02-7612. Self-Regulatory Organizations; Order Granting Approval to a Proposed Rule Change and Amendment No. 1 Thereto by the Philadelphia Stock Exchange, Inc. Relating to an Increase in the Maximum Guaranteed Size for AUTO-X Eligible Orders in ...

March 22, 2002.

I. Introduction

On September 27, 2001, the Philadelphia Stock Exchange, Inc. (“Phlx” 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 increase its automatic execution guarantee for options overlying the QQQ from 100 contracts to 250 contracts. On October 9, 2001, the Phlx filed Amendment No. 1 to the proposed rule change.^[3] On November 15, 2001, the proposed rule change and Amendment No. 1 were published for public comment in the Federal Register.^[4] The Commission received no comments on the proposed rule change, as amended. This order approves the proposed rule change, as amended.

II. Description of the Proposed Rule Change

The Exchange proposes to increase the maximum order size eligibility for its automatic execution system (“AUTO-X”) in QQQ options from 100 contracts to 250 contracts. Under the rules of the Phlx, through AUTOM,^[5] orders are routed from member firms directly to the appropriate specialist on the trading floor. Of the public customer market and marketable limit orders routed through AUTOM, certain orders are eligible for AUTOM's automatic execution feature, AUTO-X. These orders are automatically executed at the disseminated quotation price on the Exchange and reported back to the originating firm.^[6]

The Exchange represents that AUTO-X affords prompt and efficient automatic executions at the disseminated quotation price on the Exchange. Therefore, the Exchange believes that increasing automatic execution levels for eligible orders in QQQ options from 100 contracts to 250 contracts should provide the benefits of automatic execution to a larger number of customer orders. Further, the Exchange notes that this increase in the automatic execution levels in QQQ options should enable the Exchange to remain competitive for order flow with other exchanges that trade QQQ options.

The Exchange notes that there are many safeguards incorporated into Exchange rules to ensure the appropriate handling of AUTO-X orders. For example, Phlx Rule 1080(f)(iii) states that the specialist is responsible for the remainder of an AUTOM order where a partial execution has occurred. Phlx Rule 1015 governs execution guarantees and requires the trading crowd to ensure that public orders are filled at the best market to a minimum of the disseminated size. In addition, Phlx Options Floor Procedure Advice F-7 provides that the size of any disseminated bid or offer by the Exchange shall be equal to the AUTO-X guarantee for the quoted option and shall be firm, except that the disseminated size of bids and offers of limit orders on the book shall be 10 contracts and shall be firm, regardless of the actual size of the orders. Violations of any of these provisions could be referred to the Business Conduct Committee for disciplinary action.

The Wheel is a mechanism that allocates AUTO-X trades among specialists and Registered Options Traders (“ROTs”).^[7] An ROT has discretion to participate on the Wheel to trade any option class to which he is assigned. The Exchange states that an increase in the maximum AUTO-X order size in QQQ options would not prevent an ROT from declining to participate on the Wheel. The Exchange states that, because the Wheel rotates in two-lot to ten-lot increments depending upon the size of the order,^[8] no single ROT will be allocated the entire 250 contracts.

The Exchange also has procedures that permit a specialist to disengage AUTO-X in extraordinary circumstances.^[9] The Exchange represents that AUTOM users will be notified of such circumstances.

With respect to financial responsibility issues, the Exchange notes that it has a minimum net capital requirement respecting ROTs.^[10] Furthermore, an ROT's clearing firm performs risk management functions to ensure that the ROT has sufficient financial resources to cover positions throughout the day. In this regard, the function includes real-time monitoring of positions. The Exchange believes that clearing firm procedures address the issue of whether an ROT has the financial capability to support the AUTO-X trading of orders in QQQ options as large as 250 contracts.

The Exchange believes that automatic execution of orders in QQQ options for up to 250 contracts should provide customers with quicker executions for a larger number of orders by providing automatic rather than manual executions, thereby reducing the number of orders subject to manual processing. The Exchange also believes that increasing the AUTO-X maximum order size in QQQ options should not impose a significant burden on operation or capacity of the AUTOM system and will give the Exchange better means of competing with other options exchanges for order flow.

