Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the Chicago Board Options Exchange, Inc., Relating to the Operation of the Retail Automatic Execution System

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 July 29, 1999, the Chicago Board Options Exchange, Inc. (“CBOE” or “Exchange”) filed with the Securities and Exchange Commission (“SEC” or “Commission”) the proposed rule change as described in Items I, II and III below, which Items have been prepared by CBOE. The proposal permits the appropriate CBOE Floor Procedure Committee (“FPC”) to implement a new order assignment procedure for the Exchange's Retail Automatic Execution System (“RAES”). The new RAES order assignment procedure is called “100 Spoke RAES Wheel.” On January 27, 2000, the Exchange filed Amendment No. 1 to the proposed rule change. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change

The CBOE proposes to amend its rules governing the operation of RAES, as set forth below. Proposed new language is in italics.

RAES Operations

This Rule governs RAES operations in all classes of options, except to the extent otherwise expressly provided in this or other Rules in respect of specified classes of options.

RULE 6.8.

(a)-(g) No change.

...Interpretations and Policies

.01-.05 No change.

.06(a) In the exercises of the their authority to determine the procedure for assigning RAES-eligible orders to Participating Market-Makers for execution, the appropriate FPCs have determined that in the absence of any specified alternative assignment methodology, an assigned Participating Market-Maker is required to buy/sell the entirety of each RAES order assigned to him up to the maximum size of RAES-eligible orders in that class of options. Alternatively, the appropriate FPC may specify that some or all options classes are subject to “Variable RAES” or to the “100 Spoke RAES Wheel.”

(b) No change.

(c) Under the “100 Spoke RAES Wheel,” RAES orders would be assigned to logged-in market-makers according to the percentage of their in-person agency contracts traded in that class (excluding RAES contracts traded) compared to all of the market-maker in-person agency contracts traded (excluding RAES contracts) during the review period. The review period will be determined by the appropriate Floor Procedure Committee and may be for any period not in excess of two weeks. The percentage distribution determined during the review period will be effective for the succeeding review period. On each revolution of the RAES Wheel, subject to the exceptions described below, each participating market-maker (who is logged onto RAES at the time) will be assigned enough contracts to replicate his percentage of contracts on RAES that he traded in-person in that class during the review period. A participation percentage will be calculated for each market-maker for each class that the market-maker trades. For this purpose all DPM Designees of the same DMP unit will have their percentage aggregated into a single percentage for the DPM unit.

Once a market-maker has logged onto RAES, he will be assigned contracts on the RAES Wheel until his market-maker participation percentage has been met. This may mean that multiple orders (or an order and a part of the succeeding order) will be assigned to the same market-maker on the Wheel. To understand how the RAES orders will actually be allocated to market-makers to meet those percentages, one must understand the concepts of “spokes” and wedges.'' A “spoke” is 1% of the RAES Wheel and often may be equal to one contract. The appropriate Floor Procedure Committee may determine the number of contracts that make up one spoke. Each market maker logged onto RAES for that class, regardless of his participation percentage, is entitled to be assigned at least one spoke on every revolution of the RAES Wheel. For example, if a spoke equals one contract then there will be 100 spokes that will be assigned to market-makers on every revolution of the RAES Wheel. If a spoke is defined as five contracts then there will be 500 RAES contracts assigned to the participating market-makers before the RAES Wheel completes one revolution. Generally, the RAES Wheel will consist of the number of spokes replicating the cumulative percentage of all market-makers logged onto the system who have a participation percentage plus one spoke for each market-maker that does not have a specific participation percentage.

A wedge is the maximum number of spokes that a market-maker may be consecutively assigned at any one time of the RAES Wheel. Because the size of the wedge may be smaller than the number of contracts to which a particular market-maker is entitled during one revolution of the RAES Wheel, that market-maker will receive more than one turn during one revolution of the RAES Wheel. The wedge size will be variable, at the discretion of the appropriate Floor Procedure Committee and may be different for different classes or the same for all classes.

The appropriate Floor Procedure Committee will notify the membership of each class of options that it subject to the “100 Spoke RAES Wheel”.

(d) No change.

