[Federal Register Volume 78, Number 156 (Tuesday, August 13, 2013)]
[Notices]
[Pages 49311-49313]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-19510]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-70132; File No. SR-ISE-2013-38]
Self-Regulatory Organizations; International Securities Exchange,
LLC; Order Approving Proposed Rule Change Related to Market Maker Risk
Parameters and Complex Orders
August 7, 2013.
I. Introduction
On June 5, 2013, the International Securities Exchange, LLC (the
``Exchange'' or the ``ISE'') filed with the Securities and Exchange
Commission (the ``Commission''), pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4
thereunder,\2\ a proposed rule change related to market maker risk
parameters and complex orders. The proposed rule change was published
for comment in the Federal Register on June 24, 2013.\3\ The Commission
received no comments on the proposal. This order approves the proposed
rule change.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 69782 (June 18,
2013), 78 FR 37870 (June 24, 2013) (SR-ISE-2013-38) (the
``Notice'').
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II. Description of the Proposal
The Exchange proposes to amend ISE Rule 722 and ISE Rule 804 to
make it mandatory for market makers to enter values into all four of
the quotation risk management parameters for all options classes in
which they enter quotes. These risk management parameters are available
for market maker quotes in single options series and for market maker
quotes in complex instruments on the complex order book. Market makers
may establish a time frame during which the system calculates: (1) The
number of contracts executed by the market maker in an options class;
(2) the percentage of the total size of the market maker's quotes in
the class that has been executed; (3) the absolute value of the net
between contracts bought and contracts sold in an options class, and
(4) the absolute value of the net between (a) calls purchased plus puts
sold, and (b) calls sold plus puts purchased. The market maker
establishes limits for each of these four parameters, and when the
limits are exceeded within the prescribed time frame, the market makers
quotes are removed.
The Exchange notes that all ISE market makers currently use the
risk management parameters when entering quotes but may inadvertently
enter quotes without populating one or more of the parameters, and
thereby be exposed to more financial risk than intended. The Exchange
indicates that, in order to forestall such an occurrence, ISE market
makers requested that the trading system be modified to reject a quote
if a value for any of the four risk management parameters for the
options class is missing. While entering values into the quotation risk
parameters would be mandatory to prevent an inadvertent exposure to
financial risk, the Exchange notes that market makers that prefer to
use their own risk-management systems could simply enter values that
assure the Exchange-provided parameters will not be triggered.\4\
Accordingly, the proposal requires that the fields for the quotation
risk management parameters be populated, but does not require that
members substantively or qualitatively manage their risk using the
Exchange-provided tools.
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\4\ For example, a market maker could set the value for the
total number of contracts executed in a class at a level that
exceeds the total number of contracts the market maker actually
quotes in an options class.
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The Exchange also proposes to amend ISE Rule 722 to limit a market
maker's financial risk exposure as it relates to the calculation of the
aforementioned ISE Rule 804 risk parameters and complex orders legging-
into the regular market.\5\ Specifically, the Exchange
[[Page 49312]]
proposes to limit the legging functionality to complex orders with no
more than either two or three legs, as determined by the Exchange on a
class basis.\6\ In the Notice, the Exchange explains that because the
execution of each leg of a complex order is contingent on the execution
of the other legs and the execution of all the legs in the regular
market is processed as a single transaction, not as a series of
individual transactions, the legging-in of complex orders presents
higher risk to market makers compared to regular orders being entered
in multiple series of an options class in the regular market and may
cause market makers to exceed the established risk parameters by a
greater number of contracts. The Exchange also notes that because the
potential to exceed the intended risk parameters is directly
proportional to the number of legs associated with a complex order, ISE
market makers have requested that the Exchange prevent complex orders
from legging into the market if they have a large number of legs. The
Exchange believes that because 85% of all complex orders have only two
legs, and very few complex orders are entered with more than three
legs, the potential risk to market makers in the regular market far
out-weighs the potential benefit of offering such functionality to a
very limited number of orders.
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\5\ Pursuant to ISE Rule 722(b)(3)(ii), complex orders may be
executed against bids and offers on the Exchange for the individual
legs of the complex order, provided the complex order can be
executed while maintaining a permissible ratio by such bids and
offers.
\6\ The Exchange states that it will issue a circular to members
identifying the options classes for which legging is limited to
complex orders with two legs and those for which legging is limited
to complex order with three legs. The Exchange also states that it
will provide members with reasonable notice prior to changing the
limit applicable to an options class.
