[Federal Register Volume 79, Number 50 (Friday, March 14, 2014)]
[Notices]
[Pages 14563-14566]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-05592]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-71669; File No. SR-ISE-2014-10]
Self-Regulatory Organizations; International Securities Exchange,
LLC; Notice of Filing of Proposed Rule Change Related to Complex Orders
March 10, 2014.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(the ``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given
that on February 25, 2014, the International Securities Exchange, LLC
(the ``Exchange'' or the ``ISE'') filed with the Securities and
Exchange Commission (``Commission'') the proposed rule change as
described in Items I 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 the
Substance of the Proposed Rule Change
The Exchange proposes to amend its rules by limiting certain types
of complex orders from legging into the regular market. The text of the
proposed rule 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
[[Page 14564]]
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
Statutory Basis for, the Proposed Rule Change
1. Purpose
The Exchange currently provides functionality that automatically
removes a market maker's quotes in all series of an options class when
certain parameter settings are triggered. Specifically, there are four
parameters that can be set by market makers on a class-by-class basis.
Pursuant to Rules 722 and 804, these parameters are mandatory for
market maker quotes. Market makers establish a time frame during which
the system calculates: (1) The number of total 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 in an options class, and
(b) calls sold plus puts purchased in an options class.\3\ Once the
limits established by these parameters are triggered, the market
maker's quotes are removed. The purpose of this functionality is to
allow market makers to provide liquidity across potentially hundreds of
options series without being at risk of executing the full cumulative
size of all such quotes before being given adequate opportunity to
adjust their quotes.
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\3\ See Securities Exchange Act Release No. 70132 (August 7,
2013), 78 FR 49311 (August 13, 2013) (SR-ISE-2013-38).
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Standard complex orders can contain up to eight (8) legs in the
trading system today while complex orders with a stock component can
contain up to eight (8) option legs and a stock leg. As discussed
above, by checking the risk parameters following each execution in an
options series, the risk parameters allow market makers to manage their
risk. This is not the case, however, when a complex order legs into the
regular market. Because the execution of each leg is contingent on the
execution of the other legs, the execution of all the legs in the
regular market is processed as a single transaction, not as a series of
individual transactions. One market maker's quotes in the regular
market can thus be hit in up to 8 instruments at the same time by a
complex order.
For example, if individual orders to buy 10 contracts for the Jan
30 call, Jan 35 call and Jan 40 call are entered, each is processed as
it is received and the market maker quotation parameters are calculated
following the execution of each 10-contract order. Thus, if the first,
or second order trigger a market maker's risk setting, their quotes
will be adjusted prior to the processing of the subsequent order.
However, if a complex order to buy all three of these strikes with a
quantity of 10 contracts is entered and is executed against bids and
offers for the individual series, the market maker parameters for
quotes in the regular market are calculated following the execution of
all 30 contracts (the sum of the three legs of 10 contracts each).
The legging-in of complex orders presents higher risk to market
makers as compared to regular orders being entered in multiple series
of an options class in the regular market as it can result in market
makers exceeding their parameters by a greater number of contracts. At
the request of market makers, the Exchange amended its rules to prevent
complex orders from legging into the regular market if they have a
large number of legs. Specifically, the Exchange currently limits the
legging functionality to complex orders with no more than either two or
three legs, as determined by the Exchange on a class by class basis.\4\
However, despite the current limitations, certain market participants
continue to use atypical multi-leg strategies (2 or more legs) to trade
with multiple quotes from a single market maker thereby causing the
single leg market maker to trade far more than its limit allows.
Although market makers can limit their risk by use of the Exchange's
risk parameters, the market maker's quotes are not removed until after
a trade is executed. As a result, because of the way complex orders leg
into the regular market as a single transaction, market makers end up
trading more than the limitations they have set and are therefore
exposed to greater risk. In turn, market makers are forced to change
their trading behavior to account for the additional risk by widening
their quotes, hurting the Exchange's quality of markets and the quality
of the markets in general available for trading.
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\4\ Id.
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At the request of members and to further minimize the impact to
single leg market makers, the Exchange now proposes to amend Rule 722
to limit a potential source of unintended market maker risk when
certain types of complex orders leg into the regular market.\5\
Specifically, complex orders with two option legs where both legs are
buying or both legs are selling and both legs are calls or both legs
are puts will be executed only in the complex order book and will not
be permitted to leg into the regular market. For example:
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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.
