02-6903. Self-Regulatory Organizations; Order Approving Proposed Rule Change by the Pacific Exchange, Inc. Relating to Rules on Collective Actions of Market Makers

March 15, 2002.

I. Introduction

On December 13, 2001, the Pacific Exchange, Inc. (“PCX” or “Exchange”) submitted to 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 proposed rule change relating to collective actions of market makers. The Federal Register published the proposed rule change for comment on February 12, 2002.^[3] The Commission received no comments on the proposed rule change. This order approves the proposed rule change.

II. Description of Proposal

The Exchange has submitted the proposed rule change pursuant to subparagraph IV.B.j of the Commission's September 11, 2000 Order,^[4] which requires in part that certain options exchanges, including the PCX, adopt new, or amend existing, rules to make express any practice or procedure whereby market makers trading any particular option class determine by agreement the spreads or option prices at which they will trade any option class. The Exchange is proposing to amend PCX Rule 6.37 (“Obligation of Market Makers”) by adding a new subsection (e) to be entitled, “Prohibited Practices and Procedures.” Proposed subsection (e)(1) would state that any practice or procedure whereby market makers trading any particular option issue determine by agreement the spreads or option prices at which they will trade that issue is prohibited, subject to three exceptions set forth in proposed PCX Rule 6.37(f), which are described below.

Subsection (1) to proposed PCX Rule 6.37(f) would permit the Lead Market Maker (“LMM”) to receive input from the members of the trading crowd on the variables of the formula the LMM uses to generate automatically updated market quotations in each option issue, but the members of the crowd would not be required to provide feedback. In addition, it would be within the LMM's sole discretion to make the final independent decision regarding the variables to be used in operating the automated quotation system. Finally, subsection (1) would state that LMMs using Exchange-approved proprietary automated quotation updating systems are not required to disclose proprietary information concerning the variables used by those systems.

Subsection (2) of proposed PCX Rule 6.37(f) would state that the obligation of market makers to make competitive markets would not preclude the LMM and members of the trading crowd from making a collective response to a request for a market, provided the member representing the order requests such a response in order to fill a large order. A large order would be defined as an order for a number of contracts that is greater than the eligible order size for automatic execution pursuant to PCX Rule 6.87.

Subsection (3) of proposed PCX Rule 6.37(f) would state that in conjunction with their obligations as a responsible broker or dealer pursuant to PCX Rule 6.86 and SEC Rule 11Ac1-1,^[5] the LMM and market makers in the trading crowd may collectively agree to the best bid, best offer and aggregate quotation size required to be communicated to the Exchange pursuant to PCX Rule 6.86(c).

The Exchange is also proposing a similar change to PCX Rule 6.82 (“Obligations of Lead Market Makers”) by adding new subsection (c)(8), which would provide that LMMs are responsible for establishing the variables in the formula used to generate automatically updated quotations in each option issue or series. It would also permit the LMM to disclose the autoquote variables to the members of the trading crowd.

III. Discussion

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.^[6] Specifically, the Commission believes that the proposed rule change is consistent with the Section 6(b)(8) ^[7] requirement that the rules of an exchange not impose any burden on competition not necessary or appropriate in furtherance of the Act.

The Commission believes that the proposed rule change should deter collective action on the part of Exchange members by clearly establishing in the Exchange's rules that options market makers are prohibited from determining by agreement the spreads or option prices at which they will trade an issue, subject to certain specified exceptions that the Commission herein approves.^[8] For instance, the proposal would permit LMMs to receive input from members of the crowd in setting the parameters of the formula used to automatically update options quotations. At this time, the Commission believes it is reasonable for the Exchange's rules to permit members of the crowd to be given a voice in setting autoquote parameters because, pursuant to the Exchange's rules, they will be obligated to execute orders at the resultant quote.

In addition, the proposed rule change would permit the LMM and members of the crowd to make a collective response to a request to fill a large order, provided that a collective response is requested. The Commission believes that this exception recognizes the desire of the marketplace to provide a single price to a request to fill a large order that a single member would not be able to fill. The Commission believes that any anticompetitive effect of this exception is limited by requiring that there be a member's specific request for a single price and that the order be sufficiently large. In addition, the Commission notes that notwithstanding this exception, a single crowd participant may voice a bid or offer independently from, and differently from, the LMM and other members of a trading crowd.

Finally, the Commission finds that the proposed rule change is designed to effectively limit the circumstances in which collective action is permissible.

IV. Conclusion

It is therefore ordered, pursuant to Section 19(b)(2) of the Act,^[9] that the proposed rule change (SR-PCX-2001-50) is approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[10]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  Securities Exchange Act Release No. 45392 (February 5, 2002), 67 FR 6567.

4.  See Order Instituting Public Administrative Proceedings Pursuant to Section 19(h)(1) of the Securities Exchange Act of 1934, Making Findings and Imposing Remedial Sanctions. Securities Exchange Act Release No. 43268 (September 11, 2000).

5.  17 CFR 240.11Ac1-1.

6.  In approving the proposal, the Commission has considered its impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f).

7.  15 U.S.C. 78f(b)(8).

8.  The Commission expects the Exchange to monitor the collective actions that are undertaken pursuant to the rule change approved herein for any undesirable or inappropriate anticompetitive effects. The Commission's examination staff will monitor the Exchange's efforts in this regard.

9.  15 U.S.C. 78s(b)(2).

10.  17 CFR 200.30-3(a)(12).