[Federal Register Volume 63, Number 210 (Friday, October 30, 1998)]
[Notices]
[Pages 58439-58442]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-29119]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-40598; File No. SR-PCX-97-48]
Self-Regulatory Organizations; Pacific Exchange, Inc.; Order
Approving Proposed Rule Change and Notice of Filing and Order Granting
Accelerated Approval of Amendment No. 2 to Proposed Rule Change
Relating to Market Maker Participation in the Pacific Exchange's
Automatic Execution System for Options (``Auto-Ex'')
October 23, 1998.
I. Introduction
On December 18, 1997, the Pacific Exchange, Inc. (``PCX'' or
``Exchange'') submitted to the Securities and Exchange Commission
(``SEC'' or ``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 which amended its rules relating
to market maker participation in the Exchange's automatic execution
system for options (``Auto-Ex''). On February 27, 1998, the Exchange
submitted Amendment No. 1 to the proposed rule change.\3\
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See letter from Michael D. Pierson, Senior Attorney,
Regulatory Policy, PCX, to Mignon McLemore, Attorney, SEC, dated
February 26, 1998 (``Amendment No. 1''). In Amendment No. 1, PCX
explains the disciplinary procedure under both the Minor Rule Plan
(``MRP'') and the Summary Sanction Procedure (``SSP'') and how ``the
wheel'' rotation operates.
---------------------------------------------------------------------------
A notice of the proposed rule change appeared in the Federal
Register on March 10, 1998.\4\ The Commission received no comment
letters addressing the proposed rule change. On October 7, 1998, the
Exchange submitted Amendment No. 2 to the proposed rule change.\5\ This
order approves the proposed rule change. Also, Amendment No. 2 is
approved on an accelerated basis.
---------------------------------------------------------------------------
\4\ Securities Exchange Act Rel. No. 39707 (March 3, 1998), 63
FR 11700.
\5\ See letter from Michael D. Pierson, Senior Attorney,
Regulatory Policy, PCX, to Mignon McLemore, Attorney, SEC, dated
October 6, 1998 (``Amendment No. 2''). In Amendment No. 2, PCX:
deletes a proposal made in the initial rule submission that would
have removed rule language stating that a market maker logged onto
Auto-Ex but who leaves the trading crowd is responsible for trades
allocated to him during his absence; provides PCX with the authority
to log a market maker off Auto-Ex if he has left the trading crowd
for more than a brief interval; and makes certain minor
clarifications regarding the operation of the proposal.
---------------------------------------------------------------------------
II. Description of the Proposal
Rules 6.87, 10.13, and 10.14 pertain to the Exchange's market maker
eligibility standards for participation in the Auto-Ex system. PCX has
proposed that a provision addressing joint accounts be added to Rule
6.87(d)(1) stating that participants in a joint account may log onto
Auto-Ex in a trading crowd outside of their primary appointment zones,
but only if they are substituting for another participant in the same
joint account, where participation in Auto-Ex trades at such station
would have been appropriate for the substituted party, and they have
obtained the approval of two Floor Officials.\6\ Moreover, the Exchange
is proposing to clarify this rule by stating that market makers who
have not been assigned a primary appointment zone may not participate
on the Auto-Ex system, and further, that all Auto-Ex transactions will
count toward a market maker's in person and primary appointment zone
requirements.
---------------------------------------------------------------------------
\6\ Floor Officials may exercise their discretion in determining
whether one market maker may substitute for another. Substitution is
usually only allowed when a market maker is on vacation or out sick.
However, there may be cases when the market maker being substituted
for may actually be on the floor but not in the joint account crowd.
Telephone call between Michael D. Pierson, Senior Attorney,
Regulatory Policy, PCX and Mignon McLemore, Attorney, SEC, August
24, 1998.
---------------------------------------------------------------------------
Rule 6.87(d)(3), as proposed, will require that, unless exempted by
two Floor Officials, market makers may log onto Auto-Ex only in person
and may continue on the system only so long as they are present in that
trading crowd. Moreover, absent an exemption from the foregoing
limitation, market makers may not remain on Auto-Ex, and must log off
when they have left the trading crowd, unless the departure is for a
brief interval (i.e., no longer than 15 minutes, under normal
circumstances).\7\
---------------------------------------------------------------------------
\7\ Compare Securities Exchange Act Rel. No. 38881 (July 28,
1997), 62 FR 41987 (August 4, 1997). The Philadelphia Stock
Exchange, Inc. amended Advice F-24 to state that Registered Options
Traders must sign-off the Wheel when leaving the Wheel assignment
area for more than a brief interval, which means five minutes or
less, or in matters of a dispute, the amount of time it takes to
call in a Floor Official and inform him of the issue at hand.
