Act Release No. 25842 (June 23,
1988), 53 FR 24359 (approving certain restrictions on the use of
telephones on the floor of the New York Stock Exchange), aff'd per
curiam, 866 F.2d 47 (2d Cir. 1989).
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By approving this proposed rule change, the Commission is not
stating that it is impermissible for an options exchange to permit
users of Terminals or other similar devices to make two-sided markets.
Indeed, the CBOE may determine to reconsider its decision not to permit
users to Terminals to engage in market making at some future time.
Nevertheless, while it is not illegal to permit off-floor market
making, the Commission believes that it is within the CBOE's
prerogative as a exchange to prohibit it. The Commission notes that the
CBOE is particularly concerned that off-floor market making effectively
would establish a market making structure devoid of affirmative market
making obligations that could result in less deep and liquid markets
during periods of market stress, when off-floor Terminal market makers
would not be required to continue making markets. The Commission
believes that these concerns are reasonable. Moreover, as noted above,
surveillance of market making through the Terminals currently would be
particularly difficult. The Commission's approval of the CBOE rule
change reflects the Commission's belief that the CBOE may act
incrementally in approving the use of Terminals for transactions in SPX
options given that the CBOE does not know the possible impact of
Terminals upon its market.
The Commission also emphasizes that it expects the CBOE to
interpret the term ``market making'' in accordance with its traditional
definition as defined under the Act, i.e., holding one's self out as
being willing to buy and sell a particular security on a regular or
continuous basis.\26\ The definition of market making should not
capture parties who enter orders on one side of the market; nor would
it capture parties who enter two-sided limit orders on occasion. A
party would not be deemed to be engaging in market making unless it
regularly or continuously holds itself out as willing to buy and sell
the security.\27\
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\26\ See e.g., 15 U.S.C. Sec. 78c(a)(38); Securities Exchange
Act Release No. 36719A (Sept. 6, 1996), 61 FR 48290, 48316 (Sept.
12, 1996).
\27\ Securities Exchange Act Release No. 36719A (Sept. 6, 1996),
61 FR 48290, 48316 (Sept. 12, 1996). The Commission notes that a
broker using a Terminal may receive numerous orders from multiple
customers, some of which are on the bid side and others on the offer
side of an SPX series. This is consistent with a brokerage function,
not a market making function. If, however, a particular customer of
a broker regularly or continuously places two-sided limit orders,
then the CBOE might, under certain circumstances, reach a different
conclusion as to the nature of the function being performed by the
broker and the customer.
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For the same reasons described below, the Commission does not
believe that the CBOE's proposal imposes a burden on competition or
restraint on technology not necessary or appropriate under the Act. As
noted above, regulatory and compliance issues are raised by off-floor
market making through the Terminals. The CBOE's restriction also serves
to ensure fair competition among persons making markets on the CBOE
consistent with Section 11A of the Act. Accordingly, the Commission
believes that any burden on competition that arguably exists by the
restriction on Terminal use is justified as reasonable and appropriate
to ensure adequate regulation of the CBOE's markets.
IBI also has claimed that the CBOE's rule change unfairly
discriminates between Terminal users and customers using other means
such as telephones to transmit orders. The Commission, however, agrees
with the CBOE that, unlike the use of Terminals, other means of
transmitting orders do not allow a customer effectively to engage in
market making. As the CBOE notes, other systems on its floor ``do not
have the technical capability to permit an investor to make and change,
with adequate speed, the wide range of quotes necessary to perform a
market making function effectively.'' The CBOE's proposal, therefore,
does not discriminate between customers using different methods of
transmitting orders, but rather serves to delineate the distinction
between market makers and customers. In summary, the prohibition does
not unfairly discriminate because it applies equally to all investors
using a Terminal, which, unlike other available technologies, have the
capability to allow market making functions.
Finally, the Commission disagrees with IBI's contention that the
CBOE's proposal places a burden on floor brokers by requiring them to
determine whether customers are engaged in market making. As noted by
the CBOE, the Application Agreement would be between the Exchange and a
member organization doing business with the public. Under the terms of
the Application Agreement, a member would be required to maintain an
audit trail sufficient to determine adherence to Paragraph C of the
Application Agreement. Thus, floor brokers would not be required to
monitor such adherence, and compliance would be within the member's
responsibilities. In any event, as noted above, the Commission believes
the CBOE's market making restriction is clear enough to provide
guidance to monitor trading activity for compliance with the
restriction.
In summary, while the CBOE's restrictions on the use of Terminals
raise regulatory issues, the Commission believes that, within the
context of the SPX options trading crowd, the market making restriction
is an acceptable exercise of the Exchange's rulemaking authority. While
the Commission recognizes that there may be different ways to address
the regulatory issues presented by off-floor market making through the
use of Terminals, the Act does not dictate that any particular approach
be taken. The Commission believes that the manner in which the Exchange
has chosen to address the regulatory issues presented by off-floor
market making reflects the considered judgement of the CBOE regarding
the attributes of Exchange membership and the organization of its
trading floor, and is a fair exercise of its powers as a national
securities exchange.
V. Conclusion
In view of the above, the Commission finds that the proposal is
reasonable and is consistent with the Act, and, in particular, Sections
6(b)(5), 6(b)(7), 6(b)(8), and 11A(a)(1)(C)(ii) of the Act.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\28\ that the
[[Page 67371]]
proposed rule change (File No. SR-CBOE-95-48) is approved.
\28\ 15 U.S.C. Sec. 78s(b)(2) (1988).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\29\
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\29\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-32333 Filed 12-19-96; 8:45 am]
BILLING CODE 8010-01-M
