[Federal Register Volume 79, Number 178 (Monday, September 15, 2014)]
[Notices]
[Pages 55033-55036]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-21869]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-73023; File No. SR-ISE-2014-10]
Self-Regulatory Organizations; International Securities Exchange,
LLC; Order Approving a Proposed Rule Change Related To Limiting Certain
Types of Complex Orders From Legging Into the Regular Market
September 9, 2014.
I. Introduction
On February 25, 2014, the International Securities Exchange, LLC
(the ``Exchange'' or ``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 relating to complex orders. The
proposed rule change was published for comment in the Federal Register
on March 14, 2014.\3\ On April 23, 2014, the Commission extended the
time period in which to either approve the proposal, disapprove the
proposal, or to institute proceedings to determine whether to approve
or disapprove the proposal, to June 12, 2014.\4\ On June 10, 2014, the
Commission instituted proceedings to determine whether to approve or
disapprove the proposed rule change.\5\ The Commission received five
comment letters on proposal.\6\ 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. 71669 (March 10,
2014), 79 FR 14563 (``Notice'').
\4\ See Securities Exchange Act Release No. 72006 (April 23,
2014), 79 FR 24031 (April 29, 2014).
\5\ See Securities Exchange Act Release No. 72359 (June 10,
2014), 79 FR 34387 (June 16, 2014).
\6\ See letters to Elizabeth Murphy, Secretary, Commission, from
Kurt Eckert, Principal, Wolverine Trading, LLC, dated July 7, 2014
(``Wolverine Letter''); Ellen Green, Vice President, Financial
Services Operations, Securities Industry and Financial Markets
Association, dated July 8, 2014 (``SIFMA Letter''); Wouter Stinis,
Head of Trading, Optiver US, LLC, dated July 9, 2014 (``Optiver
Letter''); letter to Kevin M O'Neill, Deputy Secretary, Commission,
from John Kinahan, Interim-CEO, Group One Trading, L.P., dated July,
7, 2014 (``Group One Letter''); letter to the Office of the
Secretary, Commission, from Martha Redding, Chief Counsel and
Assistant Corporate Secretary, NYSE, Inc. dated July 10, 2014
(``NYSE Letter'').
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II. Description of the Proposal
The Exchange proposes to amend ISE Rule 722 to prohibit certain
types of complex orders from legging into the regular market (i.e.,
executing against individual quotes for each of the legs of the complex
order in the regular market).\7\ Specifically, ISE proposes that
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
only trade against other complex orders in the complex order book and
will not be permitted to leg into the regular market.\8\ ISE also
proposes that complex orders with three option legs where all legs are
buying or all legs are selling, regardless of whether the options are a
calls or puts, will only trade against other complex orders in the
complex order book and will not be permitted to leg into the regular
market.\9\ ISE describes these types of two and three leg complex order
strategies as ``atypical'' complex order strategies in that they are
geared toward an aggressive directional capture of volatility.\10\
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\7\ See Notice, supra note 3, at 14564. ISE Rule 722(b)(3)(ii)
rule states that complex orders up to a maximum number of legs
(determined by the Exchange on a class basis as either two legs or
three legs) will be automatically 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.
\8\ See Notice, supra note 3, at 14564. The Exchange offers some
examples of such strategies as follows: (i) Buy Call 1, Buy Call 2;
(ii) Sell Call 1, Sell Call 2; (iii) Buy Put 1, Buy Put 2; (iv) Sell
Put 1, Sell Put 2. See id.
\9\ See id. The Exchange offers some examples of such strategies
as follows: (i) Buy Call 1, Buy Call 2, Buy Put 1; (ii) Buy Put 1,
Buy Put 2, Buy Put 3; (iii) Buy Call 1, Buy Call 2, Buy Call 3; (iv)
Buy Put 1, Buy Put 2, Buy Call 3; (v) Sell Put 1, Sell Put 2, Sell
Call 1. See id.
\10\ See id. Hereinafter these two and three legged complex
order strategies that are the subject of this proposal will be
referred to as ``directional complex orders.'' ISE states that most
traditional complex order strategies used by retail or professional
investors, unlike directional complex orders, seek to hedge the
potential move of the underlying security or to capture a premium
from an anticipated market event. See id.
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The Exchange further proposes to amend ISE Rule 722 to prevent
legging orders \11\ from being generated on behalf of the two-legged
complex orders where
[[Page 55034]]
both legs are buying or both legs are selling and both legs are calls
or both legs are puts.\12\ According to the Exchange, preventing the
generation of legging orders for these types of two-legged complex
orders is necessary to effectuate the proposed limitation to exclude
these types of complex orders from trading in the regular market.\13\
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\11\ ISE Rule 715(k) defines a legging order as 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.