Compare CBOE Rules 24.16(c)(iii) (stating that any member of the
joint account that has been logged onto RAES must log off whenever
he leaves the SPX trading crowd for other than a brief interval) and
24.17(a)(iv) (stating that an individual member who is logged onto
RAES must log off whenever he leaves the trading crowd).
---------------------------------------------------------------------------
Proposed Rule 6.87(d)(4) will eliminate language which currently
states that if a market maker logs onto Auto-Ex during Expiration Week,
then he is required to remain on the system for the duration of that
Expiration Week. When the Auto-Ex rule was initially adopted, there was
some concern that there might be inadequate market maker participation
on Auto-Ex during Expiration Week. Based on several years' experience,
the Exchange now believes that there is no lack of market maker
participation on the Options Floor that justifies a need for the
Expiration Week requirement. If there is inadequate Auto-Ex
participation in a particular options issue,\8\ however, Floor
Officials have the authority to require market makers to log onto Auto-
Ex.\9\
---------------------------------------------------------------------------
\8\ In PCX Rules 6.87(d)(1), (2), (4), and (6) the term
``issue'' or ``option issue'' is used instead of or replaces the
term ``class.'' The Exchange believes that ``class'' does not
encompass all options of the underlying stock. Thus, for purposes of
this proposal, the term ``issue'' or ``option issue'' refers to all
types of option contracts (puts and calls) of the same class of
options covering the same underlying security. See Amendment No. 2,
note 5 supra.
\9\ PCX Rule 6.87(d)(6).
---------------------------------------------------------------------------
There are two limited situations, however, in which participation
in the Auto-Ex system is mandatory--both are proposed to be codified in
the rule. Under section (d)(4) of Rule 6.87, a market maker who has
logged onto Auto-Ex at any time during a trading day must participate
on the Auto-Ex system in that option issue whenever present in that
trading crowd during that trading day. Under subsection (d)(5), market
makers may not log off the Auto-Ex wheel during the first ten minutes
of a ``fast market'' \10\ that has been declared in an issue traded
``on that wheel,'' \11\ in the absence of an exemption from two Floor
Officials.
---------------------------------------------------------------------------
\10\ PCX Rule 6.28.
\11\ See note 33 infra.
---------------------------------------------------------------------------
PCX proposes that subsection (e) of Rule 6.87 be amended by adding
a provision specifically prohibiting market makers from ``directed
trading'' \12\ of option contracts resulting
[[Page 58440]]
from recent executions over Auto-Ex. The rule states that market makers
who receive an execution through Auto-Ex may not re-direct the option
contracts from that trade to another market maker without first giving
the other Members in the trading crowd an opportunity to participate.
---------------------------------------------------------------------------
\12\ ``Directed trading'' is a violation of Rule 6.73 (``Manner
of Bidding and Offering''), which provides in part: ``All bids and
offers shall be general ones and shall not be specified for
acceptance by particular members.''
---------------------------------------------------------------------------
Subsection (f) of Rule 6.87, as proposed, adds a provision on price
adjustments to codify procedures outlined in the Exchange's initial
proposal to conduct the POETS pilot.\13\ The Commission permanently
approved the pilot in 1993.\14\ The provision states that due to
instantaneous execution, an incorrect quote appearing on the screen may
result in an Auto-Ex trade at an incorrect price, and that an Auto-Ex
trade executed at an erroneous quote should be treated as a trade
reported at an erroneous price. It also states that the price of the
Auto-Ex trade should be adjusted to reflect accurately the market quote
at the time of execution, and that this will result in public customers
and market makers receiving correct files at prevailing market quotes
through Auto-Ex. It further states that the determination as to whether
an Auto-Ex trade was executed at an erroneous price is to be made by
two Floor Officials, and that in making their determination, the Floor
Officials should consider such factors as: (1) The length of time the
allegedly incorrect quote was displayed; (2) whether any non-Auto-Ex
trades were effected at the same price as the Auto-Ex transaction; and
(3) whether any members of the trading crowd were aware of orders
actively being represented in the trading crowd that appear to have
been ``printed through'' by the Auto-Ex trade.\15\
---------------------------------------------------------------------------
\13\ Securities Exchange Act Rel. No. 27423 (November 6, 1989),
54 FR 47434 (November 14, 1989) (notice proposing to conduct POETS
pilot) at Exhibit 4.
\14\ Securities Exchange Act Rel. No. 32703 (July 30, 1993), 58
FR 42117 (August 6, 1993).
