[Federal Register Volume 59, Number 150 (Friday, August 5, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-19107]
[[Page Unknown]]
[Federal Register: August 5, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34465; File No. SR-CBOE-93-30]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change by the Chicago Board Options Exchange, Inc. Relating to the
Stopping of Option Orders by Market-Makers and Designated Primary
Market-Makers
July 29, 1994.
I. Introduction
On June 24, 1993, the Chicago Board Options Exchange, Inc.
(``CBOE'' 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 proposal that establishes procedures for permitting
market makers and designated primary market makers to grant stops to
option orders.\3\
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\1\15 U.S.C. 78s(b)(1) (1982).
\2\17 CFR 240.19b-4 (1993).
\3\When a market maker of DPM agrees to a floor broker's request
to ``stop'' a market order, the market maker of DPM is obligated to
execute the order at the best bid or offer, or better if obtainable.
The stopped order then becomes the new inside bid or offer.
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Notice of the proposed rule change was published for comment in
Securities Exchange Act Release No. 33013 (Oct. 4, 1993), 58 FR 53005.
No comments were received on the proposal. This order approves the CBOE
proposal.
II. Description of the Proposal
The Exchange states that the purpose of the Rule is to implement a
comprehensive method for executing ``stopped'' options transactions on
the Exchange, comparable to stopping rules that are in operation at
other exchanges. The proposed rule change provides that an Exchange
market-maker (``market-maker'') or designated primary market-maker
(``DPM'') is authorized, though not required, to grant a stop on an
option transaction and that a floor broker is authorized, but not
required, to accept a stop. In addition, the proposed rule change sets
forth the conditions which attach to a market-maker's or DPM's granting
of a stop.
A ``stop'' is defined as a guarantee that an option order will be
executed at the stop price or better. The Exchange believes that the
practice of stopping an option order provides many benefits for
marketplace participants, market-makers or DPMs, floor brokers, and
customers alike. The Exchange also believes a stop benefits the
customer by providing an opportunity for the floor broker to try to
obtain a better price for that customer without risk. According to the
Exchange, a stop provides one means whereby a floor broker may satisfy
the ``due diligence'' standard which he or she is required to meet
under Exchange rules and enables the floor broker to lock in a
desirable price while attempting to better that price. Additionally,
the Exchange believes that a stop also provides the market-maker or DPM
with an opportunity to compete for order flow by better meeting the
needs of floor brokers, and it provides additional price discovery for
the trading crowd.
The conditions under which an Exchange market-maker or DPM may
grant, and a floor broker may accept, a stop are set forth in paragraph
(b) of the proposed rule. First, a market-maker or DPM granting a stop
on a straight order or on only the option portion of a buy-write
transaction must make the trading crowd and the Order Book Official
aware of the terms, price, and size of the stop. Second, all stopped
orders must be time-stamped by the floor broker at the time the stop is
granted. Third, a market-maker or DPM must be prepared to execute, if
requested, one or more additional orders up to, but not to exceed in
aggregate, the total quantity of contracts executed in the original
stopped transaction at the same stop price or better. Fourth, floor
brokers are required to either execute the stopped order at the stop
price and size at the time a transaction occurs in the crowd at the
stop price, or to release the market-maker or DPM from his or her
guarantee. Finally, proposed Exchange Rule 8.17(b)(5) describes how a
floor broker must bid or offer to improve on the stop price guarantee:
``In improving on the stop price once a floor broker has accepted a
stop, a floor broker must bid no more than one fractional trading
increment less than the stop and must offer no more than one fractional
trading increment greater than the stop. A fractional trading increment
is the minimum fractional change allowed for bids and offers consistent
with [Exchange] Rule 6.42.'' When attempting to better the stop price,
any bid or offer that improves the established market for a particular
option series would be reflected on the screen.\4\
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\4\Telephone conversation between Barbara Casey, CBOE, and
Stephen M. Youhn, Derivative Products Regulations, SEC (July 14,
1994).
