02-15428. Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the Chicago Board Options Exchange, Inc. Relating to Handling of Customer Orders

June 13, 2002.

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 June 10, 2002, the Chicago Board Options Exchange, Incorporated (“CBOE” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I, II, and III below, which Items have been prepared by the Exchange. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change

The CBOE proposes to amend its rules to adopt an order handling facility to allow customer orders larger than CBOE's “auto-ex” size to automatically secure CBOE's disseminated prices up to the disseminated size of the Exchange, while allowing for potential price improvement. The text of the proposed rule change is set forth below. Proposed new language is italicized.

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Chicago Board Options Exchange, Incorporated Rules

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Rule 6.10 LOU System Operations

This Rule governs the operation of the Large Order Utility (“LOU”) system.

(a) Definitions. For purposes of this Rule, the following definitions shall apply.

(i) The term “LOU” means a facility of the Exchange that provides order routing, handling, and execution for eligible options orders routed electronically to the Exchange.

(ii) The term “In-Person Wheel” means an order allocation mechanism whereby orders are evenly assigned to Market-Makers logged onto the In-Person Wheel for up to five contracts per Market-Maker for each order.

(iii) The term “Linkage Order” means an order routed to the Exchange through the Options Intermarket Linkage pursuant to the Plan for the Purpose of Creating and Operating an Intermarket Options Linkage.

(b) LOU Eligibility.

The following criteria must be met for an order to be eligible for LOU:

(i) The order must be a market order or marketable limit order that is not for an account in which a member, or any non-member broker-dealer (including foreign broker-dealer) has an interest;

(ii) The order must be of a size greater than the RAES eligibility limit for the subject option series as established pursuant to Rule 6.8(c);

(iii) the order may not be a Linkage Order;

(iv) at the time the order is received, the Exchange must be disseminating a quote at the national best bid or offer (NBBO) for the appropriate side of the market;

(v) at the time the order is received, the Exchange's disseminated quote may not be a manual quote;

(vi) the order must be in an option class which is designated as subject to the terms of Rule 6.8.B concerning booked orders; and,

(vii) the order must be in an option class designated by the appropriate FPC as subject to this Rule 6.10.

The senior person then in charge of the Exchange's Control Room shall have the authority to turn off LOU with respect to a class of options if there is a system malfunction that affects the Exchange's ability to disseminate or update market quotes.

(c) Order Receipt.

(i) Orders Equal to or Smaller than the Exchange's Disseminated Quotation Size. When LOU receives an order smaller than the Exchange's disseminated quotation size, the system will automatically stop the order against the Exchange's disseminated market. The order will then be automatically routed for representation in the crowd to allow for price improvement and to allocate the order to members of the trading crowd pursuant to paragraph (d) below.

(ii) Orders Larger than the Exchange's Disseminated Quotation Size. When LOU receives an order larger than the Exchange's disseminated quotation size, the system will automatically stop a portion of the order against the Exchange's disseminated market up to the Exchange's disseminated size. The stopped portion of the order will then be automatically routed for representation in the crowd to allow for price improvement and to allocate the order to members of the trading crowd pursuant to paragraph (d) below. Simultaneously, the balance of the order that was not stopped at the Exchange's disseminated price will be routed for normal order handling.

(d) Execution and Allocation. Upon receipt, the LOU order (or the stopped portion of the LOU order) shall be announced and exposed to the crowd to allow for price improvement. Any portion of a LOU order that does not receive price improvement will be allocated as follows:

(i) The LOU order will be assigned in open outcry consistent with Rule 6.45 and Rule 8.87. To the extent an order is not fully assigned in open outcry, the remaining portion of the order will be assigned to Market-Makers via the In-Person Wheel. If a portion of the LOU order still remains after the In-Person Wheel allocations are exhausted, the balance of the order shall be assigned in accordance with the RAES trade allocation methodology in effect for the subject option class pursuant to Rule 6.8, Interpretation and Policy .06.

(e) Obligations of Participating Market-Makers. Any Market-Maker who is present in the trading crowd and who makes markets in a particular security traded in that crowd, must be logged onto the In-Person Wheel for that security.

* * * Interpretations and Policies:

.01 The provisions of Rule 8.17 regarding stopping of option orders shall not apply to orders received pursuant to this Rule 6.10.

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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 IV below. The Exchange 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

Introduction. The Exchange is proposing to adopt a new Rule 6.10 governing the handling of larger customer orders. Under the new system, to be called the Large Order Utility (“LOU”), the Exchange will stop eligible customer orders at the Exchange's disseminated price up to the size of the disseminated quote, and subsequently allocate those customer orders in open-outcry, thereby allowing for price-improvement while guaranteeing an execution at a price equal to or better than the stop price. As proposed, the appropriate Floor Procedure Committee (“FPC”) would determine which option classes would be subject to the requirements of proposed Rule 6.10.