\12\ See Notice, supra note 3, at 14565. The Exchange notes that
legging orders cannot be generated for complex orders with three
options legs, and, therefore, is not proposing to prevent the
generation of legging orders for complex orders with three option
legs where all legs are buying or all legs are selling, regardless
of whether the options are calls or puts. See id.
\13\ See id.
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In addition, the Exchange proposes to amend Supplemental Material
.08 to ISE Rule 716 (Facilitation Mechanism and Solicited Order
Mechanism) and Supplemental Material .10 to ISE Rule 723 (Price
Improvement Mechanism) to ensure that directional complex orders do not
leg into the regular market through an auction.\14\ ISE represents
that, under its current rules, if an improved net price for a complex
order in the Exchange's auctions can be achieved from bids and offers
for the individual legs of the complex order in the regular market, the
complex order would receive that better net price.\15\ ISE proposes to
prevent directional complex orders from interacting with the regular
market during an auction in connection with the Exchange's proposal in
order to prevent directional complex orders from executing against the
regular market.\16\ Accordingly, the Exchange proposes to amend
Supplemental Material .08 to ISE Rule 716 and Supplemental Material .10
to ISE Rule 723 to provide that if an improved net price can be
achieved from bids and offers for the individual legs for directional
complex orders during an auction, ISE will cancel the auction at the
end of the auction's exposure period.\17\
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\14\ See id.
\15\ See id.
\16\ See Notice, supra note 3, at 14565.
\17\ See id.
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According to the Exchange, the proposed rule amendments are
designed to prevent directional complex orders from bypassing the
Exchange's market maker risk parameters for the regular market.\18\ ISE
states that the market maker risk parameters are designed to
automatically remove a market maker's quotes in all series of an
options class when any of four parameter settings established by the
market maker are triggered.\19\ ISE describes these market maker risk
parameters as a functionality that allows market makers to provide
liquidity across many different options series without being at risk of
executing the full cumulative size of all of their quotes before being
given adequate opportunity to adjust their quotes.\20\ According to
ISE, when a complex order legs into the regular market, all of the legs
of a complex order are considered as a single transaction for purposes
of the market maker risk parameters, and not as a series of individual
transactions.\21\ Thus, the trading system performs the market maker
risk parameter calculations after the entire complex order executes
against interest in the regular market. According to the Exchange, the
manner in which complex orders leg into the regular market may cause
market makers to trade above limits set in their market maker risk
parameters.\22\ As a result, the Exchange believes that market makers
may alter their trading behavior to account for the additional risk by
widening quotes, hurting the Exchange's quality of markets and the
quality of markets in general.\23\ Further, according to ISE,
directional complex orders that bypass market makers' risk parameters
may result in artificially large transactions that distort the market
for related instruments, including the underlying security or related
options series.\24\ The Exchange believes that the potential risk to
market makers of allowing directional complex orders to execute against
market makers' quotes in the regular market outweighs the potential
benefit of allowing directional complex orders to execute against
interest in the regular market.\25\ By limiting directional complex
orders from legging into the regular market, the Exchange believes that
market makers will post tighter and more liquid markets for regular
orders and traditional complex orders, while reducing the frequency and
size of related market distortions.\26\
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\18\ See id. at 14564 and ISE Rule 804(g) (Automated Quotation
Adjustments). See also Supplemental Material .04 to ISE Rule 722
(Automated Spread Quotation Adjustments).
\19\ See Notice, supra note 3, at 14564.
\20\ See id.
\21\ See id.
\22\ See id.
\23\ See id.
\24\ See id.
\25\ See Notice, supra note 3, at 14565. ISE notes that the
number of directional complex orders is small relative to the total
number of complex orders executed on the Exchange on a given day.
See id.
\26\ See id.
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Finally, ISE represents that directional complex orders may trade
against other complex orders in the ISE complex order book and may rest
on the ISE complex order book until they are traded or canceled by the
member that entered them.\27\
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\27\ See id.
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III. Summary of Comment Letters
As previously noted, the Commission received five comment
letters.\28\ All of the commenters support the proposal and believe the
Commission should approve it.
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\28\ See supra note 6.
