[Federal Register Volume 78, Number 52 (Monday, March 18, 2013)]
[Notices]
[Pages 16726-16729]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-06087]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-69110; File No. SR-ISE-2013-22]
Self-Regulatory Organizations; International Securities Exchange,
LLC; Notice of Filing of Proposed Rule Change To Suspend Certain Market
Maker Quotation Requirements and To Suspend Rule 720 Regarding Obvious
Errors During Limit Up-Limit Down States in Securities That Underlie
Options Traded on the ISE
March 11, 2013.
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 March 8, 2013, the International Securities Exchange, LLC
(``ISE'' or ``Exchange'') filed with the Securities and Exchange
Commission (``SEC'' or ``Commission'') the proposed rule change as
described in Items I, II, and II 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.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The Exchange proposes to suspend certain market maker quotation
requirements and to suspend Rule 720 regarding obvious errors during
limit up-limit down states in securities that underlie options traded
on the ISE on a pilot basis. The text of the proposed rule
[[Page 16727]]
change is available on the Exchange's Web site www.ise.com, at the
principal office of the Exchange, and at the Commission's Public
Reference Room.
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 Exchange 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 self-regulatory organization 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 the
Statutory Basis for, the Proposed Rule Change
1. Purpose
On May 31, 2012, the Commission approved the Plan to Address
Extraordinary Market Volatility (the ``Plan''),\3\ which establishes
procedures to address extraordinary volatility in NMS Stocks. The
procedures provide for market-wide limit up-limit down requirements
that prevent trades in individual NMS Stocks from occurring outside of
specified Price Bands. These limit up-limit down requirements are
coupled with Trading Pauses to accommodate more fundamental price
moves. The Plan procedures are designed, among other things, to protect
investors and promote fair and orderly market.\4\
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\3\ Securities Exchange Act Release No. 67091 (May 31, 2012), 77
F.R. 33498 (June 6, 2012) (File No. 4-631) (``Plan Approval
Order'').
\4\ Id. at 33511 (Preamble to the Plan).
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ISE is not a participant in the Plan because it does not trade NMS
Stocks. However, the ISE trades options contracts overlying NMS Stocks.
Because options pricing models are highly dependent on the price of the
underlying security and the ability of options traders to effect
hedging transactions in the underlying security, the implementation of
the Plan will impact the trading of options classes traded on the
Exchange. Specifically, under the Plan, upper and lower price bands
will be calculated based on a reference price for each NMS Stock.\5\
When one side of the market for an individual security is outside the
applicable price band, the national best bid or national best offer
will be disseminated with a flag identifying it as non-executable
(i.e., a ``Straddle State''). When the other side of the market reaches
the applicable price band, such national best bid or offer will be
disseminated with a flag identifying it as a Limit State Quotation.\6\
If trading for a security does not exit a Limit State within 15
seconds, a Trading Pause will be declared by the Primary Listing
Exchange.\7\ The Trading Pause will last at least five minutes\8\ and
will end when the Primary Listing Exchange disseminates a Reopening
Price.\9\
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\5\ The reference price equals the arithmetic mean price of
eligible reported transactions for the NMS Stock over the
immediately preceding five-minute period. See Section I(T) of the
Plan.
\6\ See Section I(D) of the Plan. The Limit State will end when
the entire size of all Limit State Quotations are executed or
cancelled.
\7\ See Section VII(A) of the Plan. The Primary Listing Exchange
is the market on which an NMS Stock is listed. If an NMS Stock is
listed on more than one market, the Primary Listing Exchange is the
market on which the security has been listed the longest. See
Section I(O) of the Plan. A trading pause may also be declared when
the national best bid (offer) is below (above) the lower (upper)
price band and the security is not in a Limit State, and trading in
that security deviates from normal trading characteristics. See
Section VII(A)(2) of the Plan.
\8\ A Trading Pause may last longer than 5 minutes if, for
example, the Primary Market declares a Regulatory Halt, or if there
is a significant order imbalance. See Section VII(B) of the Plan. If
the Primary Listing Exchange does not report a Reopening Price
within ten minutes after the declaration of a trading Pause and has
not declared a Regulatory Halt, all trading centers may begin
trading the security. Id.
\9\ The Reopening Price is the price of a transaction that
reopens trading on the Primary Listing Exchange following a Trading
Pause or a Regulatory Halt, or, if the Primary Listing Exchange
reopens with quotations, the midpoint of those quotations. The
Exchange notes that under ISE Rule 702(c), trading on the Exchange
is halted whenever trading in the underlying security has been
paused by the primary listing market. Accordingly, the Exchange need
not adopt any rule changes to address this aspect of the Plan.
