

[Federal Register: February 10, 2006 (Volume 71, Number 28)]
[Notices]               
[Page 7089-7095]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr10fe06-127]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53222; File No. SR-CBOE-2005-60]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Granting Approval of Proposed Rule Change and 
Amendment No. 1 Thereto and Notice of Filing and Order Granting 
Accelerated Approval to Amendment No. 2 to the Proposed Rule Change 
Relating to an Automated Improvement Mechanism

February 3, 2006.

I. Introduction

    On August 5, 2005, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``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 to adopt an electronic price 
improvement mechanism. On September 2, 2005, the Exchange filed 
Amendment No. 1 to the proposed rule change.\3\ The proposed rule 
change, as amended, was published for comment in the Federal Register 
on October 18, 2005.\4\ On October 12, 2005, the Exchange filed 
Amendment No. 2 to the proposed rule change.\5\ The Commission received 
two comment letters with respect to the amended proposal,\6\ and on 
December 2, 2005, the Exchange filed its response to the comment 
letters.\7\ This order approves the proposed rule change as amended by 
Amendment No. 1, notices and solicits comments on Amendment No. 2, and 
grants accelerated approval to Amendment No. 2.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 1 superseded and replaced the proposed rule 
filing in its entirety.
    \4\ See Securities Exchange Act Release No. 52577 (October 7, 
2005), 70 FR 60586.
    \5\ In Amendment No. 2, the CBOE proposes to amend proposed CBOE 
Rule 6.74A(b)(1)(E) so that members, not floor brokers, may submit 
RFR responses on behalf of customer orders resting at the top of the 
Exchange book. Amendment No. 2 also would amend proposed CBOE Rule 
6.74A.06 with respect to information that the Exchange may provide 
to the Commission regarding a pilot program that would end on July 
18, 2006.
    \6\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Matthew B. Hinerfeld, Managing Director & Deputy General Counsel, 
Citadel Investment Group, LLC on behalf of Citadel Derivatives Group 
LLC (``Citadel''), dated November 8, 2005 (``Citadel Letter'') and 
from Annah Y. Kim, Chief Regulatory Officer, Boston Options Exchange 
Regulation (``BOX''), dated November 10, 2005 (``BOX Letter''). 
Citadel also commented on the American Stock Exchange LLC's 
(``Amex'') proposal to implement the Amex New Trading Environment 
Price Improvement Auction (``PIA'') (File No. SR-Amex-2004-107). 
This Order and Notice does not address the Amex proposal. A 
discussion of the comment letters is provided in section III below.
    \7\ See letter from Angelo Evangelou, Managing Senior Attorney, 
Legal Division, CBOE, to Jonathan G. Katz, Secretary, Commission, 
dated December 2, 2005 (``Response Letter'').
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II. Description of the Proposal

    The Exchange proposes to establish an electronic auction system 
(Automated Improvement Mechanism or ``AIM''), which would expose 
certain orders electronically in an auction to provide such orders with 
the opportunity to receive an execution at an improved price.
    The AIM auction is available only for orders that an Exchange 
member represents as an agent (``Agency Order''). To initiate the 
electronic auction, the Exchange member (``Initiating Member'') who 
represents an Agency Order would submit the Agency Order and a second 
order for the same size as the Agency Order (on the opposite side of 
the Agency Order) into the auction. If the Agency Order is for less 
than 50 contracts, the Initiating Member must stop the entire Agency 
Order as principal or with a solicited order at the better of (A) the 
national best bid or offer (``NBBO'') price improved by one minimum 
price improvement increment, which increment shall be determined by the 
Exchange but may not be smaller than one cent or (B) the Agency Order's 
limit price (if the Agency Order is a limit order). If the Agency Order 
is for 50 contracts or more, the Initiating Member must stop the entire 
Agency Order as principal or with a solicited order at the better of 
the NBBO or the Agency Order's limit price (if the Agency Order is a 
limit order). Thereafter, other Exchange participants would compete 
with the Initiating Member's second order to execute against the Agency 
Order. The second order submitted by the Initiating Member could be an 
order for the principal account of the Initiating Member (``principal 
order'') or an order solicited by the Initiating Member to trade with 
another member or a non-member customer or broker-dealer (``solicited 
order'').\8\ Under the proposal, the Initiating Member may enter the 
second order in one of two formats: (1) At a specified single price or 
(2) with a non-price specific commitment to match as principal the 
price and size of all auction responses (``Auto-Match''). If the 
Initiating Member enters the second order with Auto-Match, then the 
Initiating Member would not have control over the prices at which it 
receives an allocation at the conclusion of the auction. After the 
commencement of an auction, the Initiating Member would not be able to 
cancel the auction.
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    \8\ See CBOE Rule 6.9 for a definition of solicited order.
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    Upon receipt of an Agency Order and the second order, the Exchange 
would commence the auction by issuing a request for responses (``RFR'') 
detailing the side and size of the Agency Order.\9\ The auction would 
last for a random time period, from 3 seconds to 5 seconds, determined 
by the Exchange's system. During such time period, any Exchange market 
maker with an appointment in the options class may submit RFR responses 
(including multiple responses). In addition, any Exchange member acting 
as an agent for customer orders resting at the top of the Exchange's 
book opposite the Agency Order, may submit RFR responses on behalf of 
such customer orders (such RFR responses may not exceed the size of the 
customer orders).\10\ The RFR responses must specify price and size, 
and may not cross the Exchange's quote on the opposite side of the 
market as the Agency Order. All RFR responses would be ``blind,'' i.e., 
the RFR responses would not be visible to any other participants in the 
auction. Under the proposal, market makers may modify or cancel RFR 
responses prior to the conclusion of the auction. The Exchange may set 
the RFR response minimum price increment at no less than one cent.
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    \9\ The Exchange would send each RFR to all members electing to 
receive RFRs (i.e., those members who have established the necessary 
systems connectivity to receive RFRs). Thus, an Exchange member's 
election to receive RFRs would not be on an auction-by-auction 
basis.
    \10\ See Amendment No. 2, supra note 5.
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    Normally, the auction would end at the conclusion of the random 3 
seconds