\15\ Compare CBOE Rule 24.15 (a)(ii) (stating that a trade
executed on RAES at an erroneous quote should be treated as a trade
reported at an erroneous price and adjusted to reflect the accurate
market after receiving a Floor Official's approval).
---------------------------------------------------------------------------
Finally, Rules 10.13 and 10.14 have been amended to expressly
outline the fines to be levied and disciplinary measures to be taken in
the event of noncompliance with the log-off requirement established in
Rule 6.87(d)(3). A market maker who fails to comply with the log-off
requirement will be subject to the following fines under the Exchange's
MRP.\16\ If the number of failures is between one and two during a
twelve-month period, the fine is $100 per violation; for between three
and five failures in a twelve-month period, the fine is $250 per
violation; and for six or more failures in a twelve-month period, the
fine is $500 per violation.\17\ The Exchange's SSP \18\ has also been
amended to incorporate violations of the log-off requirement. Under the
relevant procedures, two Floor Officials may summarily fine a Member
for a designated rule violation if certain procedures are followed.
---------------------------------------------------------------------------
\16\ PCX Rule 10.13.
\17\ Compare CBOE Rules 24.16(h) and 24.17(g) and Phlx Rule 970
and Floor Procedure Advice F-24 (fee schedules for failure to adhere
to log on and off requirements).
\18\ PCX Rule 10.14.
---------------------------------------------------------------------------
III. Discussion
The Commission believes that the proposed rule change is consistent
with the Act and the rules and regulations promulgated thereunder.
Specifically, the Commission believes that approval of the proposed
rule change is consistent with Section 6(b)(5) \19\ of the Act.\20\
Pursuant to Section 6(b)(5), the proposed rule change benefits the
public because refining the eligibility criteria to reflect the actual
trading environment of the Exchange should improve the operation of the
POETS system, thereby contributing to the maintenance of fair and
orderly markets and the protection of investors. The Commission
believes that the proposal should help to ensure adequate market maker
participation in Auto-Ex, which should, in turn, contribute to the
effective and efficient execution of public investor orders at the best
available price.
---------------------------------------------------------------------------
\19\ Section 6(b)(5) requires the Commission to determine that a
registered national securities exchange's rules are designed to
promote just and equitable principles of trade, and, in general, to
protect investors and the public interest.
\20\ Pursuant to Section 3(f) of the Act, the Commission has
considered the proposed rule's impact on efficiency, competition,
and capital formation. The changes made to the eligibility criteria
should provide depth to the market by ensuring that a contra-party
is available to interact with the customers' orders. This added
depth should result in faster customer trade executions, thus
improving efficiency in the marketplace. This added depth to the
Auto-Ex system should also promote competition. As these trades are
executed at the NBBO, the market maker receives the spread on these
transactions, which should provide incentive for market makers to
participate in the system. 15 U.S.C. 78c(f).
---------------------------------------------------------------------------
The Commission believes the proposed joint account provision will
provide more continuity and depth to the Auto-Ex system as the
eligibility criteria have been expanded to allow a market maker to
participate outside his appointment zone under the limited circumstance
where he is substituting for another market maker in the same joint
account. The Commission understands that the purpose of this rule is to
allow a market maker to participate in a joint account that may be
outside his primary appointment zone when the other joint account
participant is unavailable to participate. For example, if the market
maker is on vacation or out sick, he would be deemed unavailable and
substitution, in these cases, would be allowed.\21\
---------------------------------------------------------------------------
\21\ Telephone call between Michael D. Pierson, Senior Attorney,
Regulatory Policy, PCX and Mignon McLemore, Attorney, SEC, August
24, 1998.
---------------------------------------------------------------------------
The Commission believes that PCX's proposed codification of Auto-Ex
log-on and log-off procedures should clarify the responsibilities and
duties of market makers and Floor Officials. The Commission notes that
the proposal should prevent inequities that can occur in the system if
wheel-assigned trades are allocated to market makers, who are logged on
the system, but not in the trading crowd. While current market maker
participation levels appear to make the mandatory log-on requirement
during Expiration Week obsolete, the Commission suggests that the
Exchange monitor participation levels, especially during market
declines and if necessary, exercise its authority to ensure substantial
participation.
The Commission believes extending the ``directed trading'' \22\
prohibition to transactions executed over Auto-Ex will promote just and
equitable principles of trade, as every member in the trading crowd
will be given an opportunity to participate in the transactions.
Moreover, extending the prohibition of directed trading to Auto-Ex
transactions should serve as a deterrent to price collusion as a market
maker cannot designate one member in the trading crowd to accept
certain bids and offers.
---------------------------------------------------------------------------
\22\ PCX Rule 6.73.
