[Federal Register Volume 62, Number 98 (Wednesday, May 21, 1997)]
[Notices]
[Pages 27814-27816]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-13277]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38634; File No. SR-CBOE-97-02]
Self-Regulatory Organizations; Chicago Board Options Exchange,
Inc.; Order Granting Approval to Proposed Rule Change Relating to the
Use of Proprietary Brokerage Order Routing Terminals on the Floor of
the Exchange
May 14, 1997.
I. Introduction
On January 21, 1997, the Chicago Board Options Exchange, Inc.
(``CBOE'' or ``Exchange'') submitted to the Securities and Exchange
Commission (``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 to extend from the Standard &
Poor's 500 index (``SPX options'') to the trading crowd in options on
the Standard & Poor's 100 index (``OEX options'') its existing policy
adopted pursuant to Exchange Rule 6.23 whereby members are permitted to
establish, maintain and use proprietary hand-held, brokerage order
routing terminals and related systems (``Terminals'') in the trading
crowd.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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The proposed rule change was published for comment in the Federal
Register on February 20, 1997.\3\ No comments were received on the
proposal. This order approves the proposal.
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\3\ Securities Exchange Act Release No. 38268 (Feb. 11, 1997),
62 FR 7812 (Feb. 20, 1997).
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II. Background
On December 16, 1996, the Commission approved a proposal by the
CBOE to adopt a policy pursuant to its Rule 6.23 \4\ allowing the use
of proprietary brokerage order routing terminals and their related
systems in the SPX trading crowd.\5\ Written Exchange approval is
required prior to a member establishing, maintaining, or using a
Terminal. The Exchange does not approve a Terminal unless and until the
member who proposes to establish one on the floor of the Exchange has
filed with the Exchange an ``Application & Agreement for Brokerage/
Order Routing Terminals in Trading Crowds'' (``Application
Agreement''). In addition, the original filing limited the use of
Terminals to the SPX options trading crowd for the routing of orders in
SPX options.
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\4\ CBOE Rule 6.23 provides that no member shall establish or
maintain any telephone or other wire communications between his or
its office and the Exchange without prior approval by the Exchange.
The Exchange may direct discontinuance of any communication facility
terminating on the floor of the Exchange.
\5\ See Securities Exchange Act Release No. 38054 (December 16,
1996), 61 FR 67365 (``SPX-Terminal Approval Order'').
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The Application Agreement approved by the Commission for use in the
SPX trading crowd addressed several important issues including
restrictions on the use of Terminals and the information thereon. The
Application Agreement prohibits the operators of Terminals from trading
with orders transmitted to the floor through Terminals except when
certain conditions are met and prohibits the use of Terminals to make
markets.
The Application Agreement requires an applicant to agree that it
will not trade with orders transmitted through the Terminal, except
when (1) No one else wants to trade with it (i.e., the member is the
contra-party of last recourse) or (2) an applicant is able to
participate in the order on the same basis that other market makers who
do not have priority participate. Under the second exception, the
member may trade with an order as long as (a) The member in the trading
crowd who is the first to respond to such order (other than the
applicant) has priority in taking the other side of such order, and (b)
the aggregate portion of such order taken by the applicant is not
greater than the portion of the order taken by every other Exchange
market maker in the crowd who wishes to participate in the order in the
same aggregate quantity.
The Application Agreement also prohibits an applicant from using
for their own benefit any information contained in any order in the
Terminal system until that information has been disclosed to the
trading crowd.
The Application Agreement also requires an applicant to agree that
its Terminal will be used to receive brokerage orders only, and that it
will not be used to perform a market making function. In adopting this
restriction, the Exchange was concerned that Terminals may enable
person not subject to Exchange control to perform market making
functions from off the floor of the Exchange without being burdened by
the cost of maintaining an Exchange membership, or the obligations
imposed on Exchange market makers.\6\
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\6\ In addition, the Application Agreement has provisions
relating to the installation and use of Terminals. These provisions
relate to surveillance, audit trails, compliance, physical,
electrical and communications requirements and termination of
approval for Terminals.