[[Page 7090]]

to 5 seconds time period. However, under the proposal, the following 
events could prematurely end the auction: (1) If the Exchange Hybrid 
System receives an unrelated order in the same series as the Agency 
Order and such unrelated order is marketable against the Exchange's 
disseminated quote (when the quote is the NBBO) or the RFR responses; 
(2) if the Exchange Hybrid System receives an unrelated non-marketable 
limit order in the same series and on the opposite side of the market 
as the Agency Order that improves any RFR response; (3) any time an RFR 
response matches the Exchange's disseminated quote on the opposite side 
of the market; or (4) pursuant to a pilot program that would expire on 
July 18, 2006, any time there is a market maker to market maker quote 
lock on the Exchange in accordance with CBOE Rule 6.45A(d).\11\
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    \11\ In connection with this pilot program, pursuant to proposed 
CBOE Rule 6.74A.06, the Exchange would provide the Commission data 
(on a confidential basis) regarding the frequency of early 
terminations of the auction, and also the frequency of early 
terminations pursuant to this provision that result in favorable 
pricing for the Agency Order. See Amendment No. 2, supra note 5.
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    At the conclusion of the auction, the Agency Order would be 
allocated in accordance with applicable matching algorithm rules in 
effect for such option class subject to the following provisions. 
First, no participation entitlement would apply with respect to an AIM 
execution. Second, public customer orders in the Exchange book would 
have priority. Third, if the Exchange received an unrelated market 
order or marketable limit order on the opposite side of the Agency 
Order which prematurely ended the auction, such unrelated order would 
trade against the Agency Order at the midpoint of the best RFR response 
and the NBBO on the other side of the market (rounded towards the 
disseminated quote when necessary).\12\ Fourth, if the Exchange 
received an unrelated non-marketable limit order on the opposite side 
of the Agency Order which prematurely ended the auction, such unrelated 
limit order would trade against the Agency Order at the midpoint of the 
best RFR response and the unrelated order's limit price (rounded 
towards the unrelated order's limit price when necessary).\13\ Fifth, 
if the best price equals the Initiating Member's single-price 
submission, the Initiating Member's single-price submission would be 
allocated the greater of one contract or 40% of the order. However, if 
only one market maker matches the Initiating Member's single price 
submission, then the Initiating Member would be allocated 50% of the 
order. Sixth, if the Initiating Member selected Auto-Match for the 
second order, then the Initiating Member would be allocated its full 
size at each price point until a price point is reached where the 
balance of the order can be fully executed. At such price point, the 
Initiating Member would be allocated the greater of one contract or 40% 
of the remainder of the order. Seventh, if the auction does not result 
in price improvement over the Exchange's disseminated price at the 
commencement of the auction, resting unchanged quotes or orders that 
were disseminated at the best price before the auction started would 
have priority, after any public customer order priority and the 
Initiating Member's priority (40%) have been satisfied. Any unexecuted 
balance on the Agency Order would be allocated to RFR responses 
pursuant to the matching algorithm except that the RFR responses would 
be capped to the size of the unexecuted balance and the Initiating 
Member may not participate on any such balance unless the Agency Order 
would otherwise go unfilled. Finally, if the final auction price locks 
a customer order on the book on the same side as the Agency Order, then 
unless there is sufficient size in the RFR responses to execute both 
the Agency Order and the booked customer order (in which case they 
would both execute at the final auction price), the Agency Order would 
execute against the RFR responses at one minimum RFR response increment 
worse than the final Auction price against the auction participants 
that submitted the final auction price, and any balance would trade 
against the customer order in the book at such order's limit price.
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    \12\ For example, if an auction is underway for an Agency Order 
to buy and the CBOE quote (as well as the NBBO) is 1-1.15, with the 
RFRs at 1.12 and an unrelated market order to sell is received by 
the Exchange, the unrelated order would execute against the Agency 
Order at 1.06 (the midpoint of the best RFRs and the NBBO on the 
other side of the market, i.e., the best bid).
    \13\ For example, using the same scenario as above except the 
unrelated order is a non-marketable limit order to sell at 1.10, the 
unrelated order would execute against the Agency Order at 1.11 (the 
midpoint of the best RFRs (1.12) and the unrelated order's limit 
price (1.10)).
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    If an unexecuted balance remains on the RFR responses after the 
Agency Order has been executed and such balance could trade against any 
unrelated order(s) that caused the auction to conclude, then the RFR 
response balance would trade against the unrelated order(s).
    The CBOE proposes several interpretations and policies to proposed 
CBOE Rule 6.74A. First, an Initiating Member would be permitted to use 
the auction only when there is a genuine intention to execute a bona 
fide transaction. Second, a pattern or practice of submitting unrelated 
orders that cause an auction to prematurely conclude would be deemed 
conduct inconsistent with just and equitable principles of trade and a 
violation of CBOE Rule 4.1 and other Exchange Rules. Third, initially, 
and during a Pilot Period, which would end on July 18, 2006, there 
would be no minimum size requirement for orders to be eligible for the 
auction. During this Pilot Period, the Exchange would submit on a 
confidential basis certain data, periodically as required by the 
Commission, to provide supporting evidence that, among other things, 
there is meaningful competition for all size orders and that there is 
an active and liquid market functioning on the Exchange outside of the 
auction mechanism. Fourth, any solicited orders submitted by the 
Initiating Member to trade against the Agency Order would not be 
permitted to be for the account of a market maker assigned to the 
option class. Fifth, the Exchange would communicate any Exchange 
determinations pursuant to the proposed rule such as eligible classes, 
order size parameters, and the minimum price increment for RFR 
responses, in a Regulatory Circular. Finally, proposed CBOE Rule 
6.74A(b)(2)(E), which would end the auction due to a lock on the CBOE 
market, would operate as a pilot program until July 18, 2006.