II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, CBOE 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. CBOE has prepared summaries, set forth in Section 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 grant the appropriate FPC authority to institute a new procedure for assigning orders on RAES to individual market makers. This new procedure is referred to as the “100 Spoke RAES Wheel.”

a. Background. CBOE FPCs currently have two options by which to allocate RAES orders: The “entire-order” procedure and Variable RAES. Under the entire order procedure, RAES orders are assigned to market makers participating on RAES one order at a time to the market maker next in line on the “RAES Wheel.” When a particular market maker reaches his turn on the RAES Wheel, the market maker is assigned one entire order whether the order is for one contract or for the maximum number of contracts eligible for entry into RAES for that particular class of options. By contrast, under Variable RAES, for each class of options in which a market maker participates in RAES, that market maker is required to designate the maximum number of contracts that he is willing to buy or sell each time it is his turn on the RAES Wheel. Additionally, the appropriate FPC may establish a minimum number of contracts which a market maker must be willing to accept. CBOE represents that its FPCs now employ Variable RAES for equity options and both narrow-based and broad-based index options. The current proposal provides the appropriate FPC with a third choice for apportioning RAES trades among participating market makers.

b. The ‘“100 Spoke RAES Wheel”. Under the “100 Spoke RAES Wheel,” RAES orders would be assigned to logged-in market makers according to the percentage of their in-person agency contracts traded in that class (excluding RAES contracts traded) compared to all of the market maker in-person agency contracts traded (excluding RAES contracts) during the review period. Agency contracts are defined as contracts that are represented by an agent and do not include contracts traded between market makers in person in the trading crowd. CBOE represents that in-person agency contracts include trading by a market maker against an order represented by a broker in the trading crowd, or against a booked order, but do not include contracts traded on RAES.

On each revolution of the RAES Wheel, subject to the exceptions described below, each participating market maker (who is logged onto RAES at the time) will be assigned enough agency contracts to replicate the percentage of contracts on RAES that he traded in-person in that class during the review period. The appropriate FPC will determine the review period but in no event will it be entitled to set the review period for a period greater than two weeks. A participation percentage will be calculated for each market maker for each class that the market maker trades. The percentage distribution determined during a review period will be effective for the succeeding review period. Thus, any new market maker entrant in the trading crowd will earn his percentage entitlement for RAES trades after spending no more than two weeks in the crowd. During the initial review period, a new market maker will receive a one-spoke entitlement. All designees of the same Designated Primary Market Maker (“DPM”) unit will have their percentage aggregated into a single percentage for the DPM unit. Because of this methodology, the DPM unit can still receive its entitled percentage even if any particular designee is not logged onto RAES at the time.

Once a percentage has been determined for a particular market maker, to understand how the RAES orders will actually be allocated to market makers to meet those percentages, one must understand the concepts of “spokes” and “wedges.” The RAES Wheel may be envisioned as having a number of “spokes,” each generally representing 1% of the total participation of all market makers in the class. That is, a market maker generally will be assigned one spoke for each 1% of his market maker participation during the review period. If all market makers who are active during the review period are logged on to RAES and no other makers are logged on, the RAES Wheel will consist of 100 spokes, representing 100% of all market maker activity during the review period. Normally, one spoke on the Wheel will be equivalent to one contract, except that the appropriate FPC may establish a larger spoke size. For example, setting the spoke size to five contracts would redefine the RAES Wheel for a particular option class as a Wheel of 500 contracts. Changing the spoke size (and thus, the Wheel size) does not change the participating percentages of the individual market makers.

For example, if there are twelve market makers in a crowd, consisting of ten veteran market makers each of whom accounted for 10% of total market trading (exclusive of RAES trades) during the review period, and two new market makers, and if nine of the veteran market makers and both of the new market makers are logged on to RAES, the RAES Wheel will consist of 92 spokes (10 spokes for each of the nine veteran market makers, and one spoke for each of the two new market makers), accounting for 92 contracts in a complete revolution of the Wheel. In this case, each of the veteran market makers will participate in ten out of every 92 contracts traded on RAES, and the two new market makers will each receive one out of every 92 contracts.