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III. Description of the Proposal
The CBOE proposes to amend the policy adopted pursuant to its Rule
6.23 that would extend the use of proprietary brokerage order routing
terminals and their related systems from the SPX options trading crowd
to the OEX options trading crowd, Exchange members would still be
required to obtain written approval from the Exchange to establish,
maintain, or use a terminal in either of the two trading crowds. The
Exchange would not approve the use of a Terminal unless and until the
member who proposes to utilize it on the floor has filed with the
Exchange an Application Agreement, and Terminals may only be used in
the crowds trading SPX or OEX options to route orders in SPX or OEX
options.\7\ To accommodate this change, the application Agreement will
also be amended to specifically allow for the use of Terminals in the
OEX options trading crowd. The terms and restrictions of the
Application Agreement remain unchanged and will be identical to those
approved in the SPX-Terminal Approval Order as described above.
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\7\ The Exchange requires applicants wishing to use Terminals in
both the OEX and SPX options trading crowds to execute separate
Application Agreements with the Exchange for each trading crowd.
Telephone conversation between Tim Thompson, CBOE and David
Sierazki, SEC, on May 13, 1997.
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IV. Discussion
Section 6(b)(5) of the Act \8\ requires that the rules of an
exchange be designated to prevent fraudulent and manipulative acts and
practices, promote just and equitable principles of trade, remove
impediments to and perfect the mechanism of a free and open market, and
in general to protect investors and the public interest. Section
6(b)(7) of the Act \9\ requires that the rules of an Exchange be in
accordance with Section 6(d) of the Act,\10\ and in general provide a
fair
[[Page 27815]]
procedure for the disciplining of members and the prohibition or
limitation by an exchange of a person's access to services offered by
the exchange. Section 6(b)(7) of the Act \11\ requires that the rules
of an exchange not impose any burden on competition not necessary or
appropriate in furtherance of the purposes of the Act. Section
11A(a)(1)(C)(ii) of the Act \12\ states that it is in the public
interest and appropriate for the protection of investors and the
maintenance of fair and orderly markets to assure fair competition
among brokers and dealers. For the reasons set forth below, 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, and, in particular, the
requirements of Sections 6(b)(5), 6(b)(7), 6(b)(8), and 11A(a)(1)(C) of
the Act.\13\
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\8\ 15 U.S.C. 78f(b)(5).
\9\ 15 U.S.C. 78f(b)(7).
\10\ 15 U.S.C. 78f(d). Section 6(d) of the Act, among other
things, requires that an exchange, in any proceeding to determine
whether a member should be disciplined, bring specific charges,
notify such member of and provide him with an opportunity to defend
himself against such charges, and keep a record.
\11\ 15 U.S.C. 78f(b)(8).
\12\ 15 U.S.C. 78k-1(a)(1)(C)(ii).
\13\ In approving this rule, the Commission has considered the
proposed rule's impact on efficiency, competition, and capital
formation. 15 U.S.C. 78c(f).
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The Commission believes that the CBOE's proposal should foster
coordination with persons engaged in facilitating transactions in
securities, remove impediments to and perfect the mechanism of a free
and open market, and protect investors and the public interest by
expediting and making more efficient the process by which members can
receive OEX orders to be executed on the floor of the Exchange. The
proposal also will promote fair competition among brokers and dealers
and facilitate transactions in options on the Exchange. Finally, the
Commission believes that the requirement that an applicant file the
Application Agreement with the Exchange and comply with it is
reasonable and ensures adequate surveillance and compliance with CBOE
Rules.