III. Discussion and Commission Findings

    After careful review of the amended proposal and consideration of 
the comment letters and the Response Letter, the Commission finds that 
the proposed rule change, as amended, to establish rules for the 
implementation of the AIM auction, is consistent with the requirements 
of the Act and the rules and regulations thereunder applicable to a 
national securities exchange \14\ and, in particular, the requirements 
of section 6 of the Act.\15\ Specifically, as discussed in detail 
below, the Commission finds that the proposal is consistent with 
section 6(b)(5) of the Act,\16\ which requires, in part, that the rules 
of an exchange be designed to prevent fraudulent and manipulative acts 
and practices, to promote just and equitable principles of trade, to 
foster cooperation

[[Page 7091]]

and coordination with persons engaged in regulating, clearing, 
settling, and 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. Section 
6(b)(5) of the Act \17\ also requires that the rules of an exchange not 
be designed to permit unfair discrimination among customers, issuers, 
brokers, or dealers.
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    \14\ In approving this proposal, the Commission has considered 
the proposed rule change's impact on efficiency, competition, and 
capital formation. 15 U.S.C. 78c(f).
    \15\ 15 U.S.C. 78f.
    \16\ 15 U.S.C. 78f(b)(5).
    \17\ Id.
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    The Commission believes that approving the Exchange's proposal to 
establish the AIM should confer benefits to the public by increasing 
competition between and among the options exchanges, resulting in 
better prices and executions for investors. The Commission also 
believes that access to the AIM auction for those who may wish to 
compete for an Agency Order should be sufficient to provide 
opportunities for a meaningful, competitive auction. The Commission 
therefore finds that for the reasons discussed below, the Exchange's 
proposal is consistent with the Act.

A. Internalization

    In its comment letter, Citadel asks the Commission to reject the 
proposal because the AIM auction and other similar auctions encourage 
internalization, which Citadel believes would hinder price discovery 
and harm investors with worse prices.\18\ Citadel states that these 
auctions harm the options markets and investors by hindering price 
discovery, discouraging aggressive quoting, eliminating substantial 
price improvement by diminishing the ability of customers to interact 
with one another; and undercutting customer limit orders.\19\ 
Therefore, Citadel urges the Commission to reevaluate the auctions 
currently in operation \20\ and determine whether such auctions should 
operate.\21\
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    \18\ See Citadel Letter, supra note 6, at p.1.
    \19\ Id. at pp. 3-4.
    \20\ Id. at p. 6. The Boston Options Exchange (``BOX''), a 
trading facility of the Boston Stock Exchange, Incorporated 
(``BSE''), operates an auction known as the PIP, see Securities 
Exchange Act Release No. 49068 (January 13, 2004), 69 FR 2775 
(January 20, 2004) (Order approving SR-BSE-2002-15 to establish 
trading rules for the BOX facility (``BOX Order'')), and the 
International Securities Exchange, Inc. (``ISE'') operates an 
auction known as the PIM, see Securities Exchange Act Release No. 
50819 (December 8, 2004), 69 FR 75093 (December 15, 2004) (Order 
approving SR-ISE-2003-06 to adopt rules for the PIM).
    \21\ See Citadel Letter, supra note 6, at p.1.
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    In the Response Letter, the Exchange states that it should be 
allowed to adopt the AIM auction for competitive reasons, since other 
options exchanges have similar auctions, and if the Commission were to 
take any actions with respect to these auctions, such actions should 
affect the options exchanges equally at the same time.\22\
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    \22\ See Response Letter, supra note 7, at pp. 1-2.
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    After considering the Citadel Letter and the Response Letter, the 
Commission believes that the Citadel Letter does not raise any novel 
regulatory concerns that would preclude the approval of the proposed 
rule change. The Commission believes that the proposed CBOE AIM auction 
provides limitations on internalization comparable to the other 
exchanges' rules that guarantee members the right to internalize their 
customers' orders. Specifically, like the auction rules previously 
approved by the Commission, the proposed AIM rules require the 
Initiating Member to expose the Agency Order in the auction before the 
Initiating Member may trade with the Agency Order.

