

[Federal Register: October 3, 2007 (Volume 72, Number 191)]
[Notices]               
[Page 56412-56415]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr03oc07-111]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-56564; File No. SR-ISE-2007-74]

 
Self-Regulatory Organizations; International Securities Exchange, 
LLC; Order Granting Accelerated Approval to a Proposed Rule Change, as 
Modified by Amendment No. 1, Relating to an Extension and Expansion of 
the Penny Pilot Program

September 27, 2007.

I. Introduction

    On August 21, 2007, the International Securities Exchange, LLC 
(``ISE'' 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 extend and expand a pilot 
program to quote certain options in smaller increments (``Pilot 
Program'' or ``Pilot''). On August 22, 2007, the Exchange filed 
Amendment No. 1 to the proposed rule change. The proposed rule change, 
as amended, was published for comment in the Federal Register on August 
29, 2007.\3\ The Commission received one comment letter on the proposed 
rule change.\4\ This order approves the proposed rule change, as 
modified by Amendment No. 1, on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 56306 (August 22, 
2007), 72 FR 49753.
    \4\ See letter to Nancy Morris, Secretary, Commission, from John 
C. Nagel, Director & Associate General Counsel, Citadel, dated 
September 12, 2007 (``Citadel Letter).
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II. Description of the Proposal

    Currently, the six options exchanges, including ISE, participate in 
the thirteen class Pilot Program,\5\ which is scheduled to expire on 
September 27, 2007.\6\ The Exchange proposes to extend and expand the 
Pilot Program to include fifty additional classes, in two phases.
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    \5\ The thirteen option classes currently in the Pilot are: 
Ishares Russell 2000 (IWM); NASDAQ-100 Index Tracking Stock (QQQQ); 
SemiConductor Holders Trust (SMH); General Electric Company (GE); 
Advanced Micro Devices, Inc. (AMD), Microsoft Corporation (MSFT); 
Intel Corporation (INTC); Caterpillar, Inc. (CAT); Whole Foods 
Market, Inc. (WFMI); Texas Instruments, Inc. (TXN); Flextronics 
International Ltd. (FLEX); Sun Microsystems, Inc. (JAVA); and 
Agilent Technologies, Inc. (A).
    \6\ The Pilot Program began on January 26, 2007 and is currently 
set to expire on September 27, 2007. See Securities Exchange Act 
Release No. 56151 (July 26, 2007), 72 FR 42452 (August 2, 2007) (SR-
ISE-2007-68). See also Securities Exchange Act Release No. 55161 
(January 24, 2007), 72 FR 4754 (February 1, 2007) (SR-ISE-2006-62) 
(``Original Pilot Program Approval Order'').
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    Phase One will begin on September 28, 2007 and will continue for 
six months, until March 27, 2008. Phase One will add the following 
twenty-two options classes to the Pilot: SPDRs (SPY); Apple, Inc. 
(AAPL); Altria Group Inc. (MO); Dendreon Corp. (DNDN); Amgen Inc. 
(AMGN); Yahoo! Inc. (YHOO); QUALCOMM Inc. (QCOM); General Motors 
Corporation (GM); Energy Select Sector (XLE); DIAMONDS Trust, Series 1 
(DIA); Oil Services HOLDRs (OIH); NYSE Euronext, Inc. (NYX); Cisco 
Systems, Inc. (CSCO); Financial Select Sector SPDR (XLF); AT&T Inc. 
(T); Citigroup Inc. (C); Amazon.com Inc. (AMZN); Motorola Inc. (MOT); 
Research in Motion Ltd. (RIMM); Freeport-McMoRan Copper & Gold Inc. 
(FCX); ConocoPhillips (COP); and Bristol-Myers Squibb Co. (BMY). These 
twenty-two options classes are among the most actively-traded, 
multiply-listed options classes, and account, together with the current 
thirteen Pilot classes, for approximately 35% of total industry trading 
volume.\7\
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    \7\ This volume is based on the Options Clearing Corporation 
(``OCC'') year-to-date trading volume data through July 16, 2007.
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    Phase Two will begin on March 28, 2008, and will continue for one 
year, until March 27, 2009. During the second phase, the number of 
options classes trading in pennies will again increase.\8\ The Exchange 
proposes to add twenty-eight more classes from among the most actively-
traded, multiply-listed options classes.\9\
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    \8\ The Exchange has committed to file a proposed rule change 
under section 19(b)(3)(A) of the Act to identify the options classes 
to be included in the second expansion.
    \9\ As proposed in its filing, ISE represents that options 
trading in penny increments will not be eligible for split pricing, 
as permitted under ISE Rule 716.
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    The minimum price variation for all classes to be included in the 
Pilot Program, except for the QQQQs, will continue to be $0.01 for all 
quotations in option series that are quoted at less than $3 per 
contract and $0.05 for all quotations in option series that are quoted 
at $3 per contract or greater. The QQQQs will continue to be quoted in 
$0.01 increments for all options series.
    During the extended and expanded Pilot Program, the ISE commits to 
deliver four reports to the Commission. Each report will analyze the 
impact of penny pricing on market quality and options system capacity. 
The first report will analyze the penny pilot results from May 1, 2007 
through September 27, 2007; the second will analyze the results from 
September 28, 2007 through January 31, 2008; the third will analyze the 
results from February 1, 2008 through July 31, 2008; and the fourth and 
final report will examine the results from August 1, 2008 through 
January 31, 2009. These reports will be provided to the Commission 
within thirty days of the conclusion of the reporting period.