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When the national best bid (offer) for a security underlying an
options class is non-executable, the ability for options market
participants purchase (sell) shares of the underlying security and the
price at which they may be able to purchase (sell) shares will become
uncertain, as there will be a lack of transparency regarding the
availability of liquidity for the security.\10\ This uncertainty will
be factored into the options pricing models of market professionals,
such as options market makers, which will likely result in wider
spreads and less liquidity at the best bid and offer for the options
class. Accordingly, during a Limit State, the Exchange will
automatically reject all incoming orders that do not contain a limit
price to protect them from being executed at prices that may be vastly
inferior to the prices available immediately prior to or following a
Limit State or Straddle State.\11\ Such un-priced orders include market
orders and stop orders, which become market orders when the stop price
is elected. The Exchange will also cancel any unexecuted market orders
and unexecuted stop orders.
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\10\ See Letter to Boris Ilyevsky, Managing Director, ISE, from
Thomas Price, Managing Director, Securities Industry and Financial
Markets Association, dated October 4, 2012 (``SIFMA Letter''). A
copy of the letter is provided in Exhibit 2 to the filing.
\11\ See SR-ISE-2013-20 (filed March 4, 2013).
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In light of the unusual market conditions, the Exchange proposes to
suspend the maximum quotation spread requirement for market maker
quotes contained in Rule 803(b)(5) and the continuous market maker
quotation requirements contained in Rule 804(e) when the security
underlying an option class is in a Limit State or Straddle State. The
Exchange believes it may be very difficult for market makers to price
options classes when there is uncertainty as to whether they are unable
to buy and sell the underlying security, or at what prices and in what
quantity. While some market makers may choose to provide liquidity in
such circumstances, the risk associated with doing so may be too great
for others.\12\ The Exchange proposes to remove maximum spread
requirements to encourage market makers to choose to provide liquidity
during Limit States and Straddle States, as market makers will be
discouraged from entering any quotations if they must do so within the
maximum spread requirement.
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\12\ The time periods associated with Limit States and Straddle
States will not be considered by the Exchange when evaluating
whether a market maker complied with the continuous quotation
requirements contained in Rule 804(e).
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The Exchange also proposes to exclude transactions executed during
a Limit State or Straddle State from the provision of ISE Rule 720, on
a one-year pilot basis. Rule 720 provides a process by which a
transaction may be busted or adjusted when the execution price of a
transaction deviates from the option's theoretical price by a certain
amount. Under Rule 720, the theoretical price is the national best bid
price for the option with respect to a sell order and the national best
offer for the option with respect to a buy order.\13\ As discussed
[[Page 16728]]
above, during a Limit State or Straddle State, options prices may
deviate substantially from those available prior to or following the
limit state. The Exchange believes this provision would give rise to
much uncertainty for market participants as there is no bright line
definition of what the ``theoretical value'' should be for an option
when the underlying NMS stock has an unexecutable bid or offer or both.
Determining ``theoretical value'' in such a situation would be often
times very subjective as opposed to an objective determination giving
rise to additional uncertainty and confusion for investors.
Accordingly, the Exchange does not believe that the approach employed
under Rule 720, which by definition depends on a reliable national best
bid and offer in the option, is appropriate during a Limit State or
Straddle State.\14\
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\13\ Rule 720 provides that if there are no quotes from other
options exchanges for comparison purposes, the theoretical price
will be determined by designated personnel in the Exchange's market
control center. However, given that options market makers and other
industry professionals will have difficulty pricing options during
Limit States and Straddle States, the Exchange does not believe it
would be reasonable for ISE personnel to derive theoretical prices
to be applied to transactions executed during such unusual market
conditions.
\14\ See SIFMA Letter, supra note 10 (requesting that exchange
obvious error rules that reference theoretical prices be reviewed to
ensure that options exchange officials do not have the discretion to
cancel executions of limit orders and stop limit orders during a
limit or straddle state).