B. Solicitation Process

    Proposed CBOE Rule 6.74A permits a member that represents an Agency 
Order to execute that Agency Order in the AIM auction against principal 
interest or against a solicited order. BOX argues that the proposal 
should define how the Initiating Member solicits the other side of the 
Agency Order. BOX contends that the proposed rules need to clarify the 
parameters for a market maker and the Initiating Member's ability to 
access customer information that may be derived from solicited orders 
and agency orders. BOX notes that the Commission required BOX to codify 
procedural protections on BOX's Directed Order process (which it termed 
its version of a solicitation process), and BOX believes that it would 
be placed at a competitive advantage if the Commission does not require 
CBOE to adopt similar procedural protections. Finally, BOX notes that 
brokers in the options industry generally limit solicitation of large 
customer orders (e.g., greater than 300 contracts). BOX believes that 
the Exchange should clarify why the proposal would permit solicitation 
of orders of all sizes, particularly for orders of less than 50 
contracts.\23\
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    \23\ See BOX Letter, supra note 6, at pp. 4-5.
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    In the Response Letter, the Exchange notes that solicited orders 
are processed on the floor of all floor-based options exchanges. The 
Exchange contends that ISE's PIM is identical to the proposed rule 
change in that the PIM auction rules allow the initiating member to 
pair the agency order with a facilitation order or a solicitation 
order. Further, CBOE notes that ISE's rules do not contain elaborate 
procedures regarding the solicitation process. The Exchange further 
notes that unlike the BOX Directed Order process, the AIM proposal 
provides that solicited orders submitted by the Initiating Member may 
not be for the account of a market maker assigned to the option class. 
Thus, the CBOE contends that any comparison between the AIM auction and 
BOX's Directed Order process is not relevant. Finally, with respect to 
the size of a solicited order, the Exchange believes that unless other 
options exchanges adopt size limits, it would be inappropriate for the 
Commission to require that the CBOE impose such size limitations on 
solicited orders for the AIM auction.\24\
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    \24\ See Response Letter, supra note 7, at pp. 4-5.
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    The Commission believes that the proposal regarding solicitation 
process is sufficiently clear. The Commission notes that CBOE Rule 6.9 
limits solicitation from members or non-member customers or broker-
dealers.\25\ In addition, CBOE Rule 4.1 prohibits members from engaging 
in acts or practices inconsistent with just and equitable principles of 
trade.\26\ The Commission further notes that CBOE has proposed an 
additional limitation in CBOE Rule 6.74A.04 that would require that any 
solicited orders submitted by the Initiating Member to trade against 
the Agency Order not be for the account of a Market-Maker assigned to 
the option class. The Commission believes that these provisions should 
permit members to solicit, in advance, the other side of an order, 
while providing for adequate disclosure of such orders to limit 
manipulation and abuse.
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    \25\ CBOE Rule 6.9.
    \26\ CBOE Rule 4.1.
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C. Competition in the AIM

    Proposed CBOE Rule 6.74A(a)(4) would require that there be at least 
three Market Makers quoting in a relevant series at the time an 
Initiating Member submits its Agency Order into the AIM.\27\ The 
Commission believes that this requirement should improve the 
opportunity for an Agency Order to be exposed to a competitive 
auction.\28\
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    \27\ See also ISE Rule 723(b)(1) and BOX Rules Chapter V, Sec. 
18(e).
    \28\ See BOX Order, supra note 20.
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    BOX questions how public customers may participate in the RFR.\29\ 
The Exchange proposes to clarify in Amendment No. 2 that members acting 
as agent for orders resting at the top of the Exchange's book opposite 
the Agency Order may submit responses to

[[Page 7092]]

the RFR on behalf of such orders.\30\ In its Response Letter, the 
Exchange further explains that at the time customer orders are 
submitted to the member representing such orders, the member and the 
customer would discuss price improvement parameters, and the CBOE 
member representing customer orders would actually represent those 
customer orders during an AIM auction.\31\ Based on the Exchange's 
representations, the Commission believes that public customer access to 
the AIM auction should be comparable to customers' access to open 
outcry auctions on the current floor-based exchanges.
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    \29\ See BOX Letter, supra note 6, at p. 5.
    \30\ See Amendment No. 2, supra note 5.
    \31\ See Response Letter, supra note 7, at p. 5.
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D. Duration of the AIM

    The CBOE proposes that the duration of each RFR period be for a 
random time period determined by the system that would not be less than 
3 seconds and would not exceed 5 seconds.\32\ The Commission believes 
that a RFR period between 3 and 5 seconds randomly determined by the 
Exchange's system should afford electronic crowds sufficient time to 
respond to, and compete for, Agency Orders submitted by an Initiating 
Member. The Commission expects that electronic systems should be 
readily available to CBOE members to allow them to respond to the RFR 
broadcasts.
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    \32\ The AIM would end prior to the expiration of the RFR period 
under certain circumstances. See proposed CBOE Rule 6.74A(b)(2) and 
discussion in text accompanying notes 33-35.
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E. Termination of Auction by Unrelated Orders