---------------------------------------------------------------------------
The Commission believes the addition of the provision on price
adjustments provides the Exchange with the flexibility to quickly
correct an Auto-Ex trade, if two Floor Officials determine that it was
executed at an incorrect price. The rule's procedures protect the
public customer and market maker by ensuring that once an erroneous
quote has been detected, their orders are filled according to
prevailing market quotes through Auto-Ex. Moreover, the rule provides
objective criteria for the Floor Officials to use in determining
whether an Auto-Ex trade was executed at an erroneous price, which
should assist them in determining if and when price adjustments should
be made. Furthermore, this provision codifies similar procedures
originally outlined in the POETS pilot, \23\ which was subsequently
approved in 1993.\24\
---------------------------------------------------------------------------
\23\ See note 13 supra.
\24\ See note 14 supra.
---------------------------------------------------------------------------
[[Page 58441]]
The Commission believes that the Exchange's proposed changes to its
minor rule plan are reasonable and provide fair procedures for
appropriately disciplining members and member organizations for minor
rule violations that warrant some type of punitive measure, but for
which a full disciplinary hearing would be an inappropriate waste of
resources in light of the minor nature of the violation. The Commission
notes that violations of the Exchange's log-off requirement are
objective and easily verifiable, and thus, lend themselves to the use
of expedited proceedings. Specifically, the issue of whether a market
maker has left the trading crowd for more than the fifteen minute
interval may be determined objectively and adjudicated quickly without
complicated evidentiary and interpretive inquiries. The Commission
believes that the proposed fine schedule and the SSP should serve to
encourage consistent market maker participation in Auto-Ex and to deter
repeated violations of the Exchange's rules.
The Commission was initially concerned, however, that the
Exchange's amended fine schedules and disciplinary procedures might
cause a member to be found in violation of Rule 6.87(d)(3) and fined
under both the MRP and the SSP. In response, the Exchange states that
its Department of Options Compliance coordinates the processing of all
violations committed on the Options Floor under both the MRP and the
SSP.\25\ Amendment No. 1 further states that before any summary
sanction is issued, Floor Officials must contact Options Compliance to
determine whether the Member has previously violated the rule, so that
the amount of the sanction may be assessed. Options Compliance
therefore, will have been notified of the action taken. In addition, if
Floor Officials issue a sanction under the SSP, the floor citation must
contain an indication of the amount of the fine pursuant to Rule
10.14(a)(3). This indication will serve to notify Options Compliance
that the matter has been resolved.
---------------------------------------------------------------------------
\25\ See Amendment No. 1, note 3 supra.
---------------------------------------------------------------------------
IV. Commission's Findings and Order Granting Accelerated Approval
of Amendment No. 2
The Commission has reviewed carefully the Exchange's Amendment No.
2 and believes, for reasons set forth below, the amendment is
consistent with the requirements of Section 6 of the Act,\26\ and the
rules and regulations thereunder applicable to a national securities
exchange.\27\ Specifically, the Commission believes the amendment is
consistent with Section 6(b)(5) \28\ of the Act, because it will
facilitate the operation of the Auto-Ex system, which will promote just
and equitable principles of trade, foster cooperation and coordination
with persons engaged in regulating, clearing and settling, and
processing information with respect to facilitating transactions in
securities.
---------------------------------------------------------------------------
\26\ 15 U.S.C. 78f.
\27\ See note 20 supra.
\28\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------
The joint account provision in Rule 6.87(d)(1) attempted to clarify
that all Auto-Ex transactions would count toward a market maker's in-
person and primary appointment zone requirements. (emphasis added) The
Commission believed this language could have been misinterpreted to
mean all Auto-Ex transactions, including those in joint accounts, would
count toward the primary appointment zone requirement, even those
transactions in options issues \29\ which were not assigned to the
market maker's primary appointment zone. Amendment No. 2 clarifies that
if an option issue is included in a market maker's primary appointment
zone, then Auto-Ex transactions in that issue that are made on behalf
of the market maker will count towards the market maker's primary
appointment zone requirement.\30\
---------------------------------------------------------------------------
\29\ See note 8 supra.
\30\ See Amendment No. 2, note 5 supra.
---------------------------------------------------------------------------
In the originally submitted proposed rule change, the Exchange
proposed eliminating language in Rule 6.87(d)(3) that holds market
makers responsible for trades executed through Auto-Ex during their
absence from the trading crowd as well as for all Auto-Ex-eligible
issues assigned to the particular wheel.\31\ The Exchange failed to
provide any written justification for this proposed change. Upon the
request of Commission staff, PCX agreed to withdraw this proposed
change.
---------------------------------------------------------------------------
\31\ See note 33 infra.
