[Federal Register Volume 78, Number 71 (Friday, April 12, 2013)]
[Notices]
[Pages 21996-21999]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-08605]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-69341; File No. SR-NASDAQ-2013-048]
Self-Regulatory Organizations; The NASDAQ Stock Market LLC; Order
Granting Accelerated Approval of a Proposed Rule Change To Adopt
Chapter V, Section 3 Subparagraph (d)(iv) Regarding Obvious Error or
Catastrophic Error Review
April 8, 2013.
I. Introduction
On March 14, 2013, The NASDAQ Stock Market LLC (``Exchange'') filed
with the Securities and Exchange Commission (``Commission''), pursuant
to Section 19(b)(1) of the Securities Exchange Act of 1934 (the
``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to
provide for how the Exchange proposes to treat obvious and catastrophic
options errors in response to the Regulation NMS Plan to Address
Extraordinary Market Volatility (the ``Plan''). The proposed rule
change was published for comment in the Federal Register on March 20,
2013.\3\ The Commission received one comment letter on the proposal.\4\
This order approves the proposed rule change on an accelerated basis.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ Securities Exchange Act Release No. 69142 (March 15, 2013),
78 FR 17251 (``Notice'').
\4\ See Letter to Heather Seidel, Associate Director, Division
of Trading and Markets, Commission, from Thomas A. Wittman, Senior
Vice President, The NASDAQ Stock Market LLC, dated April 5, 2013
(``Nasdaq Letter'').
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II. Description of the Proposed Rule Change
Since May 6, 2010, when the financial markets experienced a severe
disruption, the equities exchanges and the Financial Industry
Regulatory Authority have developed market-wide measures to help
prevent a recurrence. In particular, on May 31, 2012, the Commission
approved the Plan, as amended, on a one-year pilot basis.\5\ The Plan
is designed to prevent trades in individual NMS stocks from occurring
outside of specified Price Bands, creating a market-wide limit up-limit
down mechanism that is intended to address extraordinary market
volatility in NMS Stocks.\6\
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\5\ Securities Exchange Act Release No. 67091 (May 31, 2012), 77
FR 33498.
\6\ Unless otherwise specified, capitalized terms used in this
rule filing are based on the defined terms of the Plan.
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In connection with the implementation of the Plan, the
[[Page 21997]]
Exchange proposes to adopt new Chapter V, Section 3(d)(iv) to exclude
trades that occur during a Limit State or Straddle State from the
obvious error or catastrophic error review procedures pursuant to
Chapter V, Sections 6(b) or 6(f), for a one year pilot basis from the
date of adoption of the proposed rule change.\7\ The Exchange proposes
to retain the ability to review trades that occur during a Limit State
or Straddle State by Exchange motion pursuant to Chapter V, Section
6(d)(i).
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\7\ The Exchange stated that various members of the Exchange
staff have spoken to a number of member organizations about obvious
and catastrophic errors during a Limit State or Straddle State and
that a variety of viewpoints emerged, mostly focused on having many
trades stand, on fairness and fair and orderly markets and on being
able to re-address the details during the course of the pilot, if
needed.
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Under Sections 6(b)(i) and (f)(i), obvious and catastrophic errors
are calculated by determining a theoretical price and applying such
price to ascertain whether the trade should be nullified or adjusted.
Obvious and catastrophic errors are determined by comparing the
theoretical price of the option, calculated by one of the methods in
Section 6(c), to an adjustment table in Section 6(b)(i) for obvious
errors or Section 6(f)(i) for catastrophic errors. Generally, the
theoretical price of an option is the National Best Bid and Offer
(``NBBO'') of the option. In certain circumstances, Exchange officials
have the discretion to determine the theoretical price.\8\
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\8\ Specifically, under Section 6(c), the theoretical price is
determined in one of two ways: (i) If the series is traded on at
least one other options exchange, the last National Best Bid price
with respect to an erroneous sell transaction and the last National
Best Offer price with respect to an erroneous buy transaction, just
prior to the transaction; or (ii) as determined by MarketWatch as
defined in Chapter I, if there are no quotes for comparison
purposes.
