02-12981. Self-Regulatory Organizations; Order Approving Proposed Rule Change by the Chicago Board Options Exchange, Inc. Relating to the Allocation of Orders for Appointed Market-Makers in Index FLEX Options

May 15, 2002.

I. Introduction

On February 15, 2002, the Chicago Board Options Exchange, Inc. (“CBOE” or “Exchange”) submitted to 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 relating to the allocation of orders for Appointed Market-Makers (“AMMs”) in Index FLEX Options. On March 18, 2002, the CBOE submitted Amendment No. 1 to the proposed rule change. The proposed rule change and Amendment No. 1 were published for comment in the Federal Register on April 2, 2002.^[3] The Commission received no comments on the proposed rule change. This order approves the proposed rule change.

II. Description of Proposal

The CBOE is proposing to amend CBOE Rule 24A.5, concerning the allocation of orders in FLEX Index Options. The proposed rule change was submitted by the CBOE pursuant to subparagraph IV.B.j. of the Commission's Order of September 11, 2000,^[4] which requires that respondent options exchanges 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 allocation of orders in that option class.”

CBOE Rule 24A.9 provides for the appointment of Appointed Market-Makers (“AMMs”) in FLEX Index Options and assigns these AMMs certain specified obligations in the trading of such options. The proposed rule change would amend CBOE Rule 24A.5, which relates to trading procedures for FLEX Options, to permit the appropriate Floor Procedure Committee—in this case, the SPX Floor Procedure Committee—to establish a participation entitlement formula for such AMMs.

The proposed rule change would also amend the participation entitlement of a “Submitting Member,” i.e., the Exchange member that initiates FLEX bidding and offering by submitting a FLEX Request for Quotes (“RFQ”). Currently, a Submitting Member who has indicated an intention to cross or act as principal on a FLEX Index Options trade, and has matched or improved the best bid or offer given in response to its RFQ, is granted priority to execute the contra side of the trade—but only to the extent of the largest of 25% of the trade, a proportional share of the trade, $1 million Underlying Equivalent Value, or the remaining Underlying Equivalent Value on a closing transaction valued at less than $1 million. The proposed rule change would reduce the percentage participation entitlement, where it applies, from 25% to 20%.

As part of the proposed rule change, the CBOE submitted a draft Regulatory Circular with which the SPX Floor Procedure Committee would exercise its authority to set the participation entitlement formula for AMMs.^[5] Specifically, the Regulatory Circular would state that the Submitting Member is entitled to cross up to 20% of the contracts in an order that occurs as a result of the Submitting Member's RFQ when all conditions of such percentage are met. The Regulatory Circular would state further that the AMM(s) is (are) entitled to the contracts remaining in the order up to an aggregate of 40% of the order, but that the Submitting Member and the AMM(s) could not receive an entitlement that collectively equals more than 40% of the order. The remaining contracts in the order would then be allocated according to the relevant Exchange rules.^[6]

The CBOE believes that it is just and equitable for AMMs in FLEX Index Options to receive a participation entitlement in return for the obligations that are imposed upon them. The CBOE believes that such an entitlement is important to encourage members of the Exchange to become AMMs, because FLEX Index Options are customized and do not have the same liquidity as standardized options, and AMMs are subject to greater risk when quoting such options.

III. Discussion

After careful consideration, the Commission has determined to approve the proposed rule change.^[7] For the reasons discussed below, the Commission finds that the proposed rule change 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.^[8]

The Commission believes that it is reasonable for the Exchange to offer AMMs a participation guarantee to encourage Exchange members to become AMMs and provide liquidity in FLEX Index Options. The Commission notes that the proposed entitlement of the AMM together with any guaranteed participation granted to the Submitting Member could not exceed 40 percent of an order. The Commission has found with respect to participation guarantees in other contexts that a maximum combined guarantee of 40 percent is not inconsistent with statutory standards of competition and free and open markets.^[9]

V. Conclusion

It is therefore ordered, pursuant to Section 19(b)(2) of the Act,^[10] that the proposed rule change (SR-CBOE-2002-09) be, and hereby is, approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[11]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  See Securities Exchange Act Release No. 45633 (March 22, 2002), 67 FR 15643 (April 2, 2002) (“Notice”). Although the Notice stated that the date of filing of Amendment No. 1 was March 18, 2002, the amendment was deemed filed on March 15, 2002.

4.  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.  The Exchange has stated that changes to this Regulatory Circular, including changes to the participation entitlement formula, will be submitted to the Commission pursuant to Section 19(b) of the Act. See Notice.

6.  The CBOE has stated that AMM(s) would not be entitled to a share in these remaining contracts unless all other participants have been satisfied. See Notice.

7.  In approving this proposed rule change, the Commission has considered its impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f).

8.  15 U.S.C. 78f(b)(5). Section 6(b)(5) requires that the rules of an exchange, among other things, be designed to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and not be designed to permit unfair discrimination between customers, issuers, brokers, or dealers.

9.  See, e.g., Securities Exchange Act Release Nos. 42455 (February 24, 2000), 65 FR 11388 (March 2, 2000) at 11398; and 43100 (July 31, 2000), 65 FR 48778 (August 9, 2000) at notes 96-99 and accompanying text.

10.  15 U.S.C. 78s(b)(2).

11.  17 CFR 200.30-3(a)(12).