
[Federal Register: May 2, 2008 (Volume 73, Number 86)]
[Notices]               
[Page 24329-24332]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr02my08-138]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-57716; File No. SR-CBOE-2007-39]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Notice of Filing of Amendment No. 2 and Order Granting 
Accelerated Approval of a Proposed Rule Change, as Modified by 
Amendment No. 2 Thereto, Regarding Penny Price Improvement

April 25, 2008.

I. Introduction

    On April 24, 2007, 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 amend its rules regarding 
price improvement for options not currently quoted in one-cent 
increments. The proposed rule change was published for comment in the 
Federal Register on May 14, 2007.\3\ The Commission received two 
comment letters in response to the proposed rule change.\4\ On March 
25, 2008, the Exchange filed Amendment No. 1 to make certain 
modifications to the original rule filing. On March 28, 2008, the 
Exchange withdrew Amendment No. 1 to the proposed rule change and 
simultaneously filed Amendment No. 2 to the proposal. This order 
provides notice of the proposed rule change, as modified by Amendment 
No. 2, and approves the proposed rule change, as modified by Amendment 
No. 2, 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. 55724 (May 8, 2007), 
72 FR 27156.
    \4\ See letter to Nancy Morris, Secretary, Commission, from John 
C. Nagel, Director & Associate General Counsel, Citadel, dated June 
4, 2007 (``Citadel Letter'') and letter to Nancy M. Morris, 
Secretary, Commission, from Michael J. Simon, Secretary, 
International Securities Exchange, LLC, dated June 1, 2007 (``ISE 
Letter'').
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II. Description of the Proposal

    Proposed CBOE Rule 6.13B will expand the ability of Exchange users 
to effect transactions in penny increments in classes and/or series 
trading on CBOE's Hybrid System that are not currently quoting in penny 
increments.\5\ The Exchange will designate the classes/series eligible 
for this penny pricing, and the penny pricing will be available 
electronically and in open outcry.
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    \5\ Amendment No. 2 clarified that the program will not apply to 
Hybrid 3.0 classes.
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    As proposed, all limit orders or quotes electronically sent to CBOE 
(regardless of sender origin type) can be priced in a one-cent 
increment. Specifically, an Exchange Market-Maker can provide the 
Exchange with indications to trade in one-cent increments that improve 
on the Market-Maker's disseminated quotation. Such indications of 
interest will be firm for all interest received by the Exchange. 
Further, all other users can electronically submit orders priced in 
one-cent increments. The Exchange will round the limit price to the 
nearest permissible quoted increment for display purposes, but will 
maintain the one-cent increment limit price for trade execution and 
allocation purposes.\6\ To the extent there is trading interest from 
multiple sources at the same one-cent increment price, priority will be 
established in the same manner as priority at a standard quoting 
increment (i.e., normal allocation procedures will be used). The 
Exchange has represented that the system will not execute an order at a 
price that would cause a trade-through of another options exchange.
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    \6\ For example, if the CBOE market is 1-1.20 and an order is 
received to buy 10 contracts at 1.08, CBOE would disseminate a 1.05 
bid for 10 contracts, and any subsequent sell market order received 
by the Exchange would trade at 1.08 for up to 10 contracts (after 
that, the quote would revert back to 1-1.20).
    Amendment No. 2 deletes a provision in the original filing that 
would have allowed the Exchange to append an indicator to the OPRA 
quote representing the existence of penny pricing. Additionally, in 
Amendment No. 2, the Exchange represents that the size and price of 
any penny pricing will not be displayed or made available to anyone 
(other than the size that is added to the Exchange's BBO to reflect 
the size of rounded, penny-priced orders).
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    With respect to open outcry, crowd members will be able to provide 
price improvement in one-cent increments over the Exchange's Best Bid 
or Offer (``BBO''). The Exchange has represented that any resulting 
trade will not cause a trade-through of another options exchange. 
Further, prior to executing any order in open outcry in a one-cent 
increment, Exchange members will be required to electronically 
``sweep'' any penny pricing interest on the book that may exist.\7\ The 
``sweep'' is designed to ensure that better-priced orders resting in 
one-cent increments are executed prior to the open outcry transaction 
and