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The Exchange also notes that complex orders with more than three
legs (in some cases more than two legs) that could leg into the market
except for the proposed limitation will be available for execution on
the complex order book. The Exchange states that the execution priority
rules contained in ISE Rule 722(b)(2) often prevent the execution of
complex orders that might otherwise be executable because legs of a
complex order cannot be executed at the same price as a Priority
Customer Order in the regular market unless another leg of the order is
executed at a price that is better than the best price in the regular
market.\7\ In other words, if there is a Priority Customer Order on the
book in one or more of the series of a complex order, the net price of
the complex order has to improve upon the price that would be available
if the complex order legged-into the market. Thus, currently there can
be complex orders resting on the book that cannot leg-into the market
because the permissible ratio cannot be satisfied by the bids and
offers in the regular market or because there are Priority Customer
Orders in the regular market in one or more of the series of the
complex order that prevent its execution. The Exchange believes that
preventing orders with more than three legs (in some cases more than
two legs) from legging-into the market would not create any unusual
circumstances on the complex order book. The Exchange also notes that
the priority of complex orders on the complex order book will not be
impacted by the proposed rule change.\8\
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\7\ Pursuant to ISE Rule 100(a)(37A) and (37B), a Priority
Customer Order is an order for the account of a person or entity
that (i) is not a broker or dealer in securities, and (ii) does not
place more than 390 orders in listed options per day on average
during a calendar month for its own beneficial account(s).
\8\ For example, if there are multiple complex orders for the
same strategy at the same price with four or more legs, they will be
executed pursuant to Rule 722(b)(3) (i.e., in time priority or pro-
rata bases on size (with or without Priority Customer priority)).
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In the Notice, the Exchange states that checking the risk
management parameters following each execution in an options series
allows market makers to provide liquidity across multiple series of an
options class while mitigating the risk of executing the full
cumulative size of all such quotes; however this is not the case when a
complex order legs-into the market.
III. Discussion
After careful review, 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.\9\
In particular, the Commission finds that the proposed rule change is
consistent with Section 6(b)(5) of the Act,\10\ which requires, among
other things, that the rules of a national securities exchange be
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, to remove impediments
to and perfect the mechanism of a free and open market and a national
market system, and, in general, to protect investors and the public
interest; and are not designed to permit unfair discrimination between
customers, issuers, brokers or dealers.
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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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The Commission believes the proposal is designed to provide market
makers with a risk management tool to assist managing the financial
exposure of market makers which in turn could enhance the integrity of
trading on the securities markets and help to assure the stability of
the financial system. The Commission believes that greater assurances
related to the management of financial risk exposure could enable
market makers to enter quotations with larger size, which in turn could
benefit investors through increased liquidity for the execution of
their orders, and that such increased liquidity could benefits
investors by improving prices and lowering volatility in the options
market.
As discussed above, the proposed rule change is designed to protect
market makers from exposure to inadvertent, excessive risk by modifying
the trading system to automatically reject quotations unless values are
entered for all four risk management parameters for all options classes
in which quotes are entered. ISE asserts that all market makers
currently utilize the Exchange provided risk management tool; and the
catalyst for the instant proposal was a request from market makers that
the entry of values into all four risk management parameters be made
mandatory to avoid inadvertent error that could result in unintended
financial exposure during quote entry. In addition, while market makers
must populate the all risk management parameters in order to have their
quotations accepted by the trading system, they may enter values in the
parameters which effectively permit them to bypass the Exchange
provided risk management tool in favor of a different, preferred risk
management solution.
In addition, the proposed rule change is designed to mitigate the
financial risk associated with complex orders that leg-into the regular
market. Specifically, the proposed rule change would limit the legging
functionality to complex order with no more than two or three legs, as
determined by the Exchange on a class basis. The Exchange represents
that it will provide reasonable prior notice via a circular to members
that identifies the applicable options classes for which legging is
limited to complex orders with two legs and those for which legging is
limited to complex order with three legs. The Exchange notes that 85%
of all complex orders only have two orders and very few complex orders
have more than three legs, thus the vast majority of complex orders
would be unaffected by this limitation. The Exchange also opined that
market maker liquidity in the regular market may be limited as a result
of the potential risk
[[Page 49313]]
of offering legging functionality for complex orders with more than
three legs (in some cases with more than two legs). In particular, the
Exchange notes that market makers may reduce the size of their
quotations in the regular market because of the risk of executing the
cumulative size of their quotations across multiple options series
without an opportunity to adjust their quotes. Thus, the Exchange
posits that limiting the legging functionality to orders with no more
than three legs (in some cases with no more than two legs) could
encourage market makers to add liquidity to the regular market which
would in turn benefit investors.
Accordingly, the Commission believes that the proposed rule change
is consistent with Section 6(b)(5) of the Act.\11\
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\11\ 15 U.S.C. 78f(b)(5)
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IV. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\12\ that the proposed rule change (SR-ISE-2013-38) is approved.
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\12\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\13\
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\13\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-19510 Filed 8-12-13; 8:45 am]
BILLING CODE 8011-01-P