    As proposed, the AIM would end prematurely under certain 
circumstances: \33\ (1) If the Exchange Hybrid System receives an 
unrelated order in the same series as the Agency Order and such 
unrelated order is marketable against the Exchange's disseminated quote 
(when the quote is the NBBO) or the RFR responses; (2) if the Exchange 
Hybrid System receives an unrelated non-marketable limit order in the 
same series as the Agency Order and on the opposite side of the market 
as the Agency Order that improves any RFR response; (3) any time an RFR 
response matches the Exchange's disseminated quote on the opposite side 
of the market; or (4) pursuant to a pilot program that would expire on 
July 18, 2006, any time there is a market maker to market maker quote 
lock on the Exchange in accordance with CBOE Rule 6.45A(d).
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    \33\ With respect to the same series, no AIM auction will run 
simultaneously with another AIM auction, nor will AIM auctions be 
permitted to queue or overlap in any manner. See proposed CBOE Rule 
6.74A(b).
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    BOX argues that the termination of the auction by an unrelated non-
marketable limit order in the same series as the Agency Order and on 
the opposite side of the market could expose the AIM auction to 
manipulation. BOX believes the proposal is unclear as to why such 
orders should terminate the auction, unless they are for the full size 
of the Agency Order; BOX notes that other similar auction systems, such 
as the systems of BOX and ISE, treat such orders as price improvement 
orders and argues that categorizing such orders as price improvement 
orders would increase the number of RFR responses and maximize price 
improvement potential in the AIM auction.\34\
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    \34\ See BOX Letter, supra note 6, at p. 3.
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    In the Response Letter, the Exchange asserts that both the 
unrelated non-marketable limit order and the Agency Order should be 
provided with price improvement (rather than the Agency Order only as 
provided in the BOX PIP and ISE PIM). The Exchange agreed with BOX that 
early termination of the auction for the purpose of manipulating the 
market would be inappropriate, and noted that according to proposed 
CBOE Rule 6.74.02, a pattern of submitting unrelated orders to end the 
auction prematurely would be a violation of Exchange rules and would be 
deemed conduct inconsistent with just and equitable principles of 
trade.\35\
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    \35\ See Response Letter, supra note 7, pp. 3-4.
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    The Commission believes that the treatment of unrelated non-
marketable orders on the opposite side of the Agency Order is 
consistent with the requirements of the Act. The Exchange's proposal 
provides that the unrelated order and the Agency Order would receive 
price improvement, and the Commission believes that allowing both 
orders to be eligible for price improvement should benefit investors 
and customers. In addition, the Exchange's proposed interpretation 
would prohibit Exchange members from deliberately submitting orders to 
end the AIM auction prematurely. The Commission, however, expects the 
Exchange to analyze the impact of unrelated orders on the AIM auction 
to ensure that Agency Orders are not being deprived of a full 
opportunity for price improvement by the premature conclusion of an AIM 
auction.

F. Allocation at the Conclusion of the Auction

1. Order Matching Allocation Algorithms
    At the conclusion of the auction, the Agency Order would be 
allocated in accordance with applicable matching algorithm rules in 
effect for such class subject to certain conditions.\36\ BOX notes that 
proposed CBOE Rule 6.74A(b)(3) does not specify the matching algorithm 
as to how orders will be allocated,\37\ and in its Response Letter, the 
Exchange has clarified that the matching algorithms are defined in CBOE 
Rule 6.45A for equity options and CBOE Rule 6.45B for index 
options.\38\ The Commission believes that the matching algorithm set 
forth in these rules is sufficiently clear regarding how orders are to 
be allocated in the AIM auction.
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    \36\ See proposed CBOE Rule 6.74A(b)(3). The Commission notes 
that to be consistent with the requirements of section 11(a) of the 
Exchange Act, 15 U.S.C. 78k(a), and Rule 11a1-1(T) under the Act, 17 
CFR 240.11a1-1(T), Exchange Members must yield priority in the AIM 
auction to all non-Member orders, unless another exception to 
Section 11(a) applies.
    \37\ See BOX Letter, supra note 6, at p. 4.
    \38\ See Response Letter, supra note 7, at pp. 3-4.
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2. Auto-Match
    To initiate the electronic auction, the Initiating Member who 
represents an Agency Order would submit the Agency Order and also 
either specify a single-price submission to cross the Agency Order or 
indicate that it is willing to automatically match as principal the 
price and size of all auction responses (``Auto-Match''). If the 
Initiating Member uses the Auto-Match feature, the Initiating Member 
would not have control over the prices at which it receives an 
allocation of the Agency Order at the conclusion of the auction.
    BOX, in its comment letter, argues that the Auto-Match feature of 
the AIM auction provides unfair competitive advantages to the 
Initiating Member. BOX contends that since the Exchange system governs 
the Auto-Match feature, it is likely to confer upon the Initiating 
Member a technological advantage in the sense that the Initiating 
Member would have the fastest response time to any competing RFR 
responses. BOX further contends that the proposal appears to provide 
the Initiating Member with an automatic ``last look'' at the best 
priced RFR response, thereby guaranteeing the Initiating Member an 
allocation in any auction. BOX also notes that RFR responses would not 
be visible to other AIM auction participants and believes that as a 
result, Exchange members would not