Large electronically routed public customer orders would generally be eligible for LOU. By immediately stopping these customer orders at the CBOE's disseminated market and transmitting a stop notification to the order sender, the Exchange believes that the LOU system would allow customers to quickly secure disseminated prices up to the CBOE's disseminated size (i.e., to effectively trade against CBOE's dynamic quote) with the added benefit of potential price improvement via an open-outcry allocation.

Eligibility for LOU. To be eligible for LOU, an incoming electronic order would be required to meet the following criteria: (i) the order would be required to be a market order or marketable limit order that is not for an account in which a member or any non-member broker-dealer (including foreign broker-dealer) has an interest; (ii) the order would be required to be of a size greater than the RAES ^[3] eligibility limit for the subject option series as established pursuant to Rule 6.8(c); (iii) the order could not be a “linkage order,” i.e., an order routed to the Exchange through the Options Intermarket Linkage pursuant to the Plan for the Purpose of Creating and Operating an Intermarket Options Linkage (“Linkage Plan”) ^[4] ; and (iv) the order would be required to be in an options class designated by the appropriate FPC as subject to the terms of Rule 6.10.

Additionally, an incoming electronic order would only be eligible for LOU if at the time of the order's receipt by the LOU system, the CBOE's disseminated market was equal to the national best bid or offer (“NBBO”). This would allow customers to receive the benefits of LOU (guaranteed prices and quick executions at CBOE's published market) when the CBOE's published price equals the NBBO. If CBOE's disseminated market was not the NBBO when an electronic customer order was received, the order would be handled under existing procedures. This would allow the trading crowd the opportunity to match the NBBO if it was so inclined. Further, once the intermarket linkage was in place, the Designated Primary Market Maker (“DPM”) would have the added ability to route an order to the exchange disseminating the NBBO if the trading crowd chooses not to match the NBBO.

Also, as previously noted, once the intermarket linkage is in place, linkage orders routed to CBOE from other exchanges would not be eligible for routing to LOU. The CBOE states that because of the unique features of the Linkage Plan, such orders must be handled in accordance with the requirements of the Linkage Plan (which allow for partial executions), and therefore would not be subject to the order handling requirements under proposed Rule 6.10.

There are two other eligibility requirements relating to the CBOE market at the time an eligible order is received that would need to be met for the order to be routed to LOU: (1) CBOE Rule 6.8.B must be in effect for the subject option class; and (2) CBOE's quote may not be a manual quote (i.e., a quote submitted manually by a market-maker).

Rule 6.8.B essentially provides that, for classes in which the rule is in effect, public customer orders routed to CBOE through the Exchange's Order Routing System (“ORS”) will be automatically executed against orders resident in the Exchange's book when such booked orders equal the NBBO. Because Rule 6.8.B is in effect for option classes designated by the appropriate FPC (i.e., it is not mandatory for all classes), and because customer orders in the book priced at the NBBO are accorded certain priorities over the trading crowd, the Exchange believes it is necessary to require that Rule 6.8.B be in effect for any option class in which proposed Rule 6.10 would be in effect.

With respect to manual quotes, LOU would not accept orders received while a manual quote is the Exchange's disseminated quote. This is to ensure that the DPM can make every possible effort to allow the incoming order to trade against the market maker responsible for the manual quote.

In sum, for an incoming order to be eligible for LOU, the order would be required to: (i) Be a market order or marketable limit order that is not for an account in which a member or any non-member broker-dealer (including foreign broker-dealer) has an interest; (ii) be of a size greater than the RAES eligibility limit for the subject option series as established pursuant to Rule 6.8(c); (iii) be in an option class which is designated by the appropriate FPC as eligible for LOU; and (iv) not be a linkage order. Further, at the time of the order's receipt, the state of the Exchange's disseminated market would need to meet the following: (i) the CBOE quote would be required to be priced equal to the NBBO; (ii) the requirements of CBOE Rule 6.8.B (governing automated book priority for larger than RAES-size public customer orders received through ORS) would have to be in effect for the subject option class; and (iii) the CBOE quote could not be a manual quote. LOU would accept orders when the above criteria are met.

How LOU would handle and allocate orders. Orders received by LOU would be automatically stopped at CBOE's disseminated price up to the disseminated size. The Exchange would transmit a stop notification to the order-sending firm. The stopped order would then be immediately routed to allow for price improvement and to allocate the order in open outcry. If the incoming order is larger than the CBOE's disseminated size, LOU would stop the portion of the order equal to the Exchange's disseminated size and handle that stopped portion as described above. The balance of the order would be routed for non-LOU order handling.

Once a stopped LOU order was routed to the trading crowd for assignment, it would be announced and exposed to the crowd to allow for price improvement. If price improvement was not attainable, the order would be allocated at the stop price in open outcry consistent with existing open outcry procedures under CBOE Rule 6.45. The DPM participation right would apply to the extent the order was stopped at the DPM's previously established market. If there still remains an unallocated portion of the order, such unallocated portion would be assigned to LOU's “In-Person Wheel.”

