Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”), and Rule 19b-4 thereunder, notice is hereby given that on October 14, 2003, the International Securities Exchange, Inc. (“ISE” or “Exchange”), filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I, II and III below, which Items have been prepared by the ISE. On January 13, 2004, the ISE filed Amendment No. 1 to the proposed rule change (“Amendment No. 1”). On January 30, 2004, the ISE filed Amendment No. 2 to the proposed rule change (“Amendment No. 2”). On March 8, 2004, the ISE filed Amendment No. 3 to the proposed rule change (“Amendment No. 3”). The Commission is publishing this notice to solicit comments on the proposed rule change, as amended, from interested persons.
17 CFR 240.19b-4.
See letter from Michael Simon, Senior Vice President and General Counsel, ISE, to Nancy J. Sanow, Assistant Director, Division of Market Regulation (“Division”), Commission, dated January 12, 2004. In Amendment No. 1, the ISE made technical corrections to the text of the proposed rule change. In addition, in Amendment No. 1, the ISE corrected an omission in the original rule text, amending ISE Rule 1614(d)(5) to include ISE Rule 717(f) as a minor rule violation meriting the fines set forth in ISE Rule 1614(d)(5) (addressing violations of order-entry rules).
See letter from Michael Simon, Senior Vice President and General Counsel, ISE, to Nancy J. Sanow, Assistant Director, Division, Commission, dated January 29, 2004. In Amendment No. 2, the ISE amended the text of the proposed rule change to clarify that Primary Market Makers must buy (sell) the number of contracts needed to maintain a firm quote for ten contracts when the disseminated ISE quotation is less than ten contracts for orders incoming from the Options Intermarket Linkage.
See letter from Michael Simon, Senior Vice President and General Counsel, ISE, to Nancy J. Sanow, Assistant Director, Division, Commission, dated March 5, 2004. In Amendment No. 3, the ISE amended the text of the proposed rule change to incorporate recently-approved changes to ISE Rule 804. See Securities Exchange Act Release No. 49278 (February 19, 2004), 69 FR 8716 (February 25, 2004) (SR-ISE-2003-34).
I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change
The Exchange proposes to modify ISE Rules 717, 803-805 and 1614 to repeal the limits on the entry of orders and revise the quotation requirements of market makers. The text of the proposed rule change is set forth below. Proposed new language is in italics; proposed deletions are in [brackets].
Rule 717. Limitations on Orders
(c) Reserved. [Order Size.
(1) Electronic Access Members are prohibited from entering into the System, as principal or agent, multiple orders for a single trading interest if one or more orders is for fewer than ten (10) contracts.
(2) Non-Customer Orders for fewer than ten (10) contracts will be rejected or cancelled automatically if such orders would cause the size of the Exchange's best bid or offer to be fewer than ten (10) contracts.]
Rule 803. Obligations of Market Makers
(c) Primary Market Makers. In addition to the obligations contained in this Rule for market makers generally, for options classes to which a market maker is the appointed Primary Market Maker, it shall have the responsibility to:
(1) [Assure that each disseminated market quotation in each series of options is for a minimum of ten (10) contracts, or such other minimum number as the Exchange shall set from time to time. When the best bid (offer) on the Exchange represents one or more Public Customer Orders for less than a total of ten (10) contracts at that price, the Primary Market Maker is obligated to] When the disseminated market quotation in a series of options is for less than ten (10) contracts, buy (sell) at that price the number of contracts needed to make the disseminated quote firm for ten (10) contracts to incoming Linkage orders as provided in Rule 1900(7) and (8).
(2) Address Public Customer Orders that are not automatically executed because there is a displayed bid or offer on another exchange trading the same options contract that is better than the best bid or offer on the Exchange.
(3) Initiate trading in each series pursuant to Rule 701.
Rule 804. Market Maker Quotations
(b) Size Associated with Quotes. A market maker's bid and offer for a series of options contracts shall be accompanied by the number of contracts at that price the market maker is willing to buy or sell upon receipt of an order or upon interaction with a quotation entered by another market maker on the Exchange. Unless the Exchange has declared a fast market pursuant to Rule 704, a market maker may not initially enter a bid or offer of less than ten (10) contracts. [Where the size associated with a market maker's bid or offer falls below ten (10) contracts due to executions at that price and consequently the size of the best bid or offer on the Exchange would be for less than ten (10) contracts, the market maker shall enter a new bid or offer for at least ten (10) contracts, either at the same or a different price.]
Rule 805. Market Maker Orders
(b) Options Classes Other Than Those to Which Appointed.
(1) A market maker may enter all order types permitted to be entered by non-customer participants under the Rules to buy or sell options in classes of options listed on the Exchange to which the market maker is not appointed under Rule 802, provided that:
(i) market maker orders are subject to the limitations contained in Rule 717[(c) and] (f) as [those] that paragraph[s apply] applies to principal orders entered by Electronic Access Members;
(ii) the spread between a limit order to buy and a limit order to sell the same options contract complies with the parameters contained in Rule 803(b)(4); and
(iii) the market maker does not enter orders in options classes to which it is otherwise appointed, either as a Competitive or Primary Market Maker.
Rule 1614. Imposition of Fines for Minor Rule Violations
(d) Violations Subject to Fines. The following is a list of the rule violations subject to, and the applicable sanctions that may be imposed by the Exchange pursuant to, this Rule:
(5) Order Entry (Rule 717). Violations of Rule 717(a), [(c)-(e)] (d)-(f) regarding limitations on orders entered into the System by Electronic Access Members, as well as violations of Rule 805(b)(1)(i) regarding [restrictions on] orders entered by market makers, will be subject to the fines listed below. Each paragraph of Rule 717 subject to this Rule shall be treated separately for purposes of determining the number of cumulative violations.