[[Page 7093]]

have sufficient information to make a fully informed decision to 
compete for the Agency Order. Finally, BOX believes the ability of the 
Initiating Member to use Auto-Match would provide the Initiating Member 
an unfair advantage over customer orders and thus raise customer 
priority concerns.\39\
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    \39\ See BOX Letter, supra note 6, at pp. 2, 5.
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    In its Response Letter, the Exchange states that a blind auction is 
a key component to AIM and that a blind auction would encourage 
participants to quote their best prices. The Exchange believes that in 
a blind auction, there is greater incentive for participants to submit 
their best prices at the outset, whereas in a non-blind auction, 
participants would need to submit only the minimal amount of 
improvement. Because AIM is a blind auction, the Exchange adds, it 
sought to propose a means by which the Initiating Member could still 
receive a guaranteed participation, i.e., Auto-Match, similar to other 
mini-auctions, like BOX's PIP. CBOE notes that since PIP is not a blind 
auction, the initiating member could always configure its system to 
match the best response. Further, CBOE points out that under the terms 
of its proposal, when the Initiating Member selects Auto-Match prior to 
the start of the auction, the available liquidity would be doubled and 
pricing would be completely out of the Initiating Member's control. 
Finally, the Exchange states that BOX's argument that Auto-Match would 
provide the Initiating Member with some sort of technological advantage 
(in the form of faster response time) over other participants is 
misleading. The CBOE notes that once Auto-Match is selected (before the 
auction), the Initiating Member does not respond at all, but instead 
must honor the prices set forth in the responses received from other 
participants.\40\
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    \40\ See Response Letter, supra note 7, at pp. 2-3.
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    The Commission believes that the Auto-Match feature of the AIM 
auction would not unfairly discriminate against other AIM participants. 
The Commission disagrees that a blind auction would necessarily deprive 
auction participants with information necessary to submit RFR 
responses. When the AIM system receives an Agency Order, the Exchange 
would submit a RFR to all participating members detailing the side and 
size of the Agency Order. RFR responses would not be visible to any of 
the auction participants, including the Initiating Member.
    Finally, the Commission believes that an Initiating Member's use of 
Auto-Match would not have customer priority issues, since the proposal 
provides that public customer orders in the book must have 
priority.\41\ At the same time, because the Auto-Match feature is 
offered only to the Initiating Member and would provide the Initiating 
Member with a guaranteed participation, the Commission believes it is 
essential that the Exchange provide data on the frequency of use of 
Auto-Match and its effect on price improvement to permit the Commission 
to monitor the impact of the proposed rule change on the competitive 
process.\42\
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    \41\ See proposed CBOE rule 6.74A(b)(3)(B).
    \42\ See Section II.G.
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G. Price Improvement versus Facilitation

    As discussed above, an Initiating Member who submits an Agency 
Order into the AIM auction must ``stop'' the Agency Order as follows: 
(1) If the Agency Order is for less than 50 contracts, the Initiating 
Member must stop the entire Agency Order as principal or with a 
solicited order at the better of (A) the NBBO price improved by one 
minimum price improvement increment, which increment shall be 
determined by the Exchange but may not be smaller than one cent or (B) 
the Agency Order's limit price (if the Agency Order is a limit order); 
or (2) if the Agency Order is for 50 contracts or more, the Initiating 
Member must stop the entire Agency Order as principal or with a 
solicited order at the better of the NBBO or the Agency Order's limit 
price (if the Agency Order is a limit order).\43\
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    \43\ See proposed CBOE Rule 6.74A(a)(2) and (3).
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    BOX argues that the AIM rules should provide a minimum price 
improvement over the NBBO for orders of 50 contracts or greater. BOX 
noted that other auction systems such as ISE's PIM and BOX's PIP 
initiate auctions for such orders with a required price improvement of 
at least one cent better than the NBBO.\44\ In response, the Exchange, 
however, points out that all of the options exchanges, other than BOX, 
allow guaranteed facilitation participation at the NBBO for orders of 
50 contracts or greater.\45\
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    \44\ See BOX Letter, supra note 3.
    \45\ See Response Letter, supra note 7, at p. 4.
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    The Commission believes that stopping an Agency Order of 50 
contracts or greater at the better of the NBBO or the Agency Order's 
limit price is consistent with the requirements of the Act. The 
Commission notes that it has approved rules of other options exchanges 
that permit facilitation at the NBBO for orders of 50 contracts or 
greater.\46\ The Commission further notes that unlike the facilitation 
mechanisms of some exchanges, once the Initiating Member has submitted 
an Agency Order and designated a single-price submission or auto-match 
into the AIM auction, it may not modified or cancelled. Therefore, the 
Agency Order submitted to the AIM auction is guaranteed an execution 
price of at least the NBBO and, moreover, is given the opportunity for 
price improvement beyond the NBBO.
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    \46\ See e.g., Rule 6.47(b)(4) of the Pacific Exchange, Inc., 
ISE Rule 716(d).
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H. No Minimum Size Requirement for AIM