III. Discussion

    After careful review of the proposal and the comment letter, 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.\10\ In particular, the 
Commission finds that the proposal is consistent with section 6(b)(5) 
of the Act,\11\ which requires, among other things, that the rules of 
an exchange be designed to promote just and equitable principles of 
trade, to remove impediments to and perfect the mechanism of a free and 
open market and a national market system, and, in general, to protect 
investors and the public interest.
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    \10\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
    \11\ 15 U.S.C. 78f(b)(5).
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    On June 28, 2005, the Pacific Exchange (now known as NYSE Arca) 
announced its intention to begin quoting and trading all listed options 
in penny increments.\12\ In June 2006, to facilitate the orderly 
transition to quoting a limited number of options in penny increments, 
Chairman Cox sent a letter to the six options exchanges urging the 
exchanges that chose to begin quoting in smaller increments to plan for 
the implementation of a limited penny pilot program to commence in 
January 2007.\13\ All six of the options exchanges submitted proposals 
to permit quoting a limited number of classes in smaller increments, 
and, in January 2007, the Commission approved those proposals to 
implement the current Pilot Program.\14\ The exchanges

[[Page 56413]]

have now submitted proposals to extend and further expand the Pilot.
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    \12\ PCX News Release, ``Pacific Exchange to Trade Options in 
Pennies,'' June 28, 2005.
    \13\ Commission Press Release 2006-91, ``SEC Chairman Cox Urges 
Options Exchanges to Start Limited Penny Quoting,'' June 7, 2006.
    \14\ See Securities Exchange Act Release Nos. 55161 (January 24, 
2007), 72 FR 4754 (February 1, 2007) (SR-ISE-2006-62); 55162 
(January 24, 2007), 72 FR 4738 (February 1, 2007) (Amex-2006-106); 
55155 (January 23, 2007), 72 FR 4741 (February 1, 2007) (SR-BSE-
2006-49); 55154 (January 23, 2007), 72 FR 4743 (February 1, 2007) 
(SR-CBOE-2006-92); 55156 (January 23, 2007), 72 FR 4759 (February 1, 
2007) (SR-NYSEArca-2006-73); and 55153 (January 23, 2007), 72 FR 
4553 (January 31, 2007) (SR-Phlx-2006-74). As noted above, supra 
note 6 and accompanying text, the current Pilot is scheduled to 
expire on September 27, 2007.
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    The continued operation and phased expansion of the Pilot Program 
will provide further valuable information to the exchanges, the 
Commission, and others about the impact of penny quoting in the options 
market. In particular, extending and expanding the Pilot Program as 
proposed by ISE will allow further analysis of the impact of penny 
quoting in the Pilot classes over a longer period of time on, among 
other things: (1) Spreads; (2) peak quote rates; (3) quote message 
traffic; (4) displayed size; (5) ``depth of book'' liquidity; and (6) 
market structure. ISE has committed to provide the Commission with 
periodic reports, which will analyze the impact of the expanded Pilot 
Program. The Commission expects the Exchange to include statistical 
information relating to these factors in its periodic reports.
    An analysis of the current Pilot shows that the reduction in the 
minimum quoting increment has resulted in narrowing the average quoted 
spreads in all classes in the Pilot.\15\ A reduction in quoted spreads 
means that customers and other market participants may be able to trade 
options at better prices. The reduction in spreads also has led the 
exchanges to reduce or eliminate their exchange-sponsored payment-for-
order-flow programs.\16\ The Commission believes that the proposed rule 
change is designed to continue the narrowing of spreads.
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    \15\ See ISE, Penny Pilot Analysis, May 23, 2007 (``ISE 
Report''). See also Amex, Penny Quoting Pilot Program Report, June 
8, 2007 (``Amex Report''); Box, Penny Pilot Data Review, June 18, 
2007 (``Box Report''); CBOE, Penny Pilot Report, June 1, 2007 
(``CBOE Report''); NYSE Arca Options, Understanding Economic and 
Capacity Impacts of the Penny Pilot, May 31, 2007 (``NYSE Arca 
Report''); and Phlx, Options Penny Pricing Pilot Report, May 31, 
2007 (``Phlx Report'').
    \16\ See Securities Exchange Act Release Nos. 55328 (February 
21, 2007), 72 FR 9050 (February 28, 2007) (SR-Amex-2007-16); 55197 
(January 30, 2007), 72 FR 5772 (February 7, 2007) (SR-BSE-2007-02); 
55265 (February 9, 2007), 72 FR 7697 (February 16, 2007) (SR-CBOE-
2007-11); 55271 (February 12, 2007), 72 FR 7699 (February 16, 2007) 
(SR-ISE-2007-08); 55223 (February 1, 2007) 72 FR 6306 (February 9, 
2007) (SR-NYSEArca-2007-07); and 55290 (February 13, 2007), 72 FR 
8051 (February 22, 2007) (SR-Phlx-2007-05).
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    The Commission notes that, as anticipated, the Pilot has 
contributed to the increase in quotation message traffic from the 
options markets. However, while the increase in quotation message 
traffic is appreciable, it has been manageable by the exchanges and the 
Options Price Reporting Authority, and the Commission did not receive 
any reports of disruptions in the dissemination of pricing information 
as a result of quote capacity restraints. Although the Commission 
anticipates that the proposed expansion of the Pilot Program may 