The Commission notes that the substantive provisions set forth in
the Application Agreement submitted with this proposal, are identical
to those approved in the SPX-FLoor Broker Terminal Approval Order.\14\
The Commission believes that the Exchange's policy regarding the use of
Terminals and the Application Agreement provide a reasonable framework
in which to introduce the use of Terminals to the OEX options trading
crowd. The Commission also believes that the requirement that an
applicant file the Application Agreement with the Exchange and comply
with it is reasonable and ensures adequate surveillance and compliance
with CBOE rules. The Commission notes, however, that the Exchange is
required to submit a proposed rule change with the Commission pursuant
to Section 19(b) of the Act, if it wants to extend the use of Terminals
beyond the SPX and OEX options trading crowds.
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\14\ See SPX-Terminal Approval Order, supra note 5. The
discussion and findings in the SPX-Terminal Approval Order are
incorporated herein.
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The Commission also believes that the termination procedures in the
Application Agreement are consistent with the Act, including Sections
6(b)(7) and 6(d) of the Act,\15\ and are designed to provide affected
members with adequate due process. The Commission notes that a member
so affected could seek relief pursuant to the Hearings and Review
provisions of Chapter XIX of the Exchange's Rules. These provisions
provide specific procedures to seek Exchange hearing and review for
persons aggrieved by action of the Exchange in terminating or enforcing
the terms of the Application Agreement.\16\
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\15\ See supra notes 9-10 and accompanying text.
\16\ See CBOE Rules 19.4, Hearing and 19.5 Review.
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As noted above, the Application Agreement prohibits a member or an
associated person from trading with orders transmitted through a
Terminal, unless no other member were to trade with the order, or the
applicant were to trade on the same basis as other members who do not
have priority. In addition, the Application Agreement prevents a member
from using for its benefit information transmitted through a Terminal,
before that information is disclosed to the trading crowd. The
Commission believes that these restrictions are an appropriate measure
to ensure that an applicant or one if its associated persons does not:
(1) Interact with an order prior to information relating to such order
becoming known to the trading crowd, which would be inconsistent with
the open auction market principles governing the Exchange's trading
system; or (2) effect transactions or change quotes in the Exchange's
market or in the markets for the underlying interest or related
interests before the information were available in the market. The
Commission also believes that the two exceptions to the general
restriction on trading with orders in the Terminal system are
consistent with these concerns, and ensure that members using Terminals
trade on the same terms and conditions as other market participants and
do not receive any trading advantages to interact with orders
transmitted through the Terminals.
For the same reasons set forth in the Commission's findings in the
SPX-Terminal Approval Order,\17\ the Commission believes that the
market making prohibition on the use of Terminals in OEX options
adequately balances the potential benefits to be derived from Terminals
with the important regulatory issues that are raised in connection with
the potential use of Terminals for off-floor market making in CBOE-
listed options. Because off-floor market makers potentially would enjoy
the benefits of other ``public customers,'' while not having the
concomitant obligations and responsibilities of CBOE market makers, the
Commission does not believe it is unreasonable for the CBOE to
determine that the introduction of unregulated market making through
Terminals in OEX options could undermine its market maker system.
Indeed, the CBOE's proposal will allow the expansion of an innovative
technology into another extremely active trading crowd, while doing so
in a manner designed to ensure the continued viability of its market
maker system.\18\
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\17\ See SPX-Terminal Approval Order, supra note 5.
\18\ See infra note 22.
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The Commission also believes that the CBOE restriction on market
making through the use of Terminals in OEX options has been effected in
a clear and reasonable manner that is not ambiguous nor overbroad, and
that takes into account regulatory and market impact concerns,
including those relating to quote competition and price discovery.\19\
Notably, the CBOE's proposal does not bar all two-sided limit orders.
Instead it only restricts the acceptance of orders placed in the
performance of a market making function. The distinction between market
making and brokerage activity is well established among market
participants. Moreover, the language of the market making restriction
expressly restricts only an aggregate pattern of orders, which
indicates whether an investor is performing a market making function,
not the occasional entry of two-sided limit orders. Thus, the
restriction on Terminal use for routing limit orders is the minimum
necessary
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for the CBOE to bar Terminal use for off-floor market making.