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Paragraph (c) of the Rule establishes priority for ``stopped''
orders over new crowd orders, excluding the public limit order book,
when the stop order is properly granted, accepted, and time-stamped by
the floor broker at the time the stop is granted and accepted.
Paragraph (d) of the Rule requires notice be given to a customer by the
floor broker or member organization within a reasonably practicable
time after that customer's order has been stopped. Paragraph (e) of the
Rule details the reporting requirements applicable to the execution of
stopped orders on the tape and on cards used for reporting Exchange
transactions.
Paragraph (f) of the Rule addresses the effect of a trading halt on
the priority and pricing of a stopped order. This aspect of the Rule,
which the Exchange asserts is substantially the same as an American
Stock Exchange, Inc. (``Amex'') provision covering the same subject,
establishes procedures for the benefit of customers by requiring the
floor broker to use due diligence to obtain any better price at which
an option might re-open after a halt, while maintaining priority at the
stop price if the reopening is at that price or an inferior price.
Finally, paragraph (g) of the Rule explicitly states that the market-
maker granting the stop is held to that guarantee by placing the
liability for correcting an erroneous or inaccurate price on the
market-maker or DPM that granted the stop.
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, and, in
particular, with the requirements of Section 6(b)(5) in that the
proposal is designed to promote just and equitable principles of trade
and to protect investors and the public interest.\5\ In addition, the
Commission finds that the proposal is consistent with the requirement
under Section 11(b) of the Act and the rules thereunder that require
specialist transactions to be consistent with the maintenance of fair
and orderly markets.\6\
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\5\15 U.S.C 78f(b)(5) (1982).
\6\15 U.S.C. 78k (1982) and 17 CFR 240.11b-1. The Commission
notes that CBOE Rule 8.1 provides that ``[R]egistered Market-Makers
are designated as specialists on the Exchange for all purposes under
the Securities Exchange Act of 1934 and the Rules and Regulations
thereunder.'' Accordingly, market-makers are considered specialists
for the purposes herein.
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Historically, the Commission has been concerned about the practice
of granting stopped orders. In the 1963 Report of the Special Study of
Securities Markets,\7\ the Commission commented that in many instances
``[t]he practice of stopping stock against orders on the specialist's
book * * * involves too great a compromise of the specialist's
fiduciary obligation for personal profit without any offsetting gain to
his market making function.''\8\ The Special Study's concern with
stopping stock was that unexecuted customer limit orders on the
specialist's book would be bypassed by the stopped order. The
Commission, nevertheless, has allowed the practice of stopping stock in
markets where the spread is twice the minimum variation because the
possible harm to orders in the book would be offset by the possibility
of price improvement when the spread between the bid and offer is
reduced.\9\
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\7\SEC, Report of the Special Study of Securities Markets of the
Securities and Exchange Commission, H.R. Doc. No. 95, 88th Cong.,
1st Sess., Pt. 2 (1963).
\8\Id. at 166.
\9\See Amex Rule 109(c); New York Stock Exchange (``NYSE'') Rule
116.30. The Commission has also approved, on a pilot program basis,
proposals by the NYSE and Amex that permit stopping stock in minimum
variation markets under certain limited circumstances where there is
an imbalance on the opposite side from the order being stopped, and
the imbalance is of sufficient size, given the characteristics of
the security, to suggest the likelihood of price improvement. See
Securities Exchange Act Release No. 28999 (March 21, 1991). 56 FR
12964 (March 28, 1991).
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The Commission believes that the same concerns attendant to the
practice of stopping stock are equally applicable to the stopping of
options orders. However, the Commission believes the CBOE proposal
addresses adequately these concerns by adopting sufficently stringent
safeguards. For example, the proposal requires a market-maker or DPM to
alert the trading crowd and Order Book Official of the terms, price and
size of the stop on a straight order or on the option portion of a buy-
write. Second, the proposal also requires a market-maker or DPM to be
ready to execute additional orders equal to the total quantity of
contracts executed in the original stopped transaction at the stopped
price. The Commission believes these conditions will serve to enhance
market depth and liquidity by increasing the trading opportunities
available to the crowd by apprising them of the order and allowing them
to better the current market, and by giving other orders the
opportunity to receive the stopped price.
