Self-Regulatory Organizations; Order Granting Approval of Proposed Rule Change by the Philadelphia Stock Exchange, Inc. Relating to the Maximum Size of Option Orders That May Be Executed Automatically

I. Introduction

On August 23, 1999, the Philadelphia Stock Exchange, Inc. (“Phlx” 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 amending its rules regarding the automatic execution of options orders to increase the maximum number of contracts eligible to be executed on the Exchange's automatic execution system (“AUTO-X”) from fifty contracts to seventy-five contracts. On September 27, 1999 and January 23, 2000, respectively, the Phlx submitted Amendments Nos. 1 and 2 to the proposed rule change. Notice of the proposal was published in the Federal Register on June 21, 2000. The Commission received no comments on the proposal. This order approves the proposal.

II. Description of the Proposal

The AUTO-X feature of the Exchange's Automated Options Market System (“AUTOM”) automatically executes public customer market and marketable limit orders in options at the Exchange's displayed bid or offer. Generally, public customer market and marketable limit orders of up to fifty contacts may be automatically executed through AUTO-X. Orders are routed through AUTOM from member firms directly to the appropriate specialist on the trading floor. Orders routed through AUTOM that are eligible for AUTO-X are automatically executed at the disseminated quotation price on the Exchange and reported back to the originating firm.

The Exchange proposes to amend Phlx Rule 1080(c) to increase the maximum order size eligibility for automatic execution through AUTO-X from fifty contracts to seventy-five contracts. The Exchange represents that AUTO-X affords prompt and efficient automatic executions at the displayed price and therefore believes that increasing automatic execution levels will provide the benefits of automatic execution to a larger number of customer orders. Further, the Exchange notes that this increase from fifty contracts to seventy-five contracts is in line with prior changes to AUTO-X levels.

The Exchange represents that its rules contain several safeguards to ensure the proper handling of AUTO-X orders. First, Phlx Rule 1080(f)(iii) states that a specialist is responsible for the remainder of an AUTOM order where a partial execution has occurred. Phlx Rule 1015 governs quotation guarantees and requires the trading crowd to ensure that public customer orders are filled at the best market for a minimum of ten contracts (“ten-contract guarantee”). Further, Options Floor Procedure Advice F-7 provides that the volume guarantees (including AUTO-X levels) are deemed to be the stated size in any bid or offer voiced or displayed on the Options Floor. Therefore, quoted markets are guaranteed up to that size. The Exchange represents that violations of any of these provisions could be referred to the Business Conduct Committee for disciplinary action.

Second, the Exchange represents that Registered Options Traders (“ROTs”) have discretion to participate on the Wheel that allocates AUTO-X trades. Consequently, an increase in the maximum AUTO-X order size does not prevent an ROT from declining to participate on the Wheel. The Exchange represents that the Wheel operates by rotating in two-lot to ten-lot increments depending upon the size of the order, and thus no single ROT will be allocated the entire seventy-five contracts.

Third, the Exchange represents that its procedures allow a specialist to disengage AUTO-X in extraordinary circumstances, and that AUTOM users will be notified of such situations. For example, in extraordinary (fast market) conditions, quotations are disseminated with an “F” and the ten-contract guarantee on the screen markets is suspended pursuant to Options Floor Procedure Advice F-10.

Finally, the Exchange notes that its rules provide a minimum net capital requirement for ROTs. In addition, a ROTs clearing firm performs risk management functions to ensure that the ROT has sufficient financial resources to cover positions throughout the day. In this regard, the function includes real-time monitoring of positions. Further, the Exchange represents that it believes that clearing firm procedures address concerns regarding whether an ROT has the financial capability to support trading of options orders a large as seventy-five contracts.

The Exchange represents that it believes that automatic execution of orders for up to seventy-five contracts will provide customers with quicker, more efficient executions for a larger number of orders, by providing automatic rather than manual executions, thereby reducing the number of orders subject to manual processing. Further, the Exchange represents that increasing the AUTO-X maximum order size should not impose a significant burden on operation or capacity of the AUTOM System and will give the Exchange better means of competing with other options exchanges for order flow.

III. Discussion

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 and, in particular, the requirements of Section 6 of the Act. Among other provisions, section 6(b)(5) of the Act requires that the rules of an exchange be designed to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating securities transactions; remove impediments to and perfect the mechanism of a free and open market and a national securities system; and protect investors and the public interest.

While increasing the maximum order size limit from fifty contracts to seventy-five contracts for AUTO-X eligibility by itself does not raise concerns under the Act, the Commission believes that this increase raises collateral issues that the Phlx will need to monitor and address. Increasing the maximum order size for particular option classes will make a larger number of option orders eligible for the Exchange's automatic execution system. These orders may benefit from greater speed of execution, but at the same time create greater risks for market maker participants. Market makers signed onto the AUTO-X system will be exposed to the financial risks associated with larger-sized orders being routed through the system for automatic execution at the displayed price. When the market for the underlying security changes rapidly, it may take a few moments for the related option's price to reflect that change. In the interim, customers may submit orders that try to capture the price differential between the underlying security and the option. The larger the orders accepted through AUTO-X, the greater the risk market makers must be willing to accept. The Commission does not believe that, because the Exchange's Options Committee determines to approve orders as large as seventy-five contracts as eligible for AUTO-X, the Options Committee or any other Phlx committee or officials should disengage AUTO-X more frequently by, for example, declaring a “fast” market. Disengaging AUTO-X can negatively affect investors by making it slower and less efficient to execute their option orders. It is the Commission's view that the Exchange, when increasing the maximum size of orders that can be sent through AUTO-X, should not disadvantage all customers—the vast majority of which enter orders for less than seventy-five contracts—by making the AUTO-X sytstem less reliable.

IV. Conclusion

For the foregoing reasons, the Commission finds that the proposed rule change is consistent with the Act and the rules and regulations thereunder applicable to a national securities exchange, and, in particular, with section 6(b)(5).

It Is Therefore Ordered, pursuant to section 19(b)(2) of the Act, that the proposed rule change (SR-Phlx-99-32) is approved.

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