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After careful consideration, the Exchange believes the application
of the current rule would be impracticable given the lack of a reliable
national best bid or offer in the options market during Limit States
and Straddle States, and produce undesirable effects. Pursuant to Rule
720, market participants have five minutes (in the case of a market
maker) and 20 minutes (in the case of an Electronic Access Member) to
notify the Exchange to review a transaction as an obvious error under
720(c) and market participants have until 8:30 a.m. the following day
to request that the Exchange review a trade as a catastrophic error
under Rule 720(d).\15\ The Exchange believes that during periods of
extraordinary volatility, the review period for transactions under the
obvious error and catastrophic error provisions would allow market
participants to re-evaluate a transaction that occurred during a Limit
State or Straddle State at a later time, which is potentially unfair to
other market participants and would discourage market participants from
providing liquidity during Limit States or Straddle States. For
example, 20 minutes after a transaction that occurs during
extraordinary volatility that triggers a Limit State or Straddle State
the market could look drastically different from a price and liquidity
level The Exchange believes that market participants should not be able
to benefit from the time frame to review their transactions in these
situations. Suspending application of Rule 720 would mitigate two of
the undesirable aspects described above--(i) the moral hazard
associated with granting a second look to trades that went against the
market participant after market conditions have changed and (ii) gaming
the obvious error rule to retroactively adjust market maker quotes by
adjusting the execution price at a later time.
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\15\ For transactions in expiring options series that take place
on expiration Friday, the Member must notify the Exchange by 5:00
p.m. Eastern Time on that same day. See Rule 720(d)(1).
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The Exchange notes that there are additional protections in place
outside of the Obvious and Catastrophic Error Rule that will continue
to safeguard customers. First, SEC Rule 15c3-5 requires that,
``financial risk management controls and supervisory procedures must be
reasonably designed to prevent the entry of orders that exceed
appropriate pre-set credit or capital thresholds, or that appear to be
erroneous.'' \16\ Secondly, the Exchange has price checks applicable to
limit orders that rejects limit orders that are priced sufficiently far
through the NBBO that it seems likely an error occurred. The
requirements placed upon broker dealers to adopt controls to prevent
the entry of orders that appear to be erroneous, coupled with Exchange
functionality that filters out orders that appear to be erroneous serve
to sharply reduce the incidence of errors arising from situations, for
example, where a participant mistakenly enters an order to pay $20 for
an option offered at $2. The Exchange also notes that pursuant to ISE
Rule 705(d), the Exchange may compensate Members for losses resulting
directly from the malfunction of the Exchange's systems, and that this
protection is independent from ISE Rule 720. Accordingly, the Exchange
believes it is appropriate to eliminate any potential protection
applying the obvious error rule might provide during Limit and Straddle
States, as its application may produce inequitable results.
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\16\ See Securities and Exchange Act Release No. 63241, 75 FR
69791 (November 15, 2010) (S7-03-10).
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The Exchange proposes to review the operation of this provision
during the one-year pilot period for the proposal and analyze the
impact of the Limit and Straddle States accordingly.\17\ In this
respect, the Exchange notes that its current obvious error rule does
not contain a provision that permits the Exchange to review trades on
its own motion. The Exchange believes that in normal market conditions,
such a provision is not necessary and undermines the objective nature
of the rule. However, during the pilot period, the Exchange will
evaluate whether adopting such a provision for review trades during
Limit and Straddle states is necessary and appropriate.
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\17\ During the pilot, the Exchange will provide the commission
with data regarding the how Limit and Straddle States effect the
quality of the options market.
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The Exchange notes that these proposed changes are consistent with
the views of the Securities Industry and Financial Markets
Association's (``SIFMA'') Listed Options Trading Committee.\18\
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\18\ Id.
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2. Statutory Basis
The Exchange believes that its proposal is consistent with Section
6(b) of the Securities Exchange Act of 1934 (the ``Act'') \19\ in
general, and furthers the objectives of Section 6(b)(5) of the Act \20\
in particular, in that it is designed to promote just and equitable
principles of trade, to remove impediments to and perfect the mechanism
for a free and open market and a national market system, and, in
general, to protect investors and the public interest.
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\19\ 15 U.S.C. 78f(b).
\20\ 15 U.S.C. 78f(b)(5).
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In consideration of the substantial risk associated with market
making during such unusual market conditions, the Exchange believes
exempting market makers from their continuous quotation obligations
during Limit States and Straddle States, and removing maximum spread
requirements for market makers quotes during such states, is necessary
and appropriate to promote just and equitable principles of trade. As
stated above, it may be very difficult for market makers to price
options classes when there is uncertainty as to whether they will be
able to buy and sell the underlying security, or at what prices and in
what quantity. Moreover, giving options market makers the flexibility
to choose whether to enter quotes and to do so without spread
restrictions is necessary to encourage market makers to provide
liquidity in options classes overlying securities that may enter a
Limit State or Straddle State. The Exchange believes that encouraging
liquidity in such options classes will help to assure a more fair and
orderly market for investors leading up to, during, and following Limit
States and Straddle States.