The proposal establishes guidelines on how a floor broker must
improve on the stop price. Once accepting a stop, a floor broker may
only bid one fractional trading increment less than the stop and may
only offer one fractional trading increment greater than the stop.\10\
As a result of this requirement, the practice of granting stops will be
limited to markets where the spread is twice the minimum variation
allowable (under CBOE Rule 6.42). Accordingly, under the CBOE's
proposal, the floor broker's requirement to gain price improvement for
the stopped order will result in narrowing the spread between the bid
and offer. This narrower spread in the quotes will be available on the
quotation screen to all market participants, and should provide
benefits to the market that offset any potential harm to the customer
limit order book.
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\10\Minimum fractional trading increments are governed by CBOE
Rule 6.42.
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The proposal also requires a floor broker to either immediately
execute the stopped order at the stop price and size when a transaction
at the same price occurs in the crowd, or to release the market-maker
from the guarantee. The Commission believes that this requirement will
ensure that a floor broker exercises due diligence in filling an order
at the stop price while at the same time serving to ensure, once a
transaction at the stop price occurs, that the market maker or DPM is
not under a limitless obligation to guarantee the order.
The Commission also believes that the CBOE proposal sufficiently
limits the practice of stopping orders to situations where the market-
maker or DPM granting the stop would not unduly impinge upon the
fiduciary obligations to orders on the public customer limit order
book. The proposal grants priority to stopped orders over new crowd
orders only, and not the public customer limit order book.
Additionally, when a floor broker attempts to improve upon a stop price
guarantee and the subsequent bid/offer matches the best bid/offer in
the customer limit order book, in accordance with CBOE Rule 6.45, the
customer limit order will have priority at that price, should an
execution occur. The Commission believes these are critical aspects of
the CBOE proposal, in that they are designed to enable market-makers to
grant stops while ensuring that customer's orders on the limit order
book will not be disadvantaged. The time stamping of all stop orders
when granted will establish an audit trail and provide a reliable
method for establishing priority. Moreover, the Commission believes
that the CBOE has adequately addressed customer notification concerns,
the effect of a trading halt on the priority and pricing of a stopped
order, and reporting requirements applicable to the execution of
stopped orders on the tape. Finally, the Exchange has agreed to issue
an Information Circular to its members which will specify the
circumstances under which a stop may be granted.
The Commission also believes that the proposal is consistent with
the prohibition in Section 11(b) against providing discretion to a
specialist (or market maker) in the handling of an order.\11\ Section
11(b) was designed, in part, to address potential conflicts of interest
that may arise as a result of the specialist's dual role as agent and
principal in executing stock or option transactions. In particular,
Congress intended to prevent specialists from unduly influencing market
trends through their knowledge of market interest from the specialist's
book and their handling of discretionary agency orders. The Commission
has stated that, pursuant to Section 11(b), all orders other than
market or limit orders are discretionary and therefore cannot be
accepted by specialists.
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\11\See supra note 6.
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After careful review, the Commission concludes that it is
appropriate to treat stopped orders as equivalent to limit orders. A
limit order is an order to buy or sell a stated amount of option
contracts at a specified price, or at a better price if obtainable.\12\
In this instance, the Commission believes that stopped orders are
equivalent to limit orders because once the stop has been granted, the
market maker or DPM is obligated to execute the order at the best bid
or offer, or better if obtainable. As with limit orders, the market
maker or DPM exercises no control or discretion over whether the order
is subsequently executed. Therefore, the Commission believes the CBOE
proposal establishes sufficiently stringent guidelines to ensure that a
market maker or DPM complies with his market duties and Section 11(b).
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\12\See CBOE Rule 6.53(b).
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Act\13\ that the proposed rule change (SR-CBOE-93-30) is approved.
\13\15 U.S.C. 78s(b)(2) (1982).
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For the Commission, by the Division of Market regulation,
pursuant to delegated authority.\14\
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\14\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-19107 Filed 8-4-94; 8:45 am]
BILLING CODE 8010-01-M