contribute to further increases in quote message traffic, the 
Commission believes that ISE's proposal is sufficiently limited such 
that it is unlikely to increase quote message traffic beyond the 
capacity of market participants' systems and disrupt the timely receipt 
of quote information. The Commission also notes that ISE has adopted 
and will continue to utilize quote mitigation strategies that should 
mitigate the expected increase in quote traffic.\17\
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    \17\ See Securities Exchange Act Release No. 55161 (January 24, 
2007), 72 FR 4754 (February 1, 2007) (SR-ISE-2007-62). Further, the 
Commission notes that the other options exchanges participating in 
the Pilot also have adopted and will continue to utilize quote 
mitigation strategies.
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    Overall trading activity in the options markets is very 
concentrated, with a relatively few options classes accounting for a 
significant share of total options volume. ISE's proposal, which will 
expand the Pilot to include a limited number of options from among the 
most actively-traded classes (based on average trading volume), will 
provide an opportunity for reduced spreads where the greatest amount of 
trading occurs, thus maximizing the economic benefit of the Pilot while 
minimizing the impact of increased quote traffic.
    The commenter suggests that relative trading volume is the measure 
that should be used to assess the success of quoting in smaller 
increments.\18\ The commenter reported the percentage change in the 
relative trading volume before and after the Pilot for each of the 
thirteen classes.\19\ The commenter's data shows an increase in 
relative trading volume for QQQQ, IWM, SHM, AMD, and SUNW, and a 
decrease in relative trading volume for MSFT, INTC, GE, TXN, A, CAT, 
WFMI and FLEX. The commenter believes the data shows that the Pilot 
works well for index and sector products, but smaller increments caused 
a decline in the relative trading volume for single stock options. The 
commenter argues that much of the decrease in relative trading volume 
in Pilot classes is a symptom of the decrease in displayed size 
available for those classes. On the basis of a decline in the relative 
trading volume, the commenter argues that single stock option classes 
should be removed from the Pilot and replaced with liquid index or 
sector option classes.
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    \18\ See Citadel Letter, supra note 4.
    \19\ The commenter measures the relative trading volume of a 
class as that class' trading volume as a percentage of total OCC 
volume. The change in relative trading volume is the relative 
trading volume from date of entrance into the Pilot to August 27, 
2007 divided by the relative trading volume from November 1, 2006 
through entrance in the Pilot.
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    Much of the recent growth in options volume has been in the large 
index and ETF products, such as the SPX, SPY, and the QQQQ. As their 
relative trading volume increases, the aggregate relative trading 
volume of other products necessarily declines (although actual volume 
levels may increase). For example, the SPX, SPY, QQQQ, and IWM 
accounted for 16.1% of total options volume in the four months before 
the pilot and rose to 21.7% of volume in the five months after the 
pilot.\20\ By definition, the relative trading volume of all other 
classes (Pilot and non-Pilot) falls from 83.9% in the pre-Pilot period 
to 78.3% in the post-Pilot period. Using the commenter's numerical 
approach, the relative market share of SPX, SPY, QQQ, and IWM increased 
by 34.8% ((21.7%/16.1%)-1). In contrast, the relative trading volume of 
all other classes fell by 6.7% (78.3/83.9%)-1) in the post-Pilot period 
compared to the pre-Pilot period. Thus, in addition to the random 
variation in relative trading volume that occurs over time, there was 
an overall decline in the relative trading volume of issues outside the 
four largest index and ETF options, although their actual aggregate 
volume levels increased.
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    \20\ The pre-Pilot period consists of the four months before the 
Pilot commenced (October 1-January 25, 2007) and the post-Pilot 
period consists of the five months after the Pilot commenced 
(February 9, 2007-June 30, 2007). The two week period when the Pilot 
classes were introduced are excluded from the analysis.
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    More specifically, for the 100 and 500 most active classes,\21\ 
relative trading volume fell for 63% and 56%, respectively, of non-
Pilot classes. In the Pilot classes, seven, or 54%, of the thirteen 
Pilot classes had a decline in market share and seven, or 70%, of the 
ten single stock option classes had a decline in relative trading 
volume.\22\
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    \21\ All of the thirteen Pilot classes fall into the 500 most 
actively-traded, and nine are within the 100 most actively-traded 
group.
    \22\ The change in relative trading volume for the median stock 
for the top 500 (100) classes is -8% (-13%), compared to a change of 
-3% for the thirteen Pilot stocks and a change of -24% for the ten 
single stock options. The Commission notes that, with a Pilot sample 
size of thirteen or ten, these statistics will be highly sensitive 
to the performance of one or two classes.