The In-Person Wheel is an order allocation mechanism that would only be applicable to LOU orders. The mechanism would evenly assign contracts to logged-on market-makers (including DPM Designees) up to a 5-contract maximum per order. Under the proposed rule, any market-maker who is present in the trading crowd and who makes markets in a particular security traded in that crowd would be required to be logged onto the In-Person Wheel for that security. If the In-Person Wheel has been exhausted for a particular LOU order and a balance still remains on the LOU order, the entirety of such balance would be assigned in accordance with the RAES trade allocation methodology in effect for the subject option class (i.e., 100-Spoke Wheel or Variable RAES) pursuant to CBOE Rule 6.8, Interpretation and Policy .06.

Examples. Below are some examples of how the LOU system would operate. Assume in all of the examples below that the CBOE disseminated market is the NBBO and that Rule 6.8.B is in effect. Also assume that there are 20 members in the trading crowd.

Example 1.

CBOE quote: 5-5.20; 300 x 450. A customer order to buy 300 contracts at the market is received electronically. Here, LOU will stop the entire order at 5.20 (thus, the order cannot receive a price worse than 5.20) and route it for potential price improvement and for allocation. A market-maker has just determined that his risk parameters allow him to sell 50 contracts for 5.10. He trades 50 of the order at 5.10. The rest of the order is allocated in open outcry to the members of the trading crowd that were willing to sell for 5.20 (including the DPM) in accordance with applicable open outcry rules including the DPM participation entitlement.

Example 2.

CBOE quote: 5-5.20; 300 x 450. A customer order to buy 300 contracts at the market is received electronically. The order is stopped and routed as in Example 1. No price improvement is received this time, and only 220 contracts of the 300-contract order are allocated in open outcry. The remaining portion, 80 contracts, will be allocated to the In-Person Wheel. In this case, each of the 20 crowd members would receive 4 contracts via the In-Person Wheel.

Example 3.

Assume the same scenario as in Example 2, except that 225 contracts are allocated in open outcry. Here, the In-Person Wheel will provide that 15 crowd members receive 4 contracts, and the other five members receive 3 contracts.

Example 4.

Assume the same scenario as in Example 2, except that 150 contracts are allocated in open outcry. In this case, the In-Person Wheel would assign 5 contracts to each of the 20 crowd members (for a total of 100 contracts). Thus, the In-Person Wheel is exhausted while a portion of the order (50 contracts) remains unexecuted. The remaining 50 contracts are therefore assigned via the RAES allocation methodology in effect for that trading crowd (either the 100-Spoke Wheel or Variable RAES, both of which are governed by Rule 6.8, Interpretation and Policy .06).

Example 5.

CBOE quote: 5-5.20; 300 x 500. The offer represents a customer limit order in the book to sell 50 contracts and the CBOE trading crowd's market of 450 contracts. A customer order to buy 300 contracts at the market is received electronically. Here, the order will automatically execute against the order in the book for 50 contracts pursuant to Rule 6.8.B before LOU stops the remaining 250 contracts on the buy order at 5.20 and then routes those contracts to the crowd for potential price improvement and allocation.

Example 6.

CBOE quote: 5-5.20; 300 x 200. A customer order to buy 300 contracts at the market is received electronically. Here, LOU will stop a 200-contract portion of the order at 5.20 (and send a stop notification for 200 contracts). The remaining 100 contracts of the order (the unstopped portion) will be routed for normal handling and representation. It will not be guaranteed a fill at the disseminated price at the time of receipt because that price was exhausted.

Lastly, the Exchange notes that the provisions of Rule 8.17 relating to the manual stopping of options order on the Exchange shall not apply to orders received and handled pursuant to proposed Rule 6.10. Rule 8.17 is applicable to manual stops and its terms would not make sense for electronically stopped orders.

2. Statutory Basis

The Exchange believes the proposed rule change will help customer orders receive fast and secure executions at disseminated prices and is therefore consistent with section 6(b) of the Act ^[5] in general and furthers the objectives of Section 6(b)(5) ^[6] in particular in that it should promote just and equitable principles of trade, serve to 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.

B. Self-Regulatory Organization's Statement on Burden on Competition

The Exchange believes that the proposed rule change does not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.

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. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

Within 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the Exchange consents, the Commission will:

(A) by order approve such proposed rule change, or

(B) institute proceedings to determine whether the proposed rule change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change 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 the filing will also be available for inspection and copying at the principal offices of the CBOE. All submissions should refer to File No. SR-CBOE-2002-31 and should be submitted by July 10, 2002.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[7]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  17 CFR 240.19b-4.

3.  RAES is the Exchange's Retail Automatic Execution System.

4.  See Securities Exchange Act Release No. 43086 (July 28, 2000), 65 FR 48023 (August 4, 2000).

5.  15 U.S.C. 78f(b).

6.  15 U.S.C. 78f(b)(5).

7.  17 CFR 200.30-3(a)(12).