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The Exchange believes that neither of these methods is appropriate
during a Limit State or Straddle State. Under Section 6(c)(i), the
theoretical price is determined with respect to the NBBO for an option
series just prior to the trade. According to the Exchange, during a
Limit State or Straddle State, options prices may deviate substantially
from those available prior to or following the 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 price should be for an option when the underlying NMS stock
has an unexecutable bid or offer or both. Because the approach under
Section 6(c)(i) by definition depends on a reliable NBBO, the Exchange
does not believe that approach is appropriate during a Limit State or
Straddle State. Additionally, because the Exchange system will only
trade through the theoretical bid or offer if the Exchange or the
participant (via an ISO order) has accessed all better priced interest
away in accordance with the Options Order Protection and Locked/Crossed
Markets Plan, the Exchange believes potential trade reviews of
executions that occurred at the participant's limit price and also in
compliance with the aforementioned Plan could harm liquidity and also
create an advantage to either side of an execution depending on the
future movement of the underlying stock.
With respect to Section 6(c)(ii), affording discretion to Exchange
staff to determine the theoretical price and thereby, ultimately,
whether a trade is busted or adjusted and to what price, the Exchange
notes that it would be difficult to exercise such discretion in periods
of extraordinary market volatility and, in particular, when the price
of the underlying security is unreliable. The Exchange again notes that
the theoretical price in this context would be subjective. Ultimately,
the Exchange believes that adding certainty to the execution of orders
in these situations should encourage market participants to continue to
provide liquidity to the Exchange, thus promoting fair and orderly
markets. On balance, the Exchange believes that removing the potential
inequity of nullifying or adjusting executions occurring during Limit
States or Straddle States outweighs any potential benefits from
applying these provisions during such unusual market conditions.
Additionally, the Exchange proposes to provide that trades would
not be subject to review under Section 6(b)(ii) during a Limit or
Straddle State. Under Section 6(b)(ii), a trade may be nullified or
adjusted where an execution occurred in a series quoted no bid. The
Exchange believes that these situations are not appropriate for an
error review because they are more likely to result in a windfall to
one party at the expense of another in a Limit State or Straddle State,
because the criteria for meeting the no-bid provision are more likely
to be met in a Limit State or Straddle State, and unlike normal
circumstances, may not be a true reflection of the value of the series
being quoted.
In response to these concerns, the Exchange proposes to adopt
Section 3(d)(iv) to provide that trades are not subject to an obvious
error or catastrophic error review pursuant to Section 6(b) and 6(f)
during a Limit State or Straddle State. In addition, proposed Section
3(d)(iv) also will include a qualification that nothing in proposed
Section 3(d)(iv) will prevent electronic trades from being reviewed on
Exchange motion pursuant to Section 6(d)(i). According to the Exchange,
this safeguard will provide the flexibility to act when necessary and
appropriate, while also providing market participants with certainty
that trades they effect with quotes and/or orders having limit prices
will stand irrespective of subsequent moves in the underlying security.
The right to review on Exchange motion electronic transactions that
occur during a Limit State or Straddle State under this provision,
according to the Exchange, would enable the Exchange to account for
unforeseen circumstances that result in obvious or catastrophic errors
for which a nullification or adjustment may be necessary in order to
preserve the interest of maintaining a fair and orderly market and for
the protection of investors.
III. Discussion
The Commission finds that the Exchange's proposed rule change is
consistent with the requirements of the Act and the rules and
regulations thereunder applicable to a national securities exchange.\9\
Specifically, the Commission finds that the proposal is consistent with
Section 6(b)(5) of the Act,\10\ in that it is designed to prevent
fraudulent and manipulative acts and practices, promote just and
equitable principles of trade, foster cooperation and coordination with
persons engaged in regulating, clearing, settling, processing
information with respect to, and facilitating transactions in
securities, remove impediments to and perfect the mechanism of a free
and open market and a national market system, and, in general, protect
investors and the public interest.
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\9\ In approving this proposed rule change, the Commission has
considered the proposed rule's impact on efficiency, competition,
and capital formation. See 15 U.S.C. 78c(f).
\10\ 15 U.S.C. 78f(b)(5).