[[Page 24330]]

that same priced orders receive executions consistent with existing 
rules governing priority of orders in the Hybrid book when trading with 
an order represented in open outcry.\8\
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    \7\ Open outcry penny pricing generally will be available in 
instances where a Floor Broker is attempting to cross an order 
pursuant to CBOE Rule 6.74, except it will not be available in those 
instances where: (i) A Floor Broker is attempting to cross orders 
during the opening rotation in open outcry (see CBOE Rule 6.74(c)); 
or (ii) a Floor Broker is utilizing the Exchange's SizeQuote 
Mechanism (see CBOE Rule 6.74(f)).
    \8\ See CBOE Rules 6.45A(b) and 6.45B(b).
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    The Exchange represents that, in activated classes/series, all 
users would receive the benefit of penny pricing either through the 
electronic submission of contra-side orders or through a Floor Broker 
``sweeping'' the electronic interest prior to executing an order in 
open outcry, and that all market participants will have the ability to 
rest orders in penny increments under the program.\9\
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    \9\ See Amendment No. 2.
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    The Exchange clarified in Amendment No. 2 that, to the extent 
penny-priced orders are received that ``cross'' one another, the second 
order received by the system will receive the benefit of price 
improvement.\10\ The Exchange may determine the applicability of split-
price priority under CBOE Rule 6.47 to transactions effected under 
proposed CBOE Rule 6.13B.\11\ The mechanics of split-price priority in 
those instances will be the same as the mechanics of split-price 
priority in five- and ten-cent increments.
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    \10\ For example, if an order is received to buy at 1.08 and 
then an order is received to sell at 1.06, those orders will trade 
at 1.08--the price of the resting order.
    \11\ Amendment No. 2 provided that the ``Exchange'' will 
determine if the split price provisions of Rule 6.47 apply to open 
outcry Penny Pricing under proposed Rule 6.13B(b), rather than the 
``appropriate Procedure Committee,'' as originally proposed. The 
Commission notes that this change is consistent with SR-CBOE-2008-
02, where the Exchange is replacing references to the ``appropriate 
Procedure Committee'' with references to the ``Exchange'' throughout 
the Exchange's rules.
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    The restrictions on principal transactions and solicited orders 
contained in Interpretations and Policies .01 and .02 under CBOE Rules 
6.45A and 6.45B will continue to apply to trading in penny increments, 
including the three second exposure requirements.

III. Discussion and Commission Findings

    After careful review of the proposal, as modified by Amendment No. 
2, and the comment letters thereto, the Commission finds that the 
proposal, as modified by Amendment No. 2, is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to a national securities exchange.\12\ In particular, the 
Commission finds that the proposal is consistent with Section 6(b)(5) 
of the Act,\13\ which requires, among other things, that the rules of a 
national securities exchange be designed to prevent fraudulent and 
manipulative acts and practices, 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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    \12\ In approving the 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).
    \13\ 15 U.S.C. 78f(b)(5).
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A. Quote Rule

    The Commission received two comment letters in response to the 
proposed rule change.\14\ One commenter argues that the proposal would 
violate Rule 602 of Regulation NMS (the ``Quote Rule'') because CBOE 
will not disseminate its best bid or offer.\15\ The Quote Rule requires 
a national securities exchange to collect, process, and make available 
to vendors the best bid, the best offer, and aggregate quotation sizes 
for each subject security that is communicated on any national 
securities exchange by a responsible broker or dealer. A ``bid'' or 
``offer'' is defined as ``the bid price or the offer price communicated 
by a member of a national securities exchange or member of a national 
securities association to any broker or dealer, or to any customer. * * 
*.'' \16\ Because the non-displayed price of a penny-priced order under 
Rule 6.13B is sent to the Exchange, but not communicated to anyone, it 
is not a bid, offer, or quotation. Thus, the Quote Rule does not 
require this information to be disseminated.
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    \14\ See ISE Letter and Citadel Letter, supra note 4. Both 
commenters expressed concern about CBOE's proposal to append an 
indicator showing when there is trading interest at a price that is 
better than the CBOE BBO. As noted above, Amendment No. 2 deleted 
this aspect of the proposal. Because CBOE has proposed to eliminate 
the indicator, this order does not make any findings with respect to 
the use of an indicator.
    \15\ See ISE Letter, supra note 4, at 2-3.
    \16\ 17 CFR 242.600(a)(8).
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    The Quote Rule also requires responsible brokers and dealers to be 
firm for their quotes.\17\ Proposed CBOE Rule 6.13B(1), which allows 
Market Makers to provide the Exchange with indications of interest that 
are superior to their own quotations in increments no smaller than one-
cent, explicitly requires such indications to be firm for all interest 
received by the Exchange. Further, as with any other electronic order 
entered into CBOE's Hybrid System, an order priced in a penny increment 
and rounded for display must be firm under CBOE's rules and Rule 602 of 
Regulation NMS.\18\
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    \17\ 17 CFR 242.602(b)(2) and (c)(3).
    \18\ See electronic mail between Angelo Evangelou, Assistant 
General Counsel, CBOE, and Johnna B. Dumler, Special Counsel, 
Division of Trading and Markets, Commission, on April 22, 2008.
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B. Transparency, Quote Competition, and Internalization

