Self-Regulatory Organizations; Order Approving Proposed Rule Change and Amendment No. 1 by the International Securities Exchange LLC Relating to the Exposure of Orders on the Exchange

I. Introduction

On February 25, 2000, the International Securities Exchange LLC (“ISE” or “Exchange”) filed with the Securities and Exchange Commission (“SEC” or “Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”), and Rule 19b-4 thereunder, a proposed rule change relating to the exposure of orders on the Exchange.

The proposed rule change was published for comment in the Federal Register on March 6, 2000. The Commission received three comment letters regarding the proposal. On March 30, 2000, the ISE amended the proposed rule change. This order approves the proposed rule change, as amended.

II. Description of the Proposal

The ISE proposes to amend ISE Rule 717 to reduce from two minutes to 30 seconds the amount of time that Electronic Access Members (“EAMs”) are required to expose agency orders on the Exchange before executing them as principal or executing them against a solicited order. According to the ISE, its order exposure requirements are intended to assure that agency orders have an opportunity to interact on the Exchange before they are executed. The Exchange proposes to reduce the exposure time because it believes that the objective of the exposure rule can be satisfied by a 30 second exposure period.

III. Summary of Comments

The Commission received three comment letters on the proposal. These commenters opposed ISE's proposal to reduce the order exposure time from two minutes to 30 seconds. Commenters argued that the proposed reduction in response time would make it easier for ISE members to execute as principal orders for less than 50 contracts without meaningful opportunity for price improvement by competitors. The commenters contend that this would undermine the intended purpose of having customers' orders reasonably exposed to other trading interest before being executed by the facilitating ISE member. Two commenters agreed that two minutes is an appropriate time frame for this purpose, but that a 30 second exposure time would make it unlikely that interested market participants would have sufficient time to gauge their risk exposure in other markets and related positions, and reveal on the ISE their true “best” price.

Commenters stated that this proposal encourages internalization because it allows an EAM to execute orders as principal if it utilizes the facilitation mechanism of ISE Rule 716(d) or has been bidding or offering on the ISE for 30 seconds. Commenters noted that an EAM could easily internalize orders by, upon receiving a customer order, holding that order until the EAM has posted a bid or offer at this intended crossing price for 30 seconds, then executing the order as principal, effectively subverting the intent of the exposure period.

In response to commenters' objections to the proposed reduction in the exposure period from two minutes to 30 seconds, the ISE states that it believes 30 seconds is a sufficient time for participants in the ISE market to respond to an order, noting that the Commission has approved exposure times of as few as 15 seconds for certain equity exchanges. With regard to the sufficiency of the proposed 30 second exposure time, the ISE contends that a 30 second order exposure time is especially appropriate in light of the fact that floor-based exchanges have no limitation on how long a crowd must interact with a proposed crossing of orders, nor do floor-based exchanges have safeguards preventing a firm from negotiating with the crowd to execute against any and all of its customer orders, regardless of size. ISE states that, because it is an electronic marketplace, it must define some order exposure time period.

In response to the commenters' claim that members can subvert the 30 second requirement, ISE argues that the only exception to the 30 second exposure rule is the situation in which an EAM had disseminated proprietary trading interest on the ISE for at least 30 seconds prior to the customer order. In this case, according to ISE, the firm has disseminated trading interest, available to all customer orders, at the stated price, thus putting itself at risk to the public. Accordingly, ISE believes that execution of the EAM's own customer orders would not deprive the public of the opportunity to trade at the same prices. Moreover, ISE notes that a broker would not be permitted, under its rules, to simply delay entering an order into the system in order to circumvent the exposure rule.

In response to the commenters' internalization claims, ISE notes that that there is little opportunity for an EAM to be assured of executing against its own customer orders. Once customer orders are entered into the system, those limit orders that do not improve upon the ISE best bid or offer are placed into the ISE's electronic limit order book last in time priority behind any existing customer orders at the same price. Thus, the ISE argues, a given EAM would have no way of knowing whether the resulting increase in the best bid or offer (assuming the order matched the ISE best bid or offer) was due to its' customer's order, as opposed to other customer orders or interest from non-customers. In addition, the ISE maintains that its proposed amendment to ISE Rule 717(d) addresses the only real opportunity for internalization in its system: The narrow case where an EAM has a limit order that improves upon the ISE best bid or offer or a market order that it is willing to execute at an improved price. The ISE argues that the proposed 30 second delay required by its amendment will remove the informational advantage that makes internalization profitable and will provide other market participants an opportunity to compete for such orders.

Discussion

After careful review, the Commission find 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. In particular, the Commission finds the proposal is consistent with Section 6(b)(5) of the Act.

Under Section 6(b)(5) of the Act, a registered national securities exchange must have rules that are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, 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 finds that ISE's proposed amendments to ISE Rule 717(d) and (e) reducing the exposure time (i.e., the amount of time EAMs are required to expose agency orders on the Exchange before executing them as principal or against a solicited order) from two minutes to 30 seconds are consistent with Section 6(b)(5) of the Act. The Commission recognizes that, on floor-based exchanges, there are no rules that govern the extent to which a given trading crowd has an opportunity to interact with a proposed crossing of orders. Because the ISE operates a unique electronic options market, it must define an order exposure time period. The Commission finds that a 30 second exposure period is a reasonable time frame for participants in ISE's market to assess market conditions and their own trading interest, and to allow a reasonable opportunity for price improvement from interested participants. The Commission finds that a 30 second exposure period strikes a reasonable balance between maintaining liquidity and efficiency in the ISE market and preventing impediments to a free and open market, while providing the appropriate safeguards for investors and the public.

In determining that a 30-second exposure period is reasonable, the Commission has considered carefully the commenters' concern that market makers might be able to subvert the 30 second exposure period by posting bids or offers for a very short period of time, and arranging to receive agency orders simultaneously when they are executable against the market maker as principal, or against other agency orders held by the market maker. In such a scenario, EAMs allegedly would pre-screen order flow, and hold orders until they can be internalized, denying the order any exposure in the market and the opportunity for price improvement. The Commission is not persuaded by this argument. The ISE allows for only one exception to the 30 second exposure period, in the scenario where an EAM has previously disseminated proprietary trading interest on the ISE for at least 30 seconds prior to receipt of a customer order. Under this limited exception, a firm will have placed itself “at risk” to the public by having disseminated trading interest available to all customer orders at a stated price. ISE Rule 717(d) states that a member must have been bidding or offering on the Exchange for at least 30 seconds prior to receiving an agency order that is executable against such bid or offer. The Commission finds that an EAM's execution of its own customer order under this particular scenario would not deprive the public of the opportunity to trade at the same price.

The Commission also has considered carefully the commenters' concerns about the potential for internalization of order flow where there is a 30 second exposure period, and finds that the proposal provides sufficient safeguards against such activity. The ISE's system is designed to ensure that, once customer orders are entered into the system, any limit orders that do not improve upon the ISE best bid or offer automatically are placed into the ISE's electronic limit order book last in time priority behind any existing customer orders at the same price. Therefore, an EAM has no guarantee that it will be able to trade against its agency orders. Because ISE's system automatically provides reasonable safeguards to prevent EAMs from executing against their own customer orders, the Commission finds that a 30 second exposure period does not pose an unreasonable risk of increasing the internalization of order flow. For these reasons, the Commission finds that ISE's proposal is consistent with Section 6(b)(5) of the Act.

V. Conclusion

It Is Therefore Ordered, pursuant to Section 19(b)(2) of the Act, that the proposed rule change (SR-ISE-00-04), as amended, is approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authorty.