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 ISE 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 Exchange 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 purpose of the proposed rule change is to revise the ISE's restrictions on the entry of orders of less than 10 contracts, along with related market maker quotation requirements. Currently, ISE rules require that the Exchange's best bid and offer (“BBO”) be at a size of at least 10 contracts at all times. To assure that the Exchange's BBO is at least 10 contracts, ISE rules contain several restrictions on orders of less than 10 contracts and certain market maker obligations.
First, ISE Rule 804 requires market makers to establish quotations of at least 10 contracts. That rule also provides that if there is partial execution against a quotation resulting in the size of the ISE BBO falling below 10 contracts, the market maker must refresh its quotation (either at the same or different price) so that it is firm for at least 10 contracts. Similarly, ISE Rule 717 prohibits Electronic Access Members (“EAMs”) from submitting orders for non-customers of less than 10 contracts that would cause the ISE BBO to be for less than 10 contracts. If an EAM enters an order for a Public Customer at the BBO for less than 10 contracts, Rule 803 requires that the Primary Market Maker (“PMM”) either trade that order or supplement the size of the order so that the displayed quotation is for at least 10 contracts. The Exchange refers to the supplemental quoting obligation as the need for the PMM to “derive” the additional size. Finally, to avoid manipulative practices related to the PMM's obligation to derive additional size, an EAM is prohibited under Rule 717 from entering multiple orders of less than 10 contracts for the same trading interest.
The derived order obligation can lead to market manipulation called “small order baiting,” where customers enter small orders seeking to induce a PMM to display greater size at that price, and then enter an order to execute against that derived size.
This proposed rule change will not change the requirement that market makers enter all quotations with a size of at least 10 contracts. It will: (1) Remove the prohibition on EAMs entering non-customers orders that improve the ISE's BBO for less than 10 contracts, (2) repeal the obligation of the PMM either to “trade out” customer orders of less than 10 contracts or derive additional size to maintain a 10-contract displayed size, and (3) since there will no longer be an obligation for PMMs to derive additional size, remove the prohibition on EAMs entering multiple orders for the same trading interest if one or more orders are for less than 10 contracts. In addition, this proposed rule change will repeal the requirement that market makers refresh their quotations if there is a partial execution that results in the ISE's BBO size's falling below 10 contracts. However, pending possible future changes to the rules governing trading in the Linkage, the Exchange does not propose to change the obligations in ISE Rule 1900 that the ISE quotation be firm for at least 10 contracts for Principal Orders and Principal Acting as Agent Orders received through the Linkage. The PMM will continue to provide “derived” size when necessary for such Linkage orders.
The ISE represents, however, that their system makes it impossible for a market maker's quote ever to drop to zero, and that this proposed rule filing will not therefore change the obligation of a market maker to maintain a continuous quote for options in which they make a market. See ISE Rules 803(b) and 804(e). Telephone conversation between Katherine Simmons, Associate General Counsel, ISE, and John Roeser, Special Counsel and Elizabeth MacDonald, Attorney, Division, Commission, February 11, 2004.
Lastly, the Exchange is proposing to amend ISE Rule 1614(d)(5) to include ISE Rule 717(f) as a minor rule violation subject to the fines applicable to violations of order-entry rules. The Exchange proposes to include 717(f) as a minor rule violation harmonizes the treatment of EAMs and market makers pursuant to that rule.
Telephone conversations between Joe Ferraro, Assistant General Counsel, ISE, and Elizabeth MacDonald, Attorney, Division, Commission, February 18, 2004, and February 19, 2004.
Id.
The Exchange believes that the proposed rule change will provide significant benefits. First, the Exchange believes that the proposed rule change will provide non-customers with more flexibility in the entry of orders by allowing them to enter orders of less than 10 contracts. It also will remove the burden on PMMs either to trade out small customer orders or derive size for such orders, which the Exchange believes will eliminate “small order baiting” manipulative conduct. At the same time, the Exchange will retain the obligation that market makers initially enter quotations for a size of at least 10 contracts. The Exchange believes that this is a necessary obligation for market makers to provide reasonable liquidity to the market place.
2. Statutory Basis
The ISE believes that the rule change is consistent with Section 6(b) of the Act in general and Section 6(b)(5) of the Act in particular. The Exchange believes that the proposed rule change is intended 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. Specifically, the Exchange believes that allowing EAMs to enter non-customer orders of less than 10 contracts will provide non-customers with greater flexibility to improve the ISE's BBO. Also, the Exchange believes that by allowing market makers to maintain quotations of less than 10 contracts, they can continue to provide investors with liquidity at their stated prices without having to refresh their quotations for 10 contracts at a potentially inferior price. Finally, the Exchange believes that eliminating the need for PMMs to “derive” quotations will eliminate opportunities for manipulative practices, such as “small order baiting.”
15 U.S.C. 78f(b)(5).
B. Self-Regulatory Organization's Statement on Burden on Competition
The proposed rule change does not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.
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 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date 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 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 amended proposal is consistent with the Act. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street NW., Washington, DC 20549-0609. Comments may also be submitted electronically at the following e-mail address: rule-comments@sec.gov. All comment letters should refer to File No. SR-ISE-2003-26. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, comments should be sent in hard copy or by e-mail, but not by both methods. 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 inspection and copying in the Commission's Public Reference Room. Copies of such filing will also be available for inspection and copying at the principal office of the ISE. All submissions should refer to File No. SR-ISE-2003-26 and should be submitted by April 7, 2004.
For the Commission, by the Division of Market Regulation, pursuant to delegated authority.
J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 04-5950 Filed 3-16-04; 8:45 am]
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