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In the filing, the Exchange notes its belief that suspending
certain aspects of Chapter V, Section 6 during a Limit State or
Straddle State will ensure that limit orders that are filled during a
Limit or Straddle State will have certainty of execution in a manner
that promotes just and equitable principles of trade and removes
impediments to, and perfects the mechanism of, a free and open market
and a national market system. The Exchange believes the application of
the current rule would be impracticable given what it perceives will be
the lack of a reliable NBBO in
[[Page 21998]]
the options market during Limit States and Straddle States, and that
the resulting actions (i.e., nullified trades or adjusted prices) may
not be appropriate given market conditions. In addition, given the
Exchange's view that options prices during Limit States or Straddle
States may deviate substantially from those available shortly following
the Limit State or Straddle State, the Exchange believes that providing
market participants time to re-evaluate a transaction executed during a
Limit or Straddle State will create an unreasonable adverse selection
opportunity that will discourage participants from providing liquidity
during Limit States or Straddle States. Ultimately, the Exchange
believes that adding certainty to the execution of orders in these
situations should encourage market participants to continue to provide
liquidity to the Exchange during Limit States and Straddle States, thus
promoting fair and orderly markets.
The Exchange, however, has proposed this rule change based on its
expectations about the quality of the options market during Limit
States and Straddle States. The Exchange states, for example, that it
believes that application of the obvious and catastrophic error rules
would be impracticable given the potential for lack of a reliable NBBO
in the options market during Limit States and Straddle States. Given
the Exchange's recognition of the potential for unreliable NBBOs in the
options markets during Limit States and Straddle States, the Commission
is concerned about the extent to which investors may rely to their
detriment on the quality of quotations and price discovery in the
options markets during these periods. This concern is heightened by the
Exchange's proposal to exclude trades that occur during a Limit State
or Straddle State from the obvious error or catastrophic error review
procedures pursuant to Section 6(b) or 6(f). The Commission urges
investors and market professionals to exercise caution when considering
trading options under these circumstances. Broker-dealers also should
be mindful of their obligations to customers that may or may not be
aware of specific options market conditions or the underlying stock
market conditions when placing their orders.
While the Commission remains concerned about the quality of the
options market during the Limit and Straddle States, and the potential
impact on investors of executing in this market without the protections
of the obvious or catastrophic error rules that are being suspended
during the Limit and Straddle States, it believes that certain aspects
of the proposal could help mitigate those concerns.
First, despite the removal of obvious and catastrophic error
protection during Limit States and Straddle States, the Exchange states
that there are additional measures in place designed to protect
investors. For example, the Exchange states 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. Additionally, the Exchange notes the
existence of SEC Rule 15c3-5 requiring broker-dealers to have controls
and procedures in place that are reasonably designed to prevent the
entry of erroneous orders. Finally, with respect to limit orders that
will be executable during Limit States and Straddle States, the
Exchange states that it applies price checks to limit orders that are
priced sufficiently far through the NBBO. Therefore, on balance, the
Exchange believes that removing the potential inequity of nullifying or
adjusting executions occurring during Limit States or Straddle States
outweighs any potential benefits from applying certain provisions
during such unusual market conditions.
The Exchange also believes that the aspect of the proposed rule
change that will continue to allow the Exchange to review on its own
motion electronic trades that occur during a Limit State or a Straddle
State is consistent with the Act because it would provide flexibility
for the Exchange to act when necessary and appropriate to nullify or
adjust a transaction and will enable the Exchange to account for
unforeseen circumstances that result in obvious or catastrophic errors
for which a nullification or adjustment may be necessary in order to
preserve the interest of maintaining a fair and orderly market and for
the protection of investors. The Exchange represents that it recognizes
that this provision is limited and that it will administer the
provision in a manner that is consistent with the principles of the
Act. In addition, the Exchange represents that it will create and
maintain records relating to the use of the authority to act on its own
motion during a Limit State or Straddle State.