    Like the BOX's PIP auction and the ISE's PIM auction, the AIM 
auction would be available for orders of fewer than 50 contracts. Under 
the Exchange's proposal, there would be no minimum size requirement for 
orders entered into the AIM, for a pilot period expiring on July 18, 
2006.\47\
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    \47\ The July 18, 2006 pilot expiration date corresponds to the 
expiration of a similar pilot program for the BOX's PIP, and ISE's 
PIM. See BOX Rules, Chapter V, Sec. 18, Supplementary Material .01, 
and ISE Rule 723, Supplementary Material .03.
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    The Commission believes that the Exchange's proposal should provide 
small customer orders with the opportunity for price improvement, and 
is consistent with the Act. In particular, any Agency Order for less 
than 50 contracts that is entered into the AIM is guaranteed an 
execution at the end of the auction at a price at least a penny better 
than the NBBO. The Commission will evaluate the AIM auction during the 
Pilot Period to determine whether it would be beneficial to customers 
and to the options market as a whole to approve any proposal requesting 
permanent approval to permit orders of fewer than 50 contracts to be 
submitted to the AIM auction. In addition, the Commission will examine 
the data submitted by the Exchange with respect to situations in which 
the AIM auction is terminated prematurely by an unrelated order. To aid 
the Commission in its evaluation, the CBOE represents that it will 
provide the following information each month:
    (1) The number of orders of fewer than 50 contracts entered into 
the AIM auction;
    (2) The percentage of all orders of fewer than 50 contracts sent to 
CBOE that are entered into CBOE's AIM auction;
    (3) The percentage of all CBOE trades represented by orders of 
fewer than 50 contracts;
    (4) The percentage of all CBOE trades effected through the AIM 
auction

[[Page 7094]]

represented by orders of fewer than 50 contracts;
    (5) The percentage of all contracts traded on CBOE represented by 
orders of fewer than 50 contracts;
    (6) The percentage of all contracts effected through the AIM 
auction represented by orders of fewer than 50 contracts;
    (7) The spread in the option, at the time an order of fewer than 50 
contracts is submitted to the AIM auction;
    (8) The number of orders of 50 contracts or greater entered into 
the AIM auction;
    (9) The percentage of all orders of 50 contracts or greater sent to 
CBOE that are entered into CBOE's AIM auction;
    (10) The spread in the option, at the time an order of 50 contracts 
or greater is submitted to the AIM auction;
    (11) Of AIM trades for orders of fewer than 50 contracts, the 
percentage done at the NBBO plus $.01, plus $.02, plus $.03, etc.;
    (12) Of AIM trades for orders of 50 contracts or greater, the 
percentage done at the NBBO plus $.01, plus $.02, plus $.03, etc.;
    (13) The number of orders submitted by Exchange members when the 
spread was $.05, $.10, $.15, etc. For each spread, specify the 
percentage of contracts in orders of fewer than 50 contracts submitted 
to CBOE's AIM that were traded by: (a) the Exchange member that 
submitted the order to the AIM; (b) CBOE Market Makers assigned to the 
class; (c) other CBOE members; (d) Public Customer Orders; and (e) 
unrelated orders (orders in standard increments entered during the AIM 
auction). For each spread, also specify the percentage of contracts in 
orders of 50 contracts or greater submitted to CBOE's AIM that were 
traded by: (a) the Exchange member that submitted the order to the AIM; 
(b) CBOE Market Makers assigned to the class; (c) other CBOE members; 
(d) Public Customer Orders; and (e) unrelated orders (orders in 
standard increments entered during the AIM auction);
    (14) The number of times that a market or marketable limit order in 
the same series on the same side of the market as the Agency Order 
prematurely ended the AIM auction, and the number of times such orders 
were entered by the same (or affiliated) firm that initiated the AIM 
auction that was terminated;
    (15) The percentage of AIM early terminations due to the receipt of 
a market or marketable limit order in the same series on the same side 
of the market that occurred within a \1/2\ second of the start of the 
AIM auction; the percentage that occurred within one second of the 
start of the AIM auction; the percentage that occurred within 1\1/2\ 
second of the start of the AIM auction; the percentage that occurred 
within 2 seconds of the start of the AIM auction; the percentage that 
occurred within 2\1/2\ seconds of the AIM auction; and the average 
amount of price improvement provided to the Agency Order where the AIM 
auction is terminated early at each of these time periods;
    (16) The number of times that a market or marketable limit order in 
the same series on the opposite side of the market as the Agency Order 
prematurely ended the AIM auction and at what time the unrelated order 
ended the AIM auction, and the number of times such orders were entered 
by the same (or affiliated) firm that initiated the AIM auction that 
was terminated;
    (17) The percentage of AIM auction early terminations due to the 
receipt of a market or marketable limit order in the same series on the 
opposite side of the market that occurred within a \1/2\ second of the 
start of the AIM auction; the percentage that occurred within one 
second of the start of the AIM auction; the percentage that occurred 
within 1\1/2\ second of the start of the AIM auction; the percentage 
that occurred within 2 seconds of the start of the AIM auction; the 
percentage that occurred within 2\1/2\ seconds of the AIM auction; and 
the average amount of price improvement provided to the Agency Order 
where the AIM auction is terminated early at each of these time 
periods;
    (18) The number of times that an RFR response matching the 
Exchange's disseminated quote on the opposite side of the market from 
the RFR responses prematurely ended the AIM auction and at what time 
the RFR response ended the AIM auction, and the number of times such 
orders were entered by the same (or affiliated) firm that initiated the 
AIM auction that was terminated;
    (19) The percentage of AIM auction early terminations due to the 
receipt of an RFR response matching the Exchange's disseminated quote 
on the opposite side of the market from the RFR responses that occurred 
within a \1/2\ second of the start of the AIM auction; the percentage 
that occurred within one second of the start of the AIM auction; the 
percentage that occurred within 1\1/2\ second of the start of the AIM 
auction; the percentage that occurred within 2 seconds of the start of 
the AIM auction; the percentage that occurred within 2\1/2\ seconds of 
the AIM auction; and the average amount of price improvement provided 
to the Agency Order where the AIM auction is terminated early at each 
of these time periods;
    (20) The number of times that a quote lock on the Exchange pursuant 
to CBOE Rule 6.45A(d) prematurely ended the AIM auction and at what 
time the quote lock ended the AIM auction, and the number of times such 
orders were entered by the same (or affiliated) firm that initiated the 
AIM that was terminated;
    (21) With respect to a quote lock on the Exchange pursuant to CBOE 
Rule 6.45A(d) that has occurred with an Agency Order to buy, the number 
of times that the quote was locked at the existing best bid and the 
number of times that the quote was locked at the existing best offer, 
and the firm that caused the quote lock;
    (22) With respect to a quote lock on the Exchange pursuant to CBOE 
Rule 6.45A(d) that has occurred with an Agency Order to sell, the 
number of times that the quote was locked at the existing best bid and 
the number of times that the quote was locked at the existing best 
offer, and the firm that caused the quote lock;
    (23) The frequency with which early termination due to a quote lock 
on the Exchange pursuant to CBOE Rule 6.45A(d) results in price 
improvement for the Agency Order; and the average amount of price 
improvement provided to the Agency Order;
    (24) The average amount of price improvement provided to the Agency 
Order when the AIM auction is not terminated early (i.e., runs the full 
three seconds); and
    (25) The percentage of all CBOE trades effected through the AIM 
auction in which the Initiating Member has chosen the Auto-Match 
feature, and the average amount of price improvement provided to the 
Agency Order when the Initiating Member has chosen the Auto-Match 
feature vs. the average amount of price improvement provided to the 
Agency Order when the Initiating Member has chosen a single-price 
submission.