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[cir] Buy Call 1, Buy Call 2
[cir] Sell Call 1, Sell Call 2
[cir] Buy Put 1, Buy Put 2
[cir] Sell Put 1, Sell Put 2
The Exchange also proposes a similar restriction to limit complex
orders with three option legs, where all legs are buying or all legs
are selling regardless of whether the option is a call or a put. For
example:
[cir] Buy Call 1, Buy Call 2, Buy Put 1
[cir] Buy Put 1, Buy Put 2, Buy Put 3
[cir] Buy Call 1, Buy Call 2, Buy Call 3
[cir] Buy Put 1, Buy Put 2, Buy Call 3
[cir] Sell Put 1, Sell Put 2, Sell Call 1
Strategies that involve these types of combinations of options are
not traditional complex order strategies used by retail or professional
investors, designed to gain exposure to a particular option class'
movement. The vast majority of complex order strategies are made up of
calendar and vertical spreads, butterflies and straddles, strategies
that seek to hedge the potential move of the underlying security or to
capture premium from an anticipated market event. In contrast, the
atypical strategies illustrated above are primarily geared towards an
aggressive directional capture of volatility. Through a combination of
buying or selling multiple option legs at once, regardless of the
implied directional move represented by a call versus a put, a market
participant using one of these strategies is aggressively buying or
selling volatility. By using the complex order mechanism that allows
for the simultaneous executions of all legs, these strategies aim to
bypass a single leg market maker's risk settings and result in an
artificially large transaction that distorts the market for other
related instruments, including the underlying security. These
distortions in the market for the underlying security and related
option series are caused by the simultaneous hedging activity triggered
by such strategies. By legging in and potentially bypassing the risk
settings of several market participants, these strategies create a
larger trade than otherwise possible through the use of `simple' or
single-leg orders which then results in the affected market
participants needing to immediately hedge these outsized positions.
This activity in turn causes an immediate
[[Page 14565]]
distortion in the market of the related securities as these market
participants attempt to simultaneously buy or sell the underlying
security or related option series. This type of effect can also be a
result of a simple, large order affecting several liquidity providers,
but in the case of a complex strategy, involving several legs and
therefore more size, the impact is more pronounced. By limiting these
types of complex orders from legging in, the Exchange will strengthen
the effectiveness of the risk tools it provides and thereby allow
liquidity providers to post tighter and more liquid markets for regular
orders and traditional complex orders, while at the same time reducing
the frequency and size of related market distortions.
Further, the Exchange currently offers an order type called
``legging orders'' \6\ to provide additional liquidity for complex
orders resting on the complex order book. A complex order resting on
the complex order book may be executed either by: (i) Trading against
an incoming complex order that is marketable against the resting
complex order, or (ii) trading in the regular market when the net price
of the complex order can be satisfied by executing all of the legs
against the best bids or offers on the Exchange for the individual
options series. Under current rules, legging orders may be generated
automatically for simple two-legged options orders with the same
quantity on both legs. However, with this proposed rule change, which
in part applies to simple two-legged options orders with the same
quantity on both legs, legging orders cannot be executed for these
complex orders due the manner in which the trading system is designed.
Specifically, the same component in the trading system handles both the
trading of complex orders in the regular market and the execution of
legging orders. Therefore, the proposed limitation to exclude these
complex orders from trading in the regular market also means that the
trading system will not generate legging orders for these types of two-
legged complex orders. The Exchange proposes to adopt language in
proposed Rule 722(b)(3)(ii)(A) to note that the trading system will not
generate legging orders for these complex orders.\7\
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\6\ A legging order is a limit order on the regular limit order
book that represents one side of a complex order that is to buy or
sell an equal quantity of two options series resting on the
Exchange's complex order book. See ISE Rule 715(k).
\7\ The Exchange is not proposing to adopt similar language in
proposed Rule 722(b)(3)(ii)(B) because legging orders cannot be
generated for complex orders with 3 option legs.
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Additionally, the Exchange's Facilitation Mechanism has been
available for the execution of complex orders since 2005 \8\ and the
Solicited Order Mechanism has been available for the execution of
complex orders since 2006.\9\ And since 2011, members have also been
able to execute complex orders in the Price Improvement Mechanism.\10\
All three mechanisms expose orders to all Exchange members for 500
milliseconds to provide an opportunity for price improvement. Complex
orders are processed in these mechanisms at a net price in the same
manner as single-legged orders. If an improved net price for a complex
order being executed can be achieved from bids and offers for the
individual legs of the complex order in the Exchange's auction market,
the order being executed receives an execution at the better net price.