A wedge is the maximum number of spokes that may be assigned to a market maker in any one “hit” during a rotation of the RAES Wheel. The concept of the wedge is to break up the distribution of contracts into smaller groupings in order to reduce the exposure of any one market maker to market risk. If the size of the wedge is smaller than the number of spokes to which a particular market maker may be entitled based on his participation percentage, that market maker will be assigned more than once during one revolution of the RAES Wheel. For example, in the case where one spoke is equal to one contract and the market maker's participation percentage is 15% (so he is entitled to 15 contracts on one RAES Wheel revolution, i.e., 15% of 100) and the wedge size is 10, that market maker first will be assigned 10 contracts on the RAES Wheel and then 5 contracts at a different place on the RAES Wheel during that same revolution. Thus, in one complete revolution of the RAES Wheel, he will be assigned two times for at total of 15 contracts (assuming one contract per spoke), consisting of one 10-contract assignment and one 5-contract assignment. The wedge size will be variable at the discretion of the appropriate FPC and may be established at different levels for different classes, or at the same level for all classes.

Trade Example. To better understand how RAES contracts would be assigned under the “100 Spoke RAES Wheel,” the Exchange provides the following example. Assume ten market makers (“MM”) are logged into option class ABC with the following participation percentages: MM1=14%; MM2-1%; MM3=8%; MM4=24%; MM5=8%; MM6=5%; MM7=3%; MM8=2%; MM9=12%; MM10=23%.

Now assume the maximum number of contracts that any market maker may receive during one turn on the Wheel, i.e., wedge size, is ten contracts. Assuming the Wheel starts with MM1 and spoke size is equal to 1 contract, the distribution of RAES contracts during one revolution of the RAES Wheel for class ABC will look as follows:

1. MM1 assigned 10 contacts

2. MM2 assigned 1 contact

3. MM3 assigned 8 contact

4. MM4 assigned 10 contacts

5. MM5 assigned 8 contracts

6. MM6 assigned 5 contracts

7. MM7 assigned 3 contracts

8. MM8 assigned 2 contracts

9. MM9 assigned 10 contracts

10. MM10 assigned 10 contracts

11. MM1 assigned 4 contracts

12. MM4 assigned 10 contracts

13. MM9 assigned 2 contracts

14. MM10 assigned 10 contracts

15. MM4 assigned 4 contracts

16. MM10 assigned 3 contracts

As can be seen, market makers 1 and 9 receive two turns on the Wheel during one revolution because their entitlement was higher than the wedge size. Market makers 4 and 10 receive three turns on the Wheel during one revolution.

The following example demonstrates how the orders of a particular size will be distributed under the scenario described above,

Order 1=20 contracts: Contra distribution is MM1=10 contracts; MM2=1; MM3=8; MM4=1

Order 2=4 contracts: Contra distribution is MM4=4 contracts

Order 3=20 contracts: Contra distribution is MM4=5 contracts; MM5=8; MM6=5; MM7=2

Order 4=20 contracts: Contra distribution is MM7=1 contract; MM8=2; MM9=10; MM10=7

Order 5=20 contracts: Contra distribution is MM10=3 contracts; MM1=4; MM4=10; MM9=2; MM10=1

d. Benefit of the Proposed Distribution Via the 100 Spoke RAES Wheel. CBOE believes that, in those classes where the 100 Spoke RAES Wheel is employed, the distribution of RAES trades will be essentially identical to the distribution of in-person agency market maker trades on non-RAES trades in that class. CBOE further believes that the implementation of the 100 Spoke RAES Wheel will reward those market makers who are most active in providing the services that a market maker is expected to perform, i.e., providing liquidity to agency business in the assigned option class.

2. Statutory Basis

CBOE believes that the proposed rule change will enhance the ability of the Exchange to provide instantaneous, automatic execution of public customers' orders at the best available prices, which furthers the objectives of Section 6(b)(5) of the Exchange Act 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 to protect investors and the public interest.

B. Self-Regulatory Organization's Statement on Burden on Competition

CBOE does not believe that the proposed rule change will result in 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

Written comments were neither solicited nor received.

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 the 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. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. 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 at the Commission's public Reference Room. Copies of such filing will also be available for inspection and copying at the principal office of the CBOE.

All submissions should refer to File No. SR-CBOE-99-40 and should be submitted by [insert date 21 days from date of publication].