Finally, the Exchange has proposed that the changes be implemented
on a one year pilot basis. The Commission believes that it is important
to implement the proposal as a pilot. The one year pilot period will
allow the Exchange time to assess the impact of the Plan on the options
marketplace and allow the Commission to further evaluate the effect of
the proposal prior to any proposal or determination to make the changes
permanent. To this end, the Exchange has committed to: (1) Evaluate the
options market quality during Limit States and Straddle States; (2)
assess the character of incoming order flow and transactions during
Limit States and Straddle States; and (3) review any complaints from
members and their customers concerning executions during Limit States
and Straddle States. Additionally, the Exchange has agreed to provide
the Commission with data requested to evaluate the impact of the
elimination of the obvious error rule, including data relevant to
assessing the various analyses noted above. On April 5, 2013, the
Exchange submitted a letter stating that it would provide specific data
to the Commission and the public and certain analysis to the Commission
to evaluate the impact of Limit States and Straddle States on liquidity
and market quality in the options markets.\11\ This will allow the
Commission, the Exchange, and other interested parties
[[Page 21999]]
to evaluate the quality of the options markets during Limit States and
Straddle States and to assess whether the additional protections noted
by the Exchange are sufficient safeguards against the submission of
erroneous trades, and whether the Exchange's proposal appropriately
balances the protection afforded to an erroneous order sender against
the potential hazards associated with providing market participants
additional time to review trades submitted during a Limit State or
Straddle State.
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\11\ In particular, the Exchange represented that, at least two
months prior to the end of the one year pilot period of proposed
Section 3(d)(iv), it would provide to the Commission an evaluation
of (i) the statistical and economic impact of Straddle States on
liquidity and market quality in the options market and (ii) whether
the lack of obvious error rules in effect during the Limit States
and Straddle States are problematic. In addition, the Exchange
represented that each month following the adoption of the proposed
rule change it would provide to the Commission and the public a
dataset containing certain data elements for each Limit State and
Straddle State in optionable stocks. The Exchange stated that the
options included in the dataset will be those that meet the
following conditions: (i) The options are more than 20% in the money
(strike price remains greater than 80% of the last stock trade price
for calls and strike price remains greater than 120% of the last
stock trade price for puts when the Limit State or Straddle State is
reached); (ii) the option has at least two trades during the Limit
State or Straddle State; and (iii) the top ten options (as ranked by
overall contract volume on that day) meeting the conditions listed
above. For each of those options affected, each dataset will
include, among other information: stock symbol, option symbol, time
at the start of the Limit State or Straddle State and an indicator
for whether it is a Limit State or Straddle State. For activity on
the Exchange in the relevant options, the Exchange has agreed to
provide executed volume, time-weighted quoted bid-ask spread, time-
weighted average quoted depth at the bid, time-weighted average
quoted depth at the offer, high execution price, low execution
price, number of trades for which a request for review for error was
received during Limit States and Straddle States, an indicator
variable for whether those options outlined above have a price
change exceeding 30% during the underlying stock's Limit State or
Straddle State compared to the last available option price as
reported by OPRA before the start of the Limit or Straddle state (1
if observe 30% and 0 otherwise), and another indicator variable for
whether the option price within five minutes of the underlying stock
leaving the Limit State or Straddle State (or halt if applicable) is
30% away from the price before the start of the Limit State or
Straddle State. See Nasdaq Letter, supra note 4.
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Finally, the Commission notes that the Plan, to which these rules
relate, will be implemented on April 8, 2013. Accordingly, for the
reasons stated above, and in consideration of the April 8, 2013
implementation date of the Plan, the Commission finds good cause,
pursuant to Section 19(b)(2) of the Act,\12\ for approving the
Exchange's proposal prior to the 30th day after the publication of the
notice in the Federal Register.
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\12\ 15 U.S.C. 78s(b)(2). The Commission noticed substantially
similar rules proposed by NYSE MKT LLC and NYSE Arca, Inc. with a
full 21 day comment period. See Securities Exchange Act Release No.
69033, 78 FR 15067 (March 8, 2013) and Securities Exchange Act
Release No. 69032, 78 FR 15080 (March 8, 2013).
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IV. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\13\ that the proposed rule change (SR-NASDAQ-2013-048), be, and
hereby is, approved on an accelerated basis.
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\13\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\14\
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\14\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-08605 Filed 4-11-13; 8:45 am]
BILLING CODE 8011-01-P