III. Discussion

After careful review, the Commission finds that the proposed rule change, as amended, 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 Section 6 of the Act.^[11] Among other provisions, Section 6(b)(5) of the Act requires that the rules of an exchange be designed to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating securities transactions; remove impediments to and perfect the mechanism of a free and open market and a national market system; and protect investors and the public interest.^[12]

While increasing the maximum order size limit in QQQ options from 100 contracts to 250 contracts for automatic execution eligibility by itself does not raise concerns under the Act, the Commission believes that this increase raises collateral issues that the Phlx will need to monitor and address. Increasing the maximum order size for QQQ options will make a larger number of QQQ option orders eligible for AUTO-X. These orders may benefit from greater speed of execution, but at the same time create greater risks for market maker participants. The specialists and ROTs signed onto AUTO-X will be exposed to the financial risks associated with larger-sized orders in QQQ options being routed through the system for automatic execution at the displayed price. When the market for the underlying security changes rapidly, it may take a few moments for the related option's price to reflect that change. In the interim, customers may submit orders that try to capture the price differential between the underlying security and the option. The larger the orders accepted through AUTO-X, the greater the risk the specialists and ROTs must be willing to accept. The Commission does not believe that, because the Phlx's Options Committee determines to approve orders as large as 250 contracts in QQQ options as eligible for AUTO-X, the Options Committee or any other Phlx committee or officials should disengage AUTO-X more frequently by, for example, declaring an “extraordinary circumstance.” ^[13] Disengaging AUTO-X can negatively affect investors by making it slower and less efficient to execute their orders. It is the Commission's view that the Phlx, when increasing the maximum size of orders that can be sent through AUTO-X, should not disadvantage all customers—the vast majority of whom enter orders for less than 250 contracts in QQQ options—by making their automatic execution systems less reliable.

IV. Conclusion

For the foregoing reasons, the Commission finds that the proposed rule change, as amended, is consistent with the Act and the rules and regulations thereunder applicable to a national securities exchange, and, in particular, with Section 6(b)(5) of the Act.^[14]

It is therefore ordered, pursuant to Section 19(b)(2) of the Act,^[15] that the proposed rule change (SR-Phlx-2001-89), as amended, is approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[16]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  See Letter from Richard S. Rudolph, Counsel, Phlx, to Nancy Sanow, Assistant Director, Division of Market Regulation, Commission, dated October 5, 2001 (“Amendment No. 1”). In Amendment No. 1, the Phlx changed the status of the proposal from a filing made pursuant to Section 19(b)(3)(A) of the Act to a filing made pursuant to Section 19(b)(2) of the Act.

4.  See Securities Exchange Act Release No. 45046 (November 7, 2001), 66 FR 57500.

5.  AUTOM is the Exchange's electronic order delivery and reporting system, which provides for the automatic entry and routing of equity option and index option orders to the Exchange trading floor. Orders delivered through AUTOM may be executed manually or routed to AUTOM's automatic execution feature, AUTO-X, if they are eligible for execution on AUTO-X. Equity option and index option specialists are required by the Exchange to participate in AUTOM and its features and enhancements. Option orders entered by Exchange members into AUTOM are routed to the appropriate specialist unit on the Exchange trading floor.

6.  See Phlx Rule 1080(c).

7.  Unlike ROTs, specialists are required to participate on the Wheel. See Phlx Rule 1080(g).

8.  See Exchange Options Floor Procedure Advice F-24(e).

9.  See Phlx Rule1080(e) and Exchange Options Floor Procedure Advice A-13.

10.  See Phlx Rule 703.

11.  The Commission has considered the proposed rule's impact on efficiency, competition and capital formation. 15 U.S.C. 78c(f).

12.  15 U.S.C. 78f(b)(5).

13.  The Phlx has filed a proposed rule change (File No. SR-Phlx-2001-27) with the Commission that would specify the procedures governing the disengagement of AUTO-X for “extraordinary circumstances,” define what constitutes “extraordinary circumstances,” and require the documentation of any action taken to disengage AUTO-X. The proposed rule change was filed pursuant to the 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) (File No. 3-10282) and is pending with the Commission.

14.  15 U.S.C. 78f(b)(5).

15.  15 U.S.C. 78s(b)(2).

16.  17 CFR 200.30-3(a)(12).