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[[Page 56414]]

    The Commission does not believe that the data at this time supports 
the conclusion that a decrease in relative trading volume in the Pilot 
classes is due to a reduction of the minimum quoting variation. In 
fact, the data demonstrates that declines in relative trading volume 
were not limited to stocks included in the Pilot, and substantial 
declines in relative trading volume, as defined by the commenter, 
describe a large portion of classes that were not in the Pilot. 
Therefore, based on the data reviewed to date, the Commission cannot 
conclude that the Pilot has had an adverse impact on volume in the 
Pilot securities. Therefore, the Commission believes that ISE's 
proposal to select additional classes from among the most actively-
traded options has a reasonable basis and is consistent with the 
Act.\23\
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    \23\ The Commission notes that the classes the commenter 
specifically recommends for inclusion in the expanded Pilot--SPY, 
DIA, OIH, XLF, and XLE--are among classes proposed by ISE to be 
included in the Pilot Program beginning September 28, 2007.
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    The Commission believes that the impact of smaller increments on 
trading volume is one of the more difficult aspects of the Pilot to 
assess, and notes that the exchange reports did not show a clear change 
in trading volume.\24\ While some industry participants expressed 
disappointment that volume had not increased, the bid-ask spread is 
only one factor that influences volume. Other factors that impact 
option volume are trading activity in the underlying security and in 
related products, volatility in the market and in the underlying 
security, as well as firm and market specific information and events. 
The Commission believes that the addition of more securities in the 
next phase will increase the sample size and should help in further 
analysis of such issues.
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    \24\ See Amex Report, supra note 15, at 6-7; CBOE Report, supra 
note 15, Attachment at pages 5-6; ISE Report, supra note 15, at 17-
20; and NYSE Arca Report, supra note 15, at 15.
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    The commenter also expressed concern that the quoted size in the 
Pilot classes is dropping to levels that are ``sub-optimal'' or 
``inadequate'' for institutional size orders, and recommended that the 
Commission carefully evaluate the impact of penny quoting on liquidity 
before allowing the exchanges to expand the Pilot. The Commission fully 
agrees that the impact of the Pilot on displayed size, as well as non-
displayed ``depth of book,'' and the impact of any decreased size on 
market and execution quality, is an area that should be carefully 
analyzed as the Pilot continues. The Commission also recognizes that 
the exchange reports show there has, in fact, been a reduction in the 
displayed size available in the Pilot classes.\25\ The Commission is 
not at this time, however, able to conclude that this decrease has 
caused a decrease in trading volume or relative trading volume, or 
other harm to the market, as a result of the Pilot Program. The 
Commission does, however, expect the Exchange to include in its reports 
an analysis of the market impact of reducing the minimum price 
increment, particularly on the ability of market participants to 
effectively execute large-sized orders. The Commission will analyze the 
information provided in the Exchange's reports, in conjunction with the 
information provided by other exchanges and market participants, to 
inform its evaluation and consideration of any exchange's proposed 
further expansion of the Pilot.
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    \25\ See Amex Report, supra note 15, at 6; BOX Report, supra 
note 15, at 2; CBOE Report, supra note 15, at Attachment page 2; ISE 
Report, supra note 15, at 7-8; NYSE Arca Report, supra note 15, at 
9-10; and Phlx Report, supra note 15, at 3-4 and 6-7.
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    The commenter further noted, to the extent that additional size may 
be available below the best bid or offer,\26\ options market 
participants discount the value of such liquidity because it is 
generally not transparent to the market and is not easily accessible 
even if displayed.\27\ The commenter noted that, unlike in the equities 
markets, market participants cannot quickly sweep multiple markets 
through multiple price levels to reach such additional liquidity. The 
Commission encourages the exchanges to consider measures that would 
facilitate access to depth of book quotes.
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    \26\ Only two exchanges provided information on ``depth of 
book'' on their markets in the Pilot classes. See NYSE Arca Report 
at 8-10, supra note 15, and ISE Report, supra note 15, at 9. ISE 
reported that the average total size of all quotes on its book at 
all price levels, weighted for volume, for all thirteen Pilot 
classes was reduced by 61%. See ISE Report, supra note 15, at 9. 
NYSE Arca compared liquidity resident in its book within the legacy 
minimum price variation to pre-Pilot top of book liquidity and 
reported that volume weighted liquidity across all thirteen Pilot 
classes decreased 1%. See NYSE Arca Report, supra note 15, at 8.
    \27\ The Commission notes that currently only NYSE Arca makes 
available quotes and orders on its book below the NBBO. See http://www.nysedata.com/nysedata/InformationProducts/ArcaBook/tabid/293/Default.aspx.
 The Commission anticipates that to the extent this 