    Both commenters expressed concern about the impact of penny pricing 
on market quality. In particular, one commenter believes such orders 
would undermine transparency in the options markets and that, because 
the prices and sizes of such orders would not be disseminated, it would 
be impossible for market participants to know the true best trading 
interest on CBOE.\19\ This commenter argues that penny pricing would 
discourage market participants from matching or establishing a new BBO 
because it would be too easy for non-displayed penny orders to jump 
ahead of displayed orders by a penny at opportune moments.\20\ Another 
commenter expresses a concern that no one will know the actual prices 
communicated to the exchange, which are prices at which transactions 
can take place.\21\ This commenter expressed concern that if other 
options markets adopted similar order types, there would be a trading 
environment in which there would be no way for customers to make 
intelligent pricing decisions or for broker-dealers to fulfill their 
best execution obligations.\22\
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    \19\ See Citadel Letter, supra note 4, at 2. This commenter 
further believes that the concerns raised by hidden penny pricing 
exceed those raised by the auction facilities on other options 
exchanges (including the Boston Options Exchange's PIP and the 
International Securities Exchange's PIM) because penny pricing would 
be a fundamental component of options trading on CBOE rather than a 
separate auction facility operating parallel to the regular options 
market. Id.
    \20\ Id.
    \21\ See ISE Letter, supra note 4, at 3.
    \22\ Id.
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    Additionally, one commenter expressed the concern that hidden penny 
pricing will enable CBOE members to internalize their order flow 
without the possibility of real order interaction. This commenter 
argues that the purpose of the requirement that a member display a 
customer order and wait three seconds before trading against the order 
is to provide other market participants with a chance to trade with the 
order before the member internalizes it. The commenter argues that, 
because only the member that enters the penny priced order will know 
the true price of the order, only that member can accurately run its 
pricing model to determine whether it is economically viable to trade 
against the

[[Page 24331]]

order. The commenter does not believe this presents a level playing 
field.\23\
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    \23\ Id.
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    Penny priced orders will allow market participants to submit an 
order priced between the minimum price variation (``MPV'') that will be 
rounded to the nearest MPV for display. Without the ability to price 
orders in pennies, market participants would not be able to submit 
orders priced between the MPV. Instead, orders, if submitted, would be 
priced (and displayed) at the MPV. Thus, CBOE's proposal will not 
``take away'' transparency that would already exist. The Commission 
recognizes that under CBOE's proposal, orders will not be displayed at 
their actual penny price. CBOE's proposal, however, will provide 
investors with the opportunity to trade at a better price than would 
otherwise be available. The Commission believes that this opportunity 
for investors to receive executions inside the disseminated best bid or 
offer could result in better executions for investors.
    In response to a commenter's concern about broker-dealers' ability 
to fulfill their best execution obligations,\24\ as just discussed, the 
Commission believes that penny-priced orders likely will provide 
another opportunity for investors to receive executions inside the 
disseminated best bid or offer for a security, which could result in 
better executions for investors. The availability of this price 
improvement feature will be a factor to be considered in a broker-
dealer's best execution routing determination, similar to other factors 
a broker-dealer must consider in connection with its best execution 
obligation.\25\
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    \24\ See ISE Letter, supra note 4, at 2.
    \25\ See Securities Exchange Act Release No. 57478 (March 12, 
2008), 73 FR 14521 (March 18, 2008) (order approving SR-NASDAQ-2007-
004 and SR-NASDAQ-2007-080), at notes 130 to 134 and accompanying 
text.
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    The Commission also believes that penny-priced orders will provide 
market participants with an additional tool to submit trading interest 
to the Exchange. The ability to price orders in penny increments may 
serve to increase liquidity to the extent that market participants find 
it to be useful and result in better executions. Further, market 
participants may be incented to compete by putting forth their best 
price--priced in a penny increment--to potentially match or better any 
other penny-priced orders resident in the System. This may result in 
more aggressive, rather than less aggressive, trading interest.
    Moreover, the Commission believes that the ability to ``fish'' 
inside the displayed quote, coupled with the restriction on the market 
participant that initially submitted the penny-priced order from 
trading with that order until after three seconds has elapsed, will 
provide a meaningful opportunity for interaction prior to the time at 
which the submitting market participant can interact with the order. 
The Commission also notes that a market participant that would like to 
trade against its customer order runs the risk that the customer order, 
if entered in a hidden penny increment, will execute against another 
penny-priced order resident in the system. The Commission does not 
believe that the availability and use of penny-priced orders will 
reduce the quality or competitiveness of the options markets by 
increasing the level of internalization in the options markets.