IV. Solicitation of Comments on Amendment No. 2

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 2, including whether Amendment No. 2 
is consistent with the Act. Comments may be submitted by any of the 
following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number SR-CBOE-2005-60 on the subject line.

[[Page 7095]]

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.
    All submissions should refer to File Number SR-CBOE-2005-60. 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, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml
). 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 also will be available for inspection and copying at the 
principal office of the Exchange. All comments received will be posted 
without change; the Commission does not edit personal identifying 
information from submissions. You should submit only information that 
you wish to make available publicly. All submissions should refer to 
File Number SR-CBOE-2005-60 and should be submitted on or before March 
3, 2006.

V. Accelerated Approval of Amendment No. 2

    The Commission finds good cause to approve Amendment No. 2 to the 
proposed rule change prior to the thirtieth day after the amendment is 
published for comment in the Federal Register pursuant to section 
19(b)(2) of the Act.\48\ The revisions made to the proposed rule 
change, as amended, in Amendment No. 2 clarified that Exchange members, 
when acting as agent for orders resting at the top of the Exchange's 
book on the other side of the Agency Order, may submit RFR responses on 
behalf of such orders. In addition, Amendment No. 2 clarified that the 
Exchange would submit certain data, as required by the Commission, 
during the Pilot Period and information submitted by the Exchange to 
the Commission would be on a confidential basis.
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    \48\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    The Commission believes that the proposed changes in Amendment No. 
2 are necessary to the proper functioning and implementation of AIM. 
The Commission believes that the proposed changes in Amendment No. 2 
provide a clearer understanding of the operation of AIM and the Pilot 
Period and raise no new issues of regulatory concern. For these 
reasons, the Commission believes that accelerated approval of Amendment 
No. 2 is appropriate. Accordingly, pursuant to section 19(b)(2) of the 
Act,\49\ the Commission finds good cause exists to approve Amendment 
No. 2 prior to the 30th day after notice of the Amendment is published 
in the Federal Register.
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    \49\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

VI. Conclusion

    For the foregoing reasons, the Commission finds that the proposed 
rule change, as amended, 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) of the Act.\50\
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    \50\ 15 U.S.C. 78f(b)(5). In connection with the issuance of 
this approval order, neither the Commission nor its staff is 
granting any exemptive or no-action relief from the requirements of 
Rule 10b-10 under the Act. 17 CFR 240.10b-10. Accordingly, a broker-
dealer executing a customer order through the AIM auction will need 
to comply with all applicable requirements of that Rule.
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    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\51\ that the proposed rule change (SR-CBOE-2005-60) and Amendment 
No. 1 thereto, are approved, and that Amendment No. 2 thereto is 
approved on an accelerated basis, except that (1) paragraph (b)(2)(E) 
of CBOE Rule 6.74A is approved on a pilot basis until July 18, 2006; 
and (2) there shall be no minimum size requirement for orders entered 
into the AIM, for a pilot period expiring on July 18, 2006.
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    \51\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\52\
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    \52\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. E6-1836 Filed 2-9-06; 8:45 am]

BILLING CODE 8010-01-P