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Several commenters state that they rely on market maker risk
parameter mechanisms to prevent them from exceeding a set amount of
risk without having the opportunity to update the price or size of
their quotes to better reflect the state of the current market.\29\ One
commenter, a national securities exchange, states that market makers
and other participants who contribute to price discovery by posting
displayed bids and offers incur significant risk of taking on large
options positions on the same side of the market, potentially causing a
liquidity provider to accumulate unacceptable risk levels very
quickly.\30\ This commenter states that, because of this, options
exchanges make available to their market makers and other market
participants risk protection tools that restrict the amount of risk a
liquidity provider can accumulate per unit time before their quotes or
orders are disabled.\31\ Another commenter, a market maker, states that
it relies on the exchange-level market maker risk parameter mechanisms
to ensure that its quotes are removed from the market when its risk
tolerance is exceeded.\32\ According to this commenter, it is because
of these market maker risk parameters that market makers are able to
quote tight spreads and deep liquidity.\33\
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\29\ See e.g., Group One Letter, supra note 6, at 1; Wolverine
Letter, supra note 6, at 1.
\30\ See NYSE Letter, supra note 6, at 1.
\31\ See id.
\32\ See Group One Letter, supra note 6, at 1. See also
Wolverine Letter, supra note 6, at 1 (stating that market makers are
reliant on exchange-level market maker risk parameters mechanisms to
protect market makers from assuming undue risk if multiple resting
quotes are executed in rapid succession).
\33\ See Group One Letter, supra note 6, at 1. See also
Wolverine Letter, supra note 6, at 1 (stating that market makers are
able to provide tight, deep, competitive markets based on the
understanding that they can, to a reasonable degree, control the
amount of risk they assume within a single trade or sequence of
trades before being able to recalculate and republish their quotes).
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Commenters generally agree that directional complex orders allow
market participants to circumvent a market-maker's risk parameters.\34\
Several
[[Page 55035]]
commenters assert that directional complex orders are not traditional
complex orders used by retail and professional investors.\35\ One
commenter notes that, while any complex order, traditional or
directional, legging into the market could circumvent a market-maker's
risk parameters, such circumvention is justifiable for traditional
complex orders but not directional complex orders.\36\ This commenter
explains that traditional complex orders, such as spreads or straddles,
are designed to provide some degree of directional protection, where
gains in one leg may be at least partially offset by losses in another,
which, according to the commenter, renders the risk of these
traditional complex orders executing as a single transaction more
tolerable.\37\ However, according to this commenter, directional
complex orders often increase the net directional exposure because they
consist of all bullish or bearish positions where no one leg hedges any
other, as is the case for traditional complex orders.\38\
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\34\ See Wolverine Letter, supra note 6, at 2; Optiver Letter,
supra note 6, at 2; Group One Letter, supra note 6, at 1; NYSE
Letter, supra note 6, at 2; and SIFMA Letter, supra note 6, at 3.
\35\ See e.g., Wolverine Letter, supra note 6, at 2; Optiver
Letter, supra note 6, at 1-2; and Group One Letter, supra note 6, at
2.
\36\ See Wolverine Letter, supra note 6, at 1-2. See also NYSE
Letter, supra note 6, at 2.
\37\ See Wolverine Letter, supra note 6, at 1.
\38\ See Wolverine Letter, supra note 6, at 2. See also NYSE
Letter, supra note 6, at 2 (noting that most complex orders ``. . .
are `self-hedged,' i.e., comprising one or more `long' sides offset
by one or more `short' sides'').
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Generally, all of the commenters agree that directional complex
orders restrict market-makers' ability to mitigate their risk and, in
turn, their ability to quote in larger sizes with tighter spreads
across many different options series.\39\ One commenter states that
without the protection offered by the market maker risk parameters, its
only remaining controls at its disposal to protect against the risk of
directional complex orders are to widen quoted spreads and/or reduce
the size of its quotes in the single leg market.\40\ This commenter
also notes that it may even cancel all its quotes in related
instruments on other exchanges where the commenter provides liquidity
in response to an execution of a directional complex order against its
quotes, or may even stop quoting altogether on venues where directional
complex orders are permitted to circumvent a market maker's risk
parameters.\41\ One commenter states that these directional complex
orders may force market makers to hedge their position more urgently
than for other transactions, which hedging may cause a larger,
temporary, market impact in the underlying securities than normal
hedging activity does.\42\ One commenter states that it would be able
to provide larger published quotes and/or tighter spreads if the
proposal is approved.\43\
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\39\ See Wolverine Letter, supra note 6, at 2; Optiver Letter,
supra note 6, at 4; Group One Letter, supra note 6, at 1-2; NYSE
Letter, supra note 6, at 1-2; and SIFMA Letter, supra note 6, at 4-
5.