C. Linkage Plan

    One commenter expresses concern as to how hidden penny-priced 
orders will interact with the requirements of the Plan for the Purpose 
of Creating and Operating an Intermarket Options Linkage (``Linkage 
Plan'').\26\ Specifically, the commenter expresses concern that, 
because the existence of hidden penny orders would not be disseminated 
to the market, they would not trigger the obligations of other market 
centers to ship linkage orders to the CBOE.\27\ Therefore, the 
commenter believes that away-markets will not be able to benefit from 
the better prices available on the CBOE, and undisplayed orders resting 
on the CBOE book would not be protected from trade-throughs by away 
markets.\28\
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    \26\ See Citadel Letter, supra note 4, at 2.
    \27\ See Citadel Letter, supra note 4, at 2.
    \28\ Id.
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    The Linkage Plan, and SRO rules adopted pursuant to the Plan, 
provide trade through protection to the national best bid and offer 
(``NBBO'').\29\ The NBBO will not include the non-displayed price of a 
CBOE penny-priced order under Rule 6.13B. Therefore, the non-displayed 
price of a penny-priced order is not subject to trade through 
protection under the Linkage Plan.
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    \29\ The national best bid or offer is defined in the Linkage 
Plan as the national best bid and offer in an options series 
calculated by a Participant. See Section 2(19) of the Linkage Plan.
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D. Penny Pilot Program

    One commenter believes that the proposal will circumvent the 
industry efforts with respect to the Penny Pilot Program (``Pilot'') by 
moving to hidden penny quoting without the benefit of careful study of 
the data yielded in the Pilot.\30\ Another commenter believes that the 
appropriate way to address penny pricing in options is through the 
current Penny Pilot. This commenter recommends that the Commission 
consider any expansion of penny quoting only through review of the 
experience under the Pilot.\31\ As discussed above, the Commission 
finds that CBOE's proposal, as amended, is consistent with the Act. The 
Commission has previously approved proposals by options exchanges, 
including CBOE, to trade in penny increments.\32\ The Commission does 
not believe itis appropriate to prohibit CBOE from implementing an 
initiative designed to allow further limited trading, not quoting, in 
penny increments.
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    \30\ See Citadel Letter, supra note 4, at 1 and 3.
    \31\ See ISE Letter, supra note 4, at 3.
    \32\ See, e.g., Securities Exchange Act Release Nos. 54229 (July 
27, 2006), 71 FR 44508 August 3, 2006) (File No. SR-CBOE-2005-90) 
(order approving CBOE's Simple Auction Liaison system); 50819 
(December 8, 2004), 69 FR 75093 (December 15, 2004) File No. SR-ISE-
2003-06) (order approving ISE's Price Improvement Mechanism); and 
49068 (January 13, 2004), 69 FR 2775 (January 20, 2004) (order 
approving BOX's Price Improvement Period).
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    The Commission finds good cause to approve the proposed rule 
change, as modified by Amendment No. 2, prior to the thirtieth day 
after the date of publication of the notice of filing of the amended 
proposal in the Federal Register. The substance of the proposed rule 
change was published in the Federal Register on May 14, 2007 for full 
notice and comment.\33\ The Commission believes that the changes 
proposed in Amendment No. 2 respond to concerns raised in the commenter 
letters and strengthen and clarify aspects of the proposal. Further, 
the Commission recently approved a similar proposal by another exchange 
that allows orders to be entered in one-cent increments, but displayed 
at the standard MPV.\34\ For these reasons, the Commission finds good 
cause for approving the proposed rule change, as modified by Amendment 
No. 2, on an accelerated basis, pursuant to Section 19(b)(2) of the 
Act.
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    \33\ See supra note 3.
    \34\ See Securities Exchange Act Release No. 57478 (March 12, 
2008), 73 FR 14521 (March 18, 2008) (order approving SR-NASDAQ-2007-
004 and SR-NASDAQ-2007-080).
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IV. Solicitation of Comments

    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:

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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 No. SR-CBOE-2007-39 on the subject line.

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 No. SR-CBOE-2007-39. 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 at 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, 100 F Street, NE., 
Washington, DC 20549, on official business days between the hours of 10 
a.m. and 3 p.m. Copies of the 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 No. SR-CBOE-2007-39 and should be 
submitted on or before May 23, 2008.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\35\ that the proposed rule change (SR-CBOE-2007-39), as modified 
by Amendment No. 2, be, and hereby is, approved on an accelerated 
basis.
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    \35\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\36\
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    \36\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
 [FR Doc. E8-9645 Filed 5-1-08; 8:45 am]

BILLING CODE 8010-01-P