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\19\ Cf., Securities Exchange Act Release No. 25842 (June 23,
1988), 53 FR 24539 (approving certain restrictions on the use of
telephones on the floor of the New York Stock Exchange), aff'd per
curiam, 866 F.2d 47 (2d Cir. 1989).
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The Commission also emphasizes that it expects the CBOE to
interpret the term ``market making'' in accordance with its traditional
definition as defined under the Act, i.e., holding one's self out as
being willing to buy and sell a particular security on a regular or
continuous basis.\20\ The definition of market making should not
capture parties who enter orders on one side of the market; nor would
it capture parties who enter two-sided limit orders on occasion. A
party would not be deemed to be engaging in market making unless it
regularly or continuously holds itself out as willing to buy and sell
the security.\21\
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\20\ See, e.g., 15 U.S.C. 78c(a)(38); Securities Exchange Act
Release No. 36719A (Sept. 6, 1996), 61 FR 48290, 48316 (Sept. 12,
1996).
\21\ Securities Exchange Act Release No. 36719A (Sept. 6, 1996),
61 FR 48290, 48316 (Sept. 12, 1996). The Commission notes that a
broker using a Terminal may receive numerous orders from multiple
customers, some of which are on the bid side and others on the offer
side of an SPX series. This is consistent with a brokerage function,
not a market making function. If, however, a particular customer of
a broker regularly or continuously places two-sided limit orders,
then the CBOE might, under certain circumstances, reach a different
conclusion as to the nature of the function being performed by the
broker and the customer.
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By approving this proposed rule change, the Commission is not
stating that it is impermissible for an options exchange to permit
users of Terminals or other similar devices to make two-sided markets.
Indeed, the CBOE may determine to reconsider its decision not to permit
users of Terminals to engage in market making at some future time.
Nevertheless, while it is not illegal to permit off-floor market
making, the Commission believes that it is within the CBOE's
prerogative as an exchange to prohibit it. In approving the market
making restriction in the SPX-Terminal Approval Order the Commission
noted that the CBOE was particularly concerned that off-floor market
making effectively would establish a market making structure devoid of
affirmative market making obligations that could result in less deep
and liquid markets during periods of market stress, when off-floor
Terminal market makers would not be required to continue making
markets. The Commission believes that these concerns are reasonable.
The Commission's approval of the proposed rule change reflects the
Commission's belief that the CBOE may act incrementally in approving
the use of Terminals for transactions in SPX, and now OEX options,
given that the CBOE is still learning about the possible impact of
Terminals upon its market.\22\
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\22\ The Commission recognizes that markets for certain equity
options can be less deep and liquid than the OEX market. However,
the rule change approved today concerns the use of Terminals only in
the OEX crowd. The Commission will consider the merits of permitting
the use of Terminals to represent two-sided limit orders that
effectively create regular two-sided markets in less liquid options
crowds when it is presented with that issue.
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In summary, while the CBOE's restrictions on the use of Terminals
raise regulatory issues, the Commission believes that, within the
context of the OEX options trading crowd, the market making restriction
is an acceptable exercise of the Exchange's rulemaking authority. While
the Commission recognizes that there may be different ways to address
the regulatory issues presented by off-floor market making through the
use of Terminals, the Act does not dictate that any particular approach
be taken. The Commission believes that the manner in which the Exchange
has chosen to address the regulatory issues presented by off-floor
market making reflects the considered judgment of the CBOE regarding
the attributes of Exchange membership and the organization of its
trading floor, and is a fair exercise of its powers as a national
securities exchange.
For the reasons stated above, and the findings set forth in the
SPX-Terminal Approval Order,\23\ the Commission believes that the
Exchange's proposal to extend the policy regarding the use of Terminals
to the OEX options trading crowd is consistent with the Act.
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\23\ See SPX-Terminal Approval Order, supra note 5.
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\24\ that the proposed rule change (SR-CBOE-97-02) is approved.
\24\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\25\
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\25\ 17 C.F.R. 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-13277 Filed 5-20-97; 8:45 am]
BILLING CODE 8010-01-M