[Federal Register Volume 78, Number 71 (Friday, April 12, 2013)]
[Notices]
[Pages 22001-22004]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-08612]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-69344; File No. SR-Phlx-2013-29]
Self-Regulatory Organizations; NASDAQ OMX PHLX LLC; Order
Granting Accelerated Approval of a Proposed Rule Change To Address
Obvious and Catastrophic Options Errors in Response to the Regulation
NMS Plan To Address Extraordinary Market Volatility
April 8, 2013.
I. Introduction
On March 14, 2013, NASDAQ OMX PHLX LLC (``Phlx'' or ``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. 69141 (March 15, 2013),
78 FR 17262 (``Notice'').
\4\ See Letter to Heather Seidel, Associate Director, Division
of Trading and Markets, Commission, from Thomas A. Wittman,
President, Phlx, dated April 5, 2013 (``Phlx 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 Exchange
proposes to adopt new Rule 1047(f)(v) to exclude electronic trades that
occur during a Limit State or Straddle State from the obvious error or
catastrophic error review procedures pursuant to Rule 1092(a)(i) or
(ii) and the nullification or adjustment provisions pursuant to Rule
1092(c)(ii)(E) or (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 electronic trades that occur during a
Limit State or Straddle State by Exchange motion pursuant to Rule
1092(e)(i)(B).
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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 Rule 1092(a)(i) and (ii), 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.
Pursuant to Rule 1092(a)(i) and (ii), obvious and catastrophic errors
are determined by comparing the theoretical price of the option,
calculated by one of the methods in Rule 1092(b), to an adjustment
table in Rule 1092(a). Generally, the theoretical price of an
[[Page 22002]]
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 Rule 1092(b), the theoretical price is
determined in one of three 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 trade; (ii) as determined by an Options Exchange
Official in its discretion, if there are no quotes for comparison
purposes, or if the bid/ask differential of the NBBO for the
affected series, just prior to the erroneous transaction, was at
least two times the permitted bid/ask differential under the
Exchange's rules; or (iii) for transactions occurring as part of the
Exchange's automated opening system, the theoretical price shall be
the first quote after the transaction(s) in question that does not
reflect the erroneous transaction(s).
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The Exchange believes that none of these methods is appropriate
during a Limit State or Straddle State. Under Rule 1092(b)(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
Rule 1092(b)(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 Rule 1092(b)(ii) affording discretion to the
Options Exchange Official 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.\9\ 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.
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\9\ The Exchange also notes that the determination of
theoretical price under Rule 1092(b)(iii) applies to trades executed
during openings. Because the Exchange does not intend to open an
option during a Limit State or Straddle State, this provision will
not apply.
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Additionally, the Exchange proposes to provide that trades would
not be subject to review under Rule 1092(c)(ii)(E) during a Limit or
Straddle State. Under Rule 1092(c)(ii)(E), 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 Rule
1047(f)(v) to provide that electronic trades are not subject to an
obvious error or catastrophic error review pursuant to Rule 1092(a)(i)
and (ii) and Rule 1092(c)(ii)(F) during a Limit State or Straddle
State. In addition, the Exchange proposes to provide that electronic
trades are not subject to review if, pursuant to Rule 1092(c)(ii)(E),
the trade resulted in an execution in a series quoted no bid.
Finally, proposed Rule 1047(f)(v) also will include a qualification
that nothing in proposed Rule 1047(f)(v) will prevent electronic trades
from being reviewed on Exchange motion pursuant to Rule 1092(e)(i)(B).
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.\10\ Specifically, the Commission finds that the proposal is
consistent with Section 6(b)(5) of the Act,\11\ 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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\10\ 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).
\11\ 15 U.S.C. 78f(b)(5).
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In the filing, the Exchange notes its belief that suspending
certain aspects of Rule 1092 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 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
[[Page 22003]]
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 electronic trades that occur during a
Limit State or Straddle State from the obvious error or catastrophic
error review procedures pursuant to Rule 1092(a)(i) or (ii) and the
nullification or adjustment provisions pursuant to Rule 1092(c)(ii)(E)
or (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 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.\12\ This will allow the
Commission, the Exchange, and other interested parties 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
[[Page 22004]]
market participants additional time to review trades submitted during a
Limit State or Straddle State.
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\12\ 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 Phlx 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,\13\ 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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\13\ 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,\14\ that the proposed rule change (SR-Phlx-2013-29), be, and
hereby is, approved on an accelerated basis.
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\14\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\15\
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\15\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-08612 Filed 4-11-13; 8:45 am]
BILLING CODE 8011-01-P