A single component in the trading system component handles both the
trading of a new complex order with the regular order book upon arrival
and at the end of the 500 millisecond exposure period. For complex
orders that are the subject of this proposed rule change, if an
improved net price for such complex orders being executed can be
achieved from bids and offers for the individual legs of the complex
order, the auction order cannot trade with the individual legs. Because
an auction order, such as a PIM or a Facilitation cannot trade outside
the ISE's best bid or offer, the auction order will be cancelled at the
end of the 500 millisecond exposure period. The cancellation of auction
orders in such instances is similar to the current handling of
situations when the bid or offer at the ISE, made up of individual
series, becomes better than the net price of the complex auction order
on the same side (bid better during an auction order where the agency
side is the buyer, ask better during an auction where the agency side
is the seller). In these instances, at the end of the 500 millisecond
exposure period, if the net price of the auction order is inferior to
the bid or offer on the same side of auction order, the auction is
cancelled without any execution. With respect to the bids and offers
for the individual legs of a complex order entered into the three
mechanisms, the priority rules for complex orders contained in Rule
722(b)(2) will continue to apply.
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\8\ See Securities Exchange Act Release No. 52327 (August 24,
2005), 70 FR 51854 (August 31, 2005) (SR-ISE-2004-33).
\9\ See Securities Exchange Act Release No. 53729 (April 26,
2006), 71 FR 26154 (May 3, 2006) (SR-ISE-2006-15).
\10\ See Securities Exchange Act Release No. 64805 (July 5,
2011), 76 FR 40758 (July 11, 2011) (SR-ISE-2011-30).
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The Exchange proposes to amend Supplementary Material .08 to Rule
716 and Supplementary Material .10 to Rule 723 to reflect how complex
orders listed in proposed Rule 722(b)(3)(ii)(A) and (B) are treated in
the Exchange's three auction mechanisms.
The Exchange notes that the number of these atypical complex orders
is small relative to the total number of complex orders executed on the
Exchange on a given day. The Exchange believes that the potential risk
to market makers in the regular market of allowing these atypical
complex orders out-weighs the potential benefit of offering such
functionality to a very limited number of orders. With this proposal,
the Exchange is not entirely restricting the execution of these types
of complex orders. These orders may still be executed in the complex
order book thus, will rest on the complex order book until they are
traded or cancelled by the member that entered them.
2. Statutory Basis
The Exchange believes that its proposal is consistent with Section
6(b) of the Securities Exchange Act of 1934 (the ``Act'') \11\ in
general, and furthers the objectives of Section 6(b)(5) of the Act \12\
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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\11\ 15 U.S.C. 78f(b).
\12\ 15 U.S.C. 78f(b)(5).
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The Exchange believes it is reasonable to limit the types of
complex orders that are eligible to leg-into the regular market. In
this respect, the Exchange notes that the vast majority of complex
orders sent to the Exchange will be unaffected by this rule change.
Moreover, the Exchange believes that the potential risk of continuing
to offer legging functionality for complex orders such as those
impacted by the proposed rule change limits the amount of liquidity
that market makers are willing to provide in the regular market. In
particular, market makers may reduce the size of their quotations in
the regular market because they are at risk of executing the cumulative
size of their quotations across multiple options series without an
opportunity to adjust their quotes. Accordingly, reducing market maker
risk in the regular market by limiting the legging functionality as
proposed herein will benefit investors by encouraging additional
liquidity in
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the regular market. This benefit to investors far exceeds the small
amount of potential liquidity provided by the few complex orders this
proposal seeks to restrict to trading in the complex order book.
B. Self-Regulatory Organization's Statement on Burden on Competition
The proposed rule change does not impose any burden on competition.
The proposed change to limit legging functionality, as proposed, will
reduce risk to market makers that are quoting in the regular market. As
such, the proposal may encourage market makers to increase the size of
their quotations, thereby adding liquidity on the Exchange.
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 up to 90 days (i) as the
Commission may designate 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 Number SR-ISE-2014-10 on the subject line.
Paper Comments
Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.
All submissions should refer to File Number SR-ISE-2014-10. 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 offices 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 Number SR-ISE-2014-10,
and should be submitted on or before April 4, 2014.
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. 2014-05592 Filed 3-13-14; 8:45 am]
BILLING CODE 8011-01-P