---------------------------------------------------------------------------
In Amendment No. 2, the Exchange proposed giving itself the
authority to log a market maker off Auto-Ex if a market maker has left
the trading crowd or floor for more than a brief interval.\32\ This
provision is consistent with the requirement that only market makers
physically present in the trading crowd are entitled to trade on Auto-
Ex. It may also help reduce unintended position exposure that can be
incurred by a market maker who mistakenly forgets to log off Auto-Ex.
---------------------------------------------------------------------------
\32\ See Amendment No. 2, p. 1, note 5 supra.
---------------------------------------------------------------------------
The proposed requirement in Rule 6.87(d)(3) that the market maker
be obligated to honor trades executed through Auto-Ex for all Auto-Ex
eligible issues assigned to the particular wheel has been removed,
because the wheel no longer operates as it did when this requirement
was initially promulgated. According to Amendment No. 2, each morning
before the opening, the system will ``shuffle'' the order of market
makers on an issue-by-issue basis. For example, the order of the market
makers may be A, B, C for issue no. 1 and A, B, C for issue no. 2, etc.
The first Auto-Ex trade of the day will be assigned at random for each
issue (e.g., in issue no. 1, the first trade may be assigned to C), but
each subsequent trade will be assigned in order, on a rotating basis
(e.g., A, B, C, A, B, C, etc.). The same procedure is followed for each
issue, so in effect, the number of issues assigned to a post determines
the number of ``wheels'' at that post. Each wheel rotates separately
from the others and trades in one issue will have no impact on the
order in which trades are assigned in another issue at the same
post.\33\
---------------------------------------------------------------------------
\33\ Id. at p. 2. This explanation supersedes the previous
explanation provided in Amendment No. 1. See Amendment No. 1, note 3
supra.
---------------------------------------------------------------------------
Furthermore, the Auto-Ex system also allow issues at a trading post
to be split up among the crowd.\34\ For example, A may only be on Auto-
Ex for issues 1 and 2, while B and C may be on the system for issues 3
through 10. \35\ Therefore, because a market maker may not be assigned
all of the issues at a particular trading post, the language obligating
market makers ``to honor trades for all Auto-Ex eligible issues
assigned to a particular wheel'' is inaccurate and misleading, given
how the wheel operates. Thus, the language has been removed.\36\
---------------------------------------------------------------------------
\34\ See Amendment No. 2, p. 2, note 5 supra.
\35\ Id.
\36\ Id.
---------------------------------------------------------------------------
The Commission finds good cause for approving proposed Amendment
No. 2 prior to the thirtieth day after the date of publication of
notice of filing thereof in the Federal Register. Amendment No. 2
addresses a Commission concern that a market maker will not be able to
circumvent the primary appointment zone requirements by using
transactions in a joint account not in his primary appointment zone to
meet his participation requirements. Thus, the joint account must be in
the substituting market maker's primary appointment zone for the
transactions to count toward his appointment zone requirements. The
Commission was also concerned that the proposed rule change did not
address the possibility of
[[Page 58442]]
collusion or manipulation of a security if both participants were
simultaneously logged-on and trading in the joint account. PCX Rule
6.40(b)(1), however, addresses this concern because it prevents a
market maker who has a financial arrangement with another member from
trading in the same trading crowd at the same time.
The Commission believes that PCX's removal of originally proposed
rule language that held market makers accountable for their failure to
follow established procedures was antithetical to its investor
protection mandate. The Commission understands the Exchange's desire to
address potential inequitable benefits and system disruptions that
could occur if a market maker fails to follow procedure. However,
removing existing language that could arguably serve as a deterrent to
these violations was, in the Commission's view, inappropriate.
Amendment No. 2 was responsive to this concern by retracting the
proposed elimination of the cited language. The Exchange proposed an
alternate provision that allows it to log a market maker off the system
when a failure to follow the required log-off procedure occurs. This
proposal strengthens the ability of PCX to enforce compliance with
Auto-Ex procedures and, accordingly, the Commission finds good cause
for accelerating approval of the proposed amendment.
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing, including whether Amendment No. 2
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. 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 PCX. All
submissions should refer to the file number in the caption above and
should be submitted by November 20, 1998.
V. Conclusion
For the above reasons, the Commission believes that the proposed
rule change is consistent with the provisions of the Act, and in
particular with Section 6(b)(5).
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\37\ that the proposed rule change (SR-PCX-97-48), including
Amendment No. 2, is approved.
\37\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\38\
---------------------------------------------------------------------------
\38\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-29119 Filed 10-29-98; 8:45 am]
BILLING CODE 8010-01-M