display of information proves to be valuable to the options market 
as a whole, other exchanges may choose to make this information 
available as well.
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    Finally, the commenter recommends removing the poorest performing 
single stock names from the Pilot and replacing them with liquid index 
or sector products.\28\ The Commission agrees that there should be a 
mechanism for removing option classes from the Pilot. The Commission 
specifically requested comment in the notice of ISE's proposal on: (1) 
Whether there are circumstances under which classes included in the 
Pilot should be removed; (2) if so, what factors should be considered 
in making the determination to remove a class from the Pilot, 
specifically whether an objective standard should be used or whether a 
more subjective analysis should be allowed; (3) what concerns might 
arise by removing a class from the Pilot, and how could such concerns 
be ameliorated; (4) how frequently should such an analysis be 
undertaken, or should the evaluation be automated; and (5) if a class 
is to be removed from the Pilot, how much notice should be given to 
market participants that the quoting increment will change, but did not 
receive any comments. The Commission will continue to consider comments 
on how to fairly and objectively determine if a class should be removed 
from the Pilot. Finally, to the extent that the Exchange files a 
proposed rule change to further expand the Pilot, the Commission urges 
it to include in any such proposal a methodology for removing classes 
from the Pilot.
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    \28\ See supra, note 23.
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    The Commission finds good cause for approving the proposed rule 
change, as amended, prior to the thirtieth day after publication of the 
notice in the Federal Register.\29\ The Commission notes that in this 
filing the ISE is proposing to participate in an industry-wide 
extension and expansion of the Penny Pilot, which is scheduled to begin 
on September 28, 2007. Concurrent with this approval, the Commission 
also is approving proposed rule changes submitted by the other five 
options exchanges to extend and expand the Pilot. Accelerating approval 
of this filing will permit the Exchange to continue its participation 
in the Pilot without interruption.
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    \29\ The Commission notes that the thirtieth day after 
publication of notice of this filing in the Federal Register is 
September 28, 2007.
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    Accordingly, the Commission finds good cause, consistent with 
section 19(b)(2) of the Act,\30\ to approve the proposal, as modified 
by Amendment No. 1, on an accelerated basis. For the reasons discussed 
above, the Commission believes that the proposed rule change is 
consistent with the Act.
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    \30\ 15 U.S.C. 78s(b)(2).

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[[Page 56415]]

IV. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\31\ that the proposed rule change (SR-ISE-2007-74), as modified by 
Amendment No. 1, be, and hereby is, approved on an accelerated basis, 
for a pilot period, which will end on March 27, 2009.
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    \31\ 15 U.S.C. 78s(b)(2).
    \32\ 17 CFR 200.30-3(a)(12).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\32\
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-19500 Filed 10-2-07; 8:45 am]

BILLING CODE 8011-01-P