All other requirements related to market maker quotes will be
applicable to market makers that choose to enter quotes during a Limit
State or Straddle State. In this respect, the Exchange notes that such
market makers continue to be subject to many obligations,
[[Page 16729]]
including the obligation to maintain a fair and orderly market in their
appointed classes, and that market makers are not permitted to make
bids or offers or enter into transactions that are inconsistent with
such course of dealings. Given that market makers are subject to these
additional obligations when entering quotes, the Exchange believes it
is appropriate to apply its normal execution principles if market
makers choose to enter quotes during Limit States or Straddle States,
even if they are not under an obligation to provide liquidity during
these brief periods. The Exchange also notes that it would be
impractical to apply a different execution algorithm during such brief
and infrequent unusual market conditions, and that in any such case,
the Exchange believes that removing incentives for market makers to
provide liquidity during Limit States or Straddle States would serve to
decrease the quality of its markets during these brief and unusual
market conditions. For these reasons, the Exchange believes that the
balance between the benefits provided to market makers and the
obligations imposed upon market makers during Limit States and Straddle
States by the proposed rule change is appropriate
The Exchange further believes that it is necessary and appropriate
in the interest of promoting fair and orderly markets to exclude
transactions executed during a Limit State or Straddle State from the
provision of ISE Rule 720. The Exchange believes the application of the
current rule will be impracticable given the lack of a relievable
national best bid or offer in the options market during Limit States
and Straddle States, and that the resulting actions (i.e., busted
trades or adjusted prices) may not be appropriate given market
conditions. This change would ensure that limit orders that are filled
during a Limit State or Straddle State would have certainty of
execution in a manner that promotes just and equitable principles of
trade, removes impediments to, and perfects the mechanism of a free and
open market and a national market system. Moreover, given that options
prices during brief Limit States or Straddle States may deviate
substantially from those available shortly following the Limit State or
Straddle State, the Exchange believes giving market participants five
minutes (in the case of a market maker) and 20 minutes (in the case of
an Electronic Access Member) to re-evaluate a transaction would create
an unreasonable adverse selection opportunity that would discourage
participants from providing liquidity during Limit States or Straddle
States. In this respect, the Exchange notes that by rejecting market
orders and stop orders, and cancelling pending market orders and stop
orders, only those orders with a limit price will be executed during a
Limit State or Straddle State. Therefore, on balance, the Exchange
believes that removing the potential inequity of busting or adjusting
executions occurring during Limit States or Straddle States outweighs
any potential benefits from applying Rule 720 during such unusual
market conditions. Additionally, as discussed above, there are
additional pre-trade protections in place outside of the Obvious and
Catastrophic Error Rule that will continue to safeguard customers.
B. Self-Regulatory Organization's Statement on Burden on Competition
The Exchange does not believe that the proposal will have any
impact on competition among exchanges or market participants on the
Exchange, as the proposal provides that market makers may, but are not
required to, provide liquidity during Limit States and Straddle States,
and that transactions executed during such states will not be reviewed
pursuant to Rule 720.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
The Exchange has not solicited, and does not intend to solicit,
comments on this proposed rule change. The Exchange has not received
any unsolicited written comments from members or other interested
parties.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
Within 45 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 self-regulatory organization consents, the Commission will:
(A) by order approve or disapprove 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. Comments may be submitted by any of
the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
Send an email to [email protected]. Please include
File No. SR-ISE-2013-22 on the subject line.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street NE.,
Washington, DC 20549-1090.
All submissions should refer to File No. SR-ISE-2013-22. This file
number should be included on the subject line if email is used. To help
the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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 Web site viewing and
printing in the Commission's Public Reference Room, 100 F Street NE.,
Washington, DC 20549, on official business days between the hours of
10:00 a.m. and 3:00 p.m. Copies of such filing also will be available
for inspection and copying at the principal office of the Exchange. All
comments received will be posted without change; the Commission does
not edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly. All
submissions should refer to File No. SR-ISE-2013-22 and should be
submitted on or before April 2, 2013.
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\21\
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\21\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-06087 Filed 3-15-13; 8:45 am]
BILLING CODE 8011-01-P