\40\ See Optiver Letter, supra note 6, at 3.
\41\ See Optiver Letter, supra note 6, at 3-4.
\42\ See SIFMA Letter, supra note 6, at 4. This commenter also
notes that retail investors' limit orders may also be adversely
impacted by directional complex orders because such orders can
result in large price swings, which may result in stop orders being
triggered. Id.
\43\ See Wolverine Letter, supra note 6, at 2. See also Group
One letter, supra note 6, at 2 (noting that by allowing market
makers to rely on the Exchange's market maker risk parameters,
``market makers can continue to provide large size quotes with tight
spreads''); and Optiver Letter, supra note 6, at 5 (asserting that
approval would ``further allow tighter markets and increased
liquidity for both complex orders and the regular market'').
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Two commenters state that they believe that the number of
directional complex orders is small relative to the total number of
complex orders executed on the Exchange in a given day.\44\ Some
commenters note that most directional complex orders come from market
makers.\45\ One commenter states that, according to one market
participant, 95% of directional complex orders that executed against
that participant's quotes over the last year originated from the market
making desk of one firm.\46\ According to this commenter, of the
complex order flow received by that same market participant from
institutional and retail customers over the past year, zero directional
complex orders came from institutional customers and just 0.1% of
retail complex orders were directional.\47\ Another commenter notes
that the average trade number of contracts executed in traditional
complex orders against the commenter's quotes in 2014 was 14.8
contracts per trade, which is, according to the commenter, generally
consistent with the Options Clearing Corporation's data indicating an
average number of contracts per average transaction of 15.6 contracts
on the Exchange.\48\ The commenter then notes that the average number
of contracts per transaction against the commenter's quotes for
directional complex orders was 157.3 contracts.\49\
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\44\ See SIFMA Letter, supra note 6, at 5; Optiver Letter, supra
note 6, at 4 (noting that it believes 3-legged directional complex
orders represents less than 1% of total orders).
\45\ See SIFMA Letter, supra note 6, at 3; Optiver Letter, supra
note 6, at 2 (noting that, in the commenter's experience, ``these
[directional] order types are overwhelmingly used by market
makers'').
\46\ See SIFMA Letter, supra note 6, at 3.
\47\ See id. Two commenters state that they believe that the
number of directional complex orders is small relative to the total
number of complex orders executed on the Exchange in a given day.
\48\ See Optiver Letter, supra note 6, at 3.
\49\ See id.
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Two commenters state that they believe that the potential benefits
of preventing directional complex orders from legging into the regular
market under the Exchange's proposal outweighs any benefits of
continuing to allow directional complex orders to leg into the regular
market.\50\ One commenter asserts that market maker risk protections in
the regular market must have priority over directional complex orders
that leg into that same regular market.\51\ Another commenter states
that it believes that approval of the proposal will deter potentially
nefarious activity without reducing liquidity for regular orders or
traditional complex orders.\52\
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\50\ See SIFMA Letter, supra note 6, at 5; Optiver Letter, supra
note 6, at 5.
\51\ See Optiver Letter, supra note 6, at 5.
\52\ See Group One Letter, supra note 6, at 2. Two commenters
also express support for the part of the Exchange's proposal that
would require that an auction be canceled at the end of the
auction's exposure period if an improved net price can be achieved
from the bids and offers for the individual legs of a directional
complex order during an auction. See SIFMA Letter, supra note 6, at
3; Optiver Letter, supra note 6, at 2.
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IV. Discussion and Commission Findings
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.\53\ In particular, the Commission finds that the proposed
rule change is consistent with Section 6(b)(5) of the Act,\54\ 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. The Commission notes that directional complex orders
may continue to trade against other complex orders on the Exchange's
complex order book, and that market participants may submit the
individual legs of a directional complex order separately to the
regular market for execution should they so choose. The Commission also
notes that all five
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commenters expressed support for the proposal.
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\53\ In approving this proposal, the Commission has considered
the proposed rule's impact on efficiency, competition, and capital
formation. See 15 U.S.C. 78c(f).
\54\ 15 U.S.C. 78f(b)(5).
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V. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\55\ that the proposed rule change (SR-ISE-2014-10) is approved.
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\55\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\56\
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\56\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-21869 Filed 9-12-14; 8:45 am]
BILLING CODE 8011-01-P